Noerr | Consultation on the European Central Bank’s supervisory approach to banking consolidation

The European banking sector has been characterised by low profitability and overcapacity. Consolidation in the banking sector is expected to improve the sustainability of banks’ business models and enhance the overall financial soundness of the European banking system. In weighing benefits against risks, the task for the supervisors is to make sure that the business combinations resulting from consolidations comply with prudential requirements and ensure effective risk management.

On 1 July 2020, ECB Banking Supervision published a guide on the supervisory approach to consolidation in the banking sector (Guide) for consultation. This is designed to enhance the transparency and predictability of supervisory actions and to help credit institutions design sustainable projects. Interested parties are invited to comment on the Guide until 1 October 2020. The key points of the Guide are as follows:

The Guide

The Guide is structured into five parts and addresses the overall approach to the supervisory assessment of consolidation projects, including expectations, the approach to key prudential aspects, the ongoing supervision of newly combined entities, and the application of the framework to consolidations involving less significant institutions. The last point in particular highlights that the Guide is primarily aimed at consolidations involving at least one significant institution (SI) which is directly supervised by the ECB within the single supervisory mechanism (SSM). Therefore, the directions given in the Guide have to be adapted when less significant institutions (LSI) are concerned.

The Guide is also not designed to apply to intra-group consolidations. The ECB emphasises that the Guide does not establish new regulatory requirements but only clarifies the principles underpinning the prudential supervisory approach within the current regulatory framework. To summarise, the Guide does not contain completely new insights, but instead provides direction regarding future – and already existing – administrative practice.

Overall approach to the supervisory assessment of consolidation projects

The Guide explains that the assessment of consolidation projects aims to ensure that the entity resulting from the business combination will meet all prudential requirements. The entity should also be sustainable to allow for permanent compliance with those requirements. The process for the supervisory assessment typically encompasses three phases. First, in order to obtain preliminary feedback on the project, parties involved in a banking consolidation transaction are encouraged to liaise early on with ECB Banking Supervision and present the key characteristics of the proposed business combination (early communication). The second phase is triggered following either a notification of a proposed acquisition of a qualifying holding in a credit institution, or an application to obtain permission for a business combination. ECB Banking Supervision then assesses the application and decides whether or not to object to the notified project (application phase). Third, if the parties are allowed to proceed with the project, the consolidation is expected to progress in line with the integration plan. This must be in a sustainable manner and in full compliance with the prudential requirements and conditions, or with commitments resulting from the application phase (implementation phase).

Supervisory expectations regarding consolidation projects

The Guide sets out the expectations of the ECB regarding consolidation projects. The sustainability of the business model is one of the key considerations. The strategy underlying the transaction will be assessed in terms of capital, strategy, business and profitability and risk profile as indicated in a group-wide business plan to be submitted to the supervisory authorities. This is not new for credit institutions or for interested acquirers. The business model of credit institutions is regularly scrutinized during the SREP-exercise and interested parties are also used to a thorough review of the business plan for the next three years that they have to submit in the course of the owner control procedure. This also means that the same concerns against these assessments may be raised against the corresponding explanations in the Guide, i.e. that one might doubt whether supervisory authorities are really in the position to assess the viability of a business model.

Another key expectation expressed in the Guide relates to the governance and risk management structure. These principles are set out in the Guidelines by the European Banking Authority on internal governance (EBA/GL/2017/11). In addition to the information given in the early communication phase (also taking into account the proportionality principle), the consolidation plan must provide further details. This includes an adequate composition of the management body, a clear allocation of responsibilities and decision making capacity, streamlined management structures and reporting lines, a strong leadership with a proven track record, timely integration of the risk management and control framework and an adequate remuneration scheme in order to set the right incentives.

Supervisory approach to key prudential aspects of the consolidation transaction

While the general supervisory expectations on consolidations do not really add new insights to the requirements of a transaction, the explanations in the Guide on key prudential aspects are interesting from a practical perspective. The ECB clarifies its approach regarding three supervisory factors that, according to past experience, can play a key role in determining the feasibility of a business combination: the appropriate ex post level of capital (Pillar 2 capital requirements (P2R) and guidance (P2G)), the prudential treatment of badwill and the transitional arrangements for the use of internal models.

Pillar 2 capital requirements and Pillar 2 guidance
The Guide states that the supervisory approach for the calculation of the ex post merger P2R and P2G will be guided by two key principles. First, a thorough assessment and mitigation of the main weakness of the combined entity and of the execution risk in the business plan. Second, an appropriate level of Pillar 2 capital, aligned with the risk profile of the combined entity. Whereas an increase in capital can be expected in the event of an insufficient improvement of the risk profile, a lower P2R and P2G level could be achieved if the combination generates an effective improvement of the resilience and risk profile of the combined entity. The determination of the ex post capital requirement and guidance should be clarified during the application process, with the aim of providing stability to the resulting business combination project in principle for at least one year.

Badwill
The explanations in the Guide concerning the regulatory treatment of badwill are of particular interest. This was one of the hot topics in the merger talks between the two largest German banks in 2019. In the current market, badwill is a likely result of a combination of two banks. Badwill occurs if a company purchases an asset at less than its net fair market value, i.e. in the context of an M&A transaction if a bank purchases another credit institution at a price that is below its book value. The supervisory approach regarding badwill is based on the recognition of its accounting value. In principle, the ECB recognises duly verified accounting badwill from a prudential perspective, expecting it to be used to increase the sustainability of the business model of the combined entity rather than being distributed to its shareholders before sustainability is firmly established. The ECB will therefore examine both the actual use of badwill and how it will contribute to strengthening the post-merger own funds of the combined entity. This makes it clear that the ECB does not generally reject badwill for regulatory capital purposes. For specific transactions this means that the ECB aims to ensure flexibility for the supervisory authorities to react on a case-by-case basis.

Internal models
As a general rule, the approval to use internal models for the purpose of calculating capital requirements are granted to a specific legal entity. In a business combination the formation of new legal entities or the transfer of exposures to existing legal entities incorporating other entities may therefore raise questions on the continued use of internal models. In such cases, subject to certain conditions, the ECB acknowledges that there will be a limited period of time in which banks resulting from the business combination might continue to use the internal models that were in place before the merger.

Ongoing supervision of the newly combined entity

In order to take swift supervisory action where required, the ECB will closely monitor the implementation of the integration plan. The enhanced monitoring framework includes specific reporting requirements for the combined entity, a clear and detailed plan for the ECB to include a new entity in its supervisory activities (such as SREP) and supervisory measures under the ECB’s supervisory powers to address risks not covered by Pillar 1. The duration of the enhanced monitoring phase will be based on the timeline of the integration plan, with the general principle being for a return to standard supervisory activities in a timely manner.

Application of supervisory approach to consolidation transactions involving Less Significant Institutions (LSIs)

The supervisory approach to consolidation also covers transactions involving LSIs with the competences of the ECB being aligned with those of the National Competent Authorities. In particular, the ECB’s competence vis-à-vis LSIs is limited to business combinations requiring an assessment of a proposed qualifying holding notification.

Conclusion and Outlook

The publication of the Guide demonstrates that the ECB and other supervisory authorities want to enhance the stability of the banking system by encouraging consolidation in the financial sector. However, the content of the Guide also highlights that the ECB is determined to closely monitor the consolidation process and to assess the sustainability of business models. Whether the Guide will be perceived by market participants as a signal that acquisitions or consolidations of credit institutions are welcomed and supported by regulatory alleviations is questionable. Past experience has shown that there is no one size fits all approach when it comes to consolidation in the banking sector, so the supervisory authorities have to retain a certain degree of flexibility. As a matter of practice, the recognition of badwill in the Guide is the only substantial encouragement for market participants to pursue consolidation plans. It is worth observing the further consultation and the reaction of the ECB to these results, but it remains that the first step in the right direction has been taken with the publication of the Guide.

CONTACTS:

• Dr. Thomas Schulz, Partner, NOERR | thomas.schulz[at]noerr.com
• Jens H. Kunz, Partner, NOERR | jens.kunz[at]noerr.com

Compliments of Noerr – a member of the EACCNY.