Regulatory Consolidation & Consolidated Supervision

1. Regulatory Consolidation & Consolidated Supervision Regulatory approach, Examples and Case Studies using Germany and UK as points of comparison

2. Sections: 1.Principles of Consolidated Supervision Section 1 Section 2 Section 3 2. Case Study A Section 4 3. Case Study B 4.Flexing Case Study B Annexes: I. Applying Consolidation Techniques II. BIS Core Principles

3. Section 1: Principles of Consolidated Supervision Section 1 Section 2 I. Principles of Consolidated Supervision II. Applying the Principles of Consolidation in Germany and the UK III. Other Elements of Quantitative Consolidated Supervision: Large Exposures and Limits on Investments IV. Going Beyond Simple Consolidation - the Use of Flanking Policies and Qualitative Consolidated Supervision Section 3 Section 4

4. THE PRINCIPLES OF CONSOLIDATED SUPERVISION The Rationale for Consolidated Supervision What is Consolidated Supervision? International Standards - BIS Core Principles International Standards - Basic Legal Principles for the EU Solo and Consolidated Supervision Quantitative Consolidated Supervision Powers of Supervisors Steps in Quantitative Consolidated Supervision Step 1: Determining the Domain of Consolidation Step 2: Identifying the Companies to be Consolidated Financial Institutions Exceptions to Consolidation Groups subject to Consolidated Supervision Elsewhere Step 3: Techniques of Consolidation Different approaches for Capital Adequacy and Large Exposures 8 9 10 12 13 14 17 18 19 20 21 22 23 24 26 Contents

5. APPLYING THE PRINCIPLES OF CONSOLIDATION IN GERMANY AND THE UK Main participation levels for consolidation Consolidation rules in Germany Consolidation rules in the UK Relevant Consolidation Rules in Germany Relevant Consolidation Rules in the UK Consolidation when banks have a Trading Book Dealing with Cross Shareholdings Consolidation of Participations - Germany Consolidation of Participations - UK General Example - Germany General Example UK Calculating Prudential Ratios Prudential Ratios for CAD in Germany Structure of Reporting Forms for CAD reports in Germany Prudential Ratios for CAD in UK Structure of Reporting Forms for CAD reports in UK Quantitative Consolidated Supervision in the UK 28 29 30 31 32 33 35 37 39 41 42 44 45 46 47 48 49 Contents

6. OTHER ELEMENTS OF QUANTITATIVE CONSOLIDATED SUPERVISION: LARGE EXPOSURES & LIMITS ON INVESTMENTS Large Exposures Ratios Large Exposures Ratios - soft limits in the Trading Book Investments in Non-Financial Institutions GOING BEYOND SIMPLE CONSOLIDATION - THE USE OF FLANKING POLICIES AND QUALITATIVE CONSOLIDATED SUPERVISION Flanking Policies for Consolidated Supervision Fitness and Properness Notification of Shareholders and Controllers Controls on Structures and Links Controls on Lending to Connected Parties Limits on Non-Financial Shareholdings Qualitative Consolidated Supervision (UK Practice) 51 53 54 55 56 57 58 60 61 62 63 64 Contents

7. Section 1: Principles of Consolidated Supervision Section 1 Section 2 I. Principles of Consolidated Supervision Section 3 Section 4

8. Principles of Consolidated Supervision Why Consolidated Supervision? Consolidated supervision is desirable because there are risks to a bank, which may pose a threat to it, arising as a result of its membership of a wider group. These risks include: · the risk that risks taken by other group companies might undermine the group as a whole; · the financial risks taken on by a bank in its links with other group companies, such as intra-group lending; and · the reputational risk to a bank if there are losses or other problems elsewhere in the group. Reputational risk is of particular concern to supervisors. It also means that even if a bank were entirely ring-fenced from the rest of its group and had no intra-group lending, problems elsewhere in the group might pose a risk to the bank. But the focus of banking supervision (solo and consolidated) remains the bank itself. The banking supervisor’s purpose in consolidated supervision is not to supervise all the companies in a group including a bank, but to supervise the bank as part of its group. The supervisor takes account of the activities of other group companies to the extent that they may have a material bearing on the reputation or financial soundness of the bank in the group. In short, supervisors are looking to spot and to prevent channels of contagion.

9. Principles of Consolidated Supervision What is Consolidated Supervision? Consolidated supervision is an overall evaluation - both quantitative and in some countries qualitative - of the strength of a group to which a bank belongs, to assess the potential impact of other group companies on the bank. The assessment is based on a number of sources of information. One source is consolidated financialreturns - quantitative consolidated supervision. This is mandatory under EU law. It is also one of the key recommendations of the Basel Committee on Banking Supervision. Consolidated supervision in the UK also includes a qualitative assessment of the whole group - including the activities of group companies not incorporated in the consolidated returns, because the nature of their assets is such that their inclusion would not be meaningful (for example industrial or insurance companies). This assessment includes, for example, consideration of the controls within a group. The additional consolidated supervision beyond the quantitative assessment is known generally as qualitative consolidated supervision.

10. Principles of Consolidated Supervision • International Standards - BIS Core Principles • Consolidated Supervision is an important element of the 1997 BIS Core Principles for Effective Banking Supervision (see Annex II). The most relevant of these principles are Principles 18 and 20: • Principle 18: “Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and statistical returns from banks on a solo and consolidated basis.” • Principle 20: “An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.” • It is an essential element of international banking supervisory standards that supervisors should supervise the consolidated banking organisation. This includes the ability to review both banking and non-banking activities conducted by the banking organisation, either directly or indirectly (through subsidiaries and affiliates), and activities conducted at both domestic and foreign offices. Supervisors need to take into account that non-financial activities of a bank or group may pose risks to the bank. Supervisors should be aware of the overall structure of the banking organisation or group when applying their supervisory methods. Banking supervisors should also co-ordinate with other authorities responsible for supervising specific entities within the organisation's structure.

11. Principles of Consolidated Supervision • International Standards - BIS Core Principles (Contd.) • Other BIS Core Principles are also relevant, especially for the flanking policies that accompany supervision on a consolidated basis. The following are particularly relevant: • Principle 3: “The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation's ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained.” • Principle 4:” Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties.” • Principle 5: “Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.” • Principle 10: “In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm's-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks.”

12. Principles of Consolidated Supervision International Standards - Basic Legal Principles for EU The Banking Consolidation Directive, Directive 2000/12/EC (formerly the Second Consolidated Supervision Directive - 92/30/EEC) sets minimum standards for the performance of consolidated supervision of groups including banks throughout the EEA (i.e. EU plus Norway, Iceland and Liechtenstein). It also sets out requirements in respect of capital requirements to be held against large exposures and concentration risks (formerly Directive 92/121/EEC). The Capital Adequacy Directive (CAD - 93/6/EEC) - building on the Own Funds (89/299/EEC) and Solvency Ratio (89/647/EEC) Directives which established basic capital requirements in terms of credit risk - introduced both a framework for capital requirements for market risk and a requirement for a consolidated assessment of groups including investment firms. The obligations in these directives require consolidation only up to the highest relevant parent incorporated in the EEA, and not to parents outside the EEA. It is open, however, to supervisors to go further than the minimum requirements. Note: the extension of consolidation and consolidated supervision does not mean that the parent or non bank members of the group are directly supervised. Only the bank is directly supervised. The interest of banking supervisors in the parent is limited to the risks - financial and non-financial - run by the parent and other members of the group, and the extent that these may expose the bank and its depositors to risk of loss. It may be important to consolidate other parts of the group, in order to have all the relevant risks included, and this is the crucial test. Supervisors will extend consolidated supervision beyond the requirements of the directives if the result is a more accurate assessment of risk to a bank.

13. Principles of Consolidated Supervision Solo and Consolidated Supervision Consolidated supervision is not a panacea. It does not cure everything. Consolidated supervision is generally regarded by supervisors as a complement to, not a substitute for, solo supervision. Solo supervision is needed as well, and the importance of it is also stressed in international standards. For events elsewhere in the group and the activities of other group companies can pose a threat to the bank in ways which consolidated supervision alone cannot detect: for example, intra-group linkages arising from transactions between the bank and other group companies will only be revealed by solo supervision. A complementary assessment of solo capital adequacy and large exposures also permits a supervisory assessment of whether there is an appropriate distribution of capital in a group. Institutions are therefore required to meet capital adequacy and large exposure obligations on both a solo and a consolidated basis. The latest consultation paper from the Basel Committee on the reform of the Capital Accord has underscored the importance of solo supervision and ensuring that there is an adequate distribution of capital around the group. Supervision on a consolidated basis is also supported by a number of flanking policies. These are discussed later in this Section.

14. Principles of Consolidated Supervision • Quantitative Consolidated Supervision • Capital adequacy • A bank is required to maintain adequate capital at all times. A bank is set a consolidated capital requirement in addition to that set on a solo basis. Generally, the same principles are used for calculating the consolidated ratios as the solo ratios. • The required capital ratio set on a consolidated basis is normally the same as that set on a solo basis for the principal bank in the group, although UK practice is somewhat different from German practice. • Where a bank fails to meet its consolidated capital ratio, supervisors considers whether this poses a threat to the bank. If they consider that the situation involves a threat to the bank and to depositors they will take action. • If the bank is the parent company of the group, they will consider whether the bank is being run prudently. • If the bank is not the parent company of the group, supervisors consider what action is needed to protect the bank. It may • also consider whether the bank continues to be run prudently. • The action needed may be, for example, to pursue the controller of the group for a rectification of the capital position, • to require better liquidity or to restrict lending to other group companies.

15. Principles of Consolidated Supervision Quantitative Consolidated Supervision (Cont..) Large exposures A bank must meet the limit and notification requirements in respect of large exposures to individual counterparties or groups of closely related counterparties on a consolidated basis. As with capital, generally, the same principles are used for calculating the consolidated requirements as the solo requirements. Adequate controls A bank must have adequate internal control mechanisms to produce any data and information which might be relevant for the purpose of supervision on a consolidated basis. Reporting obligations on banks A bank is required to submit consolidated returns covering capital adequacy at least twice a year and large exposures at least four times a year.

16. Principles of Consolidated Supervision Quantitative Consolidated Supervision - Minimum Standards Capital adequacy Large exposures Major shareholdings 8% Capital Ratio calculated in BIS basis • Limit of 25% of capital on exposures to a counterparty or a group of connected counterparties • Limit of 800% on exposures in excess of 10% of capital • Post-notification of such exposures to regulators. • Holdings of 10% or more of a non-financial company that exceed 15% of bank capital: excess deducted. • Where total of such holdings exceeds 60% of bank capital: excess deducted.

17. Principles of Consolidated Supervision • Powers of Supervisors • In order to be able to discharge their supervisory responsibilities, supervisors need adequate powers. Powers to require the production of information are especially relevant. Supervisory powers are not explicitly co-ordinated at EU level, and there is some variation in what supervisors can do reflecting local history and culture. • In general supervisors must be able to require the following sorts of information: • Notification of directorate, key managers and significant shareholders • Prior notification of changes to the above • Prior notification by prospective shareholder (not the bank) of intention to acquire significant holding in bank • Reports of financial information, including large exposures • In addition, supervisors need powers to require banks - or persons who might have information relevant to the supervision of authorised banks - to provide any information which might reasonably be required for the performance of their supervisory duties. These powers should explicitly extend to: • Parent companies • Sister companies • Subsidiary companies • Related companies • Major shareholders

18. Principles of Consolidated Supervision Steps in Quantitative Consolidated Supervision There are six steps in consolidated supervision: 1. Identify the domain of consolidation. This involves mapping the group structure, the types of business done and determining how and to what extent control is exercised. 2. Determine the companies to be consolidated. This involves identifying the perimeter of regulatory concern and the limits of the regulatory consolidation (as opposed to the accounting consolidation). 3. Identify the consolidation technique to be used. This involves an assessment of the extent to which the affairs of the company being consolidated might impact on the bank. 4. Calculate the capital base 5. Bring in the risk assets 6. Calculate the prudential ratio Steps 1-3 can involve considerable complexity and difficult judgements. These issues are discussed on the following pages, followed by illustration of how they are applied in Germany and the UK. Steps 4 and 5 are arithmetical consequences of the decisions taken in steps 1-3. They are illustrated in the Annex, and also discussed in relation to German and UK practice in Sections 2, 3 and 4 of this report. Step 6, the calculation of prudential ratios is referred to in this section by way of illustrating German and UK practice.

19. Principles of Consolidated Supervision Step 1: Determining group structure (i.e. the domain of consolidation within a group including a bank) Consolidation is required in the following cases: (a) when the bank is itself the parent of companies which are financial institutions; and (b) when the bank is not the parent company, but: (i) the bank is part of a group or sub-group that are wholly or mainly financialinstitutions; and (ii) the parent of the group or sub-group is itself a financial institution. To qualify as a financial institution, the exclusive or main businessof a company must be either to carry out one or more financial activities (see below) or to acquire holdings in companies undertaking these activities. ‘Mainly’ and ‘main business’ means the balance of business. Consolidation is generally required when companies carrying out financial activities comprise over 50% of the group or sub-group balance sheet. In determining the balance of business, the off balance sheet activities of group companies, and fee-based services provided by group companies are taken into account. Where the balance of business test is inconclusive, the number of subsidiaries which fall into the financial and non-financial categories is looked at. As a general rule, the presumption will be in favour of consolidation. Group consolidation must at a minimum extend up to the highest relevant EEA parent, except where another EEA supervisor performs consolidated supervision. In addition to consolidating a whole group, the UK may also consolidate a sub-group from a bank down, depending on the scale and complexity of business of the sub-group. This is not generally the practice in Germany. The new BIS proposals may lead to greater emphasis being placed on sub-group consolidation.

20. Principles of Consolidated Supervision Step 2: Scope of consolidation: Companies to be consolidated Regulatory consolidation is not the same as accounting consolidation, although accounting consolidation is the starting point for regulators and many concepts are shared. Having determined the domain of consolidation, the supervisor then determines which companies within that domain need to be consolidated. Consolidation extends to all relevant financial companies within that domain: that is the parent company; its subsidiaries and companies in which the parent or its subsidiaries have a participation. The definitions used of parentand subsidiaryare those contained in the Seventh Company Law Directive (83/349/EEC). The notion of subsidiaryis also normally extended to cover a company over which the parent or one of its subsidiaries exercises dominant influence. The criteria used to determine whether dominant influence exists are those provided by accounting standards. The threshold for the consolidation of group companies which are not subsidiaries - participations- is the ownership of 20% or more of the voting rights or capital. Companies whose business is not financial are not usually included in the consolidation. Insurance and the broking of insurance are not financial activities for this purpose, and so these companies are not included in a consolidation. Where a non-financial company is excluded from consolidation the investment in that company is deducted from consolidated capital and its assets are not included in group weighted risk assets. The method of valuation used for the investment should be the normal accounting practice followed by the bank.

21. Principles of Consolidated Supervision Step 2: Scope of consolidation - What are Financial Institutions? Companies undertaking one or more of these activities are classified as financial institutions for the purposes of consolidated supervision: (a) Ancillary banking services (defined as ‘ an undertaking the principal activity which consists in owning and managing property, managing data processing services, or any other similar activity which is ancillary to the principal activity of one or more credit institutions’ ). (b) Lending (including, consumer credit, mortgage credit, factoring with or without recourse, financing of commercial transactions (including forfaiting)). (c) Financial leasing. (d) Money transmission services. (e) Issuing and administering means of payment (e.g. credit cards, travellers' cheques and bankers' drafts). (f) Guarantees and commitments. (g) Trading for own account or account of customers in: · money market instruments (cheques, bills, CDs etc.); · foreign exchange; · financial futures and options; · exchange and interest rate instruments; · transferable securities. (h) Participation in securities issues and the provision of services relating to such issues. (i) Advice to undertakings on capital structure, industrial strategy and related questions and advice and services relating to mergers and the purchase of undertakings. (j) Money broking. (k) Portfolio management and advice. This category includes fund management companies. (l) Safekeeping and administration of securities. The following activities are not covered by the above list: insurance; insurance broking; estate agency.

22. Principles of Consolidated Supervision Step 2: Scope of Consolidation - Exceptions to Consolidation As provided for by article 3.3 of the 2CSD (now replaced by article 52.3 of The Banking Consolidation Directive), in a limited number of cases the supervisors may permit the exclusion from a bank’s consolidated returns of subsidiaries or participations which otherwise meet the criteria for consolidation, where: · inclusion would be inappropriate or misleading; · the companies which otherwise would be consolidated have a combined balance sheet total lower than the lesser of Euro 10 million and 1% of the balance sheet total of the parent; or · there are legal impediments to the transfer of information. The de minimis exemption may only be made for a number of companies if the sum of their balance sheets meets the numerical test; otherwise they must all be included in consolidated reporting. This prevents the formation of a number of small companies being a way round the consolidation requirements. Use of the legal impediments criterion for exclusion other than on a temporary basis is likely to be inconsistent with the Basel minimum standards and the requirements of EU directives on the supervisability of group structures and has to be considered in this light. Where such an exclusion is agreed, the investment in that company is deducted from consolidated capital and its assets are not included in group weighted risk assets. The method of valuation used for the investment should be the normal accounting practice followed by the bank.

23. Principles of Consolidated Supervision Step 2: Scope of Consolidation - Groups supervised by other supervisors Limitations to rules where a bank is subject to consolidated supervision elsewhere Where a bank is a member of a group including a number of EEA-incorporated banks/credit institutions, EU supervisors may, at their discretion and following discussion with the other supervisor(s), agree to forgo consolidation. For a group including a bank whose parent is incorporated in a country outside the EEA, consolidation of the whole group is not normally required. This is the responsibility of their home authority. In determining the appropriate treatment in these cases, supervisors take into account whether the parent company is subject to consolidated supervision by another supervisor that adheres to Basel minimum standards for the supervision of international banking groups and their cross-border establishments. In those cases in which it determines that a whole-group consolidation would not be appropriate, EU supervisors nonetheless requires sub-consolidation from the highest relevant EEA parent down. Groups not subject to consolidation When a bank belongs to a group or sub-group for which supervisors determine consolidation would be inappropriate (for example in cases where the preponderance of the group's business comprises industrial or insurance business), supervisors may require the parent institution and its other subsidiaries to supply it with any data or information which it considers relevant to the purpose of supervising the bank. When the parent of a bank is an insurance company, banking supervisors do not normally require consolidation down from the insurance company, pending further harmonisation of the basis of accounting for banks and insurance companies. However, supervisors will seeks to co-operate and share information with the supervisors of the insurance company parent.

24. Principles of Consolidated Supervision Step 3: Techniques Of Consolidation Having determined the domain of consolidation, and having identified the companies to be consolidated within that domain, supervisors must then determine the consolidation technique to be used. Full Consolidation Full consolidationmeans including in the group’ s consolidated returns all the relevant assets and liabilities of the companies being consolidated. Line By Line Consolidation Line-by-line consolidationis a technique for achieving full consolidation. The consolidation of balance sheets according to conventional accounting rules (including the netting of balances between companies included in the consolidation). Pro Rata (or Proportional) Consolidation Pro rata consolidationmeans including in the group’ s consolidated returns only the group’ s share of assets and liabilities in the affiliate concerned. So for a company in which the group holds 25%, the capital adequacy returns would include 25% of that affiliate’s capital, 25% of its other liabilities and 25% of its assets, and the large exposures returns 25% of its exposures. Balances between companies included in the consolidation would be netted in full. Deduction The investment in the affiliate is deducted from capital base. The assets of the affiliate are not included in the calculation of weighted risk assets.

25. Principles of Consolidated Supervision Step 3: Techniques Of Consolidation (Contd..) Aggregation Plus Aggregation plusis a technique of consolidation introduced to help apply the market risk requirements of the EU Capital Adequacy Directive. The local supervisor’s capital rules are used to generate a capital requirement for the affiliate. This is aggregated with the capital requirements arising as a result of the group’s other business. The aggregate capital requirement is then compared with consolidated group capital. When a subsidiary is consolidated using aggregation plus based on the relevant local supervisor’s capital regime, all the deductions from capital made by the local regulator must be deducted from the consolidated capital base. So where, for example, the local supervisor applies a deduction in respect of illiquid assets, this deduction is reflected in the consolidated capital base. Aggregation plus has the advantage that there is only one capital calculation in respect of the affiliate for both solo and consolidated supervision. It is only permitted where the capital regimes are deemed to be broadly equivalent to the CAD. Because an affiliate’s capital requirements are computed on an individual company basis when using aggregation plus, intra-group exposures are not netted out and there is no allowance for the offsetting of positions between companies, when looking at the group position. The application of these techniques is illustrated in the Annex to this report.

26. Principles of Consolidated Supervision Types of Consolidation - and when to use them Capital Adequacy Having decided which group companies need to be consolidated, the correct technique for consolidation needs to be determined in each case. The precise technique to be used depends on the nature of the company to be consolidated, and the extent of the participation in the company being consolidated. While the principles of consolidation are very similar in Germany and the UK, practice differs slightly. These differences are explored below. Large Exposures For large exposures purposes, affiliates are always consolidated on a line-by-line basis (irrespective of whether the exposure is in the banking or trading books). The application of large exposure limits to counterparty exposures is based upon the sum of all the counterparty exposures to an individual entity or group.

27. Section 1: Principles of Consolidated Supervision Section 1 Section 2 I. Principles of Consolidated Supervision II. Applying the Principles of Consolidation in Germany and the UK Section 3 Section 4

28. Main participation levels for consolidation Applying the principles of consolidated supervision Parent Bank UK GERMANY Particip-ation No Consolidation No deduction from capital (unless financial institution) No Consolidation No deduction from capital <= 10% No consolidation, no deduction from capital (unless financial institution), but limits on total holdings Voluntary partial consolidation or deduction from capital Particip-ation 10 <= 20% Significant control: Mandatory partial consolidation No significant control: Voluntary partial consolidation or deduction from capital Associate Full consolidation/deduction. Pro-rata consolidation only if other partners are substantial. 20 <= 50% Subsid. Majority of votes: Full consolidation otherwise: partial consolidation or deduction > 50% Majority of votes: Full consolidation/deduction

29. Consolidation Rules in Germany Applying the principles of consolidated supervision Participations Participations under 10% in all companies are normally weighted as a risk asset. Participations of between 10 and 20% are either deducted from capital, or subject to voluntary pro-rata consolidation. Holdings in non-financial companies are also subject to to EU rules which penalise major holdings in non-financial companies. Associate companies (participation of between 20% and 50%) Participations between 20%-50% which give rise to substantial control are normally pro-rata consolidated. Where there is no significant control, the holding is either deducted from capital or is subject to voluntary pro-rata consolidation. Subsidiaries Where there is full control, the subsidiary is fully consolidated using the line-by-line technique. Where holding the majority of shares does not give full control, then the holding is subject either to pro-rata consolidation or to deduction.

30. Consolidation Rules in the UK Applying the principles of consolidated supervision Participations Participations under 20% in non financial companies are normally weighted as a risk asset (although subject to EU rules which penalise major holdings in such companies). Participations in banks and regulated financial institutions which are not consolidated are deducted from capital (see below). Associate companies (participation of between 20% and 50%) Participations between 20%-50% in non financial companies are normally deducted from capital. Full consolidation is normally required for financial institutions. Line by lineconsolidation is the normal technique, except where the company is subject to the prudential supervision of another regulator in the UK, EEA or CAD-equivalent territory when aggregation plus is used. Full and pro rata consolidation The normal technique of consolidation is full consolidation of all majority shareholdings and participations. The UK agrees to proportionate (‘pro rata’ ) consolidation of participations only in exceptional circumstances, where it is satisfied that there are other significant shareholders who have the means and the will to provide as much parental support to the entity as the shareholder subject to consolidated supervision. This is most likely to be another bank.

31.                     x x x x            x x     x x x x   x x x x   Relevant consolidation rules in Germany Applying the principles of consolidated supervision Mother- Bank Parent Bank Investment firm Financial institution Line by Line Deduction Ancillary Pro rata Bank Subs. Bank Particip-ation x x x < = 10% Subs. Bank Particip-ation 10 < = 20% No Control Subs. Bank Associate QMB 20 < = 50% SRM OSR Subs. Bank > 50% Subsid. QMB SRM

32. Bank or Regulated Financial Institution (CAD) Unregulated Financial Institution Non-financial Company Weight as risk asset Weight as risk asset Deduct Participation < 10% Deduct Weight as risk asset Weight as risk asset Participation < 20% Consolidate Aggregation Plus* Consolidate Line by Line* Deduct Associate 20% - 50% Consolidate Aggregation Plus Consolidate Line by Line Deduct Subsidiary > 50% Relevant Consolidation Rules in UK Applying the principles of consolidated supervision * Pro Rata consolidation may be used in specific circumstances

33. Consolidation When Banks Have A Trading Book Applying the principles of consolidated supervision For capital adequacy purposes, the primary distinction is between what is consolidated into the group banking book and what into the group trading book. Risks consolidated into the banking book Risks are consolidated into the banking book in the following cases; the technique used is always line-by-line consolidation: Banking books of other group banks Assets of financial companies other than investment firms Risks consolidated into the trading book Risks are consolidated into the trading book in the following cases; the technique used usually aggregation plus: Trading books of group banks (and foreign exchange and commodity exposures) Risks in group investment firms Consolidation of a trading book may be carried out on a line-by-line basis, if a bank can satisfy its supervisor that all the following conditions are met: (a) the parent bank has integrated monitoring of trading book positions across the entities using line-by-line consolidation; (b) the banking subsidiary or investment firm satisfies its local supervisory requirements on a solo basis; (c) the parent bank is able to carry out adequate line-by-line consolidation on a daily basis; and (d) capital resources are freely transferable between the banking subsidiary and the rest of the group. Only where line-by-line consolidation is used may banks offset long and short positions in different financial instruments in the calculation of consolidated capital requirements for market risk. Banks wishing to offset exposures must have prior approval.

34. Consolidation When Banks Have A Trading Book (Cont..) Applying the principles of consolidated supervision Use of the line by line option is rare. The conditions are often difficult to satisfy and, in the case of investment firms, the supervisor may take the view that the local securities regulator’s capital regime provides a better measure of capital than the banking regime. If, the relevant securities regulator’s regime provides a more accurate measure of the capital required by the subsidiary, aggregation plus will be used.

35. Bank I 40% 40% Bank II Bank III 40% 40% Bank IV Dealing with Cross- Shareholdings Applying the principles of consolidated supervision

36. Bank I 40% 40% Bank II Bank III 40% 40% Bank IV Dealing with Cross Shareholdings (Cont..) Applying the principles of consolidated supervision Cross shareholdings exist if several subsidiaries have participations in the same "other" subsidiary. From the perspective of the top-level consolidated unit (in this case Bank I), all indirect participations are added in order to decide upon the type of consolidation. In this case Bank I has indirect participation of 16% in Bank IV via Bank II and also 16% indirect participation via Bank III. As the total participation is 32% a pro rata consolidation would be necessary in Germany (assuming that the participations represent the extent of the control that the holder is able to exercise). If Bank I had 65% participation in each of Bank II and Bank III (with the participations of Bank II and Bank III in Bank IV unchanged) the resulting indirect participation of Bank I in Bank IV would be 52% (0,65 x 0,4 = 0,26 for both sides) requiring full consolidation in Germany. In UK, unless there were other independent and very substantial shareholders involved, this structure would require full consolidation.

37. Consolidation of various participations - Germany Applying the principles of consolidated supervision Bank I 5% 33% 100% 100% 15% Bank VIfull Bank IIrisk weight Bank IIIdeduct or PR Bank IVPR Bank Vfull 33% 100% 50% 50% Inv. Firm full Bank VII Bank IXPR Bank VIIIdeduct or PR 51% 50% Not consolidated Ancillary Banking Services full Inv. Firm risk weight Consolidated

38. Consolidation of Various Participations - Germany (Contd..) Applying the principles of consolidated supervision • Bank II does not have to be consolidated as the participation is less than 10%. • Bank III does not have to be consolidated, as the participation is less than 20%. It has however to be deducted or, alternatively, to be voluntarily consolidated on a pro rata basis. • Bank IV has to be consolidated on a pro rata basis as the percentage is between 20% and 50% (given the necessary distribution of control). • Bank V and VI have to be fully consolidated as the participation is more than 50% • Bank VII does not have to be consolidated as it is a subsidiary of a non-consolidated entity. • Bank VIII does not have to be consolidated as the participation is under 20% (33% x 50% = 16.5%). Deduction or voluntary pro rata consolidation would be possible. • Bank IX would have to be consolidated on a pro rata basis as the participation is more than 20% (100 x 33% = 33%). • The subsidiary of Bank IX would not have to be consolidated as the participation is less than 20% (see bank VIII). • The other units have to be consolidated as the participation is more than 50%.

39. Consolidation of various participations - UK Applying the principles of consolidated supervision Bank I 5% 33% 100% 100% 15% Bank VIfull Bank IIdeduct Bank IIIdeduct Bank IVfull Bank Vfull 33% 100% 50% 50% Inv. Firm full Bank VII Bank IXfull Bank VIIIdeduct 51% 50% Not consolidated Ancillary Banking Services full Inv. Firm deduct Consolidated

40. Consolidation of Various Participations - UK (Contd..) Applying the principles of consolidated supervision • Bank II does not have to be consolidated, as the participation is less than 20%. The investment has, however, to be deducted because it is in a bank. • Bank III does not have to be consolidated, as the participation is less than 20%. It has however to be deducted, as with Bank II. • Bank IV probably a full consolidation would be necessary, unless there are other independent major shareholders. • Bank V and VI have to be fully consolidated as the participation is more than 50%. • Bank VII does not have to be consolidated as it is a subsidiary of a non consolidated entity. • Bank VIII does not have to be consolidated as the participation is under 20% (33% x 50% = 16,5%). Deduction would be required. • Bank IX probably a full consolidation would be necessary, unless there are other independent major shareholders. • The subsidiary of Bank IX would not have to be consolidated as the participation is less than 20% (see bank VIII), but as a regulated investment firm the investment would have to be deducted from the bank‘s capital base. • The other units have to be fully consolidated as the participation is more than 50%

41. General Example - Germany Applying the principles of consolidated supervision Industrial company 100% 100% 100% Bank Non-bank Bank 50% 50% 90% 90% 90% 90% Bank IV FDL 2 BankII Bank III Non Bank Bank V 100% 50% Asset Manager Bank VI

42. General Example - UK Applying the principles of consolidated supervision Industrial company 100% 100% 100% Bank Non-bank Bank 50% 50% 90% 90% 90% 90% Bank IV FDL 2 BankII Bank III Non Bank Bank V 100% 50% Asset Manager Bank VI

43. General Example Applying the principles of consolidated supervision An Industrial company which does not qualify as a financial holding company (which has to be determined on an individual basis) may theoretically have more than one bank as a subsidiary in Germany and also the UK. However, the supervisory authorities would most likely require a lot of detailed information on the nature and size of the various units and a solid explanation why it is necessary to have more than one bank. The authorities have not shown much "sympathy" for this type of structure in the past, and the provisions of EU directives on the supervisability of structures have strengthened their position on this. The consolidation principles are the same as on the previous pages, although there are some variations between German and UK practice. • In Germany: • Non-banks (industry, insurance etc.) do not have to be consolidated, they are considered to be regular Assets which have to be risk weighted and backed with 8% Capital. • Asset Managers do not have to be consolidated. • Bank IV has to be fully consolidated as the participation is 50% • Bank VI has to be consolidated on a pro rata basis (50% x 50% = 25%) in Germany as it is more than 20%. • In the UK: • Non-bank commercial companies (industry, retail etc.) do not have to be consolidated, they are considered to be regular Assets which have to be risk weighted and backed with regulatory Capital. • Investments in insurance companies, while considered to be non-financial, do have to be deducted from the regulatory capital of the bank. • Asset Managers have to be consolidated, like all financial firms. • Bank IV has to be fully consolidated as the participation is 50% • Bank VI has to be consolidated either on a pro rata basis (50% x 50% = 25%) or on a full basis if there are no other major shareholders.

44. Calculating Prudential Ratios Applying the principles of consolidated supervision As Consolidation for accounting purposes can be very different from a regulatory consolidation in Germany and the UK, German and UK banking supervisors do not use consolidated financial statements which have been produced for statutory financial reporting. Indeed, it is impossible to derive capital charges for market risks from statutory financial reports as information about individual risk positions is required. Rather, supervisors throughout Europe use a suite of regulatory returns which have been specifically designed to give supervisors the information they require. These detailed returns are private documents between the bank and its supervisors. This does not mean that the supervisors do not take an interest in the published financial statements, and do not study them and follow up points of interest and discrepancy between public and private information. But it is the regulatory returns which form the basis for calculating prudential ratios and which are the financial supervisors prime source of information.

45. Prudential ratios for CAD in Germany Applying the principles of consolidated supervision Consolidated Tier 1 and 2 capital >= 8% Capital ratio = Consolidated RWA Consolidated own funds >= 8% Overall ratio = Consolidated RWA + 12,5 x (consolidated capital charges for Market risks) Calculation every month (end of month) for the aggregated numbers Calculation every quarter (end of quarter) for the detailed numbers

46. Structure of reporting forms for CAD reports in Germany Applying the principles of consolidated supervision SA1.1 SA1.1 QS1.1 GB1.1 SA1.1 SA1.1 SA1.2 SA1.2 QS1.2 SA1.2 SA1.2 SA1.3 SA1.3 QS1.3 QG1.1 SA1.3 SA1.3 FW1 FW1 QFW FW1 FW1 GB1 RW RW QRW RW RW QG1 OP OP QOP OP OP RI RI QRI RI RI Forms for solo-basis ZK ZK QZK XXX ZK ZK AK AK QAK Forms for Consolidation AK YYY AK HB HB QHB HB HB SA 3 SA 3 QS 2 SA 3 SA 3

47. Applying the principles of consolidated supervision Prudential ratios for CAD in the UK BANKING BOOK Consolidated Tier 1 and 2 capital >= individual minimum % Capital ratio = Consolidated RWA BANKING AND TRADING BOOK Consolidated own funds >= individual minimum % Overall ratio = Consolidated RWA + 12,5 x (consolidated capital charges for Market risks including risks consolidated by Aggregation Plus) Bank must be able to calculate ratio every day Calculation every quarter (end of quarter) for the detailed numbers for solo bank, with consolidated report every half year

48. Structure of reporting forms for CAD reports in UK Applying the principles of consolidated supervision Capital Adequacy Reporting in the UK has been rationalised into a single form - the BSD 3. It is very extensive, covering 46 pages. It includes some information which is not necessary to calculate ratios, but which supervisors find of interest. Capital for Settlement Risk Capital for Counterparty Risk Subsidiaries Consolidated by Aggreg.n + Assets - loans, investments Securities, investments Capital for FX Risk Capital for Large Exposures Dealing with Aggregation + Credit to directors & group members Information on OTC contracts banking book Information on interest rate general risk Capital for Position Risk Off balance sheet items Provisions & Bad Debts Information on equity risk Information on OTC contracts trading book Capital Exposures netted or guaranteed Information on Commodity Risk Capital Adequacy Summary Information on counterparty risk on repos Non Capital Liabilities Profit & loss Output Exposures netted or guaranteed Backtesting Results for VaR Models Banking Book, Balance sheet & Trading Info Trading Book

49. Quantitative Consolidated Supervision in the UK Applying the principles of consolidated supervision Capital adequacy Unlike Germany, where banks under normal circumstances have to meet only the BIS 8% ratio, the UK supervisory body sets specific ratios for each bank and banking group on a solo and consolidated basis. These ratios (calculated on a BIS basis) are often significantly above the 8% minimum. They take into account the individual nature of each institution, its business , its risks and the quality of its systems and management. A trigger ratio is set. This is the minimum level of capital the bank may have. A target ratio is also set that is above the trigger. If a bank’s ratio falls below target, this prompts immediate discussions with the management of about the level of capital in relation to the business risks being run. If the trigger ratio is breached, this prompts immediate consideration of whether the bank continues to be run prudently and whether banking authorisation should be revoked. The required capital ratio set on a consolidated basis is normally the same as that set on a solo basis for the principal bank in the group, but may be different. Factors which may lead to a different consolidated requirement being set include: i) the location of capital in the group, in particular to ensure that reliance is not being placed on surplus capital which is locked into particular companies or countries because of regulatory considerations, exchange controls or taxation; ii) the degree of risk diversification in the group as a whole, compared with that of the principal bank; and iii) any risks which arise on a group basis but are not reflected in the factors influencing the principal bank’ s ratio.

50. Applying the principles of consolidated supervision Quantitative Consolidated Supervision in the UK (Contd..) Large Exposures As in Germany, bank must limit the total of its exposures, other thanits exempt exposures, to individual counterparties or groups of closely related counterparties exceeding 10% of its large exposures capital base to a maximum of 800% of its large exposures capital base. However, the UK supervisors impose a sub-limit. The total of exposures in excess of 10% other than exempt exposures, should not exceed 300% of its large exposures capital base without the supervisory authority’s written approval. Major Shareholdings All holdings of capital instruments issued by other credit institutions and financial firms irrespective of amount have to be deducted from regulatory capital,unless these positions are held for trading and with the permission of the supervisory authority. This deduction applies to all long positions in instruments which are included in the capital of the issuing credit or financial institution and to indirect holdings of capital taken via instruments issued by their holding companies on their behalf, or via holdings in investment vehicles established exclusively or mainly to hold credit or financial institutions’ capital instruments. It covers any holdings of instruments of a capital nature relating to credit or financial institutions. The rationale for this is to avoid “double gearing”, the double use of capital provided by parties outside the financial system. By holding the capital instrument of another bank, the bank is deemed to have lent that part of its regulatory capital to the other bank. The lending bank should therefore not be allowed to gear up on it.