- CONTRIBUTION
Brexit and the EU banking sector: from the fundamental freedoms of the Internal Market to third country status
Contribution by Andrea Enria, Chair of the Supervisory Board of the ECB, for the Revue d’économie financière special issue on Brexit
26 January 2023
Abstract
The Brexit referendum has fundamentally changed the relationship between the United Kingdom and the European Union, also within the banking sector. With the United Kingdom becoming a third country from an EU and a single European market perspective, overseeing an orderly relocation of banking activities to the EU has presented significant challenges. In fact, European customers can no longer be served directly from the United Kingdom. This contribution explains how the EU, and the European Central Bank (ECB) in particular, is overseeing this relocation process, and describes the ECB’s supervisory approach in dealing with a number of thorny issues raised by Brexit. The ECB has been firm in its principles, particularly its “no empty shell” policy requesting banks to locate within the EU strategic and risk management capabilities commensurate with their level of risk. But it has also been flexible and proportionate in applying those principles and very keen to establish intense and transparent cooperation with the UK authorities. This is indispensable to support the significant amount of cross-border banking business which will continue to characterise our markets for the foreseeable future.
Introduction: a steep challenge
It has now been more than six years since the United Kingdom (UK) referendum on European Union (EU) membership took place. At that time I was working in London as Chairperson of the European Banking Authority (EBA), which had been created a few years earlier to deliver greater regulatory harmonisation, stronger convergence in supervisory practices and closer cooperation among EU supervisory authorities, with the ultimate goal of supporting financial integration and stability in the single European market. While colleagues were disappointed and anxious about the EBA’s imminent relocation to another European capital, we had to deal with the massive policy challenge of redesigning our relationship with the UK in the area of banking. As in many other areas of public policy, Brexit had an immediate disruptive effect on well-established institutional arrangements and deeply integrated market realities.
Since the introduction of the euro in 1999, an integrated banking sector had started taking shape in the new currency area, mainly in the money market, wholesale banking and capital market business. Nonetheless, a first wave of cross-border consolidation in the early 2000s had not led to an equally fast integration in the retail banking sector, where proximity to customers, trust in established local brands and differences in regulatory frameworks still played an important role. Paradoxically, the banking integration in the euro area that had occurred was mainly in the non-retail financial markets that were located in the UK, in other words outside the euro area itself but still within the Single Market in financial services.
Moreover, the launch of the capital markets union project in 2015 while a new settlement for the UK within the EU was being negotiated, was seen as a way to cement and further develop the City of London’s role at the heart of the single European market in financial services. The then Commissioner for Financial Services, Jonathan Hill[1], emphasised this point, stressing the mutual benefits for firms and citizens on both sides of the Channel.
To be sure, while the banking union, which became operational in 2014, was designed in particular for the euro area but open also to other Member States willing to join, the capital markets union was conceived from the start as an EU-wide Single Market project spanning all the then 28 Member States, with London at its centre.
In order to grasp the relevance of the London marketplace for the rest of the EU just before Brexit, we just have to look at both centrally cleared and uncleared over-the-counter (OTC) derivatives. As at December 2019, almost 80% of all euro area clearing members’ OTC derivatives positions were cleared through UK central counterparties. And as at August 2019, over a quarter of uncleared OTC derivatives held by euro area counterparties were sourced from the UK, namely by large investment banks operating out of London.
Moreover, global investment banks based in the UK were, and still are, also key providers of financial services to euro area non-financial firms. For instance, global banks play a very active role in debt and equity issuance, as well as in mergers and acquisitions and syndicated loans. For illustration, we can look at some average percentages during the period from 2012 to 2019. We see that the share of euro area corporate debt issuance via non-euro area banks was around 50%, the share of corporate equity issuance via non-euro area banks was slightly below 50%, mergers and acquisitions involving euro area non-financial corporations financed by non-euro area-owned banks were above 30%, and issuance of syndicated loans to euro area non-financial corporations led by non-euro area-owned banks was above 25% (Bergbauer et al., 2020).
In this context, the exit from the EU in 2021 implied the immediate reclassification of the UK as a third country, albeit an unusual one which for more than forty years had been a core member of the European Community and later of the EU, and as such had always fully accepted and implemented the acquis communautaire and the ethos behind it. Nonetheless, in the banking sector UK-based firms wishing to provide services in the EU were no longer able to do so via passporting, i.e. the right to serve customers across the EU from their home Member State, either through the free provision of (cross-border) services or by establishing local branches under preferential terms.
I will describe below the complex relocation of business by international banks[2], via the establishment of new legal entities and a thorough reorganisation of their corporate structures to adapt their business to the new reality.
I will argue that the EU, and in particular the European Central Bank (ECB) as the lead banking supervisor of the relocating entities, applied a clear and consistent policy in order to guide this complex process. I would characterise this policy as firm in its key principles but flexible and proportionate in its application.
In fact, from day one we have maintained a “no empty shells” policy, which is a clear prudential orientation to avoid companies being established in the EU without any real strategic and risk management capabilities, relying only on the direct and exclusive steer of their parent companies in the UK.
Our rationale has always been that if the business is relocated to the EU, the responsible supervisor should be able to effectively supervise the local business and ensure its safety and soundness.
At the same time, we provided relocating firms with the necessary time to adjust and did not neglect the benefits of global, firm-wide arrangements in certain areas of business and risk management, always keeping in mind the materiality of risks and the specificities of each bank’s business model.
A third key ingredient of the ECB’s approach to Brexit has been a close and transparent cooperation with the UK authorities, particularly with the Prudential Regulation Authority (PRA). We have always been acutely aware that, Brexit notwithstanding, the EU and the UK banking markets will remain strongly and deeply interconnected for the foreseeable future.
Needless to say, public authorities entrusted with prudential supervision would not be able to deliver on their mandate to guarantee the safety and soundness of individual banks and the financial stability of the entire banking sector without close cooperation, transparency and mutual trust.
The relocation effort
Preparation for Brexit started well ahead of the UK’s withdrawal from the EU in January 2021. The ECB invited incoming banks to develop a target operating model (TOM) for their operations in the banking union, with a view to coming to an agreement with their new supervisor on their intended approach to trade, book and manage risk in the EU in a way that ensured prudent risk management and effective supervision.
The TOMs were also linked to a timeline to actually create new company structures or reorganise existing ones, relocate business and ensure the availability of an adequate amount and seniority of staff to smoothly run the new entities. This process was also associated with a tentative timeline for the ECB’s comprehensive assessment, in line with the legal requirement to review asset quality and conduct a stress test to ensure the resilience of the new entities coming under direct supervision of the ECB within the Single Supervisory Mechanism.
Understandably, in the initial stages of this process several banks tried to minimise the impact of the relocation, aiming to establish a gateway and continue serving their customers in the EU while maintaining as much as possible their London establishments as the main hub for managing European business.
But it soon became clear to all participants in the process that given both the legal requirement to establish an intermediate parent undertaking (i.e. a separate holding company or parent institution) in the EU beyond certain thresholds of assets and the “no empty shell” policy announced by the ECB, coping with the new reality created by Brexit would require a more significant effort.
The TOMs agreed with the ECB back in 2018 envisaged a relocation of assets from the UK to the EU banking union for a total of around €1.2 trillion. Banks were granted sufficiently long transition periods for the relocation and, where necessary, the ECB ensured a good deal of flexibility. For instance, in the wake of the COVID-19 outbreak, the ECB allowed banks to postpone their plans to account for the impact of the lockdown measures and travel restrictions on the relocation of staff, while reiterating that remote working arrangements would not change the fundamental need to relocate staff to the EU.
This relocation process is now almost complete. Taking a sample of nine of the biggest international banks, assets booked on the balance sheet of legal entities established in the euro area increased from around €275 billion to more than €1.3 trillion at the end of the first quarter of 2022, representing an almost fivefold increase.
Also, in terms of legal entities authorised to carry out the banking business, there was a significant increase of authorised credit institutions or expansion to other activities of already existing authorisations. The ECB, as the EU institution exclusively competent to grant banking licences in the jurisdiction of the Single Supervisory Mechanism, authorised fifteen new credit institutions (six significant institutions, under direct ECB supervision, and nine less significant institutions) and the activities of sixteen existing credit institutions (two significant institutions and fourteen less significant institutions) were expanded. With the introduction of the Investment Firms Directive and Regulation, the ECB expects to receive licence applications from investment firms, which the ECB will directly supervise.
The ECB closely monitors the set-up of the boards of the new local establishments in the EU to ensure a sufficient number and quality of independent directors and avoid “dual hatting”, i.e. top managers fulfilling the same or similar functions at both the parent company outside the EU and the EU subsidiary. This requires constant vigilance from supervisors. These prerequisites are important to ensure effective local steer and challenge within boards and to emphasise the focus on local markets and customers and the need for appropriate management of the risks in the European franchise.
Initially, the boards tended to be comparatively smaller and largely dominated by parent company representatives. Following ongoing dialogues with the Joint Supervisory Teams (JSTs), composed of staff from the ECB and the national supervisory authorities, the boards are now closer to the average size of all banks under European banking supervision, and the number of independent directors has increased accordingly. Now, almost all institutions have at least a quarter of board members qualifying as independent. Those with more scope for improvement are in intense dialogue with the responsible JSTs regarding improvements to their governance arrangements.
Also in terms of staff, notwithstanding the delays generated by pandemic-driven restrictions, the relocation is close to the finish line, with an increase in local resources which sometimes more than quadrupled from end-year 2019 to end-year 2021. In some cases, this process has yet to be completed as part of the desk-mapping review (see below), but clear timelines and processes have been agreed with relocating banks.
An interesting development, which carries lessons also for the more general issue of cross-border integration in the euro area banking sector, concerns numerous cases involving third-country banking groups, in particular Swiss and US groups, which relocated various activities to the euro area using the legal tool of the European Company, or Societas Europaea. This structure was used to transform several existing legal entities in various euro area countries into branches of a single credit institution incorporated in a Member State (e.g. Germany for some Swiss and US banks) through passporting and freedom of establishment.
As I have already pointed out (Enria, 2021a, 2021b), there is a paradox here that non-European banks are apparently making better use of the fundamental freedoms of the Internal Market and the banking union than European banks, with a seamlessly integrated organisational structure unhampered by the regulatory fragmentation for separate legal entities in different Member States embedded in the European prudential framework.
Another institutional aspect worth mentioning is the framework for cooperation with the UK authorities. The Joint Declaration on Financial Services Regulatory Cooperation annexed to the Trade and Cooperation Agreement includes an undertaking to set up a structured cooperation process between the two sides. On 26 March 2021 the European Commission and the UK Government announced that they had reached agreement at the technical level on a Memorandum of Understanding (UK Treasury, 2021). Unfortunately, due to intervening political problems, this Memorandum of Understanding has not yet been signed at the time of writing.
However, this did not impede the development of cooperation arrangements with the UK competent authorities. When the UK was a Member State, there was clearly no necessity for specific cooperation arrangements with the UK competent authorities, since cooperation and exchange of information were enshrined in European legislation, which in many cases actually requires joint decisions for cross-border banking groups within colleges of supervisors. After Brexit all this had evidently changed, and we felt it necessary to define our cooperation obligations within a sound institutional framework. To this end, in April 2019 the ECB agreed a comprehensive post-Brexit cooperation framework with the UK authorities in the form of a Memorandum of Understanding, which came into effect on 1 January 2021, at the end of the transition period.
The Memorandum of Understanding, which is based on a template prepared and negotiated by the EBA, covers the prudential supervision of entities other than insurance undertakings and pension schemes. It provides for the exchange of information as well as the reciprocal treatment of cross-border banking groups. The ECB and the PRA have also agreed on how to share responsibilities relating to the supervision of branches. We have signed a statement of intent on the exchange of benchmarking information and analyses of relevant entities of groups headquartered in other third countries, as far as allowed by applicable law.
Let me underscore that the negotiations with the UK authorities were significantly facilitated by the existing rules on professional secrecy and confidentiality clearly deriving from the European legislative framework, in particular the Capital Requirements Directive. And I can also add that the day-to-day cooperation and information exchange between ECB Banking Supervision and the competent UK authorities, in particular the PRA, is regular, wide-ranging and extremely effective.
ECB Banking Supervision and Brexit
Moving assets and staff was an important focus of the Brexit relocation process. But for the ECB as prudential supervisor, key to completing the process was the establishment of firms with a robust internal organisation, the ability to run operations and manage risks without relying excessively on other legal entities – including in a stressed scenario – and, last but not least, a structurally profitable franchise.
Since the very beginning of the Brexit process, the ECB, working in close cooperation with the EBA (European Banking Authority, 2017), has been very clear about the supervisory expectations regarding the relocation of international banks that can no longer rely on passporting for their UK legal entities, whether via the free provision of cross-border services or the freedom of establishment through branches (Lautenschlager, 2017).
In cases where national regimes allow the provision of cross-border services from a third country, the ECB clearly stated that it expected banks not to use such set-ups for carrying out large volumes of activities in the EU in a business-as-usual environment. Material activities and services involving EU clients should be carried out predominantly within the EU.
Moreover, European banking regulation has always made it clear that core banking services cannot be provided from a third country. To dispel any residual doubts, the European Commission’s recent proposal on amendments to the Capital Requirements Directive (European Commission, 2021) introduces a new article (Article 21c) clarifying that in the absence of physical presence, such as a subsidiary or branch, only “reverse solicitation” of banking services is permitted. To avoid disrupting legitimate existing practices in capital markets, it should be clearly spelled out in the legislative text that this provision applies only to core banking services.
In the design of our supervisory approach, the guiding principle has always been to protect the integrity of the Single Market and to safeguard the fundamental freedoms provided for in the Treaty.
In this context, as already mentioned, our most important request has always been that credit institutions in our jurisdiction do not operate as empty shells. Rather, they need autonomous operational and risk management capabilities, including adequate human and financial resources.
We have always spelled out that any bank operating in the euro area should be a real bank and should not rely exclusively on the parent company outside the EU or the wider banking group for its financial and operational viability.
On the technical side, we clearly stated from the outset that we would not accept risk management structures for trading activities that rely extensively on the use of back-to-back booking models, where the actual risk management would take place in a legal entity outside the EU.
Our fundamental principle is that our banks should not only be front offices serving clients in the euro area; they should also be fully responsible for managing the risks on their balance sheet. In our view, a bank having, on top of the credit risk of the client, counterparty risk vis-à-vis another legal entity within the group located outside the EU – to which the risk management of the exposure, including hedging positions, is transferred – is a significant prudential risk. In the event of financial stress or default at the level of the parent entity, the local entity can be left with large unhedged positions and little to no access to the staff and infrastructure needed to wind them down smoothly.
This, in turn, undermines both the local entity’s recovery capacity during severe stress and, in some cases, its resolvability. This is particularly relevant under a third-country framework where, during episodes of financial stress, the diverging interests of the numerous entities and stakeholders involved may lead to retrenchment and ring-fencing. But even during normal times, having risk management resources and infrastructure located offshore can hinder a bank’s ability to identify, measure and monitor risk and can make governance and decision-making less transparent. Lastly, reallocating risk and revenue to third-country affiliates can worsen the incentive structure for local bank management.
Our supervisory approach has been anchored around this solid prudential rationale and a deep respect for the key principles of the Single Market.
The first area in which we had to apply this approach was in the exercise of the options and discretions the EU prudential framework entrusts to competent authorities, particularly those concerning the rules on intragroup large exposures. Without delving into the most technical details, I will briefly explain how these complex features of prudential regulation are playing a part in the supervision of cross-border banking activities after Brexit.
Needless to say, back-to-back booking models within a cross-border banking group create large intragroup exposures between separate legal entities in different jurisdictions. But these intragroup exposures do not appear on the consolidated balance sheet of the whole group. There is an economic argument that international banking groups should, from a prudential perspective, actually be treated as single economic entities.
But the difficult trade-offs and conflicts that can emerge during stress events or an outright crisis justify the prudential rules on intragroup large exposures, which, within our legislative framework, leave competent authorities’ significant room for discretion (Regulation, 2013). ECB Banking Supervision issued its first regulation and guide on options and discretions available in Union law in March 2016 (ECB, 2016; Regulation, 2016)[3], when the Brexit referendum may still have been viewed as a low-risk event.
For the specific option of exempting cross-border intragroup large exposures from the large exposure limit (which is 25% of the legal entity’s Common Equity Tier 1 capital), the ECB adopted a very liberal approach at the time: it did not distinguish between exposures towards entities within the EU – i.e. credit institutions established in a Member State – and exposures towards credit institutions established in a third country. Whenever Article 400(2)(c) of the Capital Requirements Regulation applied (i.e. each time a group followed rules on consolidated supervision under EU legislation or the legislation of an equivalent third country), all intragroup exposures were exempted from the large exposures limit, irrespective of the location of the receiving legal entity (article (9)(3)) (Regulation, 2016).
This has changed since Brexit, and the relevant legislative provisions (Regulation, 2022) have been amended accordingly, leaving only exposures to counterparties in an EU Member State exempted ex ante from the large exposures limit by operation of law. For all exposures to counterparties in a third country, including the UK, a decision will now be made on a case-by-case basis, following an application from the supervised entity.
This notwithstanding, as some banking groups have been structured on the basis of this exemption, we have set out that, while we will be monitoring the issue closely and in accordance with our policy on booking models (ECB, 2018), we do not expect banks that have already been granted the exemption to reapply for continuing to exempt exposures to entities in third countries, including the UK[4]. We want to maintain continuity in our supervisory actions, particularly when considering exposures towards counterparties established in the UK, which were most affected by this regulatory change.
At the same time, as part of our fundamental policy goal of preventing the establishment of empty shells or credit institutions without standalone risk management capabilities, we have launched a desk-mapping review in which we are examining booking and risk management practices across trading desks active in market-making activities, treasury and derivative valuation adjustments (Enria, 2022).
To this end, we assessed the standalone risk management capabilities of 264 trading desks of seven incoming firms, focusing our supervisory actions on the most material desks. Our analysis found that some 70% of the desks assessed still implemented a back-to-back booking model and around 20% were organised as split desks, whereby a duplicate version of the primary trading desk located offshore is established within the euro area legal entity to manage the part of the risk originated there.
Our approach was purely risk-based and sought a proportionate outcome based on the materiality of the risks. To identify the material desks, we analysed the risk profile of the activities carried out in terms of total risk-weighted assets, trading income, notional amount of trading activities and operational capacity. We concluded that 21% of the 264 desks were material from a prudential perspective. For those 56 material trading desks we will soon be issuing binding supervisory decisions that will require specific onshore risk management, operational and governance capabilities within the EU legal entity where the desk is located.
We have been using a proportionate approach, also cognizant of the complexity of certain trading products and the centralised integrated risk management models of global groups. Our fundamental objective is for legal entities under our direct supervision to have risk management capabilities commensurate with the prudential risk their business is generating. The supervised entities are free to decide what range of products to offer to their clients.
Throughout the process we engaged in a close dialogue with our colleagues at the PRA, providing full transparency on the general criteria adopted, the progress made in our assessments and the specific application to individual firms. At the time of writing, our teams are in a dialogue with individual banks on draft decisions, which should give our supervisors a complete picture of the business impact of the requirements. The banks are expected to take full ownership of the results of the desk-mapping review and the required adjustments to their risk management structures and practices.
A final example of flexibility in the application of prudential rules post-Brexit is the temporary recognition of the supervisory approvals granted by the PRA for the use of internal models to quantify capital requirements.
I believe that these examples of our supervisory actions in the context of the Brexit relocation illustrate that our approach has, from the outset, been based on clear principles but also proportionate in its application. We have worked hard to balance the need to take into account the new third-country status of the UKK with the opportunity to leverage as much as possible the close business relationship enjoyed by our banking sectors over many decades, as well as our supervisory cooperation.
Conclusion
For the foreseeable future the UK will be a third country with respect to the EU. It is, however, a unique third country with a history and a legal framework that are unmatched in terms of proximity to the EU. Although the UK decided to leave the EU, we cannot ignore its paramount importance for our history and economy, especially in the financial services sector.
Difficult political negotiations between the UK and the EU are still ongoing. On the financial sector, I note with some concern that the UK Government’s recent decision to introduce in the House of Commons a new Financial Services and Markets Bill – which also seeks to repeal all EU law retained in the financial services sector (House of Commons, 2022) – is often accompanied by political calls to launch a deregulation agenda.
Yet I am confident that the shared commitment made at international standard setting bodies, in particular the Basel Committee on Banking Supervision, will ensure strong prudential standards on both sides of the Channel. This important point also needs to be considered in the legislative process currently under way to implement the final Basel III reforms in the EU, where I see equally worrying calls for deviations from the international standards to reflect loosely defined “specificities” of our banking sector. The ECB and the PRA are both arguing for a full, loyal and timely implementation of Basel III.
Political and legal difficulties aside, I firmly believe that the cooperation between the competent authorities in the UK and the EU, particularly in the banking sector, where my responsibilities lie, should continue unabated – as has been the case in the past few years, with excellent and mutually satisfactory results.
Hill (2015): “The Single Market makes London a gateway for investment across the world into the whole European Union, the UK’s single biggest market for export of its financial services…If we get Capital Markets Union right then the companies and people who work in these buildings in the old Docklands can be – and be seen to be – the creators of prosperity for many millions across the continent. ”
Some terminological clarifications: at ECB Banking Supervision we often informally use the notion of “Brexit” banks, i.e. some US, Swiss and UK banks that have significantly restructured their operations as a consequence of Brexit and the loss of the EU “passport” for cross-border banking services. That meant a “relocation” of a significant part of their business from London to euro area financial centres, which include, as far as the banking sector is concerned, in particular, Frankfurt and Dublin and, to a lesser extent, Paris. The term “relocation” is used in a broad meaning, including both business relocation (e.g. transfer of booking of assets from a UK legal entity to an existing euro area legal entity) and “physical” relocation through the establishment of a new legal entity with a new banking licence in the Single Supervisory Mechanism.
For an analysis of how the ECB has exercised the option set out in Article 400(2)(c) of the CRR, see Bassani (2019,chapter 4.04).
ECB Banking Supervision (2022, p.33): “From the date of application of the amending Regulation, credit institutions will need to apply to the ECB for prior permission to exempt intragroup exposures to entities in third countries from the large exposures limit. However, where credit institutions already have intragroup exposures to entities in third countries, and those exposures are already benefiting from the exemption, the ECB does not expect the institutions to apply to continue exempting those exposures”.
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