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The Supervision of Financial Conglomerates, July 1995

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The Supervision of Financial Conglomerates, July 1995 THE SUPERVISION OF FINANCIAL CONGLOMERATES A REPORT BY THE TRIPARTITE GROUP OF BANK, SECURITIES AND INSURANCE REGULATORS July 1995 PREFACE At the initiative of the Basle Committee on Banking Supervision (the Basle Committee), a Tripartite Group of bank, securities, and insurance regulators, acting in a personal capacity but drawing on their experience of supervising different types of financial institution, was formed in early 1993 to address a range of issues relating to the supervision of financial conglomerates. Some of these issues had been explored by regulators within their own industries but not hitherto from a cross-industry perspective. The purpose of the ensuing report, which is now being published as a discussion document, is to identify problems which financial conglomerates pose for supervisors and to consider ways in which these problems might be overcome. The term "financial conglomerate" is used in the report to refer to "any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)". Although it is recognised that supervisory problems also arise in the case of "mixed conglomerates" offering not only financial services but also non- financial or commercial services, financial conglomerates are the primary focus of the report. As the deregulation of domestic financial markets has progressed over the past decade in tandem with the growing internationalisation of markets, a notable development has been the emergence of corporate groups which provide a wide range of financial services, normally incorporating insurance and securities activities as well as traditional banking facilities. Such entities are increasingly becoming reality not only in the major financial centres but in many emerging markets too, and, moreover, many of them operate across a wide range of countries. The regulatory authorities have for several years recognised that the supervision of these entities poses particular problems and studies have been conducted by the bank, securities and insurance regulators to explore the issues from their own perspectives. The present report represents the first time the issues have been addressed by three sets of supervisors, working together. The results of the work, which are summarised in an accompanying executive summary, show that considerable progress has been made in identifying broad areas of agreement between supervisors in the three disciplines. The report sets out a number of recommendations as to ways in which the supervision of financial conglomerates could be improved. The three main areas to which the report suggests that supervisors' attention needs to be drawn are the following. First, in relation to capital adequacy (paragraphs 7 to 15 of the executive summary), the Tripartite Group has concluded that a desired group-wide perspective could be achieved either by adopting a consolidated type of supervision, as traditionally used by bank supervisors, or by a "solo-plus" approach, where the supervision of individual entities is - ii - complemented by a general qualitative assessment of the group as a whole, and, usually, by a quantitative group-wide assessment of the adequacy of capital. The qualitative approach would use information about the group companies to make a judgement about the risks which group companies pose for regulated entities and as a source for early warnings about problems elsewhere in the group. The appropriateness of consolidation or the "solo-plus" approach in a quantitative assessment may vary with the nature of the conglomerate. The report concludes that three techniques - the "building-block prudential approach" (which takes as its basis the consolidated accounts at the level of the parent company), a simple form of risk-based aggregation and risk- based deduction - are all capable of providing an accurate insight into the risks and capital coverage. A fourth possible technique, "total deduction", was also explored. The second principal area of attention concerns the need for intensive cooperation between supervisors responsible for different entities within a conglomerate and the necessary exchange of prudential information between them (paragraph 22 of the executive summary). There is general support for the idea of appointing a lead supervisor or "convenor", who would be responsible for gathering such information as the individual supervisors require in order to have a perspective on the risks assumed by the group as a whole (including information on non-regulated entities). To this end, the report suggests it might be helpful to draw up Memoranda of Understanding or Protocols between the relevant supervisors. The third principal issue concerns group structures (paragraph 20 of the executive summary). Experience has shown that supervision can be impeded by complex structures and the report expresses the Group's view that supervisors need powers to obtain adequate information regarding managerial and legal structure and, if necessary, to prohibit structures which impair adequate supervision. Other issues which the report addresses include: contagion, in particular the effect of intra-group exposures (paragraphs 16-17 of the executive summary); large exposures at group level (paragraph 18); problems in applying a suitability test to shareholders and fit and proper tests to managers (paragraphs 19 and 21); rights of access to information about non-regulated entities within a conglomerate; supervisory arbitrage; and particular problems posed by mixed conglomerates engaged in both financial and non-financial activities (paragraphs 23-24). * * * * * * This report was sent to the Basle Committee, the Technical Committee of the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) earlier this year. These three groups welcome the report as a valuable analysis of the issues and potential solutions to a supervisory challenge that is becoming increasingly relevant as financial markets become more integrated in the wake of progressive deregulation. Accordingly, it has been agreed that the report should be made available to supervisory colleagues in other countries, financial industry participants and the general public. - iii - While the contents of the report have not been endorsed by the three groups, the three groups consider the report as a sound basis for further collaborative efforts. In order to take work forward in what each regards as an important area, the Basle Committee, IOSCO and the IAIS have agreed to the establishment of a joint forum to develop practical working arrangements between the different supervisors of financial conglomerates for consideration by the three groups and their individual member authorities. The new group will be expected to propose improvements in cooperation and information exchanges between supervisors, and work towards developing the principles on which the future supervision of financial conglomerates would be based. The group will consist of a limited number of nominees from each of the three supervisory disciplines and will work under the present Chairmanship of the Tripartite Group, Mr. Tom de Swaan, Executive Director of de Nederlandsche Bank N.V. CONTENTS Page No. Executive summary 1 I. Introduction 10 II. Description of financial conglomerates and their structures 13 (i) Definition 13 (ii) Structure 14 III. Supervisory issues 16 (i) Overall approach to supervision 16 (ii) Assessment of capital adequacy 16 (iii) Contagion 18 (iv) Intra-group exposures 20 (v) Large exposures at group level 23 (vi) Conflicts of interest 27 (vii) Fit and proper tests for managers 27 (viii) Transparency of legal and managerial structure 28 (ix) Management autonomy 30 (x) Suitability of shareholders 30 (xi) Rights of access to prudential information 31 (xii) Supervisory arbitrage 35 (xiii) Moral hazard 36 (xiv) Mixed conglomerates 36 IV. Capital adequacy 39 (i) Different approaches to the assessment of capital adequacy in financial conglomerates 39 (ii) Participations of less than 100%: availability of capital surpluses in partly-owned subsidiaries 48 (iii) Capital adequacy at group level: suitability of excess capital for use in subsidiary entities 56 (iv) Unregulated holding companies/unregulated dependants 58 (v) Regulatory intervention issues 63 V. Conclusion 65 Appendix I List of Tripartite Group Members 67 Appendix II Analysis of responses from members of the Tripartite Group 69 to a questionnaire on the supervision of financial conglomerates Appendix III Capital adequacy: worked examples 100 Appendix IV The "one-to-one rule" in the Netherlands 114 Executive Summary Introduction 1. The deregulation of domestic financial markets over the past decade together with the internationalisation of financial markets has led to new ways and means of doing business in the highly competitive, integrated world economy of the 1980s and 1990s. One notable development has been the emergence of financial conglomerates, often with significantly large balance sheets (and off-balance-sheet positions), providing a wide range of financial services in a variety of geographic locations. 2. Over the past several years, a number of supervisory and regulatory groups within the international financial community have sought to explore the ways in which some of their concerns relating to the supervision of financial conglomerates could be addressed. Those
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