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The Supervision of Financial Conglomerates

Executive Summary


1. The deregulation of domestic financial markets over the past decade together with the internationalisation of financial markets has led to new ways and means of doing business in the highly competitive, integrated world economy of the 1980s and 1990s. One notable development has been the emergence of financial conglomerates, often with significantly large balance sheets (and off­balance-sheet positions), providing a wide range of financial services in a variety of geographic locations.

2. Over the past several years, a number of supervisory and regulatory groups within the international financial community have sought to explore the ways in which some of their concerns relating to the supervision of financial conglomerates could be addressed. Those groups have approached the subject from the perspective of a particular sector ­ the supervision of banks, or of securities firms, or of insurance companies. This report brings together the efforts of a Tripartite Group of bank, securities and insurance regulators, who are acting in a personal capacity but are able to draw on the experience of their respective institutions. The Tripartite Group was set up at the beginning of 1993 specifically to consider ways of improving the supervision of financial conglomerates.

Working Definition

3. The Tripartite Group agreed that, for its purposes, the term "financial conglomerate" would be used to refer to "any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)". It was recognised that many of the problems encountered in the supervision of financial conglomerates would also arise in the case of "mixed conglomerates" offering not only financial services (perhaps restricted to just one of the three sectors mentioned above), but also non-financial or commercial services. However, the primary focus of this report is on financial conglomerates.

Present Situation

4. The present situation with regard to the supervision of conglomerates was clarified through the medium of a questionnaire (Appendix II to this report analyses the responses). This provided valuable information on the types of financial conglomerates in existence and their different structural features, many of which are largely a reflection of national laws and traditions. From the responses to the questionnaire, it was also possible to compare approaches to the overall supervision of financial conglomerates.

Identification of Issues

5. Subsequently, building on previous work in other forums, the Tripartite Group identified a number of problems which financial conglomerates pose for supervisors, and discussed ways in which these problems might be overcome. Among the issues discussed were the overall approach to the supervision of financial conglomerates; the assessment of capital adequacy and ways of preventing double gearing; contagion, in particular the effect of intra­group exposures; large exposures at group level; problems in applying a suitability test to shareholders and a fitness and propriety test to managers; transparency of group structures; the exchange of prudential information between supervisors responsible for different entities within a conglomerate; rights of access to information about non-regulated entities; supervisory arbitrage; and mixed conglomerates.

Overall Approach to Supervision

6. The rapid growth of financial conglomerates which cut across the banking, securities and insurance sectors, raises questions as to whether the traditional approach to prudential supervision ­ whereby each supervisor monitors institutions in one constituency without much contact with supervisors responsible for other parts of the group ­ is still appropriate. Fundamentally, the Tripartite Group agreed that supervision of financial conglomerates cannot be effective if individual components of a group are supervised on a purely solo basis. The solo supervision of individual entities continues to be of primary importance, but it needs to be complemented by an assessment from a group­wide perspective.

Capital Adequacy

7. Banks, insurance companies and securities firms are subject to different prudential requirements, and accordingly supervisors face a difficult problem in determining whether there is adequate capital coverage. The Tripartite Group discussed this issue in some depth and concluded that the desired group­wide perspective can be achieved either by adopting a consolidated type of supervision, or by a "solo­plus" approach to supervision. For the purposes of this report, the following working definitions were agreed upon:

Consolidated Supervision ­ This supervisory approach focuses on the parent or holding company, although individual entities may (and the Tripartite Group advocates that they should) continue to be supervised on a solo basis according to the capital requirements of their respective regulators). In order to determine whether the group as a whole has adequate capital, the assets and liabilities of individual companies are consolidated; capital requirements are applied to the consolidated entity at the parent company level; and the result is compared with the parent's (or group's) capital.

Solo­Plus Supervision ­ This supervisory approach focuses on individual group entities. Individual entities are supervised on a solo basis according to the capital requirements of their respective regulators. The solo supervision of individual entities is complemented by a general qualitative assessment of the group as a whole and, usually, by a quantitative group-wide assessment of the adequacy of capital. There are several ways in which this quantitative assessment can be carried out (see below).

8. Recognising the different starting points of the solo-plus and consolidated supervision approaches, the Tripartite Group discussed a range of techniques available to supervisors for making a quantitative assessment of capital adequacy in a financial conglomerate. The Group recognised the value of accounting­based consolidation (involving a comparison, on a single set of valuation principles, of total consolidated group assets and liabilities, and the application at parent level of capital adequacy rules to the consolidated figures) as an appropriate technique for assessing capital adequacy in homogeneous groups. This is the technique commonly used by bank supervisors in respect of banking groups; under European legislation, it is also a technique applied to groups made up of banks and securities companies.

9. As a means of applying accounting-based consolidation in respect of heterogeneous groups, the Tripartite Group considered a technique referred to as "block capital adequacy", which envisages the classification and aggregation of assets and liabilities according to the type of risk involved (rather than according to the institution to which they pertain), and the development of harmonised standards for assessing a conglomerate's capital requirement. However, this technique was not thought to be a practical possibility for heterogeneous groups in the immediately foreseeable future.

10. Instead, the Tripartite Group concluded that three techniques ­ the "building­block prudential approach" (which takes as its basis the consolidated accounts at the level of the parent company), a simple form of risk­based aggregation and risk­based deduction ­ are all capable of providing an accurate insight into the risks and capital coverage. It is suggested that these three techniques might form the basis of a set of minimum ground rules for the assessment of capital adequacy in financial conglomerates and that some form of mutual recognition of their acceptability would be eminently desirable. The Group also agreed that "total deduction" might be recognised as a fourth technique, which deals effectively and conservatively with double gearing but one which does not in itself seek to provide a full picture of the risks being carried by the conglomerate. The type and structure of the conglomerate in question may determine which of these four techniques is most appropriate for supervisory use.

11. Detailed consideration was given to the way in which supervisors should regard a parent institution's participation of less than 100% in a financial subsidiary for the purposes of assessing group capital adequacy. It was agreed that simple minority shareholdings over which the group has neither control nor significant influence (i.e. less than 20% of the shares or voting rights owned) should not be taken into account for group capital adequacy purposes. They would normally simply be regarded as portfolio investments and would be treated by the parent's supervisor in accordance with the relevant solo rules. Only in exceptional circumstances would supervisors expect to integrate such shareholdings in an assessment of capital adequacy from a group perspective.

12. Where the group has what is deemed to be a "significant influence" (i.e. ownership of between 20% and 50% of the shares or voting rights) over a subsidiary undertaking, a pro­rata approach is advocated with regard to the inclusion of capital in the group­wide assessment. As far as subsidiary undertakings which are not wholly­owned, but over which the group has effective control (i.e. more than 50% of the shares or voting rights owned), are concerned, most members of the Tripartite Group agreed that the full extent of any deficit should be attributed to the group. However, there was less of a consensus as to the appropriate treatment for any capital surplus in such a subsidiary. Some members favoured attributing such surpluses in full to the parent group for capital adequacy purposes, while others considered a pro­rata approach to be more appropriate. A few members were inclined towards an asymmetric approach, under which any capital deficit would be attributed to the group in full but surpluses would only be attributed pro­rata.

13. The suitability and availability of capital surpluses for transfer from subsidiary to parent, and from one subsidiary to a sister company, were other issues considered by the Tripartite Group. The divergent definitions of capital from sector to sector, make it necessary for supervisors to examine both the distribution and structure of capital across a financial conglomerate in order to ensure that excess capital in one group entity, which is used to cover risks in another, is suitable for those purposes. The Group agreed that the simplest approach would be to assess the extent and nature of any excess in a dependant by reference to the capital requirements of that dependant; but to admit any excess for the purposes of the parent only to the extent that the excess capital elements are suitable according to the rules applied to the parent (or other regulated entity). The supervisors of the parent and the dependant would clearly need to liaise closely over the acceptability and admission of different forms of capital.

14. As far as availability is concerned, some members of the Tripartite Group, recognising various obstacles to the free movement of capital surpluses around a group, are in favour of applying a test before accepting that surpluses in individual group entities are available at parent / group level. Other members of the Group, however, view a financial conglomerate as a single economic unit and, from a "going concern" perspective, they are prepared to assume that capital surpluses in individual entities are available to the group as a whole. It did not prove possible to reach a consensus on this point.

15. A difficult problem occurs when a group includes substantial non­regulated entities, either at the ownership level or downstream. The Tripartite Group is of the view that, notwithstanding moral hazard, supervisors should be able to obtain prudential information about the unregulated entities in a group in order to supervise the regulated parts effectively, and to be able to conduct a group­based risk assessment. Most members of the Group take the view that unregulated entities whose activities are similar to those of regulated entities should be included in group­wide assessments of capital adequacy through the application of notional capital requirements derived from the analoguous regulated activity. A small minority of the Group, on the other hand, have a preference for the establishment of qualitative standards aimed at the regulated entities (rather than notional capital requirements for the unregulated ones) wherever they appear in the group structure. Most members also advocate that unregulated holding companies at the top of the group structure and intermediate holding companies should be encompassed in the group­wide assessment of capital adequacy.


16. Contagion is recognised as one of the most important issues facing supervisors in relation to conglomerates. Psychological contagion ­ where problems in one part of a group are transferred to other parts by market reluctance to deal with a tainted group ­ is difficult for supervisors to guard against. However, contagion resulting from the existence of extensive intra­group exposures can, in principle, be contained and the Tripartite Group believes that, at the very minimum, it is essential for supervisors to be informed on a regular basis of the existence and nature of all such exposures.

Intra­Group Exposures

17. The Group takes the view that the potential problems of intra­group exposures are best tackled as an element of solo supervision, not least because the parent regulator's perspective is likely to be quite different from that of a subsidiary's regulator. Solo regulators should ensure that the pattern of activity and aggregate exposure between the regulated entity for which they are responsible and other group companies is not such that failure of another group company (or the mere existence of such intra­group transactions) will undermine the regulated entity. Solo supervisors also need to liaise closely with other group supervisors when uncertainties arise; they need powers to limit or prohibit intra­group exposures when necessary; and they should be particularly concerned about situations where funds are being invested by a subsidiary in securities issued by a parent, or are being deposited directly with a parent.

Large Exposures at Group Level

18. Wide differences between the large exposure rules pertaining in the banking, securities and insurance sectors provide ample scope for regulatory arbitrage, and the differences are such that it is difficult to envisage the gaps being bridged in the foreseeable future. The Tripartite Group agreed that a combination of large exposures to the same counterparty in different parts of a conglomerate could be dangerous to the group as a whole and a group­wide perspective is therefore considered necessary. One practical way of proceeding might be to develop a system whereby the parent or lead regulator is furnished with sufficient information to enable him to assess major group-wide exposures to individual counterparties; this would provide valuable information on gross exposures. It might be possible to identify suitable "trigger points" of concern which, when reached, would trigger discussions on a case­by­case basis between the supervisors involved on the nature of any perceived problems and on any proposed action to be taken.

Fit and Proper Tests for Managers

19. Most supervisors already have the power to check the fitness and propriety of the managers of the firms for which they are responsible. The problem facing supervisors in applying such tests is that, as the banking, insurance and securities businesses become more and more integrated, it is possible that decision-making processes will be shifted away from individually­regulated entities to the parent or holding company level of the structure, enabling managers of other (perhaps unregulated) companies in the group to exercise control over the regulated entity. Because of this, the Tripartite Group believes that, in applying the fit and proper test to managers, supervisors should be able "look through" a conglomerate's legal structure and focus on the people who are actually managing the supervised entity, regardless of exactly where they feature in the group's organigram.


20. The Tripartite Group is of the view that the way in which a conglomerate is structured is crucial to effective supervision. It believes that supervisors need powers, at both the authorisation stage and on a continuing basis, to obtain adequate information regarding managerial and legal structures, and, if necessary, to prohibit structures which impair adequate supervision. Where supervision is impaired, supervisors should be able to insist that financial conglomerates organise themselves in a way that makes adequate supervision possible.

Suitability of Shareholders

21. The Tripartite Group is of the view that shareholders who have a stake in a financial conglomerate (enabling them to exert material influence on a regulated firm within it) should meet certain standards, and that supervisors should endeavour to ensure that this is the case by applying, on an objective basis, an appropriate test, both at the authorisation stage and on an ongoing basis. Responsibility for applying such a test clearly rests with the supervisors of individually regulated entities, but the Tripartite Group advocates close cooperation between supervisors and a sharing of information on shareholders in this respect.

Access to Information

22. In the case of a financial conglomerate, intensive cooperation between supervisors is essential and supervisors should have the right to exchange prudential information. There was general support for the idea of appointing a lead supervisor or "convenor", who would be responsible for gathering such information as they require in order to have a perspective on the risks assumed by the group as a whole (including information on non-regulated entities). Using this data, a convenor would make an assessment of the capital adequacy of the group and would also be responsible for ensuring that the supervisors of individual entities are made aware of any developments which might affect the financial viability of the group. In addition, when supervisory action involving more than one regulated entity is called for, the convenor would be responsible for the coordination of this action. This would not interfere with the power of the solo supervisor to obtain information regarding the group and to act individually when necessary. In all probability, the convenor would be the supervisor of the dominant operational business entity in a group. The Tripartite Group also believes that the precise role of the lead regulator or convenor, and indeed the responsibilities of all individual supervisors involved in financial conglomerate, could be defined and agreed upon effectively through the establishment of Memoranda of Understanding or Protocols between the relevant supervisors, particularly when a financial conglomerate has a complex structure. Where the relevant supervisors are located in the same country, however, more informal information sharing arrangements may be sufficient. External auditors are recognised as another valuable source of information for supervisors.

Mixed Conglomerates

23. Although many of the problems associated with the supervision of financial conglomerates also arise in the case of "mixed conglomerates" (groups which are predominantly industrially or commercially oriented but contain at least one regulated financial entity), the latter also raise some rather different issues for supervisors and can demand a fundamentally different approach. For example, there are difficult issues to be tackled in ascertaining the suitability of the shareholders of the regulated entities and the fitness and propriety of the managers responsible for running the regulated businesses. Intra­group exposures are another problem area and it is essential that supervisors establish that such business is conducted at "arm's length" (i.e. at the terms prevailing in the market in general at the time). Clearly, there is scope for supervisory discretion in this area, but supervisors must be satisfied that, as a rule, intra­group business is not being conducted at rates or on terms which significantly differ from those prevailing generally.

24. At the heart of the problem with regard to mixed conglomerates is the difficulty for supervisors in assessing overall group capital adequacy because supervisory rules and practices cannot be extended to commercial and industrial entities in the same way as they can to non­regulated financial entities. The Tripartite Group believes that, ideally, supervisors should be able to insist on the establishment of an intermediate holding company to provide a legal separation of the regulated financial parts of a mixed conglomerate from the non-financial parts; this would enable supervision to be carried out in the same way as for other financial conglomerates.


25. In summary, considerable progress has been made in identifying broad areas of agreement between supervisors in the three disciplines and a number of recommendations have been made as to ways in which the supervision of financial conglomerates could be improved. However, any further progress that can be made by the Tripartite Group seems certain to be restricted by the informal nature of the group. It is hoped that this paper will provide a sound basis for any further work that may be undertaken in this regard.


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