Business combinations within the banking sector are complex, not least because of the prudential regulatory implications. An early alignment with the competent prudential supervisors – in particular the European Central Bank (ECB) in case of significant institutions – is critical for an efficient consolidation transaction. On 12 January 2021, the ECB provided more clarity on its supervisory approach (PDF) and outlined its expectations in relation to three key prudential aspects.

What are the ECB’s requirements on consolidation transactions?

A consolidation transaction can come in different forms, such as mergers between regulated institutions or an acquisition of one regulated institution by another. The ECB will not assess whether consolidation transactions are beneficial nor will it push any particular kind of consolidation transaction. However, the ECB confirms that it will ensure that the entity resulting from the consolidation transaction will comply with prudential requirements and that its business combination will be sustainable, so that the combined entity will also comply with prudential requirements in the future.

For that purpose, the ECB expects that the business combination strategy is supported by a credible and comprehensive group-wide business plan that must establish, among other things, full compliance with the applicable regulatory requirements, supervisory measures and expectations, such as Pillar 2 requirements (P2R) and Pillar 2 guidance (P2G), and macroprudential buffers. 

The ECB further assesses the envisaged governance and risk management framework of the combined business and expects a consolidation plan that outlines the timely integration of the risk management and internal control framework. The ECB further emphasises the close monitoring of the consolidation plan by the management function and strong oversight by the supervisory function. However, it also accepts that, for IT integration for example, only a limited level of detail can be provided during the early stages of the transaction.

What are the key prudential aspects that the ECB addresses?

The ECB addresses three key aspects that often play a central role in determining the feasibility of a business combination:

  1. post-consolidation P2G and P2R;
  2. the prudential treatment of 'badwill'; and
  3. the transitional arrangements for the use of internal models.

P2G and P2R

P2G and P2R cover risks that are not adequately addressed by the Pillar 1 framework and the level of capital that is needed to withstand adverse scenarios, respectively. Consequently, the ECB will assess the main weaknesses of the combined entity and the execution risk of the business plan, and on this basis clarify the post-consolidation P2G and P2R requirements. 

The weighted average P2G and P2R of both institutions serve as a starting point and may be adjusted in the individual case. For instance, according to the ECB, a lower level of P2G and/or P2R may be achieved by diversification effects of combined credit portfolios or cost-cutting in back-office functions. On the other hand, significant execution risks in relation to the integration plan may justify an increase in P2R and/or P2G.

Badwill 

An accounting badwill generally occurs when the purchase price is lower than the fair value of net assets, eg because of downward pressure on the market valuation of institutions. In line with applicable law, the ECB confirms that, in principle, it recognises duly verified accounting badwill from a prudential perspective.

On the other hand, the ECB expects that such a 'bargain' is used to benefit the sustainability of the consolidated institution, eg to cover integration or transaction costs, or increase the prudence of assets’ valuations (for non-performing loans in particular). 

Further, the ECB expects that potential benefits are – subject to special treatment under national company laws – not distributed until the sustainability of the combined entity is ensured. The ECB announced that it could enforce this by appropriate supervisory measures.

Internal models

The ECB confirms that approvals for the use of internal models are granted to a specific entity and cannot be transferred to another legal entity. Consolidation transactions may therefore result in a transfer of exposures without a transfer of the permission to apply a related internal model. 

However, the ECB acknowledges that a (temporary) fallback to a standardised approach may increase volatility of risk-weighted assets and reduce risk sensitivity, which may lead to an unnecessary supervisory burden.

The ECB is therefore prepared to allow the continued use of existing models for a limited period of time. As a prerequisite, a clear model mapping and a credible internal model roll-out plan that considers the issues created through the merger must be submitted. The ECB may in individual cases also impose capital add-ons if capital requirements are underestimated.

How does the ECB supervise consolidation transactions?

Should a formal procedure be required, the supervisory assessment can be distinguished in three phases: 

  1. early communication;
  2. application (if an application is needed); and 
  3. implementation. 

Early communication (ie before the general public is informed) is explicitly encouraged by the ECB within the limits of the market abuse regime. This can help to get confirmation whether a formal decision is needed and early feedback on the supervisory approach that the ECB intends to take.  

The ECB can assume different roles during the application phase for consolidations depending on the transaction structure and relevant member states law. The consolidation transaction may trigger a qualifying holding procedure and/or a merger approval procedure (if national law provides for such procedure). The ECB may also make related supervisory decisions (eg in relation to the post-merger P2R and P2G) during the application phase. Otherwise, a consolidation transaction may be assessed as part of the ongoing supervision of the institutions involved.

During the implementation phase, in which the consolidation transaction is implemented, the ECB will subject the combined entity to an enhanced monitoring framework in terms of execution risks, including specific reporting requirements and a plan to include the combined entity in the supervisory activities (such as the supervisory review and evaluation process (SREP)) as well as supervisory measures, if there are deviations from the agreed plan. 

Supervisory measures include (but are not limited to) additional risk reduction, capital, funding and liquidity requirements. A swift convergence to the standard processes (eg the supervisory examination programme (SEP) and SREP) is preferred by the ECB. If there has been no previous ECB banking supervision assessment, then the supervisory decisions that end the application phase can comprise a first decision on own-funds requirements (but not a full SREP decision).

What are the main takeaways?

Consolidation transactions in the banking sector should be communicated early and clearly to the ECB. For that purpose, the ECB guidance has helpful direction on the most relevant topics that should be thoroughly prepared, clearly communicated and solved at an early stage. The guidance also shows that the ECB is willing to engage constructively in contemplated business combinations and is not, as a matter of principle, sceptical about such transactions.

In addition, a careful reading of the guidance unveils some of the ECB’s expectations in terms of the information and documents that must be submitted. However, each consolidation transaction will have a different focus and there is of course no 'one size fits all' solution, as the ECB reminds us. And it is worth bearing in mind that other relevant players should be taken on board for consolidation transactions, in particular the deposit protection schemes.