Brexit: an ECB supervision perspective

More than six months have now passed since the United Kingdom officially started the process of leaving the European Union (EU). Since then, the European Central Bank (ECB) has interacted with banks that currently operate in the euro area via the United Kingdom (for example through subsidiaries and/or branches) and have submitted their Brexit-related relocation plans.

ECB Banking Supervision appreciates the progress banks have made in their Brexit preparations. However, some elements in a number of banks’ plans do not fully meet the ECB’s expectations and requirements of banks operating in the euro area. Banks do not only need to be well-capitalised and have sufficient liquidity and funding. They also need to have substance locally. In other words, there cannot be empty shells or letter box banks.

It is not straightforward to draw a line between a well-established bank that is integrated into an international group and an empty shell that is overly reliant on group entities in third countries. Still, some of the relocation plans submitted seem to lean towards the latter. This is indicated by the extensive sourcing of risk management capabilities and governance structures from outside the EU and – connected with that – the transfer of risks via back-to-back booking models.

Many banks have indicated their wish to transfer all market risk to a third-country group entity. In practice, this would mean that the banks in question were fully reliant on the third-country entities. In terms of supervision, the ECB is not comfortable with such an approach, which, as the recent past has revealed, could create risks in crisis situations where local capabilities may be crucial to continue operations. This is a key reason why the ECB and the national supervisors expect banks – at least over the medium term – to manage parts of their risks locally and not to be fully reliant on back-to-back transactions of this type.

For market risk, this means having permanent local trading capabilities and local risk committees (including local infrastructure, staff and risk management functions). It also means actually trading and hedging risks with diversified counterparties and not just the group. This ensures recoverability in the event that the group entity is no longer able to provide its services to the local one.

With regard to the staffing of banks the ECB has noticed that several of the banks’ plans include references to dual-hatting, a practice where staff carry out functions in more than one group entity. Such plans need to be thoroughly assessed as they may limit independence, create conflicts of interest and result in insufficient time being available for each function. Concerns would be even greater if employees of a euro area bank were seen to be spending most of their working time in a third country and not, therefore, being physically present in the euro area. In general, ECB Banking Supervision expects control functions and local governance to be sufficiently independent and banks to have staff in place locally.

Transitional arrangements for specific aspects may be agreed upon with supervisors. But certain elements will need to be in place from day one, such as the risk management function. Banks must have full control of their balance sheets and be able to see the full risk picture; the management bodies of EU banks must be fully responsible for the activities carried out by the banks they manage. In the event of transitional arrangements being agreed upon with the ECB and/or national supervisors, banks should set out clearly what the steady state will be, commit to this and explain how and when they will get there. So far, this expectation has not been adequately reflected in banks’ proposals.

ECB Banking Supervision looks forward to continuing its dialogue with banks on these and other Brexit issues over the coming months.