Usually every January the European Central Bank (ECB), acting at the helm of the Banking Union's Single Supervisory Mechanism (SSM), publishes its overall compliance assessment along with Banking Union Supervised Institution (BUSI) specific findings from the previous year's Supervisory Review and Evaluation Procedure (SREP)1 . In many ways this supervisory scorecard not only drives BUSIs to set themselves "New Year's resolutions" but also sets out who makes the "naughty or nice" list for the next supervisory cycle and thus the next i.e. 2020 SREP exercise.

In summary this means that the national competent authority (NCA) or the ECB-SSM will issue a decision (i.e. a legally binding administrative act) spelling out the capital requirements beyond regulatory own funds established for the BUSIs at hand. In case the capital base was found to be inadequate, banks will have to build up capital. BUSIs may, moreover, be required to improve their liquidity situation beyond the minimum regulatory requirements, or they may be required to remedy identified deficiencies. Together these measures are intended to ensure that BUSIs will be sufficiently resilient even under adverse business conditions, thus contributing to the maintenance of financial stability. Following up on the SREP process, supervisors will monitor banks' compliance with the requirements and measures detailed in the SREP decisions during off-site analysis and, if required, through on-site inspections.

The SSM-run SREP, now entering its sixth year, continues to build off EU-wide methodology set by the European Banking Authority (EBA). However, it also contains some SSM specifics and its own methodology, which it refines and updates periodically.2 Some of the differences include the style of its approach, evaluation of its findings and this is crucial in allowing the ECB-SSM to set remedial actions BUSIs are expected to address. These remedial actions include both quantitative measures, such as capital add-ons including the Pillar 2 Requirements (P2R)3, as supplemented by Pillar 2 Guidance (P2G), as well as details on remedial action and relevant qualitative measures. Unlike the P2R, the P2G is not legally binding but the ECB-SSM expects BUSIs to follow and apply the P2G in full. For the first time the ECB is publishing individual SREP results in addition to continuing to publish aggregate results. 

On January 28, 2020, Andrea Enria, former Chair of the EBA and since January 1, 2019 Chair of the SSM Supervisory Board, highlighted the results of the 2019 SREP cycle at an ECB press conference.4 These highlights included some general statements, firm-specific messages, as well as the first-time publication of individual P2R figures for those ca 120 BUSIs5 that are, for SSM purposes, categorized as significant credit institutions (SCIs) and thus directly supervised by the ECB-SSM and indirectly by NCAs. It is also likely to be of relevance for those BUSIs that are for SSM purposes categorized as Less Significant Institutions (LSIs) and thus supervised directly by NCAs and indirectly by the ECB-SSM. Overall, the results painted a picture of a continued need for improvement across a breadth of areas that also continue to feature in the SSM's 2020 Supervisory Priorities.6

This Client Alert assesses the ECB-SSM's findings, the relevant remedial actions and opportunities for BUSIs and an overview of how this might fit into a range of supervisory touchpoints already underway or scheduled in the SSM's 2020 Supervisory Priorities, given the increased focus on using thematic reviews and on-site inspections. BUSIs and their affiliates may wish to read this analysis in the context of actions taken by non-Banking Union supervisors, whether using SREP or not, and the wider set of measures discussed in greater detail on Dentons' Eurozone Hub

Overall SREP 2019 key messages

Enria set out some good news and bad news at the January press conference. On the good side, overall SREP requirements for P2R (2.1%) and P2G (1.5%) remain unchanged from 2018 and overall CET1 capital stands at 10.6%. However, business model outlook remains a key area of concern owing to low profitability, earnings below cost of capital, along with weaknesses and a deterioration in internal governance standards as well as operational risk management. This echoes the sharper tone on these areas identified in the 2020 Supervisory Priorities but also explains why the ECB has been explaining quite openly that it would be open to increased consolidation and mergers in the European banking sector, albeit that merger policy is strictly not within its SSM nor central banking mandate. 

Most SCIs have CET1 levels above the overall capital requirements and P2G. Six BUSIs that participated in the 2019 SREP cycle showed CET1 levels below the P2G. For those that have not taken satisfactory measures in the last quarter of 2019, remedial actions have been requested within a precise timeline. From the 2019 sample, the share of BUSIs receiving an overall score of 3 increased to 43% in 2019 from 38% in 2018. Meanwhile the share of BUSIs classified as worst performers, i.e. those scoring 4, decreased to 8% from 10%. At the same time the percentage of those BUSIs that scored 2 decreased to 49%, from 52%. No SCI scored 1.

91 BUSIs received "other" qualitative measures; in 2018 this was 83. Qualitative measures are applied for all BUSIs scored 4 in the SSM-run SREP 2019, while other supervisory actions have been implemented for the remaining BUSIs, depending on the BUSI-specific risk profile. Qualitative measures are addressed to significant institutions via SREP decisions in order to remediate a wide range of weaknesses regarding internal governance and risk management (including ICAAP and ILAAP, NPL, IT and data quality). Internal governance (see below) is the risk area addressed by the highest number of measures. 40 institutions received qualitative liquidity measures (45 in 2018). Most of the weaknesses related to issues on the ILAAP, the Liquidity Coverage Ratio and stress-testing framework enhancement.

Governance (including decision making7) is an area at the forefront of the ECB-SSM's 2020 Supervisory Priorities. The announcements noted a downward trend in compliance, with 76% in the 2019 sample scoring 3 (in 2018 this was 67% of the sample) and only 18% in 2019-sampled BUSIs scoring 2, while in 2018 this was 25%. In addition to the quantitative findings, the ECB-SSM noted that "...findings show that in a significant number of instances management bodies are not effective and internal controls are weak. Furthermore, some BUSIs reported material losses which were mostly due to conduct risk events. This is reflected in the growing number of BUSIs that scored 3 for operational risk: 77%, up from 63% in 2018. IT/cyber risks have also been a key source of operational risk." This is not only quite damning but also flags that supervisors will step-up frequency and sharpen the tone of on-site inspections, notably having recruited and/or reallocated staff at ECB-SSM and NCA level to focus on this supervisory engagement.

Moving from NPL reduction to improving underwriting standards

The ECB-SSM and Enria were, however, candid in pointing out that BUSIs have put a lot of effort into bringing down non-performing loans and exposures (collectively NPLs), with overall volumes having shrunk. The volume of NPLs is expected to decrease further if markets continue to perform in a relatively orderly fashion. The ECB-SSM's plan is to bring down NPLs by 35% over the next two years. This plan targets old vintages (i.e. including those originating pre Global Financial Crisis) of NPLs, which are the most difficult. This means that although BUSIs are on the right track with asset quality, it is important to clean their balance sheets before the next recession hits. BUSIs must thus pay attention to the underwriting strategies and thus also the EBA's Guidelines in this area (see our dedicated coverage on this). 

Outlook

For SCIs, faced with remedial actions from the SSM-SREP and a full list of impacts heading their way  ̶  not only from the 2020 Supervisory Priorities but other global, EU, Eurozone and national driven changes  ̶  they may want to engage strategically with a mix of some "quick wins" and precautionary action in light of the 2018 Supervisory Priorities, notably in relation to NPLs, improvements to governance, risk, control functions and internal audit (which we understand will receive specific scrutiny, including in respect of operationalization of Brexit plans), IT and cyber risks. 

SCIs might equally want to assess how best to advance their fintech and digitization exercises as these will play a heightened role in the SSM-run SREP and the on-going focus on business models and profitability. Even if BUSIs, notably SCIs, might be forgiven in thinking that the similarities of the supervisory priorities for 2020 mean that these are no different to those of the preceding years, the outcome from supervisory engagement in 2020 is likely to be very different. This is due to the fact that the ECB-SSM has grown in size, coordination and confidence. Despite some continued shortcomings, it is now overall a more intrusive supervisor in terms of its rulemaking and policing of those rules. It is also increasingly changing its tone in certain communications, even if it has become more open to pragmatic dialogue where it can. 

The ECB-SSM now quite crucially has a far greater breadth of supervisory tools at its disposal. That trend is likely to continue as the Europeanization of financial service regulation expands across the Eurozone and its Banking Union, despite certain critical comments from a handful of national supervisory authorities. Moreover, as the ECB-SSM continues to embed a common supervisory culture across the various ECB and national level components, this Europeanization, along with possibly some efficiencies, could actually benefit BUSIs in applying more of a single compliance strategy when looking at the Banking Union. 

Finally, BUSIs, especially those with cross-border activities, specifically with non-EU operations, may wish to seek legal counsel to be able to manage any requirements and/or remediation programs that affect them on a group/sub-group/entity level, as certain NCAs across the EU have country-specific rules. BUSIs with cross-border activities may need to manage deficiencies on several levels, where local and/or consolidated supervisors demand to have the issues managed locally, to not share information beyond the borders of the specific location and/or to adhere to additional local regulatory requirements. Regardless of the supervisory touchpoints on SREP, whether SSM-led or not, the supervisory tone of the competent authorities is increasingly focusing on qualitative standards in addition to its much more established track record in reviewing quantitative metrics.

Lastly, whilst allocation of the budget amongst the European System of Financial Supervision and the Banking Union remains an issue, human capital has begun to gather a requisite amount of field experience, and with knowledge capture and retention improving over time, the lessons learned in certain areas are being transposed as human capital rotates into new supervisory relationships. In summary, the remainder of 2020 will be busy for BUSIs and supervisors alike, but it may also lead to real advances in a level playing field and thus convergence of rules, interpretations and approaches and thus more cost efficiency for BUSIs.

Footnotes

1. See our coverage on SREP 2019 and a description of SREP as a core supervisory tool available here. In summary, SREP looks at BUSIs operations and whether they have:

  • an effective business model

  • adequate risk management systems

  • a solid capital base, and

  • an adequate liquidity and stable refinancing profile.

The outcome of this assessment is then translated into scores as follows:

Score Assessment
1 There is a low risk that the BUSI may face material consequences (losses)
2 There is a low to medium risk that the BUSI may face material consequences (losses)
3 There is a medium to high risk that the BUSI may face material consequences (losses)
4 There is a high risk that the BUSI may face material consequences (losses)
F Fail

2. See 2019 Methodology here.

3. The Pillar 2 Requirement (P2R) is a capital requirement which applies in addition to, and covers risks which are underestimated or not covered by, the minimum capital requirement (known as Pillar 1). P2Rs are binding and breaches can have direct legal consequences for banks. The P2R is determined via the SREP. The capital demand resulting from the SREP also includes the Pillar 2 Guidance (P2G), which indicates to banks the adequate level of capital to be maintained to provide a sufficient buffer to withstand stressed situations.

4. See introductory statement and presentation slides here along with a web recording of the proceedings here. Coverage of past SREP results back to 2015 is available here (using the relevant tabs) and the current SSM 2019 SREP Methodology Booklet is available here, building off the SSM SREP Methodology Booklet (which ought to be read in conjunction with the EBA Guidelines on SREP) and the public-facing version of the SSM Supervisory Manual.

5. Which make up 80% in terms of assets under management of the Banking Union's banking sector.

6. See Dentons' Eurozone Hub's regulatory strategy "playbook" Navigating 2020 available here.

7. See also coverage on the EBA's Benchmarking Report on Diversity Practices which criticizes the effectiveness of boards available here.

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