OBLB Keywords

Branches of third-country banking groups (Third-Country Branches or TCBs) have a very significant footprint in the European Union (EU) with a sizeable amount of assets on their books relative to the respective host country banking sectors. A recent report by the European Banking Authority (EBA) on the treatment of TCBs under the national law of the EU Member States shows that the individual asset sizes of some of the TCBs operating in the EU now exceeds the threshold that would qualify them as ‘significant institutions’ under the direct supervision of the European Central Bank (ECB) within the Single Supervisory Mechanism (SSM) framework.

After Brexit, regulation and supervision of third-country groups providing banking services in the EU has taken a new and even more challenging dimension with a total number of active TCBs currently exceeding 100. As some third-country banking groups use increasingly more complex and opaque legal structures through a mix of subsidiaries and branches across multiple Member States, their supervision by competent authorities has become a daunting task.

Specific risks with respect to third-country banking groups in the EU range from dual-hatting of board members which often create conflicts of interest, to various booking and accounting practices which shift risks from one entity to the other across multiple Member States. In the absence of a legal requirement for competent authorities to exchange comprehensive information on TCBs with each other, there remain significant blind spots with respect to the supervision of these groups across the EU.

TCBs are technically not credit institutions authorised under Chapter 1 of Title III of the Directive 2013/36/EU (the Capital Requirements Directive or CRD IV). This means that they are not included in the scope of the SSM and the related supervisory requirements. Their authorisation to provide banking services in the EU is subject to national legislations of the respective Member States, often with disparate requirements applied in each jurisdiction. This absence of a common framework results in a patchy regulatory landscape with disjointed set of prudential regulations. This raises serious concerns regarding regulatory arbitrage opportunities and financial stability risks.

In response to these concerns, the European Commission (EC) proposed a set of reforms on 27 October 2021 to harmonise the regulatory treatment of TCBs operating in the EU as part of wide-ranging amendments to the revised Capital Requirements Directive (CRD VI), Capital Requirements Regulation (CRR III) and the Bank Recovery and Resolution Directive. These proposals are referred to as the Banking Package 2021. Proposals specific to TCBs in the package include a number of provisions designed to ensure application of minimum standards and aligned prudential requirements throughout the EU with respect to the regulation of TCBs.

Rather than subjecting TCBs to a full range of supervisory requirements similar to those that currently apply to credit institutions, the EC’s proposals aim to create a proportionate set of prudential requirements for them that by and large builds on the existing national frameworks currently in force in Member States. Accordingly, the proposed Article 48a of the Directive categorises TCBs as ‘Class 1’ and ‘Class 2’ to avoid any undue burden for small ones with a non-material footprint in the EU, while introducing more onerous regulatory requirements for Class 1 TCBs.

Class 1 TCBs comprise those that hold assets equal to or in excess of €5 billion, as well as all TCBs authorised to take deposits from retail customers and those which are considered ‘non-qualifying’, regardless of their asset size. As per the proposed Article 48b, a TCB is considered ‘qualifying’ only if its head office is established in a country that has in place a supervisory and regulatory framework and confidentiality requirements equivalent to those in the EU, as long as this country is not listed as a high-risk third-country with respect to anti-money laundering and counter terrorist financing regulations. In addition, those Class 1 TCBs that have assets in excess of €30 billion on their books would be subject to the systemic importance assessment as per Article 48o summarised below. Class 2 TCBs, on the other hand, comprise the remaining smaller TCBs which will be subject to much less stringent rules.

This means that a total of around 40 Class 2 TCBs would be subject to relatively less stringent prudential and reporting requirements. On the other hand, the compliance and transitional costs for around 60 Class 1 TCBs could be quite significant. For the time being only three TCBs have assets in excess of the systemic importance assessment threshold and would, therefore, be potentially subject to a subsidiarisation or restructuring requirement by the lead competent authority or, where applicable, EBA.

Of course, only time will show what the final CRD VI/CRR III framework will look like and it is not likely to be finalised very soon due to the lengthy negotiation period ahead among Member States, which may result in substantial changes to the final rules. However, third-country banking groups would be well advised to start thinking about the potential impact of the forthcoming framework on their branches in the EU.

The revised Directive include a number of significant provisions for TCBs. For instance, the EC proposes a requirement for banking services to be undertaken in the EU through a branch or subsidiary, unless the third-country undertaking in question provides banking services to clients and counterparts in a Member State through reverse solicitation of services, ie it is the client or counterpart that approaches the undertaking in the third-country to solicit the provision of the services in question. It also introduces an explicit authorisation requirement for the establishment of TCBs to provide banking services, including a reauthorization requirement for the existing ones, subject to formal regulatory approval procedures and minimum requirements.

The EC also proposes to introduce a minimum ‘capital endowment requirement’ (CER) which will be calculated as a percentage of the branch’s liabilities for Class 1 TCBs or a fixed amount for Class 2 TCBs. For Class 1 TCBs, CER will be calculated as 1% of the TCB’s average liabilities on their books over three years or €10 million, whichever is higher. For Class 2 TCBs, CER will be set at €10 million for all branches. At the same time, it proposes a liquidity coverage requirement for Class 1 TCBs.

The EC’s other proposals include certain internal governance and risk control requirements, particularly with respect to back-to-back booking or intragroup operations, as well as rules with respect to booking arrangements in order to track the assets and liabilities linked to the business conducted by the TCBs in the Member States. They also include reporting requirements with respect to financial information in relation to the assets and liabilities on their books.

On the other hand, the EC proposes to subject TCBs to regular reviews of competent authorities including for AML purposes.  For Class 1 TCBs this also requires including them in the supervisory colleges. For TCBs that have assets on their books in an amount equal to or higher than €30 billion, this Article also introduces heightened scrutiny for systemic risks, allowing authorities to require TCBs to subsidiaries or restructure, where necessary.

These provisions, if agreed, would impact third-country banks’ costs of operating in the EU, as well as their businesses and operating models across the EU, depending primarily on whether they qualify as Class 1 or Class 2 TCBs, and whether they undertake banking activities on a cross-border basis. In particular, given that the third-country groups with assets of €40 billion or more and at least two subsidiaries in the EU are already required to establish one or two intermediate EU parent undertakings by 30 December 2023 as per the Directive (EU) 2019/878 (CRD V), systemic Class 1 TCBs could face significant strategic, operational and compliance challenges.

Mete Feridun is a Professor of Finance at Eastern Mediterranean University, Cyprus.