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

Consolidated Supervision: Managing the Risks in a Diversified

Financial Services Industry

Barbara Baldwin

June 2001

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

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

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

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”

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

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

Consolidated Supervision

Preconditions for Effective CS– The legal framework– Independence of the supervisory

agency– Degree of commitment to the process

Consolidated Accounting

What is it?

Why do it?

Which accounting standards apply?

What is the scope of consolidation?

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

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

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

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

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

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

Supervisory Cooperation and Coordination

Basic principles for cross-border supervision:– No foreign establishment should escape

supervision– Supervision should be adequate

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

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)

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

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

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

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

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

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

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