Handbooks in Central Banking
No: 15
CONSOLIDATED SUPERVISION OF BANKS
Ronald MacDonald
Series editor: Simon Gray
Issued by the Centre for Central Banking Studies, Bank of England, London EC2R 8AH Telephone 0171 601 5857, Fax 0171 601 5860
June 1998
Bank of England 1998 ISBN 1 85730 131 5
Foreword
The series of Handbooks in Central Banking has grown out of the activities of the Bank of England’s Centre for Central Banking Studies in arranging and delivering training courses, seminars, workshops and technical assistance for central banks and central bankers of countries across the globe.
Drawing upon that experience, the Handbooks are therefore targeted primarily at central bankers, or people in related agencies or ministries. The aim is to present particular topics which concern them in a concise, balanced and accessible manner, and in a practical context. This should, we hope, enable someone taking up new responsibilities within a central bank, whether at senior or junior level, and whether transferring from other duties within the bank or arriving fresh from outside, quickly to assimilate the key aspects of a subject, although the depth of treatment may vary from one Handbook to another. We hope they will also be helpful to those with some experience, but who are facing new problems as the economy and markets develop. While acknowledging that a sound analytical framework must be the basis for any thorough discussion of central banking policies or operations, we have generally tried to avoid too theoretical an approach. The Handbooks are not intended as a channel for new research.
We have aimed to make each Handbook reasonably self-contained, but recommendations for further reading may be included, for the benefit of those with a particular specialist interest. The views expressed in the Handbooks are those of the authors and not necessarily those of the Bank of England.
We hope that our central banking colleagues around the world will continue to find the Handbooks useful. If others with an interest in central banking enjoy them too, we shall be doubly pleased.
We would welcome any comments on this Handbook or on the series more generally.
Simon Gray
CONSOLIDATED SUPERVISION OF BANKS Ronald MacDonald Contents Page Abstract 3 1 Introduction 5 2 Corporate groupings 7
3 Supervisory problems with banks in groups 11
4 Consolidated prudential reports 14
5 Quantitative consolidated supervision 24
6 Qualitative consolidated supervision 29
7 Supervision of international banking groups 31
8 Conclusions 33
Appendix 35
Abstract
This Handbook aims to explain the nature and importance of consolidated supervision of banks and the techniques by which it can be implemented. It begins by describing the pioneering work of the Basle Committee in relation to the consolidated supervision of international banking groups. It then discusses the many different forms of corporate grouping to which banks may belong and the particular difficulties which can arise in the supervision of such banks. The construction of consolidated prudential reports is considered with emphasis on the scope of consolidation and the accounting techniques which can be used for this purpose. The scope for carrying out quantitative monitoring of banks on the basis of consolidated reports is described. After examining qualitative aspects of consolidated supervision, the Handbook discusses problems peculiar to the consolidated supervision of international banking groups and describes the initiatives which have been taken at international level to overcome them.
CONSOLIDATED SUPERVISION OF BANKS 1 Introduction
Consolidated supervision is an essential tool of banking supervision. In simple terms, it is a response to the fact that banks very frequently carry on part of their business - in some cases the major part - through subsidiaries and affiliates. Moreover, a bank may often belong to a group headed by a holding company, and in such cases supervisors need to take account of the activities of the holding company and fellow subsidiaries of the bank. Consolidated supervision therefore signifies a comprehensive approach to banking supervision which seeks to evaluate the strength of an entire group, taking into account all the risks which may affect a bank, regardless of whether these risks are carried in the books of the bank or related entities.
It could be argued that the principle of shareholder limited liability makes such an approach unnecessary in cases where a bank holds only fully paid shares in its subsidiaries (and has not guaranteed their liabilities vis-à-vis third parties). In practice, however, most banks are well aware that the bankruptcy of a subsidiary would seriously damage their own reputation and cause a weakening of depositor confidence. Consequently, banks have usually no alternative but to underwrite the losses of all entities under their control. In any case, supervisors would be most concerned about the “fitness and properness” of the directors of a bank who proposed to rely exclusively on its legal liability and abandon the creditors of its dependent entities. Moreover, a bank which is itself a subsidiary company within a wider business grouping may be exposed to “upstream” risks arising from its owners or from “parallel” entities within the group. For these reasons, supervisors have to monitor banks on a consolidated basis.
The development of consolidated supervision - particularly as it is applied to
internationally operating banking groups - owes much to the work of the Basle
Committee on Banking Supervision. In 1975 the Committee recommended that the supervisory authorities of banks with foreign subsidiaries, joint ventures and branches1 should monitor the risk exposure of such banks on the basis of consolidated reports which reflect their total business, irrespective of the legal entities or countries in which it is conducted. In 1992 the Committee went further and recommended that supervisory authorities should not normally permit banks from foreign countries to open establishments within their jurisdiction unless they can be satisfied that the home country supervisor of an applicant bank has the capability to supervise both the new establishment and the parent bank on a consolidated basis, in accordance with minimum standards laid down by the Committee. More recently, in its “Core Principles for Effective Bank Supervision” (September 1997), the Committee has expressed the view that the consolidated supervision of banking groups is an essential element of banking supervision which should be practised on an on-going basis.
At the national level, most developed countries now have laws and regulations to ensure that the banks they have licensed can be supervised on a consolidated basis. Consolidated supervision is obligatory for all banks incorporated in the eighteen member countries of the European Economic Area2 and must be carried out in accordance with specified minimum standards. It is also practised - among others - by the supervisory authorities in Australia, Canada and the United States. Despite these developments there are still countries which do not practise consolidated
1
Branches are not separate legal entities. For the purposes of this handbook it is assumed that the business of banks’ domestic and foreign branches is always aggregated with that of the head office, and they are not considered further.
2
This comprises the 15 member states of the European Union (EU) plus Iceland, Liechtenstein and Norway.
supervision; and within those which do, there exist wide differences in the scope and intensity of the consolidated supervision which is practised.
Against a background of growing international encouragement to countries to practise consolidated supervision of banks, the purpose of this handbook is to assist policy-makers and bank supervisors by explaining the intrinsic merits of consolidated supervision and the techniques through which it can be implemented.
Nevertheless, while consolidated supervision is undoubtedly an essential element of effective bank supervision, it should not be regarded as an alternative to the normal supervision of individual licensed banks. Rather, it should be seen as complementing the supervision of banks on a “solo” basis, and very frequently supervisors can apply the same techniques of financial assessment and regulation on both a consolidated and an unconsolidated basis.
2 Corporate Groupings
Corporate groups which contain banks vary widely in terms of structure, range of activities and complexity. Inherent in all group structures, however, is the relationship between parent and subsidiary companies, and those inter-company relationships which allow one company to exercise significant influence over a second company, without having actual control.
National regulations in the field of company law and financial reporting frequently define what is meant by parent and subsidiary companies. In some countries, a parent company is defined as a company which owns more than 50% of the shares. In others, the fundamental concept used is control rather than ownership, with various criteria established to determine whether control exists. For bank supervisors the broader concept of “control” is the more relevant criterion: any
company which is under the control of another should be regarded as a subsidiary, regardless of the size (if any) of the controlling company’s shareholding. Bank supervisors may be able to use existing definitions in their country’s company law or accounting regulations, but in those countries where no legal definition of a subsidiary exists, or where the definition is very narrow, it will be necessary for bank supervisors to produce their own definition as a first step towards bringing banks’ subsidiaries within the scope of consolidated supervision. It is, of course, important to recognise that subsidiary companies are often owned indirectly through intermediate companies, sometimes through long and complicated chains of ownership. Such intermediate companies are usually non-trading holding companies, established for the sole purpose of holding shares in subsidiaries and other companies. When defining subsidiaries, it is also important to take account of enterprises, such as partnerships or joint ventures, which do not have legal personality.
The company law and accounting regulations in many countries also provide detailed definitions of the relationship which exists where one company holds a minority shareholding in another and exercises influence over its operations: in accounting language such investee companies are often referred to as “associated companies” or “associates”. The European Council Directive on the Consolidated Supervision of Credit Institutions uses the term “participation” in this context and defines it as “the ownership, direct or indirect, of 20% or more of the voting rights or share capital of an undertaking” (without referring to the degree of influence exercised). This definition is therefore similar, though not identical, to certain existing definitions of associated companies. While recognising that legal definitions will differ from country to country, this handbook for reasons of convenience, uses the term “participation” throughout to describe all investments which represent between 20% and 50% of an voting power in the investee company, and those investments of less than 20% where the parent - despite the small size of its shareholding - is able to exert significant influence over the investee.
It is also helpful to classify corporate groupings according to their activities. In the context of bank supervision three broad categories can be identified: banking groups, “mixed-activity” groups and financial conglomerates.
A banking group exists whenever a licensed bank establishes or acquires subsidiary companies (or takes participations) in order to carry on particular activities. Many different factors - legal, regulatory, commercial or fiscal - may determine the decision of a bank to operate through subsidiary companies. In some countries banks are prohibited by law, prudential regulations or their own articles of association from investing in the shares of commercial and industrial companies. As a general rule, banks tend to invest only in other companies which carry on banking or quasi-banking financial activities: for example, money transfers, leasing or trading in securities. Thus, a typical banking group might consist of a licensed bank with subsidiary companies engaged in a range of specialised financial activities and possibly one or more subsidiary banks and other companies established in foreign countries. In some cases the group might be headed by a holding company rather than a licensed bank. The function of such a parent company would be to hold shares in the bank and other group companies, and to manage its investments. The holding company may also raise capital to support the group’s activities. The extent to which the parent runs the group as if it were a single entity will vary from group to group. There may also be other non-trading holding companies at various intermediate levels within the group structure.
By contrast, a mixed-activity group is one which controls commercial and industrial companies as well as banks. An important factor behind the emergence of mixed activity groups has been the relatively large amounts of capital required for the establishment of new banks. In many countries - particularly developing countries, and the countries of Eastern Europe and the former Soviet Union -shortage of savings has meant that very often large industrial or commercial concerns have been the only institutions capable of providing the initial amounts of capital
which the establishment of new banks requires. In other countries large commercial companies have also diversified into commercial services: for example, large food retailing companies in the United Kingdom have seen opportunities to exploit their IT systems and network of outlets by offering banking services to their existing customer base. Whatever its origin, it is worth noting that a mixed activity group may often contain a sub-group of banks and other financial companies which operates as a single entity. Looked at in isolation, such a banking sub-group is little different from the banking groups described above.
The term “financial conglomerate” looks like a suitable description to apply to any group (or sub-group) of companies engaged in banking and related activities. However, within the field of financial regulation, the term has acquired a more technical meaning. In essence, “financial conglomerate” has come to mean a group which engages in a range of different financial activities which were traditionally kept separate - and are still kept separate - by law or regulation in many countries. The activities in question are banking, trading in securities and insurance. Since 1993 joint committees established by the Basle Committee, the Technical Committee of the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors have studied a range of the issues related to the supervision of such groups (for example, the assessment of overall capital adequacy). In the course of this work they have defined the term “financial conglomerate” to mean “any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance).” It will be readily appreciated that many banking groups - for example, those formed in countries in which banks are allowed to own securities companies - also fall within this definition of “financial conglomerate”, and that there is considerable overlap between the issues relating to the supervision of financial conglomerates and the consolidated supervision of banking groups. These issues are considered below within the context of consolidated supervision of banks. However, issues relating to
financial conglomerates which do not include banks lie outside the scope of this handbook.
3 Supervisory Problems with Banks in Groups
Banks which form part of corporate groupings present supervisors with a number of problems which do not occur, or are usually less significant, in the case of single entity banks. The following are among the most important.
(a) Contagion
This is primarily the risk that financial difficulties encountered by a non-bank member of a group can endanger the financial stability of a bank in the same group. This danger is probably greatest when a bank has credit exposure to related companies and their ability to repay the bank is threatened. However, even if there is no financial exposure, news of losses or falling profits in such companies may still weaken depositors’ confidence in the bank and bring it under liquidity pressure. Loss of confidence, resulting in liquidity pressure, may also be triggered by non-financial causes, such as reports that the management or staff of related non-bank companies have been involved in illegal or unethical business practices.
(b) Group exposures to particular counterparties
Banks in most countries are subject to regulations which limit their credit exposure to an individual counterparty (or group of related counterparties). However, it is also important to limit the size of individual large exposures incurred by banking groups. Indeed, without the application of large exposure limits to banking groups, individual banks can easily circumvent the limits which apply to themselves.
(c) Transparency of legal and managerial structures
Business groups frequently have highly complex structures, which make the effective supervision of banks situated within such groups more difficult. Moreover, the legal and managerial structures of a group may differ, particularly when a group has adopted matrix management under which staff members report on particular aspects of their work to a range of directors or senior managers based in other group companies and, sometimes, in other countries. Such arrangements must be thoroughly analysed by supervisors in order to identify lines of accountability within the group. In the most worrying cases groups may have deliberately chosen a complex structure in order to obscure their operations or true ownership, and thereby avoid effective supervision of their activities.
(d) Quality of Management
In cases where a group is headed by a non-bank parent company the directors and shareholders of the parent company have effective control over any bank in their group, by virtue of the parent’s legal power to remove the bank’s board of directors, and for this reason it can be assumed that the directors of the subsidiary bank will normally act in accordance with their wishes. Therefore, in such situations there is a risk that a bank will be “de facto” controlled by persons who may lack the necessary skill or integrity to act as directors of a bank. In practice, this problem may be resolved if supervisors have a legal duty to vet the suitability of all persons and entities which have the ability, directly or indirectly, to exercise control or significant influence over the operations of a bank. It may also be resolved if the parent company is prepared to devolve management autonomy to the bank’s own directors. It is therefore important that supervisors establish the precise degree of independence which has been given to the directors of such a bank and are informed in good time about any changes which the parent company makes to its controls over the bank. Directors of a non-bank parent company may sometimes be exposed to serious
conflicts of interest and inclined to favour the interests of the non-bank companies which they control to the detriment of the bank’s depositors.
e) Rights of Access to prudential information
In order to supervise effectively supervisors may from time to time require information about related non-bank companies. Very often it may be possible for them to obtain such information on a voluntary basis from the bank in question. Nevertheless, there may also be occasions when other group companies are unwilling or unable to supply the required information to the bank for onward transmission to the supervisors. To overcome this problem it is essential that the supervisory authority has legal powers to obtain information it requires directly from the related non-bank companies. The flow of information can be a particular problem in the case of foreign parents or subsidiaries since legal powers to obtain information may have no validity in foreign jurisdictions. Supervisors should therefore always establish that there will be no barrier to the flow of such information before they allow their banks to open establishments abroad or grant authorisation to new banks with foreign ownership.
(f) Moral hazard
When practising consolidated supervision, supervisors have to take care not to give the impression that the activities of a whole group are being supervised, even if only informally. This is particularly important in the case of mixed activity groups. “Moral hazard” can arise if the management of non-bank companies come to believe that the supervisory authorities will give them support - in the event of financial difficulties - in order to prevent their difficulties weakening depositor confidence in a related bank. Similarly, business counterparties of non-bank companies may also take greater risks than normal in their dealings with such companies if they perceive the likelihood of official support for an entire group. In short, the perception that
official support is likely - should the group get into difficulties - will tend to weaken market discipline.
4 Consolidated Prudential Reports
A major element of consolidated supervision is the production of financial reports on a consolidated basis and it is essential that supervisory authorities have legal powers to require banks to submit them. These reports combine the assets, liabilities and off-balance sheet positions of banks and their related companies, treating them in effect as if they were a single business entity. When supervisors have such reports they can measure most of the financial risks which banking groups incur and apply supervisory standards, such as minimum capital ratios, at the level of a whole banking group. However, when introducing such reports, supervisory authorities need to give guidance to banks on (a) the scope of consolidation (this involves specifying the types of entity which should be included in consolidated prudential reports) and (b) methods of consolidation (this concerns the accounting techniques which banks should use when compiling consolidated reports).
(a) Scope of consolidation
Since bank supervisors lack techniques for measuring the risks inherent in non-financial activities, consolidated prudential reports normally include only those
related entities which carry on activities of a banking or financial nature. In this
case “related entities” include all such subsidiaries and participations of a bank, together with “parallel” or “sister” banks and financial institutions which are controlled by the same shareholders as the bank itself. Risks inherent in non-financial group companies are assessed qualitatively.
In most cases entities which carry on banking or financial activities will be readily identifiable. If necessary, however, the definition of financial institutions applied in the collection of national economic statistics may be used for this purpose. Useful guidance is also available in a list of financial activities specified by the European Council Directive on the Consolidated Supervision of Credit Institutions. This list (reproduced in the Appendix), which is fairly comprehensive, prescribes those entities whose assets and liabilities have to be included in consolidated reports submitted to supervisors in EU countries, and could provide a model for other countries.
It is worth noting that insurance has been omitted from the EU list, even though insurance is clearly a financial activity. This is because ithe risks of insurance companies are different from those of banks.3 A balance sheet which combined the assets and liabilities of an insurance company with those of a bank would not provide a suitable basis for measuring banking risks and applying banking ratios. It is therefore advisable to omit insurance companies from consolidated reports.4
Holding companies located at the top of a banking group are something of a
special case. If they do not themselves carry on any financial activity, it is arguable that they should be excluded from the consolidation. Nevertheless, they exercise control over the group’s activities and are likely to play a pivotal role in raising any new capital from external sources which is needed to support the group’s activities (typically a group holding company will issue new shares on the capital market and “downstream” the funds to other group companies). For this reason it seems appropriate to include non-trading holding companies in consolidated reports, 3
In a general insurance company the fundamental risk is uncertainty as to the amount of the company’s liabilities. In a life insurance company the main risk is that the value of assets will fall without any corresponding reduction in the actuarial value of liabilities.
4
Nevertheless, it is still possible to measure on a consolidated basis the capital adequacy of a banking group which includes an insurance company. This is discussed on page 21 below.
particularly in cases where the majority of group companies are engaged in banking and other financial activities. However, in cases where the holding company controls a mixture of financial and non-financial companies, the argument for consolidating the holding company seems less compelling.
A useful yardstick for deciding such cases would be to determine the “balance of business” within the group: this could be done, for example, by calculating the total assets of the banking and financial entities within the group. If the resulting figure exceeded 50% of the group total, the holding company might be consolidated with the assets and liabilities of the financial members of the group. A result of lower than 50% would indicate a mixed activity group rather than a banking group. In this case it might not be appropriate to consolidate the holding company. It would, however, still be necessary to consider whether the group’s banking and financial companies constituted a distinct banking sub-group and whether consolidated reports should be compiled in respect of that sub-group alone.
In cases where a bank is controlled by a bank authorised in a foreign country it is not normally necessary or appropriate to extend consolidation “upwards” to include the foreign parent bank. In such situations, however, it is important to establish that the worldwide banking group in question is subject to effective consolidated supervision by the authorities in the country where it is authorised and has its head office. (This point is discussed further in Chapter 7 below.)
In certain circumstances it may be advisable to allow banks to omit financial subsidiaries from their consolidated reports. The special case of insurance companies has already been mentioned but there may be other similar cases where inclusion could cause consolidated reports to be misleading or inappropriate. For example, financial entities should be excluded if they are established in countries with exchange controls or other regulations which would prevent the repatriation of capital realised from their sale or liquidation. Also, in the interests of administrative
efficiency, it may be worthwhile to allow banks to exclude very small subsidiaries: in some countries banks establish subsidiaries which have only the minimum amount of share capital required by company law and keep these companies on the “shelf” until they need one for a special purpose. Such subsidiaries can be excluded by means of a de minimis exemption: for example, if the aggregate amount invested in these subsidiaries is less than 1% of the parent bank’s own capital and reserves.
The assets and liabilities of related non-financial entities are not, of course, consolidated and the group’s investments in such entities appear as a single asset item in the consolidated prudential report.
(b) Methods of consolidation
(i) Subsidiaries
Many countries have accounting regulations which require companies with subsidiaries to publish consolidated financial statements. A useful guideline for consolidated financial statements, sometimes employed in countries which do not have regulations requiring their preparation, is International Accounting Standard No.27 “Consolidated Financial Statements and Accounting for Investments in Subsidiaries” published by the International Accounting Standards Committee. Consolidated accounts are very useful for the shareholders of a parent company since they reveal the full amount of the profits5 earned by the parent and its subsidiaries together and make possible a more accurate evaluation of the group’s business performance and financial condition. Consolidated financial reports for supervisors can be compiled using such accounting regulations: the only difference is that any non-financial and insurance companies in the group are excluded from the consolidation.
5
By contrast the unconsolidated accounts of a parent company include the profits of subsidiaries only to the extent that they are distributed as dividends to the parent.
In a consolidated balance sheet the full balance sheet values of the assets and liabilities of the parent company and its subsidiaries are combined on a line-by-line basis. All intra-group assets and liabilities are eliminated. The share capital of the consolidated subsidiaries is also excluded in order to avoid double-counting of capital. In the case of subsidiaries which are less than 100% owned by the parent company the consolidated balance sheet also contains a liability item “minority interests”. This represents the percentage portion of the net assets of the subsidiaries which belongs to the other “minority” shareholders in these companies6. Consolidated financial reports for bank supervisors are generally constructed in the same way and an example is given in Figures 1(a) and (b) on pages 20 and 21.
6
This is only a very brief outline of the process of compiling consolidated financial statements. For further information reference should be made to relevant accounting standards and textbooks. The most widely followed approach is “acquisition accounting”. If a company acquires an existing company as a subsidiary by way of purchase, the parent initially records the investment in its own accounts at purchase cost. During the subsequent consolidation process the assets and liabilities of the subsidiary are written up or down to their current market value, and any difference between the purchase cost and the revalued net assets of the subsidiary gives rise to an item of positive or negative goodwill in the consolidated balance sheet. The pre-acquisition reserves of the subsidiary are not included in the consolidated balance sheet. Acquisition accounting also applies when a company establishes a new subsidiary - as in the example in Figures 1 (a) and (b) - but no goodwill arises in such cases and there are obviously no pre-acquisition reserves which have to be excluded. The alternative accounting method is “merger accounting” or “pooling of interests”, which is allowed in some countries in cases where two companies merge as the result of their shareholders exchanging their existing shares for shares in a new combined enterprise. Under merger accounting , there is no revaluation of assets and liabilities, and the pre-merger reserves of both companies are included in the consolidated balance sheet.
(ii) Participations
Participations were defined in Chapter 2 as investments in the share capital of other companies which permit the investor to exercise significant influence - but not control - over the investee’s operations. This relationship should be accurately reflected in consolidated financial statements. From a supervisory perspective, it is also important to note that a banking group may not be able to liquidate a participation quickly. For example, a bank might wish to dispose of a participation in order to liberate capital which it needed in its own balance sheet. However, the sale of a participation could be difficult to achieve without the support of the other shareholders. Moreover, it would not be possible for the bank, acting in isolation as a minority shareholder, to realise its participation by putting the investee company into voluntary (solvent) liquidation.
It is possible to practise full consolidation of participations in banks and financial companies, treating them as if they were subsidiaries. Full consolidation allows supervisors to see the total amount of assets and liabilities over which a banking group exercises control or influence. This approach does, however, have two major disadvantages. Firstly, a consolidated balance sheet constructed in this way will contain certain assets and liabilities which the parent company does not
control and it is normal accounting practice to consolidate fully only in cases where
a parent company has control. Secondly, the existence of a “majority” of other shareholders will distort the amount of minority interests included in the consolidated balance sheet. Since minority interests are treated as capital in the calculation of consolidated capital ratios, full consolidation of participations will overstate the amount of capital which a banking group has under its control, and could allow the group to accumulate excessive assets. It would, of course, be possible to deduct the (so-called) minority interests arising on the consolidation of participations from the figure for capital used in the calculation of the consolidated capital ratio.
Figure 1(a)
Castor Bank has established 2 subsidiaries. It owns 100% of the share capital of Castor Loans Company (a non-bank financial company whose principal activity is consumer credit) and 75% of Pollux Bank (another bank). The individual balance sheets of the 3 entities in the group are as follows:
CASTOR BANK CASTOR LOANS CO. POLLUX BANK ASSETS Cash 50 45 40
Balances at central bank 200 - 100
Balances at commercial banks 400 225 300
Government bonds 650 440 610
Loans to customers 1,500 1350 900
Amounts due from related companies 100 300
-Shares in subsidiaries 80 -
-Premises 20 - 50
3,000 2,360 2,000
LIABILITIES
Customers’ deposits 2,400 - 1,300
Borrowing from banks 50 2,200 600
Amounts due to related companies 300 100
-Share Capital 200 35 60
Reserves 50 25 40
Figure 1(b)
This illustrates the process of compiling a consolidated balance sheet for the Castor Group. Intragroup assets and liabilities have been eliminated. A new line -minority interests - is required to reflect the 25% of the net assets of Pollux Bank which are not owned by Castor Bank.
CASTOR BANK CASTOR LOANS CO. POLLUX BANK CONSOLIDATED BALANCE-SHEET ASSETS Cash 50 45 40 135
Balances at central bank 200 - 100 300 Balances at commercial banks 400 225 300 925
Government bonds 650 440 610 1,700
Loans to customers 1,500 1,350 900 3,750
Premises 20 - 50 70
2,820 2,060 2,000 6,880
[Amounts due from related companies] [100] [300] [Shares in subsidiaries] [80] 3,000 2,360 2,000 LIABILITIES Customers’ deposits 2,400 - 1,300 3,700
Borrowing from banks 50 2,200 600 2,850
Minority interests [25] 25
Share capital 200 200
Reserves 50 25 30* 105
2,700 2,225 1,955 6,880
[Amounts due to related companies]
[300] [100]
-[Share capital of subsidiaries] [35] [45]* 3,000 2,360 2,000
* These figures represent Castor Bank’s 75% share of the capital and reserves of Pollux Bank.
However, this would be a rather contrived solution to the problems arising from full consolidation. On balance, therefore, the full consolidation of participations is likely to be inappropriate, except in cases where the benefit of bringing the total risks of a participation into the capital adequacy calculation is thought to outweigh the disadvantage of inflating consolidated capital.
Pro rata or proportionate consolidation is an alternative to full consolidation.
In this case only a percentage of the investee company’s assets and liabilities - equal to the group’s percentage shareholding in the investee company - is included in the relevant item in the consolidated report. Pro rata consolidation is a particularly appropriate method of consolidation in cases, such as joint ventures, where two or more banks are involved in the management of a single entity and both may be relied on to provide support should the joint venture get into difficulties.
A further possibility is to apply “equity accounting” to participations. This has the advantage of being a treatment which is widely recognised in national accounting regulations for banks and non-banks alike. Equity accounting was developed as a response to the inadequacies of earlier methods of accounting for companies’ long-term investments in the shares of other companies. Traditionally, such investments were carried in the balance sheet at cost, and the revenue from them was recognised only on the basis of dividends received. It was realised, however, that this accounting treatment was inadequate in meeting the information needs of shareholders, particularly in cases where the investing company exercises a degree of influence over the operations of the investee companies. Under equity accounting the consolidated profit and loss account includes the investing company’s pro rata share of the investee company’s profits, while the value of the participation in the consolidated balance sheet reflects cost plus the investing company’s accumulated share of post-acquisition profits or losses. The advantage of equity accounting is that the effect of the influence exercised by the investing company (or bank) becomes more transparent: for example, the percentage of annual profits which
an investee company distributes as dividends may fluctuate from year to year. However, figures for group profits are more meaningful if they reflect fluctuations in an investee company’s profits (ie its business performance) rather than merely the variations in its dividends (which may be influenced by other factors).
Although equity accounting does not reflect the actual amounts of assets and liabilities held through participations, it is an appropriate method for including participations in banks’ consolidated prudential reports.
Addendum: solo consolidation
This apparently contradictory term is used by bank supervisors in the United Kingdom to describe a strictly limited form of consolidation, which can be used - in certain circumstances - to replace the normal unconsolidated monitoring of a bank as a single legal entity. The technique recognises that banks sometimes have subsidiaries which - despite their separate legal personality - are controlled and managed as if they were an integral part of a parent bank, and that it is administratively inefficient to monitor a parent bank separately from subsidiaries of this type. Prudential reports are therefore submitted which fully consolidate the assets and liabilities of the subsidiaries in question with those of the parent bank, and the parent bank is exempted from submitting reports in respect of its own assets and
liabilities. However, solo consolidation is only practised in cases where certain strict
conditions are fulfilled:
(i) the subsidiary is at least 75% owned by the parent bank;
(ii) the subsidiary either is wholly funded by the parent bank and has no public deposits, or all of its assets represent claims in respect of the parent bank;
(iv) there are no potential obstacles to the payment of surplus capital by the subsidiary to the parent bank, taking account in particular of foreign exchange controls, legal and regulatory problems and taxation; and
(v) the aggregate investments of the parent bank in “solo consolidated” subsidiaries do not exceed its own net worth.
Banks which are subject to solo consolidated supervision are, of course, also required to submit consolidated reports in the normal way, if they have other financial subsidiaries which do not satisfy the conditions listed above. Such reports amalgamate the assets and liabilities of the “solo consolidated group” with those of the other consolidated subsidiaries.
5 Quantitative Consolidated Supervision
(a) Consolidated prudential reports allow supervisors to monitor several aspects of the financial condition of banking groups on a quantitative basis.
At present banking supervisors in most countries regulate the capital adequacy of their banks in relation to credit risk in accordance with the system of risk-weighting and minimum 8% capital ratio contained in the Basle Capital Accord (1988). The Basle Committee recommends that supervisors should apply the minimum 8% capital ratio to all internationally operating banks on both an unconsolidated and consolidated basis. Within the European Economic Area all banks with subsidiaries are required to maintain a minimum 8% capital ratio on a consolidated basis, regardless of whether these subsidiaries are domestic or foreign. Of course, the actual capital ratio of a banking group - as measured by the Basle framework - will reflect the credit risks incurred by the non-bank entities of the
group. An illustration of how the measured capital ratios of a parent bank and its consolidated banking group may differ is given in figure 2 below.
When calculating consolidated capital ratios it is prudent to deduct from the figure for consolidated capital the balance sheet value (calculated in accordance with equity accounting or otherwise) of any subsidiaries and participations which have not been fully consolidated. This treatment should be applied to all such investments in non-financial and insurance companies. Moreover, if an insurance company within the same group as a bank is failing to meet its own capital requirement, imposed by a separate insurance regulator, the shortfall in the insurance company’s regulatory capital can also be deducted from the capital figure used to calculate the consolidated capital ratio of the banking group.
(b) Large Exposures
The monitoring and control of large individual exposures incurred by banking groups (or sub-groups) is a most important aspect of consolidated supervision. Legislation is needed to limit the amount of the exposure which a banking group may incur towards a single counterparty (or group of closely related counterparties); normally, such a limit is expressed as a percentage of the group’s capital. In addition, it is also helpful if the legislation imposes an obligation on banks to report all group large exposures at a lower threshold than the permitted maximum, so that supervisors can monitor (permitted) concentration risk at group level.
(c) Connected Exposures
Limits on exposures incurred by individual banks towards connected persons such as influential shareholders, directors, their close relatives and separate legal entities controlled by them, should also be applied to banking groups and sub-groups. Such limits are particularly useful in the case of mixed activity sub-groups.
Figure 2
Calculation of the risk-weighted capital ratio of Castor Bank on an unconsolidated and consolidated basis, in accordance with the 1988 Capital Accord, using the balance sheets in figures 1(a) and (b):
Unconsolidated Consolidated A Capital
Share Capital 200 200
Reserves 50 105
Less shares in subsidiaries (80)
-Minority interests - 25
170 330
B Risk-weighted Assets Risk weighting
Unweighted Weighted Unweighted Weighted
Cash 0% 50 - 135
-Balances with central bank 0% 200 - 300 -Balances with commercial banks 20% 400 80 925 185 Government bonds 0% 650 - 1,700 -Loans to customers 100% 1,500 1,500 3,750 3,750
Amounts due from related companies 100% 100 100 - -Premises 100% 20 20 70 70 2,920 1,700 6,880 4,005 C Risk-weighted Ratios 170 x 100 = 10.0% 1,700 330 x 100 = 8.2% 4,005
(d) Market Risks
Banking groups sometimes contain subsidiary investment firms, which are separately licensed and supervised by securities regulators. The securities regulators normally impose capital requirements on the investment firms; and these take account of the market price risks and credit risk to which the firms are exposed. At the same time, the parent bank (and other group banks) are also subject to capital requirements in respect of their market risks if they trade actively in financial markets: this will be the case if the banks in question are incorporated in European Union countries (which have implemented the EU Directive on Capital Adequacy) or in countries which are applying the Market Risks Supplement to the Basle Capital Accord (1996).
A problem arises because securities regulators and banking supervisors may use different methods for calculating capital requirements for market risks. It is clearly inconvenient for subsidiary investment firms to have to compute their capital adequacy on two bases in order to satisfy their securities regulator (at the level of the firm) and the banking supervisor (at consolidated group level)
To get round this difficulty UK bank supervisors employ a method of consolidation known as “aggregation plus”. Under this, the amount of the capital requirement imposed on an investment subsidiary by the securities regulators is added to the capital requirements for the remainder of the group. The total capital requirement calculated in this way is then compared with consolidated group capital in order to assess capital adequacy on a consolidated basis. Under this method, the actual risk-weighted assets and other positions of the investment subsidiary are not included in the consolidated calculation for the group; consequently, any exposures of the subsidiary towards other group members are not netted out, and group capital
requirements are higher than if the investment subsidiary’s risk-weighted positions had been consolidated on a line by line basis. However, this procedure can only be used when the securities regulator applies capital requirements in respect of market risk which are equivalent to those applying to the market risks of UK banks.
Another solution to the same problem is the technique known as “deduction
plus”. In this case the assets and liabilities of a securities company subsidiary are
not included in the consolidated balance sheet. However, the value of the group’s investment in the securities company is deducted from the figure for consolidated capital, together with any amount by which the capital of the securities company falls short of any capital requirement separately imposed by its own securities regulator. The consolidated capital ratio is then calculated. As mentioned above, this technique can also be applied to groups which contain an insurance company.
(e) Liquidity
Few supervisory authorities apply liquidity ratios or comparable quantitative measures on a consolidated basis except in the case of closely integrated banking groups operating within a single country. In the case of international banking groups it is likely that their subsidiary banks in foreign countries will be subject to separate liquidity monitoring by local supervisors. However, home country supervisors conducting consolidated supervision should also assess the global liquidity management policies of such groups in order to ensure that they can ensure adequate liquidity in all their establishments at all times. Deposit concentrations present a different kind of risk: banks which have a very narrow depositor base are more likely to experience liquidity difficulties than banks with a largenumber of small individual deposits. It is therefore essential that deposit concentrations can - and should - be monitored on a consolidated basis.
6 Qualitative Consolidated Supervision
(a) Banking Groups
It is essential that supervisors have a through understanding of the banking groups (or sub-groups) which are subjected to the consolidated monitoring described above. The starting point will normally be the construction of a chart which shows every company included in the bank’s consolidated financial reports. This should also show the extent of outside shareholders’ interests in subsidiaries and participations. However, in addition to the legal structure, it is helpful to prepare a separate chart which shows the managerial structure of the group. This chart should identify all significant business units in the group. A “business unit” is an organisational unit which generates income and is separately identified in the group’s management information systems. It may not necessarily be a separate legal entity. Significant business units can be identified by quantitative means; for example, a business unit might be regarded as significant if its annual profits/losses or risk-weighted assets represented 5% or more of the group’s profits or regulatory capital respectively. In such cases, supervisors should obtain information about the nature of the unit’s business, the risks to which it is exposed, and the ways in which these risks are managed. Much of this information may have to be obtained during on-site visits.
Information of this kind serves as a starting point for assessing whether a banking group has an appropriate risk management system covering all aspects of its business and whether its internal controls, including group internal audit, are sufficiently rigorous.
It is also important to monitor changes among the other shareholders in a group’s partly owned subsidiaries and participations, since this could signify a weakening or strengthening of the financial resources available to the group.
Wherever possible, supervisors should also try to ensure that the same accounting firm acts as the external auditor of all legal entities in a group. This may, however, prove difficult to achieve if supervisors are not required to approve the auditors of related non-banking companies. Such an approach will also be impracticable if the auditing firm does not maintain offices in all the countries in which the group has established subsidiaries.
(b) Mixed Activity Groups
If it is possible to identify a separate sub-group of banks and financial companies within a mixed group, consolidated prudential reports can be obtained for the sub-group and it can be supervised as if it were a banking group. However, it is also important to make some assessment of the risks emanating from the commercial or industrial companies in the group. To do this, supervisors have little alternative but to use whatever means they can to assess the bearing these entities might have on the financial soundness and reputation of a group bank. Possible sources of information are group annual reports and meetings with the senior management of the group. There can be no question of supervising non-bank group entities as if they were banks; as mentioned above, to appear to do so could send misleading signals not only to the management of these entities but also to their to their customers and suppliers.
It is normally advisable to “ring-fence” a bank (or banking sub-group) which belongs to a mixed-activity group. The objective of this approach is to isolate the bank’s operations from those of the remainder of the group. This involves ensuring that the bank management can operate independently of the group management and placing severe limits on the exposure of the bank towards other group companies and the volume of funding it receives from them; in some cases nil exposure limits may be appropriate. In some countries banking regulations have, historically, allowed banks to act as financing vehicles for the industrial groups which controlled them
and in many instances the resulting large exposures have been very harmful to the banks in question. Much would be gained by the ring-fencing of such banks, which could be achieved through agreed programmes for the phased reduction of intra-group exposures to acceptably low levels.
Ring-fencing should also be followed in cases where a bank from an overseas country, which does not capably practise consolidated supervision, is granted a licence to establish a subsidiary (please see the next chapter).
7 Supervision of International Bank Groups
The Minimum Standards for the supervision of international banking groups and their cross-border establishments, issued by the Basle Committee in June 1992,7 established four main principles:
(1) all international banks should be supervised by a home country authority that capably performs consolidated supervision
(2) the creation of a cross-border banking establishment should receive the prior consent of both the host country and home country authority
(3) home country authorities should possess the right to gather information from their cross-border establishments
(4) if the host country determines that any of these three standards is not being met, it could impose restrictive measures or prohibit the establishment of banking offices.
7 Most of the Minimum Standards have been given legal force in European Union countries through implementation of
The first of these principles raises the question of how a supervisory authority can be judged to perform consolidated supervision “capably”. Because of institutional, historical, legal and other factors, different supervisory authorities tend to practise their supervision by different methods, and consequently there is no single methodology which can be used as an international standard. Nevertheless, there are certain common factors on which host supervisors typically base their judgement of the quality of consolidated supervision practised by home country supervisors. These are essentially the elements of quantitative and qualitative supervision described above. However, some points require to be emphasised in the international context:
- the extent and quality of the consolidated prudential reports which the home country supervisor receives: do these adequately measure group capital adequacy, credit concentrations, market risks, asset quality and provisioning requirements?
- the methods employed by - or available to - the home country supervisor to verify the accuracy of consolidated prudential reports.
- the willingness and capability of the home country supervisor to visit and examine entities in foreign locations.
- the track record of the home country supervisor in the taking of remedial action when problems arise in the domestic offices of banks.
The third of the Minimum Standards is also of great importance for home country supervisors. Effective consolidated supervision is impossible unless supervisors can obtain adequate information in respect of all the establishments which belong to a banking group. Unfortunately, there are some jurisdictions where the laws of bank secrecy prohibit banking establishments from disclosing information about their affairs either to their head offices or their home country supervisors. It is therefore essential that home country supervisors should establish
that there will be no legal impediment to the transfer of prudential information, before they allow any of their banks - in accordance with the second Minimum Standard - to open a subsidiary (or other establishment) in the country or territory in question.
The Minimum Standards deal only with international banking groups. Sometimes, however, commercial or industrial entities - with no banking experience - seek to establish subsidiary banks in foreign countries. Clearly, consolidated supervision cannot be applied in such cases. Supervisory authorities which receive licence applications from such groups have to handle them in accordance with their normal procedures. In deciding such cases it is essential that supervisors obtain comprehensive and reliable information about the financial condition and reputation of the owners of the proposed bank: this may prove difficult in practice but one helpful source of information should be the banking supervisory authority in the country where the group has its headquarters. Supervisory authorities which are considering such cases must also take into account that, if a bank of this type is licensed, it will belong to a “mixed activity” group and that they will need to conduct consolidated supervision on the lines discussed in Chapters 5 and 6.
8 Conclusions
It will be apparent from this handbook that consolidated supervision has much in common with the supervision which is already practised at the level of individual banks; and that its main importance lies in the recognition that banking and other financial activities are not always confined within the balance sheets of those particular entities which have been licensed as banks. As financial markets continue to develop new instruments and techniques, it is likely that banks will increasingly conduct parts of their business off-balance sheet - through subsidiary companies and
participations. At the same time, the gradual erosion of traditional barriers between different types of financial institution (banks, securities companies, insurance companies etc) will also alter the structure of the businesses which provide financial services. The opening of domestic financial markets to foreign participants will have a similar effect. Bank supervisors must respond to the challenge of these developments for banks and the additional risks they represent for depositors. Seen in this light, consolidated supervision is an essential tool whose time has arrived.
APPENDIX
Companies undertaking one or more of these activities are classified as “financial”:
1 Ancillary Banking Services (defined as: “undertaking the principal activity of which consists in owning and managing property, managing data processing services, or any other similar activity which is ancillary to the principal activity of one or more credit institutions”).
2 Lending (including, inter alia, consumer credit, mortgage credit, factoring with or without recourse, financing of commercial transactions (including forfeiting)).
3 Financial leasing
4 Money transmission services
5 Issuing and administering means of payment (e.g. credit cards, travellers’ cheques and banker’s drafts).
6 Guarantees and commitments
7 Trading for own account or account of customers in: (a) money market instruments (cheques, bills, CDs etc); (b) foreign exchange;
(c) financial futures and options;
(d) exchange and interest rate instruments; (e) transferable securities.
8 Participation in securities issues and the provision of services relating to such issues.
9 Advice to undertakings on capital structure, industrial strategy and related questions and advice and services relating to mergers and the purchase of undertakings.
10 Money broking
11 Portfolio management and advice
12 Safekeeping and administration of securities.
Source: Bank of England Notice on the implementation of the Directive on the Consolidated Supervision of Credit Institutions (BSD/1993/1)
Further Reading
Papers issued by the Basle Committee provide useful guidance on the consolidated supervision of
international banking groups. The following are particularly relevant:
- Principles for the supervision of banks’ foreign establishments (1983)
- Information flows between banking supervisory authorities (1990)
- Minimum standards for the supervision of international banking groups and their cross-border establishments (1992)
- The supervision of financial conglomerates (A report by the Tripartite Group) (1995)
- The supervision of cross-border banking (1996)
On the question of consolidated supervision both within and beyond national borders, the following directives of the European Union contain the principal requirements for consolidated supervision which apply to banks incorporated within member states of the European Economic Area:
- Council Directive 92/30/EEC of 6 April 1992 on the supervision of credit institutions on a consolidated basis, Official Journal of the European Communities, No L 110/52 (28 April 1992)
- Council Directive 93/6/EEC of 15 March 1993 on the capital adequacy of investment firms and credit institutions, Official Journal of the European Communities, No L 141/1 (13 June 1993)
- European Parliament and Council Directive 95/26/EC of 29 June 1995 ... reinforcing prudential supervision, Official Journal of the European Communities, No L 168/7 of 18 July 1995
(generally referred to as the “post-BCCI Directive”)
An example of how banks in a single country are supervised on a consolidated basis is provided in the following supervisory notices issued by the Bank of England:
- Implementation in the United Kingdom of the Directive on the Consolidated Supervision of Credit Institutions (BSD/1993/1)
- Implementation in the United Kingdom of the Capital Adequacy Directive (S&S/1995/2)
- Implementation in the United Kingdom of the Capital Adequacy Directive (amendments to S&S/1995/2) (S&S/1995/4)
- A Risk Based Approach to Supervision ( the RATE Framework) (1997).
NB The Bank of England announced in May 1998 that its supervisory notices would be replaced in the near future by a composite “Guide to Banking Supervisory Policy”.
With regard to the compilation of consolidated financial statements, there are numerous accounting textbooks which deal with the subject in varying degrees of detail. In certain countries the provisions of company law and accounting regulations prescribe the use of particular methods; in countries where no regulations on this subject have been issued, banking supervisors considering the introduction of consolidated prudential reports may obtain guidance from the International Accounting Standards issued by the International Accounting Standards Committee. Many of the individual IAS are relevant to the compilation of consolidated financial statements by banks, including the following:
- IAS 22 Business Combinations
- IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiaries
- IAS 28 Accounting for Investments in Associates
- IAS 30 Disclosures in the Financial Statements of Banks and Similar Institutions
- IAS 32 Financial Instruments: Disclosure and Presentation
International Accounting Standards Committee 166 Fleet Street
London EC4 2DY England
Telephone: +44 (171) 353 0565 E-mail: [email protected] Fax: +44 (171) 353 0562 Web Site: www.iasc.org.uk
Handbooks in this series
No
Title
Author
1
Introduction to monetary policy
Glenn Hoggarth
2
The choice of exchange rate regime
Tony Latter
3
Economic analysis in a central bank:
models versus judgment
Lionel Price
4
Internal audit in a central bank
Christopher Scott
5
The management of government debt
Simon Gray
6
Primary dealers in government securities
Markets
Robin McConnachie
7
Basic principles of banking supervision
Derrick Ware
8
Payment systems
David Sheppard
9
Deposit insurance
Ronald MacDonald
10
Introduction to monetary operations
Simon Gray and
Glenn Hoggarth
11
Government securities: primary issuance
Simon Gray
12
Causes and management of banking crises
Tony Latter
13
The retail market for government debt
Robin McConnachie
14
Capital flows
Glenn Hoggarth and
Gabriel Sterne
15
Consolidated Supervision of Banks
Ronald MacDonald
16
Repo of Government Securities
Simon Gray
The text of the Handbooks can be found on the Bank of England’s web site “www.bankofengland.co.uk”
