On 19 May 2022, the European Central Bank (ECB) updated its supervision blog by posting an update by its chair, Andrea Enria. The posting concerns Brexit and the relocation of business by international banks from London to subsidiaries in the euro area.
The blog posting refers to the ECB’s supervisory work in the form of a desks-mapping review. This is where the ECB reviews the booking and risk management practices across trading desks active in market-making activities, treasury and derivative valuation adjustments. The purpose of the review is to ensure that third-country subsidiaries have adequate governance and risk management capabilities and do not operate as empty shells. The ECB issued its supervisory expectations on booking models in 2018 and clarified that banks needed to retain demonstrable control and oversight of balance sheet risk assumed in the euro area. Banks not only need to ensure adequate levels of local capital and liquidity, they also need adequate local risk management staff in terms of quantity and quality as well as appropriate local internal governance, IT and reporting infrastructures.
In the blog Mr Enria refers to empty shells which are a real concern for the ECB for a number of reasons including that they create a heightened operational and counterparty risk vis-à-vis their parent affiliate.
Mr Enria explains that the first phase of the desks mapping review has been completed. It focussed on 264 trading desks across seven institutions and affiliated investment firms. It found that the 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 and around 20% 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.
The ECB assessed that during the first phase 21% of the 264 desks warranted targeted supervisory action. For desks identified as material the ECB will be issuing individual binding decisions to the incoming banks. These decisions may, for instance, require the bank to 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.
The blog also mentions that the ECB is not setting specific targets for the relocation of banking business to the euro area. Instead, it wants 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. The extent of the actual relocation and specific booking configuration will depend on the current set-up of each bank and how it decides to implement the supervisory expectations. The ECB is mindful that its expectations may lead to changes to the current set-up of some banking groups and intends to apply its policy in a proportionate manner.
Finally, the blog adds that the review of trading desks does not mark 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.