ECB-SSM and EBA update ECON on recent bank failures – focusing on the outlook ahead
RegCORE Client Alert | Banking Union
Following recent bank failures that occurred outside of the EU, the European Parliament’s Economic and Monetary Affairs Committee (ECON) on 21 March 2023 held a public hearing See here.Show Footnote and structured dialogue that sought input from Andrea Enria, the Chair of the Supervisory Board of the European Central Bank’s (ECB) Single Supervisory Mechanism (SSM) and Jose Manuel Campa, the Chair of the European Banking Authority (EBA). Video coverage available here and here.Show Footnote Both Mr. Enria and Mr. Campa presented on the specific circumstances that led to the recent bank failures, presented their assessment on the resilience of the EU’s Single Rulebook on financial services and what that means for EU financial stability. This most recent dialogue followed on from a similar discussion at a plenary debate on 15 March 2023 where Mairead McGuiness, European Commissioner for Financial Services, Financial Stability and Capital Markets Union, warned that “…the EU should stay alert after this collapse”. Highlights available here.Show Footnote
Given that the recent bank failures have had an impact within the EU and equally highlighted areas of potential weakness in rulemaking and supervision, both Mr. Enria and Mr. Campa also explained what they considered to be areas where future rulemaking and reform would be required and beneficial, both for the banking sector and financial stability overall. The European Parliament’s Economic Governance and EMU Scrutiny Unit (EGOV) equally published “in-depth analysis” in preparation of the public hearing with Mr. Enria on 21 March 2023. Available here.Show Footnote Mr. Enria provided further context of recent developments during a keynote speech held at the 22nd Handelsblatt Annual Conference on Banking Supervision. Available here.Show Footnote
This Client Alert summarises the key takeaways from these discussions and analyses future options and potential impact. Notably firms that have an inadequate management of interest rate risk, inflation and/or (the risk of non-viability of) niche business models that are not appropriately managed were highlighted as meriting more intrusive scrutiny. The inadequacy of banks’ management of unrealised losses raises lessons for wider financial services firms as well as for supervisors.
Consequently, it is very conceivable that, as with the immediate statements from EU authorities following the recent failures, there would be additional scrutiny despite there, currently, “being no direct read-across of US events to euro area significant banks.” A number of supervised firms, operating in the Banking Union but equally across the wider EU-27, will likely need to be able to rapidly respond to questions from regulators and “explain and defend” exposures and their (risk) management.
Key takeaways from ECON’s 21 March 2023 hearing and structured dialogue
While both Mr. Enria and Mr. Campa clearly communicated that more than a decade of financial services reforms have made the EU’s banking sector more resilient, largely as result of more robust rules in the EU’s Single Rulebook coupled with a more harmonised single supervisory culture and enhanced supervision, some targeted improvements were still necessary and desirable. In short, while the EU’s rules and thus the banks operating and supervised in the EU context, may be in a better starting position, certainly when compared to international peers, regulatory reform remains a continuing priority and ongoing journey to finetune and forward-plan. EU policymakers, supervisors and regulated firms must remain vigilant and not become complacent. This means finalising those reforms that remain pending but equally those in the pipeline.
The following presents a summary of the key takeaways considered by ECON’s Committee Members in the focus of their questions raised at both the public hearing and structured dialogue:
- Uninsured deposits: Mr. Enria noted that SSM banks do not exhibit the outlier characteristics of severe interest rate risk and a reliance on a concentrated, uninsured deposit base. Although uninsured deposits are an essential source of funding in the eurozone, they are more relevant for business models that have a well-diversified asset and liability portfolio, including their depositor base. Importantly, Mr. Enria noted that “all of our banks must meet Liquidity Coverage Ratios and Net Stable Funding Ratio regulations”. More than half of the existing buffers of highly liquid assets are cash and central bank reserves, which reduces the possibility of mark-to-market losses should liquidity requirements occur. Indeed, recent data show that banks that have seen some deposit outflows appear to have maintained their levels of surplus liquidity. Nevertheless, bank deposits have also grown more vulnerable to interest rate fluctuations and subject to being shifted quickly. This sensitivity is heightened by digitization and rapid communication technologies, both of which have the potential to speed the search for deposit returns. Adding uncertainty to financial stability may reinforce the risk of a downward spiral.
- Uncrystallised and/or long-term (bond) losses are marked to market: Mr. Campa emphasised the importance of taking a more comprehensive look at banks' positions. Mr. Enria stated that he disliked the phrase "unrealised losses" for these assets. Many EU banks have a liquidity buffer made up of 50% cash and deposits reserves with central banks. As a result, people could go a long time before "realising" their losses. There are significant hidden losses. However, firstly they are not disguised, and second, it will be a long time before these losses are realised. He also emphasised that mark to market value should continue to be the primary way they are judged.
- Interest rate risks: Mr. Campa noted that this has been an area of enhancement monitoring with a recent Regulatory Technical Standards on Interest Rate Risk in the Banking Book management. Equally, ECON members raised questions on the inclusion of high interest rate risks in the scenarios to be used in the forthcoming 2023 stress tests. Mr. Campa noted that the stress test will, for the first time, incorporate a scenario with higher interest rates, prolonged inflation, and slow economic development. Mr. Enria further stated that just because there have not been high interest rates in the stress test scenario, this does not mean that supervisors were not concerned about interest rates risk.
- Liquidity risk buffers: Mr. Enria noted that liquidity buffers are accounted for at market value, although banks may still account for assets at amortised costs. Banks would suffer if their assets lost value due to rising interest rates. If banks want to account for the use of the liquidity buffer, they should be prepared to sell these assets in the market at any time, which should be done from mark to market in an accounting book.
- Similar non-respect of the hierarchy of claims as in Swiss approach: ECON committee members raised their concerns and received reassurance that in the EU, current rules would not allow the claims hierarchy to be disregarded as it was the case in the Swiss intervention on Additional Tier (AT) 1 instruments. SSM supervised banks’ related AT instruments did not have similar clauses as those set out in Swiss issuances. The ECB-SSM, EBA and Single Resolution Board had published a joint press release reassuring market participants that the EU authorities would follow established principles on claims hierarchy See coverage here.Show Footnote either in the case of resolution or an orchestrated private solution that does not trigger or result in formal resolution proceedings.
- Finalisation of EU Banking Package by 2025 without divergence of final Basel III standards: the ongoing implementation efforts were framed in discussions as “Basel III is not the bible but is the best global authorities could come up with to protect the stability and soundness of banks.” Nevertheless, the discussion focused on two areas of divergence that could cause concern:
- CVA risks: which is a deviation that only exists in the EU and may be quite impactful in certain lines of business where there are interest rate vulnerabilities.
- Commercial and residential real estate business: in particular which are very sensible to a volatile interest rate environment.
- Distribution of SSM bank dividends: In a response from the ECON Chair questioning whether the SSM would adopt a decision on dividends and buyback restrictions, Mr. Enria clarified that the ECB-SSM has already distribution plans in place in respect of relevant supervised banks and market developments had not affected the SSM’s assessments of those plans.
- Non-bank financial institutions: Mr. Enria highlighted the ECB-SSM’s work in reviewing the governance and risk management practices of those firms categorised by the ECB-SSM as “significant institutions” most exposed to counterparty credit risk and risks related to prime brokerage, supervisors were able to identify and tackle those deficiencies which, if left unaddressed, would overly expose banks dealing in derivatives and offering clearing, securities and investment banking services to other banks and non-bank financial institutions.
- FinTechs: Mr. Enria also mentioned the desire to favour banks and financial institutions who are engaged in new technologies, new instruments, and experiment with creative instruments. To allow this model to thrive, there is a desire to relax the regulatory and supervisory constraints. While banks must invest in new technology, Mr. Enria emphasised that they must be regulated as banks and stringent in the application of rules. The ECB-SSM had published its own supervisory expectations on what such FinTech credit institutions must fulfil in order to become and remain authorised. See our coverage available here.Show Footnote
- Cryptoassets: Mr. Enria provided an explanation that the interlinks between the cryptoasset and the traditional financial and notably banking sector was very limited. Despite this, Mr. Enria stressed the importance on the globally approved prudential regulatory and risk standards from the Basel Committee Banking Supervision and the necessity that these be introduced in the EU as soon as possible. Mr. Campa stated that the EBA is evaluating the key component of cryptoassets as payment mechanisms, analogous to e-money regulation, and whether particular regulations on reserve needs should be proposed. Banks that hold cryptoassets should exercise extreme caution. Banks should not hold them or sell them to their customers.
- Pressing need to finalise the EU’s revised crisis management and deposit insurance (CMDI) framework and implement the Banking Union’s third pillar – the European Deposit Insurance Scheme (EDIS): Mr. Enria flagged the need to finalise the CMDI review and advance implementation of EDIS notably to minimise differences in the operations of national deposit guarantee schemes which otherwise lead to different dynamics in EU Member States.
- EU and SSM needs to conduct fit-and-proper assessments of banks’ managers: before they take up their positions. Relevant supervisors must be able to ensure that candidates meet the high standards of professional competence required of them. In this regard the EU and ECB-SSM authorities have published and are further operationalising new fit-and-proper guidelines.
- EU AML reforms: the discussion with ECON also flagged the urgent need for a rapid finalisation of replacing the EU’s Anti-Money Laundering Directives with an EU Regulation and the introduction of a centralised EU-wide Anti-Money Laundering Authority (AMLA). See dedicated coverage on this development from our EU RegCORE.Show Footnote
No Banking Union without Capital Markets Union: As a capstone to the above Mr. Campa emphasised that an inadequate Banking Union has ramifications for the Single Market, resulting in fragmentation and risk sharing limitations. The EBA made several proposals, emphasising that the Banking Union cannot be read without the Capital Markets Union. Mr. Enria explained that nevertheless supervisors can continue to manage crises in the absence of EDIS: “The system is not broken, but the way they do things is extremely convoluted, particularly when it comes to deploying crisis financing due to varied regimes and the involvement of [deposit guarantee schemes] at the national level”.
Contagion risks: Mr. Enria emphasised that there are interest rate and liquidity risks in the sector that might cause contagion. In general, the best response is to avoid this from happening is to ensure that banks appropriately manage interest rate and liquidity risks. When interest rates shift, it is critical to focus on funding banks of banks. In terms of the effects on technology sector companies, EU banks have been able to easily assist technology sector companies in coping with these liquidity strains. Mr. Campa stated that the EBA believes that recent failures in the US and in Switzerland would adversely impact the lending dynamic in the EU. Nonetheless, credit markets remain a source of concern in several parts of the EU, particularly in commercial and residential real estate. Mr. Enria noted that the results of a tighter monetary policy are however in line with expectations.
EGOV expresses its views on uninsured deposits and EDIS
In addition to the above, EGOV notably considered the policymaker question of how to deal with uninsured deposits above the statutory threshold in light of the US authorities’ actions. While the US’ actions of protecting uninsured depositors seemingly did not necessitate the controversial step of tapping general taxpayers' funds, such a mechanism to protect trust beyond the statutory limit comes at a cost. Other banks may have to pay for one bank's and its "sophisticated" depositors' reckless behaviour, as well as weaknesses in the authorities' regulatory and supervisory structure. Aside from the direct costs to banks, extensive bailouts of uninsured depositors in a reasonably benign financial climate may generate expectations among uninsured depositors and banks, and as a result, may instil less conservative behaviour in the future and thus drive moral hazard risk. Finally, if some but not all banks are expected to receive bailouts for uninsured deposits, competitive distortions could occur.
The lessons learned from the US approach to granting additional protection to uninsured depositors is important for European policymakers as well. There are at least two issues at stake: (1) Are there instances under which bailing out uninsured depositors is desirable, and if so, (2) how is such bailing out of uninsured deposits practicable, particularly in terms of funding?
To address these issues, the EU’s current CMDI framework empowers resolution authorities to exempt some obligations from bail-in. One such legal goal is to prevent contagion to other banks, which would seriously disrupt the financial system. The US developments for instance demonstrates the importance of discretion and political responsibility in this decision: On the one hand, EGOV notes that there is the risk of destabilising the larger banking system; on the other hand, there are significant direct and indirect costs associated with protecting uninsured depositors from losses.
EGOV equally notes, that if EU resolution authorities feel obliged to avoid uninsured depositor bail-in, they must consider additional limits. The first is the “no-creditor-worse-off” principle, which states that other creditors must not receive less in resolution than they would in insolvency; however, other unsecured creditors may receive less if a greater portion of the bank's assets are utilised to repay depositors. Second, the Single Resolution Board can only use the Single Resolution Fund if it can bail-in 8% of the bank's total liabilities otherwise. This may not be achievable, especially if uninsured deposits are unable to participate in the bail-in. Finally, paying for uninsured depositor bailouts may necessitate State Aid approval. EU policymakers will want to use the CDMI framework review to ensure these questions can, where relevant and desirable, be resolved in a manner that drives resilience.
Scrutiny of ECB-SSM Supervisory Review and Evaluation Process (SREP) results for 2022
On 8 February 2023 (two days earlier than in 2022) the ECB-SSM published the results of the SREP The SREP process itself has been evolving rapidly over the past couple of years − starting as a national-centric process, with the national competent authorities (NCAs) influenced by Basel III/IV, to becoming one that is shaped by supervisory approaches in the Banking Union. The SSM-run SREP 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. 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 firms are expected to address. These remedial actions include both quantitative measures, such as capital add-ons including the Pillar 2 Requirements (P2R), 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.Show Footnote In summary, the SSM-run SREP looks at firms’ operations and whether they have:
- an effective business model (the supervisors review in particular if BUSIs have a viable and sustainable business strategy)
- robust internal governance (the subject of the review here is the capabilities of the management bodies; effectiveness of risk management)
- sufficient regulatory capital (sufficiency of buffer to absorb losses)
- adequate liquidity (funding the BUSI in a sustainable way, ability to cover short-terms cash needs).Show Footnote 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 – FailShow Footnote that was concluded for 2022 (SREP 2022). See coverage here in respect of our analysis of SREP 2021.Show Footnote SREP is an important supervisory tool used by the ECB-SSM but also by national competent authorities (NCAs) in setting the tone for the supervisory dialogue along with priorities as part of the ECB-SSM’s overall compliance assessment and firm-specific findings.
SREP acts as a supervisory scorecard and in the context of the ECB-SSM takes the form a formal decision (a legally binding administrative act) that sets out regulatory capital requirements, including beyond regulatory own funds and additional capital known as the Pillar 2 Requirement (P2R), that are to be maintained by the individual supervised firm. SREP, as administered in the Banking Union, is currently subject to an ongoing review process which may introduce further changes (see standalone coverage from our EU RegCORE on what this means for market participants).
Despite deteriorating economic conditions and financial market dynamics following Russia's invasion of Ukraine, the weighted average of Pillar 2 requirements remained close to the previous year's level, at 2.0% of risk-weighted assets (RWA), up from 1.9% in 2022, as rising interest rates led to improved profitability and capital generation. The ECB releases the entire list of P2R for each individual bank; 27 banks had their P2R raise (ranging from plus 0.01% to 0.5% of total capital), 14 banks saw their P2R decline (ranging from minus 0.033% to minus 0.25%).
However, the following notable results and changes from the 2022 SREP were that:
- According to the 2022 SREP report, the ECB "took concrete steps to address worrying developments in leveraged finance, as aggregate exposures of significant institutions to leveraged transactions continued to rise and underwriting standards deteriorated further," after banks failed to respond adequately to specific guidance issued in 2017. As a result, for a few banks with exceptionally high exposure to risks from leveraged transactions, a specific capital add-on was incorporated in the P2R decision.
- Internal governance and risk management remained a high priority. The ECB discovered that many banks lacked sufficient resources for all of their control tasks (risk management, compliance, and internal audit), and that management bodies paid insufficient attention to compliance and internal audit functions. No bank received a score of 1 in the ECB's internal governance four-step evaluation, but roughly three-quarters of all banks received a score of 3, indicating that there is still plenty of room to strengthen internal governance and risk management systems. As a result, that aspect dominated the qualitative measures in the 2022 SREP cycle (32%), followed by measures relating to the risk management framework (17%), internal audit (12%), or compliance function (11%), and risk data aggregation and reporting (9%).
- According to an examination of the aggregated Profit and Loss figures, net interest income has increased by 9% in a year-to-year comparison, which is plausible given the recent normalisation of interest rates, commission income has increased by 5%, and provisioning for credit losses has decreased by 1%, all of which contribute to an increase in net profits of more than 6% in a year. At the same time, we note that the aggregated statistics show significant losses on financial assets held for trading and significant gains on financial assets held at fair value; these developments in the profit and loss results defy simple explanation and warrant a supervisor's comment.
- The aggregate Non-Performing Loans ratio declined further to 2.3%, while the proportion of loans with a considerable increase in credit risk ("stage 2 loans") increased somewhat, reaching 9.8%.
2023 EU-wide stress test – setting the adverse scenario
EBA performs a stress test exercise on the largest European banks The scope of the EBA stress test encompasses 70 EU banks, covering roughly 75% of total banking sector assets in the EU and Norway, while the ECB performs stress test to 99 euro area banks, out of which 42 directly supervised banks that are outside the EBA stress testing sample. The previous stress testing exercise took place in 2021, during a time marked by pandemic confinement in most countries.] every two years; the ECB conducts its own stress test in tandem, for medium-sized banks that are not included in the EBA-led stress test sample due to their smaller size. The ECB employs the same stress test methodology, templates, and stress scenarios as the EBA. The European Systemic Risk Board (ESRB) provided the adverse scenario, while national central banks gave the baseline scenario. Following the beginning of the EBA 2023 EU-wide stress test exercise, the ESRB discovered mistakes in specific values provided to the EBA; these errors were later remedied (see communication from the ESRB to the EBA dated 1 March 2023). Available here.Show Footnote
In general, the adverse scenario is used to assess banks' resilience to a hypothetical severe scenario of a significant deterioration in the overall outlook for the economy and financial markets over the next three years, with the goal of ensuring a significant level of severity across all EU countries.
According to the EBA press release for the 2023 stress test exercise, “the narrative depicts an adverse scenario related to a hypothetical severe worsening of geopolitical developments, accompanied by an increase in commodity prices and resurgence of COVID-19 contagion. This results in high inflation and adverse effects on private consumption and investment coupled with a worldwide economic contraction. The worsening of economic prospects is reflected in a substantial global increase of long-term interest rates, a sustained drop in GDP and increased unemployment”.
According to the EBA, the adverse scenario for the 2023 exercise predicts more severe shocks for several macro-financial variables than in prior stress tests: In the adverse scenario, real GDP at the EU level is assumed to decline by 6% cumulatively over the three-year horizon, while the unemployment rate would increase by 6.1 percentage points, both relative to the starting point. Inflation would likewise be significantly over the baseline over the entire horizon, by 3 percentage points in 2023 and 1.5 percentage points in 2025.
ECB-SSM charts path to a more risk-focused and transparent supervisory approach
At the Handelsblatt conference, Mr. Enria announced that in order to embed agility and a more risk-focused approach in SSM supervision for the long-term, the ECB has decided to introduce
“…a new, supervisory risk tolerance framework, which is designed to enable supervisors to better adjust to bank-specific needs. Under the new framework, supervisors will be able to devote more time to address our strategic priorities and those vulnerabilities that are key for a specific bank, focusing their efforts where they are most needed. To make this possible, we are enabling our supervisors to plan their activities in a more flexible way, in accordance with a multi-year SREP. This approach will allow our supervisors to better calibrate the intensity and frequency of their analyses, in line with the individual bank’s vulnerabilities and broader supervisory priorities. This will also streamline the supervisory activities in a proportionate and risk-based manner, as we wouldn’t tick all the boxes every year. As a result, we expect a reduced burden for the banks too.
Importantly, this will not mean less supervision, or a “light touch” approach, but rather more focused and impactful supervision homing in on the most material risks. It will also give us more flexibility to tackle new and emerging risks in a rapidly changing macroeconomic and interest rate environment.
But increasing supervisors’ scope for discretion to prioritise among risks must not come at the expense of lowering the consistency of our supervision across banks. Therefore, alongside allowing our supervisors greater discretion, we are also bolstering our internal controls functions, to preserve the principle that like risks be treated in a like manner.”
In further signaling on the direction of supervisory focus and engagement, Mr. Enria clearly reminded market participants (see analysis from our EU RegCORE on these developments) that:
“being more risk-focused doesn’t mean being any less intrusive. On the contrary, we are placing increasing emphasis on a structured escalation of our supervisory interventions where banks’ progress is lagging behind clearly set timelines.
One example of our willingness to escalate is leveraged finance, where we acted to address concerning signs of risk build-up as well as a protracted attitude of complacency on the part of some banks.
We are also willing to escalate our interventions in other areas where we see persistent sluggishness in the response from banks, using the whole range of enforcement and sanctioning measures at our disposal. For example, on risk data aggregation and reporting, banks with adequate risk data aggregation and reporting capabilities are still the exception and full adherence to the BCBS 239 principles has yet to be achieved. This is despite the intensity of supervisory pressure in recent years and the large number of findings that have been identified.”
US bank failures were, from an EU perspective at least, considered atypical, affecting US banks with little exposure to the European banking system, they do raise lessons of relevance to EU market participants, supervisors as well as legislative and regulatory policymakers. A highly concentrated client base with uninsured deposits, as well as a lack of effective risk management set the path for liquidity and solvency concerns eventually leading to fast resolution action by US authorities.
Similarly, Swiss-led intervention on AT1 instruments followed a route that would not have been followed in the EU. The EU resolution framework clearly defines the hierarchy of claims, and CET1 capital would always be the first to absorb losses and would be fully written down before AT 1 instruments could be written down. A number of announcements from key policymakers in the EU have confirmed that commitment to established creditor hierarchy principles.
Most importantly, policymakers in the EU and the Banking Union have acknowledged that the capital and liquidity positions of EU banks have improved. The adoption of Basel rules to all banks operating in the EU ensures even more resilience. Equally, the EU’s general regulatory structure and the Single Rulebook have provided an extra degree of protection. Better risk management is provided by increased oversight and governance. While these core building blocks are all in place, both EU and Banking Union specific regulatory policymakers are assessing where to bolster protections and available tools to be able to better respond given the most recent market developments.
Despite the EU and the Banking Union being in a comparably more protected position than the banking sectors in other jurisdictions, it is nevertheless expected that the relevant EU authorities, in particular the ECB-SSM, will step up their efforts with more intrusive supervision and less variability in how rules are applied in order to shore up and remediate identified shortcomings so as to prevent future failures and their adverse impact on the EU’s Single Market. Aside from this factoring into EBA and ECB-SSM stress testing, the lessons learned from the recent failures and the direction of travel following the ECON dialogue points to a sharper use of supervisory tools, notably in the context of the 2023 SREP as administered across the EU and in the Banking Union. This comes at a time when the design and deployment of ECB-SSM administered SREP is itself being proposed to be subject to targeted changes. Lastly, the biggest challenge for policymakers and more importantly market participants in future supervisory cycles ahead remains whether the proposed CDMI reforms (see our standalone coverage on that development) will actually add value in terms of greater protections and bolstering of market confidence, particular in the continued absence of EDIS as the Banking Union’s missing third pillar of protections that complement the SSM and the Single Resolution Mechanism.
PwC Legal is assisting a number of financial services firms and market participants in forward planning for changes stemming from these developments.
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