This blog was published on 27 October 2021.
The European Commission’s legislative proposal to revise the Capital Requirements Directive (CRD6) will, if adopted, introduce a tougher and more intrusive approach to the regulation and supervision of branches of third country banks.
At a glance
- In essence, this is a “levelling up” proposal. It will transform what today is a largely national approach to the authorisation and supervision of third country branches (TCBs) into a harmonised and standardised framework. In future, the Commission (which will decide whether a third country’s banking prudential approach is equivalent), the EBA and the ECB will all have a more central and influential role in relation to TCBs.
- The new regulatory framework will introduce tiering of TCBs based on their size. All TCBs will experience a significant (and potentially costly) increase in regulation, including from maintaining capital endowments in the branch, new internal controls and governance requirements, the need to commission independent reports and more granular regulatory reporting.
- However, the most intrusive measures are reserved for systemically important TCBs which could, under certain circumstances, be required to turn their branches into subsidiaries.
- The influence of Brexit is apparent in the proposal, particularly its focus on booking arrangements and the need to track and report on business done with EU clients by means of reverse solicitation.
- Overall, this package represents a significant overhaul of the EU’s regulation of TCBs. Much will depend on how supervisors use the range of tools that will in future be available to them, particularly in respect of systemically important TCBs. If used to their full extent, they will alter the costs and benefits of doing business in the EU through a TCB, just at the time many third country banks are reassessing their European footprints in the aftermath of Brexit. The treatment of TCBs is another factor they will have to incorporate into their assessment of the economics of doing business in the EU.
The European Commission has just published its legislative proposal on CRD6 as part of its wider package of legislation to implement Basel 3.1 and deal with a number of other matters relating to bank prudential regulation. The purpose of this blog is to highlight some of the key issues in CRD6 that relate to the regulation and supervision of TCBs. As always there are many devils in the detail which we do not cover here. Moreover, the full picture will not be complete until the proposal becomes law (a lot could change between now and then) and the EBA has produced numerous guidelines and technical standards, as required by the proposal.
At present, responsibility for the authorisation and supervision of TCBs rests with individual Member States and their national competent authorities (NCAs), resulting in fragmented and potentially inconsistent approaches. The EBA identified the drawbacks of this in a report which it published in June. The Commission’s proposal picks up where the EBA left off and puts forward a standardised and harmonised framework in which NCA discretion, while not eliminated, is certainly constrained.
Authorisation and equivalence
All TCBs will be subject to an authorisation requirement, including a reauthorisation requirement for existing TCBs. The proposal provides for a 12-month transitional period following the 18-month transposition period for CRD6. This means that TCBs will have two years and six months starting from the date of the implementation of the Directive to obtain the authorisation.
The proposal differentiates between:
- Class 1 (individual branch): total value of the assets booked by the TCB in the Member States is equal to or above EUR5bn or it takes retail deposits, or it is not a “qualifying TCB”. [A qualifying TCB is from a country whose banking prudential regime and confidentiality requirements are equivalent to the EU’s and which is not listed as a country which has strategic deficiencies in its AML and CTF regimes.] As at 31 December 2020, 66 out of a total of 106 TCBs qualified as Class 1.
- Class 2 (individual branch): assets below EUR5bn. As at 31 December 2020, 40 TCBs qualified as Class 2.
In future, TCBs will have to assess carefully the costs and benefits of increasing their assets above the Class 2 threshold.
Minimum regulatory requirements
We have set out below some of the main minimum requirements which apply to all TCBs. While some of these requirements are already in place in individual Members States, imposing them uniformly across the EU represents a material step-up on the status quo.
- Capital endowment requirement. For Class 1 TCBs, 1% of average liabilities over the previous three years subject to a minimum of EUR10mn. For Class 2 TCBs, EUR5mn. The assets which are eligible to meet the requirement are: cash or cash equivalents; EU government/central bank debt securities; and any other instrument (guidelines to be developed by the EBA) that is available to the TCB to cover losses as soon as those losses arise. These assets must be held in an escrow account and pledged in favour of the national resolution authority.
- Liquidity requirements (which can be waived by NCAs for qualifying TCBs). In essence this involves complying with the LCR. HQLA must be held in escrow and pledged, as for the capital requirements. We assume that assets used to meet the capital requirement cannot also be used to cover the liquidity requirement, and vice versa.
- Internal governance and controls. A lengthy set of requirements, including a lot of focus on outsourcing and on delegation of critical/important functions to the TCB’s head office. Controls over back-to-back and intragroup operations are deemed particularly important. In this connection, TCBs which engage in back‑to‑back or intragroup operations must have adequate resources to manage the resulting counterparty credit risks. Perhaps most significantly, supervisors will have to commission “periodically” an independent third party to assess implementation and ongoing compliance with the internal governance and controls requirements.
- Booking requirements. TCBs must maintain a “registry book” – a comprehensive and precise record of all the assets and liabilities associated with the TCB (including those booked or held remotely in other branches or subsidiaries of the same group). There is also a requirement for a regular independent assessment of compliance with the booking requirements. The focus on booking, outsourcing and reverse solicitation (cf. the section on reporting below) most likely results from the Commission’s and ECB’s experience of Brexit.
A significant addition to the proposals (which was not covered in the earlier EBA report) is that third country banks undertaking CRD Annex 1 activities in an EU Member State must do this via a branch or subsidiary presence, unless this regulated activity is performed via reverse solicitation. This would potentially threaten the patchwork of national regimes providing for third country access which allow third country banks to access certain EU markets without a physical presence. It should be noted that the CRD6 proposals are limited to CRD activity (i.e. lending and deposit taking) rather than extending to the full remit of MiFID activity. There is likely to be significant interest in these proposals from Member States, a number of which clearly value an open approach to market access.
An assessment of systemic importance is triggered when the aggregate assets of all TCBs from the same group across the EU are equal to or exceed EUR30bn on average over the immediately preceding three years or in absolute terms for three out of the immediately preceding five years. The EBA will develop indicators of systemic importance which will take into account, inter alia, the size, interconnectedness, substitutability and complexity of the TCB’s activities.
If a TCB is deemed systemically important, the relevant supervisors must use one of the following powers:
- require the TCB to subsidiarise, or to restructure its assets/liabilities so that it ceases to be systemically important;
- impose additional requirements on the EU branches and/or subsidiaries of the third country group, including Pillar 2 capital add-ons for both branches and subsidiaries
- defer imposing any of these requirements for a period of no more than 12 months, subject to the supervisor conducting a reassessment of the TCB’s systemic importance within that 12-month period.
The Commission notes in its impact assessment that as at 31 December 2020 only three TCBs exceeded the EUR30bn threshold and would therefore be subject to potential subsidiarisation.
There is a lengthy list of periodic reporting which TCBs must submit, including of information relating to their head office. Class 1 firms will have to report the information at least biannually; Class 2 firms at least annually. Points of note include the need for the TCB to confirm that its head office complies with its applicable prudential requirements on a solo and group basis; details of the head office’s recovery plan and where the TCB features in that plan; and the business strategy for the TCB. The requirement to report services provided by head office to EU-based clients on a reverse solicitation basis is unexpected and will require data collection and careful monitoring/ classification. The EBA will develop common reporting templates. Complying with these reporting requirements will likely be a significant challenge for some TCBs, particularly those that are not set up to provide this breadth and depth of reporting to a robust standard.
The legislative process for CRD6 has only just begun and, to state the obvious, the shape of the Commission’s proposal may change significantly as it progresses through political negotiations However, what is already clear is that if it were to be adopted in its current form, it would have a significant impact on TCBs operating in the EU, particularly on Class 1 and any systemically important TCBs.
The Commission notes that the powers it is proposing are similar to those available to other regulators. However, one important distinction is that other international regulators have had and used their powers for a number of years and this “track record” gives TCBs some clarity and certainty over how the powers will be deployed. This will not be the case in the EU once the new framework is finalised. So there is bound to be uncertainty, at least for an initial period.
This uncertainty comes at a time when most third country G-SIBs are re-evaluating their presence in the EU in response to several drivers – the overall sluggish business environment, exacerbated by post-Brexit inefficiencies in their operating models, and the prospect of future regulatory change, including through the introduction of the IPU. TCB branch assets count towards the calculation of the IPU threshold, and this proposal will give TCBs further reason to consider shrinking or otherwise optimising their balance sheets. This all adds up to a very complex equation which third country banks will have to solve in order to determine a sustainable and viable business model for their operations in the EU.
"While third-country banking groups should be free to choose to enter specific markets within the EU via branches or subsidiaries, greater harmonisation of the regulatory and supervisory framework is warranted, also to ensure a firm-wide view of risks and risk management and a level playing field within the banking union." Andrea Enria, Chair of the Supervisory Board of the ECB, 1 July 2021