14.32

The Bank is responsible for the consolidated supervision of all major UK banking groups. The Bank has no responsibility for the direct supervision of companies within banking groups which are not authorised by it (even where it is the consolidated supervisor of such groups). Such powers as it has in respect of such companies are exercisable only to the extent that such companies may adversely affect the interests of depositors with the bank itself.

14.33

The matter with which we are primarily concerned in this section is how the Bank's existing arrangements for the supervision of groups, such as Barings, with substantial operations outside the banking entity, should be improved.

Understanding the business and associated risks

14.34	In its conduct of consolidated supervision of banking groups the Bank has hitherto concentrated on collecting data from such groups concerning their consolidated capital adequacy and consolidated large exposures. We understand that this approach is followed by many regulators abroad and is currently regarded as good practice. We believe the collection and monitoring of this information is important and should continue to form an important part of the Bank's consolidated supervision.
14.35	However, we recommend that the Bank should go further than this. We believe the Bank should explore ways of increasing its understanding of the non-banking businesses (particularly financial services businesses) undertaken by those banking groups for which it is responsible for consolidated supervision, and how those businesses interrelate to one another and to such groups' banking businesses. It should also seek to obtain a more comprehensive understanding of how the risks in those businesses are controlled by the management of the group. By doing this the Bank will be better able to determine which companies within those groups, or which activities of such companies, are so significant that problems with respect to them might reasonably be expected to pose difficulties for the bank. In doing this the Bank should ensure that it defines clearly its relationship with other regulators, since their responsibilities for the regulation of the relevant entities within a group are unchanged. However, it should also co-ordinate effectively with them, possibly including assembling joint teams of supervisors with other regulators in appropriate cases.
14.36	We urge the Bank to prepare internal guidelines to assist its staff in identifying those parts or activities of a banking group which are capable of posing material risks to the bank concerned and to advise them of the steps which they should take to assess and monitor, and to ensure that safeguards are in place to protect depositors against, such risks. We understand that the Bank has been progressively setting up regular bilateral meetings with the management of significant overseas, and non-banking UK based, businesses for some time. Such meetings should be formally incorporated as a requirement in management guidelines and should include questioning, inter alia, the sources of profitability, sources of funding and control systems within relevant parts of the group. Where a banking group has substantial operations overseas this should result in an increased dialogue between the Bank and the relevant local regulator regarding such operations.
14.37	The Bank should ensure that it understands the key elements of the management and control structures of those banking groups where it is responsible for consolidated supervision. Where the Bank has confidence in the management of an institution its practice has been to discuss organisational issues at regular prudential meetings. In some instances, it has received details of changes to management responsibilities but, as with Barings, this has not always been the case. As previously stated, the potential for confusion as to management responsibilities is greatest during the course of a reorganisation. The Bank should receive prior notice of a significant reorganisation within, and of significant new operations being commenced by, a banking group, together with relevant reporting responsibilities. What is significant for one institution may not be for another and we have, accordingly, requested the Bank to develop proposals to BOBS regarding the most practical way in which our recommendation can be implemented.
14.38	The information currently received by the Bank goes some way in assisting the Bank in the discharge of its supervisory responsibilities. However we think that, to enable the Bank to improve its understanding of the businesses of the institutions it supervises and to ask relevant questions of management, the scope of the returns currently submitted should be extended to include more information about the businesses of the groups as a whole. For example, this might include details of profitability by product line. The Bank should review the existing content of returns with this objective in mind.
14.39	We are concerned that senior management of institutions may not always be aware of the standards of accuracy being applied in the preparation of returns to the Bank. The monitoring of these returns forms a central part of the Bank's supervisory approach and therefore it is of fundamental importance that they are accurate in all material aspects. We believe that senior management should more openly acknowledge their responsibility for the accuracy of the returns and that a senior director previously notified to the Bank under Section 36(l) of the Act should be nominated by the institution to sign the most important returns - the BSD 1 and the LE - on behalf of the board of the institution. We think this will emphasise to management the need to ensure high standards within the institution. The nominated director should meet the Bank a least once each year (probably as part of a prudential meeting) to discuss the accuracy and timely completion of returns.

Solo consolidation

14.40	We have described in Section 12 the meaning of solo consolidation. Because of the failure of controls in Barings, following the solo consolidation of BSL with BB&CO, funds which as a matter of law constituted loans by BB&CO to BSL were passed to BFS without limit.
14.41	We understand that solo consolidation was originally intended to facilitate the utilisation of special purpose financing vehicles by banks.
14.42	The solo consolidation of a bank and a substantial UK securities company number of difficult issues with regard to the division of supervisory responsibilities between the Bank and the SFA, in particular because the bank may incur exposures to its securities subsidiary without limit, and therefore the Bank places increased reliance on the regulation by the SFA of that subsidiary. We consider that solo consolidation of any active trading entity with a bank should require the formal approval of the Executive Director in charge of S&S or one of the Bank's Governors. Solo consolidation should only be proposed if, as a minimum, the following requirements are met (in addition to the criteria which the Bank already requires to be satisfied): first, solo consolidation must result in supervision, whether by the Bank or another regulator but in any event to the satisfaction of the Bank, of every solo consolidated entity and should only be contemplated where this is practicable; secondly, the controls within all of the proposed solo consolidated entities must be adequate to ensure that exposures to companies outside the solo consolidated group can only be incurred in a controlled manner; and thirdly, the Bank must have the means to receive on a continuing basis suitable reassurance regarding such controls, either through Section 39 reports into systems and controls across the solo consolidated group or through other equivalent means agreed with the other regulator (if any).
14.43	Internal guidelines should be prepared for Bank staff as to the procedures to be followed with respect to the granting of solo consolidation and the supervision of the solo consolidated group thereafter. Such guidelines should include a requirement that once solo consolidation has been granted a notice should be served under Section 38(3) of the Act to ensure that the criminal sanction imposed by Section 38 applies to the solo consolidated group.

Liaison with other regulators

14.44	The Barings case illustrates the need for close collaboration between the Bank and other regulators, both in the United Kingdom and overseas. We understand that plans are in place for the Bank and the SFA to review their method of working together, including a review of the Memorandum of Understanding (MoU) between them. We welcome such a review, which will provide a useful opportunity to take into account our recommendations above regarding the coordination of supervisory functions and solo consolidation. A similar review should, in our view, take place of the MoUs between the Bank and other UK regulators.
14.45	Our terms of reference do not extend beyond the UK system of regulation. However, we note that the existence of regular and open contact between regulators internationally, in order to assist them in the discharge of their respective responsibilities through such measures as the exchange of information, is desirable and is to be encouraged. We also support the development of formal MoUs between regulators internationally, in order to provide a sound basis for the relationship and to set out what one regulator can reasonably expect the other to do.
14.46	We recognise that considerable progress has been made in promoting and removing legal impediments to the free flow of information between banking supervisors in the G10 countries and that this is progressively extending to a wider group. We support the continuation of these efforts and would suggest that this process be further extended to include other regulators of financial services businesses, such as those involved in securities trading.

Internal audit

14.47

The Audit Conurtittee and the internal audit function should be a valuable source of information to the Bank. It is not realistic for the Bank to review all internal audit reports as a matter of course, but we note that the Bank has started meeting the internal audit departments of major UK banks. We commend this initiative and believe it should be extended to other areas of the Bank's supervision of banks covered by S&S. Where the Bank acts as consolidated supervisor the scope of these meetings should extend to include the group internal audit function.

14.48

We also recommend that for large UK incorporated institutions the Bank liaises regularly with the Chairman of the Audit Committee. This would provide the Bank with an opportunity to discuss internal audit, control and related issues with a nonexecutive director and to ask whether there are matters he or she is aware of which should be brought to the attention of the Bank.

On-site visits

14.49	At present the Bank conducts a limited number of visits in the UK to authorised institutions. These visits are an adjunct to the Bank's primary supervisory processes and much of the work performed involves discussion with management and staff. It is not intended that detailed testing or checking should be performed during such visit although a sample of credit files will normally be reviewed in the smaller institutions. These visits provide an opportunity for the Bank to make a more informed assessment of management, gain a better understanding of the institution through seeing it operating first hand, and, to a limited extent, check whether the results of the visit are consistent with the information the Bank receives from other sources, including management, the auditors and the reporting accountants.
14.50	We note that no such visit to Barings was ever undertaken, although we understand two were planned for 1995. In the past the selection of banks to visit was generally determined by the quality of the bank's loan portfolio. During 1994 the Bank established a traded markets team to examine risk models on site. The primary function of the team is to determine whether banks have appropriate systems to assess the capital required for their trading activities using such models, although it also advises S&S more generally on trading issues. We commend this development and recommend that the Bank undertakes a review, in the light of the Barings episode, of the number and skills of the people available for on-site visits and for general internal consultation on derivatives and other trading activities and also on banks' credit portfolios.
14.51	We have considered whether the supervision of UK banks would be improved if the Bank were to undertake, as a matter of course, regular inspection visits to all authorised institutions (or possibly all banking groups) and perform extensive detailed testing; an approach akin to that employed in a number of other countries. This might provide the Bank with more first hand knowledge about each institution (although note that bank failures resulting from the unauthorised activities of bank personnel have also occurred in inspection based regimes), but we feel there are a number of disadvantages associated with this kind of approach. It would also involve a very significant increase in the cost of supervision which would ultimately be passed on the customer or taxpayer. From the work which we have undertaken during this inquiry we do not believe that a wholesale change to this style of supervision is justified. We would prefer to see the existing supervisory tools available to the Bank developed further in the manner set out elsewhere in this section.

Reporting Accountants

14.52	Under Section 39 of the Act the Bank can require an authorised institution to commission a report from reporting accountants on any matter about which it can require information under the Act.
14.53	For the larger or more complex institutions, such as BB&CO, the Bank normally requires work to be commissioned annually covering one prudential return and one aspect of the internal control systems. At present reporting accountants usually undertake Section 39 work in respect of overseas operations of banks or bank subsidiaries (whether in the UK or overseas) only by reference to documents or information received by the authorised institution and do not usually travel overseas. We acknowledge that these operations and subsidiaries may be under the remit of other regulators. However, we believe that, in appropriate circumstances, the scope of Section 39 reports should be extended and reporting accountants required to go outside the bank and, if necessary, outside the UK. (We understand that both have been done in the past, but not frequently.) We suggest this matter be included within the guidelines referred to in paragraph 14.36.
14.54	When reporting on a particular return the reporting accountants are presently required to report on whether all relevant and material information has been extracted from the accounting and other records and accurately reflected in the return. They are not generally required to form an opinion on whether such records are themselves accurate or on the effectiveness of the systems of control which have been established to ensure the accuracy of the information in the records and the correct transfer of that information to returns. However, we understand that in 1994 the Bank began requiring certain major banks it supervises to commission reports on their systems of control over the accuracy of the information in their records and its transfer to returns; we understand these reports covered the systems and controls over the preparation and inputting of data 'in major overseas locations. We believe the Bank should periodically require authorised institutions to commission such reports. We also believe that all Section 39 reports should indicate the extent of the work performed by the reporting accountants for the purposes of their preparation, and we recommend that the Bank initiate discussions with the accountancy profession on this matter.
14.55	At present the Bank normally requires Section 39 reports to be commissioned annually, although it does require work to be commissioned on an ad hoc basis in certain circumstances. We would encourage the Bank to require Section 39 reports on a more flexible basis, particularly in circumstances where control systems or management structures materially change during the course of a year, where there is a plan to develop significantly or grow a specific aspect of the business, or where a previous Section 39 report has highlighted significant errors or weaknesses.

Large exposures/b>

14.56

In Sections 12 and 13 we pointed out shortcomings in the implementation of the Bank's large exposures policy. We regard these errors as shortcomings in implementation, rather than as failures of the underlying policy, but are of the view that it is desirable for the Bank's policy to be made more explicit, by means of further guidance to managers. For the future we recommend that the internal guidelines are extended so that existing concessions are formally reported to the relevant Head of Division on an annual basis to ensure that he or she is content for them to continue.

14.57

Repeated or significant breaches of the large exposure rules warrant prompt investigation by the Bank. Heads of Division should receive a summary of such breaches on a regular basis. Furthermore, in order to be provided with an overview, BOBS will in future wish to receive a regular report summarising breaches of the large exposure rules.

Guarantees and comfort letters

14.58

The Barings case also illustrates the need for regulators to be aware of guarantees and comfort letters given by banks in respect of the obligations of other group members. While a guarantee is a legally binding obligation, the status and effect of a comfort letter are not always as clear, largely because the term is one of art only: such letters can range from virtual guarantees to mere statements of awareness (although letters falling within the latter category should not be disregarded, since they may pose reputational risks for the bank issuing them). We understand that the Bank was in the process of determining the extent of the issuance of comfort letters and guarantees at the time of the Barings collapse. We think that this should be clarified as soon as possible. The supervisory treatment of these instruments internationally is not uniform at present, with regulators in different countries adopting varying approaches; as a result, any immediate change in the approach adopted by the Bank may have implications for the competitiveness of UK banks. We encourage regulators to agree a common approach which properly takes into account the risks attendant upon the issuance of these instruments as soon as practicable.

Quality assurance review

14.59

At the present time supervisors in the Bank are not subject to an independent quality assurance group review of their supervision of banks in their section. We would commend such a practice to the Bank, believing it would assist in the continuous improvement of supervisory practices and procedures and challenge important decisions made. The modus operandi of such reviews should be determined by the Bank. We have asked the Bank to make regular reports to BOBS regarding the results of such reviews.

Resources

14.60

We acknowledge that implementation of our proposals will require additional resources to be devoted to banking supervision, including specialists with the required experience and expertise. We see this additional burden as a necessary consequence of performing effective supervision of institutions involved in material and complex trading activities.

Changes to the Banking Act

14.61

From this inquiry we have not identified any matters that make an immediate amendment to the Act necessary. With reference to paragraph 14.46, however, if there are legal obstacles to the Bank sharing information with other regulatory authorities the appropriate legislative changes should be made to remove them.

Implementation

14.62

We have asked the Bank to report to us by 31 December 1995 on the progress made towards implementation of our recommendations.