47. Contagion entails the risk that financial difficulties encountered by a conglomerate's individual elements could have an adverse impact on the financial stability of the group as a whole and possibly even on the markets in which the constituent parts operate. Contagion thus relates to the danger that, if certain parts of a conglomerate are experiencing financial difficulties, they may infect other healthy parts of the conglomerate as a result of which the operation of the healthy parts may be hampered or even made impossible. Regulators need to be aware of the threat of contagion, and close monitoring of the relationship between regulated entities and the rest of the companies comprising the conglomerate is of paramount importance in this respect.

48. This is probably one of the most important issues facing supervisors in relation to financial conglomerates because the increasing complexity of financial groups means that there could be a higher risk of contagion. Although conglomeration offers advantages in terms of greater financial capacity and wider diversification of activities, there are also some disadvantages. Problems arising in one part of a conglomerate can and do infect other group companies, including regulated companies; moreover, these problems can spread even if the other companies are financially very sound.

49. The Tripartite Group has identified two distinct types of contagion. The first of these is essentially psychological, where problems associated with one part of a conglomerate are transferred to other parts merely by market reluctance to deal with a tainted group. The risk of this type of contagion is particularly acute for those institutions which depend on market confidence either for funding or for trading purposes. For example, the question for banks would be the extent to which depositors' funds would be perceived to be at risk if another member of the financial group of which it was a part encountered financial difficulties. Supervisors need to be aware of institutions likely to encounter liquidity problems if weaknesses become apparent in supervised or unsupervised entities in the same group. Whatever means a bank employs to distance itself from a troubled affiliate, there is a risk that its good name could suffer and it could feel compelled to protect itself. In the case of insurance companies, the question would relate to the extent to which payments under insurance policies (including any bonuses dependent on company investment performance) are perceived to be threatened by problems in another part of the same group. It is therefore essential that supervisors monitor the extent to which each supervised institution in a conglomerate is exposed to this type of contagion risk.

50. The second type of contagion identified by the Tripartite Group relates to the existence of intra­group exposures. The circumstances under which such exposures can create risks for a regulated entity within a financial conglomerate will depend on the size and the nature of the exposures involved as well as on the financial strength of the group of companies to which the regulated entity is exposed. Experience has shown that intra­group exposures can significantly exacerbate problems for a regulated entity once contagion spreads to it. The problems caused by intra­group exposures and ways in which supervisors might seek to alleviate these problems are discussed in more detail in the next section of this chapter.

51. It has been suggested by some that one way of counteracting contagion risk resulting from intra­group exposures would be to establish a system of firewalls preventing regulated entities within a conglomerate from helping other entities in the same conglomerate if the provision of such help resulted in the provider being in breach of its capital requirements. The capital standards applied by some securities regulators, for example, are designed to insulate firms and, if necessary, to allow them to be wound down in an orderly and timely way without loss to customers and counterparties; this approach has worked well for securities firms in the United States. However, these firms are less likely to fail as a result of a withdrawal of credit lines because their balance sheets are highly liquid; moreover, there is no predisposition within a securities conglomerate to prop up each individual entity. Many banking groups, on the other hand, are very sensitive to market funding and experience has shown that, whenever difficulties arise in one part of a banking conglomerate, the psychology of the market is such that participants are quick to withdraw or to lower credit lines from other entities in the same group. For this reason, banking groups may be prepared to go to considerable lengths to prevent the failure of any entity bearing the banking name.