Convergence in the Financial Services Industry: Implications of the 2007 Financial Crisis - Research Proposal Example

Convergence in the Financial Services Industry: Implications of the 2007 Financial Crisis Dissertation Proposal Background After the stock market crash in the late twenties that ushered in the Great Depression, the US legislature was critically aware that there must be a need for more stringent regulations to govern financial institutions and provide protection for the banks many depositors. During that time, the Glass-Steagall Act was promulgated, essentially prohibiting banks from engaging in other, riskier, activities such as investment that necessitates speculation. The Glass-Steagall Act imposed the firewall between financial institutions involved in banking and those involved in non-banking financial services. This piece of legislation was in force for eighty years; however, in 1999 the Gramm-Leach-Biley Act was passed repealing Glass-Steagall and thus allowing firms to engage in both bank and non-bank function. In the pre-crisis study of Barth, et al., in the year 2000, the repealing statute was attributed to “increasingly persuasive” evidence that the liberalization of the financial industry does not enhance the risk of contagion. Today, in hindsight, members of Congress are wondering whether or not the repeal was indeed wise. The eight decades Glass-Steagall was in force did not produce a single major incident when it was necessary to institute a government bail out for the industry. On the other hand, only eight years from the time the repeal had taken effect and the financial markets crash to parallel the 1932 takes place, necessitating a heavy infusion of taxpayers’ money in the industry. Broadbanking (also known as convergence), entailing the integration of several financial products and services under a single corporate roof, was suddenly blamed for the worsening of the crisis. It now becomes important to determine whether banks should or should not re-establish its China wall between banking and non-banking services. Aims and objectives The study aims to provide a comprehensive situationer on the trend towards convergence in the financial services industry and implications for the post-2007 financial crisis environment. In the course of realising this goal, the paper shall seek to comply with the following objectives: 1. To describe the status of financial institutions in the global financial system in terms of: 1.1. convergence between banking and insurance 1.2. convergence between banking and investments 1.3. convergence between insurance and pension markets 2. To determine the repercussions of the financial crisis of 2007 on financial institutions which have converged financial services operations 3. To examine the consequences and challenges of convergence in the financial services industry in terms of: 3.1. the competition 3.2. the regulatory environment 3.3. the consumers 3.4. the shareholders 4. To formulate recommendations towards future directions for financial services convergence Methodology The dissertation is intended as a descriptive-interpretive study on the phenomenon of convergence among the financial services institutions, which was a persistent trend prior to the financial crisis of 2007 and which at present remains an important subject of study. The research methodology will employ primarily analysis of qualitative data, evaluating and describing the convergences among specific financial institutions whose operations have combined banking, insurance, investment, and pension, and other financial services as may emerge to be significant. The case study method shall be employed in analysing and profiling as many global financial institutions as may be determined to have services that have undergone convergence. The discussion shall abide by a framework established by Van den Berghe, Verweire and Carchon (1999), a pre-financial crisis OECD commissioned-study which had conducted a similar study on convergence in the financial services industry and which this study shall dovetail and update in light of the 2007 financial crisis. One of the major findings will be to determine if the conclusions arrived at in Van den Berghe et al. remain to be valid and relevant in a post-crisis scenario. The following figure shows the framework developed by Van den Berghe, et al., and which for consistency shall be employed as research paradigm in this dissertation. The diagram is fashioned after the value chain as developed by Michael Porter, which specifies the activities that create the added value for the end-product that finally makes its way to the customer. For each step, there is a cost attached which, hopefully, is less than the value contributed by that step. Figure 1: The Financial Conglomerates Control Framework Source: Van den Berghe, Verweire and Carchon (1999) There are three main parts to this version of Porter’s value chain. At the front side are boxes marked Corporate Governance and Management, Infrastructure, Capital Policy, Technology and Accounting and Reporting, which are the support activities in the financial institution. Capital governance and management refers to a determination of the management structure best suited to enhance synergies. Infrastructure is concerned whether a physical integration (or infrastructure) is an essential element in creating the synergies. Capital policy refers to the investment policy applied by the firm on behalf of its shareholders, whether the investment policy is integrated, as with asset liability management, risk management, and so forth. Technology involves the technological issues, or a determination as to what extent technological systems are employed. Finally, accounting and reporting also refers to MIS or management information systems, referring to the implications the creation of a conglomerate may have on the management information system of two or more partners (Van den Berge et al., 1999). Spanning across the support activities in the arrow portion are the organic business functions or primary activities, namely Distribution, Operations Management, Market Development and Product Development. Together, this face of the diagram shows the primary and support activities that create synergies and determine the conglomerate’s risk level. At the back side are certain structural aspects which influence the potential for realizing the expected synergies as well as the estimated risk level. These are the legal structure, the capital structure, and the organisational structure of the financial institution under study. Finally, at the upper front are indicated some environmental factors which act as control variables that may be salient to the comparative analysis of financial convergence and financial conglomeration. It is important to cite a more detailed definition of the structural factors at the face of the diagram at the opposite end of the arrow. The legal structure refers to the manner in which two or more companies are constituted or formed. Early academic investigations tended towards a belief that the degree of success of a firm is related to the method of entry into the industry, referring to the legal structure. Secondly, the capital structure provides an insight into the capital ties or relationships between and among the various firms in the group. The risk of contagion is mainly of a financial nature, and the chances thereof increases the more closely related or integrated the capital structure of the firms. That is, when one of the companies in the group would, due to the risky nature of their activities (e.g. investments), suffer a huge loss due to market volatility, then the other companies who themselves engage in less risky activities would suffer an erosion of corporate wealth all the same because the capital structure relates the companies. Finally, companies may choose to modify their organizational structure, to facilitate cooperation among the different units in the group. The more fully converged the activities, the more pressing the initiative to reorganize in order to maximize the possible synergies in operations. Seldom do financial conglomerates adapt their organizational structures, however, and instead prefer to adhere to the legal structure (Van den Berghe, et al., 1999). Data The data shall be derived from the annual reports of financial institutions that have embarked on convergence of financial services in their operations. Other sources of data shall include government and institutional reports that treat on convergence in this industry. Data shall be secondary in nature, as the fact of convergence is an accomplished event and the information thereby gathered have been reported to government regulatory agencies or industry monitoring entities. Data to be gathered shall be mainly qualitative, and where quantitative information may be sourced in the nature of financial statements and accounts, such shall be subject to financial analysis as may be appropriate, including the use of financial ratios, common size or time-series techniques, and growth rate comparisons. Structure of the dissertation The dissertation shall be structured as follows: 1. Chapter 1 - Introduction 1.1. Background of the study 1.2. Theoretical framework 1.3. Aims and objectives 1.4. Significance of the study 1.5. Operational definition of important terms and concepts 2. Chapter 2 – Literature Review 2.1. Pre-crisis convergence studies 2.2. Effects of the financial crisis on the industry 2.3. Post-crisis convergence studies 2.4. Synthesis and identification of research gap 3. Chapter 3 – Methodology 3.1. Research strategy 3.2. Research methods 3.3. Gathering of data 3.4. Treatment of data 4. Chapter 4 – Data and Discussion 4.1. Convergence at the distribution level 4.2. Convergence at the operations level 4.3. Convergence at the market level 4.4. Convergence at the product development level 4.5. Integration of support activities 4.5.1. Management and corporate governance 4.5.2. Capital policy 4.5.3. Information technology 4.5.4. Accounting and reporting 4.6. Possible consequences and challenges 4.6.1. Implications for competition 4.6.2. Implications for regulation 4.6.3. Implications for customers 4.6.4. Implications for shareholders 5. Chapter 5 – Summary and conclusions Literature Review Pre-Crisis Convergence Studies Earlier studies looked at the diversification of banks and envisioned a model that evaluates financial conglomerates’ alternative corporate structures. Herring & Santomero (1990) elaborated on four models: Model 1 otherwise termed the German model, involved complete integration of all activities within the operations of a single corporate being. No legal or operational separation is involved between the activities, although it is not uncommon for a firewall or China wall to be set up, mainly as a means of enhancing customer perception of value. Theoretically, the fully integrated conglomerate, by virtue of economies of scope, is capable of meeting any required output at what should be the lowest cost level. However, there are real concerns from the vantage of public policy, because of conduct that may potentially be seen as anti-competitive, risk-contagious, and tantamount to a conflict of interest (Koguchi, 1993). It is also likely that the cost of supervision is higher than in other cases. As of the end of the last decade, no country permitted complete integration for firms that produce financial services. Model 2 is the British model, which consists of a banking firm that is the parent company for separately-incorporated subsidiary firms. The subsidiaries perform non-bank financial functions and as such, a semblance of legal separateness characterizes this model. Because of the inability to take full advantage of economies of scope, this model would tend to be less operationally efficient and costs of services would be higher. On the other hand, the advantages of this model includes a more effective risk control, the possibility of tax benefits, and also lower costs of regulatory oversight. Model 3 is the US model, wherein the parent company is a shell or holding company and sole owner of a banking subsidiary and non-banking subsidiaries. Herring and Santomero specify that the legal separateness for this model is more extensive than that of the British model, and therefore economies of scope becomes less of a possibility. Social benefits realized in the second model, however, are enhanced for this model, and regulation and supervision of the various activities are much simplified. There is also less risk of contagion that the non-bank activities may cause the banking subsidiary. Finally, Model 4 is characterized by a complete legal and operational separateness. The holding company operates as an investment company and there are no operational synergies that exist among the various subsidiaries. According to Herring and Santomero, the fourth model should in no way be considered an integrated financial corporation, as no operational synergies exist, only financial. Supervisory concerns are non-existent. Effects of the Financial Crisis on the Financial Services Industry The occurrence of a financial crisis causes some structural effects in key players in the industry. In a study by Aizenman, Glick & Lothian (2010), the trilemma configuration – namely the triple goals of monetary independence, exchange-rate stability, and financial integration – were examined in the context of a financial crisis. There is a scarcity of policy instruments available to countries, particularly emerging markets, such that a country may attain at most two, but never all three, goals in the trilemma. The years leading to the crisis saw emerging markets opting for greater exchange-rate flexibility, necessitated by accumulating a large hoard of international reserves. The matter of financial crises takes on added significance because of the necessary implications of international contagion and the resultant snowballing effect. Arndt, Crowley & Mayes (2009) noticed that the very definition of globalization has no consensus, except by qualification as to context and discipline. There appears to be a general agreement that globalisation necessarily includes increased openness to trade, foreign investment, and financial flows. However, despite a greater degree of economic openness, trade patterns that are a result thereof can be subject to great variations. The various markets may be open to different degrees – for instance, the market for goods could be more liberated and robust than the financial markets, and so forth. The globalization of financial crises is not an entirely modern phenomenon. Bordo & Murshid, (2006) compared the strength and patterns of the transmission of financial market shocks, and the subsequent currency crises, between two periods characterized by waves of globalization – the pre-World War I classical gold standard era, roughly between 1880 to 1914, and the post-Bretton Woods era, between 1975-2001. The findings surprisingly show that episodes of financial market distress were more globalized during the period prior to 1914, than they were in the last quarter of the past century. The study attributed this greater systemic stability in the present financial system to three factors: (1) stronger cross-country interdependence prior to 1914 due to economies’ adherence to the fixed exchange rates of the gold standard; (2) the increasing financial maturity of advanced countries through time, and (3) the widening of the center of the global financial system to include a more highly diverse group of countries spanning a broader geographical area, coupled with better policies and improved financial systems. The study further determined that in the pre-1914 era, financial shocks proceeded outwardly from the core countries of Europe, particularly the UK, towards the periphery. Present day shocks that originate the group of advanced countries do not generally get transmitted to the emerging countries, and shocks originating within emerging countries are usually confined to regional markets, but not global markets. This points to a more stable model currently being implemented than that prevailing in the pre-1914 environment. Post-crisis Convergence Studies There are various elements of convergence, one of which is the convergence of accounting standards employed in financial institutions. Chand & White (2007) observed that an inevitable development that results from heightened globalization of the world’s economies is the establishment of one set of financial reporting standards. Offhand, the development of financial reporting standards should on its face be relegated to the International Accounting Standards Board, as embodied in the International Financial Reporting Standards (IFRS). The IFRS supposedly translates complex versions of “local reality” into objective, universally cognizable and acceptable standardized information. This view that a single regulatory framework could uniformly meet the financial reporting needs of all societies, however, is too simplistic because it fails to account for institutional variations in infrastructure, legal frameworks, culture, and social, economic and political systems among nations. There is one important observation by Chand and White (2007): that the push for a single standard financial reporting method is not primarily in response to the need to be accountable to society in pursuit of its interests, but actually it is in response to the need for accountability of multinational enterprises before the world’s capital markets; this is specifically relevant for firms listed on multiple stock exchanges in different countries. Chand, Patel & Day (2008) comment on academic literature findings confirming national accounting systems of different countries exhibit some form of clustering based on similarities in the characteristics of their financing reporting protocol. Some authors, (Miller and Bahnson, 2009; Iwata, 2009), question the wisdom of placing the full power of standard setting upon one entity, referring to the IASB, and in the process granting it monopoly power, while some question the profession’s state of preparedness (Reed & Pence, 2009; Baker, 2008). The IASB’s independence has already been called into question in the past, when it was noted that European bankers had to comply with stricter disclosure requirements than their US counterparts who had greater latitude (Miller & Bahnson, 2009). Aside from the financial report standardization, studies have also gravitated towards implications of banking regulation. Ojo (2009) scored the decline of traditional banking, leading banks to venture into more profitable activities but as a result undermining the role of banks while exacerbating the risk exposure of both corporate and individual stakeholders. The inability of regulators to maximize their potential for risk control emerged during globalization because of inadequacies in tools to impose limits on the multinational conglomerate financial institution. Synthesis and Research Gap The preceding studies, if upheld by other academic inquiries that shall be unearthed in the course of this study, point to the fact that convergences has been a significant consideration in the pre-2007 crisis period. As concluded by Van den Berghe et al. (1999), “financial convergence is here to stay and supervisors must and cannot prevent this” (p. 82). Recalling that this study was conducted in 1999, before the subprime mortgage debt has accumulated substantially, it is apparent that the environment has sufficiently changed to challenge the validity of this finding in the context of the present milieu. One of the alleged causes for the aggravation of the recent financial crises are the converged banks, investment and insurance companies for which the default risk had not been contained and consequently spread to affect bank depositors. This study shall fill in the gap that has materialized as a result of the financial crisis, in order to draw fresh implications on convergence of financial services, and provide validation of the early studies, with the hope of shedding fresh insight for institutional development and regulation. REFERENCES Aizenman, J.; Glick, R; & Lothian, J R. (2010) The emerging global financial architecture: What’s new and what’s old? Journal of International Money and Finance, pp. 104, doi:10.1016/j.jimonfin.2010.01.011 Arndt, S W; Crowley, P M & Mayes, D G (2009) The implications of integration for globalization. North American Journal of Economics and Finance. vol. 20, pp. 83-90 Baker, N (2008) Getting up to speed with IFRS. Internal Auditor, Oct 2008, vol. 65, issue 5, pp. 32-37 Barth, J R; Brumbaugh, R D Jr; & Wilcox, J A 2000 The Repeal of Glass-Steagall and the Advent of Broad Banking. Economic and Policy Analysis Working Paper 2000-5. Journal of Economic Perspectives, May 2000 Bordo, M D & Murshid, A P (2006) Globalization and changing patterns in the international transmission of shocks in financial markets. Journal of International Money and Finance, vol. 25, pp. 655-674 Chand, P; Patel, C; & Day, R (2008) Factors Causing Differences in the Financial Reporting Practices in Selected South Pacific Countries in the Post-Convergence Period. Asian Academy of Management Journal, vol. 13, no. 2, 111-129, July 2008 Chand, P & White, M 2007 A critique of the influence of globalization and convergence of accounting standards in Fiji. Critical Perspectives on Accounting, vol. 18, pp. 605-622 Herring, R J & Santomero, A M (1990) The corporate structure of financial conglomerates. Journal of Financial Services Research, vol. 4, no. 4, December 1990, pp. 471-497 Iwata, E (2009) Will going global extend to accounting? USA Today, 01/06/2009 Koguchi, K (1993) Financial conglomeration. Financial Market Trends, vol. 4, Oct., pp. 7-62 Miller, P B W & Bahnson, P R (2009) The Spirit of Accounting: Rethinking the rush toward convergence. Accounting Today, April 16-19, 2009 Ojo, M (2009) The growing importance of risk in financial regulation. Munich Personal RePEc Archive. MPRA Paper No. 19117 . Reed, R M & Pence, D K (2009) International Accounting Curriculum: IFRS Now, IEG 11 later? International Journal of Global Management Studies, Vol. 1 Issue 1, p46-52 Van den Berghe, L A A; Verweire, K; & Carchon, S W M (1999) Convergence in the Financial Services Industry. OECD Commissioned Study, Tokyo Executive Seminar on Insurance Regulation and Supervision, Tokyo, 27-28 September 1999. Read More