Notifications

Ref DBS.FID No. C-7 / 01.02.00/2002-03

September 2, 2002

Dear Sir,

As you might be aware, RBI had set up a multi-disciplinary "Working Group on Consolidated Accounting and Other Quantitative Methods to Facilitate Consolidated Supervision" under the Chairmanship of Shri Vipin Malik, formerly Director, Central Board of RBI. The report of the Group, submitted in December 2001, was examined in RBI and it has been decided to implement the recommendations of the Group, with appropriate modifications, for the select all-India financial institutions also. The report can be accessed at the RBI web site www.rbi.org.in.

2. The consolidated supervision of financial intermediaries has acquired special significance in the Indian context due to the emergence of complex group structures. In such structures, a supervised entity might belong to a Group headed by a holding / parent entity which in turn might also have several other subsidiaries and affiliates – some of which might not even be subject to a formal regulation / supervision. The primary objective of consolidated supervision is to evaluate the strength of an entire Group taking into account all the risks (including those arising from the operations of related entities) that may affect the supervised entity in the Group – regardless of whether these risks are carried in the books of the supervised entity or the entities related to it. It needs being emphasised that the purpose of consolidated supervision is not to supervise each and every entity within a group but to supervise the regulated entity as a part of the Group, so as to take into account the likely risks that may arise from various parts of the Group for the supervised entity. Failure of large and established international banks in the past on account of the operations of their subsidiaries illustrates the magnitude of such risks, which has heightened the supervisory concerns.

3. The proposed supervisory framework for consolidated supervision envisages the following three components, as recommended by the Working Group:

1. consolidated financial statements (CFS),
2. consolidated prudential returns (CPR), and
3. application of prudential regulations like capital adequacy, large exposures and liquidity gaps on group-wide basis.

While the CFS is proposed as a public document to be prepared and published annually (in addition to the annual reports of the FIs and their subsidiaries published at present), the CPR is envisaged as a set of two off-site returns viz., CPR-1 and CPR-2, to be submitted to RBI, initially at half-yearly and quarterly intervals, respectively. While the CFS would be required to be published from the financial year commencing from April 1, 2002 onwards, the CPRs are to be submitted to RBI for the period ending September 30, 2002 onwards. The CPRs may be submitted by the FIs to the Financial Institutions Division except in case of the FIs which have a bank in the group - in which case the CPRs may be sent to the Chief General Manager, OSMOS Division, Department of Banking Supervision, Central Office, Reserve Bank of India, Centre I, World Trade Centre, Colaba, Cuffe Parade, Mumbai - 400 005.

4. As a part of implementation of consolidated supervision, It has also been decided to prescribe the group-wide prudential norms for capital adequacy and large exposures for the FIs. The FIs would be expected to ensure compliance with these norms, on an ongoing basis from the year ending 31 March 2003, taking into account the assets and liabilities of their subsidiaries / associates also, in addition to compliance by the FIs /subsidiaries / associates with the prudential norms that may be applicable to them, on solo basis. The group-wide capital adequacy and large exposure norms would be as indicated below:

The FIs should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 9 per cent on an ongoing basis from the year ending 31 March 2003. The regulatory capital for the purpose of CPR should be determined keeping in view the following guidelines:

1. Currently investment made by parent bank towards equity capital of the subsidiary is being deducted from the bank’s Tier I capital. In line with the international best practice it is proposed to introduce the system of deduction of investments in unconsolidated entities in equal proportion from Tier 1 and Tier 2 capital with reference to the Group CRAR. This prescription would be relevant only in respect of investment in entities which are not being consolidated in the CPR.
2. Regulatory capital requirements of solo entities, where the standards are more stringent than those for the FIs, should be treated as the minimum capital and where the capital adequacy norms are non-existent or relaxed, the norms applicable to FIs may be used as a proxy for measuring capital adequacy standards at the conglomerate level.
3. Risks inherent in unconsolidated entities (i.e., entities which are not consolidated in the CPR) in the group need to be assessed and any shortfall in the regulatory capital in the unconsolidated entities should be deducted (in equal proportion from Tier 1 and Tier 2 capital) from the group capital in the proportion of the Group's equity stake in the entity.

As a prudential measure aimed at better risk management and avoidance of concentration of credit risks, in addition to prudential limits on exposure by solo entities, the FIs at the group-wide level should also adhere to the following prudential limits, on an ongoing basis from the year ending 31 March 2003:

Computation of capital funds, exposure, etc., would be done in the same manner as prescribed for the FIs .

5. Needless to say, an appropriate MIS would be a pre-requisite to support the consolidated supervision; the FIs are, therefore, advised to build up requisite MIS for the purpose to enable development of the database.

6. The draft guidelines for the proposed consolidated supervisory framework, as applicable to the select all-India financial institutions are furnished in the Annexure and the guidelines for compilation of CFS and CPR are furnished at Appendix A and Appendix B, respectively, for your comments. The comments may please be furnished to us at the earliest but not later than September 15, 2002, preferably by fax.

Yours faithfully,

(Rajesh Verma)
General Manager-in-Charge

Encls.: As above

The RBI had set up a multi-disciplinary Working Group in November 2000 under the Chairmanship of Shri Vipin Malik, formerly Director, Central Board, RBI, for examining the feasibility of introducing consolidated accounting and other quantitative methods to facilitate consolidated supervision and to make recommendations accordingly. The Working Group, which had detailed deliberations with the representatives of select FIs as well, submitted its report in December 2001 - which can be accessed at the RBI web site www.rbi.org.in. The recommendations of the Working Group were examined in the RBI and it has been decided to implement them with appropriate modifications, wherever considered necessary, in respect of the select all-India financial institutions also. The following draft guidelines have accordingly been formulated for effecting consolidated supervision of the FIs.

2.1 For the purpose of these guidelines, the terms 'parent', 'subsidiary' and 'group' would have the same meaning as ascribed to them in the Accounting Standard 21 (AS-21) of the Institute of the Chartered Accountants of India (ICAI).

2.2 An ‘associate’ of an FI would be an entity in which the FI holds more than 20% but less than 50% of the paid up equity capital or voting rights in respect of that entity, directly or indirectly, as on the date of the FI’s last published balance sheet.

2.3 For the purpose of compiling the CPR, which requires consolidation of subsidiaries and associates engaged only in 'financial activities', the activities listed in Appendix B-3 would be deemed to be the "financial activities".

For the present, consolidated supervision would be implemented for all the groups where the parent (i.e., the holding / controlling entity) is an institution which falls within the regulatory / supervisory domain of the RBI.  Accordingly, these guidelines would be applicable to the nine FIs which, at present, are regulated and supervised by this Division as all-India financial institution, viz., IDBI, IFCI Limited, TFCI Limited, IIBI Limited, IDFC Limited, EXIM Bank, NHB, NABARD and SIDBI.

The consolidated supervision as proposed to be implemented by the RBI, would include the following elements:

1. Consolidated Financial Statements [CFS], which are intended for public disclosure for market discipline.
2. Consolidated Prudential Returns [CPR] for supervisory assessment of risks which may be transmitted to banks (or other supervised entities) by other group members.
3. Application of certain prudential regulations like capital adequacy, large exposures, etc. on group-wide basis.

The guidelines for compilation of CFS and CPR, as also the reporting formats, are furnished at Appendix A and Appendix B, respectively.

The CFS should be prepared primarily in terms of the AS-21 of the ICAI keeping in view the following aspects:

1.1 Components: CFS should normally include consolidated balance sheet, consolidated statement of profit and loss, Notes on Accounts, other statements including cash flow statement and explanatory material that form an integral part thereof.

1.2 Effective date: All the FIs falling within the purview of consolidated supervision of RBI, whether listed or unlisted, should prepare and publish CFS with effect from the financial year commencing from April 1, 2002 (1st July 2002 in case of National Housing Bank), in addition to the solo financial statements, as published at present.

1.3 Extent of consolidation: A parent presenting CFS should consolidate the financial statements of all subsidiaries - domestic as well as foreign, except those specifically permitted to be excluded under the AS 21 the ICAI. The reasons for not consolidating a subsidiary should be disclosed in CFS. The responsibility of determining whether a particular entity should be included or not for consolidation would be that of the parents' Statutory Auditors.

1.4 Compliance with Accounting Standards: CFS should be prepared in terms of AS -21 and other related Accounting Standards prescribed by the ICAI, viz., AS 23 relating to 'Accounting for Investments in Associates in Consolidated Financial Statements' and AS 27 relating to 'Financial Reporting of Interest in Joint Ventures'.

1.5 Format of CFS: Since AS 21 does not prescribe a format for publishing consolidated financial statements, FIs should publish their CFS in the format furnished at Appendix A-1. As stated above, the CFS would be in addition to the FIs’ and their subsidiaries' solo annual accounts prepared as per the formats prescribed under their respective statutes or the Companies Act, 1956.

1.6 Reference date for consolidation: The financial statements used for the purpose of consolidation should be drawn up to the same reporting date. When the reporting dates are different, the subsidiary often prepares, for consolidation purposes, statement as at the same date as that of the parent. When it is impracticable to do this, AS 21 permits use of financial statements drawn upto different reporting dates provided the difference in reporting dates is not more than six months and prescribes that adjustments should be made for the effects of significant transactions or other events that have occurred during the intervening period.

1.7 Accounting policies:

1.7.1 CFS should be prepared using uniform accounting policies for like transactions and other events in similar circumstances. If it is not practicable to do so, that fact should be disclosed together with the proportions of the items in the consolidated financial statements to which the different accounting policies have been applied.

1.7.2 If different entities in a group are governed by different accounting norms laid down by the respective regulator for different businesses then, in cases where "term lending" or "refinancing" is the dominant activity, accounting norms applicable to the FI should be used for consolidation purposes in respect of like transactions and other events in similar circumstances. In situations where no accounting norms have been prescribed by the regulatory authority of the subsidiary / associate, and different accounting policies are followed by different entities of the group, ‘balance of business’ test may be applied for deciding the applicable accounting norms. The 'balance of business' test would imply that a line of business or activity accounting for more than 60 per cent of the aggregate assets and aggregate income of the group would be deemed to be the 'dominant activity' of the group, and the accounting policies / norms applicable to that 'dominant activity' would apply to the subsidiary / associate for which no accounting norms have been prescribed by the sectoral regulator. For dissimilar items and circumstances, different accounting policies would have to be followed.

1.8 Accounting for investments:

1.8.1 The investments in associates (other than those specifically excluded under AS 23) and subsidiaries should be accounted for under the "Equity Method" of accounting in accordance with Accounting Standard 23.

1.8.2 The investments in subsidiaries and associates (which are excluded under AS 23) should be accounted for as per AS 13 (relating to Accounting for Investments) issued by the ICAI unless excluded by AS 13, in which case the relevant valuation principle will apply.

1.8.3 The investments in joint ventures should be accounted for under the ‘proportionate consolidation’ method as per Accounting Standard 27 on "Financial Reporting of Interests in Joint ventures" issued by ICAI.

1. The FIs falling within the scope of consolidated supervision of RBI should, in addition to the CFS, also prepare CPRs, in the format attached at Appendix B-1 and B-2, for submission to RBI, as part of the off-site reporting system. The objective of the Consolidated Prudential Return (CPR) is to collect consolidated prudential information at the level of the group to which the supervised institution belongs. It aims to capture data in the prescribed format mainly on the following aspects:

1. Consolidated Balance Sheet ;
2. Consolidated Profit & Loss Account;
3. Select data on financial/ risk profile of the group; and
4. Operations of subsidiaries / related entities

To begin with, only two CPRs are being prescribed - CPR 1 and CPR 2. While the first three aspects ('a' to 'c' above) would be captured in CPR 1, the operations of the subsidiaries / related entities are to be reported in CPR 2. CPR 1 would be a half-yearly return, to be submitted as at the end of March and September whereas CPR 2 would be a quarterly return to be submitted as at the end of each calendar quarter in respect of each subsidiary / related entity, separately. The reporting frequency would be reviewed and modified, if necessary, in due course. The CPRs would be in addition to the Consolidated Financial Statements (referred to at Appendix A) and the existing off-site returns compiled and submitted to RBI on solo basis by the FIs. Two prudential parameters viz., capital adequacy and large exposures would also need to be reported in CPR 1 on a group-wide basis, for which group-wide prudential norms are also being prescribed now, as detailed in the following paragraphs. The first set of CPRs should be submitted for the period ending September 2002.

1.1 In preparation of CPRs, the data to the extent applicable, may be derived from the consolidated balance sheet and profit and loss account, prepared as per guidelines in Appendix A, also taking into account the instructions contained in the formats of the CPRs and the consolidated prudential norms now prescribed at Para 7 of this Appendix.

2. Definitions: For the purpose of CPRs, the following definition would apply:

2.1 Subsidiary: It is an entity that is 'controlled' by another entity known as 'parent'.

2.2 Parent: It is an enterprise that has one or more subsidiaries.

2.3 Control: It is defined as:

1. the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or
2. control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.

2.4 Related entities: The term 'related entity' would include all such 'subsidiaries' and 'associates', which are, controlled by the same shareholders as the FI itself.

(For the purpose of compiling CPR, the test applied for identifying related entities is ‘common control’ and not only the size of the ownership stake or shareholding in the controlled entity. For consolidation in the supervisory context, the "related entity / common control approach" replaces the 'subsidiary approach' of AS 21.)

2.5 Associate: An ‘associate’ of an FI would be an entity in which the FI holds more than 20% but less than 50% of the paid up equity capital or voting rights in respect of that entity, directly or indirectly, as on the date of the FI’s last published balance sheet.

3. Scope of consolidation and reporting: The FIs within the supervisory domain of RBI, which are a parent / holding entity within the group, should submit CPR encompassing the information and assets and liabilities of all those "related entities" under their control which are engaged in "financial activities". An illustrative list of 'financial activities' is furnished at Appendix B-3. For the purpose of preparation of CPR, while the general principles / guidelines for preparation of CFS may be used, the consolidation for CPR purposes should be confined to only those 'related entities' which are engaged in "financial activities" (Cf. Appendix B-3) and should exclude group companies, which are engaged in:

1. insurance business (regardless of their status in the group - as parent or as related entity), and
2. businesses not pertaining to financial services.

The FIs should justify the exclusion or inclusion of any entity for the purpose of CPR. In cases of exclusion, RBI would undertake assessment of risks in such entities on an off-site basis and / or as a part of the on-site examination of the FI concerned.

4. Consolidation of cross-border related entities: In respect of a related entity engaged in financial activity and established in a country, which prevents repatriation of capital, the risks should be assessed qualitatively and investments should not be included in the assets of the parent FI filing the CPR. The countries having problem of repatriation and the cases where the investors are called upon to fund the losses should be identified by the FIs required to submit the CPR and appropriately factored into the CPR. The FIs should also consider the possibility where they may not be an 'investor' in the foreign entity but may be a subsidiary / associate of an entity from a foreign territory. The likely burden on the FI in this eventuality should also be appropriately factored into the CPR.

5. Consolidation of a parent in the securities industry: If a securities trading company is the parent in the group, the FI in the group is required to consolidate and provide the consolidated prudential report since market risks of the parent could decisively impact the FI (the related entity).

6. Consolidation in mixed activity groups: In case of the "mixed activity groups" (which control commercial and industrial entities as well as banking and other financial entities), only the banking / credit / financial sub-group of the larger mixed group is required to consolidate the financials for the purposes of compiling CPR. For deciding whether the non-bank parent company of a mixed group should also be consolidated in preparing CPR with the credit / financial sub-group to which the supervised entity belongs, the 'balance of business test', enumerated at para 1.7.2 of Appendix A, could be a criterion. However, the reporting to RBI under the CPR should be kept confined to only the credit / banking / financial sub group. The parent entity in a mixed activity group, which would normally not be a supervised institution, need not be consolidated in the CPR. The information available in the CFS of the parent, prepared in accordance with AS 21, would instead be used for monitoring the group-wide activities.

7.1 For the purpose of application of prudential norms on a group-wide basis, a 'group' is defined as a group of entities (which might also include a licensed bank) engaged in financial activities, with the FI as the parent. As a part of consolidated supervision, the prudential norms/ limits, as detailed below, in the following areas have been prescribed for compliance, on a group-wide / consolidated basis:

1. Capital Adequacy
2. Large Exposures
3. Liquidity mismatches

7.2.1 The FIs should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of nine per cent on an ongoing basis from the year ending 31 March 2003.

7.2.2 The assessment of group-wide capital adequacy on a consolidated basis becomes necessary to obviate the phenomenon of double-/ multiple-gearing of capital within a group - that is, deployment of the same capital of the parent in several other legal entities/ subsidiaries ('down-streaming' of capital). This could lead to situations where each entity in a group might be in compliance with the solo regulatory capital prescription but at the group-level / on consolidated basis there could be a capital deficit. Thus, assessment of group capital merely on the basis of solo capital requirements of the constituents could overstate the external capital of the group. Hence, assessment of group capital should exclude intra-group holdings of regulatory capital.

7.2.3 The regulatory capital for the purpose of CPR should be determined keeping in view the following guidelines:

1. Where the solo regulatory capital norms for the related entities, are more stringent than those for the FIs, such norms should be treated as the regulatory minimum capital for such entities. Where, however, the capital adequacy norms for the related entities at the solo level are non-existent or less stringent than the norms for the FIs, the norms applicable to FIs should be applied to the related entities, as a proxy for solo norms, for computing the capital adequacy ratio at the consolidated level.
2. Under the extant norms, the investment made by the parent FI towards equity capital of the subsidiary(ies) is required to be deducted from the FI’s Tier I capital. In tune with the international best practice, however, it has been decided that in computing group-wide CRAR, the investments of the parent FI in unconsolidated entities should be deducted in equal proportion from Tier 1 and Tier 2 capital of the parent FI. It may be noted that this prescription would apply only in respect of investment in entities which are not being consolidated in the CPR.
3. Risks inherent in unconsolidated entities (i.e., entities which are not consolidated in the CPR) in the group need to be assessed independently and any shortfall in the regulatory capital in the unconsolidated entities should be deducted, from the group capital, in equal proportion from Tier 1 and Tier 2 capital. The amount of shortfall to be deducted from group capital should be proportionate to the Group's equity stake in the unconsolidated entity(ies).
4. The FIs' investments exceeding 20 per cent of its own paid up equity capital in any entity should be considered significant and should be deducted in equal proportion from Tier 1 and Tier 2 capital of the parent FI.
5. If, in case of related party or intra-group exposures, risk is seen to be transferred to unregulated entities in the group, assessment of group capital adequacy could be done by using either "risk-based aggregation" or "risk-based deduction" approach wherein the risks of unregulated entities in the group need to be assessed on a notional basis and capital requirements computed and aggregated with those of the group. An illustration of the methodology of the 'risk-based aggregation' and 'risk-based deduction' approach is furnished at Appendix B-4.

6. Participations, which confer effective control and / or meet company law definition of 'subsidiary', are usually consolidated in full and minority interest shown separately from the group shareholders’ funds. Where the group participation in a regulated dependant gives rise to significant influence and exposure to risk, but falls short of control, only the pro rata share of surplus regulatory capital of the regulated dependent should be regarded as available to support risk in the parent FI or other entities in the group.

Accordingly, for the purpose of CPR, pro rata share of regulatory capital in excess of the subsidiary’s own regulatory capital requirements, and which could be regarded as, in principle, available to support risk in the parent or in other entities in the group, should a shortfall arise, can be recognised in the group-wide capital adequacy assessment. However, the parent should provide for the entire deficit in the regulatory capital of the subsidiary in the group-wide capital adequacy assessment. This treatment should be applied to group participations, which are in excess of 50 per cent but not in cases where the participation falls short of control.

7. Any solo deficits in a dependants’ capital should be attributed/ deducted in full in the group capital assessment if it appears that the parent is likely to have to support the dependant without assistance from other external participants.
8. Consolidation of insurance subsidiaries is not mandated. As such, the FIs' investments in insurance subsidiaries may be deducted in equal proportion from its Tier 1 and Tier 2 capital.
9. Significant minority and majority investments by the FIs in commercial entities, which exceed certain materiality level should also be deducted from the FI's capital. The materiality level should be reckoned as 15% and 60% of the FI's equity capital for 'individual significant investment' and aggregate of such significant investments, respectively.
10. Capital for market risk: In computation of consolidated group capital, the capital charge for market risk, prescribed for the FIs, should also be taken into account. In case of unregulated entities in the group or where the sectoral supervisor has not prescribed any capital charge for market risk for a related entity, the norms for capital charge for market risk as applicable to the FI should be used as proxy for such related entities.

As a prudential measure aimed at better risk management and avoidance of concentration of credit risks, in addition to prudential limits on exposures of solo entities, the FIs at the group-wide level should also adhere to the following prudential limits:

Computation of capital funds, exposure, etc., for the group as a whole would be done in the same manner as prescribed under the extant norms for the FIs. The individual exposures of the entities in the group should be consolidated for determining the group-wide exposure levels.

Maturity wise distribution/ analysis of assets and liabilities should be disclosed on a consolidated basis in the CPR, in order to reflect the liquidity risk faced by the group. The prudential limits for negative liquidity mismatches in the first two time bands of 1-14 days and 15-28 days, at 10% and 15% of the aggregate cash outflows in these time buckets, as applicable to the FIs under the extant ALM Guidelines, shall also apply at the consolidated group level. Intra-group transactions and exposures should be excluded from this consolidation.

This report may be prepared by placing all cash inflows and outflows of all the entities in the group in the maturity ladder according to the expected timing of cash flows, following the guidelines prescribed vide Circular DBS.FID. No. C-11/01.02.00/1999-2000 dated 31 December 1999.

The format suggested is in vogue for the FIs at present and the reporting institutions may consolidate the liquidity gap report putting together transactions which are of the similar nature following the format.

Entities undertaking one or more of the following activities should be considered to be engaged in "financial" activities:

1. Ancillary Banking Services (defined as: "undertaking the principal activity of which consists in owning and managing property, managing data processing services, or any other similar activity which is ancillary to the principal activity of one or more credit institutions").

2. Lending (including, inter alia, consumer credit, mortgage credit, factoring with or without recourse, financing of commercial transactions (including forfeiting)).

3. Financial leasing

4. Money transmission services

5. Issuing and administering means of payment (e.g. credit cards, travellers’ cheques and banker’s drafts).

6. Guarantees and commitments

7. Trading for own account or account of customers in:

1. money market instruments (cheques, bills, CDs etc);
2. foreign exchange;
3. financial futures and options;
4. exchange and interest rate instruments;
5. transferable securities.

8. Participation in securities issues and the provision of services relating to such issues.

9. Advice to undertakings on capital structure, industrial strategy and related questions and advice and services relating to mergers and the purchase of undertakings.

10. Money broking

11. Portfolio management and advice

12. Safekeeping and administration of securities.

(Source: Bank of England Notice on the implementation of the Directive on the Consolidated Supervision of Credit Institutions (BSD/1993/1)

Some of the examples on the situations that can be faced by the supervisors in assessment of capital adequacy included in the 'Capital Adequacy Principles Paper' submitted to the Basel Committee are indicated in the Annexure.

The parent is an insurance company, which has a 100% investment in a bank, which in turn has a 100% investment in a securities firm.

Wilhout provisions to account for this corporate structure in measures of capital adequacy, it appears that solo capital requirements for the individual entities in this group are met. However, it is clear that a portion of the capital of the parent insurance company, i.e. the amount of 500 invested in bank B 1 is levered twice, once in the parent and again in bank B1 (double gearing). Furthermore, the amount invested by B1 in the securities firm B2 (250), which has already been levered twice, is now being levered a third time, in the securities firm (when capital is being levered more than twice, it is said to be an instance of multiple gearing).

On the face of it, the group has total capital and reserves of 2,900 to cover total solvency requirements of 2,000. If the multiple gearing is eliminated, the adjusted capital and reserves reduce to 2,150 leaving a surplus of only 50 over the capital requirements of 2,000. All three techniques should yield these results.

An unregulated holding company with two regulated 100% subsidiaries and the unregulated 100% subsidiary. Both regulated entities meet their solo requirements.

(i) Assume the solo capital requirements/solvency margins of the regulated companies are as follows:

(ii) Under the building-block prudential approach, the aggregated solo capital requirements and proxies (B1: 100; B2 : 300; B3 : proxy of 150: Total: 550) are to be compared with the consolidated capital (300 + 100 = 400). The group has a solvency deficit of 550 -400 = 150.

(iii) Under the risk-based aggregation method, the solo capital requirements and proxies are again aggregated (550); the total requirements are compared to the sum of the capital held by the parent and its subsidiaries, deducted from the amount of- the intra-group holding of capital [300 (parent) + 800 (B1) + 300 (B2) + 100 (B3) -1,100 (investments) = 400]. Again, the group has a solvency deficit of 150.

(iv) Under the risk-based deduction method, in the balance sheet of the parent the book value of each participation is replaced by its surplus or deficit value, i.e. total assets minus liabilities and minus capital requirement/proxy of the subsidiary. The book-values of B1 (800),B2 (200) and B3 (100) are replaced by the solo surplus/deficit identified under (i): B1 (700), B2 (0), B3 (-50).

The revised balance sheet of the parent holding company is then as follows:

Again, the result of the calculation shows a group solvency deficit of 150.

(v) When there is an unregulated holding company, the total deduction method is not applicable.

Although both regulated entities meet their own solo or sector solvency requirements, the financial conglomerate on a group-wide basis is undercapitalised. The explanation is twofold: first, there is excessive leverage in the group, as the parent has downstreamed debt to its subsidiaries in the form of equity capital, and secondly there is an undercapitalised unregulated entity in the group.

The undercapitalisation of the group is a potential risk for both regulated entities. As shown in the example, the undercapitalisation can be revealed by applying appropriate measurement techniques for the assessment of capital adequacy at group level.

This example shows that where minority interests are present the choice between full integration and pro-rata integration can have a material effect on the assessment of group capital adequacy.

A decision has to be made, explicitly or implicitly, as to how to deal with minority interests in the various entities of the group. Essentially, the question is whether to include them by using full integration or to exclude them by using a pro-rata approach.

The example, using the risk-based aggregation method, demonstrates that full consolidation may yield a less conservative result than the pro-rata approach in cases where there are important surpluses and no deficits at solo level elsewhere in the group and thus, may mislead supervisors about the situation of the group.

Consider first a regulated parent and its 100% participation in a regulated subsidiary .

Both institutions (parent and subsidiary 1) comply with their respective capital requirements at solo level. The assessment of capital adequacy at group level, however, reveals that there is an element of double gearing, which would call for regulatory action from the parent's regulator. As a result, the parent would have to increase its capital or to reduce its risk or the subsidiary's risk. (Since the parent has a 100% stake in the first subsidiary, there is no difference between full and pro-rata integration).

Consider a situation where the parent also has a 60% participation in a second subsidiary with a considerable surplus at solo level.

The group position would be as follows:

While pro-rata integration reveals a deficit at group level, full integration of the second subsidiary in the group calculation reveals no deficit because the second subsidiary's surplus compensates for the previous deficit at group level. This is because full integration regards capital elements attributable to minority shareholders as available to the group as a whole unless supervisors decide to limit the inclusion of the excess capital of this subsidiary. Of course, if the second subsidiary had a capital deficit at solo level then full integration would reveal a larger deficit at group level than pro-rata integration because full integration has the effect of placing full responsibility for making good the deficit on the controlling shareholder (the parent).

This example, which uses the risk-based aggregation method, illustrates, as did example 3, the implications of using a full-integration or a pro-rata approach. At the same time, it shows the application of a notional capital proxy to an undercapitalised unregulated entity whose business activities are similar to those of the regulated entities.

The existence of solo requirements should normally prevent deficits at solo level in firms of the group. In cases where one entity of the group has a solo deficit, supervisors should consider whether excess capital in other firms of the group can cover such 'solo deficit. In the following example this excess capital is needed to cover notional deficits in an unregulated entity:

The surplus at group level stems exclusively from the partly-owned subsidiary. However, in the event that the parent also had a participation in an undercapitalised unregulated entity, t}1e group position would bc as follows:

Under the full integration approach, the surplus in subsidiary 1 is regarded as available to the group as a whole and it thus more than compensates for the deficit in subsidiary 2. The pro-rata approach on the other hand, only takes account of that part of the surplus in subsidiary 1 which is attributable to the parent and, as shown, this is not sufficient to offset the deficit in subsidiary 2 and the parent would either have to reduce its own risks, to increase its own capital or to renounce to the acquisition of the second firm.