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The key overarching objective of this project was to ensure that all significant institutions have prudent and sound risk management frameworks in place, as well as a local presence which enables effective supervision commensurate with the risks that they take.
On 1 January 2021, the United Kingdom left the single European market. From the EU’s perspective, the United Kingdom is now a third country. UK-based banks wishing to provide services within the EU can no longer do so via passporting, i.e. the right of a bank to serve customers across the EU from one of its Member States, either through the free provision of services or by establishing local branches under preferential terms.
The desk-mapping review, in other words, the review of booking and risk management practices across trading desks active in market-making activities, treasury and derivative valuation adjustments, is aimed at ensuring that third-country subsidiaries have adequate governance and risk management arrangements in place and do not operate as empty shells. The desk-mapping review was initiated because ECB Banking Supervision found that (i) banks had not made sufficient progress in ensuring adequate local trading presence and risk management capabilities in their newly established entities in the euro area; and (ii) banks needed clearer instructions in order to appropriately implement the target operating models previously agreed with their Joint Supervisory Teams. In this respect, ECB Banking Supervision closely collaborated with other supervisory authorities, particularly those in the United Kingdom, to make sure that the rationale behind its supervisory policies was properly understood by all parties involved.
As the supervisor for the euro area, it is the ECB’s duty to protect its depositors and other creditors of local legal entities, prevent the disruption of banking services and safeguard broader financial stability in its area of jurisdiction. In this context, empty shell structures – legal entities located in the euro area that book exposures remotely with their parent entity or book them locally, but rely fully on risk management hubs and financial infrastructures located in third countries, often by means of back-to-back mirror transactions and hedges transferring the risk to their parent entity – are a very real concern.
First, these structures are exposed to heightened operational and counterparty risk vis-à-vis their parent affiliate. In the event of financial stress or default at the level of the parent entity, the local entity can be left with large unhedged positions and little to no access to the staff and infrastructure needed to wind them down smoothly. This, in turn, undermines both the local entity’s recovery capacity during severe stress and, where applicable, its resolvability. This is particularly relevant under a third-country framework where, during episodes of financial stress, the diverging interests of the numerous entities and stakeholders involved may lead to retrenchment and ring-fencing. Second, even during normal times, having risk management resources and infrastructure located offshore can hinder a bank’s ability to identify, measure and monitor risk and can make governance and decision-making less transparent. Third, reallocating risk and revenue to third-country affiliates can worsen the incentive structure for local bank management.
The first phase of the desk-mapping review, which was launched across seven institutions and affiliated investment firms, found that incoming banks did not yet retain full control over their balance sheets, as required under the ECB’s 2018 supervisory expectations. Some 70% of the trading 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 was established within the euro area legal entity to manage the part of the risk originated there.
The supervisory scrutiny applied by the ECB in response to these findings was purely risk-based and took a proportionate approach based on materiality. 56 trading desks warranting supervisory action were identified based on a common set of risk indicators. Following this materiality assessment and its engagement with supervised entities in the course of 2022, the ECB will issue/issued individual binding decisions which may require incoming banks to (i) 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; (ii) ensure the desk has the adequate infrastructure and number and seniority of traders to manage risk locally; (iii) establish a solid governance and internal control framework of remote booking practices with parent affiliates; and (iv) ensure limited reliance on intragroup hedging.
The review of trading desks and their associated risks does not mark the end of the 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.