EU v US intermediate financial holding company regimes

On 23 November 2016, the European Commission published draft legislative proposals to amend key pieces of the EU’s banking and resolution regimes covering the Fourth Capital Requirements Directive (CRD IV)¹, Capital Requirements Regulation (CRR)², Bank Recovery and Resolution Directive (BRRD)³ and the Single Resolution Mechanism Regulation.⁴ In relation to CRD IV and CRR, changes were proposed to introduce the outstanding elements of the Basel Committee’s reforms, including the binding leverage ratio and the net stable funding ratio (among others), as well as a range of EU-specific measures.

The most controversial of these proposals is the requirement for large non-EU (known as ‘third country’) banks to establish an intermediate parent undertaking in the EU. This is commonly referred to as an EU intermediate holding company (EU IHC) regime (though this is slightly misleading as intermediate parent undertakings are permitted to be either an institution⁵ or a financial holding company⁶). It is intended that the proposals will come into force in 2019 at the very earliest, although this may well become 2020 as, unlike the 1 January 2019 deadline for the G20’s ‘total loss absorbing capacity’ (TLAC) commitment, this is an EU-specific proposal at the Commissions’ sole initiative.

There is no international standard which corresponds to this proposal. Instead the Commission has indicated in a press release that the proposals have been introduced “to facilitate the implementation of the internationally agreed standards on internal loss-absorbing capacity for non-EU G-SIIs in EU law and, more broadly, to simplify and strengthen the resolution process of third-country groups with significant activities in the EU”.⁷

For others, however, the proposed EU IHC regime has been viewed as a response to the US regulations that were issued by the US Board of Governors of the Federal Reserve System (FRB) that require certain large foreign (i.e. non-US) banking groups to form intermediate holding companies (FBO rules) (outlined in more detail below). Indeed, the need for the EU IHC regime is questionable, given the existing discretion for a Member State’s competent authority (e.g. the UK’s PRA) to deem that prudential supervision in a third country is not equivalent and to take necessary action, including requiring the establishment of an EU holding company (Article 127 CRD IV).

The table below provides a summary of the EU and US regimes, followed by consideration of the practical effects of the EU’s proposal. A more detailed analysis is set out at the end of this briefing.

The proposals point towards further fragmentation in the global financial regulatory framework,⁸ which would likely increase the burden on banks to monitor compliance with multiple sets of regulatory requirements across the globe. It is clear that the finer details of how the proposal will operate in practice are as yet uncertain – for instance, as the EU’s internal MREL policy has not yet been finalised, it is hard to judge the financial impact of the EU’s IHC proposal.

Furthermore, there is the difficulty of structural separation rules such as those currently in force in the US between banks and broker-dealers and, should the UK become a ‘third country’ following Brexit, the imminent UK ring-fencing regime. Given the EU’s own (long delayed) structural reform project, some understanding might be hoped for, though it remains unclear whether the proposal will be amended to account for this (perhaps – at the most onerous – to require multiple EU sub-groups).

At present, given the timing of this proposal, the primary difficulty for third country banking groups is the uncertainty this adds to the complications already created by Brexit. The practical implications of the EU IHC regime will need to overlay any Brexit planning considerations as banking groups begin to assess the scope of their activities and EU businesses in the UK. This will need to account for a number of issues to which there is currently no answer – will the proposals be introduced before Brexit? Will any deal between the UK and the EU require the UK to adopt a similar position after Brexit? Will the EU’s proposal be amended to allow any parallel future UK regime to be sufficient to satisfy the EU requirement?

Third country banking groups with two or more subsidiary institutions in the EU will be within scope if they fall into one of two categories. First, they will automatically be subject to the requirement if they have been designated as ‘Globally Systemically Important Banks’ (G-SIBs) by the Financial Stability Board (a designation that has, since its inception in 2012 largely been followed by home country regulators). Second, other (i.e. non-G-SIB) third country banking groups will be caught if the total value of their assets in the EU is at least €30 billion.

The ‘total value of assets in the EU’, includes all assets of the group’s EU subsidiaries and EU authorised branches. Additionally, though the test to determine whether an institution is “significant” under the Single Supervisory Mechanism (SSM) is also €30 billion, the SSM test considers the assets of a single institution and does not similarly account for branch assets. This means that the EU IHC test may capture a broader scope of entities than just those supervised by the ECB under the SSM.

The primary effect of the EU IHC requirement is to establish a single EU intermediate parent and so create an EU sub-consolidation group within a broader third country banking group. Although there must be a single EU IHC for all institutions that are part of the same third country group, there is no requirement to establish a new entity – instead entities could be reorganised to lie under an existing entity. The proposal does not dictate where in the EU the EU IHC must be established.

The creation of a new EU sub-consolidation group would not necessarily increase capital, liquidity or TLAC⁹ requirements. This will depend largely on how the new EU sub-consolidation group is structured and the linkages (e.g. intra-group debts and funding arrangements) that are maintained or created between its constituent entities. However, it is important to recall that EU subsidiaries are already subject to the EU’s prudential rules under CRD IV / CRR and that consolidated requirements can be less than the sum of requirements that apply to individual entities.

It is generally thought that third country groups would face increased costs due to the on-going suite of obligations that come with consolidation, including consolidated reporting / disclosure, risk management and governance. Where the EU IHC is established in the Eurozone, it can be expected that the ECB would take on the consolidated supervision for any new EU sub-groups which contain an institution that meets the €30 billion threshold as this coincides with the trigger for its role under the SSM.

From a resolution perspective, for those third country banking groups that are subject to ‘Single Point of Entry’ (SPE) resolution, the Commission’s claim that the EU IHC requirement improves the resolvability of third country G-SIBs can be challenged as this entails that only the third country entity at the top of the global group is subjected to resolution whilst its subsidiaries (such as the EU IHC) continue to operate. However, it is arguable that having a group of entities subject to consolidated oversight – rather than independent subsidiaries of a third country parent – may simplify resolution in planning and implementation. Further, if for any reason the third-country SPE resolution were to fail, despite the BRRD’s co-operation mechanisms, this simplification may enable EU resolution authorities to conduct a resolution of the EU sub-group (though this benefit would potentially be undermined by allowing an operating entity to act as the EU parent undertaking). Finally, the EU sub-group may also have an EU Resolution College (in addition to the likely existence of a global Crisis Management Group) and, for those EU sub-groups supervised by the ECB under the SSM (per above), it is expected that the EU’s Single Resolution Board will be the EU sub-group’s resolution authority.

The FRB’s FBO rules require non-US banks with US non-branch/agency assets of $50 billion or more (and at least US $50 billion in consolidated assets worldwide) to establish a US-based intermediate holding company (FBO IHC).¹⁰ In general, subject to limited exceptions, the FBO group must hold its entire ownership interest in any US subsidiary (such as a broker dealer or commercial paper subsidiary) through its FBO IHC.

The FBO IHC requirements are, in some respects, less flexible than the EU IHC regime. Whilst the EU allows the parent undertaking to be an operating company, the FBO rules require the establishment of an intermediate holding company. Further, FRB permission is needed to designate an existing US company as the FBO IHC. Similar to the requirements for the holding companies of US banking groups, the FBO IHC is subject to examination by the FRB and must meet certain enhanced prudential standards such as for capital and liquidity, although the leverage ratio requirement for FBO IHCs was delayed until 2018.¹¹

In other respects, the US and EU regimes are aligned. Like the requirements for US G-SIBs, only the IHCs of FBO’s that are identified in the FRB’s final regulations as global systemically important FBOs are subject to the FRB’s TLAC and long-term debt requirements, compliance with which is required by January 1, 2019.¹² Also in line with the EU rules, the FBO IHC is not required to follow a global SPE model – instead the resolution strategy in the US will follow the FBO’s resolution plan for all its US operations as drafted by the FBO and submitted for review by the FRB and FDIC.¹³

Despite the potential benefits, the flexibility of the EU regime has its costs. The EU’s regime takes effect at a substantially lower level than the US regime: €30 billion threshold for third country non-GSIB groups translates as approximately $32 billion (a substantially lower bar than the US requirement) and for third country G-SIBs there is no threshold. Moreover, and somewhat perversely, this also means that a non-G-SIB’s EU sub-group with $30 billion of relevant assets would not be caught by the EU IHC regime but a G-SIB’s EU sub-group with $1 billion would be caught. The EU’s threshold calculation currently includes branch assets, even though these will not be subject to consolidated oversight within the EU sub-group. If the EU were to deviate from its current position and exclude branch assets, the number of third country non-G-SIBs that are subject to the EU regime could significantly reduce.