This blog was published on 24 May 2022.


At a glance

  • The ECB recently published a blog setting out the findings of its desk-mapping review, which looked at how widely seven international banks transferred the risk of their eurozone operations outside of the EU.
  • The ECB’s review is grounded in concerns about the prudential soundness of banks’ risk management arrangements.
  • The ECB is particularly concerned about “empty shell” structures and is uncomfortable with banks’ use of split desks.
  • While the ECB’s review has only assessed the practices of seven international banks, its findings will be relevant to all banks subject to the SSM.
  • It appears likely that many of the seven banks will have to appoint more senior staff to their EU entities and overhaul their booking model practices, adding to their costs.
  • Banks will want to ensure they consider the findings of the ECB’s review alongside the EU’s wider set of proposed reforms to third country branches and cross-border market access.
  • This is not the end of the ECB’s supervisory scrutiny of incoming banks’ post-Brexit operating models, although the ECB has not provided a timeline for when it might complete its work.

Introduction

On 19 May 2022, Andrea Enria, Chair of the Supervisory Board of the ECB, published a blog setting out the findings of the first phase of the ECB’s desk-mapping review, i.e. the review of booking and risk management practices across trading desks active in market-making activities, treasury and derivative valuation adjustments.

The review assessed how widely seven international banks transfer the risk of eurozone operations outside the bloc, in particular to the UK. This transfer of risk is typically done via back-to-back mirror transactions and hedges transferring the risk to their parent entity.

Concerns over empty shell structures

In the blog, Mr Enria sets out the ECB’s “very real concern” about banks’ use of empty shell structures – legal entities located in the euro area that book exposures remotely with their parent company or book them locally but rely fully on risk management hubs located in third countries.

Whilst it is clear that the ECB has assessed banks' use of, and has concerns about, both remote booking and back‑to‑backs, the review’s findings do not distinguish between the two. The ECB’s focus is on the risks which the EU entities originate.

Mr Enria emphasised the ECB was taking a risk-based approach: “The ECB is not setting specific targets for the relocation of banking business to the euro area. Instead, we want to ensure that incoming legal entities have onshore governance and risk management arrangements that are commensurate, from a prudential perspective, with the risk they originate.” This tackles any criticism that the motivation for the review is to cause market activity and jobs to move from the UK to the EU. The ECB is very clear that the review is grounded in concerns about the prudential soundness of banks’ risk management arrangements and the need for a local presence which enables effective supervision.

Findings from ECB’s desk‑mapping review

  • The review looked at 264 trading desks across the seven banks.
  • It found that incoming banks do not yet retain full control of their balance sheets, as prescribed in the ECB’s 2018 expectations.
  • Some 70% of the desks assessed still implemented a back-to-back booking model, which allows them to offset EU trades with their UK entities and effectively manage the risk from there.
  • Around 20% of the desks were organised as split desks, “whereby a duplicate version of the primary trading desk located offshore is established within the euro area legal entity to manage the part of the risk originated there.”
  • 21% of the desks assessed during the first phase warranted targeted supervisory action. This represents around 46% of the risk-weighted exposure amount (RWEA) of the incoming banks’ trading desks.
  • Considering the trading desks whose current set-up already provides for local risk management in the euro area, the implementation of the desk-mapping review is expected to lead to up to 67% of the RWEA of these seven incoming banks’ trading desks being managed in accordance with the ECB’s expectations.

One conclusion we draw from this is that the ECB is uncomfortable with split desks, with a preference for desks which handle EU clients or assets to be wholly in the EU. It is also unclear what the ECB’s attitude is to the 33% of RWEA which are not managed in accordance with its expectations. As the review is still ongoing, it is possible that these will be dealt with in the next phase (discussed below).

Although the ECB’s emphasis is very much on the business which the EU entity originates being governed and risk managed in the EU, it does leave open the possibility of the ECB agreeing to some centralised risk management of products outside the EU. The two it mentions are FX and complex products.

ECB actions for banks

  • The ECB identified the 56 most material desks, where it will issue individual binding decisions to the incoming banks.
  • These decisions may require the bank to:
    1. appoint a head of desk within the euro area legal entity with clearly defined reporting lines and a compensation structure linked to the performance of that entity;
    2. ensure the desk has the adequate infrastructure and number and seniority of traders to manage risk locally;
    3. establish a solid governance and internal control framework of remote booking practices with parent affiliates;
    4. ensure limited reliance on intragroup hedging.

Further ECB activity and next phase

Mr Enria emphasised that this is not the end of the ECB’s supervisory scrutiny of incoming banks’ post-Brexit operating models. Investigations into credit risk-shifting techniques, the reliance on parent entities for liquidity and funding, and internal model approvals are still ongoing, although the ECB has not provided a timeline for when these might be concluded.

Conclusion

The blog makes clear that the ECB has engaged with its European, UK and international counterparts to make sure that they understand the rationale behind its approach. This is consistent with what the PRA’s Executive Director, Nathaniel Benjamin, said to the House of Lords European Affairs Committee in March when he noted that the PRA and ECB would consider any proposals for staff relocations “together” before anything went ahead and that the ECB had expressed optimism that they could find an approach that “works for everyone”. Mr Benjamin said that to date there had not been any attempts to “move large numbers of staff to the continent”.

Mr Benjamin also indicated that “anything not firmly grounded in prudential standards would be problematic for us [the PRA]”. As noted above, the ECB has emphasised that the review’s findings and the ECB’s actions are indeed rooted in prudential concerns.

Banks' booking models have been an area of supervisory focus across a number of jurisdictions, and the ECB’s review reflects common supervisory concerns about how such risks are handled. While the ECB’s review has only assessed the practices of seven international banks, its findings will be relevant to all banks subject to the SSM. The review makes clear that the ECB is concerned that its 2018 supervisory expectations are not being fully complied with, and all banks subject to its supervision will want to review their practices to ensure they are aligned with the ECB’s expectations. 

While the overall numbers for staff and capital being relocated remain unclear, the PRA’s previous comments suggest that the overall figures may not be large. While only 21% of desks reviewed will have to make material changes to the way they are structured and staffed, it’s clear that these are the larger (and riskier) of the desks the ECB reviewed, as they account for 46% of the banks’ RWEA.

This said, it appears likely that many of the seven banks will have to appoint more senior staff to their EU entities and overhaul their booking model practices, adding to their costs. Retaining risk within the EU entity will consume more regulatory capital, although whether this will require additional capital injections remains unclear.

Finally, banks will want to ensure they consider the findings of the ECB’s review alongside the EU’s wider set of proposed reforms to third country branches and cross-border market access, in order to form a joined-up picture of what this means for their future European footprints and legal entity structures.