Brexit: Booking models and “empty shells”
Brexit has triggered a discussion of the booking model practices used by international banks. This issue is inextricably linked with the question of how to prevent empty shell entities from being set up. This is an important question, since booking models and hedging practices can impede the development of local capabilities by transferring the management of certain risks. This in turn may create operational risks and financial stability issues for the country hosting the empty shells. An empty shell bank typically does not have adequate local risk management and governance structures, or sufficient local staff and operational independence, to manage risks effectively and ensure a safe continuation of the local business or smooth wind-down of positions in crisis situations. But how is European banking supervision, through the Single Supervisory Mechanism (SSM), approaching these concerns, and what is expected from banks?
When assessing booking model practices, the ECB and national supervisors will focus on five key areas.
Internal governance, staffing and organisation
European banking supervisors expect banks to have an adequate, skilled and locally based management body that is able to effectively oversee the local entity’s activities and booking practices.
The ECB and national supervisors also expect banks to manage the risk for their material products and risk categories locally without overly relying on third-country operations. This is consistent with European banking supervision’s policy that banks should have robust risk management frameworks in place.
Another expectation is that banks’ front office capabilities should be sufficient to cover their business activities and be in line with the bank’s strategy and business plan.
Business origination and FMI access
A key supervisory expectation in the context of managing market risk is continuous access to financial market infrastructures (FMIs). Banks are expected to ensure that their access to FMIs is not fully dependent on group entities in third countries. They must have business continuity arrangements in place to ensure their access to FMIs at all times for all relevant exposure classes. The ECB and national supervisors expect supervised banks’ contingency plans to cover crisis scenarios in which they do not rely on third-country group entities for access to FMIs.
Booking and hedging strategy
Banks should not rely only on intragroup back-to-back hedging strategies or remote booking with group entities in third countries. Relocated banks should have a certain level of proven trading and hedging capacities on the ground. Moreover, their business plans should include details of how trading, hedging, risk management and operations could continue to be conducted in crisis situations, albeit potentially on a reduced basis compared to business as usual.
Some banks rely on pricing, trading, hedging or risk management capabilities that are based in third countries. They will need to provide details to the supervisor of how they plan to transfer or establish these capabilities to sufficiently service their material European businesses and/or entities. Furthermore, these banks should retain demonstrable control and oversight of balance sheet risks within the EU perimeter.
IT infrastructure and reporting
Banks are expected to be able to produce complete and accurate data on their booking models, hedging strategies and intragroup exposures. This will ensure that risks associated with intragroup positions can be both monitored by the bank and reviewed by the ECB.
The supervisory expectations on booking models will be applied proportionately and in relation to the materiality and complexity of the bank’s capital market activities, on a case-by-case basis. Therefore large banks with high interconnectedness and complex capital market operations will be subject to higher supervisory expectations.
Banks that are planning to relocate business from the United Kingdom to the euro area should incorporate these expectations in their applications for authorisation and Brexit plans. Existing SSM banks are expected to review their governance, models and arrangements as part of their planning process and incorporate considerations related to their booking models in their business plans and regulatory submissions (e.g. information on their internal capital and liquidity adequacy assessment processes).
The ECB and national supervisors will carefully assess banks’ plans to establish or expand operations in the euro area, to ensure that their capabilities are aligned with their business activities. Banks will be expected to provide an overview of how they plan to develop their front office capabilities, risk management and infrastructure in line with the transfer of business from UK to euro area entities. This is in line with the principles set out in the Opinion of the European Banking Authority on issues related to the departure of the United Kingdom from the European Union.
The ECB plans to publish more information on its expectations regarding booking models and empty shells in the near future, for example by publishing additional FAQs on this subject.