Banks' Brexit relocation plans inadequate, ECB warns

Out-Law News | 17 Nov 2017 | 9:57 am | 3 min. read

Some of the plans submitted by UK-headquartered banks wishing to continue to operate in the euro area after Brexit have been criticised as inadequate by financial regulators.

Some of the relocation plans submitted to the supervision arm of the European Central Bank (ECB) for approval "seem to lean towards" the use of 'shell' companies, and a structure that is "overly reliant on group entities in third countries", the regulator said in an update. It is particularly concerned about the use of 'back to back' risk transfer models, in which firms transfer risk to risk management and governance functions located outside of the EU.

"Banks do not only need to be well-capitalised and have sufficient liquidity and funding," said ECB Banking Supervision in its statement. "They also need to have substance locally. In other words, there cannot be empty shells or letter box banks."

The ECB said that it had received Brexit-related relocation plans from a number of banks which currently 'passport' into the euro area from a subsidiary or branch in the UK. It said that the preference of many of these banks was that all market risks would be borne by a "third-country group entity", presumably the UK branch or subsidiary.

"In practice, this would mean that the banks in question were fully reliant on the third-country entities," it said in its statement.

"In terms of supervision, the ECB is not comfortable with such an approach which, as the recent past has revealed, could create risks in crisis situations, where local capabilities may be crucial to continue operations. This is a key reason why the ECB and the national supervisors expect banks – at least over the medium term – to manage parts of their risks locally and not to be fully reliant on back-to-back transactions of this type," it said.

As a minimum, the ECB said that banks would be expected to locate "permanent local trading capabilities and local risk committees (including local infrastructure, staff and risk management functions)" within the euro area.

"It also means actually trading and hedging risks with diversified counterparties and not just the group," it said. "This ensures recoverability in the event that the group entity is no longer able to provide its services to the local ones."

The ECB said that its preference would be for banks located in the euro area to employ dedicated staff, rather than for staff to carry out functions for more than one business within the group. This practice is known as 'dual-hatting', and features in "several" of the plans the regulator has received from banks to date, it said.

"Such plans need to be thoroughly assessed as they may limit independence, create conflicts of interest and result in insufficient time being available for each function," it said. "Concerns would be even greater if employees of a euro area bank were seen to be spending most of their working time in a third country and not, therefore, being physically present in the euro area."

"In general, ECB Banking Supervision expects control functions and local governance to be sufficiently independent and banks to have staff in place locally," it said.

Although banks relocating to the euro area may be able to agree transitional arrangements about "specific aspects" of their business with regulators in the destination country, the ECB warned that "certain elements", particularly risk management functions, would have to be put in place immediately. Banks must also be able to "set out clearly what the steady state will be, commit to this and explain how and when they will get there", it said.

"So far, this expectation has not been adequately reflected in banks' proposals," it said.

UK regulator the Prudential Regulation Authority (PRA) is anticipating up to 10,000 UK-based financial services jobs to shift to the EU on 'day one' of Brexit, its chief executive, Sam Woods, told a House of Lords committee earlier this month. The actual number of jobs that will move will depend on the nature of the UK's future trade arrangements with the EU, although Woods has described industry estimates of as many as 75,000 long term job losses as "plausible".

Banking law expert Tony Anderson of Pinsent Masons, the law firm behind, said that future regulatory requirements for affected banks was a "grey area, especially as the terms of Brexit and therefore the future trading relationship between such banks and the Eurozone has yet to be discussed in any real depth".

"It is expected that these plans will evolve over time to reflect the trading relationship as it becomes apparent," he said.