The risk of contagion or financial infection refers to the exposure (or damage) that a tainted activity or component might inflict upon the financial services conglomerate. A bank, for example, may have a property and casualty subsidiary that has experienced enormous losses. If the bank transfers significant amounts of capital to the insurer, it might jeopardize the entire group’s financial security. This transaction may be completely transparent or accomplished surreptitiously depending upon management’s objectives (e.g., off-market or inter group transactions).
Although no one questions the possibility of financial contagion within a financial services conglomerate, financial conglomeration could lead to greater diversification. If true, this fact theoretically should lower overall firm risk, not increase it. Information disclosure and analysis by customers, intermediaries, rating agencies, and governments have been suggested as means of controlling the contagion exposure. Many observers believe, however, that a completely different approach is necessary whereby deposit insurance is privatized and regulation focuses on a narrow range of financial services activities.
Transparency is concerned with the assurance that accurate information needed by customers, intermediaries, rating agencies, and governments will be readily available. The more complex the organizational structure, the less transparent it is ordinarily. To assume that customers have the time or the resources to perform due diligence on a financial conglomerate is unrealistic.
Traditionally, so long as there was enough unrestricted capital to meet contingencies, organizations were deemed safe. Although this approach may have worked reasonably well when institutions stayed within sectoral boundaries and like institutions were roughly comparable, the new world of mixed services requires a broader consideration of factors (e.g., competitive position).
Management responsibility is concerned with the possibility that managers compromise their entity’s sound operation in favor of the conglomerate’s fiscal health (e.g., through unwise loans to connected parties). Where a financial services group is regulated functionally, how can each sector’s regulator be assured that managers will fulfill their responsibility to meet regulatory requirements given other interests within the group?
Financial services regulators have struggled with this problem for many years as regulated units have become part of broadly based financial and commercial groups. Although there are serious analysis and enforcement limitations on regulatory agencies, some believe the solution is to include a broad obligation to disclose major inter group transactions. Disclosure would entail transactions that affect the regulated entity or the basic integrity of the regulated unit’s assets and operating capacity. At a minimum, these data should constitute a prerequisite for continuing authority to operate.
Double-gearing, a European term, exists when a company includes the capital of subsidiaries to meet its own solvency requirements. This double counting acts to artificially inflate the conglomerate’s capital adequacy. Supervision becomes more complex if certain operations within the conglomerate are unregulated. Clear, uniform accounting standards and requirements are necessary to identify double-gearing. Issues related to appropriate disclosure and the appropriate Focus of regulatory responsibility must be resolved.