1. To provide banking, securities and insurance supervisors with principles and measurement techniques (a) to facilitate the assessment of capital adequacy on a group-wide basis for heterogeneous financial conglomerates; and (b) to identify situations such as double or multiple gearing which can result in an overstatement of group capital and which can have a material adverse effect on the regulated financial entities.

2. This paper does not seek to specify mandatory techniques for giving effect to the principles set out below. Rather, the paper sets out techniques that have been found useful by a number of supervisors in assessing group-wide capital or in evaluating the impact of certain practices on regulated entities. Supervisors should have the flexibility to utilise the techniques appropriate for the specific circumstances of the particular financial conglomerates with which they deal. Several relevant techniques are outlined in this paper and other prudent techniques may be developed in the future. In applying them, supervisors have discretion to exclude entities which are immaterial to the risk profile of the group or its capital adequacy.

Background

3. The emergence of corporate groups which provide a wide range of financial services, known as financial conglomerates and typically incorporating at least two of banking, securities and insurance, has added an additional dimension for the solo supervisors of entities within those groups. Supervisory concerns have been explored from the perspective of each of the three supervisory disciplines and also from a broader perspective by the three groups of supervisors working together.

4. A central issue has been to ensure that the objectives of individual supervisors as they relate to the entities for which they have regulatory responsibility are not impaired as a result of the existence of financial conglomerates. Supervisors collectively recognise the need for individual supervisors of businesses within a conglomerate to satisfy themselves that there is sufficient capital available to the individual regulated entities to ensure their viability. Different supervisors attach different weights to the relative importance of the two objectives identified in the opening paragraph of this paper while recognising that neither is exclusive of the other.

5. The solo capital adequacy requirements of each of the banking, securities and insurance sectors are different with varying definitions of the elements of capital, and varying approaches to asset and liability valuations. Each sector's capital adequacy requirements reflect the nature of the different businesses undertaken by each sector, the differing risks to which they are exposed, and the different ways in which risk is managed by the firms and assessed (and/or constrained) by supervisors.

6. The elaboration and application of capital adequacy measurement techniques on a group-wide basis, and the possibility of the exercise of supervisory powers including those providing for remedial action which may prove necessary, is not intended to create an expectation that the full extent of regulation extends to unregulated entities within a financial conglomerate. The supervisory measures adopted should be construed so as to take this into account.

Assumptions

7. The capital adequacy requirements (and other features of the financial control regimes) that banking, securities and insurance supervisors prescribe for the institutions and groups within their own jurisdictions are taken as given. Supervisors may wish to exercise their judgement on the degree to which they will rely on the application of these requirements in jurisdictions which do not apply similar standards of supervision. The requirements within each sector are not in all cases uniform, but the trend is towards convergence within each sector. Further progress on the elaboration and convergence of capital adequacy requirements in the insurance sector is however desirable, including for insurance groups.

8. The elaboration of acceptable techniques of capital measurement for heterogeneous financial conglomerates does not preclude the use of an accounting-based consolidation approach, or other prudent approaches that meet the analogous objectives to those in paragraph 1, for financial conglomerates made up of homogeneous entities.

Definitions

9. For the purposes of this paper, heterogeneous financial conglomerates are conglomerates whose primary business is financial, whose regulated entities engage to a significant extent in at least two of the activities of banking, insurance and securities business, and which are not subject to uniform capital adequacy requirements.

10. Group-wide basis is a term employed to indicate that the entire group, including the parent and all its regulated and unregulated entities, are being considered.

11. Capital and regulatory capital are used interchangeably to mean the aggregate amount of elements eligible for inclusion in the regulatory definition of capital.

12. Regulatory capital requirement is the minimum amount of regulatory capital required by a supervisor, which if not maintained will usually permit or require supervisory intervention.

Guiding Principles

13. The objective in developing measurement techniques for the assessment of capital adequacy on a group-wide basis for heterogeneous financial conglomerates has been to identify approaches that should yield broadly equivalent results not to promote a single technique for universal application.

14. In principle, the use of the different techniques outlined in the annex to this paper should yield broadly equivalent results if applied to any particular group; in practice, the exercise of reasonable discretionary judgement by supervisors will give results within a range of acceptable outcomes.

15. The use of these techniques does not diminish the need for solo supervisors to establish the solo capital position against solo capital requirements for individual regulated businesses, to the extent required by sectoral capital adequacy regimes.

16. In order to fulfil the objectives in paragraph 1, acceptable capital adequacy measurement techniques should be designed to:

1. detect and provide for situations of double or multiple gearing, i.e. where the same capital is used simultaneously as a buffer against risk in two or more legal entities;

17. Double gearing occurs whenever one entity holds regulatory capital issued by another entity within the same group and the issuer is allowed to count the capital in its own balance sheet. In that situation, external capital of the group is geared up twice; first by the parent, and then a second time by the dependant. Multiple gearing occurs when the dependant in the previous instance itself downstreams regulatory capital to a third-tier entity, and the parent's externally generated capital is geared up a third time. Although double and multiple gearing are normally associated with a parent downstreaming capital to its dependant, it can also take the form of an entity holding regulatory capital issued by a sister affiliate or by an entity above it in the group's organisation chart. Supervisors need to be alert to the implications of double or multiple gearing in the entities that they supervise, regardless of whether those entities hold capital issued by a parent company, a dependant, or an affiliate.

18. The principal issue raised by double or multiple gearing is not the ownership structure as such (although some structures may also raise broader supervisory concerns), but the consequences of that structure for the assessment of a financial conglomerate's group-wide capital. When double or multiple gearing is present, assessments of group capital that are based on measures of solo capital are likely to overstate the external capital of the group. Supervisors should bear in mind that only capital issued to external (i.e., non-group) investors provides support to the group, although some forms of internally generated capital may provide support for individual companies on a solo basis. Consequently, assessments of group capital should exclude intra-group holdings of regulatory capital. Three capital adequacy measurement techniques for making that adjustment are described in annex 1 to this paper. Annex 2 provides numerical illustrations.

19. The situation is somewhat different when two entities within a group each holds regulatory capital issued by the other. In that case, none of the reciprocal holdings represents externally generated capital. The solution, however, is the same: both intra-group holdings should be excluded from assessments of group capital.

20. The structure of corporate groups means that it is inevitable that at least one entity will own shares and possibly other capital instruments issued by other entities within the group. While from a commercial perspective such structures are not inherently unsound, some may pose a prudential concern. For example, large intra-group holdings of capital can permit difficulties in one entity to be transmitted more quickly to other entities within the group. Thus, in addition to making the necessary adjustment to measurements of group capital, supervisors should be alert to ownership structures that pose such prudential concerns.

21. Paragraphs 16 to 19 deal with double or multiple gearing within a group. Supervisors should also be aware that similar problems of double or multiple gearing can also occur between different conglomerates holding cross participations in each other or in each other's dependants.

2. detect and provide for situations where a parent issues debt and downstreams the proceeds in the form of equity, which can result in excessive leverage;

22. A situation of excessive leverage can occur when a parent issues debt (or other instruments not acceptable as regulatory capital in the downstream entity) and downstreams the proceeds to a dependant in the form of equity or other elements of regulatory capital. In this situation, the effective leverage of the dependant may be greater than its leverage computed on a solo basis. While this type of leverage is not necessarily unsafe or unsound excessive leverage can constitute a prudential risk for the regulated entity if undue stress is placed on the regulated entity resulting from the obligation on the parent to service that debt. A similar problem can arise where a parent issues capital instruments of one quality and downstreams them as instruments of a higher quality.

23. In the particular case of an unregulated holding company, (i.e. one not subject to any sectoral capital adequacy requirement), at the top of a financial conglomerate, an assessment of group-wide capital adequacy by supervisors will need to encompass the effect on the group of the capital structure (and liquidity when appropriate)of such a company. To achieve this supervisors will need to be able to obtain information about the unregulated holding company e.g. via the regulated entities or via public domain information, and so to make an assessment of its ability to service all external debt. This is one aspect of a more general need for supervisors to consider the impact on regulated entities of unregulated parent holding companies.

3. include a mechanism to detect and provide for the effects of double, multiple or excessive gearing through unregulated intermediate holding companies which have participations in dependants or affiliates engaged in financial activities.

24. Assessment techniques need to be able to address situations where the intermediate holding company provides regulatory capital to another group entity. The group-wide capital adequacy measurement technique used should effectively eliminate the effect of intermediate holding companies and yield the same results as would be produced if there were no such intermediate holding company, or if it were consolidated in the relevant sector for risk assessment purposes. The unregulated intermediate holding company could be a non-trading financial holding company whose only assets are its investments in dependants, and/or a company engaged in activities ancillary to the regulated entity (e.g. a service company to the group).

4. include a mechanism to address the risks being accepted by unregulated entities within a financial conglomerate that are carrying out activities similar to the activities of entities regulated for solvency purposes (e.g. leasing, factoring, reinsurance).

25. For unregulated entities, supervisors have a number of analytical alternatives, including the substitution of a capital proxy for the relevant sector, the application of other ad hoc treatments that represent a prudent treatment of the risks being accepted, or as a fallback, use of total deduction treatment described in paragraph 37 and annex 1. For unregulated entities whose activities are similar to regulated entities (for example, leasing, factoring, reinsurance), a comparable or "notional" capital proxy (including any valuation requirements for assets and liabilities) may be estimated by applying to the unregulated industry the capital requirements of the most analogous regulated industry.

26. The total deduction treatment should not normally be applied to a reinsurance company in a group. If the capital proxy treatment is not applied to a reinsurance company in a group, the supervisor of any insurance company in the group should consider whether it is prudent to give credit for reinsurance placed with the reinsurer in assessing the solo capital adequacy of the regulated group insurers.

27. More generally, where risk has been transferred from regulated companies in a group to unregulated companies in the group, supervisors of the regulated companies may need to look through to the overall quantum and quality of assets in the unregulated companies, especially where a notional capital proxy has not been used.

5. address the issue of participations in regulated dependants (and in unregulated dependants covered by principle 4) and to ensure the treatment of minority and majority interests is prudentially sound.

28. The framework and mechanism for identifying and mapping group relationships is embodied in company law and accounting conventions. For the purposes of prudential supervision, the accounting treatment should be used as the point of departure although the precise way in which capital is measured and aggregated will need to be determined by the supervisor in the light of his assessment of group relationships.

29. Where the group has neither control of nor significant influence by virtue of its participation(s) in a regulated company, the regulated entities' investments should be treated in accordance with the solo supervisors' rules for capital adequacy assessment for investments in similar companies. This approach will normally be applicable to group participations of less than 20%, and it will normally result in the participation(s) being treated on the same basis as participations of less than 20% in unregulated companies.

30. Where group participations in a regulated dependant are such as to give the group shared control, only the pro-rata share of regulatory capital in excess of the dependant's own regulatory capital requirements should normally be regarded as available to support risks in the parent company or in other entities in the group and to be recognised in a group-wide capital adequacy assessment, subject to the conditions in paragraphs 32-35. Where in the view of supervisors, group participations in a regulated dependent are such as to give significant influence and exposure to risk, but falling short of control, supervisors should normally use the same approach. The test of significant influence and exposure to risk can usually be expected to apply to participations of 20% or more (and on occasion between 10 and 20%), but under 50%.

31. Such participations below 50% may occasionally be treated as not conferring significant influence or exposure to risk, in particular if voting participation is under 20%, there is no right to board membership, large exposure or asset spread rules are met, and there is no co-ordination of business plans and development. Conversely, the test may exceptionally be met by participations in the range 10-20%.

32. Under accounting conventions, participations which confer effective control and/or meet company law definitions of subsidiaries are usually consolidated in full and minority interests shown separately from the group shareholders' funds. This is on the basis that if the subsidiary were disposed of, or funds corresponding to its assets transferred to the shareholders (usually through a dividend), the minority shareholders would receive their proportion of the proceeds. For prudential purposes, regulatory capital in excess of such a subsidiary's own regulatory capital requirements, and which can be regarded as in principle available to support risks in the parent company or in other entities in the group should a shortfall arise, can be recognised in a group-wide capital adequacy assessment, subject to the conditions set out in paragraphs 32-35. This treatment can be expected to apply to group participations in excess of 50%, including 100% participation.

33. A group-wide assessment of any participations covered by paragraphs 29-31 needs to determine whether an adequate distribution of capital exists within the group. This may lead supervisors to judge that although group-wide capital covers the risks of the group, its improper distribution may endanger regulated entities within the conglomerate; in other cases it may point to a shortfall in group-wide capital overall. Such an assessment should take into account restrictions (e.g. legal, tax, rights of other shareholding interests, restrictions which may be imposed by solo regulation of dependants, foreign exchange) on the transferability of excess regulatory capital (whether by the transfer of assets or by other means) in such dependants.

34. The requirement is not that such transfers should actually take place, but it should be ascertained that funds equivalent to any capital in excess of the capital requirement of a dependant and included in the group-wide capital assessment could legitimately be moved should the need arise. This test may lead supervisors in their group wide assessment of capital, to limit the inclusion of excess capital in such dependants to the funds which they judge to be available to the parent or other parts of the group, taking account of any restrictions of the kind identified in paragraph 32.

35. Supervisors should be aware that fully integrating non-wholly-owned subsidiaries may overstate the extent to which excess regulatory capital is available to the group as a whole, unless the assessment described in paragraphs 32-33 has been carried out, while this treatment of deficits may overstate the group's responsibility to inject capital.

36. Conversely, a pro rata attribution of any deficit may understate a parent's de facto responsibility to provide additional capital. Any solo deficits in dependants should therefore be attributed in full in the group capital assessment if it appears to the supervisor that the parent is likely to have to support the dependant without assistance from other external participants in the dependant. The larger the group participation in a dependant, the more likely such support will be required.

37. Regulatory capital in a dependant and the matching capital requirements should be calculated according to the rules applicable to the financial sector and jurisdiction in question. The supervisor of the parent should establish that any excess capital in the dependant and to be recognised in the parent or group balance sheet comprises capital elements acceptable under his own rules.

Total deduction

38. If it is not possible or practicable to make a prudent valuation of the capital in a regulated dependant, the value of the participation to the rest of the group should be set at zero, i.e. the book value of the investment should be fully deducted, unless circumstances (e.g. the existence of a guarantee from the parent to the dependant) suggests that an even more prudent treatment should be applied. This approach is likely to be appropriate if the regulatory competence of the dependant's jurisdiction is uncertain, and may also be appropriate where the local regulatory requirements and/or type of business undertaken is markedly different from those prevailing in the same sector in the parent/group jurisdiction.

Market risk

39. An emerging issue for supervisors is the treatment of market risk. In many cases, the existence of market risks in different parts of a group may lead supervisors to judge that full offset of positions is not appropriate, and that an aggregation or deductive approach may give the best group wide assessment of risks; in others a consolidation approach that fully offsets market risk may give a more accurate picture. This is an area where the appropriate guidance to supervisors is likely to evolve over the next few years.

Techniques

40. The Joint Forum has identified three techniques of capital measurement which are capable of yielding comparable and consistent assessments of the capital adequacy of financial conglomerates: the "building-block prudential approach", the risk-based aggregation method and risk-based deduction method. In addition the "total deduction" technique can also be of value, especially in addressing problems of double/multiple gearing. The particulars of these techniques are set out in annexes 1 and 2 to this principle.

Annex 1
Supervisory Measurement Techniques Relating to Heterogeneous Financial Conglomerates

Annex 2
Summary and Examples of Measurement Techniques