Author: | Published: 30 Sep 2004
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The EU Financial Conglomerates Directive of December 16 2002 imposes an extra layer of prudential requirements on groups active in both the banking and investment services industries, taken together, and the insurance industry. These requirements relate to capital adequacy and monitoring of intra-group transactions and risk concentration. EU member states were required to implement the directive into their national laws by August 11 2004, and it will take effect in 2005.

Definition of financial conglomerates

The directive applies to financial conglomerates, that is, groups that meet the following criteria (subject to limited derogatory powers given to the competent national authorities):

  • The group must include at least one EU regulated financial entity, meaning a credit institution, investment firm or insurance company.
  • At least one of the group's entities must be within the banking and investment services industry and at least one within the insurance industry. An industry is broader than its regulated component. It also encompasses unregulated financial entities such as financial leasing, factoring, consumer and mortgage credit companies as well as reinsurance companies.
  • The group must have significant activities in both the banking and investment services industry, taken as a whole, and the insurance industry. A group will be deemed to have significant cross-industry activities if its smallest financial component (that is, either the banking and investment services component or the insurance business) (i) represents more than 10% of the total financial industry activities of the group (in terms of both balance sheet total and solvency requirements), or (ii) has a balance sheet total in excess of e6 billion.
  • If a non-regulated parent heads the group rather than an EU regulated entity (that is, a mixed financial holding company), the financial component of the group, in addition to being significant in both industries, must also represent more than 40% of the group's total balance sheet. This requirement does not apply to groups headed by an EU regulated entity.

In cases in which a group taken as a whole does not constitute a financial conglomerate, but one of its subgroups does, the directive will apply to the subgroup. The term group is defined broadly so as to cover vertical groups as well as so-called horizontal groups (meaning, groups that are not characterized by a parent-subsidiary relationship but nevertheless form a group because their constituent companies are managed on a unified basis).

The directive is primarily targeted at bancassurance groups, that is, groups that have integrated an insurance business into their banking operations. More generally, the directive covers all banking and investment services and insurance groups with significant cross-industry activities, meaning banking and investment services groups with insurance subsidiaries, or insurance groups with banking and/or investment firm affiliates, that constitute at least 10% of the combined financial business. Although not the primary focus, certain mixed industrial-financial conglomerates may also fall within the ambit of the directive. Possible examples are certain car manufacturers with significant leasing, consumer credit and insurance activities, as well as conglomerates with important unregulated financial business that also happen to have some regulated business within the EU (even if relatively minor). Groups that are not headed by an EU regulated entity must, in addition to having sufficient cross-industry activities, have a financial industry component that represents at least 40% of the group's total business. However, even if a group does not as a whole meet the thresholds, it may still be covered by the conglomerates directive which applies also to subgroups of larger groups that meet the tests.

The directive's purpose is to enable assessment of the overall solvency and risk position on a group-wide basis. To this end, conglomerates must eliminate intra-group holdings of regulatory capital and aggregate significant risk exposures. While forms of industry-specific consolidated supervision already exist in the banking and insurance industries separately, groups that straddle these two industries are not yet supervised on a group basis. Consolidated supervision rules in the banking industry are limited to the credit institutions, investment firms and financial institutions (for example, leasing, consumer credit, factoring and asset management companies) that are part of the relevant group. Insurance undertakings are excluded from such supervision. Conversely, supplementary supervision of insurance groups covers only its insurance and reinsurance activities.

Although the concept of establishing a system of group-wide supervision for financial conglomerates is straightforward in theory, it is difficult in practice to construct a consolidated view of a banking-insurance conglomerate given the differences in the solvency rules that apply to the banking and investment services and insurance industries. These differences reflect the differing nature of the businesses, the differing risks to which they are exposed and the differing approaches to risk management and assessment by firms and supervisors. Banking supervisors typically emphasize overall systemic stability and soundness, focusing primarily on the asset side of the balance sheet to ensure adequate coverage of credit and market risks. In contrast, the primary concern of insurance supervisors is to protect policyholders against the risk of individual bankruptcy, with a focus on the liabilities assumed by insurance undertakings. Although the trend is towards convergence, the European Commission does not anticipate substantial harmonization in the short or even medium term.

The directive takes the industry rules as a given. With the exception of certain conforming amendments, it does not seek to harmonize the varying regulatory capital definitions or solvency requirements, nor is it concerned with issues of individual supervision of regulated entities. The banking and investment services and insurance businesses of a financial conglomerate continue each to be subject to consolidated or supplementary supervision on an industry basis. The directive complements these industry rules by imposing additional supervision of capital adequacy requirements, intra-group transactions and risk concentration on a conglomerate basis. The ways in which risks should be accounted for and the rules on the eligibility of regulatory capital are not affected. Similarly, the conglomerates directive does not interfere with the discussions on the Basel II Capital Accord, which is to revise the regulatory capital requirements for banks. Conversely, any industry amendment will affect the way in which capital and solvency requirements are computed under the conglomerates directive.

Key supervisory concerns

The primary focus of the directive is to curtail the use within financial conglomerates of the same regulatory capital in two or more entities of the group (multiple gearing) and the use as regulatory capital of funds raised by a parent company as debt and downstreamed to a regulated subsidiary as equity (excessive leveraging). Double and multiple gearing in particular has been a major concern since it enables a group to use the same capital as a buffer more than once, that is, to cover the capital requirements of the parent company as well as those of a subsidiary (and possibly also those of subsidiaries further down the chain). As a result, while on an individual basis each regulated entity may seem to hold sufficient capital to cover its own risks, on a group-wide basis, after elimination of intra-group holdings, there may well be a shortage of regulatory capital. The capital adequacy measurement techniques provided by the directive also address the use of unregulated parent and intermediate holding companies.

Additionally, the directive deals with the treatment of third-party minority interests in consolidated subsidiaries, specifically whether they may be counted as regulatory capital at the parent level. Where unregulated financial entities conduct activities that are similar to those of regulated entities, a notional capital amount must be applied to cover the risks assumed by those entities as if they were regulated entities. Furthermore, the directive tackles transfers of risk from one segment of the group to another for regulatory arbitrage purposes, with a view to benefiting from differences in regulatory treatment.

In short, the directive aims to ensure that the capital adequacy of regulated entities, which may be sufficient on an individual or industry consolidated basis, is not impaired as a result of their being part of a cross-industry financial conglomerate.

Capital adequacy requirements

The directive's prudential requirements focus on the EU regulated entities of a conglomerate. In principle, they apply only to credit institutions, investment firms and insurance undertakings that are licensed in the EU and are part of a financial conglomerate. There is one exception. For purposes of calculating capital adequacy at the conglomerate level, notional solvency requirements must be included for unregulated financial industry entities, such as leasing, consumer credit, portfolio management and reinsurance companies, even though these entities are not subject to capital requirements on a stand-alone basis.

Although the supplementary supervision under the directive looks to the financial conglomerate as a group, the capital requirements are not imposed on a fully consolidated basis. Rather, capital requirements, computed in accordance with the relevant industry rules, are applied only to its regulated and non-regulated financial industry components. The conglomerate must ensure that it has sufficient capital available within the conglomerate to meet those capital adequacy requirements. These are calculated by using one of the three methods set out in Annex I to the directive (see box 2).

Will the directive increase the cost of compliance with capital requirements?

Whether the directive's supplementary supervision at the conglomerate level will increase the cost of compliance with regulatory capital requirements depends very much on the kind of group, the way it is structured and how it is subject to consolidated supervision under existing industry rules.

The effects may vary from member state to member state. The supervisory authorities of certain member states, such as the UK, Belgium, Sweden and the Netherlands, appear to have anticipated these developments in large measure by subjecting groups with significant banking and insurance arms to a form of consolidated prudential supervision that is broadly comparable to the requirements of the directive. In other member states, the elimination of cross-industry intra-group holdings within a conglomerate may have a greater impact and lead to an increase in capital requirements. Even in member states in which comparable requirements already exist, the directive will give competent authorities regulatory tools that will strengthen their powers.

At an individual unconsolidated level, regulated entities could be affected by an amendment to the industry rules introduced by the conglomerates directive in order to level the playing field. Regulated entities that are neither part of a financial conglomerate nor subject to consolidated banking and investment services or supplementary insurance supervision will be required to deduct from their capital any shareholding of 20% or more in entities of other financial industries. This requirement supplements the rule, which already exists in the banking industry, that requires regulated entities to deduct from their capital shareholdings in, and subordinated claims on, entities of the same industry. As an alternative to the deduction of cross-industry shareholdings, they may be allowed by national law to apply one of the capital adequacy measurement techniques of the conglomerates directive (see box 2).

As noted above, the directive may also have an impact on mixed industrial-financial conglomerates, or subgroups within such conglomerates, that comprise at least one EU regulated financial entity and meet both the 40% financial-industry activities threshold and the 10% cross-industry activities test (see box 1). Relative to their regulated business, these groups tend to have more unregulated financial entities, such as leasing and consumer credit subsidiaries, for which notional solvency requirements will be applied at the conglomerate level. The actual effect of these notional requirements on mixed conglomerates may be greater than the effect on banking groups, since under applicable industry consolidated supervision rules, banking groups are already required to apply capital requirements to their unregulated financial subsidiaries.

Finally, the directive also extends the geographical scope of the banking and investment firm industry rules so as to match them with the requirements applicable to financial conglomerates. Until now, consolidated supervision of non-EU headed banking and investment firm groups has been limited to their EU components, but following the implementation of the directive, the competent EU authority will have to determine whether a group's worldwide activities are subject to a form of consolidated supervision that is equivalent to the group supervision applicable to EU-headed banking and investment firm groups.

Measuring capital adequacy

Annex I to the directive contains three methods for the calculation of capital requirements: (i) the accounting consolidation method, (ii) the deduction and aggregation method and (iii) the book value/requirement deduction method. A combination of the three methods is possible. These methods were developed in 1999 by the Joint Forum on Financial Conglomerates, composed of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors.

In each method, eligible capital and solvency requirements are calculated separately on the basis of the relevant industry rules before being combined to produce an overall position of the group. For each industry, solvency requirements must be covered by capital that is eligible under the rules of the relevant industry. Any capital deficit at the level of the conglomerate, however, can be covered only by capital elements that are eligible under the rules of both industries (so-called cross-industry capital). Conglomerates cannot therefore use certain tier II subordinated debt to cover a deficit at the conglomerate level.

Each of the methods eliminates the possibility of double gearing. According to the Joint Forum and the European Commission, the three techniques are functionally equivalent, but this does not mean that they will yield similar results in individual cases. It is therefore important for conglomerates to carry out a mapping exercise to evaluate the possible effect of each of the different methods on their capital needs. Ultimately, though, it is up to the supervisor to decide on the method or combination of methods to be used.

An important distinction between methods is that full consolidation may be applied only under the first method, which allows counting of third-party minority interests. The second and third methods allow only pro rata consolidation. However, where a subsidiary has a capital deficit, the total deficit must be taken into account, provided that in circumstances in which the parent's exposure is strictly and unambiguously limited, pro rata inclusion may be permitted.

Accounting consolidation method
This method looks at the fully consolidated accounts of the financial conglomerate. By definition, all intra-group holdings and exposures are eliminated.

  • The capital of the financial conglomerate calculated on the basis of the consolidated position of the group must be at least equal to:
  • the sum of the solvency requirements for each different financial industry represented in the group.

Deduction and aggregation method
The starting point is the unconsolidated accounts of each of the entities in the group.

  • The sum of the capital of each regulated and non-regulated financial industry entity must be at least equal to:
  • the sum of:
    - the solvency requirements for each regulated and non-regulated financial industry entity in the group; and
    - the book value of the participations in other entities of the group.

Book value/requirement deduction method
Again, the starting point is the unconsolidated accounts. This method stems from the insurance industry and is not used in the banking industry.

  • The capital of the parent company or the entity at the head of the financial conglomerate must be at least equal to:
  • the sum of:
    - the solvency requirement of the parent company or the head entity in question; and
    - the higher of (i) the book value of the parent company's shareholdings in other entities in the group and (ii) these entities' solvency requirements.

Other elements

The supplementary supervision organized by the directive also covers monitoring and reporting of significant intra-group transactions and risk concentration concerning the regulated entities of financial conglomerates, at conglomerate level. The competent coordinating authority (see below) is to determine on a case-by-case basis the types of transactions and risks that will be subject to regular reporting. At least until review by the European Commission in 2007, this is likely to take the form of an additional annual summary report. The directive does not define any quantitative limits. Pending further harmonization at the EU level, the coordinator will set thresholds. Monitoring is to focus on possible risk of contagion, conflicts of interests, risk of circumvention of industry rules and the aggregate level or volume of risk. The directive further requires adequate risk management processes and internal control mechanisms, including sound administrative and accounting procedures.

The directive sets criteria for designating among the competent supervisory authorities of the member states involved a single authority for each conglomerate that is responsible for coordinating supplementary supervision and related exchange of information. As a general rule, the coordinator will be the competent authority of the member state in which the entity that heads the financial conglomerate is established.

Groups headed outside the EU

A partially unresolved issue is the extent to which EU regulated financial subsidiaries of non EU-headed financial conglomerates will be subject to the directive. Those EU subsidiaries will not be covered by the supplementary prudential requirements of the directive if they are considered to be subject to equivalent supervision on a group basis in the home country of the parent undertaking. In each case, the supervisory authority of the EU member state that would otherwise have been competent will assess the equivalence of the relevant body of non-EU rules. In its general guidance that was published on July 6 2004, the EU Financial Conglomerates Directive and the Banking Advisory Committee came to the conclusion that, on balance, the US and Swiss supervisory regimes were to be deemed broadly equivalent to the requirements imposed by the directive, notwithstanding certain caveats. Ultimately, however, equivalence is to be determined on a case-by-case basis by the coordinating EU member state (in consultation with the other relevant competent authorities).

In the absence of equivalent non-EU supervision, the supplementary prudential requirements of the directive are to be applied by analogy to the worldwide group. It is not clear how this analogous application is to be conceived. The UK Financial Services Authority has signalled that it does not believe worldwide supervision to be feasible, especially in respect of major non-EU groups. Alternatively, the competent authorities could require the establishment of a holding company within the EU and then apply consolidated supervision to the EU subgroup in conventional fashion or could otherwise require a form of ring-fencing of the EU subsidiaries from the rest of the group.

The UK Financial Services Authority provides interesting guidance on various aspects of the directive in its Consultation Paper 204 of October 2003 and Feedback on CP204 of July 2004. (These can be  found on its website: The views of the UK Financial Services Authority are likely to be key in this debate, as it is expected to be the coordinating competent authority for most US-headed groups.


The directive's full effect will only become clear once certain implementing rules have been adopted and it is applied in practice. The picture is somewhat nebulous at this stage. Much will depend on how some of the outstanding issues will be resolved in practice and how the national authorities will use the relatively broad discretionary powers conferred on them. For example, must only a conglomerate's European or also its worldwide financial activities be taken into account for purposes of calculating the 10% and 40% thresholds? In which cases will a conglomerate be allowed to take into account minority interests and when not? How will supervisors decide on the capital measurement method to be used?

The Financial Conglomerate Committee is to implement certain rules, issue further guidelines and align national supervisory practices. The work of this committee may be key if the directive is to succeed in its ambitions. The European Commission will have to evaluate this by 2007.

This article first appeared in the June 2003 issue of IFLR.

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