The drive to create harmonization across the EU regarding third country bank services has led to the end of relaxed cross-border business. Under CRD VI, third country entities providing core banking services must transition to local regulated and capitalized branches or subsidiaries. With regulators considering both systemic risk and interconnectedness as well as brightline valuation, the chances of being compelled to transition to a subsidiary, with the associated financial and operational overheads, increase. Sydney Hassal, Managing Consultant, D2 Legal Technology, explains why it is now vital to optimize capital through effective netting.
Cross-Border Business
The EU Capital Requirements Directive IV (2013/36/EU) (CRD IV) has been updated by CRD VI (2024/1619) (CRD VI) to bring in new third-country entity rules. Applying from January 2027, the requirements will have significant impact for all third country banks, including those in the US and UK, delivering core banking services to clients in the EU.
The key implication of CRD VI is that banks will not be able to provide cross-border services into the EU without a local presence. Whether this presence is a branch (Class 1 or Class 2) or a subsidiary in each member state where they operate, is dependent upon the CRD VI regulations and thresholds. However, while the asset valuation thresholds are clearly defined, regulators are also looking closely at interconnectedness and systemic risk (Article 131 criteria) when determining whether an entity can remain a branch operating under cross border rules or must convert to a full subsidiary locally.
Given the operational and financial implications of transitioning from branch to subsidiary, the onus is on third-country entities to rapidly understand their current position with regards to the new CRD VI valuation model.
Cross-Border Risk
The Gross Fair Value accounting definition is used when calculating the brightline assets triggers – €5 bn for Class 1 Branch, €40 bn for a subsidiary. However, under Article 48j of Directive (EU) 2024/1619[1], regulators will also look to determine the extent to which the entity is systemically connected within the capital markets trading space by considering Risk Weighted Assets (RWA). If the RWA footprint is larger than the balance sheet suggests, local regulators may see the entity as representing a more significant risk, and use their discretionary power to drive a bank into the Class 1 or 2 supervisory category or even require conversion to a full local subsidiary.
Furthermore, it is important to recognize that the regulations for determining when branch establishment is required vary and are not harmonized across jurisdictions. For example, a branch set up specifically for derivatives trading in one member country may attract more risk than the local regulator can accept and be compelled to convert to a subsidiary, even if the brightline value is significantly below the threshold. That risk factor could also be considered by other regulators during their own valuation assessment.
Netting Implications
For capital markets businesses, the financial, operational and legal implications of transitioning from a local branch to a subsidiary are significant. The shift will also impact documentation, market risk, credit risk, settlement, reporting and capitalization. Branches that must convert to subsidiaries will also require an extensive repapering exercise, with new agreements to be executed with their book of clients.
With just six months to go before CRD VI comes into place, the pressure is on to minimize RWA. This includes proactive steps to maximize offset netting across the book, capturing opportunities for balance sheet netting and reviewing opportunities to reduce counterparty credit risk via clearing. In addition, proactively gathering and updating documentation will pay dividends both for entities close to the Class 1/Class 2 line, and those that wish to remain a Class 2 branch under the new rules.
Working with an experienced consulting firm to undertake a full review of all counterparty agreements, netting and collateral enforceability potential, and full document evaluation process, including proactively reviewing trading and client names for possible migration to amended documentation, is another fundamental step. For those that have to transition to a subsidiary, third party negotiation support will also be key in achieving the change before the deadline.
[1] See “Amendments to Directive 2013/36/EU”; Article 1(13), Section II, Sub-Section 3, Power to require authorisation under Title III and requirements on third-country branches which have systemic importance, Articles 48(i)-(j) at: https://eur-lex.europa.eu/eli/dir/2024/1619/oj/eng
