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ECB annual report on supervisory activities

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The European Central Bank published its’ second report on supervisiory activities, giving an overview on the organisational set-up, financial stability issues, proceedings and the Single Supervisory Mechanism as well as legal supervisory instruments. The state of the European banking sector in 2015 and the beginning of 2016 is examined, and supervisory priorities for 2016 are highlightened.

Annual report on supervisory activities
23 March 2016
European Central Bank

>  Annual report on supervisory activities
>  ECON briefing on the presentation of the peport at the European Parliament

Foreword of Danièle Nouy, Chair of the Supervisory Board:

When the first Annual Report was published in March 2015, the Single Supervisory Mechanism (SSM) was not even half a year old; it had a promising future but hardly any history. With this second issue of the Annual Report, we can look back on one-and-a-half years of European banking supervision[1]; the SSM still has a promising future, but it also has an encouraging past.

Over the course of 2015, we made good progress in promoting the objectives of European banking supervision. We contributed to the safety and soundness of credit institutions and to the stability of the financial system. We also promoted the unity and integrity of the internal market based on equal treatment of credit institutions. The SSM fostered harmonisation, it followed an intrusive approach to banking supervision, and it intensified cooperation with European institutions and other supervisors, as well as communication. We have certainly not yet reached our objective of truly European banking supervision, but we have come much closer.

Fostering integration and harmonisation – past successes and future challenges

In 2015, European banking supervision took a great step towards harmonised and unbiased supervision by conducting a euro area-wide Supervisory Review and Evaluation Process (SREP) according to a common methodology. For the first time, all significant institutions in the euro area were assessed against a common yardstick. Quantitative and qualitative elements were combined through a constrained expert judgement approach, which ensured consistency, avoided supervisory forbearance and accounted for institutions’ specificities. The common methodology greatly benefited from the previous experience and best practices of the national competent authorities (NCAs). Overall, and with a view to the coming years, the experience of the first harmonised SREP has been very encouraging.

Nevertheless, enhanced harmonisation of supervisory practices within the SSM cannot happen without a further harmonisation of the rules. The European regulatory framework – the CRR/CRD IV – offers more than 160 provisions where some discretion remains for supervisors or national governments to decide on the concrete implementation of the relevant European norms. Some of these “options and national discretions” (ONDs) cater for specific national features. Many of them, however, are the mere reflection of unquestioned traditions, pure national interest and regulatory capture. They have material effects on the level of prudence of the framework and on the comparability of capital ratios. They also add an additional layer of complexity as well as a source of regulatory arbitrage.

In order to address this issue we set up a High-Level Group which identified about 120 ONDs which can be exercised by the ECB and where harmonisation is possible. These ONDs cover a wide range of topics such as the treatment of deferred tax assets, large-exposure intragroup exemptions and intragroup liquidity waivers. We have agreed on a single implementation of these national options and discretions for the entire euro area, aligning it with global standards or, if there is no such standard, adopting the most conservative approach. This gave rise to a regulation and a guide which were subject to public consultation and adopted by the ECB. The regulation will enter into force in October 2016. This is a major step towards a harmonised regulatory framework for the euro area.

Still, the regulatory framework remains fragmented to a certain degree. With regard to CRD IV, for example, Member States have interpreted several provisions differently. National legislation varies from strict word-for-word transpositions of European legislation to national gold-plating. And in some countries national legislators are increasing fragmentation even further by converting non-binding supervisory practices into binding legal acts.

It is the prerogative of national law-makers to transpose EU directives. Nevertheless, a fragmented regulatory framework is at odds with the overarching objectives of the banking union. At the same time, dealing with a wide array of different national legislations is far from ideal for the single European supervisor. Consequently, we actively encourage further harmonisation of the regulatory framework for the banking sector. As long as regulation remains fragmented, the convergence of supervisory practices cannot ensure a fully level playing field. In this regard, the SSM actively contributes to the work of the European Banking Authority (EBA) in establishing the single rulebook and the single supervisory handbook at the EU level.

The banking sector and supervisory activities in 2015

The starting point for our supervisory work in 2015 was provided by the results of the 2014 comprehensive assessment. This was enhanced by an analysis of the macroeconomic environment and an extensive analysis of the key risks for the banking sector. Based on that foundation, the Supervisory Board defined five priorities which guided our supervisory activities in 2015. These priorities were:

  • business models and profitability drivers;
    governance and risk appetite;
    capital adequacy;
    credit risk;
    cyber risk and data integrity.

Throughout 2015, the Joint Supervisory Teams (JSTs) engaged in discussions with banks’ senior management to clearly articulate the SSM’s supervisory expectations and challenge the viability of business models and profitability drivers. Horizontal analyses on peer groups, taking into consideration specificities of different business models, were conducted by an expert group with strong involvement of NCAs.

On the issue of governance and risk appetite, an extensive thematic review was launched in March 2015 which fed into the SREP. The review was concluded in January 2016 with the issuance of follow-up letters for the institutions. As part of the supervisory cycle, the performance of the thematic review also allowed JSTs to identify follow-up supervisory actions for 2016 as well as areas for future on-site inspections. A report on the best practices identified during the thematic review will be published later in the year.

In 2015, capital adequacy was a priority which we addressed on an ongoing basis. The results of the comprehensive assessment gave the JSTs a good starting point for their follow-up. The work on ONDs represented a leap towards a more harmonised definition of banks’ regulatory capital across the SSM. Another area of focus was the preparation of a targeted review of banks’ internal models to make sure that they deliver the adequate risk-weighted assets (RWA) intensity. The objective is to ensure their compliance with regulatory standards and to foster their consistency across institutions. Over the course of 2015, a first stocktake has been conducted and a proposal for a targeted review of internal models over the coming years has been devised.

With regard to credit risk, a thematic review on leveraged finance was initiated in 2015. The objectives of the review were to obtain a better understanding of leveraged finance activities in supervised institutions, to assess the key drivers and dynamics of this market as well as to identify best practices. The review also aimed at enabling benchmarking of institutions with regard to leveraged finance. In addition, the Supervisory Board established a temporary task force to develop and implement a consistent supervisory approach towards supervised institutions with high levels of non-performing loans.

Regarding cyber risk and data integrity, a thematic review on IT cyber security was started in early 2015 with the objective of capturing the cyber risk profiles of the significant institutions and conducting a benchmarking exercise on the data gathered from banks. Initial results were used to identify banks where on-site inspections were to be carried out in 2015 and 2016. The Supervisory Board also approved an operating and communication model for cybercrime incidents and the setting-up of a cybercrime incident database. To support work in these areas, an expert group with involvement of NCAs was launched.

The European banking sector at the beginning of 2016

In the first quarter of 2016, the European banking sector experienced a deterioration of the global financial environment. Nevertheless, the European banking sector of today is very different from that of the past. First and foremost, the banks have improved the quality and quantity of the capital they hold. Since 2012 the CET1 ratio of significant institutions in the euro area has risen, on average, from 9% to around 13%. These institutions are well prepared to meet the fully phased-in regulatory capital requirements that will be in effect from 2019 onwards. And with regard to supervisory capital requirements, European banking supervision has clearly stated the levels of Pillar 2 capital it expects the banks to hold in steady state. All things being equal, supervisory requirements will not be increased further.

Altogether, the European banking sector is much better prepared to cope with unexpected headwinds than just a few years ago. In addition, the significant institutions further increased their profits in 2015. Consequently, they were able to pursue appropriate distribution policies, while still meeting regulatory and supervisory capital requirements. This is also true with regard to distributions on Additional Tier 1 capital instruments.

However, there is still a subset of European banks that show elevated levels of non-performing loans. These loans were identified during the 2014 comprehensive assessment, using a harmonised definition for the first time ever. And equally important, these non-performing loans have been reasonably well provisioned for. We are therefore in a reasonably comfortable position to promote further progress in bringing down the levels of non-performing loans over the next few years in an orderly manner.

Finally, there has been a breakthrough concerning the structure of the banking system. With the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Board (SRB), we now have in place a resolution regime that allows for the orderly failure of banks. This regime ensures that the costs of resolution are no longer borne by taxpayers but by the shareholders and creditors of banks. Nevertheless, while the BRRD appropriately increases market discipline, the increase in spreads observed in the first quarter of 2016 does not appear justified in light of the much higher capital levels that banks hold.

Supervisory priorities for 2016

In 2016 business models and profitability drivers of banks will continue to be a major focus of activity for European banking supervision. Both are being challenged by the prolonged period of low interest rates and the high level of asset impairments. Further important elements of risks, whose importance varies across countries, include credit risk and heightened levels of non-performing loans as mentioned above, a reversal of the search for yield, conduct and governance risk, sovereign risk, geopolitical risk, growing vulnerabilities in emerging economies, as well as, once again, IT and cybercrime risk. Banks also need to prepare for new regulatory capital requirements.

These risks and challenges served as a point of departure for defining our supervisory priorities for 2016. As many of the key risks and challenges have not significantly changed since 2015, there is an overlap between our supervisory priorities for this year and last year. In addition, some priorities for 2015 were, from the beginning, conceived over a time horizon of more than one year. Against this background, the SSM has adopted five supervisory priorities for 2016, which were made public at the beginning of 2016, namely:

  • business model and profitability risk;
    credit risk;
    capital adequacy;
    risk governance and data quality;
    liquidity.

Business model and profitability risk remains a key priority in 2016. Building on the analyses performed in 2015, a thematic review has been started on bank’s profitability drivers at the firm level and across business models. In this context, an area of supervisory focus will be to examine whether profitability is achieved, among other things, through a weakening of credit underwriting standards, greater reliance on short-term funding, or an increase in risk exposures.

Credit risk also remains a key priority. The deterioration in the credit quality of loans to corporates and households and in credit underwriting standards, as well as the persistently high level of non-performing loans, are a source of concern in a number of euro area countries, particularly those hard hit by the crisis. In addition to following up on the work started in 2015, ECB Banking Supervision will also investigate excessive risk concentrations in certain areas such as real estate. A strongly related issue is the implementation of the new accounting standard “IFRS 9 – Financial Instruments”, which has a bearing on the measurement of credit impairments as well as the valuation of financial instruments. A relevant thematic review will be launched shortly.

Another priority for 2016 is capital adequacy. Of particular relevance in this regard are the consistency and quality of banks’ Internal Capital Adequacy Assessment Processes (ICAAP) including their internal stress testing capabilities, and the conduct of supervisory stress tests such as the EU-wide stress test coordinated by the European Banking Authority. Further pivotal elements of supervision in 2016 are the follow-up on the quality and composition of banks’ capital (also in relation to ONDs) as well as the examination of banks’ preparedness for new regulatory standards such as the minimum requirement for own funds and eligible liabilities (MREL) and total loss-absorbing capacity (TLAC). The targeted review of banks’ internal models and their RWA intensity will be another top priority in 2016 and subsequent years.

Banks’ risk governance and data quality also remain a priority in 2016 against the backdrop of low profitability and a potential search-for-yield, paired with cheap and ample funding. Moreover, the financial crisis clearly showed that banks’ governing boards often lacked the information they needed to make good business decisions. A priority now for the SSM is to clearly communicate supervisory expectations vis-à-vis banks in that respect. Furthermore, a thematic review will assess compliance with the Basel Committee on Banking Supervision’s (BCBS) principles for effective risk data aggregation and risk reporting. This review will also reinforce the follow-up actions to the SSM’s 2015 thematic review of risk governance and risk appetite. Finally, ensuring data quality and security requires state-of-the-art IT infrastructure. IT risks will therefore be part of the analysis.

Finally, liquidity was added as a new supervisory priority in 2016. The experience of the 2015 SREP has shown that many banks do not yet fully meet supervisory expectations regarding sound management of liquidity risks. Consequently, the SREP methodology on liquidity risk is being developed further. This includes dissecting the robustness of the bank’s liquidity coverage ratio and understanding the reliability of the bank’s liquidity risk management and risk appetite as expressed through the Internal Liquidity Adequacy Assessment Process (ILAAP) or a comparable framework.

In many ways these priorities are valid for both the significant banks, which are directly supervised by the ECB, and less significant institutions, which are directly supervised by the NCAs and indirectly by the ECB. A consistent approach is ensured across the whole of the SSM in close coordination with the NCAs and in accordance with the principle of proportionality.

Consolidating the SSM model of supervision

The supervisory priorities for 2015 and 2016 emphasise the forward-looking nature of the SSM’s approach to banking supervision. Our main objective is to address potential issues in a timely manner. Based on increased opportunities for benchmarking and peer comparison, we also promote multiple perspectives on risk. We aim to develop a deep understanding of the risk factors, risk appetite and business model of each institution, with due regard to the diversity of bank’s business models within Europe. This is an obvious strength of a European banking supervisor.

What has been achieved so far is mainly thanks to the dedication and hard work of our teams. In 2016, we will continue to develop an SSM team spirit within the ECB and the NCAs. Such a team spirit is essential given that all the highly skilled people contributing to the SSM are employed by different authorities, located in different countries and engaged in a unique form of integrated cooperation. In line with the general request of EU legislators, we will continue to develop human resources policies on training, performance feedback and intra-SSM mobility in order to promote a common supervisory culture and a truly integrated supervisory mechanism.

Much work still lies ahead for the SSM in implementing best practices for independent, intrusive and forward-looking supervision that ensures a level playing field for banks in the euro area. As we gain experience and grow closer together, we will approach this objective at an increasing pace.

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