160. A difficult problem occurs when a group includes substantial non­regulated activities, either at the ownership level or downstream. Supervision can only be directed at regulated entities and any sanction can only be imposed on them. It can be argued that it is difficult to insist on receiving information about non-regulated entities of a group, and yet not bear any responsibility for the well­being of those entities. The Tripartite Group itself was of the view that, notwithstanding moral hazard, supervisors should be able to obtain prudential information about the unregulated entities of a group in order to supervise the regulated parts effectively, and to be able to conduct a group-based risk assessment. There is however substantial opinion that any approach which might be adopted must avoid the impression that there is a supervisory function in relation to the unsupervised entity standing alone.

161. The following questions arise.

- Is it possible to distinguish between types of non­regulated entities with which supervisors should be concerned and those which can be excluded for supervisory purposes? If so, how should such a distinction be drawn? If not, is it possible to separate non-regulated entities which demand particular attention (e.g. leasing / factoring, reinsurance in some jurisdictions) from others? What view should be taken of group holding companies and intermediate holding companies?

- Should capital adequacy assessments be attempted for non­regulated group holding companies? If so, on what basis, and on the basis of which regulatory rules?

- If not, what problems nonetheless need to be addressed in respect of groups as a whole (e.g. contagion, capital leverage)? For example, should supervisors control the quality of capital in the regulated entity (e.g. the downstreaming of debt as equity by non­regulated holding companies) and, if so, how?

162. It is obviously risky to exclude unregulated entities from supervisory consideration, wherever they appear in the group structure. For unregulated entities whose activities are similar to regulated activities (notably ­ in some jurisdictions ­ leasing, factoring and reinsurance), it was agreed that it should be possible to include in the group­wide assessment of capital adequacy a notional requirement for the unregulated undertaking calculated by the application to its business of some or all of the capital standards (and valuation requirements for assets and liabilities) of the appropriate regulator (e.g. insurance rules would be applied to a reinsurance company, banking rules to a leasing company etc.). An alternative would be to use accounting techniques to consolidate the unregulated undertaking with its regulated analogue and then apply the analogue regulator's capital standards to the consolidated numbers (e.g. a reinsurance company would be consolidated with an insurance company and the insurance sector's capital standards applied to the joint figures). The resultant sub­consolidated capital requirement would then be brought into the overall assessment of group capital adequacy.

163. In principle, any additional capital needed by the group as a result of the integration of unregulated financial entities should be situated in the parent or holding company of the group. Attention was drawn to the need to be mindful about creating inequality of competition between, say, leasing companies included in group assessment and those which were not.

164. Where there are unregulated entities ­ which may or may not be seen as holding companies ­ undertaking activities which cannot be regarded as financial activities (or little or no activity at all), it is suggested that the capital required by such entities is in fact dictated by the market. In other words, they can be virtually ignored for the purposes of assessing group capital adequacy because of the very low risk of contagion arising from non­financial companies. If, however, there are significant fixed assets in the unregulated entity, most members thought that there may be grounds for identifying a notional capital requirement, reflecting the extent to which those assets absorb capital, with the possible addition of a working capital requirement.

165. A small minority of the Tripartite Group, however, expressed a preference for the establishment of qualitative standards aimed at the regulated entities (rather than the application of notional capital requirements to unregulated entities either at the ownership level or downstream). They had in mind, for example, requiring notification of large capital withdrawals from the regulated entity, placing limitations on the withdrawal of funds in certain circumstances and obtaining information on other group companies. Instances of double gearing would be identified and these members would foresee the regulatory structure allowing appropriate measures to be taken in respect of the regulated entities. That said, ways of dealing with companies which undertake non-financial activities were not discussed in any great detail by the sub­group. It was recognised that, at the margin, there could be a problem in defining what were and what were not "financial activities".

Unregulated Company as Intermediate Company in Structure

166. Unregulated companies appearing as an intermediate company in the group structure may be mere holding companies or companies which are carrying out ancillary business on behalf of a bank, insurance company or securities firm. The main issue in the case of an intermediate unregulated holding company was thought to be ensuring that the structure of the group was conducive to effective supervision of the regulated entities. The technique for assessing group­wide capital adequacy must effectively eliminate the effects of such companies; it must ensure that the group calculation yields results which are the same as those one would obtain if there were no intermediate holding company. There were not thought to be any specific problems in doing this because supervisors could either adopt the look­through approach (under which, subject to tests as to availability and suitability, the solvency surpluses / deficits of the unregulated holding company itself and all companies owned by it would be taken into account), and/or they could integrate by using one of the methods described earlier in this paper, which would have the same effect. On this approach, third party debt issued by an intermediate holding company should be seen as a liability for the purposes of its (regulated) parent. The situation which supervisors should be seeking to guard against is the one where an intermediate holding company takes on debt with a view to channelling the proceeds to regulated entities elsewhere in the group (perhaps through the purchase of another group company's subordinated debt). An assessment of capital adequacy from a group­wide perspective, using either the building block prudential approach or risk­based deduction, would deal with this problem by the straightforward elimination of intra­group exposures if the holding company is included in the entities to be integrated; in risk­based aggregation, meanwhile, the emphasis on recognising only externally generated capital within the group should overcome this difficulty. At the end of the day, it comes back to ensuring that the existence of the intermediate holding company does not interfere with or circumvent the normal regulatory rules.

Unregulated Holding Company at Top of Structure

167. The most common problem in respect of holding companies at the top of a group structure is that they can conceal cases of double or excessive gearing arising from, for example, the issuing of debt and the downstreaming of the proceeds as equity. This situation is recognised as unacceptable (under EU legislation) in relation to banking and securities business, and is one which poses risks of financial strain for insurance companies. The problem for supervisors is that their regulatory powers do not as a rule extend to the unregulated holding company. There was agreement among members of the Tripartite Group that this problem should be addressed. At a minimum, it was considered necessary for supervisors to have the power to obtain information from (or about) unregulated holding companies so that, if necessary, they could make a qualitative assessment of the overall ability of the holding company to service any debt. Most members did not think it necessary to supervise the holding company itself and did not seek powers to be able to impose sanctions on it. They were of the view, however, that the relationship between the holding and the regulated entities needed to be monitored closely and, if a capital deficiency was identified, then there should be coordination between all the subsidiaries' supervisors on how to address the problem.

168. The "one­to­one rule" applied by bank supervisors in The Netherlands (as described in Appendix IV) was noted. In a nutshell, this ensures that there is as much capital in an unregulated bank holding company as there is in its subsidiaries (i.e. the holding company has to cover one­to­one the sum of the capital situated in its regulated subsidiaries). Although the supervisors can only take sanctions against the regulated entity, the one­to­one rule in reality facilitates indirect supervision of the holding company. The possibility of extending this rule to financial conglomerates appealed to some members, both as a means of eliminating double or excessive gearing flowing from an unregulated holding company and as a technique for identifying at an early stage capital pressures within a financial conglomerate. If the sum of the capital in the regulated entities of a conglomerate exceeded the capital available in the holding company, it would be for the lead regulator (where this was obvious) to coordinate supervisory action. Where the lead regulator is not obvious, (e.g. sister companies of similar size below a non­regulated holding company), the capital structure needs to be addressed in the first instance by the respective regulators independently; subsequently, the position could be considered jointly and a future modus operandi could be agreed upon.

169. Views on the precise sort of action that should be taken tend to be coloured by differences in the nature of the insurance, banking and securities businesses and by differences in the philosophy of regulators towards protection of customers. Securities supervisors, for example, require securities firms to have sufficient liquid assets to repay promptly all liabilities at any time; securities firms are therefore highly liquid and can be wound down in a timely manner. Insurance supervisors are also likely to be less worried about illiquidity risk arising from contagion than their banking counterparts (although market volatility and the leverage effect of derivatives are causing some concerns). Moreover, bank risks are often short to medium term, while life insurance risks are generally long term. In seeking to protect the interests of life policy holders, most life insurance regulators are concerned primarily with the regulated insurer and with restrictions being placed on transfers of funds to other group companies or to shareholders. What is acceptable at the group level will depend to some extent on the mix of businesses that the group undertakes.

170. It is recommended that an exercise be conducted, selecting, say, the leading financial conglomerates in each country which are headed by a non­regulated (on a solo basis) holding company and which have subsidiaries in other jurisdictions; the idea would be to identify the lead regulator in each case. Under the EU's BCCI Directive, it was noted that supervisory authorities are only able to grant authorisation to banks, securities firms and insurance companies that are part of a group if they are satisfied that the structure of the group permits effective supervision. Supervisors needed enough information, not only to enable them to understand the structure of a financial conglomerate, but also to enable them to supervise the regulated entities effectively.

Conclusions

171. The Tripartite Group agreed that:

i. Unregulated entities whose activities are similar to those of regulated activities (e.g. leasing, factoring and reinsurance) should be included in group wide assessments of capital adequacy. Most members felt that the most effective way of doing this is to apply notional capital requirements derived from the analogous regulated activity. A small minority of the Group had a preference for establishing qualitative standards in respect of the regulated entities rather than notional requirements in respect of the unregulated ones;

ii. Intermediate holding companies need to be integrated into group capital adequacy assessments, using one of three techniques discussed in this paper (or by accounting-based consolidation if that is appropriate);

iii. As regards unregulated holding companies at the top of a financial conglomerate structure, supervisors need to include the holding company in their assessment of group-wide capital adequacy. If they fail to do so, there is a risk that financial conglomerates will structure themselves in such a way that a meaningful group­wide assessment of capital adequacy is not possible. Furthermore, supervisors need to have appropriate powers to obtain sufficient information about an unregulated holding company to enable them to make a qualitative assessment both of its overall ability to service any external debt and of any other measures that might be necessary in relation to regulated entities. If concerns become apparent, the regulator of the leading regulated entity can be expected to need to liaise with regulators of other parts of the group before supervisory action is taken;

iv. Notwithstanding the above, supervisors should not lose sight of the distinction between regulated and unregulated entities within a financial conglomerate. Supervisory powers, and the related sanctions, can only be directed at regulated entities if moral hazard is to be avoided;

v. An exercise should be carried out in which the leading financial conglomerates headed by non­regulated holding companies and which have subsidiaries in other jurisdictions should be identified for each of the major industrialised countries. The intention would be to build up a picture of the number of regulators and jurisdictions typically involved in the supervision of parts of a large financial conglomerate, and to see whether identification of the lead regulator in each case is obvious.