Felix Hufeld addresses Association of Foreign Banks in Germany

The following is an excerpt from a speech by Felix Hufeld President of the Federal Financial Supervision Authority (BaFin) concerning, amongst other things, Brexit and financial services moving from Longon to mark 35 years of the Association of Foreign Banks in Germany on 30 August 2017 in Frankfurt am Main. The complete transcript can be found here.

Ladies and Gentlemen,

It is now slightly over a year ago that the decision was made in favour of Brexit. I don’t know how you felt about it, but for me Brexit felt like a turning point, possibly the biggest setback in European integration since the European Coal and Steel Community was first founded in 1951. For a long time it looked as though Jacques Delors, former President of the European Commission, had almost set the path of politics in stone with his words “Europe is like a bicycle: you keep pedalling or you fall off.” More and more countries joined the European Union, and more and more responsibilities fell within the remit of the European Parliament and the European Commission.

And not just for the fun of it, or because the political decision-makers felt like it, but because a more connected world called for European, if not global answers. This was true in particular for financial regulation, which is now undoubtedly one of the most rigorously and thoroughly Europeanised legal fields there is. And again, not without reason. In an environment of complex and globally established markets, financial regulation depends on strong European players. The same is true for the member states of the EU, which need the maximum possible level of harmonisation and protection in a single economic area. Furthermore, Europe needs a strong, unified voice in the concert of global standard setting – just think of Basel, for example. This applies all the more if the USA really does decide to proceed down a path of more deregulation and less international cooperation.

As necessary as Europeanisation is in this matter, it also creates friction. We didn’t need Brexit to see that an increasing number of people from many different places were lamenting the apparent dominance of international bodies over national interests.

It would be wrong to look only at other countries or other continents – or only at the filter bubbles on Twitter. Similar expressions of political volition and resentment can be found in Germany, too, both online and in the real world. I don’t find that surprising, either. Concepts that in some speeches are called “an ever closer union” and “European harmonisation” simply mean loss of sovereignty in everyday life at national level.

This becomes particularly relevant when individual European regulations and the national implementation thereof lead to public debates, as we saw recently in the case of the Mortgage Credit Directive, for example. A European directive, the essential goal of which was to protect financial stability, entered into a fraught relationship with the hopes, fears and concerns of individual citizens, for example young families, who expressed these concerns to their representatives in the national parliament, which in this case was the German Bundestag.

This means that even Europe’s ever closer union calls for constant tuning between too much and too little, between bold vision, feasibility and impact analysis, taking particular account of the extent to which different interest groups are affected. And maybe the approach of seeking the greatest possible level of uniformity by trying to spell out each individual detail should give way to a new European conviction of an increased focus on principles. To say it in the language of cycling: The Tour d´Europe has to make headway. But the route and pace must be chosen carefully so that the peloton does not run the risk of failing to keep pace. Or, even worse, that some might want to fall behind.

Ladies and Gentlemen,

As much as I lament Brexit, there is little point in regretting missed opportunities or engaging in Brit bashing. We should look to the future and build a foundation for the time after the United Kingdom’s departure from the European Union. Of course, that will not be an easy task. Above all else the question looms of future reciprocal market access in the relationship between the United Kingdom and the EU27 countries. For the time being we have to assume that the UK will become a third country following Brexit. And that in itself will become an exciting challenge, both for politicians and for financial regulators and supervisors.

It is clear that the existing building blocks for market access based on equivalence, as known from the relationship with Switzerland or Bermuda, cannot be applied to the departure of the United Kingdom. The size of the financial market there and the vast level of mutual economic dependency that has built up over the last decades are alone sufficient as an argument against such an approach.

Just under half of the United Kingdom’s total exports go to the European Union, making the EU the UK’s largest market worldwide. Looking at imports shows a similar picture. The issue is even more complex in the financial sector, because economies of scale caused by historical circumstances have made London the hub for capital flows to the EU. For an industry with such cross-border interdependencies and in which trillions of euros are moved around in cyberspace, dealing appropriately with a situation such as Brexit presents a significant challenge. And there is no master plan, nor an emergency handbook that companies or regulators can simply pull out of their pockets. This is uncharted territory for all of us, and we have to pave our path as we proceed along it.

If we break the bigger regulatory picture down into its individual parts, at first glance the situation looks manageable. But, in actual fact, on many issues the devil is in the detail. Scores of banks are intending to move their offices to Germany and other countries because Brexit will mean that they will lose their European passporting rights that allow them to conduct business in EU countries.

As the passport may only be used by banks authorised in the EU, some branches in EU27 countries will undoubtedly be converted into subsidiaries. In addition to this, there will also be newcomers. Our objective is to provide these banks with guidance for their projects in Germany, offer them legal certainty and, at the same time, ensure the stability of the German financial centre. Moreover, we must make certain that all institutions across the eurozone are supervised and regulated in accordance with the same standards. But another thing is clear: everything we do, we do as supervisors, not as agents for location policy. One thing that we definitely will not accept is the presence of empty shells containing nothing more than a letterbox and a telephone diverting calls to London.

However, there is a broad array of possibilities between letterbox companies and a wholesale move to Germany. We will therefore look closely into each business model and weigh up each legally possible option. We will also keep a close eye on the further development of the European Commission’s proposal to create “Intermediate EU Parent Undertakings (IPUs)”, i.e. single parent companies into which banks from third countries are supposed to bundle their EU subsidiaries in the future.

This discussion is still a long way from being over. First of all, the European legislator needs to introduce the necessary legal requirements during the review of the Capital Requirements Directive (CRD). In this respect, we, as supervisors, would also welcome an EU-wide harmonisation of the rules and regulations on third-country branches, which at present are regulated only at national level.

Would it help financial stability if any cliff effects that might occur in spring 2019 could be effectively minimised? I think so! We are therefore prepared, for example, to relieve banks of work that at short notice is almost unachievable. For instance, we have decided, in agreement with the ECB, to permit internal models for calculating capital in sister companies for a limited time period where these have previously been authorised by the British supervisory authority, the Prudential Regulation Authority (PRA), provided that certain conditions are met. However, the institutions must first of all submit to us the applications required for this, including an action plan. And, of course, binding agreements must be reached regarding specific further activities.

Usually, several supervisory interviews and workshops will be required, in which the models that the institutions have used previously and the structure of possible transition processes will be clarified, step by step. Only after a number of checks will the bank be able to use its internal model in practice. The bank will remain on the radar of ongoing model supervision, however, with the goal of establishing, within a predetermined period of time, a model structure which we have inspected ourselves.

We have already conducted initial workshops with some institutions, and the experiences so far have been very positive. Others are taking their time in letting us know their intentions. I’m sure that everyone in Germany knows the saying “he who comes too late is punished by life”. Supervisors are not that merciless. But I would like to point out that our resources are limited, too. Institutions would do well to submit their applications for authorisation extensions or licences sooner rather than later, and rectify any potentially missing details during a dialog-oriented application process. Otherwise they run the risk of ending up at the back of the queue.

Ladies and Gentlemen,

Another hot topic is that of back-to-back models. Back-to-back here means EU undertakings concluding a transaction in financial instruments and at the same time entering into inverse trading transactions with a company based in London in order to transfer the market price risks. In principle there is no reason to object to this. However, we expect institutions to have adequately trained employees available for such transactions who are able to assess how many risks and which risks – including market risks – are actually being passed on to the UK, or, looking at it the other way around, how many are to remain in the EU. The banks must be in a position to sensibly manage the remaining risks at all times – even if a back-to-back transaction should suddenly no longer be possible or be subject to disruptions. An out of sight, out of mind mentality would be dangerous.

Many institutions find it convenient for their back office and internal control functions, such as risk control, compliance or internal auditing to be carried out largely by a company based in London. The same applies here: in principle, as in many other situations, outsourcing is possible.

As is always the case, however, it comes down to finding the right balance. If an institution goes overboard in outsourcing sensitive areas, the in-house control systems might be thinned out so much that the institution becomes disproportionately dependent on partners in the UK or elsewhere. Simply latching on to group structures will therefore not be allowed. Appropriate control units must be present within the EU undertaking, and all undertakings wishing to move into the EU for the first time should therefore prepare for the fact that these functions are to be present within an institution in the EU27 countries. This corresponds to the line taken by the Single Supervisory Mechanism (SSM), which has already stated its basic position on this – and, of course, we share that view. However, there are possible exceptions to this rule for those subsidiaries which are considered immaterial from a risk point of view.

Limits are set on outsourcing in particular where the core areas of banking and control functions are concerned. And if we look closely at the core areas and control functions, we do this all the more for the management board. The duties of a management board member cannot be fulfilled by “just dropping by”.
It must be ensured that the managers are also able to complete their on-site duties in full. “Fly and drive” might be acceptable in some cases and for a transitional period, but in the long-term we also expect the top level of management to be present in the EU27 countries with more than just a nameplate.

It is not without reason that euro clearing is a hot topic at the moment. After all, more than 95% of all interest rate swaps in euros to date have been cleared through London. If something were to go wrong, a call for help could quickly be made to the central banks to provide liquidity. For this reason, a few weeks ago the European Commission published its ideas for the stricter supervision of central counterparties domiciled outside the European Union.

It is obvious that clearing activities in euros outside the European Union cannot simply be met with a shrug; instead, EU standards for financial regulation and supervision must be enforced in one way or another.

But the question gripping us all is: how, exactly? In the end, the European Commission left this unanswered, but instead suggested a staged process. In my opinion, this is the correct approach. Before making a decision, however, we should take the time to carry out a comprehensive analysis of the systemic risks and weigh up the possible reactions and consequences, including the possible reactions of third parties.

Moreover, we must not forget that nowadays almost all business processes in the financial sector depend on functioning IT infrastructures. As such, it comes with the territory that those banks that are planning a comprehensive division of work between operating units in the UK and the EU need to place a particular focus on their IT systems. These are highly complex platforms, and platforms doesn’t just mean IT. We are talking about knowledge, processes and people which have gathered together over many years, almost like a complete work of art, and now have to be split apart.

Supervisors know the significance of this issue and are prepared to allow old IT ecosystems to continue running for the time being until it is possible for completely new structures to be built and proven to be sufficiently sound. Many a time in the past we saw large IT migration projects being met with delays and unexpected problems, simply because their complexity was underestimated. In theory it would be conceivable to leave such platforms in their former locations entirely, but I have my doubts as to whether this would be of any use in practice. New offices have to be connected to the existing infrastructure in one way or another, meaning that migration processes are likely to remain unavoidable.

The institutions therefore have to carefully weigh up which strategy they wish to pursue: partial or complete relocation. Anybody who has moved house knows that while it is inconvenient, it also offers a good opportunity to declutter. Just as private individuals might get rid of Grandma Edna’s transistor radio, banks can take the chance to modernise old IT systems and processes that have diverged over time.

Yet from the point of view of a New York head office, for example, decluttering might also mean simply focussing completely on the USA or the Far East if the disputes between the UK and the EU27 countries are too drawn-out.