At the beginning of this month, the European Central Bank (ECB) took the unusual step of publishing a Guide on the supervisory approach to consolidation in the banking sector. Regulators generally prefer to maintain flexibility in their supervisory approaches so the ECB’s decision to go public would suggest that consolidation is set to become a trend over the coming months, even years. The ECB considers that consolidation could be useful in addressing some of the structural challenges that Euro area banks are currently facing and which have been accelerated by the COVID-19 shock. These include challenges to profitability, excess capacity in the banking system and the increasing importance of digitalisation to banks business models. It also hopes consolidation could foster risk sharing and diversify income streams, leading to a more resilient banking union. The ECB recognises there will be risks to execution but hopes that making its approach more transparent will help to bring about ‘prudentially sustainable consolidation projects.’

So what does the Draft Guide say?

The Guide sets out the ECB’s approach to numerous areas including:

  • the consolidation process starting with early communication, followed by the application and implementation
  • sustainability of the business model as set out in the group wide business plan
  • the ECB’s expectations of the consolidated entities governance and risk management framework
  • timing for early communication
  • the ECB’s approach to setting Pillar 2 capital requirements and Pillar 2 guidance
  • the treatment of badwill
  • the ECB’s approach to banks using internal models after a merger
  • how the ECB will perform enhanced monitoring of execution risks
  • how the ECB will foster swift convergence of the newly combined entity with standard supervisory activities
  • how the approach applies to consolidation transactions involving Euro banks not regulated by the ECB

We discuss some of the key points below.

The ECB continues to emphasise the sustainability of firm’s business models. To help the ECB to assess sustainability, the production of a credible and comprehensive business plan is key. It expects the plan to contain short, medium and long term targets with a roadmap for how to achieve these targets. It should also include a reconciliation of the projected financials to the current financial position of the entities and establish compliance with regulatory requirements, such as firms ICG and capital buffers. Plans should be based on conservative assumptions and contain at least one adverse scenario. The ECB says it will focus on the plausibility of the assumptions in the plan, the valuation of assets and liabilities, the composition of the main profitability drivers and the liquidity and funding structure. The business plan will also guide the ECB’s approach to setting Pillar 2R and Pillar 2G.

Another key focus of the draft Guide is the integration plan which needs to be provided early on but is expected to form the basis for the ECB’s supervisory approach throughout the process. The ECB would look to provide their feedback on the integration plan in the early communication phase. It expects the consolidation to progress in line with the plan but will also be monitoring execution risks by asking firms to report on the progress of the plans implementation and on the issues encountered. Where firms deviate from the agreed plan and timeline, it may take swift supervisory action. Actions could include additional requirements on risk reduction, capital, funding and liquidity or reporting requirements. The ECB also expects to use the integration plan alongside the roll-out plan, to inform their assessment of business viability, with a particular focus on IT issues.

The ECB intends to provide stability in its approach to Pillar 2 through early engagement, consistency and a swift return to BAU supervision, but this does depend on things going to plan. The ECB expects to set the P2R and P2G during the application process for at least a year, unless there are substantial new developments. This would be based on a weighted average of the two entities P2R and P2G prior to consolidation. The ECB would then adjust upwards for significant execution risks or where it sees an insufficient improvement in the risk profile of the combined entity. A downward adjustment could occur where there is an improvement in the resilience of the business model and the risk profile of the combined entity. The ECB says it would like a speedy return to standard supervisory activities, such as the SREP. For entities already supervised by the ECB, the ECB does not expect to set an increased own funds requirement, unless implementation is not meeting the milestones set out in the plan.

 For entities that have permission to use internal models, the ECB has taken a pragmatic approach. It acknowledges that will be a limited period of time in which banks resulting from the business combination might continue to use the internal models that were in place before the merger, but expects there to be a clear model mapping and a credible internal models rollout plan in place, which it may supplement with other conditions.

The ECB considers there is a strong likelihood that badwill will be generated on some transactions and recognises accounting badwill that has been verified, which has the effect of flattering capital ratios. However, it expects that the potential profits from badwill will not be distributed to the shareholders of the combined entity until the sustainability of the business model is firmly established. The ECB intends to examine how badwill is used and how it will contribute to strengthening the post-merger own funds of the combined entity.

The consultation is open until 1 October, so interested parties have plenty of time to feed back their thoughts to the ECB. If the ECB is right in its expectation, then the Euro area banking sector can look forward to interesting times ahead.