Double Counting of Capital Prevention - Detailed Explanation

Double counting of capital, also called Double Gearing, Multiple Gearing or Double Leveraging, is the cardinal sin in financial conglomerate regulation.

Definition: Double gearing occurs whenever one entity holds regulatory capital issued by another entity within the same group, and the issuer is allowed to count the capital in its own balance sheet. The same euro of capital is counted twice to meet solvency requirements in two different regulated entities.

Example:
Parent Bank has €100 capital. It invests €40 as equity in its Insurance Subsidiary.

• Insurance subsidiary shows €40 as its own capital.
• Parent Bank still shows €100 as capital (not deducting investment).
  Group claims €140 capital, but real external capital is only €100. If losses of €50 occur in both, group collapses.

1. Why Regulators Care - 3 Purposes

Per BIS Consolidated Supervision framework:

1. To ensure all banking operations are subject to supervision
2. To prevent double-leveraging of capital
3. To evaluate and control all risks globally

Joint Forum on Financial Conglomerates lists essential elements:
(1) detection and correction of multiple uses of capital i.e double or multiple gearing, (2) assessment of group risks, (3) minimisation of regulatory arbitrage

2. Three Techniques to Prevent Double Counting

Joint Forum identified three techniques capable of yielding comparable assessment of capital adequacy:

A. Building-Block Prudential Approach
Take solo capital of each regulated entity, sum them, and compare to sum of solo requirements. Intra-group holdings are eliminated.

B. Risk-Based Aggregation Method
Consolidated balance sheet of conglomerate, eliminate intra-group exposures. Most common under FICOD.

C. Risk-Based Deduction Method / Total Deduction Method
Bank must remove from its balance sheet assets its equity and other regulatory capital investments in insurance subsidiaries and significant minority investments in insurance entities. This removes double counting.
Also valuable especially in addressing problems of double/multiple gearing

Basel III text Para 84-89 specifically says amount of investment in financial entities to be deducted to avoid double counting.

3. Global Regulatory Framework

a) Basel Framework - Banks + Insurance

When measuring regulatory capital for banks, the Committee believes it is appropriate to deduct banks' equity and other regulatory capital investments in insurance subsidiaries and also significant minority investments in insurance entities... Alternative approaches should in any case include a group-wide perspective for determining capital adequacy and avoid double counting of capital

Basel also requires: No additional capital recognition is permitted in order to avoid any double counting

And: A banking firm must deduct reciprocal cross-holdings in shares of banking, financial or insurance entity if holding has effect of artificially inflating firm's capital position

b) EU - FICOD Directive 2002/87/EC (as amended by 2011/89/EU)
Adopted in 2002, it aimed at supplementary supervision focusing on potential risks of double gearing (multiple use of capital) and on group risks: contagion, management complexity, risk concentration, conflicts of interest.

Article 6 of FICOD requires:

• No double counting of same capital
• If transferability of capital across group is insufficient, capital may not be included in conglomerate capital resources.

FCA guidance: FICOD sets out specific solvency requirements designed to prevent different entities in a conglomerate from using the same capital more than once as buffer against risk

c) India - RBI
RBI approach: Rather than deducting investments in insurance and securities entities, banking supervisors may apply alternative techniques which provide for elimination of double counting of capital, in line with principles developed by Joint Forum.

RBI Financial Conglomerate Guidelines require:

• Mechanism to detect and provide for effects of double, multiple or excessive gearing through unregulated intermediate holding companies which have participation in dependants or affiliates
• For bank investments >20% in financial services company, prior approval of Dept of Regulation needed to prevent group entities used to circumvent rules.

d) UK PRA Rulebook
Capital may not be included in firm's conglomerate capital resources if it would involve double counting or multiple use of same capital

4. Case Laws and Regulatory Actions

There is no classic "plaintiff vs defendant" on double counting because it is supervisory action, but key enforcement cases:

Case 1: European Banking Sector Restructuring Post-2008 - The Classic Example
A notable example is a European bank that had to restructure its investment in an insurance subsidiary. Pre-Basel III, the bank could count subsidiary's capital as part of its own, effectively double-counting. Post-Basel III, this was no longer permissible, leading to significant capital raise. This was applied to ING, Aegon, Allianz SE, where bancassurance models were forced to deduct insurance holdings.

Case 2: Joint Forum Principles Case - Detection of Unregulated Holding Company
RBI and BIS note: At present there is no case of an unregulated entity acting as holding company of a bank - because if allowed, double gearing through unregulated intermediate holding companies would hide leverage. This is why RBI rejected Tata Sons' plea to surrender CIC registration while retaining massive leverage across group entities - would have created regulatory loophole for other large conglomerates. Doctrine: Surrendering upper-layer CIC status to avoid listing while still using same capital across financial entities = impermissible double gearing.

Case 3: UK Financial Services Authority vs Financial Conglomerates 2011 - FICOD Implementation
House of Lords debate on Solvency II and FICOD: FICOD has created new supervisory powers which increase standards of governance for largest financial groups. This has helped address gaps that arise from sectoral supervision, in particular risk of double gearing, which can arise in absence of robust group-level policies on capital governance. FCA used these powers to require Old Mutual, HSBC Holdings to submit supplementary capital adequacy returns proving no double count.

Case 4: Basel Committee v/s Cross-Holdings - Total Deduction Technique Applied
Basel FAQ clarifies: amount only includes total assets of entity multiplied by percentage of entity's capital that has not been deducted under paras 84-89. It is subtracted so as to avoid double counting. Enforcement in QFCRA rulebook: Deductions are necessary to avoid double counting of bank's own capital from direct holdings, indirect holdings via index funds and potential future holdings as result of contractual obligations to purchase own shares

Case 5: FDIC Final Rule on CECL Double-Counting 2020
FDIC finalizes rule to resolve double-counting associated with CECL - adjusts calculation of loss severity measure to remove double-counting of specified portion of CECL transitional amounts. Shows US regulator also eliminates double count in deposit insurance assessment.

5. Prevention Checklist for Spanish / EU / Indian Banks

If you are preparing a Financial Conglomerate Capital Adequacy Report for Banco de España / RBI:

1. Inventory: List all intra-group capital instruments - CET1, AT1, Tier2 issued by any group entity and held by another.
2. Apply Deduction: Under Basel III / CRR Art 36, deduct significant investments (>10%) in financial sector entities from own CET1.
3. Reciprocal Cross-holdings: Must be fully deducted - PRA BANK 3.2.33.
4. Unregulated Intermediate: Check SPVs, holding companies - if they have participations in regulated entities, apply building-block approach.
5. Transferability Test: Can capital move in stress within 9 months? If not, cannot be included.
6. Disclosure: Banks should also disclose national regulatory approach used with respect to insurance entities in determining reported capital positions.