7.2 Assessment methodology

Competent authorities should undertake a qualitative review of the business strategy of the applicant credit institution in order to achieve an overview of the types of activities that it intends to take up, their geographical distribution, the credibility of the underlying assumptions and the associated risk profile of the applicant credit institution.

For this purpose, competent authorities should achieve a clear view on:

• (a) the types of activities that the applicant credit institution intends to take up, including the identification of the core and non-core business lines and of the types of targeted customers. This analysis should be functional to determine the activities covered by the authorisation, or, consistently with paragraph 58, the scope of the authorisation, as well as, as the case may be, the availability of other suitable authorisation regimes. The review should also provide the competent authority with an understanding of the associated risk profile, including ML/TF risk, and the impact on the capital requirements, liquidity and funding needs as well as on internal governance arrangements.
• (b) the geographical distribution of the activities, including their envisaged exercise through subsidiaries and branches or through the freedom to provide services within the EU or in a third country, and the planned future expansion. In particular where the business model envisages the use of digital solutions, competent authorities should assess whether the planned cross-border activities would fall under the ‘freedom to provide services’ or the ‘right of establishment’. The analysis should support, among other things, the competent authorities’ understanding of the need for any further regulatory requirement to gain access to the target markets (e.g. passport notification), any related regulatory risk, and the business or financial rationale for the envisaged corporate structure and geographical distribution. It should also be supported by the analysis of the ML/TF risk associated with a jurisdiction, conducted in the context of the assessment of the operational structure. Where an applicant credit institution intends to carry out a large part of its activities outside of the jurisdiction where it submitted the application for authorisation, the competent authority, in accordance with recital (16) CRD, should assess whether the choice of the jurisdiction of application has the purpose of avoiding stricter regulatory standards (e.g. in respect of the AML/CFT regime) in force in another Member State.
• (c) the overall strategy, exploring the business rationale of the applicant credit institution, as well as the overall group strategy when the applicant belongs to a group. This includes an appropriate understanding of the strategic goals, the key business drivers, any identified competitive advantage, quantitative and qualitative objectives of the business plan, including the company’s product or service, the value proposition, and the market positioning.

With specific regard to innovative business models and/or delivery mechanisms, competent authorities should also pay attention to the description of the innovative features of the envisaged services and products, including any potential increased exposure to ML/TF risk. In line with the proportionality and risk-based approach, competent authorities may consider reviewing the underlying explanation of the new product’s attractiveness, product pricing, structure and comparative advantage. Such a review should be coordinated and complemented with the target market analysis as described in section 7.2.3, and the potential impact of the external key indicators on the business strategy.

A clear understanding of the planned business strategy will allow the competent authorities to assess the related funding strategy, the relevant external and internal factors to achieve the strategic goals and the plausibility of the quantitative assumptions. Overall, the assessment should provide the competent authority with a view on the strengths, weaknesses, opportunities and risks of the business strategy.

7.2.2 Funding structure, liquidity assessment and management

Competent authorities should achieve a clear view on the planned sources to finance the planned business activities, including the source(s) of the initial capital amount. Competent authorities should review the information submitted by the applicant credit institution (in particular pursuant to Article 4 of the RTS on information for authorisation) to assess the liquidity profile and the liability structure, with a special focus on the credibility of the underlying assumptions. With respect to the liability structure, the competent authorities should assess the different sources of funding (types of liabilities, instruments and counterparties), the related costs, embedded options and their contractual and behavioural maturities. A clear view on the liquidity profile and the liability structure will allow the competent authorities to assess the projections for the regulatory liquidity and funding ratios such as the LCR¹⁸ and NSFR¹⁹ , also having regard to their development over the planning horizon due to the gradual increase in business activities and the implementation of the funding strategy (e.g. gradual attraction of depositors) in the set-up phase. Competent authorities should also take into account that while in the first year of activities the majority of the available sources of funding are usually stable (e.g. share capital) and the proportion of liquid assets is high, the development of the regulatory ratios may vary depending on the planned business activities and the related funding strategy of the applicant.

¹⁸ See Commission Delegated Regulation (EU) 2015/61 to supplement Regulation (EU) No 575/2013 of the European Parliament and the Council with regard to liquidity coverage requirement for Credit Institutions.

¹⁹ See Title IV – Part Six CRR (introduced in CRR II).

Competent authorities should perform a more intense assessment, including detailed questions relating to potential alternative scenarios, if the funding structure shows high levels of concentration or an imbalanced funding profile (e.g. excessive maturity mismatch).

Funding costs should be assessed in the context of the assessment of the financial forecast (see 8.2.5) as part of the profit and loss of the applicant credit institution and, where feasible and appropriate, they should be compared against peers. Furthermore, the underlying assumptions – in particular the planned interest rates – should be assessed against the business and macroeconomic environment.

The competent authorities should review the submitted information, in particular as set out in Article 4, letter (g), n. (ii) to (v)²⁰ of the RTS on information for authorisation , in order to assess the applicant credit institution’s ability to finance, monitor, update and report its liquidity position and the relative buffers, in line with its needs²¹ .

²⁰ Article 4, letter (g) of the RTS on information for authorisation provides that the application shall set out ‘an outline of the following frameworks and policies of the applicant credit institution: […] (b) liquidity risk management policy; (c) funding concentration and diversification policy; (d) collateral management policy; (e) deposit policy’.

²¹ See section 9.4, Internal control framework.

Competent authorities should review the submitted information in particular as set out in Article 4, letter a) n. (v)²² of the RTS on information for authorisation , with the aim of assessing the overall preparedness of the internal liquidity adequacy assessment process, having regard, for instance, to the following aspects:

• (a) liquidity governance. Competent authorities should gain a clear understanding of the effective capacity of the institution to manage its liquidity, including whether the respective functions have sufficient resources to ensure sound liquidity management and are able to compute the NSFR and LCR. Competent authorities should also gain a clear understanding of the reporting lines set up to discuss the institution’s liquidity and related risks, including the intended content and frequency of reports to the management body, senior management and relevant committees (if applicable) in order to establish that they can discuss and challenge the relevant matters;
• (b) the funding strategy and liquidity planning. Competent authorities should gain a clear understanding of the capacity of the credit institution to design scenarios, including stress testing and contingency funding plans;
• (c) the liquidity internal controls framework. Competent authorities should gain a clear understanding of the envisaged processes of reviewing, validating and substantiating with evidence (e.g. reports, control evidence).

²² Article 4, letter (h) of the RTS on information for authorisation provides ‘The application shall set out all of the following on the financial situation of the applicant credit institution: […] a summary of the internal liquidity adequacy assessment, at consolidated, sub-consolidated and individual levels as applicable, demonstrating that the credit institution’s liquidity resources will be adequate to meet its individual liquidity requirements; […]’.

Consistently with the proportionality approach set out in paragraph 70, competent authorities should assess the applicant credit institution’s ability and preparedness to withstand funding stress. For this purpose, competent authorities should analyse the impact of the submitted funding and liquidity stress scenario, such as a rise of funding costs, on the liquidity and funding ratios.

Where relevant, competent authorities should ensure that the submitted description of the relevant process for the preparation of the recovery plan captures liquidity and funding indicators.

In the assessment of risks to liquidity and funding, competent authorities should verify the applicant credit institution’s future compliance with minimum requirements provided by the relevant EU and national implementing legislation. However, the scope of the assessment could be extended beyond those minimum requirements, with the aim of allowing competent authorities to request higher liquidity resources from the applicant credit institution in order to compensate for unidentified risks and uncertainties.

7.2.3 Key external factors including business environment

To form a view on the plausibility of an institution’s strategic assumptions, competent authorities should cover the business plan’s key external factors, including the business environment, as part of their overall assessment, in accordance with the criteria indicated below.

Consistently with the proportionality approach set out in paragraph 70, competent authorities should review the overview of the target markets analysis submitted by the applicant credit institution with the aim of achieving an appropriate understanding of the existing business environment, considering the activities of the main existing players and prospective competitors in the target market(s), and of the likely development of the business environment.

For this purpose, competent authorities should review the analysis of the trends in the target market that may have an impact on the institution’s performance and profitability. These may include, on a case-by-case basis, regulatory and macroprudential trends (e.g. changes to retail banking product distribution legislation or changes in maximum loan-to-value ratios allowed for mortgages), technological trends (e.g. moves to electronic platforms for certain types of trading) and societal/demographic trends (e.g. customer composition, product switches as a result of changing market trends, greater demand for Islamic banking facilities).

Where appropriate and on a case-by-case analysis, reference to existing players and potential competitors could include, in addition to incumbent financial institutions, global technology companies expanding into financial services. Such an analysis should also be conducted in coordination with the review of the target market, including the impact of such competitors on the applicant credit institution, for instance on direct consumer marketing.

7.2.4 Key internal factors

Consistently with the proportionate approach set out in paragraph 71 and on a case-by-case basis, competent authorities should undertake an analysis of qualitative features of the applicant credit institution’s envisaged business model to understand its success drivers and key dependencies in forming the applicant credit institution’s view.

In this regard, the areas for analysis by competent authorities should include the main endogenous factors that influence the success of the business model, such as the applicant credit institution’s envisaged strengths in the relationships with customers, suppliers and partners, the quality of IT platforms and operational and resource capacity, as well as factors such as third-party providers, intermediaries, potential exposure to ML/TF risk and specific regulatory drivers.

Competent authorities should also assess whether the financial forecasts match the business strategy laid out in the plan, whether there is a clear plan towards implementation and the capacity to execute and implement the business plan. In this latter regard, the competent authorities’ review should also take into account the assessment of the management’s professional capability on an ongoing basis, including with regard to the business plan and its changes over time, and the availability of sufficient human resources to ensure the implementation of the business strategy. To support this assessment, competent authorities should take into account the previous professional experience of the members of the management body.

7.2.5 Financial forecasts

Competent authorities should perform a quantitative review of the applicant credit institution’s business plan focusing on the submitted financial forecasts, for both the base case and stress scenario – having regard to the geographical distribution, the types of activities and the market position at the individual and, where applicable, consolidated group or sub-consolidated level (Article 4, letter (a) of the RTS on information for authorisation²³ ). Competent authorities should also review financial positions (e.g. based on the balance sheet), risk (e.g. based on the total risk exposure amount, ‘TREA’, or other measures of risk) and/or organisational and/or statutory constraints.

²³ Article 4, letter (a) of the RTS on information for authorisation provides that the application shall set out ‘forecast information on the applicant credit institution at an individual level and, where applicable, at consolidated group and sub-consolidated levels (indicating the share represented by the credit institution), at least on a base case and stress scenario basis, including: [..]’.

The purpose of the quantitative review of the financial forecasts of the business plan should be to assess the credibility of the underlying assumptions (with respect to business growth, generation of revenues, estimation of costs and underlying risks), of the viability and sustainability of the applicant’s business model and of its overall ability to achieve the projected results in compliance with prudential requirements in both the base case and stress scenario.

The assessment of the financial forecasts should reflect the applicant credit institution’s targeted business strategy with respect to the applicant credit institution’s most material geographies, including subsidiaries, branches, activities provided via freedom to provide services, types of activities, business lines and product lines based on profit contribution (e.g. based on P&L) and examine the credibility of the underlying quantitative assumptions (e.g. business per region, income from fees, number of customers, staff costs, macroeconomic assumptions, etc.).

When assessing the profitability of the business plan, competent authorities should pay special attention to those areas of the targeted business strategy which are most relevant for the future sustainability of the business model and survival in stress situations. To the extent possible, and where appropriate, they should also have regard to the applicant credit institution’s exposure to existing or new risks and vulnerabilities.

For these purposes, competent authorities should review the explanation of the initial viability of the credit institution and of the sustainability of the business model over a period of time required by the applicant credit institution to reach the steady state, in any case over at least a three-year period. With regard to the stress scenario, it should be sufficient for the credit institution to be able to comply with the prudential requirements at the end of the planning horizon.

Competent authorities may need to assess a business plan with a longer time horizon, for instance of up to five years. This may be the case, for instance, in respect of those applicants whose business cycle develops over five years or whose three-year business plans show sustainability weaknesses. In such cases, the level of intensity of the assessment should be calibrated according to the business plan’s risk profile, potential weaknesses and uncertainty linked to the longer time horizon.

To the extent possible and where appropriate, competent authorities should determine a relevant peer comparison for the applicant credit institution. The competent authority should determine the peer or the peer group on the basis of the rival product/business lines targeting the same source of profits/customers and base the analysis on supervisory, market and macroeconomic data in the possession of the competent authority. In such cases, the assessment’s output deriving from the peer comparison should complement the competent authority’s expert judgment. If the peer comparison is not feasible, the competent authorities should rely on expert judgment.

Competent authorities should consider assessing profitability trends and ratios, having regard to the risks the applicant credit institution envisages assuming and the relative performance compared to peers. To support this assessment, competent authorities may refer to the most common profitability and risk indicators such as return on equity, return on assets, cost to income ratio, cost of risk and leverage ratio. The competent authority’s use of specific indicators should reflect the type and level of risk envisaged by the applicant credit institution to generate profits (for instance an institution generating lower and more stable returns with a conservative risk appetite may be more sustainable than one with high returns but a very aggressive risk appetite). Competent authorities should carefully assess the risk underlying the economic performance (e.g. the level of risk of assets), also taking into account risk-adjusted indicators to the extent possible.

Competent authorities should be able to gain a clear understanding of the institution’s sources of profit and loss generation (notably of the underlying drivers such as volumes – stock and flow – and prices/margins) in order to identify the key drivers and dependencies of a business performance and potential vulnerabilities. Where appropriate in light of the proportionality approach set out in paragraph 70, competent authorities should perform a breakdown of revenues / source of income in order to understand whether the expected sources of revenues are consistent with the overall targeted business strategy (type of business model, size of the business). In this regard, competent authorities should pay attention to excessively optimistic profit expectations, relating for instance to the forward interest rate and to other relevant revenue generating assumptions, and their potential impact on the reliability and, ultimately, the sustainability of the projections.

Consistently with the principle of proportionality set out in paragraph 70, competent authorities should review the applicant credit institution’s product pricing and structure. For this purpose, consideration may be given, for instance, to the:

• (a) reliance on risky or concentrated sources of income (e.g. sub-prime mortgages, leveraged finance loans, consumer credit, specific customer groups) and its effects on the business model, such as increased vulnerability to changes in the business environment (e.g. decrease in price of real estate, decrease in demand for the products financed through the consumer loans);
• (b) reliance on more volatile sources of income (e.g. trading income, hedging income or other non-recurring sources) and the implications for the long-term sustainability of revenues.

Competent authorities should gain a clear understanding of the various revenue models (e.g. interest-income-based (e.g. customer credit business) or fee-income-based (e.g. trade finance, correspondent banking, custody or advisory services), the specific revenue drivers, the key performance indicators and the level of risk of the related business lines. In all cases, they should gain a clear understanding of the applicant credit institution’s revenue model, how it expects to generate income in both business-as-usual and stress situations and the credibility of the underlying assumptions.

Competent authorities should pay particular attention to high growth rates and associated risk assumptions, including in relation to the applicant credit institution’s adequacy of execution and risk management capabilities, to support the achievement of the targeted projections, in accordance with the analysis carried out pursuant to paragraph 92. The assessment of the credibility of the underlying assumptions should be conducted having regard to various elements, including the overall business strategy, product pricing, the business environment, the funding strategy, risk tolerance and appetite, the existence of policies aimed at ensuring sound and prudent management, etc. With reference to the sustainability of the business model, competent authorities should gain a thorough understanding of the cost structure and the relevant indicators, for example the development of the cost to target income ratio (absolute or relative to peers) at the end of the envisaged business plan time horizon and in stressed situations.

The target cost structure (e.g. labour, administrative or IT costs) should be reviewed in absolute terms and, where possible and appropriate, compared to peers, being mindful of the significant negative impact that the underestimation of certain costs, in particular during the start-up phase or in stressed situations, may have on the sustainability of the business model and/or strategy. Competent authorities should pay attention to recurring cost concentrations that may reflect rigidity in the cost structure.

With specific regard to cost models, applicant credit institutions significantly relying on technology-enabled business models are likely to incur lower marginal costs than credit institutions with transactions linked to high variable costs. As a consequence, such business models’ profitability is in principle likely to increase after a certain critical mass is achieved that absorbs the fixed investment costs. Competent authorities should therefore consider key expenditures for such applicants, such as engineering or product marketing talent and investment in infrastructure.

7.2.6 Overall supervisory view

Based on the business plan and financial projections provided, the competent authorities should develop their overall supervisory view to assess (a) whether the applicant credit institution’s business model will be viable and sustainable and (b) whether the applicant credit institution will be able to comply with the prudential requirements over the planning horizon. Based on the competent authority’s expert judgment, the objective of the overall supervisory view is to form an integrated and comprehensive assessment of the business plan and financial forecasts and in particular of the credibility of the underlying assumptions. The supervisory view should be based on the assessment of the information received on the business strategy, business environment (potential peers, market trends and other external factors that could affect future profitability) and key internal factors, and compared to the applicant credit institution’s own views (financial forecasts, as explained in paragraphs 93 to 106), in order to assess their overall credibility.

Based on the reviewed information, the competent authority should challenge the applicant credit institution’s assumptions and develop its own supervisory view. If the assumptions are not credible, competent authorities may develop alternative assumptions and conduct a sensitivity analysis to determine the quantitative impact on the related areas of the business plan. The line-by-line challenge and the respective application of alternative assumptions, if needed, will allow the competent authority to quantify and assess the overall impact of the sensitivity analysis on the financial forecasts and ultimately on the most relevant prudential requirements. The competent authority may challenge the base case as well as stress case scenario.

The development of the supervisory view and the sensitivity analysis should be subject to proportionality as laid out in paragraph 70, considering the relative risk and complexity of the envisaged business model. Where the overall supervisory view differs from the applicant’s view, competent authorities may consider sharing specific observations with the applicant credit institution, with the aim of closing the information gap and deepening the understanding of the assumptions made by the applicant credit institution. The supervisory dialogue may be conducive to the submission of a revised business plan and financial forecast by the applicant credit institution, reflecting any necessary remediating measures to ensure its viability and sustainability and, ultimately, compliance with prudential requirements for the planning horizon. In such a situation, competent authorities may also consider mitigation measures, in the form of conditions precedent, obligations subsequent or restrictions as laid down in section 4.2, paragraphs 25–32.