UK: EBA Critiques Critical Functions In Recovery Plans

The Bank Recovery and Resolution Directive (BRRD), a core piece of post-crisis regulation aimed at ending 'too big to fail', is being implemented across the EU. As part of the journey towards full and consistent implementation, the European Banking Authority (EBA) recently published a comparative analysis of the recovery plans of 27 (unnamed) European cross-border banking groups which collectively account for around half of the banking assets in the EU.

The report focuses on how the banks have dealt with "critical functions" and "core business lines" in recovery plans, with an emphasis on the former.  The general message is that the EBA would like to see firms demonstrate a deeper understanding of their critical functions, and provide more analysis of how they fit into the recovery plan as a whole. The EBA recognises that the concepts are relatively new, making the analysis challenging, but while it commented on the good progress being made with recovery planning in general, it clearly believes that more work is needed. The work done to date provides only "an adequate basis for further improvement."

Some of the findings, summarised below, reflect the fact that the analysis required is a challenging departure from the way in which banks think about their businesses. Business lines and functions often cut across multiple legal entities, which can be unimportant in business-as-usual, but recovery and resolution planning requires an understanding of the interconnections between those entities and their relative roles in supporting a bank's activities. Some of the EBA's commentary also indicates an expectation that the analysis should be substantive rather than merely pro forma – identifying critical functions is not just about creating lists, but is also about understanding how they relate to the wider business.

One challenge is that recovery plans need to balance comprehensiveness with utility; there is always a danger that supplying exhaustive information reduces the usefulness of the documents. In our experience, getting the right degree of granularity and the right balance of qualitative and quantitative analysis can be challenging, particularly as there is a degree of judgment required in gauging when a function becomes "critical".

This is the first of several such comparative reports the EBA will produce over the course of 2015 and 2016, and the findings will likely feed into the development of technical standards, views on best practice, and supervisory expectations. It also enables a degree of benchmarking against peers, as banks can assess their own work against the EBA's findings.

Critical functions

Critical functions are, broadly speaking, the activities performed by banks which are essential to the real economy, the cessation of which would cause significant disruption to the economy or financial stability. Their importance is reflected in the fact that ensuring the continuity of critical functions is the first objective of resolution according to the BRRD. The BRRD requires banks to identify their critical functions as part of their recovery plans, and EBA technical standards elaborate the way in which the analysis should be incorporated into those plans. There is also guidance from the Financial Stability Board on which industry can draw.

Of the 27 recovery plans reviewed, only 12 included assessment of critical functions. This was partly due to the fact that in some EU countries guidance had been issued such that critical functions were only to be addressed in resolution plans, and partly due to the fact that the plans reviewed were written before the BRRD had been implemented. But implementation of the BRRD means that those banks which did not deal with critical functions in their recovery plans, and indeed the remaining several thousand banks in the EU whose plans were not reviewed, will have to undertake the analysis.

The general picture was one of "substantial variation" between banks, and the EBA highlighted several areas in which the level of detail was not in line with the expectations set out by the FSB and others. Some of the main findings included:

  • Some firms included only a "brief description" of critical functions, which was "often based on judgmental evaluation and qualitative considerations" rather than quantitative analysis;
  • Analysis of critical functions according to the "systemic importance" and "substitutability" criteria was generally good, being supported with a wide range of data and "clear and well-documented expert judgment";
  • There was "no consistency" in the quantitative thresholds used to determine when market share in certain functions should be considered significant;
  • Analysis of the potential impact of the failure of a critical function on end users was only included in a few cases. The EBA noted that this analysis is more complex than for substitutability and systemic importance, but that its omission could mean that some critical functions are missed;
  • Analysis of critical functions was not effectively linked to other elements of the recovery plan so that, for instance, the relationship between critical functions and recovery options was generally not considered;
  • There were "material weaknesses" in some banks' definitions of critical functions, creating confusion between critical functions and core business lines;
  • Mappings of critical functions to legal entities were not accompanied by sufficient explanatory information, limiting the usefulness of the analysis.

The EBA highlighted the variations between banks, but yet – in its technical advice to the European Commission – did not favour the introduction of quantitative thresholds for determining criticality. While the reluctance to set quantitative thresholds may be understandable, it does pose some challenges. How will banks determine criticality and how will different supervisors and resolution authorities assess them for comparability purposes? According to the EBA the answer lies in "a discussion between institutions, supervisory authorities and resolution authorities with the objective of achieving a consistent approach." But it is difficult to see how such consistency can be achieved without the authorities using benchmarks of some description to guide their assessments, and if such benchmarks are indeed used, why not make them public?

The comparative report and the advice point to some areas where supervisory dots could be joined up. First, supervisors could in future use their stress tests to focus on how capital and liquidity actions taken in a stress environment will ensure the viability of critical functions and core business lines, thus testing one requirement of a recovery plan. Second, there appears to be a strong link between the core business lines that need to be identified for recovery and resolution planning and the business model analysis which supervisors will undertake as part of their review and analysis of banks' ICAAPs. Recognising these linkages should both promote internal consistency between different supervisory initiatives and increase efficiency for banks, supervisors and resolution authorities alike.

What next?

It has always been clear that developing RRPs would be an iterative process. The work that industry has done to date will be increasingly under scrutiny as the BRRD is transposed and supervisors and resolution authorities begin to apply its requirements more stringently. Industry should take note of the substance of the EBA's findings, and make sure they have enough resources available to do the deeper analytical work likely to be expected by the authorities in future.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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