ECB's revision of its options and discretions may threaten Brexit back-to-back booking models

Following a public consultation that ended on 30 August 2021, the ECB published its finalised version of the revised instruments together with a feedback statement containing its assessment of comments received during the consultation period. The revised package amends the ECB's O&D instruments published between 2016 and 2017:

• The ECB guide containing policy guidance for Joint Supervisory Teams of significant institutions (ECB Guide);
• The ECB Regulation (EU) 2016/445 on the exercise of O&Ds (ECB Regulation);
• The ECB Guideline 2017/697 addressed to NCAs in respect of generally applicable O&Ds to less significant institutions (ECB Guideline); and 
• The ECB recommendation ECB/2017/10 addressed to national competent authorities in respect of the case-by-case application of O&Ds to less significant institutions (ECB Recommendation). 

Background

The Single Rulebook, in spite of its name, while providing for a single framework of banking standards across the EU, contains a significant number of O&Ds. When exercising supervision over the banks in the Euro Area, the Supervisory Mechanism (SSM) has sought to align the approach to these variations to ensure the "high-quality, Union-wide supervision" that the ECB and the national competent authorities (NCAs) are to exercise. Supervision of significant institutions (SIs) is attributed to the ECB while NCAs are responsible for supervising less significant institutions (LSIs). The ECB's O&D instruments provide transparency and predictability for banks and a harmonised supervisory approach across the SSM.

Since the current O&D instruments were adopted in 2016-17 the ECB’s amendments principally aim to bring them up to date with CRD V and CRR II, which came into force in December 2020 and June 2021 respectively. The changes relate largely to the now binding liquidity requirements (LCR and NSFR) as well as to leverage ratio and capital requirements. 

Additionally, the ECB changes certain O&D policies based on "supervisory experience…gained…since 2016-17". Among these is a modified approach to the application of the intragroup exemption for large exposures provided for in Article 400(2)(c) CRR.

New approach to the large exposure exemption

The ECB’s changes generally retain the possibility of exemption from the large exposure limits in Article 395(1) CRR, but to modify the supervisory approach where exposures to a non-EU group entity are involved.

Under the current O&D framework, applicable to all intragroup exposures, SIs can apply the exemption themselves pursuant to Article 9(3) of the ECB Regulation if they meet all the relevant criteria for a full exemption.

With the change to Article 9(3) of the ECB Regulation, the self-assessment procedure is limited to exposures to EU-affiliates (and in fact extended for such entities to cover partial exemptions as well) whereas exemptions for large exposures to non-EU entities in the group are subject to a case-by-case assessment by the ECB or NCA.

Under the new regime the institution can apply the exemption only after having obtained prior regulatory approval (from the ECB for SIs or the relevant NCA for LSIs) and the ECB has the power to scrutinise and object to exemptions of large exposures to third country affiliates. 

The rationale for the shift in policy is in the ECB's own words "the concentration risk…resulting from systematic use of back-to-back booking practices between different entities in consolidated banking groups" that was not equally present in 2016-17.

This could be a scarcely veiled hint at the Brexit-driven, back-to-back models employed by UK banks to manage their Brexit transition. Following the UK's exit from the single market and the end of the passport regime, trading and lending activities are now undertaken on an unprecedented scale by smaller, less well-capitalised and often newly established EU affiliates with the risk reallocated to the UK parent.

The ECB has repeatedly warned against what it sees as an excessive reliance on such back-to-back models for the banks' risk management. After the transition period ended on 31 December 2020, the ECB is moving towards a post-Brexit era in which it seeks to regain tighter control of banks' risk management strategy.

Approval of the exemption

The requirements that need to be met for the exemption to apply are set out in Article 400(3) CRR and further specified in Annex I to the ECB Regulation. These remain largely unchanged under the proposed amendments with the ECB merely requesting additional information to be submitted in the amended ECB Guide.

Existing exemptions

Institutions that already have exemptions in place for existing intragroup exposures to non-EU entities are not required to apply for approval, the ECB has confirmed. To that extent, these will be grandfathered under the new regime.

However, the ECB will review the compliance with the eligibility criteria as part of its ongoing supervision and expects institutions to notify material changes that could impact its ability to fulfil one or more of the conditions of eligibility. Incurrence of new exposures to a non-EU group entity will certainly trigger a case-by-case assessment.

Approval of exemptions going forward

The ECB will assess an application for an exemption primarily against the conditions in Article 400(3) CRR and Annex I of the ECB Regulation, which include:

• The counterparty risk is eliminated or reduced by the specific nature of the exposure or the relationship between the group entities;
• Satisfactory assessment of the counterparty's risk evaluation, measurements and control procedures;
• Justification of the proposed exposures by the group's funding structure and strategy;
• Unbiased internal decision-making process (i.e., comparable to third-party lending) regarding the approval of exposures; and
• Risk management procedures that enable the institution to continuously ensure the exposures are aligned with its risk strategy.

Additionally, the applicant must manage any remaining counterparty risk by (a) robust risk management policies and risk control procedures in place; (b) identification of the exposures as part of its ICAAP management and (c) consistency between the management of concentration risk and the recovery plan. 

The ECB will further take into account the following non-exhaustive factors in its case-by-case analysis: 

1. Adequate cooperation and information exchange arrangement with third country regulator;
2. Ability of applicant to provide regular information on the counterparty;
3. Alignment of booking practices and risk strategy;
4. Third country group structure does not hinder timely repayment by counterparty;
5. Absence of negative precedents regarding transfer of funds by counterparty; and
6. Establishment of sound collateral management and independent price verification capabilities.

As part of the approval process the institution must submit to the ECB (a) a signed statement by the institution's legal representative and approval by the management body to confirm compliance with the above criteria; and (b) an external or internal legal opinion confirming that there are no impediments to timely repayment of exposures by the counterparty. 

Results of the public consultation

While receiving a significant number of comments from the public expressing concerns regarding the envisaged revision, the ECB only made a limited number of amendments and clarifications to the ECB Guide. In particular, the ECB made only a minor clarifying amendment to the ECB Guide in relation to the large exposure exemption. It stressed that the shift to an ex-ante approval was not intented to prevent banks from incurring intragroup exposures to third-country entities but to increase supervisory oversight.  

No changes were made to the ECB Regulation, the ECB Guideline, or the ECB Recommendation.

Application of ECB guide and O&D instruments

The ECB Guide and ECB Recommendation will apply as of 28 March and 25 March 2022, respectively, whereas the NCAs need to comply with the ECB Guideline from 1 October 2022. The ECB Regulation will enter into force on its publication in the OJ.

While the revised instruments – except for the ECB Regulation – are not legally binding on NCAs, they are required to declare under the “comply or explain” procedure whether they will comply with the envisaged revisions or provide their reasoning for not complying. It is expected that the majority of NCAs will choose to comply.

Outlook

The shift in ECB policy calls for banks to proactively assess their compliance with the criteria set out by the ECB, in particular the additional factors indicated by the ECB.

The ECB has been conducting a desk-mapping exercise as part of which it assesses how international banks manage their EU business. UK-headquartered banking groups are likely subject to particular scrutiny. They should continuously review their booking model and risk management strategy, even where no new exposures are contemplated.

In particular, the extent of the dependencies of their EU entities on the UK parent credit institutions in a post-Brexit context are liable to be questioned by the ECB and banks should proactively assess them. While interdependencies within bank groups have long existed and back-to-back booking has proven to be a useful mechanism to manage market risk, these have been met with some scepticism in the Brexit context. The ECB has made no secret of its stance: "Our message is clear: EU products and transactions with EU clients involving non-EU products should be booked in the EU".

Booking arrangements and intragroup exposures will likely not soon disappear from the ECB agenda and banks should engage in constructive dialogue to discuss their booking models and compliance with ECB expectations.

Further Reading

See the ECB press release containing the revised instruments here.

See the ECB feedback statement on the public consultation here.