At the heart of the methodology for identifying large exposures, the determination of CCGs represents a real daily operational challenge for banks. The existing guidelines have provided a good basis for the work by relying on the concepts of control relationship or economic dependence, or interdependence between control relationships and economic dependence. However, in view of the residual difficulties of the exercise reported by banks and supervisory authorities, the EBA is publishing an RTS which proposes a toolbox, a series of criteria and indicators to further develop the methodology for determining CCGs.
1. Clarification of the definition of a GCC based on the existence of a single risk between several natural or legal persons
A CCG represents two or more natural or legal persons who are so closely linked by idiosyncratic risk factors that it is prudent to treat them as a single risk. Idiosyncratic risk arises when, due to special circumstances of bilateral interrelationships, the financial problems of one person are transferred to another person or persons who would not otherwise be directly affected.
2. Within the framework of the CRR, the RTS specifies and harmonises the rules for determining GCC
In accordance with the requirements of the CRR, the EBA is mandated to clarify the definition of a CCG. A first version of the guidelines already applies since 1 January 2019 to banks and competent authorities. These develop the concepts of control and economic dependence, which are the backbone of the definition of a connected customer group. Both concepts remain unchanged in CRR2.
These new RTS repeal and partially replace the previous guidelines
- The conditions for determining the control relationship, the economic dependency relationship and their interaction remain almost unchanged.
- The explanatory examples, the alternative approach for exposures to central governments and the supervisory expectations regarding control and management procedures for identifying customer connections remain unchanged.
- The RTS provide clear and harmonised specifications on the criteria for forming a group of related customers. These include :
- Provide a comprehensive framework for identifying the group of connected
- Provide guidance on when to redouble efforts to identify connected client groups.
- Provide guidance on how institutions should identify CCGs following the two types of interconnections separately and on when both conditions prevail.
- Clarify in an operational way the concept of interconnection – i.e. where a relationship of control and/or economic dependence should lead to the grouping of customers because they constitute a single risk.
- Propose practical examples for the definition of CCGs.
- Clearly define the circumstances in which interconnections by means of a control and/or economic dependency relationship give rise to a single risk.
- Provide legal provisions for the assessment of situations where control and economic dependencies co-exist and therefore an overall group of connected customers should be defined, as opposed to two or more separate groups of connected customers.
- Specify the exceptional situations in which the establishment can demonstrate to its competent authority that there are circumstances that refute the existence of a single risk.
3. Identification of a group of connected clients
3.1. A GCC based on the control relationship in the accounting sense
The assessment of a control relationship is only the first step in the assessment of the links between natural and/or legal persons, which is carried out before assessing any potential economic dependence and the possible links between control and economic dependence relationships.
Where a controlling relationship exists, the controlling person or entity has legally enforceable rights that establish a strong form of financial dependence of the controlling entity on the controlled person or entity.
The definition of control refers to the definition of the relationship between a parent and a subsidiary, as two legal entities that are subsidiaries of the same parent entity do not control themselves. However, when these legal entities are part of the same consolidated financial statements – i.e. controlled by the same natural and/or legal person – the single risk can be identified, even if there are no exposures to the natural or legal person that controls the group.
Thus this definition of control is as defined in the accounts or by the accounting standards to which an institution may be subject.
If the controlling entity experiences financial problems, it can be assumed that it will use its rights to extract capital and/or cash from the controlled entity, thereby weakening the latter’s financial position. Thus, the financial problems may be transferred to the controlling person or entity, so that both the controlling person or entity and the controlled entity would experience financial problems (“domino effect”).
From the point of view of prudential risk arising from client exposures, it is therefore appropriate to attach the strong assumption of a single risk to a control relationship between different natural and/or legal persons.
However, the CRR provides for an exception which allows the institution to refrain from constituting a group of related customers when it can demonstrate that, despite the existence of a control relationship, these natural and/or legal persons do not constitute a risk.
3.2. The RTS toolkit for determining GCCs based on the control relationship
A CCG is identified when it can be concluded that there is a control relationship between the natural and/or legal persons (“control group”)
- For customers to whom EU accounting rules do not apply, the RTS lists the circumstances that constitute a control relationship and further provides a non-exhaustive list of indicators that institutions should use to assess the control relationship.
- In cases where no consolidated financial statements are to be prepared, the RTS provides a non-exhaustive list of circumstances of control criteria and indicators of control for the assessment if there is a similar parent-subsidiary relationship between the natural and/or legal persons. The two-part list contains circumstances that always constitute a control relationship between natural and/or legal persons and indicators that should be taken into account by institutions in their assessment, as any of these circumstances could constitute a control relationship between natural and/or legal persons.
- The RTS also addresses the case of intra-group exposures, i.e. where the reporting bank is itself part of a comparator group (in other words: an institution owned/controlled by another institution and which is part of a banking group that holds interests in financial and non-financial entities). In these cases, the institution considers the existence of a single risk because the entities in its own group are part of the same consolidated financial statement.
3.3. A GCC based on the economic dependency relationship
If it is likely that the financial difficulties of one natural or legal person will spread to others, affecting the full and timely repayment of liabilities, there is an idiosyncratic risk that must be addressed by considering the natural and/or legal persons to be connected.
Economic dependence between natural and/or legal persons can therefore be mutual or one-way.
Dependency may arise in the context of commercial interconnections that are not related to sectoral or geographical risks, exposing the natural and/or legal persons concerned to the same idiosyncratic risk factor:
- Links in the supply chain.
- Dependence on large customers or counterparty exposures.
- Financial dependence.
If this idiosyncratic risk materialises, one or both debtors may experience repayment difficulties. Therefore, the interconnections between natural or legal persons due to bilateral business relationships may lead to a contagion risk independent of sectoral or geographical risks. The fact that the existence of common idiosyncratic risk factors can lead to a risk of contagion for otherwise unrelated natural and/or legal persons is at the heart of the concept of interconnection. The objective of the definition of economic interconnection is to identify channels of contagion arising from economic dependencies that a natural or legal person cannot overcome without experiencing hardship.
However, if a natural or legal person is currently economically dependent on another person, if it might still be possible for the entity to easily (i.e. in a timely manner without undue increase in costs) find a replacement or compensate for any loss (or loss of profits) inflicted by the financially distressed person without generating repayment difficulties, the reporting bank may not consider such persons as a single risk.
- Economic dependence may arise when the funding problems of one natural or legal person are likely to spread to another due to the same main source of funding. This does not include cases where natural and/or legal persons obtain funding from the same market (e.g. the commercial paper market) or where a common source of funding is due solely to geographical location.
- In many cases, small and medium-sized enterprises will not have the capacity or commercial incentive to have financial relationships with institutions other than their local bank and, moreover, for most of them the personal relationship with their bank advisor is the key to better financial services. This fact does not in itself justify considering these natural and/or legal persons as interconnected, even if they have a common source of funding (potentially even the reporting bank itself).
- These funding dependencies can normally be replaced. Similarly, natural and/or legal persons who are dependent on their existing source of funding due to poor creditworthiness do not represent unique risks.
3.4. The RTS toolkit for determining GCCs based on the economic dependency relationship
Institutions must :
- Take into account the non-exhaustive list of situations provided in the RTS when assessing connections between shadow banking entities.
- Give due consideration to the fact that the relationships between legal entities falling under the definition of shadow banking entities will most likely not consist of equity. but rather of a different type of relationship – i.e. de facto control situations or relationships characterised by contractual obligations, implicit support or reputational risk (e.g. sponsorship or even branding)
- Consider cases where the common source of funding is provided by the institution itself, its financial group or its related parties and cannot be replaced in a timely manner without excessive cost increases.
- Assess any risk of contagion that may arise from the following situations:
- Use of a single funding entity (e.g., the same entity or the same entity that cannot: be easily replaced).
- The use of similar structures (e.g. where the entity has certain liquidity support mechanisms provided by a sponsor and is allowed to use them when in financial difficulty).
- Dependence on commitments from one source (e.g. guarantees or other potential funding).
- Credit support for structured transactions or uncommitted liquidity facilities, including direct, indirect or reciprocal financial assistance), taking into account its creditworthiness, in particular where there are maturity mismatches between the maturity of the underlying assets and the frequency of refinancing needs.
- Consider all available information on whether their clients share a common external funding source.
- Reinforce their investigation of the economic dependencies of their clients in all cases where the sum of all exposures to an individual client exceeds 5% of Tier 1 capital.
- Conduct a thorough search for any type of “soft information” (e.g. other publicly or privately available information) that usually exists at the level of banking advisors and relationship managers, even if this information goes beyond the institutions’ clients.
3.5. Interrelationship between the control relationship and economic dependence
The concepts of control and economic dependence are based on two different types of interconnection which have to be assessed separately. However, there are situations in which these two types of dependencies are interrelated and could therefore coexist within a single CCG in such a way that all natural and/or legal persons involved constitute a single risk. This occurs when a CCG is first established on the basis of a control relationship, and successively extended by another natural and/or legal person or a second CCG due to some form of economic dependency.
In particular, it is recalled that a control relationship establishes a very strong form of dependency between the entities (control as legal dependency). Thus, it is also a manifestation of economic dependence and not a separate alternative.
3.6. The RTS toolkit for determining GCCs based on the correlations between control relationships and economic dependence
The RTS specifies the requirement for aggregation where a single risk between two or more natural and/or legal persons would lead to a chain of contagion (“domino effect”).banks must consider each case separately, i.e. determine the possible “domino effect” based on the individual circumstances.
- The chain of contagion leading to the possible failure of some or all of the entities involved is the relevant factor for the grouping and must be assessed on a case-by-case basis.
- Downstream contagion should be presumed where an entity is economically dependent on another customer and is itself the head of a “control group” – i.e. a CCG formed because of the existence of a control relationship.
- If the other customer is part of a CCG, then the controlling group of the economically dependent entity should be included in the CCG with which the economic dependency relationship exists. This is because in order to overcome its own outstanding payment difficulties, the economically dependent entity will most likely withdraw resources from the controlled entities, leading to resource withdrawals and extending the risk of contagion downstream.
- Backward spillover from the controlling entities to the economically dependent entity should only be presumed where the controlling entity is also economically dependent on the economically dependent entity, which is the economic link between the two controlling groups.
The RTS is sufficiently clear to allow their implementation. The planned changes are of moderate complexity. However, it is still quite difficult in practice to determine CCGs on the basis of the economic dependency relationship as the latter is a more complex area, which often depends on expert advice and thus hampers the use of automated procedures. Other operational difficulties include the determination of the GCC where the reporting bank itself belongs to a GCC and for cases where the reporting institution does not have exposures to the head of a GCC, but has exposures to two or more of its subsidiaries.
EBA: European banking Authority
GCC: Group Connected Clients