Banking regulation and supervision after Brexit

Speech by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, at the eighth Brussels EU/UK Dinner Discussion held by the Representation of the State of Hesse to the European Union

Brussels, 28 September 2021

Introduction

Thank you for inviting me to speak today. It is a pleasure to join this discussion, as the relationship between the European Union and the United Kingdom is a hugely important topic for Europe as a whole, given that the financial links between the UK and the EU are, and in all likelihood will continue to be, highly relevant and significant for our economies. Let me begin by stating what is obvious now, but was very much less so five years ago: we have successfully managed the first part of the transition and have avoided any damaging cliff effects when the United Kingdom left the European Union. Of course, as a supervisor, I am always telling bankers that past success is not a reason to become complacent about risk – we need to be constantly reassessing and take the full measure of the risks that lie ahead. So that is another reason to welcome tonight’s discussion. Professor Tröger’s introductory remarks based on the SAFE White Paper on banking supervision after Brexit have highlighted the issues and risks linked to possible post-Brexit divergence. I note that the picture painted by the report is not particularly alarming. I can confirm that, from a supervisory perspective, which is my remit, the ECB is confident that continuous and faithful adherence to international standards, which we unfailingly support, should normally allay the most significant concerns. Nevertheless, on the European side, we need to have a comprehensive view of the potential risks banks are exposed to as well as the effective capacity to manage and supervise them. To do so, further amendments to the European framework may be necessary.

Preserving international standards

I will start with the basic facts: for the purposes of banking regulation and supervision, the United Kingdom is now, after Brexit, a third country. It is a unique one, with many more links to the European Union than others. The UK remains a major banking jurisdiction – it is home to a very large banking system that includes two global systemically important banks, and it is also an important host country and international financial centre where all the world’s major banks, including from the EU, have significant banking activities. This is why, both before and after Brexit, I have had no doubts about the United Kingdom’s commitment to the international standards for banking supervision. Not only has the UK promoted these standards since their inception – I recall that the first Basel accord on capital standards was drawn up under the aegis of Peter Cooke, Associate Director at the Bank of England – but fundamentally it has an even greater incentive to do so today. As shown by the great financial crisis, which had a heavy toll on the United Kingdom, the costs of a banking crisis for an important banking centre are so high that it is completely rational to promote and strictly adhere to international standards of robustness when looking to develop an international banking activity. This is equally true for the European Union, both now and in the future.

This is why the most important message about prudential regulation – one which ECB Banking Supervision is equally committed to promoting both in Brussels and in London – is that we all need to implement the last set of Basel standards agreed in 2017 on time and in a complete manner. This last leg of the Basel III reforms is the best way to ensure the convergence of capital standards for international banking supervision worldwide, and is therefore key for the relationship between the United Kingdom and the European Union, and for our relationships with the United States and Japan, among others. It is our best tool, recommended by the international community of experts, to promote consistency and trust in the calculation of risk-weighted assets, and it strikes a sound balance between standardised and internal model-based approaches. The reform also increases the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment risk and operational risk. Finally, it is designed to be long-lasting – once fully implemented, it will provide a stable and solid reference framework for all supervisors of international banking.

I would also like to add that we do not see any benefit in further delaying implementation. Quite the contrary, this is a risk we want to avoid. We supported the Basel Committee’s decision to delay the implementation date of the final Basel III reforms by one year to 2023. And the effects of the coronavirus (COVID-19) pandemic are unlikely to persist during the time frame for full implementation of the Basel III reforms. Therefore, continuing along the phase-in path will not jeopardise the financing of the recovery. Indeed, the economic outlook for Europe is favourable: real GDP in the euro area is expected to surpass its pre-pandemic level by the end of 2021, and corporate profits are expected to reach pre-pandemic levels before the end of 2021. In addition, according to the most recent impact study published by the European Banking Authority (EBA), while the impact of the Basel III reforms varied across the banks sampled, most are currently already able to meet the new requirements. So, it seems likely that they would be able to maintain lending to the economy even if some further pandemic-related losses materialised in the short term. Finally, the ECB’s recent analysis^[1] of the macroeconomic impact of implementing the last leg of the Basel III reforms, which used alternative economic scenarios with varying effects from the COVID-19 pandemic, shows that the short-run phase-in costs of the Basel III reforms in terms of GDP growth losses are outweighed by long-term resilience gains. This conclusion does not change under the different COVID-19 impact simulations, and the postponement of implementation by one year to 2023 helps neutralise negative effects on bank lending.

Moreover, preserving an environment that supports credibility in the international banking markets relies on the commitment of all signatories to faithful and timely implementation in their jurisdictions. Postponing or watering down these last Basel III reforms in the United Kingdom or in the EU would send the wrong signal and jeopardise this common good that is key in preventing and mitigating the risks worldwide. Let me therefore emphasise the need to mutually reinforce our commitment to it, by ensuring that the UK and the EU will proceed in the same direction and in as coordinated a manner as possible, while also looking at what is being done in other major banking markets such as the United States.

Strengthening the EU framework

Let me now turn to my second point: does the EU framework need to be adjusted in order to appropriately deal with the risks related to the close links between the EU and UK banking sectors? I will again start with the basics: we need to ensure that our third-country framework is adequate and sufficiently robust. Our first real-life test in this area was managing the transition. And, as I said before, this was a test we passed in that, thanks to the preparations by industry and the public sector for the post-Brexit regime change, we clearly avoided disruptions from cliff effects. But this success was just the start of the journey – we will have to see how business evolves in the future. To focus on the EU side, the United Kingdom is now a third country, meaning that there will be no UK/EU “passported” cross-border provision of services, and banks need to establish either subsidiaries or third-country branches to carry out activities in the EU. I will now examine these aspects from the perspective of ECB Banking Supervision.

Our stance on the cross-border servicing of clients has been clear from the start: empty shell institutions are not acceptable in the euro area.. Banks must allocate sufficient capital and liquidity, as well as an appropriate amount of high-quality resources for risk management, to establishments within the banking union. We communicated our expectations early on, for example in our supervisory expectations on booking models that were published in 2018. In cases where national regimes allow the provision of cross-border services from a third country, the ECB expects banks not to use such set-ups as a means to carry out large volumes of activities in the EU in a business-as-usual environment. Rather, activities and services involving EU clients should be carried out predominantly within the EU.

All banks in the EU need to have adequate risk management policies, procedures and controls in place, ensuring proper risk governance. This means having the necessary resources in the EU to perform these tasks for the head office.

We apply exactly the same policy approach to the subsidiaries of third-country banks, which are EU banks from a legal perspective. They also need to have the necessary resources in the EU to perform the risk management tasks for their head office. We will of course extend this approach to the former investment firms that now have to be licensed as credit institutions. We have fully understood the need to have transition plans, both for transferring the business when it becomes necessary and for developing the proper management risk controls. In particular, we have given the new subsidiaries time to adapt their business and allowed them to continue using models approved by the UK’s Prudential Regulation Authority, giving them more time to adapt the models for validation at EU level. We are now following up with the banks to see how they have adapted to European banking supervision and to ensure that they meet our supervisory expectations.

However, the current EU framework needs to be adjusted to account for the issue of third-country branches. As illustrated in the EBA’s report on the treatment of incoming third-country branches under the national law of Member States^[2], third-country branches carry out a significant volume of activities in the EU and could be relevant for financial stability. At aggregate level, the assets held by these branches amount to €510 billion, and third-country groups are increasingly using branches as a means of accessing and operating in the EU market. Many third-country groups access the EU market by setting up branches and subsidiaries. Overall, branches are used more by third-country groups with a larger footprint in the EU. The recent Capital Requirements Directive amendments (CRD V) introduced a requirement for third-country groups to set up an intermediate parent undertaking (IPU) in the EU if their activities in the EU exceed certain thresholds. The establishment of an IPU allows the consolidating supervisor to evaluate the risks and the financial safety and soundness of the entire group in the EU. However, third-country branches remain branches of the third-country group and will not be part of the IPU.

As the EBA report underlines, the absence of harmonisation of these branches at European level means that their supervision and reporting requirements, which are governed by national law, vary considerably across Member States. This is particularly important for the ECB, as it will be the main supervisor of the IPUs and subsidiaries of many of the larger third-country groups in the EU. We must take the opportunity provided by the review of the Capital Requirements Regulation and Directive^[3] to increase harmonisation in this area. The EBA report makes several suggestions for the co-legislators, some of which will not be new to our UK colleagues, as they have adopted similar approaches at national level. It will, of course, be up to the co-legislators to decide on the approach and the most appropriate level of harmonisation. Therefore, my message today is that, if we want to ensure the effective supervision of these groups, we need to have mechanisms in place that allow for a complete picture of the activities which are relevant for financial stability and that enable us to ensure adequate coordination of supervision.

Conclusion

I would like to conclude this overview by underlining a fundamental consideration about how a supervisor may approach the delicate issues of the EU/UK relationship post-Brexit. I do not think anybody expects a supervisor to deal with global political issues about how the relationship between such close neighbours should be framed. Instead, our task is to advocate in all circumstances for a robust supervisory framework that is conducive to securing the resilience of the banking system. The banking business is one of the most international elements of the global economy. This discussion is therefore an excellent opportunity to underline the two best ways to avoid the risks of a race to the bottom, namely promoting international cooperation on and convergence to high prudential standards, and enhancing the European Single Market approach to ensure that we can adequately capture and manage all relevant risks within our European framework.