Germany: ECB-SSM's Supervisory Relocations On Principles (SPoRs) – How Do These Sharpened Supervisory Expectations Impact Firms BREXIT-Proofing?

Last Updated: 11 September 2018
Article by Michael Huertas and Katja Michel

The European Central Bank (ECB), acting in its role as the lead in the Single Supervisory Mechanism's (SSM) pillar of the Eurozone's Banking Union has been increasingly clear to the relevant national competent authorities (NCAs) as well as existing firms, notably Banking Union Supervised Institutions (BUSIs), or those looking to relocate, on what it thinks about BREXIT-proofing: Those relocating or looking to start the process of moving from Britain to the Eurozone have been reminded that they could and should do better and that time is tight. This is especially the case following the UK Government's release on August 23 of its "No Deal Guidance" for banking and financial services.1

Even if some are doing better than others, a number have yet to start. For those that have submitted plans some may have been told that these are lacking. For those that have submitted their plans and applications for legal entity structuring post-BREXIT and have not been invited to improve their plans, they might nonetheless be behind on implementing the Eurozone specific policies, processes, procedures and people. Work is needed to hang the meat onto the skeleton applications. This Client Alert assesses some of those requirements and the outlook ahead especially as the ECB-SSM announced further SPoRs, a number of which stem from bilateral supervisory dialogue, notably on booking models during August 20182 along with expectations on risk management and governance arrangements (the August 2018 Update), which build directly on the EBA's own SPoRs as well as its sister authorities, which are covered in this series of Client Alerts from our Eurozone Hub. The August 2018 Update notably introduces a distinction between ECB-SSM SPoRs, as they apply to "onshore" i.e. EU-27 and "offshore" entities and what is permitted where. It should come as no surprise that the expectation is for most functions and substance of business to be originated and managed onshore by EU-27 entities.

BREXIT has turned messy

The UK's move to introduce a "temporary permissions regime" thereby allowing incoming EU firms to continue to operate in the UK once they become third country entities (TCEs) has not been reciprocated across the EU let alone by the ECB-SSM in the Banking Union. The pressure is on for firms to step up preparations and to do so regardless of any outcome in the BREXIT negotiations including the existence and/or length of a transition period (if any). The ECB-SSM stated, at the first major SSM Press Conference in February 2018, that certain applicants may be eligible to be given more time to implement their relocation plans. However, this will only be available where applicants have already presented "high-quality and credible plans for their "steady state situation..." and are "...in control of their own risks."

Despite that warning and the prospect of an olive branch, the hard deadline for financial services firms to submit licence applications was set by the UK authorities as March 30, 2018 and by the ECB-SSM as June 30, 2018. Those dates have come and gone.

So what now?

The politics have worsened, and the EU's SPoRs have tightened. The ECB-SSM, like its European Supervisory Authorities (ESAs), notably the European Banking Authority (EBA), itself needing to relocate from the UK to Paris, and the European Securities and Markets Authority (ESMA) have been clear in drawing regulatory and supervisory red lines. The ECB-SSM's view, which builds upon the work of the EBA3: "The bottom line is that banks must remain in control of their own risks. We therefore expect incoming banks to be able to produce complete and accurate data on booking models, hedging strategies and intragroup exposures. But euro area banks [i.e. existing BUSIs] should also review and disclose any changes to their booking models during the ongoing supervisory process." Notably the ECB-SSM clarified in its August 2018 Update that it will apply its supervisory expectations in "a proportionate manner to the individual cases, taking into account the materiality and complexity of the bank's capital market activities."4 This however does not translate into a free pass for those firms operating other business and distribution models and the need for these to still prepare. The emphasis on originating and managing risk within the EU-27 as opposed to offshore and having the requisite human and technical resources within the EU-27 is made quite clearly. The same is true in existing and new BUSIs having "no heavy reliance on third country risk hubs...entities are expected to manage their market and counterparty risk independently and have independent trading capability (incl. market access on the basis of contractual arrangements in the name of the [BUSI in the EU-27]... and have effective decision-making powers regarding issues relating to the entity's booking model, as well as full control of its balance sheet and of transactions booked to the entity."

The ECB-SSM's supervisory scrutiny does not just stop at booking models, delegation and avoiding "empty shells" through testing sufficient presence and substance. The ECB-SSM, in addition to exercising its own rulemaking and supervisory powers, applies and tailors the Single Rulebook to the Banking Union and supervised institutions. It does this through actual rulemaking, often hardwiring draft concepts and principles of the EBA and other ESAs to its operations as well as the use of soft law methods, allowing flexibility advanced through means which range from "non-binding Guidance that forms part of the supervisory dialogue" along with its own supervisory expectations and SPoRs issued to the wider market along with more tailored but quite public statements directed to firms. Some of the requirements and how the ECB-SSM approaches in its supervisory culture to make the Single Rulebook more single may be culturally foreign to a number of jurisdictions and firms – including those in the UK.

Couple this with the emerging supervisory tone that the ECB-SSM will not fully distinguish between whether a firm's EU-27 entity's presence is a branch, thus not within the full perimeter of the ECB-SSM, or a standalone subsidiary (the ECB-SSM's preference) and thus within the Banking Union supervisory perimeter. The terminology used instead is "onshore" versus "offshore" and looks at branches, subsidiaries business activity and viability as well as capabilities (as a going concern as well as on a business continuity basis) under one roof. This assessment also looks at the "adequacy of sales/business origination capabilities within the [BUSI] entity located onshore to ensure asset growth and revenue plans are achievable and supported by trading capabilities that are appropriate for executing trades and hedging risks". This also includes an expectation that the new or expanded onshore entity is "expected to develop effective independent price verification (IPV) and fund transfer pricing (FTP) capabilities and processes to price and evaluate intragroup arrangements and is expected not to be systematically loss-making.

That amended supervisory perimeter is also expected to extend through actions being mooted by the EU Commission and endorsed by the ECB-SSM to directly supervise those "broker-dealer" arms of BUSIs that are currently not subject to Banking Union supervision but national authority supervision but which undertake "bank-like" activity – currently a conveniently undefined term.5 This marks a potential sharpening of tone and breadth of coverage. It also means specific compliance considerations especially as the ECB-SSM has some clear expectations on build-up periods on management information systems' capabilities and BCBS 239 compliance.

The August 2018 Update also closes the door on some structuring expectations and assumptions by stating that (emphasis added in bold): "dual hatting and secondments of members of the management body, key functions holders and staff employed by the [BUSI] are expected to be used only in exceptional circumstances [undefined term] and in duly justified cases." This will affect existing and new BUSIs, a number of whom may want to reassess how they map and manage compliance with the ECB's own Guide qua rules on fitness and propriety assessments (see our dedicated Eurozone Hub coverage on this) and the rules of national competent authorities.

Getting serious on compliance with SPoRs will need specialist advice on the rules, the supervisory approaches and supervisory culture as well as how it fits into the wider set of global, EU and Eurozone-specific developments that have varying degrees of impact on the "change the business," "run the business" and "change the compliance" workstreams affecting financial services firms. The ECB-SSM's views on SPoR compliance are also flanked by its work across its 2018 as well as multi-annual supervisory priorities notably:

  • The review of the SSM Regulation, where there is some scope for further administrative adjustments and streamlining of certain processes. This builds upon reforms that are being put in place following the 2016 Report of the European Court of Auditors;6
  • Work on the ECB-SSM's NPL Guide Addendum as well as the EU's wider NPL Action Plan,7 which despite the political pushback it received still went ahead with the ECB-SSM regime now forming part of tailor-made supervisory dialogue with BUSIs;
  • Results of the 2017 supervisory Interest Rate Risk in the Banking Book (IRRBB) sensitivity analysis run by the ECB-SSM, which remarked that most BUSIs were managing interest rate risk well. The update provided to ECON was timely given the start of the 2018 EU-wide supervisory stress tests, the start of the ECB-SSM's 2018 Supervisory Review and Engagement Process (SREP) review cycle, the ECB's forward guidance as a central bank on the normalization of interest rates as a monetary policy tool along with the ending of its asset purchase programmes are just around the corner.

So where have BUSIs and other firms fallen short and how could supervisory perimeters expand?

A number of structuring options have been advanced by market participants, often still putting UK-centric interests first in a manner that either misses the whole existence of or specific contents of the SPoRs. The ECB-SSM has repeatedly concluded:

"In assessing the relocation plans available so far, the ECB has identified some deficiencies, especially regarding the tendency to set up 'empty shell' banks in the banking union, overly relying on services provided group entities in the United Kingdom...."

And:

"Additionally, we see a tendency to relocate bank-like activities to investment firms or third country branches which are out of the SSM's scope, thus leading to a fragmentation of supervision and possibilities for regulatory arbitrage. Here we rely on you as European legislators to introduce the necessary changes to the prevailing regulatory framework."

These are damning statements and aimed at those that have tried to be cute rather than compliant. The two prime deficiencies are something that were central to most supervisory statements issued by the ECB prior to the ESA's and the NCAs released their own SPoRs. Whilst there may be a fair amount of finger-pointing, what is more pertinent is for a fair degree of firms to take specialist advice and remedial action especially as goodwill amongst supervisors may begin to deteriorate where firms are not prepared. Moreover the ECB-SSM is a strong supporter of the EU's proposals on introducing "K-Factors" for MiFID Investment Firms undertaking "bank-like activity" as well as supervising branches set-up by third-country firms in the EU which may not be subject to full Banking Union supervision8 or for BUSIs' operating third country branches in the EU – suggesting that either side of the Channel and the Irish Sea may be subject to more invasive thematic reviews and firm specific supervisory inspections. Its new rules on on-site inspections9 is just one step in cementing how the ECB-SSM applies the Single Rulebook.

Besides the Banking Union supervisors at the ECB-SSM and NCA level working to push the supervisory perimeter through legislative and soft-law measures, supervisory convergence is a cornerstone of institutional improvements being carried out. This means closing loopholes, working better together and more efficiently, joining ranks and allocating support to areas of expertise. In short, it would be exceptionally shortsighted for firms and certain professional advisors to build BREXIT-plans on assumptions that EU supervisors can overturn by changing their supervisory scope and scrutiny faster than a supervised institution may be able to rejig its structure.

The ECB-SSM isn't the only voice

Another issue that remains worth considering is that certain NCAs, in particular those that have a strong track record in their own supervisory engagement processes in the banking as well as other financial services sectors, are themselves quite active in publishing their own clarifications on how they will administer the SPoRs along with their supervisory priorities. Some NCAs are walking a fine line between communicating the strict nature of the SPoRs whilst also trying to entice firms to come to their jurisdiction. Some NCAs have been better than others at making "their" jurisdiction appear more appealing to relocating firms. The ECB-SSM however may take steps to clampdown on some of these arbitrage practices, especially as it is, in addition to having harmonized rules in the standards that licence applications10 must follow, is the final body that decides on whether to grant or refuse regulatory permissions.

In any event, while the Banking Union aims to make the Single Rulebook more single, the narrative from respective NCAs add local market context and own standards, notably in those areas where the NCA is the lead competent authority rather than the ECB-SSM. This is especially the case in relation to conduct of business measures where the ECB-SSM has yet to develop an interest for how it might affect those prudential workstreams for where it is the lead authority and how to craft a common supervisory culture in that area to streamline the Single Rulebook for financial services. Despite the on-going Europeanization of financial services rulemaking and supervision moving from NCAs to ESA and/or the ECB-SSM, one area where consensus could not be clearer is that firms need to comply with the SPoRs and start the relocation process sooner rather than later.

Outlook and next steps

As a result, in light of the ECB-SSM's continued statements and verdict on SPoR compliance levels, affected firms will need to:

  • Review existing and pending BREXIT-proofing and relocation plans, some of which might need to be revisited to make sure assumptions made on the structuring side of things do not fall foul of the SPoRs and other supervisory expectations and take remedial action if necessary;
  • Critically assess certain structuring decisions and assumptions, notably in relation to outsourcing or booking models, even if structured in a SPoR compliant manner, require a greater degree of documented justification as to why a particular decision was taken and the circumstances influencing that decision and the evaluation of adequacy of control functions; and
  • Allocate sufficient time and resources in order to take account of potentially more protracted and more invasive supervisory touchpoints along each of the levels of supervisory engagement. In addition to reviewing structuring assumptions, in-house steering teams may want to consider appropriate support in relation to preparing SPoR friendly policies, procedures, processes and people in relevant strategic and risk-taking roles as well as the requisite control functions.

Footnotes

1 The UK's No-Deal Guidance Note "Banking, insurance and other financial services if there's no Brexit deal" mirrors some of those conclusions – please see our Eurozone Hub's coverage on the text of the Guidance Note which is available https://www.gov.uk/government/publications/banking-insurance-and-other-financial-services-if-theres-no-brexit-deal/banking-insurance-and-other-financial-services-if-theres-no-brexit-deal#individual-and-business-customers---uk-based-customers-of-uk-based-providers

2 See our Client Alert from our Eurozone Hub on this development.

3 See our Client Alert from our Eurozone Hub on this development.

4 Capital market activities are not to be distinguished between those in the Trading Book and those in support of the Banking Book.

5 See our Eurozone Hub's coverage on this development.

6 See: https://www.eca.europa.eu/en/Pages/DocItem.aspx?did=39744

7 See our Eurozone Hub's dedicated coverage on the EU's NPL Action Plan and the ECB-SSM's own work in this area.

8 Please see our dedicated coverage from our Eurozone Hub on these developments.

9 See: https://www.dentons.com/en/insights/articles/2018/august/3/the-draft-ecb-ssm-supervisory-guide-to-on-site-inspections-and-internal-model-investigations

10 See our coverage on ECB-SSM final rules on licence applications: https://www.dentons.com/en/issues-and-opportunities/eurozone-hub/-/media/73a225386d0d4c1f91bf3ea003077b11.ashx and on fit and proper assessments: https://www.dentons.com/en/insights/alerts/2018/july/2/ecb-ssm-releases-its-updated-may-2018-supervisory-guidance

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