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Brexit: banks must prepare for the end of the transition period

Blog post by Yves Mersch, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB

Frankfurt am Main, 9 July 2020

As of 1 January 2021, banks located in the EU and the United Kingdom will operate in two separate regulatory and supervisory environments. Providers of financial services between the EU and the United Kingdom will no longer enjoy the benefits of the Single Market.

Many euro area banks doing business across the Channel, as well as UK banks operating in the euro area, have made considerable progress in view of this event. Some are well on track to finish their preparations by the end of the year. Others, however, still have much work to do.

Broadly speaking, the main priority for banks over the past few months has been tackling the multi-faceted consequences of the coronavirus (COVID-19) pandemic. There is no doubt about the challenges they face in these circumstances. We therefore provided ample support to banks in order to soften the impact of the pandemic, through our monetary policy and supervisory action.

On the supervision side, we have encouraged banks to use their capital buffers so they can provide loans to struggling businesses. We have freed up capital by bringing forward a change in the capital composition of Pillar 2 requirements. We have also adjusted supervisory timetables and processes to provide operational relief to banks. For example, we granted them an additional six months to correct qualitative shortcomings identified in the 2019 Supervisory Review and Evaluation Process (SREP).

However, this relief should not be misinterpreted – our measures in response to the COVID-19 pandemic focus on maintaining banks’ ability to support the economy. They do not extend to essential end-of-year Brexit preparations. It is in banks’ own interests to maintain their focus on these preparations, especially during these difficult times. The question for banks is how the pandemic might affect them, both in terms of the business environment and their operational set-up, as they approach the end of the transition period. If anything, the impact of not being prepared will be greater now, in the COVID-19 context, as banks may be weaker and are operating in a more fragile environment.

For these reasons, and in view of the current state of the Brexit negotiations, the ECB has recently reassessed banks’ preparedness for the end of the transition period in December. Our supervisory teams have discussed with banks their progress towards the post-Brexit target operating models to which they have committed. We intentionally established these supervisory dialogues well in advance of Brexit. It is now crucial that banks focus on filling the gaps and progressing towards their target operating models.

Taking into account the operational difficulties created by COVID-19, the ECB identified three intertwined priority areas. First, contingency planning, to ensure banks are prepared for any stresses on funding and trading markets that may accompany stepping from the old business-as-usual situation into the new post-Brexit world. Second, strengthening risk management and governance arrangements to support banks’ ability to safely manage their business in and from the Continent. This includes the third priority area: reducing remote booking of EU activities, so-called back-to-back booking, so banks retain full local oversight of the business they originate and manage. As end-state target operating models continue to apply, banks should relocate assets if, or once, commensurate onshore risk management capabilities are in place. Staff relocations can be delayed on account of new lockdown measures or travel restrictions only.

In some areas, banks are planning to rely on equivalence decisions by the European Commission, even though these decisions are not granted at this stage. Also, while equivalence can offer limited additional possibilities to banks in the short term, it does not constitute a sustainable basis for their business models. As the UK and EU regulatory systems evolve, taking account of the UK policy announcement on financial services, the conditions for equivalence decisions may fall away and the decisions may be withdrawn. In any case, equivalence does not replicate the benefits of passporting and does not exist in all areas. So banks must act now to prepare for the future and be ready for all possible contingencies.

Consequently, today’s announcement by the European Commission regarding the temporary equivalence of UK central counterparties is welcome, but it does not mean banks can avoid preparing in this area. The temporary equivalence that might be granted responds to the industry’s demand for more time to adjust clearing operations to the United Kingdom’s new status as a third country. It remains critical for the industry to continue these actions in order to avoid possible new cliff-edge risks at a later stage. Where equivalence is time-limited, the cliff is still there. It is simply further away.

All of this underpins the ECB’s expectation that banks will soon reach their end-state target operating models. The qualitative dimension will remain a cornerstone of supervisory teams’ assessment, as mentioned in the February Supervision Newsletter.[1] Banks that have failed to hire staff with sufficient seniority and skills, neglected to make necessary transfers of material assets, or unduly split trading desks across multiple legal entities, will not be considered as complying with the ECB’s requirements. Not addressing this qualitative dimension means operating as (half-) empty shells – something that the ECB will not accept. The ECB’s expectation is very clear: all activities related to European products or European customers should, as a general principle, be managed and controlled from entities located in the EU.

Where this is not yet the case, we might tighten our measures to ensure banks finish building up fully fledged capacities, in terms of both business activity and risk management. For euro area banks with a footprint in the United Kingdom, the requirements established in last year’s SREP decisions continue to apply and will have to be met in due course, taking into account the end of the transition period.

We would like to acknowledge all the effort banks have already put in to preparing for Brexit. We will continue to engage with all affected banks to ensure that they reach their target operating models in a timely manner.

  1. Available on the ECB’s banking supervision website.