Financial Regulatory Observer
March 2019

31
December 2020
The end of the transition period from the the start of Brexit

 

The current draft of the Withdrawal Agreement (WA) sets out arrangements for the UK’s departure from the EU and Euratom. While it contains numerous provisions on a wide range of issues, financial services are not specifically addressed. Still, Part IV of the WA is of great importance for this sector. Firstly, it provides that there will be a transition period running from Brexit day until December 31, 2020 (Article 126 WA). Secondly, during this period EU law and its acquis will continue to apply to the UK as if it were a Member State (Article 127(1) WA). Lastly, the Joint Committee may extend the transition period by adopting a single decision (Article 132(1) WA). So, the WA would secure the continuation of the status quo in relation to financial services during the transition period, including the EU passporting regime.

From passporting to partial equivalence after the transition period

The EU passporting regime grants Member State financial service providers unrestricted rights to offer financial services throughout the EU under the license granted by their home country and under the supervision of their home country supervisory authority. Due to the EU law principle of mutual recognition and harmonized market access, there is no need to open a local subsidiary and have it licensed in order to provide services in another Member State.

The current draft of the Withdrawal Agreement sets out arrangements on a wide range of issues for the UK’s departure from the EU, but financial services are not specifically addressed

 

Once the transition period has ended, the UK would become a third country. UK financial institutions would lose their automatic passporting rights, and hence their market access to the EU and vice versa. To prepare for this change, the EU and the UK have opted for the regime of equivalence in the draft political declaration on the framework for the future relationship (Point 38 of the Future Framework). This would enable the EU Commission to recognize the UK regulatory and supervisory rules as equivalent to the corresponding EU rules. The EU Commission would have to verify that the UK has legally binding requirements, ensures effective supervision and achieves the same results as required by EU rules. The equivalence assessment would start following Brexit day and be concluded by June 2020.

The benefits reaped from the equivalence regime will probably be far less attractive than those under the automatic passporting regime. Equivalence decisions can only be taken in the areas where it is explicitly provided for under EU legislation. For example, equivalence is not provided for under CRD IV, which means that UK banks can only offer services in Member States in which they are licensed. Other legislative acts include a third-country equivalence regime limited to specific areas, such as MiFID II/MiFiR in relation to investment services. Furthermore, equivalence may only be granted partially, for a limited period, or only to a limited number of a non-UK country’s supervisory authorities. Hence, UK financial service providers would potentially gain only restricted market access in limited areas, which could be revoked at a moment’s notice. This is why the UK’s Chequers plan (a UK Government white paper on Brexit published in July 2018) proposed to introduce a regime of “enhanced” equivalence. However, the Future Framework agreed upon so far falls far short of this.

Similar to the UK’s notion of “enhanced” equivalence, the Association of German Banks (Bundesverband der deutschen Banken e. V.) has issued a proposal to revise the equivalence regime so that decisions would be made on the basis of reciprocity and to extend its scope inter alia to CRD IV services. This is, however, still to be debated at the EU level.

No deal scenario

In the event of a hard Brexit, the UK’s passporting rights will immediately cease at 11:00 p.m. GMT on March 29, 2019. UK entities’ market access to the EU will most likely depend on country-specific rules in force on that date. To avoid major market disruption and instability, the EU has published notices and called upon its Member States to prepare for the eventuality.

March 2019 – June 2020
EC equivalence assessment period, during which the EC will need to verify that the UK regulatory and supervisory rules are equivalent to the corresponding EU rules

 

EU Brexit preparedness

The series of Brexit preparedness notices published by the EU Commission reminds stakeholders that, in the event of a hard Brexit,UK entities would no longer hold an EU passport. This would result in the cessation of the application of CRD IV, CRR and PSD II to UK providers of banking and financial services, of MiFID II and MiFIR to UK investment service providers and of Solvency II to UK insurance/reinsurance providers (extending to online sales).

In order to provide cross-border services into the EU, UK entities would have to apply for authorization in each Member State in which they want to operate. Each entity would be assessed on its own merits by the relevant authority. EU subsidiaries of UK entities would need to be licensed. The notices state that in order to continue using their subsidiaries to provide services, UK entities would need to adhere to the rules of the respective Member State. Moreover, UK subsidiaries of EU-licensed entities would still be required to abide by EU law when conducting their business in the UK.

The EU Commission urges UK entities to assess contracts relating to the provision of financial services on an individual basis, as they might be unable to fulfill all of their contractual obligations without their EU passport.

The Draft German Brexit Act upholds parts of the existing passporting regime for the benefit of UK financial service providers operating in Germany for a transitional period of up to 21 months post-Brexit

 

Grandfathering provisions of EU Member States: The German example

On January 4, 2019, the German Government initiated a legislative process regarding a draft act supplementing the act on taxrelated provisions concerning the withdrawal of the UK from the Union (Draft German Brexit Act, Brexit- Steuerbegleitgesetz), which would be directly applicable in Germany in the event of a hard Brexit. The draft act has two aspects. On the one hand, it entails Brexit-related amendments to German tax law. On the other hand, it contains amendments to several financial services acts, introducing a possible transition period during which UK financial service providers could continue to provide services (banking and financial) and wind up existing contracts in Germany until the end of the transition period (insurance). The amendments regarding financial services are subsidiary to a potential harmonized response on the EU level.

As to the tax-related amendments, the draft aims to insure that current fiscal privileges relying on the UK’s EU and EEA membership will, post-Brexit, continue to apply to those fiscally relevant actions that were executed pre-Brexit. This entails amendments to the Income Tax Act (Einkommensteuergesetz), the Corporation Tax Act (Körperschaftsteuergesetz), the Transformation Tax Act (Umwandlungssteuergesetz) and the Foreign Tax Act (Außensteuergesetz).

As to financial services, the draft act would amend the German Banking Act (Kreditwesengesetz, KWG) and the Insurance Supervision Act (Versicherungsaufsichtsgesetz), empowering the Federal Financial Supervisory Authority (Bundesanstalt für Finanzaufsicht, BaFin) to grant companies domiciled in the UK, which have until now operated cross-border in Germany or have a German subsidiary, to continue their existing business. According to the draft act, it is at the discretion of BaFin to order the application of the EU passport regime in whole or in part to UK-licensed entities for a transitional period not exceeding 21 months starting on Brexit day. BaFin can do so, for example, by means of a general decree which will effect all UK entities concerned.

The application of the EU passport regime to banking transactions or financial services can only be considered insofar as the activity is closely related to pre-Brexit contracts. The explanations annexed to the act make it clear that such a close connection is to be presumed if the activity is legally or economically linked to existing contracts. The draft would thus give affected UK-based companies the opportunity to continue their business in Germany pursuant to section 32(1) KWG within the transitional period. For insurance services, the draft is narrower and only permits those insurance contracts that were agreed upon pre-Brexit to be continued and wound up during the transition period. According to the explanations, this means that UK insurers have to terminate existing contracts with German counterparts and wind them up or to establish a subsidiary in Germany and have it licensed within the transition period.

With regard to the German Covered Bond Act (Pfandbriefgesetz), the draft act proposes protection for British assets covered pre-Brexit. These may continue to be used as coverage until their maturity. In the Building Societies Act (Gesetz über Bausparkassen), the additions grant protection for existing investments in the UK and for the security of claims under real estate liens. The amendments made to the Investment Ordinance (Anlageverordnung) and the Pension Fund Supervisory Mandate (ch 30, Pensionsfonds-Aufsichtsverordnung) mean that German insurance companies and pension funds may keep assets located in the UK as part of their security assets to fulfill their obligations towards the insured pensioners, in so far as these assets have been acquired prior to March 30, 2019.

In summary, the Draft German Brexit Act would directly address the consequences of a hard Brexit for financial services by upholding parts of the existing passporting regime for the benefit of UK financial service providers operating in Germany for a transitional period of up to 21 months post-Brexit. During this period, certain aspects of market access might remain as if UK financial service providers were still holding an EU passport. This, however, would be limited to services agreed upon before Brexit and areas contained in the draft. The time allotted would give UK entities the opportunity to adhere to the German requirements applicable to third-country entities. Consequently, the Draft German Brexit Act facilitates grandfathering but offers less market access than the pre-Brexit EU passporting regime.

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Credit institutions are required to hold a sufficient amount of MREL at all times, consisting of “own funds” instruments and eligible liabilities

 

The Minimum Requirement for Own Funds and Eligible Liabilities (MREL) was introduced in 2016 as part of the bank recovery and resolution directive (BRRD). In the event of a bank failure, the MREL acts as a “buffer” that resolution authorities can use when applying the bail-in tool to absorb losses and provide new regulatory capital to the failing institution.

Although MREL has largely remained a silent issue since then due to the prudent approach followed by regulators in its implementation, the time is now coming for European banks to meet binding MREL targets.

The road to MREL

Resolution authorities have so far adopted a prudent stance in applying the new requirements, which have been phased in gradually. This caution was also due to the timing and complexities surrounding the startup of the Single Resolution Board (SRB) and Single Resolution Mechanism (SRM), the ongoing discussions at the EU level regarding the review of the EU’s regulatory framework on prudential requirements and bank resolution (the Banking Reform Package), and around the significant impact that MREL targets will have on the capital structure of EU banks.

In 2016, the SRB started developing its MREL policy together with national resolution authorities in the Banking Union and communicated non-binding MREL targets to banking groups under its remit. The purpose was to enable banks to prepare for future binding MREL requirements and at the same time to refine the SRB methodology for MREL calibration.

In 2017, the SRB adopted its first binding decisions on MREL requirements for major banking groups, while the 2018 resolution planning cycle was split in two waves of resolution plans—the second one being based on the updated MREL policy it published on January 16, 2019. In this updated policy, the SRB announced its intention to “raise the bar” on MREL targets to better prepare for the upcoming changes to the regulatory framework deriving from the approval of the Banking Reform Package, on which the European Parliament and the Council reached a political agreement on February 15, 2019.

Bank-specific MREL targets are accordingly in the process of being set by resolution authorities in light of the new rules regarding bank capital that will soon be enacted at the EU level. To ensure a smooth transition to full MREL implementation, the SRB has decided to set individual transition periods of up to four years, taking into account bank and market-specific characteristics. But the SRB will also set non-binding interim targets, and banks will be required to submit an implementation and monitoring plan and provide enhanced disclosure on their liability data.

16
January 2019
Updated MREL policy published

 

MREL, capital structures and funding strategies

Credit institutions are required to hold a sufficient amount of MREL at all times, consisting of “own funds” instruments and eligible liabilities that can be used by resolution authorities to absorb losses and recapitalize institutions that are failing or likely to fail. The rationale underpinning the MREL requirement is reflected in the default formula for MREL calibration, which is based on two components:

• The loss absorbency amount (LAA), which is the amount of MREL capital that should ensure the full absorption of losses incurred by the bank in case of resolution. The default LAA is equal to the sum of the bank’s Pillar 1 and Pillar 2 capital requirements and its fully loaded combined buffer requirement
• The recapitalization amount (RCA), corresponding to the amount of MREL capital that would be used by the resolution authority to restore the capital position of the credit institution following resolution. The default RCA is equal to the sum of the Pillar 1 and Pillar 2 capital which the bank would need to maintain to hold a banking license, plus an additional buffer to ensure sufficient market confidence after resolution (which according to the SRB methodology is equal to the combined buffer requirement minus 125 basis points).

It is important to note that the RCA does not apply to those credit institutions where the preferred strategy of the resolution authority is the liquidation of the credit institution or banking group. Hence, the quantitative impact of the MREL requirement will be less significant for smaller credit institutions or groups, whose failure should not pose systemic risks.

Resolution authorities may set and adjust the LAA and RCA on a case-by-case basis, considering also the possibility of adopting resolution tools other than the bail-in (i.e., sale of business, establishment of a bridge institution or a “bad bank”/ asset separation vehicle) in case of a resolution. Notwithstanding this bank-specific approach, the SRB confirmed that the benchmark level of MREL should be at least equal to 8 percent of total balance sheet liabilities and own funds. This benchmark level should ensure that in case of a resolution, the bank can access financing arrangements such as the Single Resolution Fund in accordance with BRRD rules.

Credit institutions must use qualifying bail-inable instruments meeting the MREL eligibility criteria set forth in the applicable regulations, which will become more stringent after the enactment of the Banking Reform Package. The question for European banks is accordingly whether they hold a sufficient amount of MREL-eligible instruments to meet their MREL targets, as determined by competent resolution authorities.

This could be a challenge for several banks, in particular because many traditional funding instruments, such as sight deposits, short-term deposits with a maturity of less than one year, and covered bonds do not qualify under the MREL eligibility rules. As a result, any shortfall would need to be filled through the issuance of MRELeligible instruments, mostly in the form of senior or subordinated notes.

Will supply outstrip demand?

€171bn
The total MREL shortfall deriving from the application of 2018 MREL policy

 

In its 2017 Quantitative Update of the MREL Report, the European Banking Authority stated that the estimated funding needs of European banks range between €206.8 billion and €284.6 billion. Meanwhile, the SRB said that, based on a sample of 100 banks representing approximately 95 percent of the total assets of SRB banks, the MREL shortfall deriving from the application of its 2018 MREL policy amounted to €171 billion, of which €67 billion would need to be met through subordinated instruments. Some research reports have put the figure as high as €526 billion because they assume that resolution authorities will require MREL targets to be met largely with subordinated issuances.

Although the outcomes of these analyses differ—not least as a consequence of the multiple samples and variables used—the figures give pause for thought. The geographical breakdown of the shortfall across EU Member States may be even more significant. Commentators have expressed concerns that, despite MREL being applied at the EU level, the depth of demand for issuers across the EU may vary significantly, especially between northern and southern Member States of the European Union, which could result in an overall fragmentation of the market for MREL and, for smaller issuers in Southern Europe, a potential barrier in terms of issuance costs.

In a study published in December 2017, the European Central Bank noted that the debt markets of Southern Euro-area countries (i.e., Greece, Spain, Italy and Portugal) are characterized by home bias, with a large portion of bank debt being issued domestically. The market capacity to absorb the issuance required to cover the MREL is accordingly country-specific and depends on the ability and appetite of local investors. This home bias could further hinder the capacity of markets to absorb MREL-eligible securities issued by banks established in Southern Euro-area countries.

Meeting MREL targets could be a challenge for several banks, because many traditional funding instruments do not qualify under the MREL eligibility rules

 

Political fears

The investment environment may prove to be challenging in 2019, as a consequence of slower economic growth, tighter monetary policy, weaker earnings and higher volatility. Political instability—with the growth of populist parties, the imminent European elections in May and the approach of Brexit—is also contributing to an unfavorable backdrop for the issuance of new debt instruments, especially in Southern Euro-area countries.

Credit institutions already face higher premiums in issuing new debt compared to previous years, so a further rise in the cost of financing could hit profitability. Italy has been caught in the crosshairs of political instability. As the government disputed its deficit plans with the European Commission, yields on Italian sovereign bonds rose, causing Italian banks, which hold a significant portion of the outstanding domestic government debt, to struggle to gain access to bond markets.

Last November, UniCredit, Italy’s largest lender, issued €3 billion in senior non-preferred notes, in what has been described as a “one and done” strategy to fulfill their total loss absorbing capacity (TLAC) requirements for 2019. The issue was priced at a 7.83% coupon, 420 basis points over the Euro mid-swap rate, which would imply almost unaffordable pricing for other Italian banks—although recent debt issuances made by Italian banks seem to show a more favorable trend.

The bind of Brexit

If the Withdrawal Agreement is not signed and no extension is agreed by March 29, 2019, the risk of MREL disqualification will become relevant on that date

 

Banks established in some EU Member States (including Italy and other Southern European countries) have traditionally turned to English law to issue bonds on the international capital markets due to decades of market practice and the confidence investors have in the English legal system. However, in the event of a no-deal “hard” Brexit, or at the end of any transition period agreed between the UK and the EU, bonds governed by English law would thereafter be considered liabilities subject to the laws of a third country for the purposes of the BRRD rules, which may prevent EU banks from counting such instruments towards their MREL capital.

The fact that the draft Withdrawal Agreement negotiated between the UK and the European Union has failed to gain approval from the UK Parliament means the outcome of negotiations remains uncertain. If the Withdrawal Agreement is not signed and no extension is agreed upon by March 29, 2019, the risk of MREL disqualification will become relevant on such date. Conversely, if the Withdrawal Agreement is signed, EU credit institutions will theoretically have an additional period of almost two years to properly adjust their indebtedness, considering the transition period (lasting until December 31, 2020) provided under Article 126 of the Withdrawal Agreement.

EU authorities have already urged EU banks to include clauses on “contractual recognition of bail-in” in their MREL-eligible instruments subject to English law, and to be prepared to demonstrate that any decision of an EU resolution authority would be effective in the UK. However, a large amount of liabilities subject to English law do not contain any such clause (e.g., because they were issued before the Brexit referendum) and could accordingly be subject to disqualification for the purposes of the MREL requirements. To avoid this outcome, EU credit institutions might either amend the terms of existing English law bonds or refinance them via new debt issuances. The costs would, however, be relevant in both cases, and there is no assurance (again) that the market will be willing to refinance the existing stock of English law debt.

The SRB has left open the possibility to provide for an extension of transitional periods for banks that have MREL shortfalls as a consequence of ineligibility of issuances governed by English law. Furthermore, EU banks have been invited to start issuing bonds under the laws of EU Member States rather than English law to avoid MREL eligibility issues. The most recent trend is currently showing top-tier Spanish and Italian banks issuing (or considering the issuance of) MREL-eligible instruments under their own national law—in line with the practice traditionally followed by French and German banks. It remains to be seen whether the same path will be followed by lower-tier banks and the market in general as they navigate political instability amid the new MREL regime.

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US regulators are committed to holding FBOs to prudential standards similar to those of their US peers and have not made significant adjustments to cater to these different operating models

 

Non-US banks operating in the US (Foreign Banking Organizations or FBOs) have unique corporate governance issues regarding the role of boards and branch leadership for their combined US operations (CUSO). US regulators expect the CUSO to be governed and resolved in the same general manner as comparable US institutions. However, the operating structure and management reporting framework of the CUSOs are different than those of US institutions due to differing home-country regulatory regimes and highly integrated operating models that rely on the global scale of parent operations. As a result, FBOs may find it difficult to readily adapt to a corporate governance model that is more segregated and legal entitybased or some other US-based approach.

The general policy of the Federal Reserve Board (FRB) regarding the treatment of US banks and FBOs is parity. That said, the operating structures, the competitive need for scale, and the active involvement of home office management greatly complicate matters for CUSOs and can often inhibit efficient and effective corporate governance. There is additional complexity for FBOs with large US operations given the requirement to form US Intermediate Holding Companies (IHCs) and the enhanced prudential standards prescribed by FRB Regulation YY.

Regulation YY requires not only that the IHC Board oversee the IHC, but that the US Risk Committee—which in most FBOs will be the same group of directors as the IHC Board Risk Committee—oversee the CUSO, even though branch operations may be outside of the legal entity for which the IHC board is responsible. Furthermore, the presence of state or other federal regulators, such as the New York State Department of Financial Services or the Office of the Comptroller of the Currency, adds an additional layer of complexity for FBOs with US branches.

Signs of progress

The regulatory agenda for FBOs, which includes guidance regarding the proper oversight roles of board and branch managers, remains in flux

 

Since US regulators are committed to holding FBOs to prudential standards similar to those of their US peers, they have not made significant adjustments to cater to these different operating models.

As a result, much more remains to be done to address these differences and variations in application across the spectrum of affected CUSOs. But industry efforts, combined with open-minded FRB leadership, have raised hopes that regulators will embrace a more tailored approach to FBO oversight.

The FRB recognizes the complexity of these corporate governance issues, and is in the process of revising expectations regarding the responsibilities of both bank boards and executive management. For example, the FRB has finalized a new rating system for IHCs and other large financial institutions and is expected to propose tailoring the enhanced prudential requirements applicable to FBOs in the near future.

The FRB has also proposed supervisory guidance regarding board effectiveness, the supervisory expectations of boards and management, and the communication between boards and management. Thus, the regulatory agenda for FBOs, which includes guidance regarding the proper oversight roles of board and branch managers, remains in flux.

A path through uncertainty

Given the uncertainty of the existing regulatory framework, there are questions regarding what boards and branch chiefs should do when confronted with supervisory criticism. With this in mind, there are some basic guiding principles that FBO boards or branch executives should consider following regardless of—or despite—regulatory uncertainty.

• Ensure a holistic approach to CUSO governance. US regulators view the CUSO as a single, unified entity; thus, it is important to understand the relationship and dependencies among various operating entities in the US in order to ensure efficient and effective regulatory compliance. Equally important is the ability to explain and demonstrate to US regulators the holistic approach employed by the CUSO with a view toward underscoring the rationality of the CUSO governance structure.
• Develop familiarity with the legal standard of care and accountable persons regime in the relevant jurisdictions. In most cases, the boards of depository institutions confront heightened fiduciary expectations imposed by regulators to ensure board accountability and oversight of management and, perhaps more relevant, regulatory and supervisory responsiveness. It is therefore important for FBO boards and branch managers to understand all applicable US federal and, where applicable, state banking laws, regulations and agency guidance, including examination guidance, particularly in the context of subsidiary boards.

The challenges posed by FBO governance are due, in part, to unique and varied corporate structures and operating models that are distinct from those of their US counterparts

 

• Double down on risk identification and internal controls. Regulatory developments, such as the Dodd-Frank Act’s mandatory supervisory stress testing and the Comprehensive Capital Analysis and Review (CCAR), underline the importance to policymakers, regulators and examiners of identifying, measuring and mitigating material risks. These developments also highlight that these practices are a founding principal of good governance for all financial institutions, whether or not subject to CCAR, and, thus, should be considered, incorporated and/or amplified where prudent to do so.
• Insist on extensive, targeted training. Management should maintain up-to-date proficiencies in identifying and managing emerging and other risks that are particularly acute for FBOs. These include, for example, cybersecurity, sanctions, anti-money laundering and Bank Secrecy Act issues, and crossjurisdictional regulatory issues in areas such as intragroup funding, privacy, data governance, and the scope of permissible activities and in-country operations. Training should be idiosyncratic and tailored to the operating circumstances of an institution and not be on a one-size-fits-all basis.
• Ensure planning of executive sessions and encourage a culture of candor and compliance. As a general principle of good governance, management and the board should foster an environment of cooperation and transparency in order to maintain the highest levels of quality and integrity. Equally important, of course, is fostering and maintaining a culture of compliance that promotes strong regulatory and supervisory relations.
• Audit data and Management Information System (MIS) integrity. Effective board oversight and supervision requires boards to monitor the activities of management and the company as a whole based on granular and reliable data at the legal entity level (or other relevant category). Relatedly, boards should ensure that MIS monitors understand and adhere to applicable risk limits, and remain apprised of and alert to specific issues under current supervision.
• Quarterly meetings with regulators and coordinated regulatory outreach. Boards should cultivate positive working relationships with regulators and coordinate their message across multiple regulators. The ability to communicate regularly, effectively and with integrity with one voice to all regulators enhances firm-wide credibility and operational efficiency. It also establishes a culture of trust that not only may help during times of stress, it is a powerful and effective approach when regulatory support or sign-off is required to facilitate a transaction, operational changes or an application approval. The unique challenges posed by FBO governance are due, in part, to unique and varied corporate structures and operating models that are distinct from those of US counterparts. While the regulatory regime for FBOs with large US operations is evolving, FBO boards and branch managers should consider implementing the points referenced above into their US operations to help better integrate the FBO and its CUSO in the US regulatory framework.

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