International banks in the UK are under increasing pressure to tighten compliance with post-Brexit rules amid a regulatory review.
According to a person familiar with the process, the European Central Bank will complete its so-called desk-mapping exercise in the first quarter. This is the first step in ensuring companies on the continent don’t operate empty shell companies while continuing to do the majority of their business in the UK.
The report comes as a year after the end of the transition period, banks and other businesses have found creative ways to circumvent Brexit, formally ushering in the UK’s exit from the EU for most financial services firms. In January 2021, senior ECB officials questioned whether London banks had moved enough staff to the EU, and since then discussions have increased over the need to potentially move billions in capital and hundreds of employees to the EU.
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National regulators from Ireland and the Netherlands have called wrong some of London’s efforts to circumvent the rules.
Of concern to the city is that the ECB probe could result in lenders across the market being assessed on their assets and risks. It could also pave the way for European regulators to become more active enforcement agencies, legal experts say, and banks are cautious.
“Some banks expect that the exercise will mean that they will have to significantly increase their presence in the EU. London must avoid being hollowed out,” Peter Smith, director of consultancy FinTechReguLab and UK fintech ambassador to trade association TISAtech, told Financial News.
The report shows what the different desks are doing with which employees, products and reporting lines. There will then be a follow-up phase to get in touch with banks. The mapping will look at some quantitative data – such as profit and loss accounts – but also aim at more detailed information to assess whether deals on EU shores are being properly conducted, the source said.
According to the person, the ECB does not intend to monitor new rules. It is simply a matter of implementing previous expectations and assessing the extent to which previous statements on issues are being followed.
Although the ECB has not given any formal details of its investigation, the aim is to ensure that risks and other controls are not concentrated in London and that EU customers are protected within its borders.
European authorities have adopted an increasingly strict tone to ensure financial institutions doing business in the EU pay more than lip service to the changes in regulations since Brexit.
Financial News has reported on several loopholes London firms are using to continue serving EU customers. These include reverse solicitation — getting the client to specifically request the overseas service, rather than the other way around — and brass plating or escorts, where overseas offices or employees are involved in the client’s work as a ticking exercise.
The practice of using specialized European platforms with multiple licenses will also be put to the test.
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Now that 12 months have passed since the transition phase, the desk-mapping report aims to “provide evidence of what is actually happening in the real world against the rules,” said Rob Moulton, global co-chair of Financial Institutions Group at Law Firm Latham & Watkins.
Tensions surrounding the exercise show “the difficulties when legitimate regulatory concerns about risk management, which are beyond the sight of relevant national authorities, are mixed up with political discussions,” a senior city politics source said.
Expect more “shadow boxes” between the UK and EU this year on who moves onto divergence first, they added.
Moulton said the ECB’s reviewers could look for evidence across companies to find individual outliers. In the further course, however, the EU authorities could deal more strictly with bans, fines and other sanctions for rule violations.
“What’s actually going to move the markets is actual enforcement…bringing up a technical case against an established player,” Moulton said. “It takes time for things to go through the machinery.”
The European Securities and Markets Authority has issued several guidance post-Brexit, encouraging companies not to flaunt new access rules.
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However, it would be up to national regulators to fine or ban companies or individuals for breaching the rules, as Esma’s role is limited to overseeing and coordinating approaches across the EU.
“This gives Esma a bigger role as an enforcement authority,” Moulton said. “When you harmonize regimes, that’s the argument that Esma is the enforcer for incoming deals because it becomes an EU issue, not a national one.”
Among the issues that could be subject to closer scrutiny are: “Regulators are obsessed with where European customers are being served from,” Moulton said.
“For the front office, where are they served and where are the customers located? Where are these risks managed in the back office?”
Esrar Moitra, a director at compliance consultancy Braithwate, said raids are unlikely to shock the city — the use of escorts and a loose interpretation of reverse solicitation, for example, are “clearly being used to expand or breach the EU’s regulatory perimeter.” .
Moitra has singled out another area that has flown under the radar: back-to-back trading, where banks conduct a parallel transaction in the UK while doing business in another jurisdiction. The two transactions are legally separate, but sales and purchases are linked, essentially shifting risk back to the UK.
Before Brexit, the ECB urged banks not to use this practice to shift risk out of the EU, but it has received limited attention since the UK left.
“When the counterparty to trade is in the EU, there are still risks to financial stability within the EU and EU regulators will lose oversight and control by devolving to the UK,” Moitra said. “When they limit the ability to transfer risk, there is a significant impact on operating costs, staffing and return on equity.”
To contact the author of this story with feedback or updates, email Justin Cash