Economics, EU – Baltic States, Financial Services, Legislation

Background

Financial conglomerates are financial groups that are active in one or more country and operate in both the insurance and banking business. Due to their size (they are often large and complex), financial conglomerates are often of systemic importance to both national and the EU’s economy.  

The financial conglomerates can provide a strong impact – often negative – on economic development; that was highlighted during recent financial crisis in 2008-09. A number of financial conglomerates had difficulties and governments in numerous EU member states had to resort to large financial injections in order to keep these financial conglomerates afloat.

The initial Directive (Financial Conglomerate Directive, 2002/87/EC gives national financial supervisors additional powers and tools to watch over these financial institutions (which is described below).

Current supervision

As a rule, ant supervision in the EU presently is mainly done at the national level. Any financial institution wanting to operate in another member state’s banking sector needs an authorisation from the national financial supervisor. Besides, it has to comply with the relevant national banking regulation.

The same applies to legal entities that want to operate in the insurance sector: such entities need to be authorized as insurance companies and must comply with the relevant insurance regulation. Supervision rules also allow for a group of authorised banking entities to be subject to consolidated banking supervision. Similarly, in the insurance sector, a group of authorised insurance entities can be subject to insurance group supervision.

Financial conglomerates are often active in numerous banking, investment and insurance business and operating in several EU member states. The Financial Conglomerate Directive (2002/87/EC) gives national financial supervisors additional powers and tools to watch over these firms. Foe example, the Directive requires supervisors to apply supplementary supervision on these conglomerates, in addition to the specific banking and insurance supervision.

Supervision’s Directive of 2002

The need for supplementary supervision arises when a financial group (i.e. conglomerate) consists of several legal entities that are authorised to do business in banking, insurance or other sectors in the financial services. Quite often, the number of legal entities within a conglomerate can reach 500 or even a thousand entities. They are controlled by a parent company, where all the decisions regarding business strategies, internal governance, group-wide risk management etc. are made. While a parent entity can be a regulated entity itself, such as a bank, investment or an insurance company, it can also take the form of a holding company.

Therefore, supplementary supervision focuses on the following problems:

• Multiple use of capital: supervisors are to make sure that capital is not used twice or more within a conglomerate. For example, funds may not be included in the calculation of capital on both the single financial entity and the parent company.
• Group risks: they arise from the group’s structure and which often are not related to specific banking or specific insurance business. They refer to risks of contagion (when risks spread from one end of the group to another), management complexity (managing more than several hundred or a thousand legal entities is a far more difficult challenge than managing 20 legal entities).  
• Risk concentration: the same risk can materialize in several parts of the financial conglomerate, and at the same time; and
• Conflicts of interest: for example, when one part of the group has an interest in selling an exposure, while another part of the group has an interest in keeping that exposure.

The 2002 Financial Conglomerates Directive allows national supervisors to monitor those risks, for example by requiring conglomerates to provide additional reporting. Supervisors can also require conglomerates to present additional risk management or internal governance measures. The Directive also requires supervisors to cooperate across sectors and across borders in order to control possible group risks.

Commission’s revision of the Financial Conglomerates Directive

During the recent financial crisis, the Commission evaluated the effectiveness of the 2002 Financial Conglomerates Directive. It found that supplementary supervision, as stipulated in the Directive, could not be carried out on certain financial groups because of their legal structure. In some cases, national financial supervisors were left without the appropriate tools because they had been obliged to choose either banking or insurance supervision under the sector-specific directives or supplementary supervision under the Financial Conglomerates Directive as the definitions for banking and insurance holding companies in the sector-specific directives and for mixed holdings in the Conglomerates Directive were mutually exclusive. The main objective of the revision of the Directive is to correct this unintended consequence of the current rules.

See: Press Release Memo/10/376; Brussels, 16 August 2010

Commission's proposal

The proposed amendments to the 2002 Directive can be summarised in the following way:

• Under the current rules, supervisors have to choose which supervision they apply when a group acquires a significant stake in another sector and when the parent entity is a holding company. The proposed changes require that the sector-specific (banking and insurance) supervision and supplementary supervision could be applied on the conglomerate's parent entity, even if it concerns a holding company.
• Banking supervision would therefore remain applicable even if the banking group acquires a significant stake in an insurance business.
• Similarly, insurance supervision would also remain applicable if the insurance group acquires a significant stake in a banking business.
• When justified by potential group risks as a whole, financial supervisors should be allowed to identify a group as a financial conglomerate and apply supplementary supervision. The identification process of financial conglomerates should allow for risk-based assessments, in addition to existing definitions relating to size ("quantitative indicators").
• Under the current rules, the balance sheet figures are determinative when identifying conglomerates. This approach sometimes results in a list of conglomerates that are not necessarily exposed to group risks, while groups that are evidently exposed to group risks are not always included within the scope of supplementary supervision.
• Financial supervisors should be allowed to waive a group from supplementary supervision if it is small (less than € 60 bln of total assets) and if the supervisor assesses the group risks to be negligible, even if the small group meets the quantitative indicators. This should enable supervisors to allocate their resources to the supplementary supervision of larger and systemically important conglomerates.

The proposed revision of the 2002 Financial Conglomerates Directive also amends the relevant banking and insurance supervision legislation, namely two Capital Requirements Directives (2006/48/EC and 2006/49/EC) and the Directive on Supplementary Supervision of Insurance Undertakings in Insurance Groups (98/78/EC).

The Commission is also currently reflecting on how to connect the present proposals with the Solvency II initiative, which represents the next generation of supervisory rules for the EU insurance and reinsurance companies.

The proposal and crisis prevention in the EU

The main objective of the new Commission’s initiative is to restore the full spectrum of supervisory tools and powers, regardless of the legal structures of financial conglomerates. This ultimate consequence of the current proposal is felt as most urgent.

Nevertheless, the initiative will also strengthen the effective supervision of financial conglomerates. The Commission believes that supplementary supervision of large, complex groups, operating in several countries, can only be effective if the same supervisory approach is applied consistently across all EU member states

Therefore, the European Financial Supervision Authorities’ are involved. As regards financial conglomerates operating in several EU countries, closer coordination between national financial supervisors will be required, particularly through the new European Financial Supervision Authorities (see IP/09/1347).

The proposals regarding those authorities are currently being negotiated between the Council and the European Parliament. The new European Banking Authority (EBA) and the new European Insurance and Occupational Pensions Authority (EIOPA) are to form a Joint Committee to oversee cooperation and coordination between national supervisors in the case of financial conglomerates.

In assisting the Commission’s proposal on further supplementary supervision, the Joint Committee is also expected to look into extending the scope of supplementary supervision to non-regulated entities such as Special Purpose Entities. These are legal entities where assets are stored off the groups' balance sheets. During the crisis, it became clear that contagion and risk concentration originated also from non-regulated parts of financial conglomerates. This issue has been highlighted also on international level in the context of the G-20 and G-8 work. It is the Commission's intention to continue to work on this issue and present further amendments to the Directive on Financial Conglomerates as regards this matter as well as other issues linked in particular to the new European supervisory structures.

Perspectives

The changes in the EU financial law will take effect after the proposal is passed through the European Parliament and the EU member states, as well as through the Council’s procedures. The Commission hopes to see the changes enter into force somewhere in 2011.

More information on the issue:

http://ec.europa.eu/internal_market/financial-conglomerates/supervision_en.htm