105. In considering the relative merits of the following supervisory techniques, it was initially assumed that all participations by parents and subsidiaries are 100%, that capital is freely transferable within the group, that the different types of regulatory capital employed are of equal acceptability, and that all the companies concerned are in the financial regulated sector. The effects of lifting these simplifying assumptions are considered in sections (ii) to (iv) of this chapter, in particular how each of these methods deals with issues such as availability and suitability of excess capital, participations of less than 100%, and unregulated entities.

106. Of the six techniques identified at the outset, two were set aside for the purposes of the Tripartite Group's further work for the reasons given below.

(a) Accounting­Based Consolidation

107. Accounting­based consolidation involves the straightforward addition of group liabilities vis­à­vis third parties at group level, comparison with total consolidated group assets on a single set of valuation principles, and application at the parent level of capital adequacy rules to the consolidated figures. It regards the group as a single economic unit with all intra­group exposures netted out, and with surplus capital in individual entities assumed to be available to the group as a whole. Accounting­based consolidation would normally include unregulated financial companies which are part of the group, but would not attempt to take account of any non­financial group companies. It is the technique applied by bank supervisors in assessing overall group capital adequacy in respect of banking groups, and, in Europe, accounting­based consolidation will also generally be possible for homogeneous groups where rules have been harmonised (although some supervisors have concerns about the masking of intra­group exposures and assumed transferability of capital in this respect). For bank regulators (and securities regulators within the European Community), consolidated supervision is, or is to become, an important element of supervision. Some of these regulators may place greater emphasis on consolidated supervision than on any solo supervision they undertake. Some of them may undertake no solo supervision at all, especially in relation to conglomerates made up entirely of homogeneous entities, as long as certain conditions are fulfilled (e.g. satisfactory distribution of capital in relation to the risks being borne by the group). From the point of view of most insurance regulators and some securities regulators, however, solo­plus supervision remains preferable, not least because they believe that, for the conglomerates for which they are responsible, consolidated supervision has certain disadvantages (e.g. the combination of disparate balance sheets to which different prudential requirements apply; the issue of availability and suitability of capital for transfer between group companies; and additional costs).

108. However, the nature of insurance liabilities, differences in valuation principles, the different correlation between asset and liability risks in insurance, and the definition of insurance capital requirements, led the Tripartite Group to conclude that accounting­based consolidation was not an appropriate technique at the present time for heterogeneous groups including insurers, banks and securities firms. Accordingly, while the Tripartite Group recognised that accounting­based consolidation may be appropriate and useful in the supervision of homogeneous groups, it decided to set this technique aside for the purposes of this report, which focuses on heterogeneous groups of the latter type.

(b) Block Capital Adequacy

109. Block capital adequacy tends to assume that all undertakings within a conglomerate are regulated financial entities. It 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 in respect of the risks which are common to banks, securities firms and insurance companies (i.e. principally credit, concentration, market and foreign exchange risks). In addition to the capital requirement for these common risks would be added a requirement in respect of the risks which are specific to the individual sectors in order to produce an overall capital requirement covering all risks taken on by the group as a whole. The common types of risk would need to be covered by forms of capital acceptable to bank, securities and insurance regulators ­ i.e. a common capital standard would need to be developed. However, the risks which are specific to individual sectors could be covered by designated own funds recognised for this purpose by regulators in the appropriate sector. Capital surpluses in individual group companies would need to meet the common capital standard if they were to be used to cover risks which are specific to group entities in another financial sector. The common capital standard would also need to take account of the correlation of different types of risk that exist within a heterogeneous group. At the present time, "block capital adequacy" is a purely theoretical technique; it is not currently applied as a tool of supervision. While it had theoretical attractions for some members of the Tripartite Group in the longer term, others queried whether the availability of funds for transfer between group companies could be assumed; they also questioned whether block capital adequacy could ever produce results which are sufficiently accurate to justify the regulatory resources that such an elaborate technique would be certain to absorb. Ultimately, all members agreed that, while "block capital adequacy" was not a technique which could be ruled out entirely, it was not a practical possibility in the immediately foreseeable future. Accordingly, it is not considered in any further detail in this report.

110. Four other quantitative techniques for assessing the adequacy of capital in financial conglomerates were considered in more detail:

Building block prudential approach;

Risk­based aggregation;

Total deduction;

Risk­based deduction.

(c) "Building Block" Prudential Approach (Based on Consolidated Accounts / Data)

111. The "building block" prudential approach takes as its starting point and basis the consolidated accounts of the financial conglomerate at the level of the parent company. Such an approach would come on top of the solo supervision of individual companies and the requirements of each type of supervisor, which would remain unchanged. A financial conglomerate's prudential data would be checked by the parent company's supervisor with information given by other regulators.

112. For prudential purposes, the consolidated balance sheet and off­balance sheet commitments would be split into four different blocks according to the supervisory regime of the individual firms involved: banks, insurance companies, securities firms and unregulated firms. Capital requirements would then be calculated by the individual regulatory authorities for the three types of regulated entity (including activities of non­regulated entities carrying out similar business to regulated entities) and added together (it is worth noting that these requirements could be different from those applicable on a solo basis because of the elimination of intra­group exposures). The aggregate amount of capital requirements would then be compared with the aggregate amount of own funds across the group (i.e. the total amount of capital recognised by the different regulators), given that each type of risk (banking, insurance, securities) should be covered by prudential own funds which are recognised as capital by the relevant supervisory authority.

113. A variant ­ which would deliver a very similar result ­ would be to deduct from the prudential capital (i.e. the own funds) of the parent company the capital requirement for its regulated subsidiaries in other financial sectors (and the notional requirement of any unregulated subsidiaries carrying out similar business). The resultant amount would be compared with the capital requirement for the parent's own activities and for subsidiary activities in the same financial sector. This might be a better way of proceeding where there is a dominant financial activity (i.e. banking, securities or insurance) and that activity is undertaken by the parent company (more often than not, this is the case). It would allow the regulator of the parent company to take responsibility for the calculation of group capital requirements and for the checking of capital adequacy across the financial conglomerate as a whole. The intention would be that this should not prejudice the responsibilities of other supervisors for individual entities on a solo basis; the legal responsibilities of each supervisor would not be affected.

114. Under the "building block" prudential approach, unregulated firms carrying out similar business to regulated entities (e.g. leasing, factoring and reinsurance) would be included ­ i.e. a notional capital requirement would be calculated in accordance with the rules of the appropriate regulatory regime. Other unregulated companies would be left out of the calculation.

115. By virtue of the fact that it is based on data relating to the group as a whole, the building block prudential approach ­ like accounting­based consolidation ­ regards the group as a single economic unit and implicitly assumes that surplus capital in individual entities is freely transferable to other group entities (irrespective of whether those entities are wholly or partly­owned ­ see section ii of this chapter). However, it is envisaged that there would need to be a separate check ­ by the regulator of the parent company ­ to ensure that there are no specific obstacles to such availability and that risks in the different blocks of business are covered by capital of an appropriate type and of sufficient quantity (i.e. satisfactory distribution of capital and risks across the group). The building block prudential approach also nets all intra­group exposures (on and off the balance sheet) automatically, rather than leaving such judgement to the supervisor. The use of audited data (i.e. group accounts and off­balance­sheet figures), rather than direct regulatory data, is seen by some members of the Tripartite Group as giving extra assurance to supervisors.

(d) Risk­Based Aggregation

116. In its simplest form, risk-based aggregation involves summing the solo capital requirements of regulated group companies and comparing the result with group capital. So, in a group comprising a parent bank with insurance and securities subsidiaries, the capital requirements of the parent bank would be summed with the capital requirements of the insurance and securities subsidiaries (as determined by their respective regulators) and capital adequacy assessed by comparing the result with the own funds of the group. Where subsidiaries are held at cost in the accounts of their parent company, a simple technique for calculating the own funds of the group is to add to the own funds of the parent the own funds of the subsidiaries and then deduct the book value of the parent's participations in the subsidiaries as shown in the accounts. An alternative technique, which can be used however subsidiaries are accounted for in their parent's books, is to identify the externally generated capital of the group. The externally generated capital of the group is found by adding to the externally generated supervisory capital of the parent the amount of any subsidiary's externally generated supervisory capital which:

- regardless of whether it "belongs" to the group, can be applied against the subsidiary's solo capital requirement (for which purpose, capital supplied to the subsidiary from the group is ignored); or

- "belongs" to the group (for example, the group share of retained reserves), has not been included in the parent's own capital (for example, because the investment in the subsidiary is held at historical cost), has not been dealt with under the preceding stipulation and is able to be transferred, directly or indirectly, to other group companies that recognise the form of capital concerned.

117. In this context, "externally generated" refers to capital not obtained from elsewhere in the group; accordingly, equity supplied by minorities, third party debt finance and retained profits arising from transactions with third parties would all qualify as externally generated group capital. The term "belongs to the group" refers to amounts which would in principle be payable to the group on the winding up or sale of the subsidiary. It thus excludes, for example, retained reserves which would be payable to a minority shareholder. The term "able to be transferred" aims to exclude amounts subject to foreign exchange controls, withholding taxes and the like. It should be noted that the strict assumptions about minority capital and transferability are not intrinsic to the general technique of risk­based aggregation and could easily be relaxed to provide a wider definition of relevant externally generated capital. In addition, the structure of the capital may be examined to ensure that banking risks are covered by capital recognised by the bank regulators, securities risks by capital recognised by the securities regulators and insurance risks by capital recognised by the insurance regulators, although this would normally be ensured by the solo supervision on which aggregation is based.

118. This form of risk­based aggregation and the building block prudential approach are indeed very similar. As in the building block prudential approach, each category of risk is treated according to the rules of the respective specialised regulator and so the application of rules stemming from another supervisory framework is avoided. The principal difference is that the building block prudential approach is based on consolidated accounts whereas risk-based aggregation uses data supplied to supervisors in the normal course of supervision; as such, it can be applied when consolidated accounts are not available. A corollary of this is that the building block approach automatically nets out intra­group exposures, while aggregation does not deal specifically with such exposures (but this does not prevent them being netted out at a later stage, if necessary).

119. A more prudent form of risk-based aggregation ­ the concepts of which are more akin to those of the total deduction method described below ­ involves aggregation of the maximum regulatory capital requirement of each subsidiary in a group. The maximum regulatory capital requirement for each regulated subsidiary is deemed to be the greater of the subsidiary's actual solo regulatory capital requirement or the investment by the group in that subsidiary. The aggregated maximum regulatory capital requirement of the subsidiaries is then added to the regulatory capital requirement of the parent company itself to produce the overall group capital requirement. The lead supervisor or convenor would compare this requirement with the externally generated capital of the group (as described above).

120. In the event that risk-based aggregation reveals an apparent capital shortfall, the lead supervisor / convenor would need to consult with other relevant supervisors and to gather such information as is necessary in order to come to a decision on whether remedial action was required, or whether the position could be accepted on the basis of the obviously temporary nature of the problem or for other reasons.

121. In the case of unregulated subsidiaries, the lead supervisor / convenor would normally expect to bring into the aggregation an amount representing the investment by the group in the subsidiary plus, in the unlikely event that there is a shortfall in the net assets of the subsidiary, the amount of that shortfall (amount 'A'). However, where the business of an unregulated subsidiary is very similar to a regulated business, the lead supervisor or convenor might decide to estimate a notional regulatory capital requirement for the unregulated subsidiary and, if this exceeds 'A', bring this into the aggregation instead.

(e) Total Deduction Method

122. The total deduction method is based on the full deduction of the book value of all investments made by the parent in subsidiaries; some supervisors also advocate the deduction of any capital shortfalls in those subsidiaries (as indicated by the capital standards of their solo supervisors) from the parent's own capital. In other words, the supervisor attributes a zero value, or in some cases a negative value, to the parent's investments. The result is then compared with the parent's solo capital requirement calculated according to the regulatory rules applicable to the parent. Supervisors using total deduction rely on the capital standards of other regulators for identifying any capital shortfalls in subsidiaries; there is no obvious way of integrating undercapitalised unregulated entities in the group­wide risk assessment.

123. As long as the parent's supervisor checks that the capital of the subsidiary at least meets regulatory norms (or, as described above, that a further deduction is made in respect of any shortfall), total deduction is equally as effective as the other techniques described in this chapter in eliminating double gearing. It is conservative, simple to apply and, importantly for some securities supervisors, it also recognises that the parent would not be obliged to bail out a subsidiary. What it does not do is produce an overall measure of risk at parent / group level, nor does it give any credit at parent / group level for surplus capital in subsidiaries. Accordingly, there is no incentive for parent institutions to ensure that their subsidiaries are any more than adequately capitalised. Instead, total deduction tends to recognise intrinsically that there may be restrictions on the ability of the parent to remove capital from a regulated subsidiary (a question addressed in more detail later in this chapter).

(f) Risk­Based Deduction

124. The risk­based deduction method looks at each company in turn starting from the lowest level of the group. It utilises regulatory data for the assets and liabilities of each company, but replaces the value of all investments in subsidiaries with an amount calculated as follows:

- Own funds of subsidiary assessed on the solo­plus supervisory basis relevant to that subsidiary, less

- Capital requirement of subsidiary,

- All multiplied by the relevant proportion of shares held in the subsidiary (e.g. 60% in the case of a 60% holding).

125. Where equity accounting is employed, this can be seen most simply as taking account in the parent company of the own funds of the subsidiary, reduced by the latter's capital requirement (see Example J in Appendix III). If there is a capital shortfall, then the method can either operate by attributing the whole of the shortfall to the parent or on the pro­rata basis described (for the attribution of surpluses) in paragraph 124 above.

126. This method can be further refined by excluding from item (a) any "own funds" that (i) are not attributable to the parent company or (ii) represent reserves or some other capital elements that are not freely transferable to the parent company or (iii) any withholding or other tax that might be payable in the event of transfer of resources. In addition, the value of shares in the subsidiary may be limited to the value that might be realised (net of any tax) by an arms length sale or transfer of the shares to a third party.

127. In other words, unlike the total deduction method, the parent is permitted to take account of its share of capital surpluses in subsidiaries. However, with the refinement in the preceding paragraph, this is subject to the proviso that it is able to satisfy the supervisor that the surplus capital it has taken into account is both available and suitable.

128. It is a very similar approach to the risk­based aggregation method in that there is an addition of the own funds of each subsidiary to those of the parent and both methods are based on regulatory rather than accounting data. However, the capital requirement of each subsidiary is matched directly against the own funds of that subsidiary, rather than being aggregated together against the own funds of the group. Therefore, it is feasible to ensure directly that risks in each sector (insurance, banking or securities) are covered by capital that is regarded as appropriate by the supervisor in that sector.

129. With the refinement in paragraph 126 above, the supervisor at parent/group level can assess whether the capital surpluses in the subsidiaries are fully available and suitable for transfer to the parent or elsewhere in the group, and also whether the type of capital involved would be acceptable on transfer.

Conclusions

130. The Tripartite Group agreed that techniques (c), (d) and (f) above (building­block prudential, the simple form of risk­based aggregation and risk-based deduction) are all in principle capable of achieving the desired objectives - providing an accurate insight into the risks and capital coverage across a heterogeneous financial group; and eliminating double­gearing. Technique (e), total deduction, deals effectively and conservatively with double­gearing. What it does not do is seek to provide a full picture of the risks carried by the group. The same can be said of the more prudent variant of risk­based aggregation described in paragraph 119. In simplified circumstances (i.e. there are no unregulated entities, and equal acceptability of different types of regulatory capital, free transferability of capital within a group, and 100% ownership of all subsidiaries are assumed), the Tripartite Group also concluded that techniques (c), (d) and (f) should yield the same (or very similar) results. Examples A­C in Appendix III demonstrate this conclusion for simple specimen cases. It is suggested that these three techniques ­ suitably developed to deal with some of the other important issues dealt with in the remainder of this chapter ­ 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. Total deduction might also be recognised as an effective technique for the purposes of preventing double gearing within a financial conglomerate, but not for providing a group­wide perspective of the risks being run by a financial conglomerate.

131. In order to deal with more complex and typical cases, two important issues arise in the context of capital assessment:

- participations in dependants:  availability and transferability of capital surpluses;

- capital adequacy at group level:  suitability of capital for intra­group transfers;

And two other issues of a more general nature also need to be confronted:

- unregulated holding companies / unregulated dependants;

- regulatory intervention issues.

While the building­block prudential approach, risk­based aggregation and risk-based deduction provide a framework for handling these issues, they do not automatically provide policy solutions to them. The Group therefore devoted considerable time to discussion of these issues; the remainder of this chapter reflects those discussions and the conclusions reached.