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Serving Two Masters – The Implications of Onshoring the Credit Requirement Regulation Provisions Post-Brexit

  • Market Insight 16 February 2021 16 February 2021
  • UK & Europe

  • Brexit

EU Banks operating in the London market and UK Banks operating in the EU will have to comply with two regimes as a result of the onshoring process of the Credit Requirement Regulation into UK law. Changes have been brought to the institutions supervising the CRR regime, group consolidations and preferential treatments. Financial services such as prudential regimes, exposures and capital requirements will be dependent on the equivalence regimes that will be adopted by the EU and the UK in the upcoming negotiations and on the bilateral agreements reached with EU national governments. The reality is that while the UK has introduced its own financial regulation, in many areas it will continue to track the EU position.

Background

In response to the global financial crisis of 2007 – 2009, the Capital Requirement Regulation (CRR) - Regulation (EU) No 575/2013 of the European Parliament together with the Directive 2013/36/EU of the European Parliament were enacted to implement in the EU the internationally agreed set of measures developed by the Basel Committee on Banking Supervision, also known as Basel III.

Period of transition and Brexit

In preparation for Brexit, the HM Treasury took steps to ensure that the UK regulatory regime regarding financial services could function smoothly independently from any temporary transitional arrangements within the EU. As a result, it enacted a number of statutory instruments in an effort to retain or “onshore” certain EU laws and guarantee legal continuity and a smooth transition following the UK’s exit from the EU. This approach was followed consistently across statutory instruments for financial services including for the EU CRR regime. As such, under the European Union (Withdrawal) Act 2018 subsequently amended by the European Union (Withdrawal Agreement) Act 2020, EU legislation which was operative between the 31st of January 2020 and the 31st of December 2020 (Implementation Period) was onshored to form part of UK domestic law.

During the Implementation Period, the UK was still considered an EU Member State which meant it still had access to EU markets on the basis of the EU regime for financial services. This period was key for financial services allowing more time for firms to prepare for the UK’s new onshoring regime to come into effect.

The UK Legislation “onshoring” the EU CRR

The legislation which imports the retained EU law version of the CRR into UK law, the UK CRR, is mainly covered by two statutory instruments: The Capital Requirements (Amendment) (EU Exit) Regulations 2018 (CRR EU Exit SI) and The Capital Requirements (Amendment) (EU Exit) Regulations 2019 (CRR II EU Exit SI). As stated by HM Treasury, the aim of these statutory instruments was not to produce any policy changes but to “reflect the UK’s new position outside the EU and to smooth the transition to this situation”.

As a result of the onshoring process, there are currently two versions of the capital requirements rules operating in parallel: the original EU version of CRR and the UK CRR, which incorporates the amendments made during the onshoring process. This new dual responsibility for banks can often be seen in many of the changes brought by the CRR EU Exit SI and CRR II EU Exit SI.

What changed?

1. Relationship with EU Institutions

At the end of the Implementation Period, after the 31st of December 2020, the UK is no longer considered a Member State and has the status of a third country. This means, the UK will no longer be represented in the EU institutions, agencies, bodies, and offices. Banks operating between the EU and the UK, will provide financial services on different terms than those contained in the EU Single Market.

The CRR EU Exit SI places the responsibility for ensuring CRR compliance on national institutions in the UK rather than EU institutions. The powers held by the European Commission were transferred to the HM Treasury in relation to delegated acts, technical adjustments, prudential requirements, and requirements for exposures to central counterparties. The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) are now responsible for issuing the risk weights and criteria that competent authorities set for exposures, a responsibility that was previously held by the European Banking Authority.

The transfer of functions from EU institutions to UK ones, can also be seen in the changes brought by the CRR EU Exit SI to macro prudential measures. Under the EU CRR regime, authorities approved by EU institutions could establish stricter macro-prudential measures by adjusting risk weights to some exposures in cases of asset bubble. Under the CRR EU Exit SI, EU institutions are no longer responsible for the implementation of macro prudential measures in the UK and UK authorities do not have to notify the EU institutions when they use macro prudential rules.

The CRR EU Exit SI was later modified by CRR II EU Exit SI to take into consideration the amendments brought to the EU CRR regime which entered into force during the Implementation Period and thus would remain applicable in the UK. The CRR II EU Exit SI updated the definitions added by the new EU CRR regime to allow for suitable cross-references to definitions in other pieces of UK legislation. The UK CRR’s geographical scope was also adjusted to reflect the fact that the statutory instruments are intended for a UK-only context. For instance, references to EU Directives were replaced with references to UK legislation and the definition of a ‘parent institution in a Member State’ changed to that of a ‘UK parent institution’.

2. Group Consolidation

The EU CRR had facilitated the capital and liquidity process for EU banking groups by allowing them to report single figures for their activities across the EU which would be overseen by a sole national supervisor acting on the EU’s behalf. This applied on a cross-EU basis however, CRR EU Exit SI amends the geographical scope of all group consolidation provisions and limits them to within the UK from the end of the Implementation Period. As such, the UK will not be able to act as the EU consolidated group supervisor for a UK group with EU business.

3. The question of Equivalence

There are four methods to conduct financial services trade with the EU. Two of these methods (“passporting” and trading on the basis of WTO rules) are currently either off the table or not particularly advantageous for the UK in comparison to the regime it benefited from when it was a member of the EU. Another possible avenue would be a bilateral free trade agreement. However, the recently concluded EU-UK Trade and Cooperation Agreement (TCA), does not include many provisions on financial services.

This leaves the method of equivalence, under which some third countries obtain preferable market access rights for some services on the grounds that their legislation and supervisory frameworks are considered ‘equivalent’ to the EU’s.

Under the EU CRR, prudential regimes considered equivalent by the European Commission receive preferential treatment which greatly benefits an array of services. The EU CRR established the amount of capital and liquidity that companies must hold against different types of exposures (exposures to central banks and central counterparties) expressed as a percentage of the total exposure. Before the exit of the UK and under the EU regime, no capital needed to be held against EU exposures, as EU sovereign debt had a 0% risk weight. Currently, with no Commission assessment of equivalence between the EU and the UK, UK exposures are no longer treated preferentially by the EU.

Furthermore, the TCA does not include market access in the form of positive equivalence determination, leaving it to unilateral decisions. The UK government views this ‘unilateral’ equivalence framework as “wholly inadequate for the scale and complexity of UK–EU financial services trade” and is pushing instead for an “enhanced provision” for equivalence. Under such regime, the UK and EU would frequently inform each other on new regulations thus limiting the likelihood of the EU unilaterally removing equivalence on short notice. The EU’s position however is that the UK could not benefit "from a system of generalised equivalence of standards" and that equivalence will be limited to specific areas of co-operation.

Similarly, to ensure that UK exposures of firms subject to the UK’s capital requirements framework continue to be treated preferentially, the CRR II EU Exit SI removes the automatic preferential treatment for EU based firms. For example, the new EU CRR regime enacts further internal requirements on non-EU Global Systemically Important Institutions (GSIIs) establishing further internal minimum requirement for known funds and eligible liabilities (MREL) for loss absorbing equity and debt. This increases the quantity of MREL material subsidiaries of these non-EU GSIIs have to maintain. In a similar vein, the CRR II EU Exit SI amends the effect of this provision to apply to non-UK GSIIs. As a result, material subsidiaries of EU GSIIs functioning in the UK will have to produce further internal MREL to meet their requirements under CRR II EU Exit SI. Equally, subsidiaries of UK GSIIs working within the EU will be regarded as third-country subsidiaries and will have to comply with the higher internal MREL requirements.

What does this mean for you?

A number of consequences arise for UK Banks headquartered in the EU being treated as third-country and hence subjected to an additional set of rules – the UK CRR – and to the supervision of the PRA.

These include the following:

  1. While the UK has introduced its own financial regulation, the reality is that in many areas it will continue to track the EU position. Given the pan-European market for credit risk mitigation, it will be essential to monitor any divergencies in approach between the PRA and EU regulators in the future.
  2. EU Banks operating in the London market, and conducting business in the UK through their London branches or affiliates, will have to comply with two regimes: the existing EU CRR supervised by their home regulatory authority, as well as, in parallel, the UK CRR. This new layer of UK regulations comes in addition to their continuing obligations under EU law so they will have to pay closer attention to the PRA’s guidelines and practice.
  3. A possible equivalence regime would still impose more stringent conditions than those applied to EU banks which previously benefited from passporting rights. In addition, even if the EU and the UK agree on an “enhanced provision for equivalence”, it would still not cover the full spectrum of financial services.
  4. The risk weighting of UK bank exposures to EU sovereign debt will no longer benefit from an automatic low-risk or risk-free weight. It will depend on the credit rating of the relevant EU governments and the equivalence decision reached by the UK with these governments.
  5. In this context, regional governments and local authorities in the EU would no longer benefit from an automatic low-risk weighting.
  6. EU Banks in the UK which are holding sovereign bonds of their home government will need to hold additional capital against such exposures since they will no longer benefit from preferential treatment.
  7. Such sovereign assets will no longer directly be eligible for Level 1 high quality liquid assets and will need to meet additional credit quality requirements.
  8. Not all provisions contained in the EU CRR regime were included into UK Law. Therefore, there is still some scope for a diverging approach in the UK CRR. This includes areas such as the new requirement for own funds for GSIIs (delayed in response to the coronavirus pandemic), the new provision regarding the reclassification of a trading book position as a non-trading book position (or vice versa), the introductions of new own funds requirements for market risk and the exemption from deductions for prudently valued software assets (brought forward in response to the coronavirus pandemic).

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Themes:

Additional authors:

Iris Kyriazi

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