The principal purpose of this paper is to describe the supervisory issues that arise when financial services are provided via a conglomerate structure, and to offer practical alternatives for regulation and supervision. In addition, the recommendations set out in the paper espouse a specific supervisory philosophy that is applicable to the supervision of financial institutions generally. The paper is intended principally as a Handbook for authorities in the World Bank Group's client countries responsible for determining financial sector regulation and conducting supervision of financial institutions. It also will be of use to World Bank Group staff engaged in financial sector operations, particularly as a guide for the establishment of project objectives.

Part I of this paper provides relevant background. It views the emergence of financial conglomerates as an inevitable market development to which most countries' regulators and supervisors (collectively referred to as the "authorities" hereafter} will need to respond. It identifies three principal supervisory concerns that arise in the context of conglomerates (contagion, transparency and autonomy) and briefly describes the two basic approaches to regulation of financial institutions used by bank, securities and insurance supervisors {consolidated regulation and separate regulation). Part I concludes with an overview of the regulatory and supervisory responses to conglomerates that are being developed in multinational forums.

Part II sets out practical regulatory and supervisory alternatives for authorities confronted with financial conglomerates. Throughout Part II, key issues requiring policy decisions are identified. Preferred regulatory and supervisory solutions, as well as alternatives, are described. Part II makes extensive reference, by way of footnotes, to the regulatory framework that has been adopted by the EEC.

The four principal tools that the authorities must employ in dealing with financial conglomerates are authorization criteria, prudential regulation, accounting consolidation, and consolidated supervision. Authorization criteria should be used explicitly to promote the probability that groups are operated in a sound manner, that the parties responsible for each regulated entity maintain autonomy within the group managerial structure so as to fulfill their responsibilities toward the individual institution, and that group structures be supervisable. Authorization criteria must include suitability standards applicable to principal shareholders, key directors and managers, and external auditors of financial groups. Supervisors must be granted the authority to prevent corporate affiliations or structures that preclude effective supervision.

Prudential regulation can be applied to conglomerates by modifying the existing regulations applicable to different types of financial institutions to take account of the group context, in particular the potential that intra-group transactions have led to an overstatement of capital and earnings. Preferably, however, prudential regulations would be applied on a uniform and fully consolidated basis, increasing their effectiveness and creating a more level playing field among institutions that promotes financial sector competition.

Accounting consolidation of group financial entities is a prerequisite for the application of consolidated prudential regulation, and also serves to improve the transparency of the group's financial position as set forth in supervisory reports and public disclosures. Consolidated supervision is based, in part, on the use of sound prudential regulations and the analysis of consolidated accounts, but must embrace a wider scope to ensure an adequate assessment of the risks arising from all group entities, including the risk of contagion arising from entities that lie outside the scope of prudential regulation and accounting consolidation, such as unregulated financial entities and entities engaged principally in commercial or industrial activities.

Changes in the regulatory framework alone will prove an insufficient response to financial conglomerates. Supervisory agencies will need to modify their supervisory policies and procedures, as well as policies relating to the recruitment, training and retention of qualified staff. The various authorities responsible for different components of the financial system will need to harmonize their activities to ensure an integrated approach to conglomerates.

Comments and questions regarding this paper may be directed to the author at The World Bank, 1818 H St., Room G-8105, Washington DC, 20433, Tel 202-473-7481, Fax 202522-3198 or DSCOTT@worldbank.org@internet.