Supervision of Groups: Key
Principles and Tools
Keith Pooley
Workshop on Cross-Border Supervision and
Consolidated Supervision
June 2-4, 2015
Beirut, Lebanon
Objectives of this session
• To understand:
– the nature and purpose of consolidated supervision
– how it differs from and adds value to solo supervision
– the main tools and techniques of consolidated supervision
• To cover:
– concepts of consolidated supervision
– challenges in carrying out consolidated supervision in practice
– capital and liquidity in consolidated supervision
– intra-group exposures
2
2
Basel Committee
Basel Concordat, 1983:
– “The principle of consolidated supervision is that parent banks
and parent supervisory authorities monitor the risk exposure including a perspective of concentrations of risk and of the
quality of assets - of the banks or banking groups for which they
are responsible, as well as the adequacy of their capital, on the
basis of the totality of their business wherever conducted”
International Standards
- BIS Core Principles
Principle 12 – Consolidated supervision:
“An essential element of banking supervision is that the supervisor
supervises the banking group on a consolidated basis, adequately
monitoring and, as appropriate, applying prudential standards to all
aspects of the business conducted by the banking group worldwide.”
So it is necessary to:
– be clear what is a “banking group”
– define what it means to supervise a group on a consolidated basis
– define how to apply prudential standards to the group
What is Consolidated Supervision?
• The overall evaluation - both quantitative and qualitative - of the strength
of a group to which a bank belongs, to assess the potential impact of other
group companies on the bank.
• The assessment is both:
– Quantitative - based on a number of sources of information, including
consolidated financial returns
– Qualitative - of the whole group (including the activities of group
companies not incorporated in the consolidated returns), including
consideration of the Group-wide systems and controls
Why Consolidated Supervision?
•
Consolidated supervision is desirable because there are risks to a bank, which
may pose a threat to it, arising as a result of its membership of a wider group.
•
These risks include:
– the risk that risks taken by other group companies might undermine the
group as a whole;
– the financial risks taken on by a bank in its links with other group
companies, such as intra-group lending; and
– the reputational risk to a bank if there are losses or other problems
elsewhere in the group.
•
Reputational risk is of particular concern to supervisors. Even if a bank were
entirely ring-fenced from the rest of its group and had no intra-group lending,
problems elsewhere in the group might pose a risk to the bank.
But the focus of Banking Supervision
For banks, membership of a group can be a source of strength:
• advantages of scale and potential benefits from diversification of risk
• access to resources (financial and others) of the group in case of need
But for the supervisor the main focus is on the risks to the bank:
•
losses from direct exposure to problems elsewhere in the group, e.g.,
through bank funding of other group companies
•
contagion: indirect impacts on the bank, e.g. from reputational
damage
•
source of financial weakness, e.g., holding company not wellcapitalised
•
access to group resources is not available in practice, when required
Consolidated supervision is not a panacea
• A complement to, not a substitute for, solo supervision, which is needed as well,
and the importance of which is stressed in international standards.
• Consolidated supervision alone cannot detect all events within a Group that can
pose a threat to the bank:
- how transparent are the risks in the group?
- what could go wrong in the group that would harm the bank – and how would a
problem affect the bank in practice?
- who is really running the bank and group, do I have access to them and do they really
understand and control the group’s risks anyhow?
- how can I be sure that capital and liquidity are adequate on a group basis?
- are there opportunities for regulatory arbitrage that may obscure risk?
- how do I interpret consolidated accounts of banking groups?
- are the numbers on bank performance reliable or distorted by group policies?
- can I rely on other supervisors (at home and abroad, as applicable) to help put
together the full picture of risk?
Consolidated Supervision in practice
Three key steps:
– identify the scope of the group that is “supervisable” in practice and
ensure that (where there are multiple supervisors) there is one
supervisor accepting responsibility for consolidated supervision
– apply bank prudential standards to the banking group (capital,
liquidity, large exposures, corporate governance etc.) with appropriate
modifications (e.g., if insurance companies are included in the group)
– carry out supervision of the banking group, including offsite
monitoring (with appropriate reporting), onsite work (including foreign
operations) under risk-based approach
Determining group structure
First key step is to identify the scope of the group...
- include bank and its subsidiaries and affiliates on appropriate basis
- include holding companies (top company and intermediate holdcos)
- include sister companies, where financial
- also funding and service companies
- and unregulated entities, where financial
- include foreign companies on the same basis (i.e. including holding companies
etc.)
...and ensure there is a supervisor clearly responsible for and best-placed to carry
out consolidated supervision:
- usually the supervisor of the top company, if a bank
- or the supervisor of the main bank in the group
Techniques Of Consolidation
Full
consolidation
Line by line
consolidation
Balance sheets added together. Intra group balances netted. Total
positions risk weighted in the required way
The consolidation of balance sheets according to conventional
accounting rules (including the netting of balances between
companies included in the consolidation).
Pro Rata (or
Proportional)
Consolidation
Balance sheets combined. Proportion of risks added, determined by
holding. Total positions risk weighted in the required way
Deduction
No consolidation
Consolidated supervision: prudential
regulation
Second key step: apply prudential standards to the banking group:
– capital requirements, using Basel standards (including Pillar 2)
– liquidity requirements: Basel requirements (when implemented)
– large exposures: limits should apply to aggregate group wide
exposures
– governance etc: requirements for an effective board of directors,
sound internal controls and risk management should apply group wide
Other requirements still apply at solo/national level – market conduct/AML
etc, but scope to examine group wide controls
Consolidated supervision: group
capital adequacy
Two overall approaches to the calculation of group capital adequacy:
- Consolidation/“line-by-line”: starts with one balance sheet for the whole group (as for
audited financial statements); investments in group companies net out as do intragroup balances; only capital raised outside the group is recognised; capital
requirements calculated on basis of group consolidated risks (credit, market etc.)
- Aggregation: starts with calculation of group capital (top company and any other
externally-raised capital); capital requirements aggregated across group, including
notional requirements for unregulated entities
Consolidation/“line-by-line” preferred for banking groups (alignment with audited group
accounts an advantage), although supervisors need to be sure capital is available across the
group, as the approach requires.
But aggregation useful for some entities (e.g. insurance companies, regulated foreign
companies) and risks (e.g. market risk calculated with internal model)
Consolidated supervision: liquidity
Basel III approach – Liquidity Coverage Ratio (LCR) to be applied on a
consolidated basis using the consolidating supervisor’s rules
For cross-border groups, Basel also recognizes the need to take account of
conditions in national markets, reflected in national regulators’ rules:
– so national standards should be used by banks, for example, for assumptions
on retail deposit outflows expected in stressed conditions
As with capital adequacy, excess liquidity must not be recognised by a crossborder group in its consolidated LCR if there are restrictions on its transfer:
– e.g., ring-fencing measures, non-convertibility of local currency, foreign
exchange controls etc)
Liquidity risk management standards also apply on a consolidated basis
Consolidated supervision: Supervision
Third key step: carry out supervision on a group basis
– require regular reports on group capital, liquidity, large exposures etc
– hold group management to account for meeting standards on group
wide basis
– assess risks across the banking group (and in wider group, if there is
one) and intra-group transactions/exposures
– carry out onsite work on group issues, e.g., examinations of companies
within the group (including foreign operations), and adequacy of group
governance, risk management, internal audit etc
To emphasize, consolidated supervision is about more than consolidated
capital adequacy. It involves understanding the risks in the group and how
they may adversely affect the bank - i.e., supervision.
Consolidated Supervision
- information requirements
Information requirements
• In order to carry out the qualitative part of the risk assessment, information is required
both on the overall structure of the group and the individual significant business units.
Group legal structure and management structure
• A bank should provide a chart that shows:
- every company included in its consolidated prudential returns: including any
subsidiary or associated company included by virtue of a deduction from capital, as
well as companies included on a line-by-line basis or by aggregation plus.
- the extent of outside shareholders’ interests in group companies.
- the group management structure. This should focus on units that carry on revenueearning activities and should indicate clearly the way in which group senior
management responsibilities are allocated.
Consolidated Supervision:
Key areas of focus
Questions to ask:
- what is the group business model (or models) and strategy?
- how is the group managed, centrally or on a devolved basis?
- what are the key risk concentrations and how are they managed at group
level?
- what are the obstacles to movement of capital and other resources
within the group, if required (is capital “fungible” in practice”?)
- what is the overall level of risk in the group: are there diversification
benefits or is the group complex and hard to manage?
- what information on the group do I need in addition to regular reporting?
- what do I need to do to be ready for a crisis affecting the group as a
whole?
Consolidated supervision:
group governance
What is adequate group wide governance and risk management?
-
management and control covers whole group (no “black holes”)
-
respects separate governance requirements applying to individual companies,
especially in different jurisdictions
-
group wide control functions: risk management, internal audit etc, in addition
to local functions (may also – e.g., internal audit – do the work of local
function)
-
supported by group wide management information (MI)
Different degrees of centralisation of management in practice
Consolidated supervision:
group governance
Senior management set the
tone and cascade accountability
for risk management
throughout the firm
Accountability for ensuring
risk is managed consistently
with the Risk Framework
approved by the Board
The maximum amount of
particular risks to which the
Group wish to be exposed
Role
of the Board
and senior
management
Confirmation of the
effectiveness
of the Risk Framework
and underlying risk and control
Risk appetite,
tolerance and limits
Provides succinct guidance to all
levels of staff on the way the
Group manage specific risks
Risk framework
and policy
Ensures line 1 and line 2 are
aware of their separate risk
management duties to the firm
Categorization and definition of
the risks
Makes risk management a core
element of the Group’s culture
by considering actions and
behaviours
Segregation of
duties
Risk identification
and measurement
Culture
Mandate of the
risk function
Risk monitoring and
reporting
Resources
The role of RMF including
ownership at Board level
A suite of risk metrics and
information to support effective
decision making at all levels
Appropriately skilled resources
able to support a growing
business and risk management
function
1
9
Consolidated supervision:
intra-group transactions
Supervisors need to oversee intra-group transactions and exposures:
-
-
can be efficient and low risk, e.g., group funding via central treasury
can also be source of risk to bank – likelihood of less disciplined approach to
credit on intra-group (and related party) lending, including less monitoring of
how funds are used
can be used to transfer risk or value to and from other parts of the group
can obscure the bank’s real performance
transactions with unregulated entities potentially high risk
Basel standards on large exposures do not cover intra-group:
- but should be monitored and transactions/exposures reported to supervisor on
a regular basis
- supervisor should understand group’s approach
Consolidated supervision:
good practices
• An effective banking supervisory system should consist of some form of both on-site and
off-site supervision.
• Banking supervisors must have regular contact with bank management and thorough
understanding of the bank's operations and their interactions with the rest of the Group.
• Banking supervisors must have a means of collecting, reviewing and analysing prudential
reports and statistical returns from banks on a solo and consolidated basis.
• Banking supervisors must have a means of independent validation of supervisory
information either through on-site examinations or use of external auditors.
• An essential element of banking supervision is the ability of the supervisors to supervise
the banking group on a consolidated basis.
Consolidated supervision:
cross border practices
Cross-border Banking – key components
• Monitoring and applying appropriate prudential norms to all aspects of the business
conducted worldwide through foreign branches, joint ventures and subsidiaries.
• Establishing contact and information exchange with the various other supervisors
involved, primarily host country supervisory authorities.
• Requiring local operations of foreign banks to be conducted to the same high standards
as are required of domestic institutions and having powers to share information needed
by the home country supervisors of those banks for the purpose of carrying out
consolidated supervision.
Consolidated supervision: simple groups
with and without holding company
MEB Holdings
Middle East
Bank
MEB Consumer
loans
MEB
mortgages
AB Bank
Consolidated supervision: a complex group multiple
activities and countries
MEB Holdings
Middle East Bank
MEB Capital
Ltd
Middle East Bank
(Singapore) Ltd
MEB Trustees
Jordan Ltd
Middle East Bank
(UK) Ltd
MEB Securities Ltd
MEB Leasing (UK)
Ltd
Dubai Funds Ltd
ME Bank
Mortgages Ltd
MEB Life
Assurance Ltd
MEB Insurance
Brokers Ltd
MEB
Microfinance
Bank Ltd
Consolidated supervision: sources of group
financial weakness
MEB Holdings
Middle East
Bank
MEB Consumer
loans
MEB
mortgages
Middle East
Bank
AB Bank
Bank capital 100
Investment in subsidiaries 80
Capital available to bank: 20 not 100
MEB Consumer
loans
MEB
mortgages
AB Bank
Holdco
Capital :
10
Debt :
90
Investment in subsidiaries:
100
How much real capital is
available to the banks?
Recap: Steps in consolidation
1. Determine the Group structure (Participation levels, majority of votes,
concept of control, type of business of each group member)
B
2. Determine the scope of consolidation (i.e., the relevant units for
regulatory consolidation)
3. Determine the type of consolidation (full, pro rata, deduction etc.) for
any relevant unit
X
Full
X
Y
Y
B
Pro rata
Y
Y
4. Add capital positions according to type of consolidation in the sequence
Tier I, deductions from Tier I, Tier II, deductions from Tiers I & II,
5. Add risk positions according to type of consolidation separately for
Risk weighted assets and market risks
6. Calculate prudential ratios in a similar way to ratios on a solo basis
26
Capital
>= 8%
Risk
Summary
• Consolidated supervision enables supervisors to take necessary action to
protect banks from the adverse effects of being part of a group
• It is not about supervising all aspects of the group directly and it supplements
rather than replaces solo bank supervision
• Defining the group’s scope (requiring restructuring, if necessary) is the key
first step
• The tools of consolidated supervision are the same as for solo supervision
(especially application of prudential standards and supervision), adapted and
extended as necessary, e.g., for non-bank risks, intra-group transactions
• Consolidated supervision covers cross-border business too – with a key role
for host as well as home supervisors, e.g., in identifying group wide risks and
contributing to coordinated supervision