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Summary of the Report on the Impact of Sectoral Rules on the Calculation of Own Funds of Financial Conglomerates

Core Content

This report, published by the Interim Working Committee on Financial Conglomerates (IWCFC) in January 2007, examines the impact of differences in sectoral rules on the calculation of own funds for financial conglomerates (FCs) in the European Union (EU). The IWCFC, a joint effort between the Committee of European Banking Supervisors (CEBS) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), evaluates how these differences affect the capital structure and regulatory capital adequacy of FCs.

The report is based on fictitious numerical examples and three calculation methods outlined in the Financial Conglomerates Directive (FCD):

1. Method 1 (Accounting consolidation method)
2. Method 2 (Deduction and aggregation method)
3. Method 3 (Book value/Requirement deduction method)

It is important to note that the IWCFC does not provide recommendations but aims to offer objective data and conclusions regarding the potential impact of sectoral rules on FCs.

Main Findings

• The differences in sectoral rules significantly affect the composition and amount of regulatory capital of FCs.
• The FCD does not eliminate or alleviate these differences, which persist across the three consolidation methods.
• The main differences identified include:
  • Treatment of hybrid instruments: Banks can include certain hybrids in Tier 1 up to 15%, while insurance companies treat them as subordinated debt with a limit of 50% of solvency margin.
  • Unrealised profits and revaluation reserves: These are not eligible in the banking sector (with some exceptions), but fully eligible in the insurance sector, subject to supervisory approval.
  • Deduction thresholds: Banks have a 10% threshold for deductions, while insurance companies use 20%.
  • Consolidation approaches: The differences in consolidation methods and capital definitions affect how capital is aggregated and assessed.

Key Points on Calculation Methods

• Method 1 compares the consolidated own funds of the FC with the sum of the capital requirements of the different sectors. It uses a neutral approach to avoid bias from national interpretations.
• Method 2 reflects sectoral differences by calculating capital requirements on a solo basis for each sector.
• Method 3 is a simplified approach that compares the parent's available capital with its capital requirement and the capital requirement of subsidiaries. It does not account for surplus capital in other group undertakings, making it less useful for analysis.

Building Block Analysis

Building Block 1: Impact of Parent Type (Bank vs. Insurance Company)

• The parent type (bank or insurance company) does not affect the total amount of own funds under Methods 1 and 2, as these methods are based on sectoral rules rather than the parent's identity.
• Under Method 3, the parent's rules are applied directly, which does influence the capital calculation.

Building Block 2: Impact of Holding Thresholds

• Participations between 10% and 20% are not automatically deducted if held by an insurance company, but deducted if held by a bank.
• This threshold difference can influence the capital adequacy of the conglomerate, depending on the sectoral rules applied.

Reality Check

• The IWCFC conducted informal discussions with industry experts to validate the hypothetical results against real-world practices.
• It was noted that market participants do not strongly advocate for harmonization of cross-sectoral rules, as the differences may not be the primary factor in capital management.
• However, some operational efficiencies could be achieved through harmonization.

Assumptions and Methodology

• The hypothetical balance sheets of the bank and insurance company were kept identical across all three methods.
• The capital requirements of both sectors were constant in the calculations.
• Unrealised gains and revaluation reserves were fully included in the insurance sector, while banks applied haircuts (45% for real estate gains).
• The report assumes that FCs apply IAS/IFRS accounting standards and that prudential filters are applied in line with CEBS and CEIOPS guidelines.

Conclusion

• The differences in sectoral rules have a significant impact on the composition and level of own funds for financial conglomerates.
• The insurance sector generally has more flexibility in recognizing certain capital elements, such as revaluation reserves and unrealized gains.
• The banking sector benefits from the inclusion of hybrid instruments in Tier 1 and subordinated loans in Tier 2.
• The report highlights the importance of sectoral differences in capital calculations and recommends further analysis and potential harmonization to address these discrepancies.