The Situation: The European Banking Authority ("EBA") published its Final Report on EBA Draft Guidelines on Outsourcing Arrangements ("Guidelines") on February 25, 2019, which will eventually replace the existing CEBS Guidelines on Outsourcing, and integrate the more recent Recommendations on Cloud Outsourcing.
The Result: The Guidelines will increase the scope of the previous CEBS Guidelines to apply to payment and electronic money institutions, as well as credit institutions and MiFID investment firms ("in-scope firms"). Intra-group arrangements will be subject to similar requirements as third party outsourcings with respect to risk assessment, and arrangements with third countries and cloud service providers will also be exposed to additional risk assessment under the new Guidelines.
Looking Ahead: The Guidelines, which seek to facilitate a more harmonized governance framework for all outsourcing arrangements, will enter into force on September 30, 2019, and allow a transitional period until December 31, 2021.
The Guidelines detail the internal governance framework that in-scope firms should implement in relation to the outsourcings of "critical or important functions that have a strong impact on the financial institution's risk profile or on its internal control framework." This wording is a departure from the CEBS Guidelines issued in 2006, which applied to "material outsourcing" only, and is consistent with the wording used under MiFID II. The EBA has stated that there is no difference between the terms "critical" or "important," and that they should be read collectively.
The CEBS Guidelines applied only to credit institutions, whereas the Guidelines broaden this scope to include credit institutions, MiFID investment firms subject to CRD, payment institutions, and electronic money institutions as the in-scope entities. In addition, in-scope entities that are subject to the cloud recommendations will have to continue to apply these recommendations.
Critical or Important Functions
Under the Guidelines, in-scope firms should consider a function as critical or important for the purpose of outsourcing:
1. Where a defect or failure would materially impair:
the compliance of the institution's conditions of authorization;
their financial performance; or
the soundness of their banking and payment services.
2. Where operational tasks of internal control functions are outsourced; or
3. Where there is an intention to outsource payment services requiring authorization by a competent body.
Outsourcing arrangements should always be considered critical or important if they are related to core business lines and critical functions, if they are directly connected to the provision of banking or payment services for which they are authorized, or if they carry a high degree of operational risk when assessed together with other such arrangements with the same service provider or in the same business area. If the review of these outsourcings is not finalized by December 31, 2021, in-scope firms should inform their supervisors accordingly, including the measure planned to complete the review or possible exit strategy.
The Guidelines emphasize that the responsibility of the institution's management body cannot be outsourced to create an "empty shell" that lacks the substance to remain authorized—the institution should remain able to oversee all risks and manage outsourcing arrangements independently. Any intra-group outsourcing arrangements must be based on objective reasons, with conditions set at arm's length and conflicts of interest explicitly dealt with. Furthermore, wherever any intra-group outsourcing of a function leads to a higher level of control over that outsourced function, it should be accounted for in the institution's risk assessment. There are concerns of a heavy-handed approach in equating the compliance demands of intra-group and third party outsourcing arrangements—the EBA is keen to note that the principle of proportionality will lead the approach in gauging levels of compliance expected for intra-group arrangements.
Where functions requiring a licence have been outsourced to service providers located in third countries (i.e., outside the European Union), the Guidelines require an appropriate cooperation agreement in the form of a Memorandum of Understanding ("MoU") between the competent authorities responsible for the supervision of the outsourcer and the service provider. Stricter requirements will apply in comparison to other outsourcing arrangements, as outsourcing arrangements outside the European Union create specific risks both for institutions and their competent authorities.
Competent authorities will be required to publish the existence of such arrangements. If a MoU or a revision of the existing contract cannot be agreed upon, institutions may have to seek out alternative service providers. While the EBA recently announced an agreed template for the MoU, outlining provisions of supervisory cooperation and information exchange between the EU supervisory authorities and the UK Prudential Regulatory Authority and the Financial Conduct Authority, activities outsourced to institutions in the United Kingdom prior to Brexit should be carefully assessed.
Institutions must identify, manage, monitor, and report all risk that they may be exposed to in relation to arrangements with third parties. The Guidelines set out a number of requirements as to how concentration risk in particular is to be assessed, which is the risk that is posed by multiple outsourcing arrangements to the same service provider. If a competent authority considers the concentration risk to be too great, then it may order the termination of the arrangement.
There is concern over this approach as it could lead to an operational risk in relation to cloud outsourcing arrangements as the cloud space is essentially dominated by only four service providers. The EBA has given reassurances that such a right would not be exercised without prior consultation, but cloud outsourcing raises challenges that must be assessed beyond concentration risk—even at the industry level, large suppliers of cloud services can become a single point of failure when many institutions rely on them.
With regard to how a concentration risk would be identified and quantified, the EBA has stated that rather than providing a quantifiable threshold, each case would be dealt with in a fact-specific manner. A register and the information to be provided in it should facilitate the assessment of concentrations at market level by competent authorities. Largely however, the concentration risk will be determined by the ability of the cloud service provider to appropriately protect the confidentiality, integrity, and availability of data.
In-scope entities may run into issues balancing the desire to be innovative market-leaders with the demands of the robust framework under the Guidelines. Many FinTech providers simply may not have the resources to meet the contractual obligations and rigid governance frameworks placed on them by institutions seeking to meet the EBA's requirements under the Guidelines. In-scope entities should therefore contemplate how best to navigate their relationships with FinTech providers ahead of the implementation date of the Guidelines.
The documentation requirements ask for a written compliance policy and a register of all outsourcing arrangements at the institution and group levels, to be regularly maintained in a database format. This will be an onerous and time-consuming task, requiring corresponding changes in the relevant contracts and internal policies and procedures. In-scope entities should begin collating this data ahead of the implementation of the Guidelines.
The Guidelines specify certain minimum requirements that must be included in all outsourcing contracts, as well as a number of additional requirements that apply when outsourcing critical or important functions. The additional requirements include provisions regarding: performance monitoring; agreed service levels; the service provider's reporting obligations; the respective parties' financial obligations; whether the service provider should take mandatory insurance; requirements to implement and test business contingency plans; termination rights; and ad hoc notification requirements when there are issues with service delivery. Corresponding internal policies and procedures will have to accompany these requirements.
Institutions will also be required to state in written outsourcing agreements that the service providers must comply with any relevant information security standards, and grant the institutions and the competent authorities necessary access and audit rights.
The EBA has confirmed that the timeframe for implementation is September 30, 2019. The transitional grace period for updating existing outsourcing arrangements in line with the new guidelines is December 31, 2021. In-scope firms should complete the documentation of all existing outsourcing arrangements, other than for outsourcing arrangements to cloud service providers, in line with the Guidelines following the first renewal date of each existing outsourcing arrangement, but by no later than December 31, 2021.
Three Key Takeaways
Outsourcings to third countries of functions requiring a license will need to be accompanied by cooperation agreements between relevant national competent authorities and may present difficulties. Without a cooperation agreement, in-scope firms may have to consider seeking alternative service providers.
Intra-group outsourcings will become subject to similar requirements as third-party outsourcings. Institutions may want to start engaging with their intra-group counterparties to meet the regulatory requirements.
Existing documentation of outsourcing arrangements will need to be amended to meet the detailed new requirements and require corresponding changes to internal policies and procedures.