The emergence and growth of conglomerates has been largely driven by the potential of such entitles to benefit from the economies of scale and scope and to capture synergies across complementary financial services/business lines. These economies result in improved operational efficiency and effectiveness due to lower costs, reduced prices, and improved innovation in products and services. However, from a supervisory perspective, the conglomerates give rise to a few concerns on account of the cross-segmental linkages inherent within them.

Typically conglomerates undertake a range of financial activities, including commercial banking, investment banking and insurance, both within their home economy and abroad. They will also be major players in wholesale financial markets, for example, as market makers in foreign exchange and OTC derivatives. In this role they will both provide liquidity to other market participants as well as being major takers of funds. They may also be an important part of the local payment and settlements infrastructure. As such, in normal times they will be an important resource for other financial intermediaries and end-users as facilitators of financial transactions and as a channel or counterparty for mitigating risk. But in others, through their linkages with domestic financial institutions and their prominent role in markets, they also have the potential to be a source of domestic financial instability.

• Sheer size and complexity of the conglomerates : First, there is the moral hazard associated with the 'Too-Big-To-Fail' position of many financial conglomerates. In addition, it becomes more difficult to manage and understand the operation of a firm as the organization grows. While both these issues are not unique to financial conglomerates, these issues tend to come to sharp focus because financial conglomerates tend to be large.

• Holding-out phenomenon : A second aspect of financial conglomerates is that financial difficulties in one subsidiary in a segment could have contagion or reputation effects on another subsidiary in a different segment on account of the 'holding out' phenomenon, especially when using the same brand name. If these entities can expect support when needed, a moral hazard problem arises, as they could be tempted to take on more risk than they would otherwise have done. These possible contagion and cross-segment moral hazard risks form an argument for supervisory intervention at the level of a financial conglomerate.

• A third set of issues prompting supervisory focus relates to the concerns about regulatory arbitrage, non-arm's length dealings, etc. arising out of ITEs - both financial and non-financial, that may further get accentuated by the non-transparency of such intra-group channels. In general, supervisory concerns arise when the ITEs:

• result in capital or income being inappropriately transferred from the regulated entity;

• are on terms or under circumstances which parties operating at arm's length would not allow and may be disadvantageous to a regulated entity;

• can adversely affect the solvency, the liquidity and the profitability of individual entities within a group;

• are used as a means of supervisory arbitrage, thereby evading capital or other regulatory requirements altogether.

• The intra-group transactions between group entities within a financial conglomerate may significantly impact on the financial performance and capital adequacy position of the individual entities involved. Internal lending may also increase the risk of contagion. Intra-group transactions may involve conflicts of interest between the parties concerned.

From a regulatory perspective, the increasing tendency towards conglomeration has led to an appreciation of the limitations of the segmental approach to supervision since such supervisory approaches reflect only the traditional business activities and perspectives within each segment not incorporating the increasing cross-segmental risk transfers and cross-segmental investments. A network of complex and overlapping managerial and operational structures within a single conglomerate further accentuate the problem. On the other hand, improved diversification and risk-spreading arising out of this would also raise issues regarding risk management and risk based supervision that may not be easy to address in a sectoral regulatory paradigm. As brought out in the 'Core Principles of Banking Supervision' of Basle Committee on Banking Supervision (BCBS) as well, an essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis that goes beyond accounting consolidation. It implies a group-wide approach to supervision whereby all risks run by a banking group are taken into account, wherever they are booked; both accounting consolidation and consolidated supervision are key aspects of the supervision of banking groups.

The lead in trying to develop a framework for supervision of financial conglomerates was taken by the BCBS, which together with International Association of Insurance Supervisors (IAIS) and International Organization of Securities Commissioners (IOSCO), had formed the Joint Forum on Financial Conglomerates (Joint Forum) in 1996, a working group that has researched and prescribed supervisory standards for financial conglomerates.

Capital Adequacy Principles: Measurement techniques and principles have been outlined to facilitate the assessment of capital adequacy on a group-wide basis for financial conglomerates. The principles do not replace existing sectoral rules for the assessment of capital adequacy but should be used to complement existing approaches. Illustrations of situations that can be faced by supervisors in practical applications of the measurement techniques are provided.

Principles for Supervisory Information Sharing: This paper provides to supervisors involved in the oversight of regulated financial institutions residing in financial conglomerates guiding principles with respect to supervisory information sharing. Guiding principles are set-out with a reference to the Ten Key Principles on information Sharing issued by the G-7 Finance Ministers in 1998.

Intra-Group Transactions and Exposures Principles: This paper provides banking, securities and insurance supervisors principles for ensuring through the regulatory and supervisory process the prudent management and control of intra-group transactions and exposures by financial conglomerates.

Risk Concentrations Principles: This paper provides to banking, securities and insurance supervisors principles for ensuring through the regulatory and supervisory process the prudent management and control of risk concentrations in financial conglomerates.

In definitional terms, there is no clear cut distinction made between consolidated supervision and conglomerate supervision. Both the terms connote an inclusive regulatory/supervisory paradigm with a holistic supervisory focus in respect of institutions having direct or indirect cross-linkages across financial segments. However, the supervisory approaches differ. The supervisory structures adopted/being adopted by different countries to provide this holistic focus have acquired varied contours ranging from a unified regulatory agency to a coordinating agency and in some cases a focused supervision of conglomerates within the framework of sectoral regulatory agencies through enhanced inter-regulatory coordination.

The model of the single integrated supervisory authorities - with competence over banking, investment and insurance activities - spread from the Scandinavian area and got a fillip with the establishment of FSA by UK in 1998. At the end of 2002, at least 46 countries had adopted the model of unified or integrated supervision by either establishing a single supervisor for their entire financial sector or by centralizing in one agency the powers to supervise at least two of their main financial intermediaries (such as banking with insurance, banking with securities or securities with insurance).

In several other countries, steps have been taken to strengthen cooperation between the existing supervisory bodies. In the Netherlands, a Council of Financial Supervisors was established in 1999 to supplement the existing forms of co-operation between the three supervisory authorities. In France also co-operation between the different authorities has been strengthened. Australia has adopted an "objective based" supervisory architecture with a distinction between prudential supervision, market integrity and systemic stability. Some regulatory regimes, however, have adopted or are in the process of adopting an exclusive supervisory framework for identified conglomerates, the most prominent among them being USA, European Union and Australia.

A brief overview of the approaches being adopted by a few major countries are given below:

• The U. S. approach to the supervision of diversified financial groups falls under the "umbrella supervision" through which the Federal Reserve has supervisory oversight authority and responsibility for bank holding companies, including financial holding companies (FHCs). In addition to this overall supervisory framework, the Federal Reserve closely monitors inter-affiliate transactions and the attendant risks

• The Financial services authority (FSA) is currently in the process of updating its arrangements for the prudential supervision of financial conglomerates. It has recently issued proposals (Consultation Paper on 'Financial Groups Directive') to implement the EU Financial Conglomerates Directive in the UK. The new regime will apply extra prudential requirements at the mixed financial group level, covering the quality of group systems and controls and the adequacy of capital across the conglomerate.

• Australia Prudential Regulatory Authority (APRA), Australia which is already a combined supervisor for both credit institutions (banks and other deposit takers) and insurance companies has brought out a comprehensive policy framework for the Prudential Supervision of Conglomerate Groups consisting of only Authorised Deposit-Taking Institutions.

• In Canada, there is no specific supervisory framework for conglomerates; they are supervised on the same basis as other financial institutions by the Office of the Superintendent of the Financial Institutions (OSFI). As for monitoring related party transactions, all federally regulated financial institutions are subject to the self dealing regime based on the guidelines issued by OSFI which limits their ability to transact with related parties.

It may be observed from the above that the main focus of monitoring ITEs is an adjunct or corollary to the process of consolidated supervision.

Inspite of the variations in the approaches and structures, most of the supervisory regimes encompass the following elements, in varying degrees, in respect of monitoring of conglomerates :

• quantitative techniques,

• risk concentration,

• intra-group transactions and exposures,

• internal controls & risk management and

• inter-regulatory coordination.

The first step towards consolidated supervision of banking entities in India was the issuance of guidelines by RBI to the banks in February 2003 based on the report of the committee set up under Shri Vipin Malik, Director on the Central Board of RBI. Consolidated supervision as exercised at present is mandated for all groups where the controlling entity is a bank.

By implication, the following are excluded from the framework at present:

• groups where a non-bank entity (financial or non-financial) is the parent; and

• foreign banks/other financial entities operating in India where the parent would be an overseas entity;

The system at present has the following components:

• Consolidated Financial Statements (CFS): These are intended for public disclosure. All banks coming under the purview of consolidated supervision of RBI, are required to prepare and disclose CFS in terms of Accounting Standard (AS) 21 and other related Accounting Standards prescribed by the Institute of Chartered Accountants of India (ICAI).

• Consolidated Prudential Reports (CPR): This is necessary for supervisory assessment of risks which may be transmitted to banks (or other supervised entities) by other group members. CPR is confined to all groups where the controlling entity is a bank. If the bank is a parent company within a group, the bank should submit Consolidated Prudential Reports for the entities under its control excluding group companies which are engaged in (a) insurance business and (b) businesses not pertaining to financial services. Apart from the consolidated Balance Sheet and P&L Statement, the CPR requires reporting of select financials of the 'consolidated bank' and the exposure levels to large borrowers/borrower groups, capital market, forex market and Unsecured Guarantees and Unsecured Advances at a 'consolidated level'.

  The existing format focuses on capturing some exposure parameters at the 'group' level, However, intra-group transactions and exposures are not being captured. Exposures to some important market segments such as debt, inter-bank, etc. as well as non-fund based exposures are also not being monitored currently. Consequently, it is not possible to evaluate the overall risks, and the possible transfer thereof, within the group structure.

• Application of certain prudential regulations like capital adequacy, large exposures / risk concentration etc. on group basis. A Consolidated bank should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) as applicable to the parent bank on an ongoing basis. In case of any shortfall in the capital adequacy ratio of any of the subsidiaries (prescribed by their respective regulators), the parent should maintain capital in addition to its own regulatory requirements to cover the shortfall. Risks inherent in deconsolidated entities (i.e., entities which are not consolidated in the Consolidated Prudential Reports) in the group need to be assessed and any shortfall in the regulatory capital in the deconsolidated entities should be deducted (in equal proportion from Tier 1 and Tier 2 capital) from the consolidated bank's capital in the proportion of its equity stake in the entity.

It may be mentioned here that in respect of banks, the guidelines on capital adequacy mandate that any equity investment in subsidiaries must be deducted from the Tier I Capital of the bank for calculation of CRAR.

• Risk concentration: Consolidated banks should also adhere to the following prudential limits on-

  1. Single & Group borrower exposures: Exposure by the consolidated bank to a single borrower/ debtor should not exceed 15% of its capital funds. Exposure by the consolidated bank to a borrower/ debtor group should not exceed 40% of its capital funds (extendable upto 50% if the additional exposure is for infrastructure projects).

  2. Capital market exposures: The consolidated bank's aggregate exposure to capital markets should not exceed 2 per cent of its total on-balance-sheet assets (excluding intangible assets and accumulated losses) as on March 31 of the previous year. Within the total limit, investment in shares, convertible bonds and debentures and units of equity-oriented mutual funds should not exceed 10 percent of consolidated bank's net worth

  3. Exposures by way of unsecured guarantees and unsecured advances: As applicable to banks.