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Conglomerates Supervision – Group Support, Double Leverage and Double Gearing

By

Monetary and Capital Markets DepartmentMichael Moore

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Outline

I. Understanding the complexity of financial conglomerates

II. Issues in conglomerates supervision

• Double gearing• Double leveraging• Holding Company / Conglomerates Supervision

III. Policy considerations

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I. Understanding complexity of financial conglomerates

Financial conglomerates definition by Joint Forum on Financial Conglomerates (JF, 1999):

“Heterogeneous financial conglomerates are conglomerates whose primary business is financial, whose regulated entities engage to a significant extent in at least two of the activities of banking, insurance and securities business and which are not subject to uniform capital adequacy requirements”

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We know how to supervise this …

BANK

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… And we know how to supervise this

BANK

BANK

BANK BANK

BANK BANK

BANK

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… But what about this?

HOLDING COMPANY

BANK INSURANCE COMPANY

FUNDS MANAGER

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… And what about THIS ???

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Main challenge in conglomerates supervision: COMPLEXITY (1)

a. Dimension (number and size)- A large conglomerate can have hundreds of licensed

entities spread across multiple sectors (banking, insurance life and/or non-life, asset management, ancillary financial services) and many countries => Structures can be difficult to understand and supervise, present the possibility of regulatory arbitrage

- financial conglomerates are large players in the economies and financial markets where they operate (e.g. top 30 EU financial conglomerates account for over 200% of EU GDP; top 30 US financial holding companies account for over 90% of the US GDP) => SIFIs for most countries – (and too-big-to-fail)

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Main challenge in conglomerates supervision: COMPLEXITY (2)

b. Diversity of activities and risk profilesBank Insurance  Securities

Assets Customer loans, securities, interbank assets

Investment portfolio Receivables secured by securities, financial instruments

Liabilities Customer deposits, interbank liabilities

Technical provisions Payables to customers

Distribution channels Branches Agents, brokers Financial intermediaries

Business time horizon

Intermediate Long (life), long or short (non life)

Short

Main risks Credit risk, liquidity risk

Underwriting risk, investment risk

Market risk, liquidity risk

Main risks transfer mechanisms

Securitization, credit derivatives, OTC derivatives

Reinsurance OTC derivatives

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Main challenge in conglomerates supervision: COMPLEXITY (3)

c. Interconnectedness

- ownership participations => multiple gearing of capital, excessive leveraging risks; risk of contagion; moral hazard issues; lack of transparency

- intra-group transactions => related parties exposures

- common exposures to debtors / sectors => concentration risks

- management processes => complexity; conflicts of interest

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II. The supervision pyramid 

Conglomeratessupervision

Group sectoral supervision

Solo supervision (individual entities)

Heterogeneous financial groups

Homogeneous financial groups

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Challenges to developing the conglomerates supervision approach

Avoid unnecessary duplication with sectoralsupervision

Provide flexibility to capture the full diversity of financial conglomerates’ structures, activities, and risk profiles (including supervisory processes adapted to the particular structures of each target group)

Ensure coordination among relevant sectoralsupervisors led by a top-level supervisor (coordinator) responsible for the overall group supervisory strategy implementation.

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Supervisory standards for conglomerates supervision

• Joint Forum (1999)• Capital measurement and adequacy at the

conglomerate level (Capital Adequacy Principles and Measurement Techniques)

• Sound and prudent management of the entities within a financial conglomerate (Fit and Proper Principles)

• Information sharing (Principles for Supervisory Information Sharing)

• Identification of a coordinator (Coordinator Paper)

• Forthcoming (2012) JF - Principles for the Supervision of Financial Conglomerates• Firms up the 1999 standards

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Example of 1999 JF Principles implementation (EU Approach)

FICOD Directive (2002) established requirements at the level of the financial conglomerate:

- Capital adequacy: requirements at the level of the financial conglomerate for own funds, capital adequacy policies, supervisory oversight

- Risk concentration: monitoring of risk concentrations across the group

- Intra-group transactions: monitoring all significant intra-group transactions (e.g. loans, guarantees, derivatives)

- Internal controls and risk management processes- Management body of mixed financial holding companies

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II.A. Assessing the capital adequacy at the conglomerate level

Objectives:

- assess the capital adequacy on a group-wide basis

-identify situations of overstatement of capital

Measurement techniques should be designed to:

- detect and provide for double or multiple gearing

- detect and provide for excessive leverage

- consider effect of unregulated intermediate holding companies

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Double or Multiple Gearing

Double/multiple gearing (legal vehicles are a necessary fact of life)

double gearing - Where one entity holds capital issued by another in

same group and issuer is allowed to count the capital in its own balance sheet

- External capital is geared up twice; parent and dependent

multiple gearing- Where the dependent in turn holds capital of a third tier entity

Potential abuse - when dependents own capital of the parent, because capital stops being capital.

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Illustration of multiple gearing (Samsung Group)

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Double or Multiple Gearing

Guiding principles – capital assessment:

- assessments of group capital based on solo regulatory capital assessment can overstate the external capital of group

- only capital issued to external investors provides support to group

- assessments of group capital need to take account of intra-group holdings of regulatory capital of the affiliates

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Double or Multiple Gearing

JF provides supervisory discretion to apply 3 alternative methods:

- the building block prudential approach- the risk-based aggregation, and - the risk-based deduction method (part of Basel)

In principle, the methods assess the group’s capital excess or deficit by summing up the capital requirements of each group entity and then subtracting intra-group holdings (See Case Study 1).

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Entities that undertake activities similar to those undertaken by regulated group entities (e.g., leasing)

• Use of capital proxy for relevant sector• Total deduction treatment

Supervisors need to take a close look at the situation,especially with respect to the nature and quality of assets inan unregulated entity where risk have been transferred fromregulated entities to unregulated entities within a group

Dealing with unregulated entities within the conglomerate

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Double or Multiple Gearing

Implementation of these rules vary in practice since:

-Differences in the sectoral rules may provide incentives for a group to take advantage of regulatory arbitrage and organize itself so that the regulatory regime for group capital requirements is the least restrictive.

-Supervisory discretion is encouraged in terms of defining, among others, regulatory capital, the participation levels of subsidiaries, the treatment of minority and majority interests, the application of accounting and actuarial principle.

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Double or Multiple Gearing

Example of possible regulatory arbitrage between sectoralrules regarding the treatment of participations (EU):

Holdings in banks Holdings in insurance companies

Insurance company Deduction if > 20% of the held entity or, if less, in case of durable link

Deduction if > 20% of the held entity or, if less, in case of durable link

Bank Deduction if > 10% of the held entity or, if less, the total amount exceeding 10% of own funds of the holder

Deduction if > 20% of the held entity or, if less, in case of durable link

The arbitrage: become an insurance holding company to avoid having to deduct the holding in a bank if holding is more than 10% and less than 20%. 

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Double or Multiple Gearing

Basel III treatment of participations:

1. Uniform treatment of participations across institutions

2. Much stricter regime• participations representing less than 10% of subsidiary

capital, full deduction is required if the value in excess of 10% of own capital (e.g. a small participation needs to be fully deducted)

• participations representing more than 10% of the capital of the subsidiary full deduction is required

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Double or Multiple Gearing

Basel III implementation (EU - too much pain right now):

1. Stricter regime for participations not part of the proposed revision of CRD IV (Capital Requirements Directive) transposing Basel III

2. Participations to be tackled within the revision of the FICOD (Financial Conglomerates) Directive supposedly taking place in 2012

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II.B. double leverage (when is debt excessive?)

Where the parent issues debt and downstreamsproceeds to dependant as equity/regulatory capital

• risks:• Lower capital ultimately available at the conglomerate

level to absorb losses (see Case Study 2)• Risk to bank, insurance firm, if parent has difficulty in

servicing the debt (i.e. subsidiaries required to contribute dividends to overcome capital shortfalls at the parent level; in turn, financial difficulties at the holding company level may have negative implications for the subsidiary funding)

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II. Hold Co/Conglomerates Supervision Experience 

• Formalized Bank and Financial Holding Company (BHC and FHC) Supervision – the effective US Model

• Coordinator oversight model – the European model (the Capital Requirements Directive and the Financial Conglomerates Directive)

• Insurance group supervision – the not so effective US model

• Mixed conglomerates with insurance and other non-financial activities (Berkshire Hathaway, Samsung)

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Supervision of Holding Companies (US experience 1)

Bank Holding Companies Act (1956)

The principle of “umbrella supervision” = sufficient to enable the supervisor to form a view of the:

a) overall condition of the holding company; b) the potential for the holding company or its nonbank

affiliates to have a material adverse impact on the subsidiary bank(s); and

c) the ability of the holding company to support its bank(s) during periods of financial stress or adversity (“source of strength” doctrine).

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Supervision of Holding Companies (US experience 2) 

US requirements for bank holding companies (BHCs) I:

Submission of periodic financial reports on the parent holding company and the major nonbank affiliates;receipt by the umbrella supervisor of examination reports prepared by the sectoral regulator of any regulated nonbank entity;Inspections power by the umbrella supervisor (the Federal Reserve) for to inspect the parent company and any other nonbank affiliate;Enforcement power – (e.g., cease and desist) authority of the umbrella supervisor against the financial services holding company and its affiliates, including authority to force the sale of the bank;

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Supervision of Holding Companies (US experience 3) 

US requirements for bank holding companies (BHCs) II:authority of the umbrella supervisor to limit double leveraging by establishing a floor below which the capital available at the parent level to support the banking subsidiary(s) would not be allowed to fall; “non bank-like” subsidiaries, such as insurance companies or securities firms, would be “deconsolidated” and their capital deducted from the parent holding company capital;umbrella supervisor would require that aggregate parent holding company capital must be at least equal to the sum of the capital expected to be maintained in each subsidiary and the capital that is necessary to support parent risk-bearing activities.

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Supervision of Holding Companies (EU experience 1) 

Example of possible regulatory arbitrage based on the group structure =>certain supervisory tools are lost following acquisition in insurance sector…

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Supervision of Holding Companies (based on AIG structure) 

Question: Who has the broad view???

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Mixed conglomerates

Combination of financial (bank, insurance, leasing etc.) and non-financial entities (commercial or industrial activities) within the same group raises the following concerns:

- complicates the determination of group-wide capital adequacy, and obscure the detection of double leveraging;- enables potentially harmful cross-funding between sister companies;- introduce further contagion risks from industrial or commercial activities spilling over onto regulated financial institutions, which have implicit official support;- creates a higher potential for general conflicts of interest;- make it difficult to apply prudential and compliance rules.

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Dealing with mixed-conglomerate groups

Financial and insurance entities

Non-financial entities

Proposed structure to enable effective supervision:

Financial and insurance entities

Non-financial entities

Separate financial and non-financial subgroups + “firewalls”

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Dealing with mixed-conglomerate groups

Possible approaches to building “firewalls”:

A sliding capital approach could be imposed at the level of the holding company to increase the required capital allocated to the investment on a sliding scale (e.g. increasing risk weights proportionate to participation)Passive ownership of cross-holding equity exposures Cap appointment of Board members to avoid potential conflicts of interest atop the inter-connected companies A ladder of divestiture could be required over a reasonable period of time for existing mixed financial – non-financial conglomerates.

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IIi. Policy Considerations – why we care?

HOLDING COMPANY

BANK INSURANCE COMPANY

FUNDS MANAGER

Group Level

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IIi. Policy Considerations

Issues: (Can you supervise at the group level?)

- Debt issuance at HC level

- Compensation of management

- Dividends and capital planning

- Acquisitions / mergers at HC level

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II. C. the need for supervision at the group level

Conglomeratessupervision

Group sectoral supervision

Solo supervision (individual entities)

Heterogeneous financial groups

Homogeneous financial groups

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III. Policy considerations

Excerpt from the November 2008 Declaration of the G20 Leaders:

The appropriate bodies [i.e., the Joint Forum] should review the differentiated nature of regulation in the banking, securities, and insurance sectors and provide a report outlining the issues and making recommendations on needed improvements.

The Joint Forum’s 1999 principles on the Supervision of Financial Conglomerates should be reviewed and updated. Mainly to include “unregulated” entities (OBS vehicles, NOHCs), but also to bring them in line with sectoral developments.

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Planned improvements of the Joint Forum principles

The governance and risk management systems and practices of financial conglomerates;Supervisory powers over unregulated parent holding companies;The oversight and access to information of unregulated entities within a financial conglomerate; The calculation of capital adequacy on a group basis with regard to unregulated entities and activities (such as SPVs);The oversight of intra-group transactions and exposures involving regulated entities; andThe coordination among supervisors of different sectors.

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Planned improvements on capital adequacy and liquidity

Capital management

-Financial conglomerates should develop and implement robust capital management policies on a group-wide basis, including a internal capital planning process that incorporates stressed scenario outcomes and is subject to adequate internal controls (open issue: misalignment of sectoral capital definitions)

Liquidity assessment and management

-Financial conglomerates should properly measure and manage liquidity risks so as to fully accommodate funding needs in periods of stress at all levels of the financial conglomerate

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Planned improvements on supervisory powers

Supervisors have legal authority and powers to require that financial conglomerates have a sufficiently transparent group structure so as to not impede effective supervision, resolution or recovery (open question: corrective action at the level of the holding company?)

Supervisors can require financial conglomerates to restructure so as to ensure that their structures do not impede effective supervision (open question: power to oppose ex ante to changes in the structure of the conglomerate – eg. acquisitions by holding companies?)

Supervisors should have powers to collect information in relation to the wider group and to perform onsite reviews

Thank you!