SRB publishes second report on resolution planning and crisis management for LSIs in 2023 and 2024

RegCORE – Client Alert | Banking Union

QuickTake

On 12 September 2024, the Single Resolution Board (SRB) published its secondFirst Report available assessing 2022 and 2023 available here.Show Footnote report (the Report)Available here.Show Footnote on resolution planning and crisis management for smaller banks i.e. those that are categorised as less significant institutions (LSIs) in the context of Banking Union supervision and resolution. LSIs, with the exception cross-border LSIs, remain for purposes of the Single Resolution Mechanism (SRM) under the direct responsibility of national resolution authorities (NRAs) with the SRB having an oversight role.

As at 1 January 2024 there were 1,915 LSIsDown from 1,939.Show Footnote at the highest level of consolidation with an aggregate total assets of EUR 4.9 trillion (approximately a third of the GDP of the 21 Banking Union participating Member States. Three quarters of LSIs are cooperative and savings banking networks. Some of the remaining 500 LSIs are custodians, investment banks, or financial market infrastructures. 17 NRAs have earmarked 70 LSIs for resolution in case of failure due to their important functions and financial stability.

The Report examines key developments amongst NRAs and LSI’s as well as their efforts, including on the 2023 resolution planning cycle (RPC) and evaluates the progress made by LSIs in terms of the build-up of their minimum requirements of own funds and eligible liabilities (MREL) and overall resolvability – key themes in the SRB’s new “SRM: Vision 2028 Strategy”As assessed in this Client Alert available hereShow Footnote and Multi-Annual Plan 2024-2028.Available here.Show Footnote A particular focus of the Report analyses the rise of digital only LSIs, in particular where they offer “Banking as a Service” platforms.

As discussed in the Report, all LSIs that had to comply with their final MREL targets as of 1 January 2024 have met their obligations, while the remaining MREL shortfalls are attributed to entities with extended transitional periods.Several NRAs prolonged MREL transitory periods as permitted under legal requirements, often owing to a change in resolution approach. The total risk exposure amount (TREA) shortfall from these postponed deadlines is EUR 2.8 billion.Show Footnote NRAs continue to phase in and proportionately implement the SRB’s “Expectations for Banks” (EfB), including its resolvability assessment (heatmap) approach. As noted in the Report, LSIs show good progress on the resolvability capabilities prioritised by their respective NRAs in 2022-2023.

As further announced in the Report, the SRB is clear that in the 2024 RPC, NRAs will focus on the remaining issues to foster LSIs’ resolvability and their own crisis preparedness. This includes ensuring that the preferred and, where applicable, variant resolution strategies can be credibly and feasibly implemented. The SRB published further details on the 2024 RPC in a new booklet published 14 June 2024 (the 2024 RPC Booklet).Available here.Show Footnote This 2024 RPC Booklet provides a comprehensive framework for resolution planning, emphasizing the need for banks to enhance their resolvability, meet MREL requirements, ensure operational continuity, and maintain robust liquidity management. The SRB’s approach aims to ensure that banks can be resolved in an orderly manner, minimising the impact on the economy and public finances. The SRB will monitor compliance with the EfB which was phased-in by end 2023. Moreover, the SRB will focus its resolution planning activities on testing banks’ resolvability and the operationalisation of the resolution strategies defined in the resolution plans. This will be integrated into the annual RPC for 2024 without changing its overall timelines and key elements.

As explored in this Client Alert, while the Report indicates progress, there are a number of key lessons that some LSIs may want to review. The Report also makes for interesting reading for other new or existing market participants in particular the Report’s views on certain types of LSIs.

Key takeaways from the Report

The SRM, overseen by the SRB, ensures the consistent application of high-quality resolution standards across LSIs in the 21 participating Member States of the Banking Union. While NRAs hold direct responsibility for LSIs, the SRB provides oversight to guarantee uniformity and effectiveness in resolution planning and crisis management. LSIs and certainly market participants engaging with them should be aware that the SRB and NRAs work collaboratively, both bilaterally and multilaterally, to maintain a level playing field.

As a recap, LSIs are subject to the Bank Recovery and Resolution Directive, as amended and supplemented (herein simplified as BRRD) and the Single Resolution Mechanism Regulation, as amended and supplemented (herein simplified as SRMR). Simplified obligations (SOs) may apply to certain LSIsOut of 1,869 LSIs 97.1% (1,814) are eligible or SOs. No LSI earmarked for resolution was considered eligible for SOs.Show Footnote, reducing the frequency and complexity of resolution planning updates. LSIs and by extension market participants engaging with them must ensure that these regulatory requirements are complied with and that the implications of SOs on the institutions’ operational and financial strategies are understood.

In light of the above, the Report aims to (i) foster convergence and harmonisation further by setting out the SRB’s evaluation and findings and (ii) facilitate transparency towards LSIs but also market participants on what has been evaluated and the signalling on supervisory expectations going forward. The Report therefore reminds NRAs, LSIs and the market that this includes the following areas of focus to LSIs generally as well as those with specialist business models and/or other special characteristics:

1. Resolution planning and coverage

• Annual RPC: LSIs must engage in annual resolution planning, which aligns with the SRB’s RPC timeline from April 1 to March 31. The 2023 RPC covered 1,939 LSIs, decreasing to 1,915 in the 2024 RPC due to mergers and reclassifications. This planning includes assessing the eligibility for SOs and setting MREL targets. LSIs are required to ensure they are included in this cycle and maintain up-to-date resolution plans.
• SOs: Most LSIs with a liquidation strategy are eligible for SOs, which reduce the frequency and complexity of resolution plan updates. 3 LSIs should verify their eligibility for SOs and understand the criteria set forth in the Commission Delegated Regulation (EU) 2019/348. The eligibility assessment involves a two-step process consisting of a quantitative test and a qualitative assessment, ensuring that LSIs’ impact on financial stability is thoroughly evaluated.

2. Resolution strategies and tools

• Preferred resolution tools (PRTs): The Report indicates that NRAs predominantly opt for bail-inOn bail-in it should be noted that on 26 June 2024, the SRB published a document addressed to banks, investors and other stakeholders as well as links to NRAs’ mechanics for bail-in (in line with EBA Guidelines). Bail-in is a key resolution tool in a banking crisis, in order to absorb losses and recapitalise failing banks. It allows the write-down of debt owed by a bank to creditors or its conversion into equity to absorb losses and stabilise the bank. The mechanics of how bail-in is applied to a bank under resolution is defined by each national authority in line with its national legal framework.Show Footnote and sale of business (SoB) as the PRT. LSIs are expected to step-up preparation around these tools by developing bail-in playbooksOn 20 June 2024 the SRB communicated that it is developing and updating its expectations for banks on valuation capabilities as part of its Vision 2028 Strategy. Bank valuation is a key tool for effective resolutions, with three reports that determine whether the bank is failing or likely to fail (valuation 1), provide input into the use of bail-in and other resolution tools (valuation 2), and to ensure that creditors would not be worse off than if the bank went into insolvency (valuation 3). A specific consultation on valuation capabilities expectations to gather views from the industry and other stakeholders on the approach will be carried out in 2025 as a continuation of and update to the current SRB valuation framework.Show Footnote along with transfer playbooks and separability analysis reports. For those with special business models, SoB may be a more applicable approach.
• Variant resolution tools (VRTs): NRAs have also identified VRTs for many LSIs, such as bridge institutions. LSIs must ensure they have operational plans for these tools, including governance, communication, and market interest assessments. Of the 70 LSIs earmarked for resolution, the VRT has been set or 36 LSIs with SoB being the VRT or bail-in in 11 cases and in one case for the bridge institution. Conversely the bridge institution is chosen in 19 cases as the main VRT to the SoB strategy. Bail-in is the VRT to the SoB in five cases.

3. MREL

• MREL targets: LSIs earmarked for resolution must meet full MREL targets, including loss absorption and recapitalisation amounts. The average MRELTREA target is 21.6%, rising to 25.2% when including the combined buffer requirement (CBR). LSIs are required to regularly monitor their MREL compliance and prepare for any transitional periods granted by NRAs.
• MREL resources: The composition of MREL capacity is crucial, with a significant reliance on Common Equity Tier 1 (CET1) capital. LSIs are expected to evidence how they diversify their MREL-eligible instruments to include senior unsecured liabilities and other eligible liabilities.

4. Specific considerations for different types of LSIs

• Cooperative and Savings Banks: These institutions, which are concentrated in Germany and Austria, often operate within non-consolidated networks with Institutional Protection Schemes (IPS). Each entity is considered on a stand-alone basis for resolution planning, requiring individual MREL targets. Cooperative banks in Austria have a 39% market share in terms of total assets. Savings and cooperative banks in Germany have a 28% and 18% national market share respectively. LSIs contribute substantially to the aggregated total assets of these cooperative and savings bank groups. For example, the aggregated total assets of Austria’s cooperative network are evenly split between Significant Institutions and LSIs.
• Foreign-owned LSIs: LSIs with majority foreign ownership must consider the implications of their parent companies' operations outside the Banking Union. The SRB reiterates the need to ensure compliance with both EU regulations and those of their parent jurisdictions.
• Financial Market Infrastructures (FMIs): LSIs functioning as FMIs, such as central securities depositories (CSDs), must adhere to both CRR and specific FMI regulations like EMIR or CSDR. They are reminded on the need to prepare resolution plans that account for their dual roles and being exempted from BRRD/SRMR resolution planning and instead subject to the CCP Recovery and Resolution Regulation. In contrast to CCPs, the CSD Refit Regulation does not provide for a specific CSD recovery and resolution regime which means that CSD specifics need to be accounted for in BRRD/SRMR plans.
• LSIs that are part of insurance groups: Numerous LSIs are affiliated with international insurance conglomerates and depend on the insurance sector for financing. In the SRB’s view, there exists a risk of exogenous shock originating from the activities of the parent insurance organisations, which would impact the corresponding LSIs. Importantly, insurance groups fall beyond the jurisdiction of the Banking Union and thus beyond the SRB’s mandate. In September 2021, the European Commission released a legislative proposal for a new EU Insurance Recovery and Resolution Directive (IRRD) as part of its extensive review of Directive 2009/138/EC (Solvency II). As discussed in a separate Client Alert the IRRD will establish a unified recovery and resolution planning framework for EU (re)insurance entities and their conglomerates. The objective of the framework is to furnish a reliable array of resolution instruments to intervene promptly and effectively in the event that (re)insurers are failing or are at risk of failure. The idea employs a 'pre-emptive' strategy, requiring insurance companies to present plans to supervisory authorities, which would be empowered to execute resolutions. The proposal delineates a variety of tools for resolutions. The IRRD’s approach, although primarily influenced by the BRRD, exhibits numerous distinctions that correspond to the unique nature, complexity, and challenges of (re)insurance entities. The Committee on Economic and Monetary Affairs (ECON) of the European Parliament adopted its report in July 2023. On 14 December 2023, the co-legislators attained an interinstitutional provisional agreement, subsequently ratified by the ECON Committee on 29 January 2024. The subsequent procedures involve the ratification of the IRRD text by the plenary session of Parliament and by the Council. It remains to be seen how the IRRD will translate into supervisory practice and operations of the NRAs.

5. Specific expectations on digitalisation

In comparison to the first report, the SRB uses the Report to communicate its views on risks of digitalisation more generally as well as specifically those that are FinTech LSIs. In many ways the SRB’s views echo those expressed by the European Central Bank, acting in its role at the head of the Single Supervisory Mechanism. In the SRB’s views the following is relevant:

• Digital-Only LSIs: So-called “FinTech LSIs” or “neobanks” are reminded that they must balance rapid client acquisition with stringent KYC and AML/CTF requirements. The Report notes that typically, FinTech LSIs start as digital startups and eventually enter the financial sector, acquiring a banking licence by application or acquisition. They should also ensure their governance structures and capital adequacy keep pace with their growth. The SRB specifically calls out that a notable distinction between FinTech LSIs and traditional business models are that traditional LSIs rely on retail deposits as their funding source whereas FinTech LSIs moving from start-up to scale-ups aim to increase valuations through venture capital and massive client acquisition.
• Digitalisation of LSI sector more broadly: The Report notes that in addition to the above-mentioned Digital-only LSIs the wider digitalisation of internal processes plus technology outsourcing carries with it risks (including those beyond just what DORA looks to capture). LSIs are viewed by the SRB as increasingly relying on external technology providers for everything from email to complex financial applications. The concept of ‘ICT as a service’ involves credit institutions using commercially available solutions instead of developing their own applications. Outsourcing core IT operations to third-party vendors for efficiency reasons creates IT concentration risk for players outside the BRRD. This issue is especially important for LSIs with limited resources for in-house IT development. A lack of commercial enterprises offering software and cloud services to the global financial system poses systemic problems. The entire national LSI industry may rely on a few huge tech businesses for software services, resulting in associated dangers. Similar to other firms, LSIs may face cyberattacks, such as DDoS attacks, malware, and phishing, to compromise their digital security measures. The danger of a core banking system failure includes substantial breakdowns in software and hardware infrastructure supporting fundamental banking activities, such as project failures or physical damages. Both types of incidents can lead to a rapid crisis scenario, as with other operational incidents and contagion.

4. Crisis preparedness and management

In terms of crisis preparedness, the Report mentions the European Commission's proposal to further strengthen the EU’s bank crisis management and deposit insurance (CMDI) framework, addressing key challenges identified by the SRB in its LSI oversight role but equally assesses:

• Crisis simulation exercises: The SRB conducted its first LSI crisis simulation in February 2024, focusing on a hypothetical failing LSI requiring the use of the Single Resolution Fund (SRF). LSIs are required to participate in such exercises to enhance their crisis readiness and understand the cooperation required among SRM authorities. The SRB and NRAs are enhancing LSI crisis preparedness and management through discussions about best practices and by developing SRM procedures. The SRB coordinated the organisation of the LSI dry run, involving active participants – the Spanish, Italian, and Portuguese NRAs and the European Commission. The SRB oversight function ensures coordination among NRAs if they participate in the same resolution colleges, but also liaise with the competent resolution units if a resolution college concerns both SRB banks and LSIs.
• Global challenges: LSIs must be ever aware of macro-financial and geopolitical risks, such as rising interest rates and potential credit quality challenges. Additionally, the increasing reliance on external technology providers poses IT concentration risks, which LSIs should mitigate through robust cybersecurity measures and contingency planning.
• Actual cases during 2023: The Report equally assesses the two LSI crisis cases arose during 2023 and in one Member State – Luxembourg. The SRB was cooperatively involved in the crisis monitoring process and the Luxembourg NRA broadly followed the established process following a non-resolution decision allowing for efficient case handling from an LSI oversight perspective. As the Report summarises these two cases include:
  • Fortuna Banque s.c.: While in the process of winding down business operations, which began in August 2022, the operational processes put in place by the bank made it no longer possible to ensure temporal adequacy between cash inflows. This led to the failing or likely to fail (FOLTF) declaration by the Luxembourg national competent authority (NCA) and the negative PIA assessment by the Luxembourg NRA. On 12 October 2023, the Luxembourg NRA informed the public that the Luxembourg Tribunal d’arrondissement (District Court) had on that day ordered the dissolution and winding up of the LSI.
  • East-West United Bank S.A.: Similarly, the FOLTF declaration and the negative PIA assessment by the Luxembourg authorities came in the particular context of the cessation of banking activities of East-West United Bank S.A., as publicly announced in August 2023. The bank’s dissolution and winding up were later ordered by the Luxembourg Tribunal d’arrondissement (District Court) on 7 February 2024. Consequently, the unavailability of deposits in both cases triggered the intervention of the Luxembourg DGS, the Luxembourg Deposit Guarantee Fund, in order to pay out the covered deposits. Moreover, in both cases, the judicial liquidation of these banks triggered the activation of the Luxembourg investor compensation scheme, the Investor Compensation Scheme (SIIL).

Outlook and next steps

The SRB has laid out a comprehensive roadmap for the continued enhancement of resolution planning and crisis management for LSIs within the Banking Union. This includes a rigorous assessment of the remaining MREL shortfalls and the implementation of the SRB’s “EfB” framework. The SRB’s oversight is expected to remain crucial in maintaining the momentum of these initiatives, ensuring that LSIs are not only compliant with regulatory requirements but also resilient in the face of potential financial crises.

A key area of focus will be the digitalisation of LSIs, particularly those operating as FinTech entities or “neobanks.” The SRB has highlighted the unique challenges these institutions face, such as balancing rapid client acquisition with stringent KYC and AML/CTF requirements, an area that is already drawing supervisory scrutiny. Moving forward, LSIs will need to ensure that their governance structures and capital adequacy keep pace with their growth. Additionally, the reliance on external technology providers for core IT operations introduces significant IT concentration risks, which must be mitigated through robust cybersecurity measures and contingency planning and the SRB as well as NRAs are likely to double down their interest on supervisory authorities’ efforts supervising LSI’s compliance with DORA and more general third-party (digital) operational risk management requirements.

The SRB’s commitment to fostering convergence and harmonisation across the Banking Union will also see a sustained emphasis on crisis preparedness and management. The recent crisis simulation exercises have underscored the importance of coordinated efforts among SRM authorities and NRAs. LSIs will be expected to participate actively in these exercises to enhance their own crisis readiness. Furthermore, the SRB will continue to work closely with NRAs to develop best practices and standardised procedures for crisis management, as amended by the CMDI, ensuring that all LSIs are well-prepared to handle potential disruptions.

Looking ahead, the SRB will also monitor global macro-financial and geopolitical risks that could impact LSIs. Rising interest rates, potential credit quality challenges, and the increasing reliance on external technology providers are just a few of the risks that need to be addressed along with geopolitical pressures causing uncertainty in markets. The SRB's proactive approach in identifying and mitigating these risks will be essential in maintaining the stability and resilience of LSIs. As part of this ongoing effort, LSIs will need to stay informed about regulatory developments and ensure that their operational and financial strategies are aligned with the evolving regulatory landscape.

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