regulatory consolidation & consolidated supervision

Regulatory Consolidation Regulatory Consolidation & Consolidated & Consolidated

SupervisionSupervisionRegulatory approach, Examples and Case Regulatory approach, Examples and Case

Studies using Germany and UK as points of Studies using Germany and UK as points of comparisoncomparison

4.4. Flexing Case Study BFlexing Case Study B

Section 1

Section 3

Section 2

Section 42. Case Study A2. Case Study A

3. Case Study B3. Case Study B

Sections:Sections:

1.1. Principles of Consolidated SupervisionPrinciples of Consolidated Supervision

Annexes:Annexes:

I. Applying Consolidation TechniquesI. Applying Consolidation TechniquesII. BIS Core PrinciplesII. BIS Core Principles

I. Principles of Consolidated SupervisionI. Principles of Consolidated Supervision

II. Applying the Principles of Consolidation in Germany and the UK

III. Other Elements of Quantitative Consolidated Supervision: Large Exposures and Limits on Investments

IV. Going Beyond Simple Consolidation - the Use of Flanking Policies and Qualitative Consolidated Supervision

Section 1

Section 3

Section 2

Section 4

Section 1: Principles of Section 1: Principles of Consolidated SupervisionConsolidated Supervision

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Contents

THE PRINCIPLES OF CONSOLIDATED SUPERVISIONTHE PRINCIPLES OF CONSOLIDATED SUPERVISION• The Rationale for Consolidated SupervisionThe Rationale for Consolidated Supervision• What is Consolidated Supervision?What is Consolidated Supervision?• International Standards - BIS Core PrinciplesInternational Standards - BIS Core Principles• International Standards - Basic Legal Principles for the EUInternational Standards - Basic Legal Principles for the EU• Solo and Consolidated SupervisionSolo and Consolidated Supervision• Quantitative Consolidated SupervisionQuantitative Consolidated Supervision• Powers of SupervisorsPowers of Supervisors• Steps in Quantitative Consolidated SupervisionSteps in Quantitative Consolidated Supervision• Step 1: Determining the Domain of ConsolidationStep 1: Determining the Domain of Consolidation• Step 2: Identifying the Companies to be ConsolidatedStep 2: Identifying the Companies to be Consolidated

– Financial InstitutionsFinancial Institutions– Exceptions to ConsolidationExceptions to Consolidation– Groups subject to Consolidated Supervision ElsewhereGroups subject to Consolidated Supervision Elsewhere

• Step 3: Techniques of ConsolidationStep 3: Techniques of Consolidation– Different approaches for Capital Adequacy and Large ExposuresDifferent approaches for Capital Adequacy and Large Exposures

88 99 1010 1212 1313 1414 1717 1818 1919 2020 2121 2222 2323 2424 2626

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Contents

APPLYING THE PRINCIPLES OF CONSOLIDATION IN GERMANY AND THE UKAPPLYING THE PRINCIPLES OF CONSOLIDATION IN GERMANY AND THE UK• Main participation levels for consolidation Main participation levels for consolidation • Consolidation rules in GermanyConsolidation rules in Germany• Consolidation rules in the UKConsolidation rules in the UK• Relevant Consolidation Rules in GermanyRelevant Consolidation Rules in Germany• Relevant Consolidation Rules in the UKRelevant Consolidation Rules in the UK• Consolidation when banks have a Trading BookConsolidation when banks have a Trading Book• Dealing with Cross ShareholdingsDealing with Cross Shareholdings• Consolidation of Participations - GermanyConsolidation of Participations - Germany• Consolidation of Participations - UKConsolidation of Participations - UK• General Example - GermanyGeneral Example - Germany• General Example UKGeneral Example UK• Calculating Prudential RatiosCalculating Prudential Ratios• Prudential Ratios for CAD in GermanyPrudential Ratios for CAD in Germany• Structure of Reporting Forms for CAD reports in Germany Structure of Reporting Forms for CAD reports in Germany • Prudential Ratios for CAD in UKPrudential Ratios for CAD in UK• Structure of Reporting Forms for CAD reports in UKStructure of Reporting Forms for CAD reports in UK• Quantitative Consolidated Supervision in the UKQuantitative Consolidated Supervision in the UK

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Contents

OTHER ELEMENTS OF QUANTITATIVE CONSOLIDATED SUPERVISION: LARGE OTHER ELEMENTS OF QUANTITATIVE CONSOLIDATED SUPERVISION: LARGE EXPOSURES & LIMITS ON INVESTMENTSEXPOSURES & LIMITS ON INVESTMENTS

• Large Exposures RatiosLarge Exposures Ratios• Large Exposures Ratios - soft limits in the Trading BookLarge Exposures Ratios - soft limits in the Trading Book• Investments in Non-Financial InstitutionsInvestments in Non-Financial Institutions

GOING BEYOND SIMPLE CONSOLIDATION - THE USE OF FLANKING POLICIES AND GOING BEYOND SIMPLE CONSOLIDATION - THE USE OF FLANKING POLICIES AND QUALITATIVE CONSOLIDATED SUPERVISIONQUALITATIVE CONSOLIDATED SUPERVISION

• Flanking Policies for Consolidated SupervisionFlanking Policies for Consolidated Supervision– Fitness and PropernessFitness and Properness– Notification of Shareholders and ControllersNotification of Shareholders and Controllers– Controls on Structures and LinksControls on Structures and Links– Controls on Lending to Connected PartiesControls on Lending to Connected Parties– Limits on Non-Financial ShareholdingsLimits on Non-Financial Shareholdings– Qualitative Consolidated Supervision (UK Practice)Qualitative Consolidated Supervision (UK Practice)

5151535354545555

5656 5757 5858 6060 6161 6262 6363 6464


Section 1

Section 3

Section 2

Section 4

Section 1: Principles of Consolidated Section 1: Principles of Consolidated SupervisionSupervision

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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. It also means that 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 (solo and consolidated) remains the bank itself. The banking supervisor’s purpose inconsolidated supervision is not to supervise all the companies in a group including a bank, but to supervise the bank as partof its group. The supervisor takes account of the activities of other group companies to the extent that they may have a material bearing on the reputation or financial soundness of the bank in the group.

In short, supervisors are looking to spot and to prevent channels of contagion.

Principles of Consolidated Supervision

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What is Consolidated Supervision?Consolidated supervision is an overall evaluation - both quantitative and in some countries 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 based on a number of sources of information. One source is consolidated financial returns - quantitativeconsolidated supervision. This is mandatory under EU law. It is also one of the key recommendations of the Basel Committee on Banking Supervision.

Consolidated supervision in the UK also includes a qualitative assessment of the whole group - including the activitiesof group companies not incorporated in the consolidated returns, because the nature of their assets is such that their inclusionwould not be meaningful (for example industrial or insurance companies). This assessment includes, forexample, consideration of the controls within a group. The additional consolidated supervision beyond the quantitativeassessment is known generally as qualitative consolidated supervision.


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International Standards - BIS Core Principles

Consolidated Supervision is an important element of the 1997 BIS Core Principles for Effective Banking Supervision (see Annex II). The most relevant of these principles are Principles 18 and 20:

Principle 18: “Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and statistical returns from banks on a solo and consolidated basis.”

Principle 20: “An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.”

It is an essential element of international banking supervisory standards that supervisors should supervise the consolidated banking organisation. This includes the ability to review both banking and non-banking activities conducted by the banking organisation, either directly or indirectly (through subsidiaries and affiliates), and activities conducted at both domestic and foreign offices. Supervisors need to take into account that non-financial activities of a bank or group may pose risks to the bank. Supervisors should be aware of the overall structure of the banking organisation or group when applying their supervisory methods. Banking supervisors should also co-ordinate with other authorities responsible for supervising specific entities within the organisation's structure.


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International Standards - BIS Core Principles (Contd.)Other BIS Core Principles are also relevant, especially for the flanking policies that accompany supervision on a consolidated basis. The following are particularly relevant:

Principle 3: “The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation's ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained.”

Principle 4:” Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties.”

Principle 5: “Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.”

Principle 10: “In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm's-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks.”


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International Standards - Basic Legal Principles for EUThe Banking Consolidation Directive, Directive 2000/12/EC (formerly the Second Consolidated Supervision Directive - 92/30/EEC) sets minimum standards for the performance of consolidated supervision of groups including banks throughout the EEA (i.e. EU plus Norway, Iceland and Liechtenstein). It also sets out requirements in respect of capital requirements to be held against large exposures and concentration risks (formerly Directive 92/121/EEC).

The Capital Adequacy Directive (CAD - 93/6/EEC) - building on the Own Funds (89/299/EEC) and Solvency Ratio (89/647/EEC) Directives which established basic capital requirements in terms of credit risk - introduced both a framework for capital requirements for market risk and a requirement for a consolidated assessment of groups including investment firms.

The obligations in these directives require consolidation only up to the highest relevant parent incorporated in the EEA, and not to parents outside the EEA. It is open, however, to supervisors to go further than the minimum requirements.

Note: the extension of consolidation and consolidated supervision does not mean that the parent or non bank members of the group are directly supervised. Only the bank is directly supervised. The interest of banking supervisors in the parent is limited to the risks - financial and non-financial - run by the parent and other members of the group, and the extent that these may expose the bank and its depositors to risk of loss.

It may be important to consolidate other parts of the group, in order to have all the relevant risks included, and this isthe crucial test. Supervisors will extend consolidated supervision beyond the requirements of the directives if the result is a more accurate assessment of risk to a bank.


13

Solo and Consolidated Supervision

Consolidated supervision is not a panacea. It does not cure everything.

Consolidated supervision is generally regarded by supervisors as a complement to, not a substitute for, solo supervision.

Solo supervision is needed as well, and the importance of it is also stressed in international standards. For events elsewhere in the group and the activities of other group companies can pose a threat to the bank in ways which consolidatedsupervision alone cannot detect: for example, intra-group linkages arising from transactions between the bank and othergroup companies will only be revealed by solo supervision.

A complementary assessment of solo capital adequacy and large exposures also permits a supervisory assessment of whether there is an appropriate distribution of capital in a group.

Institutions are therefore required to meet capital adequacy and large exposure obligations on both a solo and aconsolidated basis. The latest consultation paper from the Basel Committee on the reform of the Capital Accord has underscored the importance of solo supervision and ensuring that there is an adequate distribution of capital around the group.

Supervision on a consolidated basis is also supported by a number of flanking policies. These are discussed later in this Section.


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Quantitative Consolidated SupervisionCapital adequacyA bank is required to maintain adequate capital at all times. A bank is set a consolidated capital requirement in addition to that set on a solo basis. Generally, the same principles are used for calculating the consolidated ratios as the solo ratios.

The required capital ratio set on a consolidated basis is normally the same as that set on a solo basis for the principal bank in the group, although UK practice is somewhat different from German practice.

Where a bank fails to meet its consolidated capital ratio, supervisors considers whether this poses a threat to the bank. If they consider that the situation involves a threat to the bank and to depositors they will take action.

• If the bank is the parent company of the group, they will consider whether the bank is being run prudently.• If the bank is not the parent company of the group, supervisors consider what action is needed to protect the bank. It mayalso consider whether the bank continues to be run prudently.

The action needed may be, for example, to pursue the controller of the group for a rectification of the capital position, to require better liquidity or to restrict lending to other group companies.


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Quantitative Consolidated Supervision (Cont..)Large exposuresA bank must meet the limit and notification requirements in respect of large exposures to individual counterparties or groups of closely related counterparties on a consolidated basis. As with capital, generally, the same principles are used for calculating the consolidated requirements as the solo requirements.

Adequate controlsA bank must have adequate internal control mechanisms to produce any data and information which might be relevant for thepurpose of supervision on a consolidated basis.

Reporting obligations on banksA bank is required to submit consolidated returns covering capital adequacy at least twice a year and large exposures at least four times a year.


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Capital adequacy

Large exposures

Major shareholdings

8% Capital Ratio calculated in BIS basis

• Limit of 25% of capital on exposures to a counterparty or a group of connected counterparties

• Limit of 800% on exposures in excess of 10% of capital• Post-notification of such exposures to regulators.

• Holdings of 10% or more of a non-financial company that exceed 15% of bank capital: excess deducted.

• Where total of such holdings exceeds 60% of bank capital: excess deducted.

Quantitative Consolidated Supervision - Minimum Standards


17

Powers of Supervisors

In order to be able to discharge their supervisory responsibilities, supervisors need adequate powers. Powers to require the production of information are especially relevant. Supervisory powers are not explicitly co-ordinated at EU level, and there is some variation in what supervisors can do reflecting local history and culture.

In general supervisors must be able to require the following sorts of information:

• Notification of directorate, key managers and significant shareholders

• Prior notification of changes to the above

• Prior notification by prospective shareholder (not the bank) of intention to acquire significant holding in bank

• Reports of financial information, including large exposures

In addition, supervisors need powers to require banks - or persons who might have information relevant to the supervision of authorised banks - to provide any information which might reasonably be required for the performance of their supervisory duties. These powers should explicitly extend to:

• Parent companies

• Sister companies

• Subsidiary companies

• Related companies

• Major shareholders


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Steps in Quantitative Consolidated Supervision

There are six steps in consolidated supervision:

1. Identify the domain of consolidation. This involves mapping the group structure, the types of business done and determining how and to what extent control is exercised.

2. Determine the companies to be consolidated. This involves identifying the perimeter of regulatory concern and the limits of the regulatory consolidation (as opposed to the accounting consolidation).

3. Identify the consolidation technique to be used. This involves an assessment of the extent to which the affairs of the company being consolidated might impact on the bank.

4. Calculate the capital base

5. Bring in the risk assets

6. Calculate the prudential ratio

Steps 1-3 can involve considerable complexity and difficult judgements. These issues are discussed on the following pages, followed by illustration of how they are applied in Germany and the UK.

Steps 4 and 5 are arithmetical consequences of the decisions taken in steps 1-3. They are illustrated in the Annex, and also discussed in relation to German and UK practice in Sections 2, 3 and 4 of this report. Step 6, the calculation of prudential ratios is referred to in this section by way of illustrating German and UK practice.


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Step 1: Determining group structure (i.e. the domain of consolidation within a group including a bank)Consolidation is required in the following cases:

(a) when the bank is itself the parent of companies which are financial institutions; and(b) when the bank is not the parent company, but:

(i) the bank is part of a group or sub-group that are wholly or mainly financial institutions; and(ii) the parent of the group or sub-group is itself a financial institution.

To qualify as a financial institution, the exclusive or main business of a company must be either to carry out one or more financial activities (see below) or to acquire holdings in companies undertaking these activities.

‘Mainly’ and ‘main business’ means the balance of business. Consolidation is generally required when companies carrying out financial activities comprise over 50% of the group or sub-group balance sheet. In determining the balance of business, the off balance sheet activities of group companies, and fee-based services provided by group companies are taken into account.

Where the balance of business test is inconclusive, the number of subsidiaries which fall into the financial and non-financial categories is looked at. As a general rule, the presumption will be in favour of consolidation.

Group consolidation must at a minimum extend up to the highest relevant EEA parent, except where another EEA supervisor performs consolidated supervision.

In addition to consolidating a whole group, the UK may also consolidate a sub-group from a bank down, depending on the scale and complexity of business of the sub-group. This is not generally the practice in Germany. The new BIS proposals may lead to greater emphasis being placed on sub-group consolidation.


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Step 2: Scope of consolidation: Companies to be consolidatedRegulatory consolidation is not the same as accounting consolidation, although accounting consolidation is the starting point for regulators and many concepts are shared.

Having determined the domain of consolidation, the supervisor then determines which companies within that domain need to be consolidated. Consolidation extends to all relevant financial companies within that domain: that is the parent company; its subsidiaries and companies in which the parent or its subsidiaries have a participation.

The definitions used of parent and subsidiary are those contained in the Seventh Company Law Directive (83/349/EEC). The notion of subsidiary is also normally extended to cover a company over which the parent or one of its subsidiaries exercises dominant influence. The criteria used to determine whether dominant influence exists are those provided by accountingstandards.

The threshold for the consolidation of group companies which are not subsidiaries - participations - is the ownership of 20% or more of the voting rights or capital.

Companies whose business is not financial are not usually included in the consolidation. Insurance and the broking of insurance are not financial activities for this purpose, and so these companies are not included in a consolidation. Where a non-financial company is excluded from consolidation the investment in that company is deducted from consolidated capital and its assets arenot included in group weighted risk assets. The method of valuation used for the investment should be the normal accounting practice followed by the bank.


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Step 2: Scope of consolidation - What are Financial Institutions?Companies undertaking one or more of these activities are classified as financial institutions for the purposes of consolidated supervision:

(a) Ancillary banking services (defined as ‘ an undertaking the principal activity which consists in owning and managingproperty, managing data processing services, or any other similar activity which is ancillary to the principal activity ofone or more credit institutions’ ).(b) Lending (including, consumer credit, mortgage credit, factoring with or without recourse, financing of commercial transactions (including forfaiting)).(c) Financial leasing.(d) Money transmission services.(e) Issuing and administering means of payment (e.g. credit cards, travellers' cheques and bankers' drafts).(f) Guarantees and commitments.(g) Trading for own account or account of customers in:money market instruments (cheques, bills, CDs etc.);foreign exchange;financial futures and options;exchange and interest rate instruments;transferable securities.(h) Participation in securities issues and the provision of services relating to such issues.(i) Advice to undertakings on capital structure, industrial strategy and related questions and advice and services relatingto mergers and the purchase of undertakings.(j) Money broking.(k) Portfolio management and advice. This category includes fund management companies. (l) Safekeeping and administration of securities.

The following activities are not covered by the above list: insurance; insurance broking; estate agency.


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Step 2: Scope of Consolidation - Exceptions to ConsolidationAs provided for by article 3.3 of the 2CSD (now replaced by article 52.3 of The Banking Consolidation Directive), in a limitednumber of cases the supervisors may permit the exclusion from a bank’s consolidated returns of subsidiaries or participations which otherwise meet the criteria for consolidation, where:

inclusion would be inappropriate or misleading;the companies which otherwise would be consolidated have a combined balance sheet total lower than the lesser of Euro 10million and 1% of the balance sheet total of the parent; orthere are legal impediments to the transfer of information.

The de minimis exemption may only be made for a number of companies if the sum of their balance sheets meets the numerical test; otherwise they must all be included in consolidated reporting. This prevents the formation of a number of small companies being a way round the consolidation requirements.

Use of the legal impediments criterion for exclusion other than on a temporary basis is likely to be inconsistent with the Basel minimum standards and the requirements of EU directives on the supervisability of group structures and has to be considered in this light.

Where such an exclusion is agreed, the investment in that company is deducted from consolidated capital and its assets are not included in group weighted risk assets. The method of valuation used for the investment should be the normal accounting practice followed by the bank.


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Step 2: Scope of Consolidation - Groups supervised by other supervisorsLimitations to rules where a bank is subject to consolidated supervision elsewhere

Where a bank is a member of a group including a number of EEA-incorporated banks/credit institutions, EU supervisors may, at theirdiscretion and following discussion with the other supervisor(s), agree to forgo consolidation.

For a group including a bank whose parent is incorporated in a country outside the EEA, consolidation of the whole group is notnormally required. This is the responsibility of their home authority.

In determining the appropriate treatment in these cases, supervisors take into account whether the parent company is subject toconsolidated supervision by another supervisor that adheres to Basel minimum standards for the supervision of internationalbanking groups and their cross-border establishments.

In those cases in which it determines that a whole-group consolidation would not be appropriate, EU supervisors nonethelessrequires sub-consolidation from the highest relevant EEA parent down.

Groups not subject to consolidation

When a bank belongs to a group or sub-group for which supervisors determine consolidation would be inappropriate (for example incases where the preponderance of the group's business comprises industrial or insurance business), supervisors may require the parentinstitution and its other subsidiaries to supply it with any data or information which it considers relevant to the purpose ofsupervising the bank.

When the parent of a bank is an insurance company, banking supervisors do not normally require consolidation down from the insurancecompany, pending further harmonisation of the basis of accounting for banks and insurance companies. However, supervisors will seeks to co-operate and share information with the supervisors of the insurance company parent.


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Step 3: Techniques Of ConsolidationHaving determined the domain of consolidation, and having identified the companies to be consolidated within that domain, supervisors must then determine the consolidation technique to be used.

Full ConsolidationFull consolidation means including in the group’ s consolidated returns all the relevant assets and liabilities of the companies being consolidated.

Line By Line ConsolidationLine-by-line consolidation is a technique for achieving full consolidation. 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) ConsolidationPro rata consolidation means including in the group’ s consolidated returns only the group’ s share of assets and liabilities in the affiliate concerned. So for a company in which the group holds 25%, the capital adequacy returns would include 25% of that affiliate’s capital, 25% of its other liabilities and 25% of its assets, and the large exposures returns 25% of its exposures. Balances between companies included in the consolidation would be netted in full.

DeductionThe investment in the affiliate is deducted from capital base. The assets of the affiliate are not included in the calculation of weighted risk assets.


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Step 3: Techniques Of Consolidation (Contd..)Aggregation PlusAggregation plus is a technique of consolidation introduced to help apply the market risk requirements of the EU Capital Adequacy Directive. The local supervisor’s capital rules are used to generate a capital requirement for the affiliate. This is aggregated with the capital requirements arising as a result of the group’s other business. The aggregate capital requirement is then compared with consolidated group capital.

When a subsidiary is consolidated using aggregation plus based on the relevant local supervisor’s capital regime, all the deductions from capital made by the local regulator must be deducted from the consolidated capital base. So where, for example, the local supervisor applies a deduction in respect of illiquid assets, this deduction is reflected in the consolidated capital base.

Aggregation plus has the advantage that there is only one capital calculation in respect of the affiliate for both solo and consolidated supervision. It is only permitted where the capital regimes are deemed to be broadly equivalent to the CAD. Because an affiliate’s capital requirements are computed on an individual company basis when using aggregation plus, intra-group exposures are not netted out and there is no allowance for the offsetting of positions between companies, when looking at the group position.

The application of these techniques is illustrated in the Annex to this report.


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Types of Consolidation - and when to use themCapital AdequacyHaving decided which group companies need to be consolidated, the correct technique for consolidation needs to be determined in each case. The precise technique to be used depends on the nature of the company to be consolidated, and the extent of the participation in the company being consolidated.

While the principles of consolidation are very similar in Germany and the UK, practice differs slightly. These differences are explored below.

Large ExposuresFor large exposures purposes, affiliates are always consolidated on a line-by-line basis (irrespective of whether the exposure is in the banking or trading books).

The application of large exposure limits to counterparty exposures is based upon the sum of all the counterparty exposures to an individual entity or group.



II. Applying the Principles of Consolidation in II. Applying the Principles of Consolidation in Germany and the UKGermany and the UK

Section 1

Section 3

Section 2

Section 4

Section 1: Principles of Consolidated Section 1: Principles of Consolidated SupervisionSupervision

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Particip-Particip-ationation

Associate Associate

Subsid.Subsid.

Main participation levels for consolidationMain participation levels for consolidationParentParentBankBank

Particip-Particip-ation ation <= 10%<= 10%

10 <= 20%10 <= 20%

20 <= 50%20 <= 50%

> 50%> 50%

No ConsolidationNo deduction from capital

Voluntary partial consolidation or deduction from capital

Significant control: Mandatory partial consolidationNo significant control: Voluntary partial consolidation or deduction from capital

Majority of votes: Full consolidationotherwise: partial consolidation or deduction

Majority of votes: Full consolidation/deduction

Full consolidation/deduction.Pro-rata consolidation only if other partners are substantial.

No consolidation, no deduction from capital (unless financial institution), but limits on total holdings

No ConsolidationNo deduction from capital (unless financial institution)

GERMANYGERMANY UKUK

Applying the principles of consolidated supervision

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Consolidation Rules in GermanyConsolidation Rules in Germany

ParticipationsParticipations under 10% in all companies are normally weighted as a risk asset.

Participations of between 10 and 20% are either deducted from capital, or subject to voluntary pro-rata consolidation. Holdings innon-financial companies are also subject to to EU rules which penalise major holdings in non-financial companies.

Associate companies (participation of between 20% and 50%)Participations between 20%-50% which give rise to substantial control are normally pro-rata consolidated. Where there is no significant control, the holding is either deducted from capital or is subject to voluntary pro-rata consolidation.

SubsidiariesWhere there is full control, the subsidiary is fully consolidated using the line-by-line technique. Where holding the majority of sharesdoes not give full control, then the holding is subject either to pro-rata consolidation or to deduction.


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Consolidation Rules in the UKConsolidation Rules in the UK

ParticipationsParticipations under 20% in non financial companies are normally weighted as a risk asset (although subject to EU rules which penalise major holdings in such companies).

Participations in banks and regulated financial institutions which are not consolidated are deducted from capital (see below).

Associate companies (participation of between 20% and 50%)Participations between 20%-50% in non financial companies are normally deducted from capital. Full consolidation is normally required for financial institutions. Line by line consolidation is the normal technique, except where thecompany is subject to the prudential supervision of another regulator in the UK, EEA or CAD-equivalent territory when aggregation plus is used.

Full and pro rata consolidationThe normal technique of consolidation is full consolidation of all majority shareholdings and participations. The UK agrees to proportionate (‘pro rata’ ) consolidation of participations only in exceptional circumstances, where it is satisfied that there are othersignificant shareholders who have the means and the will to provide as much parental support to the entity as the shareholder subject to consolidated supervision. This is most likely to be another bank.


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Relevant consolidation rules in Germany

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20 < = 50%20 < = 50%

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32

Relevant Consolidation Rules in UK

* Pro Rata consolidation may be used in specific circumstances* Pro Rata consolidation may be used in specific circumstances


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Participation < 10%Participation < 10%

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Associate 20% - 50%Associate 20% - 50%

Subsidiary > 50%Subsidiary > 50%

Weight asWeight asrisk assetrisk asset




DeductDeduct

DeductDeduct

DeductDeduct

DeductDeduct

ConsolidateConsolidateLine by LineLine by Line

ConsolidateConsolidateLine by LineLine by Line*

ConsolidateConsolidateAggregationAggregation

Plus*Plus*

ConsolidateConsolidateAggregationAggregation

PlusPlus

33

Consolidation When Banks Have A Trading Book

For capital adequacy purposes, the primary distinction is between what is consolidated into the group banking book andwhat into the group trading book.

Risks consolidated into the banking bookRisks are consolidated into the banking book in the following cases; the technique used is always line-by-line consolidation:

Banking books of other group banksAssets of financial companies other than investment firms

Risks consolidated into the trading bookRisks are consolidated into the trading book in the following cases; the technique used usually aggregation plus:

Trading books of group banks (and foreign exchange and commodity exposures)Risks in group investment firms

Consolidation of a trading book may be carried out on a line-by-line basis, if a bank can satisfy its supervisor that all the followingconditions are met:

(a) the parent bank has integrated monitoring of trading book positions across the entities using line-by-line consolidation;(b) the banking subsidiary or investment firm satisfies its local supervisory requirements on a solo basis;(c) the parent bank is able to carry out adequate line-by-line consolidation on a daily basis; and(d) capital resources are freely transferable between the banking subsidiary and the rest of the group.

Only where line-by-line consolidation is used may banks offset long and short positions in different financial instruments inthe calculation of consolidated capital requirements for market risk. Banks wishing to offset exposures must have prior approval.


34

Consolidation When Banks Have A Trading Book (Cont..)

Use of the line by line option is rare. The conditions are often difficult to satisfy and, in the case of investment firms, the supervisor may take the view that the local securities regulator’s capital regime provides a better measure of capital than the banking regime. If,the relevant securities regulator’s regime provides a more accurate measure of the capital required by the subsidiary, aggregation plus will be used.


35

Dealing with Cross- Shareholdings

Bank IIIBank III

Bank IBank I

Bank IVBank IV

Bank IIBank II

40%40% 40%40%

40%40%40%40%


36

Dealing with Cross Shareholdings (Cont..)

Cross shareholdings exist if several subsidiaries have participations in the same "other" subsidiary.

From the perspective of the top-level consolidated unit (in this case Bank I), all indirect participations are added in order to decide upon the type of consolidation. In this case Bank I has indirect participation of 16% in Bank IV via Bank II and also 16% indirect participation via Bank III.

As the total participation is 32% a pro rata consolidation would be necessary in Germany (assuming that the participations represent the extent of the control that the holder is able to exercise). If Bank I had 65% participation in each of Bank II and Bank III (with the participations of Bank II and Bank III in Bank IV unchanged) the resulting indirect participation of Bank I in Bank IV would be 52% (0,65 x 0,4 = 0,26 for both sides) requiring full consolidation in Germany.

In UK, unless there were other independent and very substantial shareholders involved, this structure would require full consolidation.

Bank IIIBank III

Bank IBank I

Bank IVBank IV

Bank IIBank II40%40% 40%40%

40%40%40%40%


37

Consolidation of various participations - Germany

Bank IBank I

Bank VBank V fullfull

100%100%Bank IIBank II

risk risk weightweight

Bank IIIBank III deduct or deduct or

PRPR

Bank IVBank IV PRPR

33%33%15%15%

Bank Bank VIIVII Bank VIIIBank VIII

deduct or deduct or PRPR

Bank IXBank IX PRPR

Bank VIBank VI fullfull

Inv. Inv. FirmFirm

fullfull

Ancillary Ancillary Banking Banking Services Services

fullfull

Inv. FirmInv. Firm risk weightrisk weight

100%100%

100%100%33%33%

50%50% 51%51%

50%50%50%50%

5%5%

Consolidated

Not consolidated


38

Consolidation of Various Participations - Germany (Contd..)

Bank II does not have to be consolidated as the participation is less than 10%.

Bank III does not have to be consolidated, as the participation is less than 20%. It has however to be deducted or, alternatively, to be voluntarily consolidated on a pro rata basis.

Bank IV has to be consolidated on a pro rata basis as the percentage is between 20% and 50% (given the necessary distribution of control).

Bank V and VI have to be fully consolidated as the participation is more than 50%

Bank VII does not have to be consolidated as it is a subsidiary of a non-consolidated entity.

Bank VIII does not have to be consolidated as the participation is under 20% (33% x 50% = 16.5%). Deduction or voluntary pro rata consolidation would be possible.

Bank IX would have to be consolidated on a pro rata basis as the participation is more than 20% (100 x 33% = 33%).

The subsidiary of Bank IX would not have to be consolidated as the participation is less than 20% (see bank VIII).

The other units have to be consolidated as the participation is more than 50%.


39

Consolidation of various participations - UK

Bank IBank I

Bank VBank V fullfull

100%100%Bank IIBank II deductdeduct

Bank IIIBank III deductdeduct

Bank IVBank IV fullfull

33%33%15%15%

Bank Bank VIIVII Bank VIIIBank VIII

deductdeduct

Bank IXBank IX fullfull

Bank VIBank VI fullfull

Inv. Inv. FirmFirm

fullfull

Ancillary Ancillary Banking Banking Services Services

fullfull

Inv. FirmInv. Firm deductdeduct

100%100%

100%100%33%33%

50%50% 51%51%

50%50%50%50%

5%5%

Consolidated

Not consolidated


40

Consolidation of Various Participations - UK (Contd..)

Bank II does not have to be consolidated, as the participation is less than 20%. The investment has, however, to be deducted because it is in a bank.

Bank III does not have to be consolidated, as the participation is less than 20%. It has however to be deducted, as with Bank II.

Bank IV probably a full consolidation would be necessary, unless there are other independent major shareholders.

Bank V and VI have to be fully consolidated as the participation is more than 50%.

Bank VII does not have to be consolidated as it is a subsidiary of a non consolidated entity.

Bank VIII does not have to be consolidated as the participation is under 20% (33% x 50% = 16,5%). Deduction would be required.

Bank IX probably a full consolidation would be necessary, unless there are other independent major shareholders.

The subsidiary of Bank IX would not have to be consolidated as the participation is less than 20% (see bank VIII), but as a regulated investment firm the investment would have to be deducted from the bank‘s capital base.

The other units have to be fully consolidated as the participation is more than 50%


41

General Example - Germany

BankBank Non-bankNon-bankBankBank

Bank VBank V

Industrial companyIndustrial company

100%

50%

FDL 2FDL 290%

Asset ManagerAsset Manager

100%

BankBankIIII

BankBankIIIIII

Non Non BankBank

90%90% 90%

100%

BankBankIVIV

BankBankVIVI

100%

50%

50%


42

General Example - UK

BankBank Non-bankNon-bankBankBank

Bank VBank V

Industrial companyIndustrial company

100%

50%

FDL 2FDL 290%


100%

BankBankIIII

BankBankIIIIII

Non Non BankBank

90%90% 90%

100%

BankBankIVIV

BankBankVIVI

100%

50%

50%


43

General ExampleAn Industrial company which does not qualify as a financial holding company (which has to be determined on an individual basis) may theoretically have more than one bank as a subsidiary in Germany and also the UK. However, the supervisory authorities would most likely require a lot of detailed information on the nature and size of the various units and a solid explanation why it is necessary to have more than one bank. The authorities have not shown much "sympathy" for this type of structure in the past, and the provisions of EU directives on the supervisability of structures have strengthened their position on this.

The consolidation principles are the same as on the previous pages, although there are some variations between German and UK practice.

In Germany:

Non-banks (industry, insurance etc.) do not have to be consolidated, they are considered to be regular Assets which have to be risk weighted and backed with 8% Capital.

Asset Managers do not have to be consolidated. Bank IV has to be fully consolidated as the participation is 50% Bank VI has to be consolidated on a pro rata basis (50% x 50% = 25%) in Germany as it is more than 20%.

In the UK:

Non-bank commercial companies (industry, retail etc.) do not have to be consolidated, they are considered to be regular Assets which have to be risk weighted and backed with regulatory Capital.

Investments in insurance companies, while considered to be non-financial, do have to be deducted from the regulatory capital of the bank.

Asset Managers have to be consolidated, like all financial firms. Bank IV has to be fully consolidated as the participation is 50% Bank VI has to be consolidated either on a pro rata basis (50% x 50% = 25%) or on a full basis if there are no other major

shareholders.


44

Calculating Prudential Ratios

As Consolidation for accounting purposes can be very different from a regulatory consolidation in Germany and the UK, German and UK banking supervisors do not use consolidated financial statements which have been produced for statutory financial reporting. Indeed, it is impossible to derive capital charges for market risks from statutory financial reports as information about individual risk positions is required.

Rather, supervisors throughout Europe use a suite of regulatory returns which have been specifically designed to give supervisors the information they require. These detailed returns are private documents between the bank and its supervisors.

This does not mean that the supervisors do not take an interest in the published financial statements, and do not study them and follow up points of interest and discrepancy between public and private information. But it is the regulatory returns which form the basis for calculating prudential ratios and which are the financial supervisors prime source of information.


45

Prudential ratios for CAD in Germany

Capital ratio = Capital ratio = Consolidated Tier 1 and 2 capitalConsolidated Tier 1 and 2 capital

Consolidated RWAConsolidated RWA

Overall ratio = Overall ratio = Consolidated own fundsConsolidated own funds

Consolidated RWA + 12,5 x (consolidated capital Consolidated RWA + 12,5 x (consolidated capital charges for Market risks)charges for Market risks)

>= 8%>= 8%

>= 8%>= 8%

Calculation every month (end of month) for the aggregated numbersCalculation every month (end of month) for the aggregated numbers

Calculation every quarter (end of quarter) for the detailed numbersCalculation every quarter (end of quarter) for the detailed numbers


46

Structure of reporting forms for CAD reports in Germany

SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

QG1QG1

GB1.1GB1.1QS1.1QS1.1

QS1.2QS1.2

QS1.3QS1.3 QG1.1QG1.1

QFWQFW

QRWQRW

QOPQOP

QRIQRI

QZKQZK

QAKQAK

QHBQHB

QS 2QS 2SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

GB1GB1

YYYYYY

XXXXXX Forms for solo-Forms for solo-basisbasis

Forms for Forms for ConsolidationConsolidation


47


Consolidated RWAConsolidated RWA


Consolidated RWA + 12,5 x (consolidated capital Consolidated RWA + 12,5 x (consolidated capital charges for Market risks including riskscharges for Market risks including risks

consolidated by Aggregation Plus)consolidated by Aggregation Plus)

>= individual >= individual minimum %minimum %

Bank must be able to calculate ratio every dayBank must be able to calculate ratio every dayCalculation every quarter (end of quarter) for the detailed numbers for Calculation every quarter (end of quarter) for the detailed numbers for solo bank, with consolidated report every half yearsolo bank, with consolidated report every half year

BANKING BOOKBANKING BOOK

BANKING AND TRADING BOOKBANKING AND TRADING BOOK

>= individual >= individual minimum minimum %%

Prudential ratios for CAD in the UK


48

Structure of reporting forms for CAD reports in UKCapital Adequacy Reporting in the UK has been rationalised into a single form - the BSD 3. It is very extensive, covering 46 pages. It includes some information which is not necessary to calculate ratios, but which supervisors find of interest.

Assets - loans,Assets - loans,investmentsinvestments

Capital forCapital forCounterparty Counterparty

RiskRisk

Capital forCapital forPosition RiskPosition RiskProvisions & Provisions &

Bad DebtsBad Debts

Profit & lossProfit & loss

ExposuresExposuresnetted ornetted or

guaranteedguaranteed

Information onInformation onOTC contractsOTC contractsbanking bookbanking book

Credit to Credit to directors & directors &

group membersgroup members

Non CapitalNon CapitalLiabilitiesLiabilities

Off balanceOff balancesheet itemssheet items

CapitalCapital

Securities,Securities,investmentsinvestments

Capital Capital AdequacyAdequacySummarySummary

Information onInformation onOTC contractsOTC contractstrading booktrading book

Capital forCapital forSettlement Settlement

RiskRisk

Capital forCapital forLarge Large

ExposuresExposures

Banking Book, Balance sheet & Banking Book, Balance sheet & Trading InfoTrading Info Trading Book

Information on Information on equity riskequity risk

Information onInformation oninterest rateinterest rategeneral riskgeneral risk

Information onInformation oncounterparty counterparty risk on reposrisk on repos

Capital forCapital forFX RiskFX Risk



BacktestingBacktestingResults forResults forVaR ModelsVaR Models

Information onInformation onCommodity Commodity

RiskRisk

Subsidiaries Subsidiaries ConsolidatedConsolidatedby Aggreg.n +by Aggreg.n +

Dealing with

Aggregation +

OutputOutput


49

Quantitative Consolidated Supervision in the UKCapital adequacyUnlike Germany, where banks under normal circumstances have to meet only the BIS 8% ratio, the UK supervisory body sets specific ratios for each bank and banking group on a solo and consolidated basis.

These ratios (calculated on a BIS basis) are often significantly above the 8% minimum. They take into account the individual natureof each institution, its business , its risks and the quality of its systems and management.

A trigger ratio is set. This is the minimum level of capital the bank may have. A target ratio is also set that is above the trigger. If a bank’s ratio falls below target, this prompts immediate discussions with the management of about the level of capital in relationto the business risks being run. If the trigger ratio is breached, this prompts immediate consideration of whether the bank continues to be run prudently and whether banking authorisation should be revoked.

The required capital ratio set on a consolidated basis is normally the same as that set on a solo basis for the principal bank in the group, but may be different.

Factors which may lead to a different consolidated requirement being set include:

i) the location of capital in the group, in particular to ensure that reliance is not being placed on surplus capital which is lockedinto particular companies or countries because of regulatory considerations, exchange controls or taxation;ii) the degree of risk diversification in the group as a whole, compared with that of the principal bank; andiii) any risks which arise on a group basis but are not reflected in the factors influencing the principal bank’ s ratio.


50

Large Exposures

As in Germany, bank must limit the total of its exposures, other than its exempt exposures, to individual counterparties or groups of closely related counterparties exceeding 10% of its large exposures capital base to a maximum of 800% of its large exposures capital base.

However, the UK supervisors impose a sub-limit. The total of exposures in excess of 10% other than exemptexposures, should not exceed 300% of its large exposures capital base without the supervisory authority’s written approval.

Major ShareholdingsAll holdings of capital instruments issued by other credit institutions and financial firms irrespective of amount have to be deducted from regulatory capital, unless these positions are held for trading and with the permission of the supervisory authority.

This deduction applies to all long positions in instruments which are included in the capital of the issuing credit or financial institution and to indirect holdings of capital taken via instruments issued by their holding companies on their behalf, or via holdings in investment vehicles established exclusively or mainly to hold credit or financial institutions’ capital instruments. It covers any holdings of instruments of a capital nature relating to credit or financial institutions.

The rationale for this is to avoid “double gearing”, the double use of capital provided by parties outside the financial system. By holding the capital instrument of another bank, the bank is deemed to have lent that part of its regulatory capital to the other bank. The lending bank should therefore not be allowed to gear up on it.

Quantitative Consolidated Supervision in the UK (Contd..)




III. Other Elements of Quantitative Consolidated III. Other Elements of Quantitative Consolidated Supervision: Large Exposures and Limits on Supervision: Large Exposures and Limits on InvestmentsInvestments

Section 1

Section 3

Section 2

Section 4


52

Other Elements of Quantitative Consolidated Supervision

Capital Adequacy is the main focus of quantitative consolidated supervision. It is not, however, the only element. In EU law, inparticular, considerable attention is also given to the supervision of large exposures on a consolidated basis, and to the control overthe extent to which banks acquire extensive holdings in non-financial companies.

The rationale for these policies is clear.

Significant exposures can be taken by non-bank members of the group of which a bank is part. A seemingly small and harmless exposure can acquire new dimensions when seen in the context of the group’s overall exposure to another counterparty - or group of closely connected counterparties.

Similarly, banks - and banking groups - need to be careful about being too closely associated with non-financial activities. In times of difficulty, banks will not want to be associated with potential problems in such companies and the potential reputational damage that suchassociation may cause. Nor are supervisors comfortable with significant proportions of banks’ balance sheets being immobilised in veryilliquid equity holdings. In addition, supervisors will be concerned that these companies should not benefit from better terms than mightbe available to similar companies without any such equity links with the lending bank.

53

Single large exposure (Banking book) Single large exposure (Banking book) % of Tier I&2% of Tier I&2CapitalCapital

Unconnected CounterpartyUnconnected CounterpartyConnected CounterpartyConnected Counterparty

Definition of large exposureDefinition of large exposure

Maximum limitMaximum limit

Aggregate total of all large exposuresAggregate total of all large exposures

10%10%

25%25%20%20%

800%800%

Unconnected CounterpartyUnconnected CounterpartyConnected CounterpartyConnected Counterparty

Definition of large exposureDefinition of large exposure

Maximum limitMaximum limit

Aggregate total of all large exposuresAggregate total of all large exposures

Single large exposure (TB + BB) Single large exposure (TB + BB) % of own funds% of own funds

10%10%

25%25%20%20%

800%800%

Large Exposures Ratio


54

Large exposures limits have to be observed on a solo and consolidated basis. The limits have to be observed on a daily basis

Large exposure in the Trading Book Large exposure in the Trading Book to an single counterpartyto an single counterparty 500%500%

Total of large exposures in the trading book Total of large exposures in the trading book using soft limitusing soft limit 600%600%

Aggregate LimitsAggregate Limits % of unused own funds% of unused own funds

Any excess has to be deducted from capital, from the total of Tier I, Any excess has to be deducted from capital, from the total of Tier I, II and III capital. Soft Limit only available for trading book and II and III capital. Soft Limit only available for trading book and

attract incremental, and penal capital charge.attract incremental, and penal capital charge.

Large Exposures Ratio - Soft Limits in the Trading Book


55

Limitations on Investments in non financial enterprisesLimitations on Investments in non financial enterprises

Book value of single major participation in Book value of single major participation in single company (apart from banks & FIs)single company (apart from banks & FIs)

15% of bank15% of bankown fundsown funds

Book value of all major participations in non Book value of all major participations in non financial companiesfinancial companies

60% of bank60% of bankown fundsown funds

Supervisors may tolerate excesses on these limits provided that Supervisors may tolerate excesses on these limits provided that the excess amount is deducted from Tier I and II Capitalthe excess amount is deducted from Tier I and II Capital

Definition of a major participationDefinition of a major participation 10% of votes10% of votesor capitalor capital

Investments in non-financial institutions




III. Other Elements of Quantitative Consolidated III. Other Elements of Quantitative Consolidated Supervision: Large Exposures and Limits on Supervision: Large Exposures and Limits on InvestmentsInvestments

IV. Going Beyond Simple Consolidation - the IV. Going Beyond Simple Consolidation - the Use of Flanking Policies and Qualitative Use of Flanking Policies and Qualitative Consolidated SupervisionConsolidated Supervision

Section 1

Section 3

Section 2

Section 4


57

Flanking Policies for Consolidated Supervision

Quantitative supervision of capital adequacy allows supervisors to get an overview of the risks being run by a group of which a Quantitative supervision of capital adequacy allows supervisors to get an overview of the risks being run by a group of which a bank is part. It does not prevent problems arising in the first place. Regulators internationally, especially through the BIS bank is part. It does not prevent problems arising in the first place. Regulators internationally, especially through the BIS Principles for Effective Banking Supervision and EU directives have therefore supplemented quantitative capital regulation with a Principles for Effective Banking Supervision and EU directives have therefore supplemented quantitative capital regulation with a number of flanking policies. These include:number of flanking policies. These include:

• Solo supervisionSolo supervision

•““Fitness and properness” criteria for major shareholders in and controllers of banksFitness and properness” criteria for major shareholders in and controllers of banks

• Notification and other requirements in respect of shareholders and controllersNotification and other requirements in respect of shareholders and controllers

• Controls over group structures and the links between banks and other companies. In particular, firms which have close links with Controls over group structures and the links between banks and other companies. In particular, firms which have close links with banks must fall within consolidated supervision, and supervisors have the right and the duty not to authorise unsupervisable banks must fall within consolidated supervision, and supervisors have the right and the duty not to authorise unsupervisable structures.structures.

• Enhanced reporting and controls over connected lending to group companies and to significant shareholdersEnhanced reporting and controls over connected lending to group companies and to significant shareholders

• Limits on the extent to which banks may hold participations in non-financial companies, and a penal treatment for holdings in Limits on the extent to which banks may hold participations in non-financial companies, and a penal treatment for holdings in excess of limits.excess of limits.

These flanking policies are seen as an essential addition to quantitative capital requirements and quantitative controls over large These flanking policies are seen as an essential addition to quantitative capital requirements and quantitative controls over large exposures.exposures.

The UK also applies a system of qualitative supervision.The UK also applies a system of qualitative supervision.

Going Beyond Simple Consolidation

58

Flanking Policies - Fitness and PropernessFitness and Properness is difficult to define, although the Forum of European Securities Commissions (FESCO) has produced some common standards. An assessment is made of directors, controllers (including major shareholders) and key managers. Supervisors require notification of subsequent changes in directors and senior management and may prevent appointments if they are deemed to be detrimental to the interests of depositors.

Generally, the assessment of fitness covers

honesty;competence;soundness of judgement;diligence; andwhether the holding of a particular position by the person is, or is likely to be, a threat to the bank’ s depositors.

Supervisors examine the person’ s previous conduct and activities in business or financial matters, including criminal convictions, regulatory offences, or improper business practices. Generally, standards are particularly high for persons with the main responsibility for conducting the bank’ s affairs, although the standards depend in part on the nature and scale of the business concerned, and each person is considered in relation to his proposed role.


59

Flanking Policies - Fitness and Properness (Contd.)Shareholder-ControllersWith regard to a shareholder controller, a key consideration is the likely impact on depositors and potential depositors, with thepresumption that the greater the degree of influence, the tougher the test of fitness is. Key considerations are: the shareholder controller’ s business record, other business interests, financial soundness and strength and, in the case of a company, the nature and scope of its business.

A controller should be a source of strength, not weakness to a bank. Supervisors will have regard to any possible contagion which might undermine confidence in the bank. If, for example, a holding company or another company which is a major shareholder in the bank were to suffer financial problems, this could lead to the bank’ s experiencing difficulties

Supervisors will carry out various background vetting checks from external sources to help them form a view.


60

Flanking Policies - Notification of Controllers and ShareholdersTo help the supervisors judge whether the fitness and properness criterion is met, there are five main notificationrequirements that banks must comply with:

1. A bank must know the identity of its directors, controllers and managers and give written notice of any changes.2. A bank must annually notify the identity of its shareholder controllers,the percentage of shares each controller holds and the percentage of voting power such controllers are entitled to exercise or control the exercise of.3. A person who intends to acquire a 10% shareholding or more in a bank must give notification to the supervisory authorities. 4. A person must notify an intention to acquire or increase a shareholding which exceeds the following thresholds: 10%, 20%, 33% and 50%. Such a shareholder must also give notice of an intention to reduce a shareholding when these thresholds are crossed.5. A person who has notified a major shareholding must give prior notice to the supervisory authority before they dispose of that shareholding.

These notification requirements are also set out in EU Directives.


61

Flanking Policies - Controls on Structures and LinksEU supervisors are required by the amending Directive 95/26/EC (“The Post-BCCI Directive”) to refuse authorisation to a credit institution whose structure renders it unsupervisable. The Post BCCI Directive obliges EU governments to legislate so that banks with unsupervisable structures had to be refused authorisation. Existing authorisations could be revoked on the same basis. The most important single lesson of the BCCI affair was seen to be that banking group structures which deny supervisors a clear view of how business is conducted should be outlawed. The Directive imposes major obligations on credit institutions and their supervisors:

• supervisors are required to refuse authorisation (and revoke authorisation) where a bank’ s close links with any other entity prevents effective supervision of the credit institution; and• a bank is obliged to provide the supervisor with the necessary information relating to its close links, to allow this• it requires banks to have their head office in the same state as their registered office;• it requires auditors and accountants performing statutory tasks in relation to credit institutions and closely linked entities in certain circumstances to report significant supervisory information to the relevant supervisor.

Supervisors require information on all of a credit institution’ s close links with any entity, regardless of the business activity of that entity (which may be non-financial and/or non-regulated).

Close linksAn undertaking is closely linked with:

(a) any entity which is its parent undertaking;(b) any entity which is its subsidiary undertaking;(c) any entity which is its fellow subsidiary undertaking; and(d) any person in accordance with whose directions or instructions its directors are accustomed to act(e) any entity in which it has a participation of 20% or more.

The concept of close links applies both to individuals and to corporate undertakings. It also applies to chains of ownership. Banks are required to notify significant changes to group structure immediately, and to submit organisation charts on an annual basis.


62

Flanking Policies - Controls on Lending to Connected PartiesThe total of connected lending is limited to 20% of capital base, except for specific concessions for a treasury role. Connected lending is reported in the large exposures regulatory return.

Because of possible contagion and the risk that the risk assessment of proposed loans to counterparties connected to thebank may be obscured by subjective considerations, supervisors pay particular attention to lending to connected counterparties. Supervisors do not expect lending to connected counterparties to form a significant proportion of a bank’s assets unless the bank fulfils a treasury role for the group, or is doing business with a group bank providing a treasury role. This is agreed in writing and is subject to conditions.

Supervisors want banks to ensure that a proper credit assessment is undertaken for proposed exposures to companies or persons connected with the bank, its managers, directors or controllers. Such an exposure may be justified only if it is undertaken for the clear commercial advantage of the bank, and it is negotiated and agreed on an arm's length basis.

Where the link with the connected company is fairly remote, for example, where a non-executive director of a large bank is adirector of the borrowing company, the exposure may be considered as acceptable up to the normal level for that bank.

Parties connected to a bank comprise:(a) group undertakings (b) associated companies (participation of 20%-50%) (c) directors, controllers and their associates(d) non-group companies with which the bank’s directors and controllers are associated.

Supervisors examine closely all exposures to companies or persons connected to a bank and may deduct them from the bank’scapital base if they are of the nature of a capital investment or are made on very concessionary terms.

This control is principally exercised at a solo level. At a consolidated level, exposures to consolidated group companies are netted out.


63

Flanking Policies - Limits on Non-Financial ShareholdingsEU Directives require deductions in respect of qualifying holdings in non-financial undertakings, which exceed certain limits. A bank’s holding in a non-financial undertaking constitutes a qualifying holding if it directly or indirectly holds 10% or more of the shares in the undertaking, is directly or indirectly entitled to control the exercise of 10% or more of the voting power at any general meeting.

For the purposes of qualifying holding deductions, commercial undertakings are defined as all undertakings other than:

(a) Banks(b) Financial institutions (c) Insurance companies.

Banks should deduct from capital the greater of the total values of the following two items:

(a) The total by which individual qualifying holdings exceed 15% of total Tier 1 and Tier 2 capital; or(b) The amount by which the aggregate of qualifying holdings exceeds 60% of total Tier 1 and Tier 2 capital.

Under EU Directives, where qualifying holdings were already in existence on 1 January 1993, banks have ten years (until 1January 2003) in which to comply with the requirements of the Directive.

Supervisors require banks which either on a solo or consolidated basis have qualifying holdings to report their positions at the same time as filing their solo and consolidated capital adequacy returns.


64

Qualitative Consolidated Supervision - UK OnlyQuantitative consolidated supervision involves a quantitative assessment of the strength of the group to which a bank belongs. It seeks to take account of the risks posed by group companies and business units, to the extent that they might have a material bearing on the reputation or financial soundness of the bank.

The qualitative assessment takes place as part of the risk assessment of the bank.

Qualitative consolidated supervision in the Risk Assessment frameworkThe qualitative part of the risk assessment of a banking group focuses on a group’ s business, controls, organisation and management. It also looks at the overall business environment of the bank and the main parts of the group, and takes account of those risks which are not inherently quantifiable, including operational, litigation and reputational risks.

In practice, the organisation of business and management in a group often does not match its legal structure. In performing arisk assessment, the UK supervisory authority seeks to understand how the bank’ s management runs the group from both a business and a control perspective. Management has to demonstrate how it reconciles running the group on business lines with the need to ensure that legal entities (for which authorisation has been granted) remain in full compliance with supervisory requirements.

A business unit is defined as an organisational unit which carries on revenue-generating activity and whose revenue is separately identified in the group’ s management information systems. A business unit may or may not be a legal entity.

Most of the information for the qualitative assessment comes from information already held on the supervisor’ s files, and through its accumulated knowledge, in particular that derived from on-site work. Where group companies are subject to supervision by other regulators, the FSA takes into account the work done by them.


65

Qualitative Consolidated Supervision - UK Only (Contd..)The UK employs a number of different approaches to assess the potential impact of group companies on the bank and has regular discussions with those members of management who are familiar with, and have responsibility for, the overall group position.

A business unit is significant if it satisfies one or more of the following quantitative criteria:

(a) the revenue of the unit in the financial year ending on the reporting date represents 5% or more of consolidated revenue for that period;.(b) the pre-tax profit or loss of the unit in the financial year ending on the reporting date represents 5% or more of consolidated pre-tax profits;(c) the unit is included in the consolidated capital adequacy returns and gives rise to 5% or more of the consolidated capital requirement at the reporting date;(d) the consolidated group’ s investment in the unit is deducted from capital in the consolidated capital adequacy returns and that investment is 5% or more of the consolidated capital base before deductions; or(e) in the case of a separate legal entity, the bank has an exposure of 10% or more of its solo capital base to the group company.

Note that because these criteria are used, the companies or business units included in the qualitative risk assessment may be different from those companies which are required to be included in a bank’ s consolidated returns, e.g. non-financial companies, such as insurance companies, may be included in the qualitative risk assessment even though they are not consolidated in the consolidated returns.


66

Qualitative Consolidated Supervision - UK Only (Contd..)Information requirementsIn order to carry out the qualitative part of the risk assessment, the UK requires information both on the overall structure of thegroup and the individual significant business units.

Group legal structure and management structureA bank must provide the UK supervisor with a chart which shows every company included in its consolidated prudential returns. This covers 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 chart should also show the extent of outside shareholders’ interests in group companies. In addition, a bank must provide the FSA with a chart of the group management structure. This should focus on units which carry on revenue-earning activities and should indicate clearly the way in which group senior management responsibilities (including the names and job titles of the people concerned) are allocated.

Information on each significant business unitThe following information should be provided to the UK supervisor for each significant business unit:(a) Descriptive information:a brief outline of the nature of its business;the name of the head of unit and his or her location;if the unit is a legal entity, its country of incorporation, whether it is regulated and, if so, the name of its regulator;if it is not a legal entity, whether it is a geographical unit or business unit and the legal entities within which the unit’s business is

recorded, together with their country of incorporation and regulator, if any.


67

Qualitative Consolidated Supervision - UK Only (Contd..)(b) Quantitative information:revenue and percentage of consolidated revenue;pre-tax profit or loss and percentage of consolidated pre-tax profit;if the unit is a subsidiary in the consolidated capital adequacy returns on a line by line basis or by aggregation plus, the

percentage of the consolidated capital requirement at the reporting date to which it gives rise; andif the unit is a subsidiary or associated company, and is included in the consolidated capital adequacy calculation as a

deduction (e.g. as a non-financial company), the percentage of the consolidated capital base, before deductions from totalcapital, which the group investment in that company represents at the reporting date.


Section 1

Section 3

Section 2

Section 4

2. Case Study A2. Case Study A

Sections:Sections:

1.1. Principles of Consolidated Supervision

69

1. Determine the Group structure (Participation levels, majority of 1. Determine the Group structure (Participation levels, majority of votes, concept of control, type of business of each group member)votes, concept of control, type of business of each group member)

2. Determine the scope of consolidation (i.e., the relevant units for 2. Determine the scope of consolidation (i.e., the relevant units for regulatory consolidation)regulatory consolidation)

3. Determine the type of consolidation (full, pro rata, deduction etc.) 3. Determine the type of consolidation (full, pro rata, deduction etc.) for any relevant unitfor any relevant unit

4. Add capital positions according to type of consolidation in the 4. Add capital positions according to type of consolidation in the sequence Tier I, deductions from Tier I, Tier II, deductions from sequence Tier I, deductions from Tier I, Tier II, deductions from Tiers I & II, Tier IIITiers I & II, Tier III

5. Add risk positions according to type of consolidation separately 5. Add risk positions according to type of consolidation separately for Risk weighted assets and market risksfor Risk weighted assets and market risks

6. Calculate prudential ratios in a similar way to ratios on a solo basis6. Calculate prudential ratios in a similar way to ratios on a solo basis

BB

XX YY YY

BB

XX YY YY

Pro rataPro rataFullFull

+ Capital I+ Capital I x x+ Capital II+ Capital II y y- Partic. I- Partic. I xxxx- Partic. II - Partic. II yyyyCons. Cap.Cons. Cap. zzzzzz

+ CR A+ CR A x x+ CR B + CR B y y= RWA cons. zzz= RWA cons. zzz

+ MR A+ MR A xxxx+ MR B + MR B yyyy= MR cons. www= MR cons. www

CapitalCapitalRiskRisk >= 8%>= 8%

Recap: Steps in consolidationRecap: Steps in consolidation

Case Study A

70

Case Study A concerns a Financial Holding Company that owns a Bank. This bank in turn has a number of financial and non financial subsidiaries, including insurance companies.

Case Study B concerns a more complex Financial Holding Company, owning a number of financial and non financial Subsidiaries which in turn have financial and non financial subsidiaries

Case ACase A

Case BCase B

In the case studies which follow, we will apply the steps outlined in 1- 6 in the previous page and apply the consolidation techniques identified in the previous section.

Case Studies - Overview

Case Study A

71

ABC HoldingABC Holding

ABC BankABC Bank

ABCABCLeasingLeasing

ABC ABC FactoringFactoring ABC LifeABC Life ABC Fund ABC Fund

MgmtMgmt

Trust OS Trust OS BankBank

ABC ABC InsuranceInsurance

ABC ABC SecuritiesSecurities

ABC Intl. ABC Intl. BankBank

ABC ABC IndustryIndustry

DEF DEF IndustryIndustry

RetailRetail

ABC ABC ServiceService

100%100% 40%40% 100%100% 100%100% 100%100% 100%100%

40%40% 5%5%100%100% 100%100% 80%80% 100%100%

• Group Structure• Concept of control• Type of business

Financial Financial EnterpriseEnterprise


InsuranceInsurance FinancialFinancialServices Instit.Services Instit.

Non-FSNon-FS Non-FSNon-FS

Non-FSNon-FSNon-FSNon-FSBankBankFinancialFinancialServices Instit.Services Instit.

InsuranceInsuranceBankBank

Financial HoldingFinancial Holding

BankBank

Step 1: Determine group structure

Case Study A

72

Step 1: Determine Group Structure (Contd..)ABC Holding holds 100% of ABC Bank and no other investment. Therefore there is (for consolidation purposes) no difference between the Bank and the Holding Company. The Holding Company is a Financial Holding Company for the purpose of the Consolidated Supervision Directive and must be consolidated. If the Holding Company also held other financial services companies, it would still be considered a Financial Holding Company and would have to be consolidated, bringing in information about those subsidiaries.

The fact and extent of control has to be established between the companies in the group as this will help determine the perimeter of consolidation, and the sort of consolidation techniques to be used. It is also necessary as part of this step to define which type of activity the subsidiaries are engaged in because consolidation also depends on the nature of activity in the company being consolidated. For the purpose of this case study it is assumed that the activities lead to the described type of business (Bank, Financial Enterprise etc.). In reality this step might be extremely complicated.

Case Study A

73


ABC BankABC Bank



MgmtMgmt




ABC ABC Offshore. Offshore.

BankBank



RetailRetail


100%100% 40%40% 100%100% 100%100% 100%100% 100%100%

40%40% 5%5%100%100% 100%100% 80%80% 100%100%

• Regulatory category of unit

• Entities to consolidate

Enities to be Enities to be consolidated in consolidated in GermanyGermany








BankBank

Step 2 - Determine the scope of consolidation in GermanyCase Study A

74


ABC BankABC Bank



MgmtMgmt




ABC ABC Offshore. Offshore.

BankBank



RetailRetail


100100%% 40%40% 100%100% 100%100%

100%100%100%100%

40%40% 5%5%100%100% 100%100%80%80% 100%100%

• Regulatory Category of unit


Entities to be Entities to be consolidated in UKconsolidated in UK








BankBank

Step 2 - Determine the scope of consolidation in the UK

Case Study A

75

Step 2: Determine the scope of consolidation (type of unit for regulatory consolidation)

For German regulatory purposes any non financial entity is not subject to consolidation (it is regarded as normal asset that has to be risk weighted in the normal way. Certain restrictions apply to investment in non financial entities. Life Insurances are also not subject for consolidation.

The approach of the UK is similar to Germany, but there are some critical differences. As in Germany, non-financial companies are not consolidated, and they are treated as risk assets unless the overall EU limits on such investments are breached. Investments in Insurance Companies have a particular treatment, and have to be deducted from capital.

A further difference is that asset management is treated as a financial company and is subject to consolidation. This produces a slightly different perimeter of consolidation.

Case Study A

76


ABC BankABC Bank


ABCABCFactoringFactoring ABC LifeABC Life ABC Fund ABC Fund

MgmtMgmt







RetailRetail


Full Con.Pro Rata

DeductionDeductionRWARWA

100%100% 40%40% 100%100% 100%100% 100%100% 100%100%

40%40% 5%5%100%100% 100%100% 80%80% 100%100%

• Type of consolidation

FRGFRG UKUK FRGFRGFRG UKFRG UK

FRG FRGFRG FRG

FRGFRG UKUK FRGFRG UKUK

FRGFRG FRGFRG UKUK FRGFRG UKUK

FRG UK

UKUKUK UKUK

UKUK

UKUK

Step 3: Determine type of Consolidation

Case Study A

77

Step 3: Determine type of Consolidation (Contd.)

The different colours represent the different types of consolidation. The upper left corner shows the type of consolidation under German regulation, the upper right part shows the treatment under the UK regime

For German consolidation all holdings between 20% and 50% (it is assumed that participation represents control) have to be consolidated on a pro rata basis. Participations of more than 50% have to be fully consolidated. In the UK, such companies will be fully consolidated, unless there are other major shareholders who are likely to support the company in the event that it hits difficulties.

We can also see here the difference between the German approach to insurance (treatment as risk asset) and the UK approach (deduction of investment).

The fund management company is consolidated in the UK, but not in Germany. Note that the UK would probably consolidate the Fund Management Company and the Securities Firm by aggregation plus.

Case Study A

78


ABC BankABC Bank



MgmtMgmt







RetailRetail


100%100% 40%40% 100%100% 100%100% 100%100% 100%100%

40%40% 5%5%100%100% 100%100%

100 ABC L100 ABC L100 T O B100 T O B100 ABC F100 ABC F100 ABC I100 ABC I100 ABC L100 ABC L100 ABC S100 ABC S100 ABC FM100 ABC FM100 ABC IB100 ABC IB100 ABC I100 ABC I100 DEF I100 DEF I100 Ret100 Ret100 ABC Sv100 ABC Sv

1200 Capital1200 Capital

120 C120 C 300 C300 C 120 C120 C 120 C120 C 120 C120 C 120 C120 C

280 C280 C 110 C110 C 110 C110 C 110 C110 C 110 C110 C 110 C110 C

80%80% 100%100%

FRGFRG FRGFRGFRG UKFRG UK

FRG FRGFRG FRG

FRGFRG UKUK FRGFRG UKUK

FRGFRG UKUK FRGFRG UKUK FRGFRG UKUK

Full Con.Pro Rata

DeductionDeductionRWARWA

• Adding Capital Positions• Deducting Participations

UK

UK

UK UKUK

UKUK

ABC has ABC has participation participation

of 100 in of 100 in every every

subsidiarysubsidiary

Step 4: Calculate the capital base

Case Study A

79

Step 4: Calculate the capital baseAs the relevant entities are defined and the type of consolidation determined the consolidation of the capital components can follow, which will give the group‘s capital base.

In order to provide a clear picture, we have used only Tier I positions in this example. (The procedure with Tier II and Tier III components would be identical, but would be clouded by issues of limits on the various sorts of capital).

The addition of the various capital components is displayed on the next slide.

Case Study A

80

= 1442= 1442

CapitalCapital PositionPosition

Position relevant for ConsolidationPosition relevant for Consolidation

120120

300300

120120

120120

120120

120120

280280

110110

110110

110110

110110

110110

12001200

100100

100100

100100

100100

100100

100100

100100

100100

100100

100100

100100

100100

Book value of Book value of ParticipationParticipation

ABC LeasingABC Leasing

ABC FactoringABC Factoring

ABC LifeABC Life

ABC Fund MgmtABC Fund Mgmt

ABC IndustrialABC Industrial

ABC RetailABC Retail

ABC Trust OS BankABC Trust OS Bank

ABC InsuranceABC Insurance

ABC SecuritiesABC Securities

ABC Int. BankABC Int. Bank

DEF IndustrialDEF Industrial

ABC ServicesABC Services

ABC BankABC Bank

Name of UnitName of Unit

120120

300300

12001200100100

100100

112112 100100

110110 100100

4040

18421842 400400

GermanyGermany UKUK

./../.

120120

300300

12001200100100

100100

280280 100100

110110 100100

100100

100100

100100

120120 100100

23302330 800800./../.= 1530= 1530

Step 4: Calculate the capital base (Contd.)

Case Study A

81

Step 4: Calculate the capital base (Contd.)The first column shows the entities of the complete group (regardless whether it has to be consolidated or not).

The second column shows the capital position of the individual companies as it would appear in the balance sheet.

The third column shows the book value of the participations, the ABC Bank has with the various other entities. The book value should normally be less than the capital in the subsidiary. However, it may be that the book-value exceeds the capital position of the subsidiary. In these cases goodwill exists, which has to be treated in a special way (deducted) - which may be different from the treatment in the financial statement (where it may be amortised over time).

The next two columns show the capital components of the units/subsidiaries relevant for German consolidation. The total of the capital positions subtracted by the total of the participations gives the consolidated capital (one position has to be consolidated on a pro rata basis)

The Final two columns show the UK position. It has been assumed that pro-rata consolidation has not been used, and the fund manager has been consolidated. The investments in the insurance companies have also been deducted.

Case Study A

82

Case Study A

Step 5: Bringing in the Asset side of the Balance Sheet

At this point the supervisor calculates the risk assets of the group applying the same principles used for the calculation of the capital base. Thus where line-by-line consolidation is used the risk assets are calculated and aggregated as if they had been held in the solo bank. Where pro-rata consolidation is used the relevant proportion of the risk assets are included. Where aggregation plus is used, the capital requirement levied by the local supervisor is multiplied by 12.5 to give a figure for notional risk assets. Total risk assets are then summed.

83

Case Study A

Step 6: Calculating Prudential Ratios

The prudential ratio can then be calculated by dividing capital base by the weighted risk assets. The ratio should be equal to or greater than 8% to comply with BIS standards.

Section 3

Section 2

Section 42. Case Study A

Sections:Sections:

1. Principles of Consolidated Supervision

Section 1

3. Case Study B3. Case Study B

85

1. Determine the Group structure (Participation levels, majority of 1. Determine the Group structure (Participation levels, majority of votes, concept of control, type of business of each group member)votes, concept of control, type of business of each group member)

2. Determine the scope of consolidation (i.e. the relevant units for 2. Determine the scope of consolidation (i.e. the relevant units for regulatory consolidation)regulatory consolidation)

3. Determine the type of consolidation (full, pro rata, deduction etc.) 3. Determine the type of consolidation (full, pro rata, deduction etc.) for any relevant unitfor any relevant unit

4. Add capital positions according to type of consolidation in the 4. Add capital positions according to type of consolidation in the sequence Tier I, deductions from Tier I, Tier II, deductions from sequence Tier I, deductions from Tier I, Tier II, deductions from Tiers I & II, Tier IIITiers I & II, Tier III

5. Add risk positions according to type of consolidation separately 5. Add risk positions according to type of consolidation separately for Risk weighted assets and market risksfor Risk weighted assets and market risks

6. Calculate prudential ratios in a similar way to ratios on a solo basis6. Calculate prudential ratios in a similar way to ratios on a solo basis

BB

XX YY YY

BB

XX YY YY

Pro rataPro rataFullFull

+ Capital I+ Capital I x x+ Capital II+ Capital II y y- Partic. I- Partic. I xxxx- Partic. II - Partic. II yyyyCons. Cap.Cons. Cap. zzzzzz

+ CR A+ CR A x x+ CR B + CR B y y= RWA cons. zzz= RWA cons. zzz

+ MR A+ MR A xxxx+ MR B + MR B yyyy= MR cons. www= MR cons. www

CapitalCapitalRiskRisk >= 8%>= 8%

Recap: Steps in consolidationRecap: Steps in consolidation

Case Study B

86

Case Study A concerns a Financial Holding Company that owns a Bank. This bank in turn has a number of financial and non financial subsidiaries, including insurance companies.

Case Study B concerns a more complex Financial Holding Company, owning a number of financial and non financial subsidiaries which in turn have financial and non financial subsidiaries

Case ACase A

Case BCase B

In the case studies which follow, we will apply the steps outlined in 1- 6 in the previous page and apply the consolidation techniques identified in the previous section.

Case Studies - Overview

Case Study B

87

100100%%

XYZ XYZ HoldingHolding

ABC BankABC Bank DEF DEF LeasingLeasing

DEF DEF InsuranceInsurance DEF BankDEF Bank

D BankD Bank

XYZ XYZ Holding Holding (or Indiv.)(or Indiv.)

XYZ XYZ Offshore Offshore

BankBank

D LeasingD Leasing

ABC ABC LeasingLeasing

ABC ABC FactoringFactoring


ABC Fund ABC Fund Manage-Manage-

mentment

D Intern. D Intern. BankBank

60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%

XYZXYZCompanyCompany(Industry)(Industry)



Non-FSNon-FS

BankBank

Financial Financial HoldingHolding

BankBank



FinancialFinancialServices Instit.Services Instit.

BankBank

BankBankFinancial Financial EnterpriseEnterprise



InsuranceInsurance

BankBank


Case Study B

88

Step 1: Determine group structure (Contd.)XYZ Holding holds 100% of ABC Bank and various financial and non financial investments. For the purpose of this illustration, it is assumed that these activities are predominantly or mainly financial (financial activities account for 50% or more of group activities). The Holding Company is therefore a Financial Holding Company for the purpose of the Consolidated Supervision Directive and must be consolidated.

The fact and extent of control has to be established between the companies in the group as this will help determine the perimeter of consolidation, and the sort of consolidation techniques to be used. It is also necessary as part of this step to define which type of activity the subsidiaries are engaged in because consolidation also depends on the nature of activity in the company being consolidated. For the purpose of this case study it is assumed that the activities lead to the described type of business (Bank, Financial Enterprise etc.). In reality this step might be extremely complicated.

Case Study B

89

Step 2: Determine scope of consolidation in Germany


ABC ABC BankBank

DEF DEF LeasingLeasing


D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%


• Regulatory Category of unit• Entities to consolidate


Non-FSNon-FS

BankBank


BankBank




BankBank




InsuranceInsurance

BankBank

Entities to be included in Entities to be included in consolidation in Germanyconsolidation in Germany

Full Con.Pro Rata

DeductionDeductionRisk AssetRisk Asset

100%100%

Case Study B

90

100%100%

GreenGreen & & RedRed dashed/dotted lines dashed/dotted linesdenote possible denote possible

sub-consolidations in the UKsub-consolidations in the UK




D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%


• Regulatory Category of unit• Entities to consolidate


Non-FSNon-FS

BankBank

Mixed Mixed ActivityActivity

BankBank




BankBank




InsuranceInsurance

BankBank

Entities to be Entities to be included in included in consolidation in UKconsolidation in UK

Step 2: Determine scope of consolidation in the UK

Case Study B

91


For German regulatory purposes any non financial entity is not subject to consolidation (it is regarded as normal asset that has to be risk weighted in the normal way, so XYZ Industrial is not consolidated. Certain restrictions apply to investment in non financial entities. Life Insurances are also not subject for consolidation. ABC Leasing and ABC Factoring are excluded from consolidation because the holdings are not sufficiently large.

The approach of the UK is similar to Germany, but there are some critical differences. As in Germany, non-financial companies are not consolidated, and they are treated as risk assets unless the overall EU limits on such investments are breached. Investments in Insurance Companies have a particular treatment, and have to be deducted from capital.

While the perimeter of consolidation in this case is identical in the UK and Germany, thereis also a possibility for supervisors to apply consolidation to sub-groups as indicated. They would only do this if there were some prudential benefit to be acquired by doingso, for example to ensure that capital was appropriately distributed across the group, or if doing so allowed better control over aspects of a group‘s activities eg if their investment banking operations were all within a particular sub-group.

Case Study B

92

100%100%




D BankD Bank

XYZ XYZ Holding (or Holding (or

Indiv.)Indiv.)


BankBank

D LeasingD Leasing




ABC Fund ABC Fund Manag.tManag.t


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%

Full Con.Pro Rata



FRGFRGFRG UK FRGFRG UK FRGFRG

FRG

FRGFRGFRG UKFRGFRG

FRG UK

FRG UK

FRG UK

FRG UKFRGFRG


UKUK UKUK

UKUK UKUK UKUK

UKUK

UKUK

Step 3: Determine the type of consolidation

Case Study B

93


The different colours again represent the different types of consolidation. The upper left corner shows the type of consolidation under German regulation, the upper right part shows the treatment under the UK regime

For German consolidation all holdings between 20% and 50% (it is assumed that participation represents control) have to be consolidated on a pro rata basis. Participations of more than 50% have to be fully consolidated. In the UK, such companies will be fully consolidated, unless there are other major shareholders who are likely to support the company in the event that it hits difficulties.

We can also see here the difference between the German approach to insurance (treatment as risk asset) and the UK approach (deduction of investment). We can also see that German supervisors deduct participations in financial companies once they pass the threshold of 15%.

Note that the UK would probably consolidate the Fund Management Company and the Securities Firm by aggregation plus.

Case Study B

94

100%100%




D BankD Bank

XYZ XYZ Holding (or Holding (or

Indiv.)Indiv.)


BankBank

D LeasingD Leasing




ABC Fund ABC Fund ManagmtManagmt


100 ABC B100 ABC B100 DEF L100 DEF L100 DEF I100 DEF I100 DEF B100 DEF B100 XYZ H100 XYZ H

500 K500 K

125 K125 K

250 K250 K 220 K220 K 280 K280 K 120 K120 K

25 ABC L25 ABC L25 ABC F25 ABC F25 ABC S25 ABC S25 ABC M25 ABC M25 D B25 D B

100 D B100 D B15 D L15 D L15 D IB15 D IB

300 K300 K 200 K200 K 30 K30 K 30 K30 K

20 K20 K 50 K50 K

95 XYZ B95 XYZ B

250 K250 K

60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

25 D B25 D B40%40%

Full Con.Pro Rata



• Adding Capital Positions

• Deducting Participations

FRGFRGFRG UK FRGFRG UK FRGFRG

FRG

FRGFRGFRG UKFRGFRG

FRG UK

FRG UK

FRG UK

FRG UKFRGFRG UKUK

UKUKUKUK UKUK

UKUK

UKUK


Case Study B

95

Step 4: Calculate the capital baseAs the relevant entities are defined and the type of consolidation determined the consolidation of the capital components can follow, which will give the group‘s capital base.



Case Study B

96

Unit Capital ParticipationABC Bank

DEF Leas.

DEF Ins.

DEF Bank

XYZ Hold.

XYZ Comp.

ABC Leas.

ABC Fact.

ABC Sec.

ABC F Mgmt

D Bank

XYZ O-Bank

D Leas.

D Int. Bank

Capital Part. Capital Part.

XYZ Holding 600 100 100 100 100 100 100 600 500 600 600ABC Bank 125 25 25 25 25 25 125 100 125 125DEF Leasing 250 250 250DEF Insurance 220DEF Bank 280 112 280XYZ Holding 120 25 95 120 120 120 120XYZ Company 250ABC Leasing 300ABC Factoring 200ABC Securities 30 30 30ABC Fund Mgmt 30 30 30D Bank 100 15 15 100 100 30XYZ O-Bank 250 250 250D Leasing 20 20 20D Int. Bank 50 20 50

1,657 720 1,855 875

Consol. FRG Cons. UK

937 980

Consolidated Capital in GermanyConsolidated Capital in Germany

Consolidated Capital in UKConsolidated Capital in UK

937937

980980

Step 4 (2): Calculate the capital base

Case Study B

97


The first column shows the entities of the complete group,(regardless whether it has to be consolidated or not.


The next set of columns shows the book value of the participations within the XYZ Group. The book value should normally be less than the capital in the subsidiary. However, it may be that the book-value exceeds the capital position of the subsidiary. In these cases goodwill exists, which has to be treated in a special way (deducted) - which may be different from the treatment in the financial statement (where it may be amortised over time).

The next two columns show the capital components of the units/subsidiaries relevant for German consolidation. The total of the capital positions subtracted by the total of the participations gives the consolidated capital (one position has to be consolidated on a pro rata basis)


Case Study B

98



Case Study B

99



Case Study B

4. Flexing Case Study B4. Flexing Case Study B

Section 1

Section 3

Section 2

Section 42. Case Study A

3. Case Study B

Sections:Sections:

1. Principles of Consolidated Supervision

101

General InformationGeneral InformationWe have looked at case study B, using a Financial Holding Company as the ultimate parent. Under EU law, We have looked at case study B, using a Financial Holding Company as the ultimate parent. Under EU law, parent companies that are defined as financial holding companies must be included in the consolidation. parent companies that are defined as financial holding companies must be included in the consolidation.

We now flex the case study and approach Case Study B as if the ultimate parent were predominantly involved in We now flex the case study and approach Case Study B as if the ultimate parent were predominantly involved in non financial activities. We also now assume that XYZ Industrial Company is very large in its own right. This non financial activities. We also now assume that XYZ Industrial Company is very large in its own right. This would make XYZ Holding a“Mixed Activity Holding Company”. Mixed Activity Holding Companies are not would make XYZ Holding a“Mixed Activity Holding Company”. Mixed Activity Holding Companies are not included in the regulatory consolidation.included in the regulatory consolidation.

It should be noted that this sort of group is rare in the EU. EU regulators have discouraged this sort of complex It should be noted that this sort of group is rare in the EU. EU regulators have discouraged this sort of complex group, for fear that problems in the non-financial parts of the group could impact adversely on the reputation and group, for fear that problems in the non-financial parts of the group could impact adversely on the reputation and finances of the bank/financial parts of the group, and for fear that the money of depositors could be directed finances of the bank/financial parts of the group, and for fear that the money of depositors could be directed improperly to support the non-financial activities of the group.improperly to support the non-financial activities of the group.

Regulators have also been reluctant to see very complex groups develop because it greatly complicates the task Regulators have also been reluctant to see very complex groups develop because it greatly complicates the task of supervision. This has been reinforced in the EU by the provisions of the Post-BCCI Directive which prevent of supervision. This has been reinforced in the EU by the provisions of the Post-BCCI Directive which prevent supervisors from giving authorisation to banks in “unsupervisable” structures.supervisors from giving authorisation to banks in “unsupervisable” structures.

Flexing Case Study B

102

100100%%




D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%




Non-FSNon-FS

BankBank


BankBank




BankBank




InsuranceInsurance

BankBank



103

100%100%




D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%


Entities subject toEntities subject to solo supervisionsolo supervision


Non-FSNon-FS

BankBank

Mixed ActivityMixed Activity

BankBank




BankBank




InsuranceInsurance

BankBank

Step 1: Determine group structure (Cont’d..)


104

Step 1: Determine Group Structure

Entities Subject to Solo Supervision

It is very hard to be precise about how German and UK supervisors would approach such a group. It would all depend on the individual circumstances of the case - and supervisors would examine the structure in great detail. They would certainly seek to push consolidated supervision as far as it was sensible to go, and they might try to create a financial sub-group covering all the banking and financial activities of XYZ Holding and subject that to consolidated supervision.

They would also reinforce solo supervision and the controls over financial and non-financial exposures to the rest of the group. They would be seeking to identify and - if possible - neutralise channels of contagion between the banks and its depositors - and the rest of the group.

Other non-bank companies within this group would also be subject to solo supervision - though not necessarily by bank supervisors. The previous slide identifies the companies which would be subject to solo supervision in the UK.


105

100%100%


ABC ABC BankBank



D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%





Non-FSNon-FS

BankBank


BankBank




BankBank




InsuranceInsurance

BankBank

Entities to be included in Entities to be included in consolidation in Germanyconsolidation in Germany

Step 2: Determine scope of consolidation in Germany


106

Step 2: Determine scope of consolidation in the UK

100%100%


ABC ABC BankBank



D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%





Non-FSNon-FS

BankBank


BankBank




BankBank




InsuranceInsurance

BankBank

Entities to be included in Entities to be included in consolidation in UKconsolidation in UK


107


In Germany, in this case, although there are banking and financial activities outside the ABC Group, the only group for the purpose of consolidated supervision is under ABC Bank. It would take in D Bank on a pro rata basis, but D International Bank would fall outside because the participation falls below the threshold for mandatory pro rata consolidation. It could be pro rata consolidated on a voluntary basis.

In the UK, in this case, although there are banking and financial activities outside the ABC Group, the only group for the purpose of consolidated supervision is under ABC Bank. Unlike Germany D Bank would probably be fully consolidated.


108

100%100%


ABC ABC BankBank



D BankD Bank



BankBank

D LeasingD Leasing





mentment


60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

40%40%

Full Con.Pro Rata



FRG UK

FRGFRG UKFRGFRG FRG UK

FRG UK

FRGFRG


UKUK UKUK UK UK



109



In Germany, in this case, although there are banking and financial activities outside the ABC Group, the only group for the purpose of consolidated supervision is under ABC Bank. It would take in D Bank on a pro rata basis, but D International Bank would fall outside because the participation falls below the threshold for mandatory pro rata consolidation. It could be pro rata consolidated on a voluntary basis.

In the UK, in this case, although there are banking and financial activities outside the ABC Group, the only group for the purpose of consolidated supervision is under ABC Bank. Unlike Germany D Bank would probably be fully consolidated.

110

100%100%


ABC ABC BankBank



D BankD Bank



BankBank

D LeasingD Leasing





mentment


100 ABC B100 ABC B100 DEF L100 DEF L100 DEF I100 DEF I100 DEF B100 DEF B100 XYZ H100 XYZ H

500 K500 K

125 K125 K

250 K250 K 220 K220 K 280 K280 K 120 K120 K

25 ABC L25 ABC L25 ABC F25 ABC F25 ABC S25 ABC S25 ABC M25 ABC M25 D B25 D B

100 D B100 D B15 D L15 D L15 D IB15 D IB

300 K300 K 200 K200 K 30 K30 K 30 K30 K

20 K20 K 50 K50 K

95 XYZ B95 XYZ B

250 K250 K

60%60% 40%40%50%50% 60%60%

100%100%9%9% 15%15% 100%100% 100%100% 45%45%

100%100% 40%40%

25 D B25 D B40%40%

Full Con.Pro Rata



• Adding Capital Positions

• Deducting Participations

FRGFRG UKFRGFRG FRG UK

FRG UK

FRGFRG UKUK UK

UK

UK

UK


UKUK


111


As the relevant entities are defined and the type of consolidation determined the consolidation of the capital components can follow, which will give the group‘s capital base.




112

XYZ Holding 600 100 100 100 100 100 100ABC Bank 125 25 25 25 25 25 125 100 125 125DEF Leasing 250DEF Insurance 220DEF Bank 280XYZ Holding 120 25 95XYZ Company 250ABC Leasing 300ABC Factoring 200ABC Securities 30 30 30ABC Fund Mgmt 30 30 30D Bank 100 15 15 45 100 30XYZ O-Bank 250D Leasing 20 20 20D Int. Bank 50

250 100 305 155150 150

Consolidated Capital in GermanyConsolidated Capital in Germany

Consolidated Capital in UKConsolidated Capital in UK

150150

150150

Step 4 (2): Calculate the capital base


113

Step 4(2): Calculate the capital baseThe first column shows the entities of the complete group (regardless whether it has to be consolidated or not).


The next set of columns shows the book value of the participations within the XYZ Group. The book value should normally be less than the capital in the subsidiary. However, it may be that the book-value exceeds the capital position of the subsidiary. In these cases goodwill exists, which has to be treated in a special way (deducted) - which may be different from the treatment in the financial statement (where it may be amortised over time).

The next two columns show the capital components of the units/subsidiaries relevant for German consolidation. The total of the capital positions subtracted by the total of the participations gives the consolidated capital (one position has to be consolidated on a pro rata basis).


Although the final capital base is the same, the results have been arrived at quite differently.


114



Case Study B

115



Case Study B

4. Flexing Case Study B

Section 3

Section 2

Section 4

2. Case Study A3. Case Study B

Sections:Sections:1. Principles of Consolidated Supervision

Annex:Annex: I. Applying Consolidation TechniquesI. Applying Consolidation Techniques

Section 1

Annexes

Part 1

Part 3

Part 2

Part 4

Full (line-by-line) ConsolidationFull (line-by-line) Consolidation

Pro-rata (or proportionate) ConsolidationPro-rata (or proportionate) Consolidation

Full and Pro Rata ConsolidationFull and Pro Rata Consolidation

DeductionDeduction

Aggregation PlusAggregation Plus

Bringing in the Asset Side of the Balance SheetBringing in the Asset Side of the Balance Sheet

Calculating Prudential RatiosCalculating Prudential Ratios

Part 5

Part 6

Part 7

Annex I: Applying Consolidation Techniques

Part 1

Part 3

Part 2

Part 4 Full (line-by-line) ConsolidationFull (line-by-line) ConsolidationPart 5

Part 6

Part 7


119

Definitions: Full Consolidation / Line-by-Line ConsolidationFull Consolidation

Full consolidation means including in the group’ s consolidated returns all the relevant assets and liabilities of the companies being consolidated.

Line By Line Consolidation

Line-by-line consolidation is a technique for achieving full consolidation, and it is the one which is most frequently used. The consolidation of balance sheets according to conventional accounting rules (including the netting of balances between companies included in the consolidation).


120

Book Val Shares inSubsidiary 50 500 Share Capital (Tier I)

50 Loan Capital (Tier II)Holding of subsidLoan Capital Tier II 10 100 Loan Capital (Tier II) 100 Tier III

Parent Bank 1

50 Share Capital Book Val. (Tier I)100 Reserves (Tier I) 50 Loan Capital (Tier II) 10 Loan Capital subscribed by parent

(Tier II)

Subsidiary Bank 2

Full (Line by Line) Consolidation


121

Full (Line by Line) Consolidation (Contd.)Parent Bank has a Share Capital of 500 (Tier I) and two components of loan capital (50 and 100) which belong to Tier II. It also has 100 of Tier III capital. The exact nature of the individual components has been simplified as it does not play a role which exact type of capital position a bank has as long as it can be clearly defined as Tier I, Tier II (upper and lower) and Tier III. In reality some additional restrictions apply as to which the individual components can be used (such as caps on the amount of Tier II and Tier III capital).

The Parent Bank also has participations in another bank (Subsidiary Bank 2) in two respects: it has Shares of the Subsidiary bank with the book value of 50 and other capital components with the book value of 10. For this purpose it is assumed that this participation in shares represents the majority of votes (= Bank 1 can effectively control the subsidiary).

The Subsidiary has Share Capital of 50 and other Tier I capital components of 100. The amount of capital in the Subsidiary can be different from the book value at which the corresponding position is recorded in the Parent bank. Normally the capital of the subsidiary should be equal or higher than the book value recorded in the books of the parent. However, if the book value of the position of the parent bank is larger than "Goodwill" has been paid. The treatment of goodwill for regulatory purposes differs from the treatment of goodwill in financial accounting as it has to be deducted from Tier 1 capital in calculating prudential ratios.


122

+ Tier I Parent+ Tier I Parent 500500

+ Tier I Subsidiary+ Tier I Subsidiary (Book value)(Book value) 50 50

+ Reserves Subsidiary 100+ Reserves Subsidiary 100

650650

- Holding by Parent 1 in Subsidiary 50- Holding by Parent 1 in Subsidiary 50

Tier I 600

Tier II 200

+ Tier II Parent (Issue 1)+ Tier II Parent (Issue 1) 50 50

+ Tier II Parent (Issue 2)+ Tier II Parent (Issue 2) 100100

+ Tier II Subsidiary+ Tier II Subsidiary held by parent held by parent 10 10

+ Tier II Subsidiary Other 50 + Tier II Subsidiary Other 50

210210

- Tier II Subsidiary held by parent 10- Tier II Subsidiary held by parent 10

Full (Line-by-Line) Consolidation: Solution 1


123

Full (Line-by-Line) Consolidation: Solution 1 (Contd)

The full amount of the capital positions of both the parent bank and the subsidiary are added for each category (Tier I and Tier II separately). The Participations of the parent bank have to be deducted from the respective Tier I or Tier II positions to prevent the double counting of capital.


124

Tier II 200

Tier III 100

Tier I 600

Own Funds 900

Full (Line by Line) Consolidation - Solution 2


Part 1

Part 3

Part 2

Part 4


Part 5

Part 6

Part 7

Pro-rata (or proportional) ConsolidationPro-rata (or proportional) Consolidation


126

Definition: Pro Rata (or Proportional) Consolidation

Pro rata consolidation means including in the group’ s consolidated returns only the group’ s share of assets and liabilities in the affiliate concerned.

So for a company in which the group holds 25%, the capital adequacy returns include 25% of that affiliate’ s capital, 25% of its other liabilities and 25% of its assets, and the large exposures returns 25% of its exposures. Balances between companies included in the consolidation are netted in full.


127

Participation in bank 40 500 Share Capital & Reserves (Tier I) 20 Other Tier I

20 Revaluation Reserves (Tier II)Holding of bank Tier II 10 200 Loan Capital Tier II

100 Tier III

Parent Bank 1

100 Share Capital (Tier I) 50 Reserves (Tier I) 10 Loan Capital (Tier II)

25 Other Loan Capital Tier II

Associate Bank 2

Bank I has a Participation of 40% in Bank IIBank I has a Participation of 40% in Bank II(together with other shareholders)(together with other shareholders)

Pro Rata (or Proportional) Consolidation


128

Pro Rata (or Proportional) Consolidation (Contd.)

The parent bank has a Participation of 40% at the subsidiary. For this example it is assumed, that the parent bank can "control" 40% of the voting rights of the subsidiary and has no special privileges over other shareholders.

Pro rata consolidation works in the same way as the full consolidation with only one difference: the capital positions of the Subsidiary are not taken at their full value, but only at the percentage representing the share of the parent bank (in this example 40%).

The other assets and liabilities would also be consolidated in the same way.


129

Tier I 520

+ Tier I Bank 1+ Tier I Bank 1 500500

+ Tier I Bank 2+ Tier I Bank 2 40 40

+ Other Tier I Bank 2 20+ Other Tier I Bank 2 20

560560

- Participation Bank 1 in Bank 2 40- Participation Bank 1 in Bank 2 40

Tier II 224

+ Revaluation Reserves Tier II Bank 1+ Revaluation Reserves Tier II Bank 1 20 20

+ Loan Capital Add Tier II Bank 1+ Loan Capital Add Tier II Bank 1 200200

+ Loan Capital Tier II Bank 2+ Loan Capital Tier II Bank 2 4 4

+ Other Loan Capital Tier II Bank 2 + Other Loan Capital Tier II Bank 2 __________________ 10 10

234234

- Participation Tier II Bank 1 in Bank 2 - Participation Tier II Bank 1 in Bank 2 10 10

Pro-rata consolidation - Solution 1


130

Pro rata consolidation - Solution 1 (Contd.)The subsidiary has total Tier I capital elements of 100 and 50. Multiplied by 40% (= 0,4) the applicable amounts for pro rata consolidation are 40 and 20. The same calculation is applied to the Tier II elements of capital where the application of pro rata consolidation at 40% results in 4 and 10 being taken into the group‘s capital base (from total Tier II elements in the subsidiary of 10 and 25)


131

Tier II 224

Tier III 100

Tier I 520

Own funds 844

Pro rata consolidation - Solution 2


Part 1

Part 3

Part 2

Part 4


Pro-rata (or proportional) ConsolidationPro-rata (or proportional) Consolidation

Part 5

Part 6

Part 7



133

Financial Holding Financial Holding Company (FHC)Company (FHC)

Financial Institution (FI) 1 Financial Institution (FI) 1 (Investment Firm)(Investment Firm)

Bank 1Bank 1

Financial Institution (FI) 2Financial Institution (FI) 2(Investment Firm)(Investment Firm)

Bank IIBank II

30%30%60%60%

50%50%90%90%


100%100%

Full and pro rata consolidation


134

Full and pro rata consolidation (Contd.)Supervision has to take place on a Solo and on a group wide basis. Banks I and II would be subject to separate solo supervision, as well as consolidated supervision at the Bank 1 level. Normally, separate consolidations do not have to be made on a "Subgroup" basis.

However, in certain situations the UK or the German Supervisor may decide that a Banking group has to make separate sub-consolidations for parts of the group. In this case the Group under Bank 1 has to be consolidated. The participation levels represent the power of control. In real cases, establishing the existence and the extent of control would be subject to a detailed individual analysis which would look beyond just voting rights and would look at whether control was also being exercised indirectly.


135

Participation FI 1 60 800 Share Capital Tier IParticipation in FHC 18 100 ReservesTier 1

200 Tier II100 Tier III

Bank 1

Part. Bank 2 25 60 Shares Tier I30 Reserves Tier I

Financial Holding Company

50 Tier I150 Tier II

Bank 2

Participation FI 2 45 100 Shares Tier I 30 Reserves Tier 1 25 Tier II

Financial Institution 1

Participation AM 50 50 Tier I 20 Tier II

Financial Institution 2

50 Tier I 30 Tier II

Asset Manager

Full and pro rata consolidation in Germany


136

No consolidation No consolidation (deduction)(deduction)

Financial EnterpriseFinancial EnterpriseFinancial Institution 1Financial Institution 1

Bank 2Bank 2

Bank 1Bank 1

Financial Institution 2Financial Institution 2

Asset ManagementAsset Management No consolidationNo consolidation

Pro Rata Pro Rata ConsolidationConsolidationFull ConsolidationFull Consolidation

Consolidation in GermanyConsolidation in Germany

Full and pro rata consolidation in Germany - Solution 1


137

Full and pro rata consolidation in Germany - Solution 1 (Contd)The Asset Manager does not have to be consolidated under German rules (only if it is located outside the EU). Under UK rules it would have to be consolidated under Aggregation Plus, wherever it is located.

This example uses the German consolidation rules. Bank 2 does not have to be consolidated under German rules as the participation - from the perspective of Bank 1 - is under 20% (30% x 50% = 15%). This participation has either to be deducted or to be pro rata consolidated on a voluntary basis.

The Financial Enterprise (30%) participation would be subject to pro rata consolidation.


138

Consolidated Tier I capital 884

+ Share Capital Bank 1+ Share Capital Bank 1 800800

+ Shares Financial Institution 1+ Shares Financial Institution 1 100100

+ Financial Institution 2 + Financial Institution 2 50 50

+ Capital Financial Holding Co. (30% of 60)+ Capital Financial Holding Co. (30% of 60) 18 18

+ Reserves Financial Institution 1+ Reserves Financial Institution 1 30 30

+ Reserves Financial enterprise (30%) 9+ Reserves Financial enterprise (30%) 9

10071007

- Participation Bank 1 in Financial Inst. 1- Participation Bank 1 in Financial Inst. 1 60 60

- Participation Bank 1 in Financial Holding Co.- Participation Bank 1 in Financial Holding Co. 18 18

- Participation Financial Institution 1 in FI 2 45- Participation Financial Institution 1 in FI 2 45



139

Consolidated Tier II 245

+ Tier II Bank 1+ Tier II Bank 1 200200

+ Tier II Financial Institution 1+ Tier II Financial Institution 1 25 25

+ Tier II Financial Institution 2 20+ Tier II Financial Institution 2 20



140

Tier II 245

Tier III 100

Tier I 884

Own funds 1221,5

Liable Capital 1221,5

- Participation Holding Co in Bank 2- Participation Holding Co in Bank 2

(30% of 25) 7,5(30% of 25) 7,5



141

SOLUTION A - FULL CONSOLIDATION, NO SOLUTION A - FULL CONSOLIDATION, NO PRO RATA CONSOLIDATIONPRO RATA CONSOLIDATION

As explained in the first section, this is the normal approach in the UK. The normal technique of consolidation is full consolidation of all majority shareholdings and participations. The UK agrees to proportionate (‘ pro rata’ ) consolidation of participations only in exceptional circumstances, where it is satisfied that there are other significant shareholders who have the means and the will to provide as much parental support to the entity as the shareholder subject to consolidated supervision. This is most likely to be another bank.

This is because reputational risk is important for banks, and it is assumed that a bank would have to support a closely connected company in a similar business area or suffer a severe reputational loss. Indeed regulators would expect them to do this.

In both cases Bank II is not consolidated because the level of control does not reach at least 20% (50%x30%=15%). However, the investment in Bank II would have to be deducted.

In the UK, two approaches are possible to the financial enterprise. It can either be fully consolidated or - if certain circumstances apply, pro rata consolidation may be possible.

Full and pro rata consolidation in the UK


142

Financial EnterpriseFinancial EnterpriseFinancial Institution Financial Institution (FDL)(FDL)

Bank 2Bank 2

Bank 1Bank 1

Financial InstitutionFinancial Institution(FDL)(FDL)

Asset ManagementAsset Management consolidationconsolidation

Normally Full, but Normally Full, but could be pro rata could be pro rata Consolidation in Consolidation in

some casessome casesFull ConsolidationFull Consolidation

Consolidation in UKConsolidation in UK

No Consolidation No Consolidation (deduction)(deduction)

Full and pro rata consolidation in the UK - Solution 1


143


+ Share Capital Bank 1+ Share Capital Bank 1 800800

+ Shares Financial Institution 1+ Shares Financial Institution 1 100 100



+ Tier 1 Asset Manager+ Tier 1 Asset Manager 50 50


+ Reserves Financial enterprise (100%) 30+ Reserves Financial enterprise (100%) 30

11201120



- - Participation Financial Institution 1 in FI 2 45Participation Financial Institution 1 in FI 2 45

- Participation FI 2 in Asset Manager- Participation FI 2 in Asset Manager 50 50

- Participation Financial Holding in Bank 2- Participation Financial Holding in Bank 2 25 25

Full and pro rata consolidation in the UK - Solution 2a


144





+ Tier II Asset Manager+ Tier II Asset Manager 30 30

+ Tier II Bank 2 50+ Tier II Bank 2 50



145

Tier II 325

Tier III 100

Tier I 880

Own funds 1325

Total Tier 1 and 2 Capital 1205



146

SOLUTION B - WITH PRO RATA SOLUTION B - WITH PRO RATA CONSOLIDATIONCONSOLIDATION

As explained in the first section, this is the exceptional approach in the UK. The normal technique of consolidation is full consolidation of all majority shareholdings and participations. The UK agrees to proportionate (‘ pro rata’ ) consolidation of participations only in exceptional circumstances, where it is satisfied that there are other significant shareholders who have the means and the will to provide as much parental support to the entity as the shareholder subject to consolidated supervision. This is most likely to be another bank.

This is because reputational risk is important for banks, and it is assumed that a bank would have to support a closely connected company in a similar business area or suffer a severe reputational loss. Indeed regulators would expect them to do this.

Full and pro rata consolidation in the UK (Contd)


147


+ Share Capital Bank 1+ Share Capital Bank 1 800 800

+ Shares Financial Institution 1+ Shares Financial Institution 1 100 100



+ Tier 1 Asset Manager+ Tier 1 Asset Manager 50 50


+ Reserves Financial enterprise (30%) + Reserves Financial enterprise (30%) 99

10571057



- - Participation Financial Institution 1 in FI 2 45Participation Financial Institution 1 in FI 2 45

- Participation FI 2 in Asset Manager- Participation FI 2 in Asset Manager 50 50

Full and pro rata consolidation in the UK - Solution 1b


148





+ Tier II Asset Manager 30+ Tier II Asset Manager 30



149

Tier II 275

Tier III 100

Tier I 884

Own funds 1251.5

Total Tier 1 and 2 Capital 1151.5

- Participation Financial Holding Co. in Bank2 - Participation Financial Holding Co. in Bank2

(30% of 25) 7,5(30% of 25) 7,5



Part 1

Part 3

Part 2

Part 4




Part 5

Part 6

Part 7

DeductionDeduction


151

DeductionThe investment in the affiliate is deducted from capital base. The assets of the affiliate are not included in the calculation of weighted risk assets.


152

In d u s tria l C om p an yB ook V a lu e 1 0 0

In su ran ce C om p an yB ook V a lu e 1 5 0

C ap ita l P os ition 2 0 0

L eas in g C om p an yTier 1 2 0Tier 2 3 0

B an k 1Tie r 1 6 0 0Tie r 2 4 0 0

100%100% 100100%%100%100%

Bank 1’s Participation in Leasing CompanyBank 1’s Participation in Leasing Company

is holding of Tier 1 capital of 10is holding of Tier 1 capital of 10

Deduction is the technique used for dealing Deduction is the technique used for dealing with non-financial companieswith non-financial companies

Insurance companies are not considered to be financial companies underInsurance companies are not considered to be financial companies under

EU law, nor is insurance broking.EU law, nor is insurance broking.

Deduction (Contd.)


153

+ Tier 1 Bank 1+ Tier 1 Bank 1 600600

+ Tier 1 Leasing Company + Tier 1 Leasing Company 2020

620620

- Participation Bank 1 Leasing Company- Participation Bank 1 Leasing Company 10 10

CONSOLIDATED TIER 1 CAPITAL CONSOLIDATED TIER 1 CAPITAL 610610


+ Tier 2 Leasing Company+ Tier 2 Leasing Company 30 30

CONSOLIDATED TIER 1 AND 2 CAPITAL 1040CONSOLIDATED TIER 1 AND 2 CAPITAL 1040

DEDUCT From Tier 1 and Tier 2 CapitalDEDUCT From Tier 1 and Tier 2 Capital

Investment in Industrial Company Investment in Industrial Company 100100

Investment in Insurance Company ______ Investment in Insurance Company ______ 150 150

Own funds 790

Deduction (Contd.)


Part 1

Part 3

Part 2

Part 4




DeductionDeduction

Part 5

Part 6

Part 7



155

Aggregation PlusAggregation plus is a technique of consolidation introduced to help apply the market risk requirements of the EU Capital Adequacy Directive. It is also used in the UK where a subsidiary is subject to the capital regulation of another domestic supervisor (such as the SFA and IMRO).

The local supervisor’s capital rules are used to generate a capital requirement for the affiliate. This is aggregated with the capital requirements arising as a result of the group’s other business. The aggregate capital requirement is then compared with consolidated group capital.

When a subsidiary is consolidated using aggregation plus based on the relevant local supervisor’s capital regime, all the deductions from capital made by the local regulator must be deducted from the consolidated capital base. So where, for example, the local supervisor applies a deduction in respect of illiquid assets, this deduction is reflected in the consolidated capital base.

Aggregation plus has the advantage that there is only one capital calculation in respect of the affiliate for both solo and consolidated supervision. It is only permitted where the capital regimes are deemed to be broadly equivalent to the CAD. Because an affiliate’s capital requirements are computed on an individual company basis when using aggregation plus, intra-group exposures are not netted out and there is no allowance for the offsetting of positions between companies, when looking at the group position.


156

In ves tm en t F irm(G erm an y)

Tie r 1 2 0 , T ier 2 2 0C ap ita l req u irem en t 4 5

B an k 2 F ran c eTie r 1 5 0Tie r 2 4 0

Trad in g B ook req u irem en t o f 3 0

L eas in g C om p an yTie r 1 2 0Tie r 2 3 0

B an k 1 U KTie r 1 6 0 0Tie r 2 4 0 0

100%100% 100100%%100%100%

Bank 1’s Participation in LeasingBank 1’s Participation in LeasingCompany is holding of Tier 1 Company is holding of Tier 1

capital of 10.capital of 10.

Bank 1 is located in UK, Bank 2 is in FranceBank 1 is located in UK, Bank 2 is in FranceInvestment firm in GermanyInvestment firm in Germany

Bank 1’s Participation in Bank 2 Bank 1’s Participation in Bank 2 is a holding of Tier 1 capital of 25.is a holding of Tier 1 capital of 25.

Bank 1’s Participation in InvestmentBank 1’s Participation in InvestmentFirm is a holding of Tier 1 Firm is a holding of Tier 1

capital of 10capital of 10

NOTE: German firm has capital shortfall, NOTE: German firm has capital shortfall, which in this example is assumed to be duewhich in this example is assumed to be due

to insufficient Tier 2.to insufficient Tier 2.

Aggregation Plus (Contd.)


157


+ Tier 1 Bank 2 (France)+ Tier 1 Bank 2 (France) 50 50

+ Tier 1 Investment Firm (Germany)+ Tier 1 Investment Firm (Germany) 20 20

+ Tier 1 Leasing Company 20+ Tier 1 Leasing Company 20

690690

- Participation in Bank 2- Participation in Bank 2 25 25

- Participation in Investment Firm- Participation in Investment Firm 10 10

- Participation Bank 1 Leasing Company- Participation Bank 1 Leasing Company 10 10

CONSOLIDATED TIER 1 CAPITAL 645CONSOLIDATED TIER 1 CAPITAL 645



158


+ Tier 2 Bank 2+ Tier 2 Bank 2 40 40

+ Tier 2 Investment Firm+ Tier 2 Investment Firm 20 20

+ Tier 2 Leasing Company+ Tier 2 Leasing Company 30 30

CONSOLIDATED TIER 1 AND 2 CAPITAL 1135CONSOLIDATED TIER 1 AND 2 CAPITAL 1135

DEDUCT CAPITAL SHORTFALL in German Firm 5DEDUCT CAPITAL SHORTFALL in German Firm 5

Own funds 1130



Part 1

Part 3

Part 2

Part 4




DeductionDeduction

Aggregation PlusAggregation PlusPart 5

Part 6

Part 7

Bringing in the Asset Side Bringing in the Asset Side

of the Balance Sheetof the Balance Sheet


160

Full consolidation Balance sheets added together. Intra group Balance sheets added together. Intra group balances netted. Total positions risk weighted in balances netted. Total positions risk weighted in the required waythe required way

Pro rata consolidation Balance sheets combined. Proportion of risks Balance sheets combined. Proportion of risks added, determined by holding. Total positions added, determined by holding. Total positions risk weighted in the required wayrisk weighted in the required way

Aggregation plus Total of risk position and capital requirement Total of risk position and capital requirement calculated for each risk category based on rules of calculated for each risk category based on rules of other countries/other supervisors.other countries/other supervisors.

Deduction No consolidation of risksNo consolidation of risks

Treated as Risk weighted asset

No consolidation of risksNo consolidation of risks

Bringing in the Asset side of the Balance Sheet


161

Credit risk / Credit risk / risk of defaultrisk of default

Market risksMarket risks

Credit risk / Banking book (BB)Credit risk / Banking book (BB)

Counterparty risk / Trading Counterparty risk / Trading book (TB)book (TB)

Settlement risk ISettlement risk I

Settlement risk IISettlement risk II

Specific risk / Debt securitiesSpecific risk / Debt securities

General interest rate riskGeneral interest rate risk

Specific risk / equitiesSpecific risk / equities

General equity riskGeneral equity risk

Option riskOption risk

Commodity riskCommodity risk

Currency riskCurrency risk

TB+BBTB+BB

TB+BBTB+BB

TB

TB

TB

TB

TB

TB

TB

TB

BBBBRelevant types of risk


162

Risk-weighted Assets Risk-weighted Assets (RWA)(RWA)

Credit risk / Credit risk / risk of defaultrisk of default

Market risksMarket risks

Balance Balance sheet itemssheet items

Book value Book value (Market value where(Market value where

appropriate)appropriate)

DerivativesDerivativesCredit equivalent Credit equivalent (MTM + Add-On)(MTM + Add-On)

Simplified standard methodSimplified standard method

Counterparty Counterparty weightingweightingxx ==

Extended standard methodExtended standard method

Internal model (VaR)Internal model (VaR)

Capital charge for market riskCapital charge for market risk

WhatWhat Valuation Valuation OutputOutputRiskRisk

Risk Calculation Methods


Part 1

Part 3

Part 2

Part 4




DeductionDeduction


Bringing in the Asset Side of the Balance SheetBringing in the Asset Side of the Balance Sheet

Part 5

Part 6

Part 7

Calculating Prudential RatiosCalculating Prudential Ratios


164

Calculating Prudential Ratios

As Consolidation for accounting purposes can be very different from a regulatory consolidation in Germany and the UK, German and UK banking supervisors do not use consolidated financial statements which have been produced for statutory financial reporting. Indeed, it is impossible to derive capital charges for market risks from statutory financial reports as information about individual risk positions is required.

Rather, supervisors throughout Europe use a suite of regulatory returns which have been specifically designed to give supervisors the information they require. These detailed returns are private documents between the bank and its supervisors.

This does not mean that the supervisors do not take an interest in the published financial statements, and do not study them and follow up points of interest and discrepancy between public and private information. But it is the regulatory returns which form the basis for calculating prudential ratios and which are the financial supervisors prime source of information.


165


Consolidated RWAConsolidated RWA>= 8%>= 8%


Consolidated RWA + 12,5 x (consolidated capital Consolidated RWA + 12,5 x (consolidated capital charges for Market risks)charges for Market risks)

>= 8%>= 8%

Calculation every month (end of month) for the aggregated numbersCalculation every month (end of month) for the aggregated numbers

Calculation every quarter (end of quarter) for the detailed numbersCalculation every quarter (end of quarter) for the detailed numbers

Prudential ratios for CAD in Germany


166


Consolidated RWA + 12,5 x (consolidated capital Consolidated RWA + 12,5 x (consolidated capital charges for Market risks including riskscharges for Market risks including risks

consolidated by Aggregation Plus)consolidated by Aggregation Plus)

Bank must be able to calculate ratio every dayBank must be able to calculate ratio every dayCalculation every quarter (end of quarter) for the detailed numbersCalculation every quarter (end of quarter) for the detailed numbersfor solo bank, with consolidated report every half yearfor solo bank, with consolidated report every half year


Consolidated RWAConsolidated RWA>= individual >= individual minimum %minimum %

BANKING BOOKBANKING BOOK

BANKING AND TRADING BOOKBANKING AND TRADING BOOK

>= individual >= individual minimum minimum %%

Prudential ratios for CAD in the UK


167

SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

QG1QG1

GB1.1GB1.1QS1.1QS1.1

QS1.2QS1.2

QS1.3QS1.3 QG1.1QG1.1

QFWQFW

QRWQRW

QOPQOP

QRIQRI

QZKQZK

QAKQAK

QHBQHB

QS 2QS 2SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

SA 3SA 3

AKAK

HBHB

OPOP

RIRI

FW1FW1

RWRW

ZKZK

SA1.1SA1.1

SA1.2SA1.2

SA1.3SA1.3

GB1GB1

YYYYYY

XXXXXX Forms for solo-Forms for solo-basisbasis

Forms for Forms for ConsolidationConsolidation

Structure of CAD reportingforms in Germany


168

Capital Adequacy Reporting in the UK has been rationalised into a single form - the BSD 3. It is very extensive, covering 46 pages. It Capital Adequacy Reporting in the UK has been rationalised into a single form - the BSD 3. It is very extensive, covering 46 pages. It includes some information which is not necessary to calculate ratios, but which supervisorsfind of interest.includes some information which is not necessary to calculate ratios, but which supervisorsfind of interest.

Assets - loans,Assets - loans,investmentsinvestments

Capital forCapital forCounterparty Counterparty

RiskRisk

Capital forCapital forPosition RiskPosition RiskProvisions & Provisions &

Bad DebtsBad Debts

Profit & lossProfit & loss



Information onInformation onOTC contractsOTC contractsbanking bookbanking book

Credit to Credit to directors & directors &

group membersgroup members

Non CapitalNon CapitalLiabilitiesLiabilities

Off balanceOff balancesheet itemssheet items

CapitalCapital

Securities,Securities,investmentsinvestments

Capital Capital AdequacyAdequacySummarySummary

Information onInformation onOTC contractsOTC contractstrading booktrading book

Capital forCapital forSettlement Settlement

RiskRisk

Capital forCapital forLarge Large

ExposuresExposures

Banking Book, Balance sheet & Trading Info Trading Book

Information on Information on equity riskequity risk

Information onInformation oninterest rateinterest rategeneral riskgeneral risk

Information onInformation oncounterparty counterparty risk on reposrisk on repos

Capital forCapital forFX RiskFX Risk



BacktestingBacktestingResults forResults forVaR ModelsVaR Models

Information onInformation onCommodity Commodity

RiskRisk

Subsidiaries Subsidiaries ConsolidatedConsolidatedby Aggreg.n +by Aggreg.n +

Dealing with

Aggregation +

OutputOutput

Structure of CAD reporting form in the UK


4. Flexing Case Study B

Section 3

Section 2

Section 4

2. Case Study A3. Case Study B

Sections:Sections:1. Principles of Consolidated Supervision

Annex:Annex: I. Applying Consolidation TechniquesI. Applying Consolidation Techniques

Section 1

Annexes

II BIS Core PrinciplesII BIS Core Principles

170

List Of Core Principles For Effective Banking SupervisionPreconditions for Effective Banking Supervision

1. An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banking organisations. Each such agency should possess operational independence and adequate resources. A suitable legal framework for banking supervision is also necessary, including provisions relating to authorisation of banking organisations and their ongoing supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal protection for supervisors. Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place.

Licensing and Structure

2. The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined, and the use of the word “bank” in names should be controlled as far as possible.

3. The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation’s ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained.

4. Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties.

5. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.

Annex II: BIS List of Core Principles for Effective Banking Supervision

171

List Of Core Principles For Effective Banking Supervision


-Prudential Regulations and Requirements

6. Banking supervisors must set prudent and appropriate minimum capital adequacy requirements for all banks. Such requirements should reflect the risks that the banks undertake, and must define the components of capital, bearing in mind theirability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the Basle Capital Accord and its amendments.

7. An essential part of any supervisory system is the evaluation of a bank's policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios.

8. Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves.

9. Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations within the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers.

10. In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm's-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks.

11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriatereserves against such risks.

172

12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor and adequately control market risks; supervisors should have powers to impose specific limits and/or a specific capital charge on market riskexposures, if warranted.

13. Banking supervisors must be satisfied that banks have in place a comprehensive risk management process (including appropriate board and senior -management oversight) to identify, measure, monitor and control all other material risks and, where appropriate, to hold capital against these risks.

14. Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to testadherence to these controls as well as applicable laws and regulations.

15. Banking supervisors must determine that banks have adequate policies, practices and procedures in place, including strict "know-your-customer" rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.



173

Methods of Ongoing Banking Supervision

16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision.

17. Banking supervisors must have regular contact with bank management and thorough understanding of the institution's operations.

18. Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and statistical returns from banks on a solo and consolidated basis.

19. Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors.

20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.

Information Requirements

21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the. Bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition.



174

Formal Powers of Supervisors

22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatoryviolations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking licence or recommend its revocation.

Cross-border Banking

23. Banking supervisors must practise global consolidated supervision over their internationally-active banking organisations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these bankingorganisations worldwide, primarily at their foreign branches, joint ventures and subsidiaries.

24. A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, primarily host country supervisory authorities.

25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home country supervisors of thosebanks for the purpose of carrying out consolidated supervision.



regulatory consolidation & consolidated supervision

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