Consolidated Regulation

Under consolidated regulation, contagion is taken to be such a concern as to justify the application of regulation to all group members engaged in financial services activities, even where the activity would not be regulated were it conducted outside the group. The extension of regulation group-wide might include, for example, capital adequacy requirements, large credit exposure limits 10/, foreign exchange position limits, shareholder and senior manager suitability standards, and required regulatory reporting and public disclosure. Transparency is enhanced by applying prudential requirements to the consolidated group, as well as to each financial institution group member, and by requiring consolidated financial reporting and public disclosure. Concerns regarding autonomy are addressed by the application of suitability standards to the principal shareholders of the group, and to the managers of all group financial institutions.

Consolidated regulation is the basis of the approach usually taken by bank supervisors, who tend to desire explicit authority over group financial entities that might affect the condition of the bank. 11/ Thus it is common to find consolidated regulation applied to banks and their financial institution subsidiaries, and increasingly, where the parent is a financial institution or financial institution holding company, to the bank's parent entity and its financial institution subsidiaries.

There are potential disadvantages and obstacles to the implementation of consolidated regulation. From a policy standpoint, extending regulation to otherwise unregulated financial institutions due solely to their group affiliation might be seen as burdensome and creating a competitive disadvantage.12/ From a practical standpoint, extension of regulation to entities regulated and supervised by other agencies requires coordination among the agencies, and may likely require modifications to agencies' current authorities and responsibilities .

Separate Regulation

Separate regulation attempts to minimize the potential that contagion will affect the regulated entity by insulating it from other group members. The mechanisms often employed are to require that the credit exposures of the regulated entity to other group members be supported by additional capital (often in an amount equal to the exposure itself), and/or to establish limits or other restrictions on credit exposures and other types of transactions. Because the object of regulation is defined narrowly as the individual regulated entity, the transparency of the organizational and managerial structure of the group is of less concern. Concerns regarding financial transparency are addressed by the constraints placed on transactions with other group members. Concerns regarding autonomy are addressed by the application of suitability standards to the principal shareholders and managers of the regulated entity.

Separate regulation is the approach often taken by securities and insurance supervisors. This approach is more functionally oriented, and is based on the principle that while certain activities (e.g. dealings with retail customers) are best regulated, other activities can and should be left unregulated.

In practice, it is difficult for supervisors to be comfortable with their attempts to insulate a particular entity within a group. Contagion can result from the public perception of an exposure, as much as from the existence of an exposure. Thus even a well-insulated regulated entity can be subject to a liquidity crisis or crippling loss of business triggered by events elsewhere within the group. Similarly, concerns regarding transparency and autonomy can only incompletely be addressed by attempting to insulate the regulated entity.

Regulation in Practice

Generally, financial conglomerate regulation is not based on the strict application of consolidated regulation or narrow application of separate regulation. Confronted with the practical obstacles to application of consolidated regulation, supervisors often must rely on processes designed to obtain information regarding entities outside the scope of their direct authority, and to control the potential exposure of the regulated entity to other group members, an approach similar to that employed under separate regulation. Alternatively, supervisors whose philosophy is based in separate regulation often attempt to make explicit assessments regarding potential risk exposures arising from other group members outside the scope of their direct authority. This is an approach which leans toward the groupwide application of prudential requirements inherent in consolidated regulation.

Although strictly applied consolidated regulation and narrowly applied separate regulation are not often encountered in practice, recognizing the philosophical distinctions between the two approaches can help to shed light on the different perspectives of the supervisors of different types of financial institutions. For most countries, forging an effective regulatory and supervisory framework addressing conglomerates will require that those differences be resolved, so as to facilitate agreement on a common approach.