ECB Guide On The Supervisory Approach To Consolidation In The Banking Sector

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On January 12, 2021, the European Central Bank ("ECB"), as the highest authority for monetary and economic policy in the euro area, presented the final version of its guide on the supervisory approach to consolidation in the banking sector.

This guide does not set new regulatory requirements for credit institutions, hence its principles should not be perceived as legally binding rules. The aim is rather to improve the planning process of bank consolidations, as the guidelines more clearly define ECB's expectations and perceptions regarding such transactions. This should make it easier for credit institutions to avoid possible misjudgements about expected actions of the supervisory authorities and eliminate existing uncertainties. The principles laid out in the guide are intended to serve as a starting point for supervisory decisions, which can be fit to the individual characteristics of each transaction.

Key Aspects Of The New Guide

A key element of the new guide is the recognition of the accounting value of negative corporate value ("badwill") in the course of bank consolidations. Badwill is created when the takeover price, which is usually based on the market capitalisation of the transferring bank, is lower than such bank's equity value. A low market capitalisation (in relation to the equity value) often reflects the uncertainty of investors regarding the assessment of the future profitability of the credit institution.

ECB's conception is that the monetary benefits of the lower takeover price (due to badwill) should be applied to cover transaction or integration costs or used for investments in the continued stability of the new credit institution's business model. Particularly, the ECB expects that any profit arising in connection with badwill will only be distributed to shareholders via dividend payments once the sustainability of the business model has been properly ensured.

In a merger or similar transactions, a substantial share of the costs can be accounted for upfront, while the potential benefits start to accrue only at a later stage. In the ECB's guide, this dynamic is accounted for in Pillar 2 (banking supervision) of the Basel framework: After the consolidation, the respective levels of mandatory Pillar 2 capital requirements (P2R) and non-mandatory Pillar 2 guidance (P2G) are calculated as the weighted averages of the respective P2R and P2G levels of both banks involved in the transaction. Based on a case-by-case assessment by the supervisor, these levels can then be adjusted upwards or downwards. The latter might be the case if it can be anticipated that the consolidation will lead to further diversification of the joint portfolio or that the business model will become more resilient and stable as a result of the consolidation.

Additionally, the guide provides for the possibility of a continued use of the internal calculation models for capital requirements for a limited period of time after the consolidation, which is a relief for credit institutions: The otherwise mandatory switch of the (acquiring) credit institution to the standardized approach in the valuation of its risk-weighted assets would represent an additional regulatory burden, could lead to an increase in risk-weighted assets and thus to an increase in the capital requirements. By the continued use of the internal calculation models for a limited period of time, this can potentially be avoided.

Bank Mergers As A Means Of Tackling Fragmentation In The European Banking Sector

Mergers or similar transactions in the banking sector pose opportunities and risks for the institutions involved as well as for the well-functioning and resilience of the entire banking sector. The European banking sector is considered to be fragmented and crowded. Strategic consolidation transactions amongst banks could counteract this. At the same time, the synergy effects of such transactions could lead to cost savings for the banks involved, which would subsequently increase the competitiveness of the new institution in the (international) market. In the past, consolidation transactions were examined on a case-by-case basis by the European banking authorities. The ECB's position on key issues – recognition of badwill, capital requirements of the merged credit institution and the continued use of internal risk assessment models (for a limited period of time after the consolidation) – will make it considerably easier for banks to plan their consolidation projects.

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