Opinion of the European Central Bank of 26 February 2021 on the liability and audit of the national supervisory authority, the establishment of small credit institutions and requirements on key function holders of credit institutions (CON/2021/7)

OPINION OF THE EUROPEAN CENTRAL BANK of 26 February 2021 on the liability and audit of the national supervisory authority, the establishment of small credit institutions and requirements on key function holders of credit institutions (CON/2021/7) Introduction and legal basis

On 7 January 2021, the European Central Bank (ECB) received a request from the Ministry of Finance of the Republic of Estonia for an opinion on a draft law amending the Law on banking, the Law on the Financial Supervisory Authority, the Law on financial crisis prevention and resolution and the Law on the National Audit Office (the ‘draft law’). The ECB’s competence to deliver an opinion is based on Articles 127(4) and 282(5) of the Treaty on the Functioning of the European Union and the third and sixth indents of Article 2(1) of Council Decision 98/415/EC , as the draft law relates to Eesti Pank, rules applicable to financial institutions insofar as they materially influence the stability of financial institutions and markets and the specific tasks conferred on the ECB concerning the prudential supervision of credit institutions pursuant to Article 127(6) of the Treaty. In accordance with the first sentence of Article 17.5 of the Rules of Procedure of the European Central Bank, the Governing Council of the ECB has adopted this opinion.

1. Purpose of the draft law

1.1 The primary purpose of the draft law is to transpose into Estonian law amendments to Union banking legislation, including the provisions of Directive (EU) 2019/878 of the European Parliament and of 3 4 the Council , Regulation (EU) 2019/876 of the European Parliament and of the Council , Directive (EU) 2019/879 of the European Parliament and of the Council and Regulation (EU) 2019/877 of the

1 Krediidiasutuste seaduse muutmise ja sellega seonduvalt teiste seaduste muutmise seaduse eelnõu 312 SE. The draft law discussed in this opinion is based on the draft law as presented to the Finance Committee of the Estonian Parliament for preparation for the first reading in the Estonian Parliament.

2 Council Decision 98/415/EC of 29 June 1998 on the consultation of the European Central Bank by national authorities regarding draft legislative provisions (OJ L 189, 3.7.1998, p. 42).

3 Directive (EU) 2019/878 of the European Parliament and of the Council of 20 May 2019 amending Directive 2013/36/EU as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures (OJ L 150, 7.6.2019, p. 253).

4 Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements, and Regulation (EU) No 648/2012 (OJ L 150, 7.6.2019, p. 1).

5 Directive (EU) 2019/879 of the European Parliament and of the Council of 20 May 2019 amending Directive 2014/59/EU as regards the loss-absorbing and recapitalisation capacity of credit institutions and investment firms and Directive 98/26/EC (OJ L 150, 7.6.2019, p. 296). European Parliament and of the Council . However, certain provisions of the draft law go further than the implementation of Union law. Liability of Finantsinspektsioon 1.2 The draft law proposes amendments to the Law on the Financial Supervisory Authority concerning liability for the actions of Finantsinspektsioon (FSA, the Financial Supervisory Authority). 1.3 According to the draft law, the FSA’s liability for a violation of rights and damage caused in conducting financial supervision and performing resolution functions as well as the reinstatement of the rights violated and compensation for the damage caused is determined on the basis of and pursuant to the procedure provided for in the Law on state liability . 1.4 The draft law also specifies the FSA’s liability for damage not related to the conduct of financial supervision and resolution functions. It provides that the FSA is liable for damage not related to the conduct of financial supervision and the performance of resolution functions in accordance with the provisions of private law. If the funds prescribed in the budget of the FSA are not sufficient, Eesti Pank is to pay the compensation. In this case, the FSA must refund to Eesti Pank the compensation paid using budgetary funds for the two budgetary years following the payment of the compensation . Audit of the FSA by the National Audit Office 1.5 The draft law proposes amendments to the Law on the National Audit Office , subjecting the FSA to the audits of Riigikontroll (NAO, National Audit Office) . These audits include an assessment of (1) internal control, financial management, financial accounting and financial statements; (2) the legality of the FSA’s economic activities, including economic transactions; (3) the performance of the FSA’s management, organisation and activities; and (4) the reliability of the FSA’s information technology systems . 1.6 According to the draft law, in the course of the audit in relation to the performance of the FSA’s management, organisation and activities, the NAO only assesses the performance of the FSA’s management in connection with the credit institutions and investment firms under its supervision . According to the explanatory memorandum to the draft law, this means that when assessing the performance of the FSA’s management, the NAO is entitled to assess the FSA’s activities in supervising the fulfilment of prudential requirements by credit institutions and investment firms and to assess the FSA’s activities in preventing or resolving a financial crisis . The explanatory memorandum expressly emphasises that this does not mean that the NAO itself carries out national financial supervision or intervenes in carrying out the supervisory tasks of the FSA. The explanatory

6 Regulation (EU) 2019/877 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 806/2014 as regards the loss-absorbing and recapitalisation capacity of credit institutions and investment firms (OJ L 150, 7.6.2019, p. 226).

7 Law on the Financial Supervisory Authority (Finantsinspektsiooni seadus RT I 2001, 48, 267, RT I, 21.11.2020, 4).

8 See Section 2 clause 26 of the draft law.

9 Ibid.

10 Law on the National Audit Office (Riigikontrolli seadus RT I 2002, 21, 117, RT I, 19.12.2019, 13).

11 See Section 5 of the draft law.

13 See Section 5 clause 2 of the draft law.

14 See the explanatory memorandum to the draft law (Krediidiasutuste seaduse ja sellega seonduvalt teiste seaduste muutmise seaduse eelnõu seletuskiri), p. 88. memorandum further states that the substantive activities of the FSA are intended to remain independent and that the NAO is to abstain from auditing the additional activities of the FSA that are carried out in relation to participation in the European System of Central Banks (ESCB) . 1.7 To facilitate the audit function of the NAO, the draft law also provides for amendments to other acts enabling the disclosure of confidential information to the NAO. The FSA is permitted to disclose to the NAO information originating from other resolution or competent authorities or from the Single Resolution Board or the ECB with the consent of such bodies and for the purposes specified in such consent . The draft law also specifies that confidential information obtained in the course of financial supervision must be held indefinitely but gives the FSA the discretion to destroy the data after ten years, provided it is no longer necessary for the FSA’s purposes . Establishment of credit institutions with an initial share capital between EUR 1 million and

EUR 5 million

1.8 The draft law proposes to transpose into Estonian law the possibility granted in Article 12(4) of Directive 2013/36/EU by enabling the establishment of credit institutions with an initial capital between EUR 1 million and EUR 5 million. However, the draft law sets out limitations to the activities of such credit institutions. In particular, they may not provide investment services and the FSA has the power to determine that such credit institutions may not provide financial services in other countries either via a branch or through the provision of cross-border services . Amendments to the definition of key personnel in the Law on banking 1.9 The draft law proposes to add a definition of key personnel members to the Law on banking. Currently, the Law on banking sets out specific requirements relating to the expertise, skills, experience, education, professional qualifications, and business reputation of the managers of a credit institution, i.e. the members of its supervisory board and management board . Under the draft law, the requirements previously applicable only to managers of credit institutions are extended to key personnel, which also include chief financial officers, heads of compliance, risk control and internal audit .

2. Observations

Financial independence of Eesti Pank

2.1 The ECB understands that, under the Law on the Financial Supervisory Authority, the FSA is an agency with autonomous competence and a separate budget, which operates within Eesti Pank and whose directing bodies act and submit reports pursuant to the procedure provided for in that law .

15 Ibid., p. 90.

16 See Section 2 clause 24 and Section 3 clause 80 of the draft law.

17 See Section 2 clause 23 of the draft law.

18 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 176, 27.6.2013, p. 338).

19 See Section 1 clause 14 of the draft law.

20 See Section 48 of the Law on banking (Krediidiasutuste seadus RT I 1999, 23, 349, RT I, 21.11.2020, 9).

21 See Section 1 clause 15 of the draft law. Eesti Pank, in turn, is organised as a public legal person . The ECB understands that Estonian law does not provide any possibility for Eesti Pank to exercise any kind of control over the activities of the FSA . The FSA conducts financial supervision and resolves financial crises only in the public 25 26 interest and in the name of the State . 2.2 Article 130 of the Treaty and Article 7 of the Statute of the ESCB and of the ECB (the ‘Statute of the ESCB’) set out a principle of institutional independence of national central banks (NCBs). The ECB has explained that the overall independence of an NCB would be jeopardised if it could not autonomously avail itself of sufficient funds to fulfil its mandate . The ECB has further specified the principle of financial independence in relation to the financial liability of supervisory authorities and emphasised that if a supervisory authority is placed within the institutional framework of the NCB and the supervisory authority has an independent decision-making process, it is important to ensure that decisions adopted by the supervisory authority do not endanger the finances of the NCB as a whole. In such cases the national legislation should enable the NCBs to have ultimate control over any decision by the supervisory authority that could affect a NCB’s financial independence . Therefore, Estonian law must ensure that decisions adopted by the FSA do not endanger the finances of Eesti Pank as a whole. 2.3 The ECB understands that, according to existing Estonian law, the liability of the FSA for the violation of rights or damage caused in the conduct of financial supervision and the bases of and the procedure for the reinstatement of rights violated and the payment of compensation for damage caused must be provided by law . Given that the FSA conducts financial supervision and resolution functions in the name of the State, the ECB understands that, ultimately, the State is liable for damage caused in the conduct of financial supervision. Against this backdrop, the ECB welcomes the clarifications introduced by the draft law, specifying that the FSA’s liability for a violation of rights and damage caused in conducting financial supervision and performing resolution functions, as well as the reinstatement of the rights violated and compensation for the damage caused, must be determined on the basis of and pursuant to the procedure provided for in the Law on state liability. Since the FSA conducts financial supervision and resolves financial crises only in the public interest and in the name of the State , the ECB understands the reference in the draft law to the Law on state liability as meaning that the FSA is primarily liable as a public authority in accordance with the provisions of the Law on state liability . Furthermore, the ECB understands that if the funds of the FSA are insufficient to rectify the damage caused, the State is ultimately liable as the FSA carries out its duties in the name of the State. 2.4 As regards the liability of the FSA for damage caused in the process of conducting financial

24 See Section 4 of the Law on the Financial Supervisory Authority.

27 See the ECB’s Convergence Report 2020, 2.2.3. Published on the ECB’s website at www.ecb.europa.eu.

28 See the ECB’s Convergence Report 2020, 2.2.3. See paragraphs 6 and 8 of Opinion CON/2002/16. All ECB opinions are published on the ECB’s website at www.ecb.europa.eu.

31 Law on state liability (Riigivastutuse seadus RT I 2001, 47, 260, RT I, 17.12.2015, 76). supervision and resolution duties, while the ECB understands that ultimately the State is liable in accordance with the provisions of the Law on state liability, the ECB would welcome further clarification in the draft law that in relation to such damage Eesti Pank is not liable under the Law on state liability, or that the State has sole liability. Under the draft law, it is not expressly clear that Eesti Pank is excluded from such liability. Rather, the possibility remains that Eesti Pank, as the legal person under which the FSA is established, could be considered liable for damage caused by the FSA while exercising financial supervision and resolution functions. This alternative interpretation is not specifically excluded by the wording of the Law on state liability . Hence, the ECB would welcome the introduction of clarifications to the draft law for the purposes of avoiding legal uncertainty in that regard. 2.5 In relation to liability for damage caused outside the performance of financial supervision and crisis resolution (i.e. damage governed by civil law), the ECB understands that, according to existing Estonian law, the FSA is liable in accordance with the provisions of private law and within the limits of the funds prescribed in its budget. If the funds prescribed in the FSA’s budget are not sufficient, Eesti Pank must pay compensation for the damage . Thus, if the budget of the FSA is insufficient, Eesti Pank could ultimately be liable for damage caused by the FSA outside the conduct of financial supervision or resolution. In this respect, the ECB also welcomes the provisions of the draft law specifying that the FSA is obliged to repay to Eesti Pank the compensation paid by Eesti Pank (in place of the FSA) from the FSA’s budget during the following two budgetary years . These provisions further ensure the financial independence of Eesti Pank. However, the ECB would welcome two clarifications to the draft law. First, the ECB notes that the proposed amendment does not provide for a compensating mechanism in cases where the budget of the FSA during the following two budgetary years is insufficient. The ECB understands that the budget of the FSA would in such instances be increased by payments from the State budget. However, the draft law does not provide for any such obligation on the part of the State. Thus, notwithstanding the draft law, Eesti Pank could still remain at least partly liable for damage governed by civil law caused by the FSA. The ECB would welcome clarification of the compensating mechanism to avoid Eesti Pank’s liability in this regard. Second, the ECB would welcome an amendment reducing the repayment period and/or requiring the FSA to pay interest to Eesti Pank on any unpaid sums due. Auditing of the FSA 2.6 The ECB notes that, under the draft law, the audit by the NAO of the FSA’s management is limited to the performance of management in relation to the credit institutions and investment firms under its supervision . 2.7 Based on the explanatory memorandum, the ECB understands that the NAO’s audit could assess the activities of the FSA in supervising the fulfilment of prudential requirements by credit institutions and investment firms and the activities of the FSA in preventing or resolving a financial crisis . In

34 See Section 2 clause 26 of the draft law.

35 See Section 5 clause 2 of the draft law.

36 See the explanatory memorandum to the draft law (Krediidiasutuste seaduse ja sellega seonduvalt teiste seaduste muutmise seaduse eelnõu seletuskiri), p. 88. this regard, the ECB notes that the audit of banking supervision authorities should be in line with the principle of independence specific to banking supervision, as set out in Article 19 of Council Regulation (EU) No 1024/2013 , which applies to both the ECB and the national competent authorities when acting within the Single Supervisory Mechanism (SSM), as well as with the limitations provided in Article 27.2 of the Statute of the ESCB and Article 20(7) of Regulation (EU) No 1024/2013 in relation to the supervisory tasks conferred on the ECB. Thus, as previously noted by the ECB, the audit should: (a) not extend to the application and interpretation of supervisory law and practices in the context of the SSM – this is of particular importance in determining the scope of the abovementioned performance of the management audit; (b) not interfere with and not include the tasks conferred on the ECB by Regulation (EU) No 1024/2013, nor be extended so that it results in an indirect audit of the ECB; and (c) be carried out on a non-political, independent and purely professional basis . The national legislative authorities should assess whether the draft law satisfies these conditions or if specifications should be introduced. 2.8 As regards the disclosure to the NAO of confidential data originating from the ECB, other resolution or competent authorities or from the Single Resolution Board, the ECB notes that, under the draft law, such disclosure is permitted only with the consent of the relevant institution and for the purposes specified by such institution. The ECB welcomes these conditions in relation to data originating from the ECB. Establishment of credit institutions with an initial share capital between EUR 1 million and EUR 5 million 2.9 The ECB acknowledges that the provisions of the draft law enabling credit institutions to be established with an initial capital between EUR 1 million and EUR 5 million arise out of the discretion granted to Member States under Article 12(4) of Directive 2013/36/EU to grant authorisation to particular categories of credit institutions with an initial capital between EUR 1 million and EUR 5 million. Thus, when exercising the discretion provided for in Article 12(4) of Directive 2013/36/EU, Member States must establish a special category of credit institutions to which the reduced initial capital requirement applies. The ECB welcomes the fact that, under the draft law, such credit institutions may not provide investment services, and that the FSA has the power to determine that such credit institutions may not provide financial services in other countries either via a branch or through the provision of cross-border services. However, the ECB cautions that a combination of a potentially large number of new entrants to the banking market having also a rather limited size and relatively low capital levels could lead to increased risks given the potential tendency of such market players to be less risk averse and to venture towards more aggressive behaviour in order to achieve their intended business goals. Thorough scrutiny needs to be applied in the assessment of such applications, for example in the form of a careful and comprehensive challenge of the business plans presented, and with a strong focus on the risks of financial losses arising during the first years of business in a highly competitive market, including enhanced business plan stress testing. In this respect, the practice of requiring applicants to always prepare an exit plan is to be seen positively,

37 Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (OJ L 287, 29.10.2013, p. 63).

38 See paragraph 2.2 of Opinion CON/2016/24. and this should be a prerequisite before an authorisation is granted. Extension of suitability requirements to key function holders 2.10 The ECB welcomes the extension of the requirements applicable to managers of credit institutions to key function holders of credit institutions as this contributes to the sound and prudent management of credit institutions. However, neither the existing provisions of Estonian law, nor the draft law, establish deadlines for the FSA or the ECB to carry out the assessment of the suitability of the members of the management body and key function holders. In that regard, consideration could be given to introducing a possible maximum assessment period. For example, the Joint European Securities and Markets Authority and European Banking Authority Guidelines on the assessment of the suitability of members of the management body and key function holders set out a maximum four-month assessment period . This ensures that all these persons are assessed in a timely manner and that a transparent process exists, which is known to market participants. This opinion will be published on EUR-Lex. Done at Frankfurt am Main, 26 February 2021. [signed] The President of the ECB Christine LAGARDE

39 See paragraphs 178 and 186 of the Guidelines on the Assessment of the Suitability of Members of the Management Body and Key Function Holders (EBA/GL/2017/12), available on the European Banking Authority’s website at www.eba.europa.eu.