Most of the larger firms in the international financial markets have more than one regulated legal entity through which they operate their business. There can be a number of perfectly valid reasons why these multiple legal entities exist – from historical merger activity to tax structures and legal and compliance requirements. However, having several legal entities presents its own challenges and these are about to become even more difficult. They will be coupled with an environment where regulators will be much more inclined to require ad-hoc reporting. One needs to remember that the purpose of consolidated reporting is to give recipients a clear and accurate view of the status of the combined enterprise.
For accounting, regulatory and management reporting purposes, there are several types of consolidated reporting that firms have to perform on a regular basis. Here is a brief summary of some key ones.
The way this information is consolidated reflects the way the firm’s management views its activities. Reporting units are usually aggregated according to management responsibility. This may mean that not all legal entities have to be included, and the structure used can differ from those mentioned previously. The objective of this consolidation structure is to give management control over the firm’s activities and to monitor the performance of key indicators. How well are we doing? Are we within management guidelines? Where are the areas of potential business improvement? These are the questions which are often answered by this type of reporting.
Firms must produce group-wide consolidated capital returns to show that they meet their legal capital requirements. Firms also need to consolidate their business exposures to ensure that they are not breaking any concentration risk limits. The consolidation of business exposures mean that financial firms need to know not only about their own structure, but also the current structure of their counterparts. Where all the legal entities are not in the same jurisdiction, then the consolidated capital number will need to take into account the differing capital requirements of each supervisor. There may sometimes be a requirement to allocate capital at group level and other times at the individual entity level. The authorities will normally grant exemptions for certain entities, where the prudency objectives, in terms of capital, liquidity and risk control are met.
One important point is that not all capital is available at each entity level. This means that arriving at the correct amount of regulatory capital at a consolidated level is not simply an addition of the capital in the constituent entities. Tracking the availability of capital can be challenging and regulators will sometimes request that non-standard consolidations are analysed periodically.
It should also be noted that financial regulators will address the prudentially regulated legal entities, not all legal entities. They may also grant waivers to allow certain entities to be reported under a combined solo consolidated entity. The result is that the legal entity structure used by the regulator may differ considerably from the ones used by legal or accounting departments.
Liquidity reporting concerns itself with ensuring that firms have adequate liquid financial resources to meet its funding needs. Clearly the requirement is to have both the group and the individual constituent entities liquid. The entities which are most important to providing a group’s liquidity may not be the same as the ones that provide capital. Consequently regulators may require firms to consolidate using a ‘liquidity-unique’ entity structure. Furthermore, like capital, liquidity is not always transferable between entities and the issues regarding transfer of liquidity are different to that of transfer of capital.
The new Basel III paper on liquidity coverage ratio (LCR) adds some further complications. Liquidity regimes will differ by each jurisdiction. The consolidated group liquidity framework will have to be able to account for these differences. This means that firms will not only have to track the requirements by the differing rules, but certain liquidity assets may be eligible in one jurisdiction but not another and these problems are in addition to transferability.
In many circumstances securitisation vehicles associated with firms will need to be consolidated with the banking group. The purpose here is to disclose off-balance sheet (OBS) risks that could materially affect the firm. These securitisation entities may not be part of the group at all, and managed at an arm’s length basis. One difficulty with this consolidation is that the information systems set up by the institution may not include information of these entities. Also the securitised assets are no longer managed by the firm, but the securitised entity. The result is that much of the firm’s management will not recognise these positions.
Observers often ask for the consolidation structures to be simplified. It should be noted that each of the above needs a different structure because the questions they are trying to answer are different. Consequently, the structure used for capital may not be at all appropriate when considering liquidity. However, all structures should reflect the same business, and business issues. That is they all need to be reconciled.
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