Financial Standards and Codes: Report of Advisory Group on Banking Supervision

Financial Conglomerates

Supervision of Financial Conglomerates

Financial conglomerates are groups of companies engaged in banking and other activities, such as securities and insurance businesses which have been traditionally, by legislation, regulation or otherwise, kept separate in many countries. Issues relating to supervision of financial conglomerates have assumed importance in recent years with the gradual removal of barriers between these businesses. Consolidated supervision has become an essential tool for supervision of financial conglomerates and the practice of the same on an ongoing basis has been listed as one of the "Core Principles for Effective Banking Supervision" by the BCBS.

The main supervisory concerns in respect of financial conglomerates are the following:

1. the risk of contagion from non-banking entities which are members of the group and may or may not be regulated,

2. risk of excessive exposure to such financial conglomerates

3. transparency of legal and managerial structures,

4. quality of management in individual units and across the group,

5. access to and sharing of prudential information

6. consolidation of financial reports and

7. moral hazard arising from the impression that non-regulated entities are also being monitored.

Such issues have been addressed during the last decade by the BCBS, the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). A Joint Forum on Financial Conglomerates (Joint Forum) was established in 1996 under the aegis of these bodies. The Joint Forum, after a series of consultations with various interested parties, brought out papers covering subjects it considered critical in the context. The subjects covered in the papers referred to above were:

1. Capital Adequacy Principles

2. Supplement to the Capital Adequacy Principles

3. Fit and Proper Principles

4. Framework for Supervisory Information Sharing

5. Principles for Supervisory Information Sharing

6. Identification of 'Coordinator' and Principles of Coordination

7. Supervisory Questionnaire.

The Joint Forum's focus has been, primarily, on diversified financial firms with complex organisational and management structures whose large scale activities cross national and sectoral boundaries. The above papers have been published as Supervision of Financial Conglomerates (February 1999).

The 'Capital Adequacy Principles' paper outlines measurement techniques and principles to facilitate the assessment of capital adequacy on a group-wide basis for financial conglomerates. The Supplement to this paper illustrates situations that can be faced by supervisors in practical applications of the measurement techniques. The 'Fit and Proper Principles' paper provides guidance to ensure that supervisors of entities within a financial conglomerate are able to exercise their responsibilities of assessing whether those entities are soundly and prudently managed. The 'Framework for Supervisory Information Sharing' paper sets out a general framework for facilitating information sharing between supervisors of regulated entities within internationally active financial conglomerates. The 'Principles for Supervisory Information Sharing' paper provides to supervisors involved in the oversight of regulated financial institutions residing in financial conglomerates guiding principles with regard to supervisory information sharing. The 'Ten Key Principles on Information Sharing' issued by the G-7 Finance Ministers in May 1998 which complement the principles of the Joint Forum are annexed to this paper. The 'Coordinator' paper provides guidance to supervisors for identification of coordinator/coordinators and principles for coordination in emergency and non-emergency situations. The 'Supervisory Questionnaire' is a tool to assist supervisors in better understanding each others' objectives and approaches. The present Indian position with regard to the principles set forth in the above papers (excluding the Supplement to the Capital Adequacy Principles paper and the Supervisory Questionnaire) is given at Annex 10. The main points arising therefrom are summarised below.

Consolidation of accounts and presentation of consolidated financial results of all group entities is still not essential under the generally accepted principles of accounting in India. The emergence of financial conglomerates with regulated entities engaged to a significant extent in atleast two out of the three activities of banking, insurance and securities business is rather recent in India. Principles and systems for their regulation as entities in a conglomerate and for coordination between the concerned different regulators are also to be developed as yet. Urgent attention would need to be paid to develop suitable mechanisms in order to detect and provide for situations of double gearing and other similar problems posed by financial conglomerates.

Generally, existing regulations ensure that unregulated entities do not normally exercise material or controlling influence on operations of regulated entities. However, in the absence of any clear guidelines or established practices on this issue, the approach adopted in this regard is not uniform. RBI should, therefore, ensure that fitness, propriety or other qualification tests are applied to managers and directors of other unregulated entities in a conglomerate if they exercise or can exercise a material or controlling influence on the operations of regulated entities.

Shareholders with shareholding beyond a threshold, say 10 per cent, are often in a position to exert material influence on regulated entities. The regulator, however, does not, as a matter of uniform policy apply any fitness, propriety or qualification tests on all such shareholders. Considering the potential of risk contained in such a situation, it would be desirable to put in place arrangements for applying fit and proper tests on all shareholders with shareholdings beyond a specified threshold say 10 per cent. Suitable legal provisions would need to be introduced in the Banking Regulation Act empowering RBI clearly in this regard.

Fitness, propriety or other qualification tests need to be applied on a continuous basis so that occurrence of any event which raises any doubt about fitness and propriety of a manager, director or a shareholder (with shareholding beyond a specified level), results in the test being applied.

It needs to be ensured that supervisors communicate with the supervisors of other regulated entities within the conglomerate when managers, directors or key shareholders are deemed not to meet their fitness, propriety or other qualification tests. Arrangements for exchange of information between all regulators involved in regulation of different entities in a conglomerate should be formalised.

RBI may consider introducing the concept of primary supervisor. In the context of almost all major banks going in for insurance as well as securities business, designating one of the supervisors as the primary supervisor will substantially improve much needed coordination between different supervisors (regulators) and add to the scope and quality of the overall supervision of the conglomerate.

RBI shares information with other supervisors more with the force of set practices and conventions than with the support of clearly stated legal provisions. In order to place the arrangement on firmer footings and in keeping with the currently accepted international practices the desirability of suitably enacting these powers needs to be considered.

The emergence of conglomerates on the Indian business/finance scene is recent. But soon regulation and supervision of different entities in a conglomerate by different regulators will be a common occurrence and practices like designating a coordinator for information sharing will have to be considered in the interest of comprehensive regulation and safety and security of the system as a whole.

The advent of MNCs many of which are large conglomerate, will accentuate this need. RBI may urgently consider the desirability of introducing and participating in a scheme of formalised coordination between different regulators and designation of one of the regulators involved as a coordinator with clearly assigned roles and responsibilities.

The structure of financial conglomerates gives rise to the possibilities of excessive risk concentrations. The BCBS has put forward certain principles in this regard in its paper on Risk Concentrations Principles (December 1999). The main points arising therefrom are summarised below.

RBI should consider issuing appropriate guidelines requiring banks to ensure that they and their subsidiaries and joint ventures put in place adequate risk management processes covering group-wide risk concentrations as well. It would also be useful to stipulate norms for concentration and exposure limits in respect of all associated entities on solo as well as consolidated basis. It is considered essential that the supervisor develops a clear understanding of the risk concentration at the conglomerate level. This issue would need to be pursued through the regulated entities.

To ensure that financial conglomerates have controls in place to manage their risk concentrations, RBI may issue instructions to banks to ensure that their up-stream and down-stream units have appropriate controls in place to manage their risk concentrations. For such controls to be effective, it is preferable to prescribe limits linked to the unimpaired regulatory capital of the bank.

Comprehensive management information and reporting system at the conglomerate level would have to be insisted upon by RBI to build a sound risk management approach. Conglomerates should have in place a process to identify their principal risks, a comprehensive measurement system, a system of limits to manage large exposures and other risk concentrations and processes of stress testing and scenario and correlation analysis.

Disclosure in respect of risk concentrations should be made mandatory. However, the process of disclosure on risk needs to be gradual so that key elements remain in focus. Suggestions in this regard have been given while examining issues involved in enhancing bank transparency. RBI may also consider requiring banks to make public the management's assessment of risk concentrations across sectors on a group-wide basis.

While the type of information usually provided in the annual report and management or director's report to the market or supervisors generally allow the users to arrive at meaningful inferences in regard to financial condition, solvency, earnings performance and brief risk profile, such disclosures on a consolidated basis are currently not mandatory. RBI currently requires banks to only append the financial statements in respect of subsidiaries/ joint ventures along with the financials of the parent unit.

Some arrangements for information sharing between domestic regulatory bodies exist. However, notwithstanding mechanisms for coordination having been established, the level of actual coordination is not very high and seldom provides the regulators opportunities to take coordinated supervisory actions. Urgent steps are required to be taken so that coordination between different regulators is of a high order and enables them to take coordinated supervisory action, particularly in the area of risk management by the different entities of a conglomerate. The range and scope of information exchange among sectoral supervisors needs to be made broader and multi-point. It would also be useful to have a structured agenda so that all material issues with cross-sectoral implications receive appropriate attention.

At present RBI has not articulated a general approach on how to deal with risk concentrations at the group level apart from issuing guidelines to banks to have arms length relationship in their commercial transactions with subsidiaries. RBI may consider including material risk concentrations at the conglomerate level as one of the possible triggers for corrective action under the framework of Prompt Corrective Action (PCA) which it is developing.

The Joint Forum of the BCBS, IOSCO and IAIS had, brought out in December 1999, a paper on Intra-Group Transactions and Exposures Principles "to provide banking, securities and insurance supervisors principles for ensuring through the regulatory process the prudent management and control of intragroup transactions and exposures by financial conglomerates". While Intra-Group Transactions and Exposures (ITEs) are a source of synergy within groups that reduce costs and enhance profits, they are also a potential source of contagion. The principles enunciated by the Joint Forum are aimed at enabling supervisors ensure an appropriate balance between the benefits and risks of ITEs. The Group's considered at length on the adherence by the Indian system to these principles, to the extent they are applicable. The main points are summarised below.

ITEs are at present not subject to compulsory public disclosure. In the interest of effective consolidated supervision and for ensuring due transparency in the dealings between the units of a conglomerate, public disclosure of ITEs should be made compulsory. Suitable regulations as well as accounting principles would need to be put in place to ensure such disclosure.

Risk management systems that are being put in place in banks need to take into account the special risks posed by ITEs. Systems need to be put in place to monitor material ITEs of the regulated financial entities on a timely basis, as needed, through regular reporting or by other means to help form a clear understanding of the ITEs of the financial conglomerate.

Supervisors should liaise closely with one another to ascertain each other's concerns and coordinate as deemed appropriate. Close coordination and liaison between supervisors is a precondition for effective supervision over regulated entities individually as well as over the groups these entities comprise. Mechanisms aimed at ensuring full coordination and free flow of information between different regulators needs to be put in place urgently.

The banking system in India is fast moving towards more complicated organisational structures, on account of which key aspects of institutional cross holdings and other sources of potential risk may not be apparent. It is, therefore, necessary to put in place policies and systems for systematic sharing of information among the supervisors. The other initiatives required relate to consolidated supervision, ensuring availability of reliable, timely and comprehensive MIS and reporting requirements in the institutions, introduction of scientific risk management systems and practices, public disclosures of risk concentrations and appointment of coordinators amongst supervisors to facilitate information sharing and coordinated supervisory initiatives.