Financial conglomerates from a prudential supervisor's perspective
Speech by Clive Briault, Managing Director, Retail Markets, FSA
Joint Level 3 Committees Conference, Brussels
24 November 2005
It is a great pleasure to attend this first joint conference of the three "level 3" committees – the Committee of European Banking Supervisors (CEBS), the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), and the Committee of European Securities Regulators (CESR) – and an honour to be invited to speak to the legislators, regulators, industry participants, and other experts here today.
As the UK FSA's member of the Committee of European Banking Supervisors (CEBS) I am going to cover this morning the FSA's approach to the supervision of financial conglomerates under the Financial Conglomerates Directive.
In particular I will address five main issues:
-
the prudential challenges posed by conglomerates;
- how supervisors should respond to these challenges;
- the importance of home/host supervisory arrangements;
- cooperation under the Financial Conglomerates Directive; and
- some implications of these for the three "level 3" committees.
Setting the scene
Under the Financial Conglomerates Directive a group must meet certain conditions to be considered a financial conglomerate. The activities of the group must be sufficiently based in the financial services sector. The group should be headed by, or contain, either a credit institution, insurance undertaking or an investment firm. The group must contain at least one entity in the insurance sector and at least one entity in either the banking or investment services sector. And the levels of activity in the banking and/or investment services sector and in the insurance sector must both be significant in terms of balance sheet totals. So for this purpose a conglomerate is a group with entities in both the insurance and the banking or investment sectors, with a significant volume of business in each.
Some conglomerates are very large and global in their operations, and are undoubtedly of systemic importance. Their failure would clearly pose considerable challenges. These groups need to be subjected to an acceptable level of global consolidated supervision and the Financial Conglomerates Directive addresses this.
There are at present 63 groups in Europe that have been identified across 18 member states as financial conglomerates, and several member states are still in the process of identification. Whatever the final tally, it will be a significant number and most of the largest financial services groups in Europe will be included on the list.
Of the 63 officially identified conglomerates in the EU, 14 are UK based. Many of these operate almost entirely within the UK, while in four cases it has been decided under Article 3.3 of the Financial Conglomerates Directive, in conjunction with the relevant competent authorities in other member states, that these groups need not be subject to the requirements of supplementary supervision prescribed by the Directive.
In addition, there are 15 non-EEA conglomerates with a European presence in which the FSA has a role to play. Indeed, the FSA is likely to be the Co-ordinating Supervisor for the majority of these.
Prudential challenges
From a prudential regulation point of view, what challenges do conglomerates pose for supervisors? I would highlight three such challenges.
First, financial conglomerates engage in a range of distinct activities which are likely to produce imperfectly correlated revenue flows. These potentially bring some benefits of diversification. But the challenge here for supervisors is that the extent and durability of these benefits is hard to know in advance. Beyond requiring firms to operate on a basis which is adequately diversified, supervisors are unwilling to give additional 'credit' for this – partly because it is very unpredictable, and partly because at times of stress such diversification can rapidly disappear.
Second, the totality of risks in a conglomerate is not the same as the sum of the risks in each of its parts. Business risks should be less than the sum of the parts if diversification is effective. However, the management and control of a conglomerate is particularly challenging. Management need to understand the full range of businesses within the conglomerate and how these interact. They also need to make sure that business lines have proper 'local' management and control, while also having centralised management and control functions whose job it is to identify and manage risks to the conglomerate as a whole.
Added to this is the commonplace observation that some conglomerates are international in nature. Business lines typically stretch across national boundaries, and business and control heads may be located in different countries (or continents) and time zones. This is neither new nor unique to conglomerates. But it further complicates the management task. It also complicates supervision to the extent that regulation tends to be national in scope – and this is still true even within Europe, let alone beyond Europe.
Third, each separate business line needs to be supported by adequate financial resources. These may be calculated in different ways – for example in banking and insurance, although we are trying to establish these on the same conceptual basis. Capital is not fully fungible around the group – the required capital supporting the insurance business cannot be raided to make up for deficiencies in the bank. There also need to be adequate financial resources at the group-wide level and capital needs to be available to support whichever part of the group needs it. This can be a difficult balancing act, again in particular where the different parts of the group are located in different countries.
Supervisory response: effectiveness and efficiency
How, in principle, should supervisors respond to these challenges?
There is a deceptively simple answer to this question, Supervisors need to ensure that there are no gaps in the assessment of business risks, controls and financial resources.
Where a conglomerate operates in a single country then, for integrated regulators like the FSA, this usually means 'group supervision' undertaken by dedicated multi-disciplinary teams, based on a single cross-sector approach to measuring, assessing and mitigating the risk posed to regulatory objectives. Where regulators are not integrated it means that the individual agencies need to communicate properly about the risks across a financial conglomerate and how effectively these are mitigated by management and controls.
Where the conglomerate is international in the scope of its operations, this introduces another dimension. Supervisors then need to talk to one another across national boundaries as well as across sectors.
When thinking about supervision, it is important to address both effectiveness (getting the job done and achieving the objectives of supervision) and efficiency (getting the job done in the most efficient way, at minimum cost to supervisors and to the firms).
A simple vision of functional and national supervisors each diligently addressing their own areas of responsibility would not in itself be effective. The key characteristic of conglomerates is that their business risks are complex and potentially difficult to control. This means that someone needs to take an overview of the group, the risks that it poses, and its financial soundness. That is logically the supervisor in the country where the conglomerate has it global headquarters. And if this 'home' state supervisor is not an integrated one, the task of developing the overview might reasonably fall to the 'functional' supervisor of the principal (the largest or highest impact) part of the group.
The job of the Co-ordinating Supervisor is to understand the scope of the conglomerate's business; to understand how business lines and activities in different national markets interact to create risks; to assess the adequacy of the management and control of the business at a global level; and to ensure that financial resources are adequate to support the demands of both individual business lines and the conglomerate as a whole.
But we need to go further and ensure that supervisors with responsibility for conglomerates operate efficiently as well. Why is this important? We need to recognise that regulation distorts markets and imposes costs on firms (and, ultimately, consumers). This means that regulation needs to be justified. This justification typically comes in two parts. First, identification of a market failure, an imperfection in the operation of markets which is a potential source of risk. In practice it is not too difficult to do this: many markets and contracts involve some degree of information asymmetry. This is why the second test is also important –that the benefits of regulatory intervention outweigh the costs. In other words, the regulation must pass a cost benefit analysis test.
What does this mean for the regulation of conglomerates? It means that measures directed specifically at the regulation of conglomerates – in common with all other regulation – have to pass the tests outlined above. We are very pleased that the Commission has undertaken to subject all new proposed measures to impact assessment. And it means that in their day to day activities, supervisors should seek to reduce the burden they impose on firms while still achieving their supervisory objectives.
Home/host supervisory arrangements
Home/host relations are central to both effectiveness and efficiency.
Simplistic solutions – such as a single European regulator or extreme versions of the lead supervisor model (where the whole task is delegated to one agency) - will not work. This is because of differences of powers, differences in the legal basis for operations, differences in resourcing, and because no one supervisor alone would bring the necessary level of oversight and proximity.
But supervisors do need to be creative, flexible and intelligent about how they interact with one another. With cross border groups increasingly centralising and outsourcing key business functions, these operational and business functions often no longer align naturally with the group's legal structure or geographical presence, yet the supervisory division of responsibilities remains. So it is only appropriate to review the roles of the corresponding supervisors.
I welcome the CEBS guidelines on home/host supervisory arrangements. These elaborate on the relevant provisions in the Capital Requirements Directive. They propose an enhanced role for the consolidating supervisor of a group, while recognising that all of the individual authorities involved in the prudential supervision of EU banking groups have an important role to play. The objective is to deliver a more integrated, coordinated and risk-sensitive supervisory approach, and thereby to meet at least some of industry's demand for a more streamlined approach. A two-way exchange of information between consolidating and host supervisors and greater mutual recognition are essential elements here.
The CEBS guidelines support an important step towards more efficient supervision at both consolidated and local levels. The proposed synchronisation of risk assessments should result in better coordination between the consolidating and host supervisors, and closer cooperation on how supervisory tasks are distributed among the respective authorities.
This practical framework developed by CEBS, together with the work of CEIOPS on co-operation for the supplementary supervision of insurance groups, should be used as a foundation model for cross-sectoral co-operation in the supervision of financial conglomerates. The Financial Conglomerates Directive concept of the Co-ordinating Supervisor is very similar to the concept of the consolidating supervisor under the Capital Requirements Directive.
The extent to which a supervisor should be willing to rely on other supervisors must be risk based. It is reasonable, for example, that host supervisors should be keen to have more direct oversight of systemically important firms while being willing to rely on the assurances of others in carrying out their obligations in respect of non-systemic ones. And as over time more European supervisors work more closely together, such as conducting joint visits, this should help to develop mutual reliance and trust.
None of this requires changes in legal responsibilities. There is ample scope within existing legislation for delivering a more pragmatic and practical approach to cooperation – for example through coordinated assessments, joint visits and to some extent mutual reliance - while respecting that supervisors have to meet their domestic obligations.
Such an approach could increase the effectiveness and efficiency of regulation by reducing duplication and make it clear to the industry that we are serious about this.
A related area is that of communications among supervisors. The importance of this in achieving effective and efficient regulation is clear – particularly in the area of conglomerates. My colleague on CEBS, Arnold Schilder, will speak in a moment about the considerable amount of dialogue among supervisors that already takes place. The CEBS work on information exchange, contained within its home/host guidelines, aims to enhance this dialogue still further.
The CEBS work proposes that the information exchange process should be proportionate and risk focused to avoid unnecessary information exchanges; that it should draw on communication within existing and further enhanced operational networks so as to be as spontaneous as possible, allowing any supervisor to take the initiative to submit an issue deemed necessary to be raised; and that information should be communicated on a timely basis. These guidelines can form a useful foundation to build on across the sectors to enhance cooperation and information exchange among the supervisors of a financial conglomerate.
Information flows can take a variety of forms. Highly formal exchanges – for example where host regulators ask to see 'primary sources' such as inspection reports - are difficult to organise and often the least appropriate. There are strict requirements governing the exchange of such information. Most information exchange (at least outside of the domain of enforcement action) does not centre on such formal material. Rather, it is about having a sensible and usually informal dialogue with supervisory counterparts in pursuit of the information and assurances we need to do our jobs. The bedrock of good communication is having a network of people who know one another well and can contact each other early when the need arises. No set of more formal arrangements can – or should aim to – supplant this.
The information exchange process should be proportionate and risk focused so as to avoid unnecessary information exchanges. It is neither possible nor desirable for supervisors to be in constant communication about every aspect of their groups. Some broad principles might usefully apply here, both within and beyond Europe.
First, supervisors should consider carefully whether information is essential or relevant. Essential information is that with a material bearing on the assessment of financial soundness of a group. To the maximum extent possible, this should be transmitted proactively by the Co-ordinating Supervisor (subject to the usual protocols). Those requesting information should always be prepared to demonstrate why what is being sought is directly relevant to their responsibilities.
Second, when assessing requests for information, supervisors need to pay regard to the significance or materiality of the institution concerned to the other supervisors seeking the information. We need to be sensitive to asymmetries here. There are many examples in Europe where market A is not hugely material to the global operations of group B. But group B may nevertheless be a major player in market A. Home supervisors need to be sensitive to this interest of host supervisors.
Finally, we would do well to establish the principle that bilateral issues should best be dealt with bilaterally. Where a single coordinator is available to act as a channel for communication flows, this route should only be used where there is a genuine commonality of interest among several supervisors.
Cooperation under the Financial Conglomerates Directive
How does the Financial Conglomerates Directive measure up to these needs for effective and efficient home/host arrangements?
The Directive seeks to establish a coherent approach to the supervision of conglomerates, ensuring that relevant parts of a conglomerate's business do not fall between the regulatory cracks while at the same time minimising the regulatory reporting burden placed on firms. And the Directive aims to ensure that all risks arising from conglomerates are recognised and addressed.
Many of us have experience in bringing supervisors together, whether in the form of banking colleges, insurance coordinating committees, or more informal supervisory dialogues. Such arrangements permit more effective supervision and, if applied wisely, bring benefits to firms in terms of reporting and more efficient supervision. The Directive provides a framework upon which to build on these already established lines of communication and co-operation. It also sets out some basic rules, for example regarding the role of the Co-ordinating Supervisor, which are of particular value in the case of the more complex groups, including those which have multiple Relevant Competent Authorities.
The Directive envisages the Co-ordinating Supervisor disseminating important information among the supervisory authorities involved, establishing an overview of the financial situation of the conglomerate, and planning and coordinating supervisory activities both in times of normal activity and in emergencies. The establishment of clear ownership of these duties and responsibilities is helpful in providing clarity and certainty for both the firms and the supervisors. Used well, this should help to ensure that material risks are addressed in a way which minimises duplication of activity by supervisors.
But is it likely that this improved oversight will, in reality, come at the cost of additional burdens for firms and hence more duplication? In many cases, the Financial Conglomerates Directive does not of itself introduce additional layers of reporting – most of the levels of consolidated reporting requirements already existed under the Banking Consolidation Directive and the Insurance Groups Directive. What is different is that the Financial Conglomerates Directive takes explicit account of the holding company at the very top of the EU structure, permitting the creation of an overall view where none may have existed before.
For non-EEA conglomerates, the question is whether another supervisory authority exists that undertakes worldwide supervision of the group. If this is the case and if, on the basis of an equivalence assessment, the competent authority (that is the authority which would be the coordinator if the group were solely EEA) is satisfied with the level of supervision provided by the third-country supervisor, then the Directive does not require anything further. If the third country supervisor is found not to be equivalent then the competent/coordinating supervisor must apply supplementary supervision under the Directive. In effect the Directive requires us to act only in response to an absence of adequate global supervision - plugging a gap in the supervisory coverage rather than adding to it.
We have only limited practical experience with the Financial Conglomerates Directive to date. It took effect only at the beginning of the year, and the first returns from groups will not be submitted to us until April next year.
It has, in practice, been in some cases a long process to identify which groups are conglomerates under the terms of the Directive; to identify and to agree upon the relevant competent authorities – and sometimes even the Co-ordinating Supervisor - for each conglomerate; and to engage with other supervisors in a meaningful college of supervisors discussion of issues and risks affecting a group as a whole.
Equally, however, there has already been some positive evidence of good discussions with other supervisors, not only in agreeing the Co-ordinating Supervisor and the relevant competent authorities, but also in agreeing the approach that should be taken and how, where necessary, a group should restructure its operation – and in some cases to address its capital position – in order to comply with the Financial Conglomerates Directive. Moreover, we are beginning to see benefits in terms of a greater understanding of cross-sector and cross-border risks and issues, including those relating to risk concentrations, intra-group transactions and the consolidated capital adequacy of groups at both global and European levels. So we certainly intend to continue with our pragmatic and cooperative approach to working closely with supervisors from other countries.
The Financial Conglomerates Directive therefore offers the opportunity to develop further a cooperative approach to supervision, if it is implemented in an intelligent and well thought out manner. Set against this is the risk that a clumsy reading of the rules and a heavy handed application could result in a duplication of reporting and more burdensome supervision. It is up to us in applying the Directive to develop a sensible, workable way of developing the supervision of financial conglomerates.
Implications for the three "level 3" committees?
Much of the focus of the three "level 3" committees so far has been on establishing their roles within sectors and addressing the pressing banking, insurance and securities issues from a single sector perspective. The three committees have already completed much valuable work. But if we are to deliver effective and efficient supervision the committees need also to focus on co-operation and the co-ordination of their activities. In this respect, we very much welcome the Joint Protocol that the three committees have recently agreed, and which is due to be formally signed later today.
It is essential that the underlying conceptual framework of banking, insurance and securities regulation is coherent. In developing the Capital Requirements Directive and the Solvency 2 Directive it is already accepted that the Basel three pillar approach will be utilised, and that the capital regimes should be risk sensitive. While recognising that there will always be differences between the sectors that the regimes will need to accommodate, the more uniform the regimes can be made the better the outcome will be for both industry and supervisors.
It is equally important that specific supervisory issues that are common to all sectors – and thus to conglomerates - are dealt with consistently. Outsourcing and the definition of capital are just two examples of current concerns that have an impact across all three sectors. It makes no sense for the three committees to develop advice to the Commission on such topics, or their own standards or recommendations, which differ in any material way unless there are sound reasons for differences based on sector specific issues.
The Commission also has a role to play here. In devising calls for advice on particular topics, the Commission should consider whether it is appropriate to request collective advice from two or three of the committees, or incorporate in their request to a specific committee a suggestion that the committee liaises with the other committees in formulating its advice.
The continuing development of conglomerates, and their growing importance in delivering financial services within Europe, brings this imperative into sharp relief. We cannot expect conglomerates to develop different processes and internal control mechanisms to deal with the same issue in different parts of their operations.
We are optimistic that, following the Joint Protocol, the three committees will develop a work programme that will deal with the critical cross-sectoral issues. It will be essential for the three committees to prioritise and determine what work may effectively be pursued collectively, and what work a specific committee might lead on and be expected to co-ordinate. The first steps are already being taken.
The day-to-day supervision of conglomerates involves more than just achieving greater consistency in the rules. It requires active collaboration amongst the relevant national and sectoral supervisors. In this respect, we welcome the intention to move towards the establishment of a Joint Standing Committee on Conglomerates, with membership drawn from CEBS and CEIOPS and with CESR participating as an observer.
The FSA is an active participant in all the "level 3" committees and we take a close interest in their development. We have thought carefully about what might be required for the committees to be judged a 'success'. We believe that there are four areas in which it will be necessary to demonstrate effective delivery – both in terms of making our processes more effective and in demonstrating to the industry that we are serious about ensuring that regulation is efficient. I have already covered three of these areas in the context of conglomerates, namely that:
-
the industry expects to see further tangible progress in the area of home/host cooperation. The industry has a right to expect regulators to collaborate effectively to achieve their regulatory objectives while minimising the burden on them;
- proper impact assessments of new measures and evidence based approaches should be extended to include all stages of the policy formation process; and
- we need to demonstrate that the three "level 3" committees are serious about cooperating on issues that cut across sectoral lines.
The fourth area is greater use of peer group review. CESR has largely made the running in this area to date. We would all agree that effective implementation of measures is essential. Some form of proportionate but effective monitoring to check that implementation is consistent with the spirit as well as the letter of the measures concerned is central to this.
Conclusion
This conference is about a key aspect of the Lamfalussy process. The FSA is a strong supporter of this process. Aspects of it are still evolving but we believe it offers an effective mechanism for introducing well conceived and proportionate European regulation while also promoting greater regulatory convergence. This applies as much to the prudential supervision of conglomerates as to other aspects of financial services regulation.