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5/7/19 - Don’t Underestimate the Burden of the EU’s New IPU Requirement

By Manuel Schnaidman and Grania VanHerwarde

The European Commission is expected to publish the final text of capital requirements rules (CRD V) before the end of the second quarter 2019. One new requirement will have a profound impact on many non-EU-based financial institutions’ operations in the EU, namely the requirement to implement an intermediate EU parent undertaking.1 The IPU requirement is analogous to the Federal Reserve’s intermediate holding company requirement for foreign banking organizations operating in the U.S., which was issued in 2014 and became effective in 2016. Although the two rules share similar objectives, there are several key differences between the regimes and regulations.

CRD V revises and builds upon CRD IV. Once published in the EU Official Journal, the directive enters into force 20 days later, and becomes applicable 18 months thereafter, so by the end of 2020, all banks falling within scope of the legislation will be required to comply with the new requirements. According to the commission, the purpose of CRD V is to “implement recent international regulatory provisions for banks, set by the Basel Committee on Banking Supervision (BCBS), address remaining regulatory shortcomings and contribute to more sustainable bank financing of the economy.”2

Summary of the Requirements

The objective of the legislation is to improve the safety and soundness and ease the resolution of third-country entities operating within the EU by placing their operations under a single IPU. The IPU is then subject to all prudential standards resulting in compliance with these standards on a consolidated basis across a group’s EU operations. If regulatory requirements in the ultimate parent entity’s domestic law make a single IPU entity unachievable, regulators may accept a structure with two IPUs.

Another objective of the IPU requirement is to enhance the supervision of the largest third-country financial groups that operate in the EU. Consolidating European operations under the IPU allows supervisors to ensure firms meet capital, liquidity, and resolution planning requirements on a consolidated, pan-European-wide basis. Previous EU legislation allowed national regulators to impose sub-consolidation of third-country banking groups at the EU level. However, this power was rarely exercised, as it created a comparative disadvantage for the country imposing further requirements compared to the rest of the EU. The new rule is, in contrast, mandatory for all EU countries.

The IPU requirement applies to non-EU financial institutions that, as of the CRD V effective date, maintain two or more branches or subsidiaries in the EU and have over €40 billion total assets. The asset threshold includes all branch and subsidiary assets domiciled within the EU. For institutions currently operating in the EU as of the CRD V effective date, there is a three-year transitional period for those institutions to come into compliance with the IPU rule. In terms of ownership, all banks and investment firm subsidiaries must be fully owned by the new IPU. Though European branch assets will be included in establishing the €40 billion threshold, branches will not be required to be subsidiaries of the IPU.

The IPU requirements are dependent upon the type of legal entity that is established. This is in contrast to the U.S. Federal Reserve’s IHC requirements. The IPU may be any of the following: a credit institution (bank), a financial holding company, or a mixed financial holding company. The IPU will need to obtain authorization in the case where it operates as a bank. One exemption is that the IPU may also be an investment firm, if all of its consolidated subsidiaries are investment firms and none of its EU entities conducts banking activities. In this case, the IPU is required to obtain authorization as an investment firm in line with Markets in Financial Instruments Directive, or MiFID II, requirements.

Some institutions may have two IPUs in cases where a single IPU would be in conflict with regulatory requirements where the ultimate parent is located. For U.S. financial institutions with large broker dealers in the EU, for instance, the dual IPU structure will be preferred as U.S. rules prevent U.S. banks and their subsidiaries from engaging in specific swap transactions.

The rule leaves open where the IPU should be domiciled, which allows institutions to determine the regulatory regime for the IPU. The relevant National Competent Authority or the European Central Bank along with the NCA, forming a Joint Supervisory Team, will supervise the IPU based on where the IPU is domiciled and on its size. The ECB has automatic direct authority for supervising all significant banks operating within the Euro-area, while NCAs continue to supervise “less significant” banks.3

This new legislation impacts third-country institutions currently operating within the EU. If the U.K. fully separates from the EU, irrespective of a hard or soft Brexit, the U.K. would be considered a third country.

What Does This Mean for My Firm?

The IPU rule requirement means that non-EU financial institutions meeting the criteria and currently operating in the EU, or contemplating expanding to that region, should begin acting now to ensure compliance with these new requirements. As noted above, the IPU rule is expected to be published before this July, triggering a three-year transitional period for institutions. In our experience, based on what we saw in the U.S. once the Federal Reserve’s IHC rule was established, the three-year transitional period for implementation was barely enough time for U.S. FBOs to come into compliance with that rule and complete their transformations.

First, financial institutions operating in the EU will need to determine if they are in-scope for this requirement. Similarly, financial institutions currently out of scope for the rule will have to assess if their current trajectory or strategy will lead them to be in-scope for the rule in the future. Brexit will add complexity to which firms are in scope based on their U.K. assets or U.K.-based parent organizations.

After determining if your firm will be in-scope, there are myriad questions that must be answered in order to begin plans to come into compliance with the new rule. These include:

  • Do parent country regulations require a dual IPU structure? If yes, how will the firm obtain approval from regulators to operate under a dual structure?
  • For dual IPU structures, which entities will fall under each IPU?
  • Which IPU legal entity type will be most appropriate based on operations? If a dual structure is required, the legal entity type decision will need to be made for both IPUs.
  • Where will the IPU(s) be domiciled?
  • What specific regulatory requirements will apply for the jurisdiction(s) in which the IPU(s) is domiciled?
  • Will the domicile affect the institution’s designation as a significant institution4 as defined by the ECB?
  • What will be the corporate governance framework under the IPU?
  • How will institutions go about recruiting for IPU boards?
  • Does the current breakdown of assets between the U.K. and EU require further consideration?
  • What will be the transitional period for U.K.-based institutions operating in the EU that will be in scope in the event that the U.K. leaves the EU?
  • How will institutions provide governance oversight to the branch(es) through the IPU?
  • What IT changes will be required to provide reporting at the IPU level?
  • What regulatory reporting changes might be required at the IPU level?

The answers to these questions may have knock-on implications; for example, it is not yet clear if individual groups will have to make their case to NCAs for a dual-IPU structure.

How We Can Help

Promontory has unique expertise to assist in all steps of the IPU process. We combine regulatory expertise across European jurisdictions with hands-on experience implementing IHCs for multiple U.S. FBOs. We can also assist with regulatory and industry insight, helping to define strategy for the IPU domicile and entity type selected. Finally, based on our broad and deep risk management experience, we can add value to implementation work across multiple areas: from enterprise risk management to risk appetite statements to compliance procedures to board composition and recruitment. From our IHC implementation experience, we have seen the roadblocks many institutions have confronted and can provide our clients with ways to avoid them.

Contact Us

Please contact one of our professionals to discuss how we can help you prepare for the IPU rule requirement.

Manuel Schnaidman
Managing Director
schnaidman@promontory.com
+1 212 284 5067

Ronald Cathcart
Managing Director
rcathcart@promontory.com
+1 212 209 7424

Eric Schwartz 
Managing Director
eschwartz@promontory.com
+1 202 384 1090

Grania VanHerwarde
Principal
gvanherwarde@promontory.com
+1 212 284 5089



FOOTNOTES

  1. Article 21b of CRD V, European Commission.
  2. Amending capital requirements,” European Commission.
  3. Single Supervisory Mechanism, European Central Bank. The ECB directly supervises the 119 significant banks of the participating countries. These banks hold almost 82% of banking assets in the euro area. The decision on whether a bank is deemed significant is based on a number of criteria.
  4. Ibid.