City could profit from EU’s IHC proposals

This article is part of
The Guide: Outlook for 2017

City could profit from EU’s IHC proposals
The UK is soon to introduce its own ring-fencing regime that could clash with new European regulations

A week after the Brexit vote, the US Federal Reserve implemented new regulations forcing foreign banks with more than $50bn (£41bn) of US non-branch assets to have in place US-domiciled intermediate holding companies (IHCs) for their US subsidiaries. These new IHCs had to take on US capital and liquidity requirements, supervision from the US authorities and demanding annual stress tests. 

Arguably, IHCs prevent banking institutions from being ‘too big to fail’, thanks to simplified holding structures reducing the risks of contagion and streamlined bail-in mechanisms. But they have strong negatives too. One EU banking group is reported to have spent $600m setting up its US IHC, and foresees further annual costs of up to $125m.

In 2013 when the US IHC proposals were unveiled, fears of a non-level playing field, regulatory fragmentation and protectionist responses from other jurisdictions alarmed Michel Barnier, the then EU commissioner for internal markets and services. He wrote to Ben Bernanke, chairman of the Federal Reserve at the time, stressing that introducing an IHC requirement, “without linking it to a proper ex ante equivalence test, would be against the global efforts towards harmonised rules in the area of prudential standards and cross-border resolution, and may have relevant negative impacts”.

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Notwithstanding the sensible earlier EU opposition to regional IHCs in Mr Barnier’s letter, on November 23 2016 the European Commission surprised the markets with new proposals for affected third-country banking groups to establish EU IHCs. These new rules will affect any banking group with an ultimate parent incorporated outside the EU that owns two or more banks, or investment firms incorporated within the area. The affected third-country group must also be a non-EU globally systemic institution, or have at least €30bn (£26bn) of assets on the consolidated balance sheet.

EU IHCs will be subject to the EU prudential regime for capital, liquidity and funding purposes, and will feel the brunt of the EU resolution regime. This will reduce flexibility in liquidity and capital management strategies, and bring increased costs of prudential management and reporting requirements – not to mention high set-up costs and ongoing compliance, risk management and governance expenses.

Surprisingly, the Commission’s EU IHC proposal does not mention Brexit. It is likely there was not enough time to do the necessary thinking, and with the proposals envisaged to take effect in early 2019 – and Brexit’s best-guess trajectory being the first quarter of 2019 – timing is almost impossible and delay is inevitable.

But if the proposal does become law pre-Brexit, US banks’ assets held in the UK will be assessed to determine whether or not an EU IHC is needed. After Brexit, that same US bank may not be required to have an EU IHC: for instance, if it has only one EU institution. Transitional or reciprocal arrangements aside, affected UK banking groups may need an EU IHC post-Brexit. 

It is unclear whether these changes will be good or bad for the City. A protectionist reaction from the EU may provoke further similar measures in other jurisdictions, and increased fragmentation may allow the UK to strike its own reciprocal deals, such as with the US, giving the City a competitive advantage.