Supervisory Measurement Techniques Relating to Heterogeneous Financial Conglomerates

Use and Description of Techniques

The three techniques, described below, are recognised as useful alternative methodologies for assessing capital adequacy, and each technique, while analysing capital from different perspectives, should provide a similar conclusion regarding capital adequacy. Supervisors may wish to use those techniques that are best suited to the way readily accessible financial data on the conglomerate are structured. Moreover, supervisors may use those techniques best suited to identify or highlight the nature of the risks assumed by the financial conglomerate or that identify potential weaknesses relevant to the structure of a particular financial conglomerate. Another analytical technique, which is similar to those used to evaluate group-wide capital adequacy, is provided as a fall back treatment to address the problem of double gearing and is directed at the parent company only.

1. Building Block Prudential Approach The "building block" approach essentially compares the fully consolidated capital of the financial conglomerate to the sum of the regulatory capital requirements for each group member. The regulatory capital requirements are based on those required by each group member's supervisor or, in the case of unregulated entities, a comparable or notional capital proxy.

Specifically, the "building block" prudential approach takes as its starting point and basis the fully consolidated accounts of the financial conglomerate as a single economic unit. By definition, all intra-group on- and off-balance sheet accounts or exposures have been eliminated. For prudential purposes, the consolidated balance sheet and off-balance sheet commitments are split into four different blocks (or sectors) according to the supervisory regime of the individual firms involved: banks, insurance companies, securities firms, and unregulated firms. Then, the regulatory capital requirements for each regulated entity or sector are calculated (these requirements could be different from those applicable on a solo basis because of the elimination of intra-group exposures). Each member's capital level is compared to its individual capital requirement to identify any capital deficits. Those deficits should be evaluated in terms of the availability of freely transferable capital of other sectors as defined in the statement of principles. Finally, the regulatory capital requirements of each regulated entity and the proxy for the unregulated entity are added together and the total is compared with the aggregate amount of capital across the group. Such an approach can be complemented by a review of the distribution of risks and capital within the economic unit, that is, whether the apparent risks within the unit are covered by an adequate type and quantity of capital.

For financial conglomerates with a regulated parent company whose activities dominate the group (i.e. banking, securities or insurance), a variation of the building block approach, which provides the same result, may be more suitable. The modified building block approach deducts from the regulatory capital of the parent company the capital requirement for its regulated dependants in other financial sectors and the notional proxy of any unregulated dependants carrying out similar business. The resulting adjusted capital amount is then compared with the capital requirement for the parent's own activities, including any capital required for the activities of any of its dependants in the same financial sector.

2. Risk-Based Aggregation The risk-based aggregation approach is very similar to the building block approach but differs by tailoring its methodology to situations in which either fully consolidated financial statements are unavailable or intra-group exposures may not readily be netted out. This methodology is also helpful for situations in which the calculation of regulatory capital is more easily derived from unconsolidated statements and where the elimination of intra-group exposures may not be appropriate. Risk-based aggregation involves summing the solo capital requirements of the regulated group and capital norms or notional capital amounts of unregulated companies and comparing the result with group capital. As a simple example, in a group comprising a parent bank with insurance and securities dependants, the capital requirements of the parent bank are summed with the capital requirements of the insurance and securities dependants (as determined by their respective regulators). Capital adequacy is assessed by comparing the result with the group's regulatory capital.

In calculating group capital (or own funds), adjustments should be made to avoid double counting capital by deducting the amount of funds downstreamed or upstreamed from one entity to another. Therefore, where dependants are held at cost in the accounts of the parent company, the group's capital should be calculated by summing the capital of the parent and its dependants and then deducting from that aggregate capital amount the book value of the parent's participation in the dependants.

An alternative technique for calculating the group's regulatory capital is to identify the externally generated capital of the group. This technique is particularly useful in the following situations: when dependants are not held at cost; when it is difficult to determine the amount of capital downstreamed from the parent; or when other intercompany transactions add complexity. The externally generated capital of the group is found by adding the externally generated regulatory capital of the parent to that of its dependants. Externally generated capital refers to regulatory capital not obtained elsewhere in the group including equity supplied by minorities, qualifying third party debt finance, retained profits arising from transactions with third parties, or other qualifying capital that is not reflected in the parent's own capital.

For externally generated capital to "belong" to the group it should be, in principle, payable to the group on the winding up or sale of the dependant. However, it may be judged that funds equivalent to such capital could readily be transferred to other parts of the group not withstanding any restrictions that might apply on the winding up or sale of the dependant.

A more prudent form of risk-based aggregation involves aggregating the greater of either the regulatory capital requirement/notional capital proxy or the investment of the group in each dependant. The aggregate figure of the dependants is then added to the regulatory capital requirement of the parent company itself to produce the overall group capital requirement. This requirement is then compared with the externally generated capital of the group (as described above).

3. Risk-Based Deduction Method The risk-based deduction method is very similar to the risk-based aggregation method but focuses on the amount and transferability of capital available to the parent or elsewhere in the group. Essentially, this approach takes the balance sheet of each company within the group and looks through to the net assets of each related company, making use of unconsolidated regulatory data.

Under this method, the book value of each participation in a dependant company is replaced in the participating company's balance sheet by the difference between the relevant share of the dependant's capital surplus or deficit. Any holdings of the dependant company in other group companies are also treated in a similar manner. However, any reciprocal interest, whether direct or indirect, of a dependant company in a participating company is assumed to have zero value and is therefore to be eliminated from the calculation.

Since the method focuses on the amount of surplus that is available for transfer to cover risks situated in other parts of the group, this approach is predicated on the use of pro-rata consolidation of non-wholly-owned dependants. At the discretion of supervisors, further scrutiny of surplus transferability may be achieved by adjusting these surpluses to exclude any capital not attributable to the parent due to withholding or other tax payable on the transfer of resources and reserves or other items that would not be transferable as capital among group members.

4. Fallback treatment for double gearing Each of the three techniques for evaluating group-wide capital adequacy of the financial conglomerate explicitly take into account adverse effects of double gearing by examining capital adequacy of the parent and each of its dependants on a solo and group-wide basis. For supervisors that wish to quickly evaluate the extent to which double gearing may have compromised the capital adequacy of the parent company, there is a simple methodology that may be employed, referred to as the total deduction method.

The total deduction method is based on the full deduction of the book value of all investments made by the parent in dependants. Some supervisors may also wish to deduct any capital shortfalls in those dependants (as indicated by the capital standards of their solo supervisors) from the parent's own capital. In other words, under this technique the supervisor attributes a zero value, or in some cases a negative value, to the parent's investments. The parent's adjusted capital level is then compared with the parent's solo regulatory capital requirement, assuming that the parent is a regulated entity.

The total deduction method implicitly assumes that no regulatory capital surpluses within dependants of the group would be available to support the parent's capital or debt service and that there is no regulatory capital deficit. Again, this procedure is designed to evaluate the extent that double gearing might impair the capital adequacy of the parent organisation and is not designed to evaluate the group-wide capital adequacy of the financial conglomerate.