Despite it being the height of the holiday season, central bankers at the ECB found the time to issue a newsletter on 14 August calling on banks supervised under the Single Supervisory Mechanism (SSM) to step up their Brexit preparations. This seems to have been driven by a perception that banks had been “easing off” on preparations, especially, since the April extension to Article 50. With the new UK government apparently sticking firmly to its policy of leaving the EU on 31 October, there is a renewed sense of urgency.
The ECB’s newsletter reiterates the positions previously expressed by the ECB regarding its expectations as to the level of substance required to be created and maintained within the territory of the EU-27, its approach to outsourcing, remote and back-to-back booking models, and related matters. The ECB also emphasises its view that banks should use the remaining time before 31 October to make sure they are fully prepared – in particular, that boards should step up their preparations to complete their target operating models and, where applicable, fulfil their commitments to the ECB to build up local risk management capabilities and governance structures in the EU-27.
Since Article 50 was triggered, the EU has generally taken a robust stance on issues relating to EU substance, pushing back on perceived attempts by UK-based banks (including international entities whose European headquarters are in the City of London) to put in place work-arounds to mitigate against the loss of passporting and status as EU authorised entities. Broadly speaking, the EU has pursued a policy of relocation from the City to the EU-27 and has sought to limit the use of “empty shells” as well as insisting on strict controls and limitations in relation to remote booking and back-to-back booking models.
Much planning and preparation has, of course, already taken place. Global banks with European headquarters in London have established new entities in Paris, Frankfurt and Ireland and have been in the process of recruiting staff in their EU locations (or relocating certain staff). Although, the ECB is now stating publicly its confidence that a no-deal Brexit will not unduly impact financial stability, it wants banks to continue preparing for all possible contingencies. However, the ECB appears to be concerned that, to date, substantially fewer activities, critical functions and staff have been transferred to EU-27 based entities than it originally expected. The ECB is indicating that while it has taken a flexible approach to date in allowing banks time to build up their capabilities within the EU-27, it intends to follow up with banks on commitments that they have made in relation to these issues, and to track their progress in establishing target operating models. This work is likely to be included in the normal ECB Supervisory Review and Evaluation Process (or SREP).
In addition to calling on banks to step up preparations for Brexit as described above, the ECB flags up a number of areas where it says its supervisory expectations have not been met. These include the controversial areas of “back-branching” and remote booking practices with back‑to‑back hedging. The former concerns the servicing of EU-27 customers from UK branches of EU banks post-Brexit. As a matter of law, as a branch (unlike a subsidiary) is the same legal entity as its licensed head office, there is not the same legal prohibition on a branch continuing to perform services on behalf of customers in the EU-27. However, as a practical matter, the attitude of regulators is crucial. The ECB has repeatedly expressed its view that the purpose of branches in third countries should be to meet local needs rather than providing services back to customers based in the EU-27 (though that view does seem at odds with how many global banks in fact operate and how they have operated for a prolonged period of time).
The ECB’s previously issued FAQs have said that banks need to be in a position to “clarify” the role of such branches and provide supervisors with detailed information on their activities. The August newsletter, in fact, goes a step further stating that entities should “adjust” (i.e. cut back) on this practice. The ECB has already said that it will review on a case-by-case basis its decisions this Spring authorising euro-zone banks to retain branches in the UK post-Brexit. The legal justification for such an approach, and whether it is required by or is consistent with EU law, can certainly be debated but the practical reality is that the ECB is in a position to exert significant leverage over SSM in-scope firms who want to obtain or retain their EU licences.
The ECB continues to press banks to curtail the use of back-to-back transactions, promising to monitor closely their booking policies. The FAQs emphasise that banks must have sufficient capabilities (e.g. local infrastructure, staff and risk management functions) to manage all material risks locally and, specifically, for back-to-back, that part of the risk generated is managed and controlled locally. The euro-zone’s central bank also expects firms to have contingency plans that enable risks being overseen in third countries to be on-shored in certain circumstances, for example, where the third country branch or affiliate is in financial difficulty.
The takeaway is clear: banks need to ensure that their target operating models are calibrated carefully and can be justified, while bearing in mind the ECB is likely to push for their reliance on UK operations to be curtailed.