Prudential supervision of financial conglomerates

Since the inception of the European Union there has been a tendency to combine insurance companies, banks and investment firms. For this reason, the Bank of International Settlements followed by the European Commission, suggested the implementation of additional, more co-ordinated supervision to tackle the potential risks that this new phenomenon represents for investors and for financial markets as a whole.

The adoption of harmonised rules on prudential supervision of financial conglomerates was one of the priority measures in the Financial Services Action Plan: it was considered essential to complete the implementation of a Single Market in Financial Services and address the loopholes existing in the sector legislation when it comes to supervising financial groups with cross-sector financial activities.

In order to accomplish such an ambitious objective, the European Parliament and the Council enacted Directive 2002/87/CE on the additional supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate (the 'FC Directive'). In essence, the FC Directive calls for a prudential supervision on a group-wide basis of 'financial conglomerates' (corporate groups consisting of credit institutions, insurance undertakings and investment firms), in particular with regard to solvency positions and the concentration of risks, intra-group transactions, internal risk controls and requirements dealing with the suitability of management.

Spanish law has provided limited consolidated supervision of companies engaged in the insurance, financial and capital market sector since 1992. Such regulations laid down specific capital adequacy requirements (implemented in 1996) and risk concentration limits (never fully implemented).

The recent implementation of the FC Directive in Spain, through the enactment of Law 5/2005 (the 'FC Law') and Royal Decree 1332/2005 (the 'FC Decree') introduces additional supervisory measures, such as the supervision of intra-group transactions and the requirement of internal risk controls, and further refines the existing rules and regulations to co-ordinate effectively the supervision of financial groups.

SCOPE OF APPLICATION

Additional prudential supervision is applicable to certain corporate groups engaged in activities from different financial sectors (insurance, banking and capital markets), the cross-sector financial activities of which are significant (ie when certain thresholds are reached), regardless of their corporate structure.

In particular, additional supervision is applicable to certain regulated entities ('RE') specifically identified in the FC Law (ie credit institutions, insurance and re-insurance undertakings, investment firms and asset managers of mutual and pension funds), when such an RE is head of a 'financial conglomerate', or when its parent undertaking is a 'mixed financial holding company' ('MFHC').

FINANCIAL CONGLOMERATES

Financial conglomerates ('FC') are defined as a group of entities engaged in the insurance and banking or investment services sector, provided that:

• Either: (a) the dominant entity of the group is an RE; or (b) (i) at least one member of the group is an RE; and (ii) the group’s activities are mainly carried-out in the financial sector (ie the ratio of the balance sheet total of the regulated and non-regulated financial sector entities in the group, exceeds the balance sheet total of the group as a whole by 40 per cent); and
   
•  the consolidated or aggregated activities of the insurance companies of the group and of the banking and investment services companies of the group are 'significant', that is: (a) for each of the insurance, banking or investment services activities (i) when the average of the ratio of the balance sheet total of each of such financial sector activities exceeds the balance sheet total of all the financial sector entities in the group by 10 per cent; and (ii) the ratio of the solvency requirements of each of such financial sector activities exceeds the solvency requirements of all the financial sector entities in the group by 10 per cent; or (b) when the balance sheet total of the smallest financial sector in the group exceeds €6bn except when it is determined that all, or part, of the additional supervision is unnecessary on the basis of the size of the smallest financial sector (ie less than 5 per cent of the balance sheet total of the group) or its market share (ie less than 5 per cent in each member state).

MIXED FINANCIAL HOLDING COMPANIES

FCs are often managed on a business-line basis which does not fully coincide with the conglomerate's legal structures. In order to take account of this trend, the requirements for management are further extended, in particular the management of non-regulated companies holding a controlling stake in REs.

In accordance with the FC Directive, the FC Law is also applicable to REs controlled by 'mixed financial holding companies' or MFHCs, that is, a holding company of REs which, together with its subsidiaries, constitute an FC.

APPLICABILITY OF SPANISH SUPERVISION

Once a group of companies is found to be an FC, Spanish authorities are entrusted with its additional supervision provided that it is headed by a Spanish FC or by an MFHC domiciled in Spain or elsewhere if being: (i) domiciled in Spain the MFHC controls at least one Spanish RE (ii) domiciled abroad and all, or the most significant, RE is Spanish. Further, FCs are subject to Spanish supervision when there is no parent undertaking at the head of the FC and its most significant RE is Spanish.

In addition, the FC Law sets forth that Spanish authorities will also be competent to supervise: (i) Spanish REs conforming an FC, subject to additional supervision by other EU authorities; (ii) MFHCs domiciled in Spain controlling an FC, subject to additional supervision by other EU authorities; (iii) Spanish REs controlled by other REs or MFHCs domiciled outside the EU and not subject to an equivalent supervision.

ADDITIONAL SUPERVISION

ADDITIONAL SUPERVISORY MEASURES

Further to the supervisory requirements provided in the applicable sector regulations, the FC Law provides for the following additional supervisory measures:

Additional supervisory measures include:

• Capital adequacy requirements at FC level – a measure aimed at avoiding the diminishing of the solvency position of the group through double gearing of capital.

To calculate the supplementary capital adequacy requirements applicable to REs in an FC, Spain adopted a combination of the available options under the FC Directive (consolidation, deduction and aggregation and book value/requirement deduction). In Spain, such requirements shall be determined as the difference between (i) the sum of the sector consolidated own funds of each sub-group conforming the FC and (ii) the sum of (a) the excess own funds requirements of each sub-group that are not eligible as own funds to the entities supervised by the co-ordinator and (b) the book value of the participations in other entities of the group as long as the value of these participations have not been eliminated as a result of the consolidation.

The capital adequacy requirements and solvency requirements of the FC should not be lower than the aggregate of the sector capital requirements and solvency requirements applicable to each entity comprising the FC.

• Quantitative limits and other restrictions dealing with risk concentration, further to information requirements applicable to risk concentrations that are deemed 'significant' (ie in excess of 10 per cent of the FC’s own funds). The implementation of those limits and restrictions by the Ministry of Economy is still pending.
   
• Quantitative, qualitative and other restrictions in connection with transactions with affiliates or related parties (ie with other companies of the FC and persons controlling or holding 20 per cent or more of the capital stock of the RE directly or indirectly), further to information requirements are also applicable to intra group transactions that are deemed significant (ie where their value is in excess of 5 per cent of the FC’s own funds). The implementation of those limits and restrictions by the Ministry of Economy is still pending.
   
• Risk control mechanisms at FC level.

Such supervisory measures are applicable to the RE heading the FC or, otherwise, all REs comprising an FC. Further, when the controlling entity of the FC is an MFHC, the risk concentration and intra group transaction sector limits applicable to the most significant financial sector in which the FC operates, shall be applicable to all of the FC’s REs operating in this sector as well as to the MFHC.

It should be noted that the application of those additional supervisory groups may be totally or partially extended to entities which (i) although not conforming a group, have a significant relationship among themselves (e.g. contractual agreements enabling management or appointment of a number of directors, financial support agreements, etc); (ii) should not be considered an FC solely for not complying with the requirement that their cross-sector activities are 'significant'.

THE CO-ORDINATOR

In order to ensure adequate additional supervision of REs with regard to an FC, a single authority is entrusted with the co-ordination of the supervision, including:

• Co-ordination of the collection and distribution of relevant information, including the distribution of information important to a competent authority's supervisory task under sector rules.
• Supervisory overview and assessment of the financial situation of FCs.
• Assessment of compliance with the additional supervisory measures provided by the FC Law.
• Assessment of the FC’s structure, organisation and internal control system.
• Planning and co-ordination of supervisory activities when necessary, in emergency situations, to attain the goals established in the FC Law.

In the event that an FC is headed by an RE, the co-ordination of its additional supervision is entrusted to the supervisor of the consolidated group in which the RE is integrated or, in the absence of a consolidated group, to the authority competent to supervise the RE on an individual basis. In all other cases, the co-ordinator shall be the supervisor of the most relevant Spanish RE in terms of balance sheet.

The co-ordinator will liaise with one entity of the FC which should be the Spanish RE controlling the FC or, in the event that the FC is not controlled by a Spanish RE, the Spanish RE identified by the co-ordinator in consultation with all competent authorities and with the FC.

ENFORCEMENT MEASURES

In case of non-compliance with the additional requirements applicable to an FC, or where the solvency of an FC may be placed in doubt, the FC Directive called for the application of corrective measures by the co-ordinator (with regard to the MFCHs) or relevant competent authority (with regard to the REs).

The FC Law further developed the measures to be applicable in these cases, establishing that, in such situations, the co-ordinator, or the relevant competent authority, shall have the same powers and authorities set forth in the Spanish regulations governing consolidated groups of financial entities.

CO-OPERATION WITH COMPETENT AUTHORITIES

The FC Law requires the competent Spanish authorities to co-operate closely with each other and with other EU competent authorities. Furthermore, Spanish authorities are called to share with EU authorities any information which is essential or relevant for the exercise of additional supervisory measures.

Prior to the adoption of any of the following decisions, Spanish authorities must consult the other competent authorities supervising the FC:

• Changes in the shareholder, organisational or management structure of RE in an FC.
• Major sanctions or exceptional measures taken by competent authorities.
• Other measures set forth in any regulation introduced.

Spanish authorities may opt not to consult other competent authorities, as provided above, in cases of urgency or where such consultation may jeopardise the effectiveness of the decisions. In this regard, the Spanish authorities shall inform the other competent authorities without delay.

Spanish and EU co-ordinators are entitled to request all the necessary information for the additional supervision of FCs directly from any entity of an FC (whether or not such entity is an RE), or indirectly, through any competent authority in possession of such information or that is entitled to request such information.

REGULATED ENTITIES OUTSIDE THE EU

Competent authorities are required to verify whether a supervision equivalent to the one provided in the FC Law is applicable to REs controlled by a MFHC or RE which head office is outside the EU and which conforms an FC. The verification shall be carried out by the competent Spanish authority which would be the co-ordinator should the criteria, set forth in the FC Law, apply.

In the event that the competent Spanish authorities deem that the FC is not subject to equivalent supervision, such REs shall be subject to the provisions of the FC Law or, conversely, to other methods of appropriate additional supervision which may include, inter alia, the establishment of a MFHC with a head office in the EU.