Clarifying the ECB’s supervisory approach to consolidation

Blog post by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB

Frankfurt am Main, 1 July 2020

ECB Banking Supervision has a long-standing objective to make our supervisory approach more transparent and predictable. In line with this objective, we have today published a draft Guide for consultation that clarifies, within the current regulatory framework, our prudential supervisory approach to consolidation in the banking sector. The draft Guide lays out the supervisory principles we apply when determining whether the arrangements resulting from a consolidation operation ensure the sound management and coverage of the risks of the banks involved.

The draft Guide will be available for public consultation until 1 October 2020. During this period, we expect to hear from stakeholders involved in banking consolidation, and we will reflect on their comments before publishing the final version of this Guide. In this context, we invite all interested parties to submit their comments in the coming months.

This blog post summarises the key components of the ECB’s draft Guide on the supervisory approach to consolidation and clarifies what goals we expect to meet through its public consultation and subsequent publication.

Possible benefits of consolidation

ECB Banking Supervision has stated several times that a certain degree of consolidation would be useful in addressing some of the structural challenges that euro area banks are currently facing. It may boost the low profitability of euro area banks by helping them achieve economies of scale, become more cost-efficient and improve their capacity to face a future that is increasingly digital and definitely global.

In addition, as stated in the past by the Chair of the Supervisory Board of the ECB^[1], consolidation can both help banks diversify their sources of income, and foster private risk-sharing within the banking union, thereby deepening it. This should help make the euro area as a whole more resilient to idiosyncratic shocks.

In its role as supervisor, the ECB is responsible for ensuring that new entities resulting from business combinations have sustainable business models, comply with prudential requirements, and have sound governance and risk management arrangements in place that ensure an adequate coverage of their risks.

It remains true that our role is neither to push for consolidation nor to stand in its way. We also do not favour one given business model over another. Our prudential mandate is not to assess whether consolidation efforts are beneficial; this needs to be decided by market participants. We also recognise that restructuring banking activities entails execution risks and could, in some cases, raise challenges in terms of resolvability. But well-designed and well-executed consolidation can help address the overcapacity and low profitability problems that have been damaging the European banking sector since the last financial crisis, and thereby contribute to the overall financial soundness of the banking system.

Increased supervisory transparency for sustainable consolidation

In order for us to duly assess, from a prudential perspective, the robustness of newly created entities resulting from business combinations, the parties involved in a consolidation project are expected to provide ECB Banking Supervision with a robust, credible and informative group-wide integration plan that allows us to carry out an accurate and thorough preliminary assessment of the expected sustainability of the business model of the combined entity. The strategy underlying the consolidation transaction will then be assessed on a case-by-case basis, according to its objectives in terms of capital, business and profitability (including expected efficiency gains), and risk profile (including quality of assets and operational risk of the combined entity).

By making our supervisory expectations more transparent in terms of what constitutes a well-designed and well-executed business combination, we intend to make our supervisory actions more predictable and thus help bring about prudentially sustainable consolidation projects – that is, projects that are based on a credible, group-wide business and integration plan, that improve the sustainability of the business model, and that respect high standards of governance and risk management.

Importantly, the parties involved in consolidation projects are invited to initiate dialogue with ECB Banking Supervision at a very early stage. Such early communication serves to set the scene and, when relevant, enables the parties to benefit from early feedback from us, which they can then incorporate when further developing their consolidation plans, including when interacting with other authorities.

Key prudential aspects of our supervisory approach to consolidation transactions

The ECB’s draft Guide on the supervisory approach to consolidation sheds light on three key prudential aspects of our supervisory approach to consolidation transactions: the setting of capital requirements and guidance, the treatment of badwill, and the use of internal models by newly formed entities.

First, we will not penalise credible integration plans with higher capital requirements and guidance. The starting point for the capital of the newly formed entity will be the weighted average of the merging banks’ Pillar 2 capital requirements and Pillar 2 guidance prior to consolidation. This starting point can then be adjusted upwards or downwards based on a case-by-case assessment. With such an approach, we recognise that, in general, a large part of the costs deriving from the combination of businesses are booked upfront, while the benefits of such transactions are accrued only at a later stage.

Second, we recognise, in principle, duly verified accounting badwill from a prudential perspective. We expect badwill to be used to make the business model of the combined entity more sustainable, for example by increasing the provisioning for non-performing loans, or to cover transaction costs, integration costs or other investments. We also expect the potential profits from badwill not to be distributed to the shareholders of the combined entity until the sustainability of the business model is firmly established.

And third, we will accept the temporary use of existing internal models for calculating capital requirements by the newly formed entity, subject to clear model mapping and a credible internal models roll-out plan to address the specific internal model issues created through the merger, as well as other conditions where appropriate. If the combined entity does not have all the required approvals for the use of internal models, new authorisations will still be required. The Guide spells out what can be done on a temporary basis and, subject to conditions, until all necessary permissions are in place.

The proposed approach will serve as a starting point for the supervisory dialogue, where the specificities of each bank will be duly considered. The flexible approach described above will apply to consolidation projects that do not trigger substantial supervisory concerns. Of course, for all consolidation proposals, the most appropriate supervisory approach will be determined on a case-by-case basis. Supervisors will then closely monitor the newly combined entity and the implementation of the agreed integration plan.

Our proposed supervisory approach acknowledges that the benefits and synergies of consolidation may take time to materialise, and that consolidation transactions also involve some risks. In this context, it is all the more crucial to monitor the implementation of the integration plan and to take swift supervisory action, where justified, in the case of a deviation from the agreed plan and timeline.

Conclusion

I believe that providing clarity about how we assess the risks and benefits of the consolidation projects submitted to us can help market participants develop consolidation strategies that are sustainable. It is therefore important that the final Guide be the product of a truly joint reflection on how to make progress with sustainable consolidation in Europe and foster a more resilient European banking sector.