Submission to the Financial System Inquiry Appendix E: Oversight of Financial Conglomerates – International Developments

The Tripartite Group

165. Internationally, supervisors have been investigating issues raised by the emergence of financial conglomerates. In July 1995, a report entitled ‘The Supervision of Financial Conglomerates’ was produced by a Tripartite Group of banking, insurance and securities supervisors drawn from the main international groups of supervisors but acting in an informal capacity. The report identified a number of problems which financial conglomerates pose for supervisors, and discussed ways in which these problems might be overcome. Although not formally endorsed by the Basle Committee on Banking Supervision, the International Organisation of Securities Commissions or the International Association of Insurance Supervisors, the report has been seen as the basis for further collaborative efforts in the area. The key issues which it identified, and responses suggested, are outlined below.

Access to information/co-ordination of regulation

166. The recommendations of the Tripartite Group were based on the premise that, while the supervision of individual entities in a conglomerate continues to be of primary importance, it needs to be complemented by a prudential assessment from a group-wide perspective. A necessary implication of this finding is the need for close co-operation between supervisors – including the right to exchange otherwise confidential information. The Tripartite Group advocated the use of a lead regulator (or convenor) – most likely, the supervisor of the dominant operational business entity in a group – to facilitate the performance of these activities for each conglomerate. Some tasks identified for the lead regulator include making an assessment of group capital adequacy, informing supervisors of constituent entities about developments affecting the viability of the group, and co-ordinating combined regulatory action. It is not intended that the existence of the lead regulator interfere with the powers and responsibilities of the solo supervisor.

Capital adequacy

167. Banks, insurance companies and securities firms face different risks and are, therefore, subject to different prudential requirements. Consequently, supervisors face a fundamental problem in determining whether there is adequate capital coverage in a financial conglomerate. The attention paid to the capital adequacy issue reflects supervisory concerns about ‘excessive’ or ‘double’ gearing. It is possible for all entities in a group to fulfil their capital requirements on an individual basis, but for the own funds of a group as a whole to be less than the sum of those requirements. Such a situation occurs where the same own funds are used as a buffer more than once – for example, to cover the capital requirements of the parent as well as the subsidiary; this can lead to the under-capitalisation of a group. The Tripartite Group discussed this issue in some depth and concluded that the desired group-wide perspective could be achieved either by adopting a type of consolidated supervision, or by a ‘solo-plus’ approach.
168. Consolidated supervision focuses on the parent or holding company, although individual entities may (and the Group advocates that they should) continue to be supervised on a solo basis according to the capital requirements of the respective regulators. In order to determine whether the group has adequate capital, the assets and liabilities of individual companies are consolidated, capital requirements are applied to the consolidated entity at the parent company level, and the result is compared with the parent's (or group's) capital. Under ‘solo-plus’ supervision, individual entities are supervised on a solo basis according to the capital requirements of their respective regulators but this supervision is complemented by a qualitative assessment of the group as a whole and, usually, by a quantitative group-wide assessment of the adequacy of capital.
169. The Group recognised several techniques by which capital adequacy can be assessed. It concluded, however, that some of these techniques (including consolidation) were suitable only for homogenous groups – that is, groups only consisting of banks or securities firms. In heterogenous groups (those including insurers, banks and securities firms), 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, mean that alternative techniques of assessing capital adequacy have to be employed. Notwithstanding this judgment, the Group stated that a range of techniques could provide an adequate insight into group-wide capital adequacy. It suggested that these techniques might form the basis of a set of minimum ground rules and that some form of mutual recognition of their acceptability by regulators would be desirable.

Contagion

170. Contagion was recognised as one of the most important issues facing supervisors in relation to conglomerates. This problem manifests itself in two forms: psychological contagion – where problems in one part of a group are transferred to other parts by market reluctance to deal with a tainted group; and contagion resulting from the existence of extensive intra-group exposures. The Tripartite Group concluded that, while it is difficult for supervisors to guard against the former, the risk of the latter can be contained by regular liaison between group supervisors on the existence and nature of such exposures. It also advocated that supervisors be given powers to limit or prohibit imprudently large exposures.

Large exposures at group level

171. A combination of large exposures to the same counterparty in different parts of a conglomerate can be dangerous to the group as a whole. While the Tripartite Group acknowledged that differences between the large exposure rules pertaining in the banking, securities and insurance sectors provide scope for regulatory arbitrage, it was accepted that these differences are unlikely to be eliminated in the near future. The Group proposed that the lead regulator concept be used as the way forward. The lead regulator would be provided with information to enable it to assess large group-wide exposures to individual counterparties. Armed with such information, the lead regulator may then be able to identify ‘trigger points’ of concern which, when reached, would prompt discussion on a case-by-case basis between the supervisors involved.

Fit and proper tests for managers

172. While most supervisors already have the power to check the fitness and propriety of the managers of the firms for which they are responsible, the rise of financial conglomerates means that it is possible that decision-making processes will be shifted away from individually-regulated entities to the parent or holding company level of the structure, enabling managers of other (perhaps unregulated) companies in the group to exercise control over the regulated entity. In order to deal with this problem, the Group recommended that solo fit and proper tests should extend upstream to managers able to exert a material influence on the regulated entity.

Structure

173. The way in which a conglomerate is structured is crucial to effective supervision. The Group counselled that supervisors need powers, at both the authorisation stage and on a continuing basis, to obtain adequate information regarding managerial and legal structures, and, if necessary, to prohibit structures which impair adequate supervision. Where supervision is impaired, supervisors should be able to insist that conglomerates organise themselves in a way that makes adequate supervision possible.

Suitability of shareholders

174. The Group was of the view that shareholders who have a stake in a financial conglomerate (enabling them to exert material influence on a regulated firm within it) should meet certain standards, and that supervisors should endeavour to ensure that this is the case by applying an appropriate test, both at the authorisation stage and on a continuing basis. Responsibility for applying such a test clearly rests with the supervisors of individually-regulated entities, but the Group advocated close co-operation between supervisors and the sharing of information on shareholders in this respect.

Joint Forum on Financial Conglomerates

175. The work of the Tripartite Group is being carried forward by a new body, the Joint Forum (JF). Unlike its predecessor, the JF is officially sanctioned by the Basle Committee, IOSCO and the IAIS. It has a mandate to draw up proposals for improving co-operation and the exchange of information between bank, securities and insurance supervisors, and to work towards developing principles for the future supervision of financial conglomerates. The JF is made up of nine members each from the Basle Committee, IOSCO and the IAIS. It is chaired by Mr Tom de Swaan, Executive Director of the Netherlands' central bank, who was also chairman of the Tripartite Group. Australia is represented by the ISC and the ASC.
176. A focus of the work of the JF has been an examination of the concept of lead regulation, with discussion centred on two broad areas: the method of selection and the responsibilities of the lead regulator. While there is support for making the supervisor of the dominant entity in the group the lead regulator, supervisors are keen to develop a formula that permits flexible application. In recognition of concerns about national sovereignty members have agreed that international lead regulatory arrangements will not be reflected in domestic law. The JF does not envisage lead regulators acting as supra-national enforcement agencies.
177. The JF is supporting a system of asymmetrical information flows. Information flows upstream should be at the lead regulator's discretion; the lead regulator would probably request regular reports from solo supervisors in order to obtain a group-wide perspective. Information flows downstream would be less frequent in most cases in order to avoid information overload and the possibility that solo supervisors could become excessively reliant on the lead regulator. The JF's advocacy of the concept is based on the idea that the framework will promote mutual trust and co-operation of regulators.
178. The JF has undertaken some work looking at the mechanism for establishing a lead regulator framework. It has ruled out the viability of a fixed multilateral memorandum of understanding model. Instead, work has begun on a set of principles for bilateral memoranda of understanding which can accommodate inter-country variations. The JF is also examining the question of the adequacy of group capital. No consensus has yet emerged; however, the JF has agreed to establish a working group of its members to develop the Tripartite Group's findings and codify a set of principles. This group's objective will be to focus on techniques and principles of assessing capital adequacy. A particular concern will be the identification and prevention of double gearing.
179. As part of its efforts to identify gaps and overlaps in, and legal impediments to, effective supervision of financial conglomerates, and more broadly to understand better how these groups ‘tick’, the JF has established a Task Force to co-ordinate a ‘mapping’ exercise, extending some initial work undertaken jointly by US and UK supervisors on banking and securites firms. The proposed work involves the collection of extensive details for a selection of conglomerates from member countries on their corporate structures, operations, management structure/approach, and the supervisory and regulatory requirements they face. The Chairman has not indicated when he expects the work of the JF to conclude; however, there seems some interest in reporting an outcome to the mid-1997 summit of the G7 Finance Ministers.