Consolidated Supervision: Managing the Risks in a Diversified Financial Services Industry Barbara Baldwin June 2001

1. Consolidated Supervision: Managing the Risks in a Diversified Financial Services IndustryBarbara BaldwinJune 2001

2. Banking Groups • Two or more legal entities • Linked through common ownership or control • Providing financial services (e.g., banking, securities, insurance) • Including at least one bank • Cross-Sector and/or Cross-Border

3. Prudential Concerns • Contagion (within and between groups) • Intra-group transactions and exposures(e.g. cross shareholdings, inter-affiliate lending) • Loss of Confidence • Extension of official safety net to nonbank group affiliates may lead to moral hazard

4. Prudential Concerns • Transparency and Regulatory Arbitrage • Complex corporate structures: • Complicate a supervisor’s assessment of group risk exposure • May be used to circumvent regulatory requirements or to facilitate fraudulent activities • May be used to exploit differences in regulatory requirements across sectors and/or jurisdictions • Conflicts of Interest

5. Supervisory Implications • “Solo” approach of supervising individual group entities, absent contact with other financial sector supervisors, is no longer adequate • “Solo supervision” must be complemented with “consolidated supervision”

6. Consolidated Supervision • The Components: • Consolidation of Accounts • Consolidated Regulation (Quantitative) • Consolidated Supervision (Qualitative) • Based on qualitative and quantitative information about the group • Allows financial sector supervisors to: • Understand the relationships among the legal entities • Assess and monitor how effectively the group identifies, manages and controls risks • Recognize insipient problems

7. Consolidated Supervision • Objectives and Principles • Promotion of systemic financial soundness • Capture all members of the financial group in the supervisory program • Formally • Informally • Making consolidated supervision operational in practice

8. Consolidated Supervision • Preconditions for Effective CS • The legal framework • Independence of the supervisory agency • Degree of commitment to the process

9. Consolidated Accounting • What is it? • Why do it? • Which accounting standards apply? • What is the scope of consolidation?

10. Consolidated Accounting • Methods of Consolidation • Full line-by-line • Equity method • Proportional Consolidation • Relevant IAS • IAS 27: Subsidiaries • IAS 28: Associates • IAS 31: Joint Ventures • IAS 25: Investments • The impact of IAS 39: Financial Instruments

11. Quantitative Consolidated Supervision • Prudential Requirements • Capital Adequacy, Large Exposures,Connected Lending • Many potential risks cannot be quantified in financial ratios • Determination of how group relationships may impact any regulated entities

12. Quantitative Consolidated Supervision • Takes wider account of the risks posed by group entities, should they have a material impact on the reputation or financial soundness of a bank

13. Qualitative Consolidated Supervision • Focuses on: • Group-wide business plans and strategies • Consolidated internal controls and risk management • Management and organizational structure • Degree of operational, legal, strategic and reputational risks

14. Qualitative Consolidated Supervision • Requires: • Availability of significant information about the consolidated group on a routine basis • Frequent communications between supervisors and group management • Supervisors must understand how the group is managed in practice, not just on paper

15. Designing the CS program • Large groups will require continual supervision from a systemic risk perspective • An analyst or group of analysts should be appointed to oversee each financial group • An annual supervisory program should be designed for each group • Supervisory resources should be allocated based upon the relative risk profiles

16. Supervisory Cooperation and Coordination • Basic principles for cross-border supervision: • No foreign establishment should escape supervision • Supervision should be adequate

17. Minimum Standards • All international banking groups should be supervised by a home country authority that capably performs consolidated supervision • The creation of a cross-border establishment should receive the prior consent of both host and home country supervisors

18. Minimum Standards • The home country supervisor should possess the right to gather information from the cross-border establishments of the banking groups they supervise • If these minimum standards are not met, the host country could impose restrictive measures necessary to satisfy its prudential concerns (including denial of an application)

19. Cooperation Between Home and Host Supervisors • Allows them to discharge their supervisory responsibilities • Ensures that the supervisory strategy for the group is comprehensive • Facilitates detection and deterrence of cross-border misconduct

20. Authorization Stage • Considerations for Host Supervisor • assess the home supervisor’s ability to “capably” perform CS • If CS is inadequate, or the parent is not a regulated entity in the home country: • Insist that certain conditions be fulfilled, or • Refuse the application • Considerations for Home Supervisor • Assess the host’s supervisory standards • If inadequate, or impediments to information transfer exist: • Insist that certain conditions be fulfilled, or • Refuse consent for the banking group to establish foreign operations

21. Authorization StageEstablishing a Strategy for Ongoing Supervision • Home and host supervisors become familiar with each other’s objectives and approaches • Allocation of responsibilities for supervision of foreign establishment agreed • Information needs established • Information sharing mechanisms agreed Formal information sharing mechanisms do not ensure, and should not be viewed as a prerequisite for, supervisory cooperation

22. Supervisory Cooperation • Establishing Effective Supervisory Cooperation • The freedom to exchange prudential information is a prerequisite for effective supervisory cooperation • National bank secrecy legislation is a major impediment for effective cross-border supervision • National bank secrecy laws should be modified to ensure adequate supervisory information sharing

23. Supervisory Cooperation • Safeguards for Information Exchange • Recipient should use the information only for supervisory purposes • Recipient should ensure confidentiality of information received • Provider should not limit recipient’s use of information in carrying out supervisory duties

24. Conclusions • Diversified financial groups are becoming the dominant institutional structure in the financial services industry • Effective consolidated supervision is integral to the maintenance of systemic financial stability

25. Conclusions • Making it work will require an unprecedented level of supervisory cooperation • Supervisory agencies will encounter a number of policy and practical issues in developing an effective framework for consolidated supervision