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On 1 July 2020, the ECB published its draft Guide on the supervisory approach to consolidation in the banking sector for consultation until 1 October 2020.The Guide describes the supervisory process and expectations for bank mergers in Europe. It provides transparency rather than new requirements. The ECB acknowledges that mergers could result in badwill which should be used to increase the sustainability of the business model of the consolidated entity rather than to be distributed to investors.

The Guide reiterates that any merger should be discussed with the ECB early on before any public disclosures. The discussion should be well prepared to demonstrate the benefits of the merger, the compliance with regulatory and prudential requirements at all times and the sustainability of the business model.

The Guide covers the following topics:

  • The overall approach to the supervisory assessment of consolidation projects;
  • The supervisory expectations regarding consolidation projects;
  • The supervisory approach to key prudential aspects of the consolidation transaction;
  • The ongoing supervision of the newly combined entity; and
  • The application of this framework to business consolidation transactions involving LSIs.

The ECB considers three project phases of a merger i.e. (1) the early communication, (2) the application and (3) the implementation phase:

  • During the communication phase, the ECB encourages parties envisaging consolidation to engage with the ECB early in the process. The ECB will notify the engaging parties, if a formal approval is required.
  • During the application phase, the concrete project plan, including underlying financials and the envisaged implementation strategy needs to be discussed with the ECB. In this phase the ECB provides its approval for continuing the planned merger.
  • Enhanced monitoring and supervision during the implementation phase should ensure a progress of post-merger integration in line with the integration plan in a sustainable manner and in full compliance with the prudential requirements and conditions.

Supervisory expectations regarding consolidation projects

The ECB expects a sustainable business model and strategy presented in a comprehensive group-wide business plan and a clear governance and risk management structure in full compliance with regulatory requirements.

The business plan should include a clear reconciliation of the projected balance sheet and profit and loss of the planned entity with the latest balance sheet and P&L of the merging entities in terms of capital positions, business structure, strategy and profitability.

The governance and risk management structure should ensure a clear decision-making capacity and adequate composition of the management body. The ECB expects a leadership team in place with a proven track record in the relevant banking business areas, M&A as well as risk management. Adequate remuneration schemes including variable remuneration linked to risk factors should set the right incentives in relation to the execution of the business combination.

Supervisory approach to key prudential aspects of the consolidation transaction

The supervisory approach consists of three main aspects:

  • The Pillar 2 capital requirements and Pillar 2 guidance;
  • The prudential treatment of a potential badwill, and
  • The transitional arrangements for the use of internal models.

The Pillar 2 capital requirements and Pillar 2 guidance

The ECB outlines that credible integration plans will not be penalised with higher capital requirements. The starting point will be the weighted average of the P2R and P2G levels applicable to the two entities prior to the consolidation under consideration of necessary adjustments in events of insufficient improvement of the risk profile. The determination of ex post capital requirements should be clarified during the application process and the underlying business plan, with credible trajectories for the level of capital in a reasonable manner (due to high costs booked at the beginning and benefits in the long run).

The prudential treatment of a potential badwill

Potential badwill can arise in amount of the difference of the price paid for the entity and the higher book value of its equity. The ECB recognises duly verified accounting badwill, unless there is specific supervisory evidence of valuation issues not yet recognised but expects badwill to be used to increase the sustainability of the business model of the combined entity e.g. by increasing the risk provisioning or covering integration costs. Furthermore, it is expected that badwill will not be distributed to the shareholders of the combined entity, until the sustainability of the business model is firmly established. In this regard, the ECB will assess the actual use of badwill and its contribution to strengthening the post-merger own funds.

The transitional arrangements for the use of internal models

Subject to a clear model mapping and a credible internal model roll-out plan tackling issues arising through the merger, the ECB grants a limited period of time, in which post-merger entities might continue to use the internal models in place before the merger.

Ongoing supervision of the newly combined entity

The ECB plans an ongoing monitoring during the implementation phase as well as a full post-merger convergence with standard supervisory activities. The monitoring includes a dedicated reporting framework including information on achieved progress, issues and problems in the key areas, the current state of the roll-out plan as well as legacy assets reduction plan.

Supervisory approach to consolidation transactions involving Less Significant Institutions

The outlined supervisory approach to consolidation also covers LSIs, with due consideration to the respective competences of the respective National Competent Authorities. ECB’s competence concerning LSIs is limited to business combinations requiring an assessment of a proposed qualifying holding notification. In general, National Competent Authority have competence for merger approvals when provided for by national law.

In conclusion, from a market perspective, it is highly appreciated that the ECB is increasing transparency and intends to make supervisory actions more predictable and avoid misperceptions of supervisory expectation. 

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