Takeaways
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The European Central Bank has been considering the booking model practices used by international banks, and how to prevent the use of “empty shells.”
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The ECB plans to publish more information on its expectations regarding booking models and empty shells in the near future.
On 14 February 2018, the European Central Bank (ECB) published an overview of the key considerations for itself and national supervisors when assessing booking model practices, as well as the issue of “empty shells”. It says that Brexit has triggered discussion of the issue, raising the question of how the single supervisory mechanism (SSM) should address these concerns, as well as asking what expectations the banks should meet. The ECB’s expectations, which are still evolving, align with the principles set out in the European Banking Authority’s October 2017 Opinion on issues related to the departure of the United Kingdom from the European Union.
Single Supervisory Mechanism
The SSM is the system of banking supervision in Europe, comprising the ECB and the national supervisory authorities of the member states and other participating countries. Along with the single resolution mechanism, it is one of the two pillars of the EU banking union. The ECB directly supervises the largest banks and the national supervisors monitor the others.
Booking Models and Hedging Practices
Banks use booking models to determine how and where their organisations transact, and how the resulting risks are managed within a specific jurisdiction and across multiple jurisdictions. Hedging involves the market use of financial instruments to offset the risk of adverse price movements.
The ECB says that “booking models and hedging practices can impede the development of local capabilities by transferring the management of certain risks” and that this can lead to “operational risks and financial stability issues for the country hosting the empty shells.”
Empty Shells
According to the ECB, an empty shell bank, typically, does not have adequate or sufficient local risk management and governance structures or staff and operational independence to manage risks effectively and ensure the safe continuation of the local business or the smooth wind-down of positions in a crisis situation.
UK-based banks, fearing the loss of their passporting rights, and looking to establish themselves in the EU27, or perhaps in the process of doing so, will need to pay close attention to the ECB’s expectations including any further information that is published by it in the near future.
—Tim Wright, Partner
Five Key Areas
The ECB and national supervisors will focus on five key areas when assessing booking model practices:
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Internal governance, staffing and organisation
Banks must:
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have an adequate and skilled management body, which is locally based and can effectively oversee the local entity’s activities and booking practices;
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locally manage the risk of their material products and risk categories without needing to overly relying on third-country operations; and
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have front office capabilities that are sufficient to cover their business activities and are in line with the bank’s strategy and business plan.
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Business origination and financial market infrastructure access
To manage market risk, banks must ensure that their access to financial market infrastructures (FMIs) is not fully dependent on group entities based in third countries (i.e. outside of the EU). They must have business continuity arrangements which ensure access to FMIs at all times for all relevant risks covering crisis scenarios in which they do not rely on third-country group entities for FMI access.
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Booking and hedging strategy
Intragroup back-to-back hedging strategies and remote booking with group entities in third countries should not be relied on, and relocated banks’ local trading and hedging capacities will need to be demonstrated. Business plans should describe how trading, hedging, risk management and operations will continue in a crisis situation albeit on a lesser scale than business as usual.
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Intragroup arrangements
Where banks rely on pricing, trading, hedging or risk management capabilities based in third countries they will need to provide their supervisor with details of how they plan to transfer or establish such capabilities so that they can sufficiently service their material European businesses and/or entities. Such banks must show that they have demonstrable control and balance sheet risk oversight within the EU perimeter.
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IT infrastructure and reporting
Banks must produce complete and accurate data on their booking models, hedging strategies and intragroup exposures, so as to ensure that risks associated with intragroup positions are monitored by the bank and can be reviewed by the ECB. These requirements will be applied proportionately on a case-by-case basis with reference to the materiality and complexity of the bank’s capital market activities. Large banks with high interconnectedness and complex capital market operations will therefore have to meet a higher bar than smaller, simpler, banks.
The ECB and national supervisors plan to carefully assess banks’ plans to establish or expand operations in the euro area. These banks should 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, ensuring that their capabilities are aligned with their business activities.
Next Steps
Banks planning to relocate business from the UK to the euro area should carefully consider, and incorporate, the ECB’s expectations into their applications for authorisation and their Brexit plans. Existing SSM banks should review and adjust their governance, models and arrangements, as appropriate, as part of their planning processes—considerations related to their booking models must be dealt with in business plans and regulatory submissions.
