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Contents

1. Introduction
2. Financial convergence
2.1. Risk transfer mechanisms
2.1.1. Transfer of credit risks
2.1.2. Transfer of insurance risks to the capital markets
2.1.3. Transfer of market risks
2.1.4. Transfer of operational risks
2.1.5. Risks from the point of view of regulation
2.2. Cross-sectoral investments
3. Financial conglomerates
3.1.1. Factors behind the establishment of conglomerates
3.1.2. Forms realized in practice
3.2. Challenges for regulation
3.2.1. Complexity
3.2.2. The danger of contagion
3.2.3. Regulatory arbitrage
3.3. Failures of regulation (case studies)
3.3.1. Presentation of inadequacies in international cooperation apropos the BCCI case
3.3.2. The failure of Baring Brothers
3.4. Regulatory responses
3.4.1. The activity of the Joint Forum
3.4.2. Structure of regulation set up by the European Union
3.4.3. Response of the US regulators to the challenge of financial convergence
3.4.4. The Australian practice of regulating financial conglomerates
4. Regulation of financial groups in the EU
4.1. EU legislation of financial groups and conglomerates in force prior to and following the failure of BCCI
4.1.1. Rules effecting the organization of financial groups
4.1.2. Consolidation and regulation of homogeneous groups
4.1.3. Cooperation and information exchange of supervisory authorities
4.2. The post-BCCI directive
4.2.1. The close link
4.2.2. Unity of head office and registered office
4.2.3. Cooperation of supervisory authorities and other authorities
4.3. Regulation of heterogeneous groups (financial conglomerates)
4.3.1. Up-to-date nature of the directive and the Financial Conglomerates Committee
4.3.2. Consolidation of group members outside the member states
4.3.3. Prudential rules relating to financial conglomerates
4.3.4. Coordinator among supervisory authorities
4.3.5. Changes affecting market players
5. Regulation in force in Hungary
5.1. Rules regulating the structure of financial groups
5.1.1. Specialisation principle
5.1.2. Acquisition limits
5.1.3. Right of veto of the supervisory authority
5.2. Consolidated supervision of financial groups
5.2.1. Institutions to be consolidated with prudential purpose
5.2.2. Limitations in defining the institutions which are to be consolidated on a prudential basis
5.2.3. Prudential rules
5.3. Summary of the problems of domestic rules of consolidation
6. Bibliography
Annex

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Introduction

One of the most important characteristics of recent years has been the increasingly closer contact among financial intermediaries on the financial markets. This has involved partly the strengthening of cross-border connections, partly the fading away of borders among financial sectors, as well as the emergence of financial conglomerates incorporating different types of financial service providers. The development of information technology and the process of deregulation taking place on the financial markets push actors clearly in this direction. From the viewpoint of satisfying customer needs, the expansion of international companies is the most important factor in motivating financial institutions to enter the international market. Large, international financial service providers rarely remain within the framework of one sector. By establishing financial conglomerates they aim to satisfy all the financial needs of both corporate and retail customers at one and the same point.

The growth of financial conglomerates has been very spectacular in the past ten years. In parallel with fusions, mostly within the country and characteristically within the sector, independent and well functioning institutions become under the control of large international financial service providers in order to exploit potential synergic advantages. This has been beneficial not only from the viewpoint of increasing financial strength but by coordinating activities of different sectors financial innovation has accelerated, too.

Institutions safeguarding the stability of the financial system have to monitor the complex products and processes thus created and - in parallel with the innovations or only a little bit behind them - find appropriate regulatory responses to the arising challenges. From among financial market tendencies the convergence of market players, thus the higher risk of "contagion", the complexity of conglomerates and the scale of their activity, and the efforts to make use of regulatory arbitrage represent the most important problems which regulators have to solve.

All this has to be undertaken in an environment where borders among nations and in relation to the activities of financial institutions are disappearing. Consequently, one of the most important challenges is to create the basis of cooperation of supervisory institutions, which are still organized on a national basis, and to ensure complete supervision of market players. In the course of this work the diversity of the supervisory structure, which is traditionally based on the type of activity, might be a problem. The need to enhance efficiency in the protection of investors' interest over and above sectors can be emphasized due to the diversity of realization and motivation of either intra-group transactions or market transactions among independent actors.

This study aims to review forms of cooperation already existing and to demonstrate regulatory reactions on the level of codification prevailing in some economic regions. The paper pays special attention to the activity of the inter-sectoral coordinating forum set up under the aegis of BIS with the purpose of regulating conglomerates, the European Council's draft directive based mostly on the Basle recommendations, and tries to evaluate the preparedness of regulators in Hungary. In the first part of the study the phenomenon of financial convergence will be thoroughly investigated. We overview the most important forms of realization, giving a detailed description of their methodology and regulatory problems caused by them.

Then follows a detailed analysis of financial conglomerates. First, the factors behind their emergence and the source of problems will be examined. After theoretical explanations two cases will be presented, where supervisory institutions were unable to overcome the problem of complexity of the given institutions, which regrettably caused the disappearance of depositors' money and led to several unlawful acts.

The next part - as a lesson of the case studies - overviews the resulting regulatory resolutions. First we briefly overview the 2001 year-end findings in relation to the differences in the regulatory environment set up by the independent regulators of the three sectors. Then we summarize principles and proposals generated by the inter-sectoral conciliation forum to regulate financial conglomerates, serving as guidelines for the majority of national regulatory institutions.

Subsequently, the paper overviews the actual, constitutional regulatory framework already accepted. It outlines legal regulatory responses of the United States and Australia concerning the challenges of the regulation of conglomerates. The most detailed descriptions are the parts on the European Council directives relating to consolidated supervision, the post-BCCI Directive and the directive drafted on Financial Conglomerates. It overviews considerations and arguments behind the setting up of the regulatory structure, and regarding most important segments details of the regulation are outlined, too. The structure of the chapter helps to follow the chronological development of regulation on the basis of market incentives and regulatory considerations, which give an explanation for the evaluation of the present and planned regulation.

In the last part of the paper the regulation of financial groups in Hungary is detailed. Consolidated supervision of financial groups existing in Hungary is at the present covered only by the Act on Credit Institutions and in the regulations of the Trading book. However, the requirements specified in these regulations are not in accordance either with EU regulations in force as of the nineties, or with the special risks of financial groups. Nevertheless, legal harmonization is mandatory for Hungary in this field, thus the modification of present rules will be inevitable in the near future.

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