Blog post by Andrea Enria, Chair of the Supervisory Board of the ECB

Frankfurt am Main, 19 May 2022

On 1 January 2021 the United Kingdom left the single European market. From the perspective of the European Union, the United Kingdom is now a third country. UK-based banks wishing to provide services in the EU can no longer do so via passporting, i.e. the right of a bank to serve customers across the EU from one EU Member State, either through the free provision of (cross-border) services or by establishing local branches under preferential terms.

? Banks that relocated business from the UK to the EU following Brexit must have adequate local governance and risk management capabilities, says Supervisory Board Chair Andrea Enria in his latest contribution to The Supervision Blog https://t.co/J1u0DB5OVb

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— European Central Bank (@ecb) May 19, 2022

Several international banks decided to relocate business from London to subsidiaries in the euro area – standalone EU legal entities subject to supervision under the Single Supervisory Mechanism (SSM entities). The alternative option of relying on third-country branches operating under national supervisory regimes has been less used, as such entities cannot provide services to customers across the whole of the EU. These firms are operating a global business model across multiple jurisdictions and need to satisfy both their home and their host supervisors.

The desks-mapping review, i.e. the review of booking and risk management practices across trading desks active in market-making activities, treasury and derivative valuation adjustments, is part of the supervisory work aimed at ensuring that third-country subsidiaries have adequate governance and risk management capabilities and do not operate as empty shells. It was launched as ECB Banking Supervision assessed (i) that banks had not made sufficient progress in ensuring adequate local trading presence and risk management capabilities in their newly established entities in the euro area; and (ii) that banks need clear instructions for appropriately implementing the target operating models previously agreed with their Joint Supervisory Team. In this work we engage with our European, UK and international counterparts to make sure that the rationale behind our supervisory policies is duly understood by all parties involved.

The booking model of a banking group defines how and where the group books its transactions for specific products and clients and how and where the resulting risks are booked and managed within the group. In its 2018 supervisory expectations on booking models^[1], the ECB clarified the need for banks to retain demonstrable control and oversight of balance sheet risk assumed in the euro area. Banks not only need to ensure adequate levels of local capital and liquidity, they also need adequate local risk management staff in terms of quantity and quality as well as appropriate local internal governance, IT and reporting infrastructures.

But why does the ECB care about this? As the supervisor for the euro area, it is our duty to protect the depositors and other creditors of the local legal entity, prevent the disruption of banking services and safeguard broader financial stability in our area of jurisdiction. In this context, empty shell structures – legal entities located in the euro area that book exposures remotely with their parent company or book them locally but rely fully on risk management hubs and financial infrastructures located in third countries, often by means of back-to-back mirror transactions and hedges transferring the risk to their parent entity – are a very real concern.

First, these structures are exposed to heightened operational and counterparty risk vis-à-vis their parent affiliate. 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, where applicable, 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. Second, 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. Third, reallocating risk and revenue to third-country affiliates can worsen the incentive structure for local bank management.

The first phase of the desks mapping review, which was launched in spring 2020 and focused on 264 trading desks across seven institutions and affiliated investment firms^[2], found that the incoming banks do not yet retain full control of their balance sheets, as prescribed in the ECB’s 2018 expectations. 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 supervisory scrutiny in response to these findings was purely risk-based and took a proportionate approach based on materiality. Based on a quantitative assessment of the materiality of the prudential risks originated by the SSM entities’ trading desks, the ECB concluded that 21% of the 264 desks assessed during the first phase warranted targeted supervisory action. This represents around 46% of the risk-weighted exposure amount (RWEA) of the incoming banks’ trading desks. Considering the trading desks whose current set-up already provides for local risk management in the euro area, the implementation of the desks mapping review is expected to lead to up to 67% of the RWEA of these seven incoming banks’ trading desks being managed in accordance with our expectations. To ensure our supervisory actions are consistent and comparable, the 56 trading desks warranting supervisory action were determined based on a common set of risk indicators. Absolute and relative (to other desks in the same institution) risk indicators were constructed for each trading desk based on (i) total capital market RWEA, to capture the risk generated by each desk; (ii) total net trading income, to gauge the relevance of revenues shifted offshore by each desk; (iii) traded notional amount, to have an absolute indication of volumes processed; and (iv) ticket count, to assess the materiality from an operational perspective.

For the desks identified as material, we will issue individual binding decisions to the incoming banks. These decisions may require the bank to (i) appoint a head of desk within the euro area legal entity with clearly defined reporting lines and a compensation structure linked to the performance of that entity; (ii) ensure the desk has the adequate infrastructure and number and seniority of traders to manage risk locally; (iii) establish a solid governance and internal control framework of remote booking practices with parent affiliates; and (iv) ensure limited reliance on intragroup hedging.

The ECB is navigating uncharted waters. No major supervisor has ever had to assume, over a short period of time, the integration of a significant number of incoming institutions with global market activities belonging to groups headquartered in third countries in its supervisory remit. The ECB is not setting specific targets for the relocation of banking business to the euro area. Instead, we want to ensure that incoming legal entities have onshore governance and risk management arrangements that are commensurate, from a prudential perspective, with the risk they originate. The extent of the actual relocation and specific booking configuration will depend on the current set-up of each bank and how it decides to implement the supervisory expectations. The ECB is mindful that its expectations may lead to changes to the current set-up of some banking groups and intends to apply its policy in a proportionate manner. For instance, we are aware that the risk arising from some foreign exchange products may be more efficiently managed in accordance with a centralised group-wide set-up. Furthermore, the ECB is also taking into account in its assessment the complexity of some products, for which the convenience of having a centralised management could be considered.

The review of trading desks and their associated risks does not mark the end of the ECB’s supervisory scrutiny of incoming banks’ post-Brexit operating models. Investigations into credit risk-shifting techniques, the reliance on parent entities for liquidity and funding, and internal model approvals are still ongoing. This work has a key overarching objective: to ensure that all SSM entities have prudentially sound risk management arrangements and a local presence which enables effective supervision and is commensurate with the risks they originate.

Source: ECB