ECB consults on the revision of its Options and Discretions under CRD CRR

Changes for large exposures intragroup exemption will significantly impact 'back-to-back' risk transfer models

On 30 June 2021, the ECB published its updates to its options and discretions (O&D) policies under EU banking legislation (CRD/CRR) for public consultation, which ends on 23 August 2021. In this context, we draw particular attention to a proposed modification of the intragroup exemption within the large exposure regime, which is to be replaced by an 'ex ante' (case-by-case) prudential assessment. Once the ECB has evaluated the responses received to the consultation, it will publish revised versions including its assessment of the comments. It is not clear when the final versions will enter into force.

The modification would address concentration risks resulting from the systematic application of 'back-to-back' booking practices between EU incorporated banks and third country entities in their consolidated banking groups including in the UK. In doing so, the ECB is specifically targeting Brexit-related exposures, as such large scale 'back-to-back' risk models were set up primarily to deal with Brexit licensing constraints against the backdrop of financial and non-financial resources being at a relatively low level for the relevant European affiliates in the group.

For EU affiliates operating in the context of third country groups, this would mean that it would no longer be possible to apply the full or partial exemption without first asking for supervisory approval. The approval process is notwithstanding the equivalence status of the third country based entity concerned.

Speedread

• The ECB is targeting systematic Brexit inspired 'back-to-back' exposure structures between EU banks and their UK affiliates
• New exposures or new types of exposures by EU banks to third country affiliates that require the benefit of the group exemption would be made subject to a formal approval process
• UK based groups that have implemented 'back-to-back' models will face increasing supervisory pressure to reduce the scale of intragroup dependency and exposures and bolster financial and non-financial resources in their EU bank affiliates

Introduction

The ECB's proposed revisions to the O&D instruments mainly reflect legislative changes since 2016 (relating particularly to CRR II which came into force on 28 June this year). Most of the revisions relate to liquidity requirements (re NSFR and LCR). In addition, they address capital reductions, the leverage ratio and the aforementioned exemption from the large exposure limit.

The O&D instruments – in terms of an administrative practice and expectation management – are aimed at providing transparency on how the ECB exercises options and discretions in the ongoing supervision of designated significant institutions (SIs), ensuring consistent application of supervisory standards and supporting consistency in the supervision of significant and less significant institutions (LSIs), i.e. strengthening convergence in the prudential regulation of banks. The O&D policies revised by the ECB in close cooperation with the national competent authorities (NCAs) are proposed to apply generally, for the first time, to both SIs and LSIs.

Large exposures limit

The ECB proposes to introduce a change to its policy on exempting intragroup exposures from the large exposures limit under Article 400(2)(c) CRR.

Currently, it is possible to self-apply a full exemption of intragroup exposures by EU banks involving third country affiliates from the large exposure limit set out in the CRR – without first requiring supervisory approval. This is done through the direct application of the relevant criteria set out in the ECB Regulation ((EU) 2016/445) in the case of SIs. The same principle applies at a domestic level for LSIs subject to the supervisory practices of the relevant NCA.

While the possibility of such an exemption is to remain in general, the current policy will be replaced by an 'ex ante' prudential assessment according to which a full, partial or no exemption would be granted.

More specifically, this would mean that the ECB – or rather its Single Supervisory Mechanism (SSM) – intends to grant such exemptions from the large exposures limit set out in Article 395(1) CRR in respect of intragroup exposures listed in Article 400(2)(c) CRR – where such exposures are to affiliates established in third countries – only after conducting a case-by-case prior assessment of the requirements set out in Article 400(3) CRR. The relevant Article 9(3) of the ECB Regulation is to be amended accordingly.

The requirements referred to in Article 400(3) CRR are further specified in Annex I to the ECB Regulation in accordance with Article 9(3) thereof.

• Generally, the risk of the exposure must be eliminated or reduced by the specific nature of the exposure, the counterparty or the relationship between the institution and the counterparty and any remaining concentration risk must be addressed by effective (written) policies and procedures.
• Further criteria to be met include the evaluation of the counterparty's risk assessment, measurement and control procedures, alignment with the group's funding structure, an arm's length bank internal decision-making process in approving such exposures, a proper risk control framework, identification of exposures as part of ICAAP management and consistency between the management of concentration risk and the group's recovery plan.
• As part of the approval process, the EU bank must submit (i) a letter of confirmation approved and signed by its management to demonstrate compliance with all criteria and (ii) an external or internal legal opinion stating that there are no impediments to the bank attaining the eligibility criteria.

There would be at least a limited grandfathering of existing exposures. Intragroup exposures to third country affiliates already fully or partially exempted from the large exposure limit under Article 9(3) of the ECB Regulation would not have to be approved. However, as part of its ongoing supervision, the ECB would review these existing exposures in light of the exemption eligibility criteria. New or new types of exposures to group entities in third countries would be subject to the case-by-case prudential assessment in full.

Targeting Brexit 'back-to-back' booking models

The ECB's announcement is mainly regarded as targeting the 'back-to-back' risk models (using to reallocate the risk of trading and lending activities) built in the course of Brexit transition between the well-established and capitalised UK headquartered banks and their often less capitalised EU affiliates. The newly acquired decision-making power under the revised O&D instruments would allow the ECB to object to requests to exclude intragroup transactions with non-EU affiliates from an EU bank's large exposures limit.

The ECB's move is intended to restrict the EU affiliates of UK banks from substantially managing their risks via such 'back-to-back' arrangements with UK and other non-EU affiliates.

The ECB itself states this impetus in its publication by saying that its "special attention to large exposures" results "from systematic use of 'back-to-back' booking practices" by some market participants in consolidated banking groups. "This", it says, "is a prudential concern which was not of the same importance when the ECB Regulation [was] first introduced". It becomes clear from this that Brexit risk transmission internal structures, now a reality, are the main driver and target of this revision. The ECB is thus (expectedly) committing towards its post-Brexit strategy. The change is an obvious and effective tool in regaining or preserving control and supervisory influence. It remains to be seen whether the equivalence status of the UK under the CRR (if any) will affect the ECB's approach.

Practical implications

Banking groups affected will have to review the extent to which they satisfy the criteria laid down by the ECB against which each application will be assessed. The proposal will involve the eligibility criteria being explained and attested to by senior management of the EU affiliates. For existing arrangement, the ECB states that it will review banks' satisfaction of the criteria in the ordinary course of the supervisory dialogue.

The ECB will look at the individual models and draw its conclusions. Whether there will still be room for such models to underpin UK based groups' scaled business models remains to be seen. We expect UK based banking groups to consider the pace and scale of dependencies at their EU affiliates proactively and thus avoiding a potentially disruptive and abrupt regulatory intervention.

Authors: Etay Katz, Partner; Tobias Bauerfeind, Associate