Progress achieved so far and 2016 priorities.
The first year of the Single Supervisory Mechanism (SSM) is behind us, and the time has come to take a look back. An understanding of the way the European Central Bank (ECB) is operating as Single supervisor, its priorities and the expected evolution of the supervision is fundamental to better understand how the regulatory requirements will evolve in the future.
At a recent seminar organized by KPMG, Luc Coene, former NBB Governor and current member of the Supervisory board of the SSM, together with Henning Dankenbring, head of the KPMG ECB Office in Frankfurt, shared their views on the past achievements of the SSM, the risks faced by the banking sector, and their expectations on the future regulatory landscape. Watch the videos on the web page of the KPMG seminar.
ECB supervision – a game changer for many banks
Since November 2014, more than 120 significant banking groups are under the direct supervision of the ECB. During this first year of the SSM, banks perceived the ECB banking supervision as very challenging. Compared to the approaches adopted by the National Competent Authorities (NCA’s) in the past, banks found the supervision much more intrusive, forward looking, and data demanding. Increased supervisory uncertainties arose as the supervisory process revealed that it was not always clear and understood by all parties, particularly around the Pillar 2 capital requirements.
The lack of harmonization across Europe and cultural differences led to inconsistencies in the Supervisory Review and Evaluation Process (SREP). In summary, the market perceives the ECB as a game changer, and banks will need to invest in infrastructure and change management in order to cope with the increased level of supervisory requirements. The banking sector will also have to prepare for continued harmonization between the different national legal requirements, and the search for better aligned governance models across Europe.
SREP – level playing field not yet achieved
The 2015 SREP exercise has been conducted by the SSM following a common methodology based on the EBA’s Guidelines. The overall SREP score is the result of an assessment of 4 different building blocks: a business model assessment, a governance and risk management assessment, an assessment of the risks to capital, and an assessment of the risks to liquidity. Based on this overall SREP assessment and score, the ECB has sent a SREP letter to each bank, containing the measures (including minimum capital and liquidity requirements) that the banks had to comply with.
In practice, because some of the building blocks were less developed in certain countries, the emphasis has been put on the 2 first blocks, whereas the 2 last blocks were in some cases only reviewed at a higher level, and will be the focus for this year. This once again highlights the need for harmonization and a level playing field amongst European banks and supervisors.
SREP outcome - Average increase of 0,5% in required capital compared to 2014
Capital requirements for SSM banks in 2015 have slightly increased: they will be higher by ca. 30 basis points on average, plus ca. 20 basis points due to the phasing in of capital buffers. Altogether, the ECB expects no more than 0,5% increase compared to 2014. These Pillar 2 capital decisions were prepared taking into account 3 main factors: banks are still facing significant risks (e.g. business model and profitability risk, higher level of non-performing loans (NPLs), ultra-low interest rates, IT and cybercrime risks, growing vulnerabilities in emerging markets); the transition needs to be smooth, from current capital positions towards a fully-loaded Basel 3 environment in 2019; and the importance of the level playing field, both within the SSM and between SSM global systemically important banks (G-SIB’s) and their main UK and US competitors.
Ongoing efforts to harmonize options and national discretions
Another important SSM project is the harmonization of the options and national discretions (ONDs) conferred by the CRD to the competent authorities, and their impact on the quality and definitions of individual banks’ CET1 capital. The ECB and the NCA’s have agreed on a single approach for the exercise of more than 120 ONDs, in coordination with the EBA. In November 2015, the ECB launched a public consultation on a draft Regulation and a draft ECB Guide on options and discretions available in Union law. T
his policy package covers important areas such as capital and liquidity, and lays down how the exercise of OND’s in banking legislation is to be harmonized in the euro area. This is a major step towards creating a level playing field in the euro area banking sector. In particular, the policy agreed at Supervisory Board level has a major impact on two ONDs: the non-deduction of insurance holdings from own funds and the phased-in deduction of Deferred Tax Assets.
Banks’s business model and profitability risk ranks first amongst the SSM priorities for 2016
To define its supervisory priorities for 2016, the SSM has identified the key weaknesses of the SSM banking sector. Business model and profitability risk, magnified by the ultra-low interest rate environment, is the most prominent risk.
Further, seven key risks have been defined, although their importance varies across countries: reversal of the search for yield; conduct and governance risk; sovereign risk; credit risk and increased levels of NPLs; geopolitical risk and growing vulnerabilities in emerging economies; IT and cybercrime risks; and finally banks’ ability to meet upcoming regulatory capital requirements.
On the basis of these key risks, the SSM has determined 5 high-level supervisory priorities for 2016:
Credit risk: elevated levels of NPLs still represent a serious prudential challenge in some European countries. A Task Force has been established to develop consistent approaches on this issue, and will be analyzing current national regulations, legal frameworks, accounting regimes, and supervisory practices relating to NPLs. Furthermore, the ECB projects to investigate exposure concentration (i.e. real estate). Finally, the supervisor plans to assess the implementation progress of IFRS9 and the potential impact on bank’s provisions.
Capital adequacy: the SSM will continue its work on OND’s, which is very important in the assessment of the quality of banks’ capital. With the arrival of MREL (Minimum Requirements for own funds and Eligible Liabilities) and TLAC (Total Loss Absorbing Capacity) requirements, the ECB will broaden its perspective from “going concern” to “gone concern”, as banks will have to prepare compliance with “gone concern” scenarios. The ECB has also launched a targeted review of internal models (TRIM) that banks use to calculate their risk-weighted assets and capital needs. Finally, the ECB has the intention to harmonize and enhance banks’ ICAAP approaches, including stress testing methodologies.
Risk governance and data quality: In 2016, the ECB will continue its assessment of board compositions, to ensure that all relevant knowledge about the business of the bank is represented within the board. The goal of the ECB is to assess whether the management of the banks is “in control”: whether it knows what is happening in its business and whether it receives the right (risk) information on which to base its decisions. Moreover, ensuring data quality and security necessitates state-of-the-art IT infrastructure. Therefore, IT risks will form part of the analysis.
Liquidity: Because some banks do not yet fully meet supervisory expectations in terms of liquidity risk management, the SSM will focus on the reliability of banks’ Internal Liquidity Adequacy Assessment Processes (ILAAP). Banks’ progress in implementing and maintaining sound frameworks for managing liquidity and funding risk, both in a going concern situation and under stressed circumstances, will be scrutinized.
The ECB has been able to set up a successful mechanism based on the cooperation between the ECB and 19 National Competent Authorities, managing to effectively and consistently supervise more than 120 banking groups.
The ECB has also made important progress in achieving more harmonization through a common SREP and the work performed on options and national discretions. However, there is still a lot to do as European banks are faced with numerous challenges which will require close supervisory attention in 2016. Thanks to the SSM, they should however be better equipped to face these challenges, through tougher and more harmonized supervision, and regulatory convergence across all euro area countries.