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

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

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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

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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

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Prudential Concerns

• Transparency and Regulatory Arbitrage
• Complex corporate structures
• Complicate a supervisors 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

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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

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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

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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

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Consolidated Supervision

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

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Consolidated Accounting

• What is it?
• Why do it?
• Which accounting standards apply?
• What is the scope of consolidation?

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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

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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

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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

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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

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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

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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

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Supervisory Cooperation and Coordination

• Basic principles for cross-border supervision
• No foreign establishment should escape
  supervision
• Supervision should be adequate

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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

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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)

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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

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Authorization Stage

• Considerations for Host Supervisor
• assess the home supervisors 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 hosts 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

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Authorization StageEstablishing a Strategy for
Ongoing Supervision

• Home and host supervisors become familiar with
  each others 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

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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

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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 recipients use of
  information in carrying out supervisory duties

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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

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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