ECB grants post-Brexit reprieve on large exposures limit

Exemption for intra-group exposures to UK will be preserved pending a decision on equivalence

ECB and Brexit

The European Central Bank is allowing the banking entities it supervises to exceed exposure limits with UK affiliates while negotiations over an equivalence deal continue. But the relief may not last long – if an agreement is not reached before the end of June, intra-group exposures between European Union entities and UK entities could attract punitive capital charges.     

A spokesperson for the ECB’s single supervisory mechanism (SSM) confirms it is holding off on enforcing the large exposure limits for UK entities for now. “Pending further developments on the assessment of the equivalence of the UK framework for financial services, the ECB has so far not asked banks to change the treatment of intra-group large exposures,” the spokesperson says.

The reprieve will come as a relief to UK and international banking groups that are serving EU clients through EU subsidiaries, while continuing to book these trades in London. Enforcing the exposure limits would have disrupted these arrangements – an outcome the ECB was keen to avoid.   

“This is very much in line with what the ECB has been saying publicly, and also some national regulators,” says Simon Grieser, a partner specialising in financial regulation at law firm Reed Smith in Frankfurt. “The ECB has been saying that it is very important that there is a smooth transition to the new relationship between the UK and the EU, with no hard cut-off of services, and this smooth transition is in the interest of both sides.”

The EU capital requirements regulation (CRR) limits a bank’s exposure to a single counterparty or connected group of counterparties to 25% of its eligible capital or €150 million, whichever is greater. Trading book exposures can exceed these levels, but will attract punitive capital charges of up to 900% on the excess.

Supervisors have the discretion to exempt exposures to intra-group entities in EU member states or third countries whose capital rules have been deemed equivalent to the EU’s regime. The SSM has granted such exemptions for a number of countries, including the US and Japan, which have been granted equivalence by the European Commission for the purposes of calculating credit risk-weighted assets (RWAs) on bank exposures.

UK entities are no longer eligible for these exemptions since the Brexit transition period ended on December 31, 2020 without an equivalence decision by the EC.

While the ECB does not have to take a decision yet on some elements of CRR (such as RWAs) that only need to be reported quarterly, it did not have this luxury with large exposures, which must be calculated and reported daily.     

“The ECB must be careful, because the monitoring requirement for large exposures [to the UK] started on January 1,” says Martin Neisen, head of regulatory management at consultancy PwC in Frankfurt. “The ECB can maybe say banks have to monitor large exposures, and if there is a breach there will not be any kind of sanctions on the bank, because there the ECB has discretion.”

Wiggle room

The CRR provides the ECB with some wiggle room on large exposures. While the articles concerning RWAs explicitly state that an equivalence determination must be made by the EC, article 400 governing intra-group exemptions for large exposures simply states that “competent authorities” can grant these if the parent or subsidiary is subject to “equivalent standards in force in a third country”, without specifying a role for the EC.

“The ECB is not restrained from still treating the UK as equivalent on a preliminary basis, because article 400, luckily, does not require a Commission decision like we have in other rules of the CRR,” says Henning Berger, head of the German financial services regulatory practice at law firm White & Case. 

Technically, this means the ECB can maintain the intra-group exemption for UK exposures indefinitely. However, the consensus among market participants is that it will not be comfortable doing so if CRR equivalence is not granted within the next few months. A risk manager at one affected bank says they are working on the assumption that, in the absence of an equivalence determination, the exemption will be revoked when the new Investment Firms Regulation comes into force on June 26, 2021.

The ECB is not restrained from still treating the UK as equivalent on a preliminary basis
Henning Berger, White & Case

The IFR introduces CRR-style large exposure limits for non-bank investment firms that trade securities on their own account, and an asset threshold of €30 billion beyond which investment firms must become licensed as full credit institutions. This is also the threshold for direct supervision by the ECB. A number of post-Brexit broker-dealer entities set up in the EU and currently regulated by national authorities are expected to trip this threshold.

Others have also circled the implementation date for the IFR on their calendars. The ECB can argue that the soundness of the banks it already supervises did not materially change in the short-term on December 31, 2020, and that it made sense to roll over existing arrangements as the UK has transposed CRR into local law. But that argument is less persuasive with respect to investment firms that will come under the ECBs supervision as credit institutions in June.

“Concerning firms coming under ECB supervision for the first time in such groups, the ECB could take the position that there is no need for some kind of grandfathering for an interim period, because everything is new,” says Berger. “In view of that, the ECB wouldn’t have a justification for saying it should just continue what it did before. It would really be in need of a clear decision on whether equivalence is granted to the UK or not, because the ECB cannot just build on the administrative practice they have created with regard to banks they already supervised on December 31, 2020.”

Mitigating steps

In the meantime, banks will be required to report large exposures as if the intra-group exemption for UK entities were no longer available, even if the limits themselves will not be enforced.

Grieser at Reed Smith suggests the ECB may go further if CRR equivalence becomes uncertain and begin urging banks to take mitigating steps on their large exposures to UK entities. “Just to stop the enforcement for, say, half a year, will not solve the problem at all. I assume [the ECB] will combine it with other measures to reduce the risk, so if the hold on enforcement is lifted, the banks will be in a better position than they were before – otherwise you run the risk that the exemption has to be in place for a longer period of time,” he says.

Most, though, are reading the reprieve on large exposures as a sign that the ECB expects the UK to be granted equivalence under CRR within the next few months.  

“The ECB is very keen to have an agreement that works from a markets perspective – within the constraints of the bank licensing that is needed – to keep it such that there are no market disruptions. They are keen, and they are expecting an agreement to be reached,” says Gerhard Schroeck, a risk and regulation partner at the consultancy Bain in Frankfurt. “The ECB wants all the Brexit entities formed in the EU to be open for business, and the large exposures limit is important from a refinancing perspective.”

The equivalence discussions with the EC have been clouded by the general diplomatic turbulence over Brexit and uncertainty around how far the UK may want to diverge from EU regulation. However, EU prudential rules are constructed on the internationally agreed Basel Committee on Banking Supervision standards, and the UK Prudential Regulation Authority has always been a keen supporter of Basel, with every indication it intends to remain so.

“Most institutions work on the assumption that there will be a CRR equivalence agreement and the current treatment continues, but all of them have a contingency plan on what it would mean if there is a discontinuation of equivalence – no-one expects that, neither supervisors nor banks, but the ECB’s stance is that all the banks need to be prepared for a negative outcome, and able to adjust quickly should equivalence be withdrawn,” Schroeck says.

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