Cross-Border Groups
The financial sector is developing towards increasingly large units crossing traditional sector divides and national borders. This makes greater demands of the managements of the groups in question and of the authorities in the relevant countries, including cooperation between the authorities.
Legislation in this area, including EU legislation, determines the distribution of management responsibility within a group and within the authorities, depending on the corporate structure chosen. The distribution of responsibility is an important element of the regulation of a financial group, and thereby also of ensuring financial stability.
During the last 15 years, the financial sector in Denmark has been characterised by the formation of increasingly large groups via mergers and acquisitions. In the banking area, the five largest banking institutions now have a market share of 81 per cent, against 55 per cent in 1989. Moreover, the mergers have crossed the traditional sector divides, and today the large banking groups also own e.g. mortgage-credit institutes and insurance companies. There have also been a number of mergers and acquisitions across national borders. Particularly in the years up to and after the millennium rollover, focus has been on the creation of a pan-Nordic banking market.
The tendency towards larger units and cross-border activities within the financial sector is also seen in most other EU member states and in the Nordic region. The background to this development has been the deregulation of financial markets and the opportunity and right to engage in cross-border activities within the EU/EEA. There may be many reasons for this development, but overall it is an indication of enhanced competition between the various segments, which increasingly offer services to the same customers. Moreover, synergies can be achieved in connection with the development of various financial products.
Financial groups crossing sector divides and national borders require enhanced regulation and supervision. Regulation must allow the groups to conduct their business and achieve the potential economies of scale. On the other hand, the supervisory authorities need to have an overview of the groups, including the distribution of risks within them. This makes great demands of cooperation between authorities across national borders.
The managements of cross-border groups also face more stringent requirements. The most appropriate course to take from a business point of view must also be in compliance with the legislation and the requirements of the authorities in the individual countries.
Mergers and acquisitions within the EU
Table 5 shows the number of mergers and acquisitions within the EU and the Nordic region during the last six years. The numbers are clearly rising.
The consolidation in the banking sector has typically been actual bank mergers, and has primarily taken place at national level. More than 70 per cent of the mergers and acquisitions in the 1990s that involved banking institutions within the EU took place from 1998 onwards.
Mergers and acquisitions in the financial sector are often motivated by economies of scale and the economies of scope from integrating different business areas.
The potential economies of scale that can be achieved via mergers of banking institutions within the same country appear to some extent to have been exhausted. This particularly applies to the largest banking institutions, cf. the high concentration in a number of EU member states, cf. Chart 48.
Economies of scale across national borders e.g. include merging shared functions (such as capital and risk management) and development and operation of information technology and business concepts on a common platform (e.g. e-banking). There are naturally special challenges related to working across different languages, etc., but IT advances entail that many of the banking institutions' systems can operate and be expanded flexibly across language barriers.
Mergers and acquisitions across national borders are also a way of diversifying risk, while the business case for setting up across national borders may be based on a need to follow customers that move abroad as industry and commerce are internationalised, as well as the desire for broad regional representation on the part of customers in third countries.
Finally, the merger activities across financial sectors indicate that the boundaries between the various financial services are becoming eroded.
Main principles behind the regulation of financial enterprises
Financial enterprises have traditionally been subject to supervision by the authorities and to extensive legislation. For insurance companies, this regulation aims to safeguard the policyholder's opportunity for a claim to be covered if an insurance event occurs. For banking institutions, the primary consideration is the depositors, who must be certain that the funds they have entrusted to the banking institutions are still at their disposal. Borrowers also have an interest in the continued operation of the banking institutions. If their loans are terminated prematurely owing to e.g. the compulsory liquidation of a banking institution, it can be difficult at short notice to find another source of financing without incurring considerable costs.
Regulation helps to ensure financial stability. Problems in one financial enterprise may rub off on other financial enterprises, and in the long term on the entire financial sector, which again may have a negative effect on the economy.
Regulation of financial enterprises is based on three pillars. Firstly, limits in the form of capital requirements have been set to the institutions' liabilities. Secondly, limitations have been set concerning the opportunity to take on risks on the asset side via placement rules. Finally, the supervisory authorities may impose sanctions on the institutions in the event of non-compliance with the rules, and in extreme cases they may in practice assume control of an institution.
The combination of capital requirements, placement rules and change of control to the supervisory authority in the event of violation of the statutory rules applies to banking institutions, investment companies and insurance companies alike. The activities of the individual sectors also have various special characteristics, and consequently regulation also differs in these respects. The banking institutions' primary task is to assume credit risks, that of the investment companies is to take on market risks, while the insurance companies' are to accept insurance risks. The capital requirements laid down for the individual types of institutions thus reflect the different types of risk.
When a financial enterprise forms part of a conglomerate, i.e. a group comprising both banking and insurance activities, it is important to ensure that the creation of the conglomerate does not lessen the effect of the rules governing the individual sectors and thereby the individual companies, or otherwise create new problems. A financial enterprise that is part of a financial conglomerate may, in addition to the ordinary risks in financial enterprises, also be exposed to risks resulting from the group affiliation, cf. Box 10.
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Box 10
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Multiple gearing: Risks relating to simultaneous use of the same capital to meet capital requirements in several companies within a group. Intra-group transactions: The possibility of transferring funds between companies in a group, where prices and terms do not correspond to market conditions. Lack of transparency: Risks resulting from the fact that complex group structures can impede assessment of the financial position of the group. Contamination: Risk that problems in one entity within the group spread to other financial corporations subject to supervision within the same group. Independence of the companies: Each financial corporation subject to supervision within a group may incur a risk that it would not otherwise have taken on, as a consequence of the parent/group's influence on company decisions. |
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Risks in relation to groups across national borders are fundamentally the same as for groups in the individual countries. The existence of cross-border activities will, however, per se increase the degree of complexity and require cooperation between authorities in different countries.
Regulation of financial groups and conglomerates within the EU
The framework for cross-border financial activities is chiefly laid down by EU regulation. The main objective is the single market for financial services, which is to ensure that foreign financial enterprises are not discriminated against in the national markets. Within the EU, as in national legislation, the regulation of financial enterprises takes the individual financial company as its starting point. It is not possible for the same legal entity to conduct both banking and insurance activities. At EU level these enterprises are regulated separately by respectively the insurance[1] and banking[2] directives. In addition, banking groups are regulated by a directive on the supervision of credit institutions on a consolidated basis[3], and insurance groups by the insurance group directive[4].
The insurance group directive enables the supervisory authority to perform supplementary supervision of a company forming part of a group, e.g. across national borders. The supplementary supervision mainly comprises the calculation of an adjusted solvency situation, which is, inter alia, to prevent multiple gearing, cf. Box 10, as well as receiving information from the other companies in the group.
The directive on the supervision of credit institutions on a consolidated basis concerns supervision of groups comprising several credit institutions, including those transcending national borders. The competent supervisory authority is that of the parent company if the latter is a credit institution. This supervisory authority is responsible for the consolidated supervision and must, for the purposes of supervision, require full consolidation of the group. The following must be stated/calculated on a consolidated basis: solvency, adequacy of own funds to cover market risks, and control of large exposures. It must also be ensured that there are adequate internal control mechanisms for the production of any data and information which would be relevant for the purposes of supervision on a consolidated basis.
As regards mixed groups, conglomerates, the conglomerates directive was adopted in 2002. It aims at ensuring uniform competition terms for different types of financial groups by imposing a number of obligations which transcend sector divides and national borders. It is not an actual consolidation directive in the same way as the credit institution directive, since the institution responsible for the consolidated supervision is not defined. Instead, the directive operates with a coordinator who is to coordinate supervisory activities between the authorities involved. The coordination primarily involves compiling information from the entire conglomerate. The directive aims to take into account the problems outlined in Box 10, since simultaneous use of the same capital in several entities of the conglomerate (multiple gearing) is not possible. In addition, the solvency position must be calculated at the level of the conglomerate, and intra-group transactions and risk concentration are regulated. To counteract lack of transparency in the conglomerate there are requirements of risk management, assessment of the fit and proper character of the management, and a requirement of close collaboration between the supervisory authorities. However, the directive does not require harmonisation of the actual supervisory provisions, or convergence of supervisory activities. It seeks solely to take account of the "extra" risks that may arise as a result of the formation of the conglomerate, and it is specified how the supervision should be coordinated. The starting point is thus still the individual company and the relevant competent authority.
The individual company subject to supervision
A licence to conduct financial activities is given to a legal entity that must independently comply with the supervisory provisions. This also applies to legal entities within a group or a conglomerate, i.e. subsidiaries. It is thus the management of each subsidiary within a group that is responsible for the operations it conducts. This responsibility cannot be transferred to the parent company. The granting of licences to and regulation of the individual financial enterprises within a group are based on the individual company being able to function independently of the group. The supplementary regulation of groups and conglomerates is thus intended to shield the individual company against "misuse" by the rest of the group/conglomerate. In this connection it is important that the management of each company is able to make independent decisions that are in the interest of that company. These issues are particularly relevant in relation to cross-border groups.
Financial groups are often managed on the basis of the financial structures across the legal entities in the group, e.g. with a view to benefiting from economies of scale and joint operations. This practice may involve a number of special risks to the extent that the individual company does not have the required degree of independence. Several of the provisions in financial legislation that are to prevent or minimise the risk of "contamination" between the companies in a group or conglomerate are based on a "firewall" principle. This means that in the event of a crisis it must be possible to seal off the individual enterprise subject to supervision from the other entities in the group. A prerequisite is that even in a crisis the enterprise can still operate independently. The supervisory authorities must thus ensure that the core functions for operating this enterprise are present within a reasonable time horizon. For instance, today it may be impossible to operate a banking institution without well-functioning IT systems.
Branches
If a financial enterprise operates with a branch structure, regulation and supervision will take place in its home country. A branch structure is only possible within the same sector, i.e. a banking institution can conduct banking activities via a branch, but not insurance activities. Home-country supervision means that the supervision of a banking institution's activities, including supervision of its financial soundness and solvency position, is the responsibility of the authority in the country where the banking institution is licensed. There can thus be no conflict between the commercial and legal structures, and activities can be placed as deemed expedient. EU regulation is based on home-country supervision, and member states are obliged to acknowledge that a banking institution that is licensed in its home country can conduct activities in the host country.
Where a branch is as large as or larger than the home-country entity, or a branch in an individual host country is so large that it has systemic importance and could affect the financial stability of the host country, very close collaboration should be established between the authorities across national borders, irrespective of the home-country supervision.