Fostering the cross-border integration of banking groups in the banking union

By Andrea Enria, Chair of the Supervisory Board of the ECB, and Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB

Frankfurt am Main, 9 October 2020

The banking union cannot yet be considered a genuinely integrated market: business is still segmented across national lines, in part due to the lack of a truly European safety net and persistent regulatory obstacles. In addition, following the Lehman Brothers collapse and during the sovereign debt crisis there were many cross-border coordination difficulties when managing crises within cross-border groups. As a result, we have been left with a heavy legacy of ring-fencing measures and impaired trust between national authorities. This is part of the structural inefficiency that still afflicts the European banking sector – the low profitability, low cost efficiency and excess capacity which serve to depress market valuations.

As we face the challenges raised by the coronavirus (COVID-19) pandemic, we should also focus on the actions needed to foster the integration of banking activities within the banking union. And this means, first and foremost, focusing on the functioning of banking groups with activities across different Member States. Of course, the ultimate aim should be to complete the banking union and have a fully integrated Single Market. In this blog post, we will highlight the need to combine the road to greater integration with safeguards for banking group subsidiaries that are located in a different Member State to their parent bank. This will ensure that, in the event of a crisis, the interests of national customers and markets will be taken into account, in particular until a European deposit insurance scheme is in place. We believe that the banking union, and the mechanisms that can be put in place within the Single Supervisory Mechanism, can restore trust in cooperative solutions that balance the legitimate calls to protect national interests with the equally legitimate need for a more integrated and efficient internal market.

Ring-fencing stands in the way of integrated markets

Host authorities have traditionally been reluctant to allow cross-border groups to manage capital and liquidity at the group-wide level in a pool established by the parent company. It is widely believed that, in times of crisis, the parent companies would protect their own interests, and that home authorities would prioritise the fulfilment of their national mission. This would give rise to a conflict of interest about whether or not to rescue different parts of the group, or whether to sacrifice the interests of national stakeholders to the benefit of the parent company. Additionally, purely contractual arrangements have not been seen as sufficiently effective, as they might be difficult to enforce in times of crisis. The tensions experienced during the last financial crisis, where groups were sometimes broken up along national lines to make their crisis manageable through the use of national tools, corroborated this negative attitude. In the face of such a lack of certainty and mutual trust, ad hoc ring-fencing measures that trapped capital and liquidity within individual Member States may have seemed an adequate solution for host countries. As a result, ring-fencing became widespread. Since the financial crisis, however, this approach has undoubtedly stalled progress in the integration of the European banking market.

This is clearly a paradox, and it is certainly not the optimal solution for Europe, and for the banking union in particular. Currently, an overall satisfactory level of capital and liquidity at group level is often accompanied by an asymmetric distribution between the parent company, with relatively thin prudential buffers, and local subsidiaries, with significant excess capital and liquidity.

Ring-fencing stands in the way of integrated markets, and this entails costs. There are short-term costs, as ring-fencing can amplify the costs of any crisis. As in the prisoner’s dilemma, cooperation might not be the commonly chosen strategy, but it would make everyone better off. There are also long-term and structural costs, as capital and liquidity are most efficiently allocated when they can flow freely.^[1]

Liquidity requirements applied at the individual bank level and national ring-fencing measures may prevent parent companies from efficiently managing their liquidity resources within the group, even within the banking union. Around EUR 200bn of high-quality liquid assets (HQLA) are not transferable in cross-border subsidiaries of significant credit institutions in order to ensure compliance with the Liquidity Coverage Ratio at individual level^[2], thereby reducing the effectiveness of centralised liquidity management. But enabling a broader pooling of liquid resources and, ideally, of capital, raises the issue of what safeguards are in place for national stakeholders when banks – whether the parent company or one or more of its subsidiaries – start seeing signs of a deteriorating financial position.

Linking group support agreements to recovery plans

Through its Single Supervisory and Resolution Mechanisms, the banking union has eliminated the distinction between a parent’s home supervisory authority and its subsidiaries’ host authorities. We now have single supervisory and resolution authorities that are European by their very nature, and therefore committed to protecting the interests of all European citizens. We must be able to leverage this to promote a more resilient and integrated European market, taking into account different concerns from both a banking union and national perspective. We have already mentioned^[3] that we can incorporate these kinds of concerns when setting prudential requirements for entire banking groups. For example, if a national risk is not reduced through diversification or netted out through consolidation, it must be taken into account in group requirements. This might help to limit the risk at the national level and reduce the need for ring-fencing.

But the crucial point lies in how we can deal with cross-border banks that encounter difficulties. For these cases, group recovery and resolution plans should play an essential role. As intended by international standard-setters and European legislators, advance planning by banks, under the scrutiny and guidance of their supervisors and resolution authorities, should ensure that a cooperative approach prevails when a situation starts to deteriorate and when it develops into an outright crisis. If we want to strengthen confidence in crisis management at the European level, the best way forward is to reinforce the role of group recovery and resolution plans, as well as their practical implementation. Let us focus in particular on recovery plans – not only because we, as prudential supervisors, have a more central role in discussing them with banks, but also because the recovery options foreseen in these plans have the potential to be activated at an earlier stage, and can therefore offer a clear opportunity to act before a crisis actually occurs.

ECB Banking Supervision has already made considerable progress in improving the coverage and credibility of banks’ recovery plans, notably by conducting an annual review and follow-up supervisory dialogue^[4]. We will continue to put a considerable amount of effort into strengthening the usability of these plans. One additional step in this direction would be to offer banking groups the option of having subsidiaries and parent companies enter into a formal agreement to provide each other with liquidity support, and to link this support to their group recovery plans. This would not only help to explicitly map out how group entities could support each other when difficulties arise, taking into account local needs and restrictions, but it would also make it possible to establish the appropriate triggers for providing the contractually agreed support at an early stage. The supervisors’ involvement would also be ensured, since recovery plans are assessed by the relevant competent authority. For significant euro area banking groups, this would be the ECB.^[5]

The provision of financial support by the parent entity would therefore be linked to internal recovery indicators at the level of the subsidiary. It would be up to the banking group – in close cooperation with supervisory authorities – to identify the most appropriate liquidity indicators for group support to be activated; these indicators would be selected according to the characteristics of each group and would be consistent with the group’s internal liquidity management policy^[6]. This would also make it possible for group support to be activated early enough for it to be effective. Safeguards could be established and recognised in recovery plans to also address the concern that subsidiaries could be drained of liquidity in the event of emerging parent company weaknesses in funding markets. For instance, a separate vehicle could be established under the responsibility of the parent to manage all the pooled liquid resources, with precise rules of engagement in the event of difficulties at any level of the group.

Creating a stronger link between group support and recovery plans would not necessarily mean that the provision of support would be triggered automatically. The bank’s management body could still refrain from taking an action foreseen in its recovery plan if it did not consider that action to be appropriate in the particular circumstances.^[7] In any event, once recovery indicators are breached, the management body would have to assess the overall situation and decide whether to activate a recovery option or refrain from taking action. In parallel, the supervisor would be made aware of the breach of the indicators^[8] and the management body’s decision to activate (or not) the group support^[9], and could be granted early intervention powers to take action on the basis of the group support agreement.

This stronger link with the group recovery plan could provide additional reassurance about the application of the group support, whether at the level of the parent or the subsidiary, since EU legislation could empower the supervisor to enforce the agreement included in the group’s recovery plan. This would, however, require a legislative change.^[10]

This solution would be more agile and effective than the group financial support agreements currently envisaged in the Bank Recovery and Resolution Directive (BRRD), as the safeguards would be triggered at an earlier stage and would require less stringent conditions, due to the enforcement power that could be attributed to the supervisor.

Introducing adequate incentives and safeguards to enter into group support agreements

One important step would be to introduce adequate incentives to enter into group support agreements. This could be done, for example, by linking the granting of cross-border liquidity waivers to, among other things, the existence of adequate intragroup financial support agreements included in the recovery plans.^[11] In addition, the decision to grant a cross-border liquidity waiver could underpin the enforceability of these intragroup agreements. For example, the decision to grant a waiver could be based on the inclusion of a clear link between the actual existence and effectiveness of financial support agreements and the granting of the waiver itself. A link of this kind, and the possibility to reassess it, could provide significant incentives for banks to comply with financial support agreements.

This could be complemented by adequate safeguards for the receiving group entities that intragroup support would be provided whenever necessary. This could be achieved, for example, by obtaining an independent legal opinion on the enforceability of the group support agreement to confirm the absence of any legal impediments (e.g. with regards to national company and insolvency laws) to its fulfilment. This could also be reinforced by encouraging certain group parent entities to issue public statements about their commitment to provide group support in the event of a crisis.

In the future, the enforceability of financial support agreements outlined in banking groups’ recovery plans could be enhanced by introducing statutory safeguards in the European legal framework, which would aim to ensure that these agreements are legally valid and also enforceable across borders, even if a resolution, insolvency or liquidation procedure is initiated at the parent level. It would be preferable if these safeguards were introduced via directly applicable EU regulations, such as the Single Resolution Mechanism Regulation, which could also be complemented by amendments to the winding-up directive (Directive 2001/24/EC) and/or the BRRD.

It is worth mentioning that this move towards greater cross-border integration would ideally be combined with a broader harmonisation of the European crisis management framework, although this would not be a requirement. In particular, the mechanisms suggested here do not aim for or require any substantial change in national laws relating to insolvency, corporate or contract law, as they build only on what is a generally recognised principle in the European legal system: that a parent company may have a legitimate interest in providing support to a subsidiary to facilitate its operations and possibly benefit from the recognition of that support by the supervisor. Similarly, subsidiaries, as separate legal entities, have a legitimate interest to protect their creditors and ensure the timely payment of their obligations in times of stress, and should have their claims on the common pool of liquid assets safeguarded within an overall, commonly agreed group policy.

Conclusion

Concluding and implementing the group support agreements proposed in this blog post would certainly help to ease concerns about the risk inherent in cross-border banking groups, since they would ensure effective support for group entities well before the point of non-viability was reached. These agreements would therefore help to strike the right balance between the legitimate interests of all stakeholders, as they would enable large cross-border banking groups to manage their liquidity in a more efficient way, while providing assurance on the provision of liquidity support to group entities located in the banking union, if needed, at an early stage. The focus on liquidity is justified by the potential link with cross-border waivers, which is allowed under the current legislative environment. But nothing would prevent a similar construct also being deployed to enable the group-wide management of capital.

Since the start of our respective mandates, we have underlined the importance of improving the cross-border integration of banking groups to bolster their ability to deploy their resources in a flexible and efficient manner in response to shocks, and thereby reduce the risk to financial stability. At a time when the full-blown effects of the crisis triggered by the coronavirus pandemic are still unclear, we should build on these proposals and seize the opportunity to make progress towards a truly integrated European banking market.