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Navigating The Complexities Of Cross-border Health Insurance In The European Union – The Toronto Center provides quality capacity building programs and advice to financial supervisors and regulators, primarily in developing countries, to promote financial stability and inclusion.
The Toronto Center has consistently promoted risk-based supervision (RBS) as the most efficient and effective approach for financial regulators[ 2] . The starting point of RBS is a thorough and detailed knowledge of each supervised entity – its business, its control and management structures and its financial resources. When an individual company is part of a larger group, it is necessary to develop a similar level of understanding of the group as a whole. This allows the manager to develop a full understanding of potential risks and to intervene to prompt the organization to address those risks.
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For the sake of simplicity, explanations and illustrations of RBS are typically presented in the context of a single institution in a single jurisdiction engaged in a single activity – often banking or insurance. In reality, however, supervisors are often confronted with more complex structures.
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The table below shows how the regulatory challenge increases as corporate structures become more complex. Complexity is greatest where conglomerates operate across national borders, and is exacerbated when the nature or level of regulation differs significantly between countries or sectors involved, or when a group contains companies that are not subject to any financial regulation at all.
In practice, the extent to which companies are able to set up complex structures depends on legal and regulatory restrictions which, in the case of cross-border groups, may be imposed by the authorities of the home country or the host country. In some jurisdictions, companies may not be allowed to offer products from different sectors at all, while others may be allowed to do so, albeit with restrictions on legal structures.
Complex structures pose a challenge for both behavior and supervision. In practice, behavioral supervision (aimed at preventing consumers of financial services from being harmed by corporate misconduct) tends to be the responsibility of the host country. However, in fulfilling this responsibility, host managers must have a keen interest in the group culture and controls in areas such as sales practices.
However complex the structure and operations of a financial firm or group, the objectives of risk-based supervision remain the same. They must have a thorough understanding of the risks that the supervised entity or the group to which it belongs are taking and how well these are controlled. Regulators must also assess the adequacy of financial resources. In some cases, supervisors may conclude that the group is too large or complex to manage or monitor effectively. The overarching purpose of this oversight is to support timely and effective intervention to address significant risks. In the case of companies or groups with cross-border activities, this requires cooperation with others.
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This section considers the most common structures for cross-border activity. For the sake of simplicity, these are examined from the point of view of companies that only operate in one sector. In practice, many companies or groups operate across borders in several sectors, making them cross-border conglomerates. These will be considered in a later section.
Regulators are very familiar with the idea of financial firms operating through branch networks within their jurisdictions. From a legal, financial and governance perspective, branches are virtually indistinguishable from the parent company:
Similar general principles apply to cross-border branches as to domestic branches. The “host” regulator in which the branch is located may have some local responsibilities – for example, in relation to conduct issues, financial crime controls or, in some cases, liquidity[ 4] . Some host regulators also impose asset continuity requirements – a requirement that funds equal to a proportion of the branch’s liabilities be held in the host country. These funds play a similar role to local capital, but not only are they a part of the liabilities, the requirements are generally not matched to the risks associated with the branch’s business.
Notwithstanding any financial and other requirements that may be placed on branches, it is generally not reasonable to seek isolated branch supervision and the ‘home’ supervisor will incorporate this into its consolidated supervision of the company as a whole. Even in those areas for which the host country supervisor remains responsible, it is advisable to engage closely with the home country supervisor to share both their insights – for example in relation to AML controls – and a group-wide perspective on risks and Risks to seek control issues.
For regulators, the main risk of overseas offices is an “agency” problem. Branch offices can be geographically distant and difficult to monitor from both the parent institution and the home regulator. Nonetheless, they are in the privileged position of using the parent company’s balance sheet, a situation that can be abused when there is insufficient control over the branch’s activities.
In contrast, subsidiaries are separate legal entities as they are incorporated in the country in which they operate. This gives them independent legal personality and means they are subject to much the same financial and governance requirements as any other legal entity in the jurisdiction. They have separate balance sheets and must have their own management and governance arrangements[ 5] . As these are separate companies, it is useful and necessary for the host country authority to oversee subsidiaries that are incorporated and have the same legal and accounting status as local companies.
Despite this legal separation, in reality there are still inseparable links between subsidiaries and parent companies. Issues such as financial strength (group capital and liquidity), management and governance, and reputational risk cannot be viewed in isolation from the subsidiary or parent company perspective. Therefore, it is necessary and desirable that the visiting supervisor maintains close contact with the home supervisor. The interactions between subsidiaries and parent companies and the associated challenges for supervisors have led to established approaches to consolidated and conglomerate supervision.
In some jurisdictions, regulations prescribe the nature of business conducted by institutions based abroad. Some host country regulators insist that operations conducted under their jurisdiction take the form of subsidiaries on the grounds that this gives them control of a dedicated local entity. Others may allow branches, but under limited conditions, such as a stipulation that the branches may not do business with retail customers.
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In contrast, some other host country regulators may not allow subsidiaries at all and insist that business, particularly by banks, be conducted through branches in their jurisdiction. Although subsidiaries are not prohibited, there may be a strong preference for branches. This reflects the view that a subsidiary’s profitability depends de facto on the profitability of the parent company and therefore largely on home country oversight, so that the apparent autonomy afforded by the existence of a subsidiary may in reality be illusory.
If the choice between branches or subsidiaries is allowed, financial firms will choose between them based on a number of (usually economic) factors such as capital efficiency or tax issues.
Subsidiaries are to some extent isolated from the parent companies due to their legal separation. In theory, a subsidiary could fail while the parent company continues. The opposite of this is also theoretically possible (but much harder to imagine), that the subsidiary will continue in the event of the failure of the parent company.
In practice, however, this isolation is extremely imperfect, primarily due to the effects of contagion and reputational damage. This is particularly acute in banking, where the business model, and particularly the maintenance of liquidity, is critically dependent on trust. In reality, knowing that “the (parent) bank, similarly, the failure of a subsidiary of Bank X can have serious repercussions on the reputation of the parent company. These reputational risks are also present, but may be less acute in other sectors. Supervisors need to be aware of these subsidiary structure limitations and their impact.
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It can be very difficult for a subsidiary to stay in business in the event of the failure of a parent company. A more likely – albeit relatively positive – outcome might be that a subsidiary with a separate balance sheet and sufficient equity can at least be sold (in whole or in part as a going concern) in such circumstances. Such a “market solution” can reduce potential instability in the host country.
Parent institutions can behave unpredictably when subsidiaries come under pressure. There are many documented cases where parents stepped in to provide financial support to affiliates, even when there was no formal or legal obligation to do so[6] . The lack of a formal commitment means that the support poses an unpredictable yet real potential burden on the parent. This is known as “entry risk” [7] . In other cases, contrary to expectations, parent institutions did not provide support to insolvent subsidiaries. In general, both home and host regulators should exercise caution when making assumptions
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