ECB-SSM: Expert Group Report – Recommendations on European banking supervision

RegCORE Client Alert | Banking Union

QuickTake

On 17 April 2023, the European Central Bank (ECB), acting in its role as the head of the Single Supervisory Mechanism (SSM) at the heart of the Banking Union, published the results of an external assessment (the Report) Assessment of the European Central Bank’s Supervisory Review and Evaluation Process, Report by the Expert Group to the Chair of the Supervisory Board, published in April 2023, available here.Show Footnote of the Supervisory Review and Evaluation Process (SREP) and welcomed its recommendations to improve efficiency and effectiveness. The Report was drafted by a group of independent experts (the Expert Group) which were appointed in September 2022. ECB appoints five experts to re-evaluate annual supervisory review process, September 2022, available here.Show Footnote

As a core element of the SSM, the SREP is an annual process amid which the ECB evaluates the risks which banks might be exposed to and analyses the mechanisms and strategies the banks are implementing to manage those risks. The Report acknowledges that the ECB has developed a harmonised SREP which has contributed to improving the resilience of the European banking sector and helped to promote a level playing field for all “significant institutions”. It concludes that the ECB is now in a position to improve the efficiency and effectiveness of its existing supervisory processes by making them more integrated and risk sensitive.

In an effort to continue strengthening supervisory practices, the Supervisory Board of the ECB has expressed its intention to evaluate the Report’s input as part of a review of supervisory processes planned for 2024. ECB welcomes expert group recommendations on European banking supervision, published in April 2023, available here.Show Footnote

As a matter to note, on 19 April 2023 the European Securities and Markets Authority (ESMA) together with the European Banking Authority (EBA) published its Final Report and Joint EBA and ESMA Guidelines on common procedures and methodologies for SREP under the EU’s Investment Firms Directive. Details available here.Show Footnote While the ECB’s own efforts on how SREP is applied in the Banking Union those developments should be reviewed in conjunction with our analysis on the final Joint EBA and ESMA Guidelines where SREP styles could differ.

Key Takeaways from the Report

Overall, the Report confirms that ECB Banking Supervision has successfully established itself as an effective and respected supervisory authority. In particular, the Report recognised that banks maintenance of adequate capital levels “looks broadly adequate”. The Report does however invite the ECB to reform risk scores and the method of setting Pillar 2 capital requirements. Given that capital cannot address all risks, the research proposes that the ECB employ all of its tools, including impactful qualitative measures pushing banks to change weak business models and governance practices.

In particular on governance (including the use management information), further announcements, were highlighted by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at a speech given at the Joint ECB/EUI “Seminar on Diverse and effective boards in a changing and competitive landscape.” Mrs. McCaul’s speech is available here.Show Footnote In that speech, Elizabeth McCaul welcomed the findings of the Report and confirmed, perhaps rather unsurprisingly given recent bank failures during March 2023 (see our standalone coverage on that), that the ECB-SSM, through use of SREP and other supervisory tools, will focus on effective governance and strategic steering of Banking Union supervised institutions. One major concern that the ECB-SSM has had over past SREP-cycles and will likely to continue to have concerns the effectiveness of management bodies in terms of their composition (particularly with a focus on diversity as well as IT expertise), collective suitability and oversight role. Almost half of the supervised banks were subject to at least one measure concerning their management body. Weak decision-making procedures and the absence of a healthy challenge culture hamper effective governance and strategic steering. According to Mrs. McCaul, “the primary causes of this inadequate scrutiny are frequently flaws in the basic operation and composition of boards and board committees. Low meeting frequency, imprecise mandates, insufficient reporting lines to independent control functions, and poor communication flows between the board and its committees or between the board and the heads of internal control functions are among the culprits. Furthermore, for around one-third of our supervised institutions, formally independent non-executive directors account for less than half of the board, limiting the board's ability to contest decisions. In other institutions, limited knowledge of banking, risk management, or more specialised fields (such as IT and climate and environmental hazards) may also be a barrier. Banks that do not think ahead in terms of board composition and experience will struggle to manage the increasingly competitive and rough waters ahead.”
Mrs. McCaul went on to state that, “While we recognise that governance structures differ amongst banks based on national traditions, there are few characteristics that I consider non-negotiable. These are the board members' independence, collective knowledge, and appropriate time commitment, as well as sufficient time committed to debate, which allows for the proper oversight and challenging capacity required to correct the bank's course.”Show Footnote

Moreover, the Report notes that while the ECB-SSM has already focused on the importance of focusing on specific risk areas during the SREP and prioritising follow-up activities. This will allow the ECB-SSM to begin adopting some of the report's suggestions as early as the 2023 cycle. Supervisors, for example, will apply a new risk tolerance framework to all important banks in order to better focus on strategic priorities and critical vulnerabilities, with greater flexibility in planning operations based on a multi-year SREP.

Against this backdrop, the Report finds that the ECB can now improve the supervision processes towards a more streamlined and risk-oriented approach, allowing to properly leverage supervisors’ judgement and experience by also preserving efficiency and effectiveness. In its Report, the Expert Group put forward the following recommendations discussed below amid which this can be achieved.

Further enhancing risk-based supervision and empowering supervisory judgement:

In recent years, the ECB-SSM has introduced a series of reforms including the multi-year assessment (MYA) and risk tolerance framework (RTF) to make SREP more streamlined, risk-based, flexible, judgement-oriented, agile, timely, and forward-looking. The Expert Group welcomed initiatives as such, through which supervisors are able to select the risk areas to be assessed each year, allowing them to dedicate more resources to in-depth reviews and avoid yearly assessments for less material risk areas or areas where the supervisory assessment has not changed.

However, according to the Report, pending full deployment of the MYA, SREP currently still aims to assess many risk areas in detail each year, without clear prioritisation. In connection with the lengthy timeline and rigidity of some of the SSM’s IT systems, supervisory resources might therefore become diverted away from the key risk drivers for each bank. In order to reap the full benefits, the Expert Group recommends, these initiatives should be integrated into day-to-day supervision and framed within a well-defined supervisory culture.  

Promoting the better integration of the outcome of other supervisory assessments into the SREP:

Although SREP is conducted as an all-encompassing review of significant institution’s risk profiles, the Report finds that such risk assessments do not sufficiently leverage all findings and outcomes from other supervisory processes. To this end, the Expert Group recommends that:

“The SREP should be a point-in-time stocktake of each significant institution’s risk profile based on supervisory information available to that point in time, rather an a yearly omni-comprehensive review of banks’ risk profiles through numerous modules.

Accordingly, the Expert Group suggests that measures addressing weaknesses identified in other supervisory processes could be issued as part of SREP decisions, according to a formalised escalation process. This requires that the information stemming from several supervisory activities beyond the SREP, conducted by the ECB-SSM, flow into the SREP assessments and measures. According to the Report, this would facilitate moving resources employed to conduct the bespoke mechanical tests currently required by the SREP to the actual monitoring of banks’ main challenges and management actions.

Streamlining the SREP process and shortening their timeline:

The Expert Group recommends measures intended to enable the SREP to evolve towards a leaner and more streamlined process. It is suggesting, in particular, streamlining SREP-specific modules, which would also require other changes like further separating the determination of capital requirements from SREP assessments, the parallel implementation of different steps in the process and the reduction of touch points with the Supervisory Board.

According to the Expert Group, this would allow the anticipation of some elements of the risk assessment (i.e., risk controls, governance and business model), which do not require financial data, and be based on all available supervisory information. The Report suggests that further time savings could be achieved, where possible, by conducting parallel runs of multiple processes including supervisory dialogue, the right to be hears and legal reviews, and streamlining Supervisory Bord reviews and approvals,

Rebalancing capital and qualitative measures:

The Expert Group suggests that the ECB’s supervisory approach is too capital centric. It is of the view that capital alone cannot address all risks, including weak business models and internal governance practices, as well as climate-related and environmental risks or IT/cyber risks. Accordingly, the Expert Group recommends the ECB to refocus its supervisory approach by strengthening the link between SREP scores and qualitative measures: “Instead of being a tool for risk quantification and numerical ranking, the objective of SREP scores should be to promote managerial actions to reduce and control risks.”

To this end, the Report also recommends that supervisors should endeavor to design and deploy qualitative measures in a targeted manner, with clear requirements focused on addressing banks’ key vulnerabilities. For this to be in line with the supervisory priorities, the Expert Group advises the European banking supervision to consider the establishment of an annual stock-take of the current state of all outstanding supervisory measures.     

Reforming the process for determining the Pillar 2 capital requirements (P2R):

The Expert Group criticises the ECB's current process for the determination of P2R. The ECB currently combines a holistic approach based on an overall risk assessment with some elements of a risk-by-risk approach derived from banks’ internal capital adequacy assessment processes (ICAAPs). The former is operationally simpler but does not permit focusing on risks that are not covered or are insufficiently covered by Pillar 1. The latter is arguably more consistent with the logic of Pillar 2 but entails potentially more operational complexity.

In the Expert Group’s view, the mixing of two “mutually incompatible” approaches of computing P2R estimates make the combination conceptually weak and adds to the operational complexity of the process. Consequentially, the ECB’s combined approach does not seem to outperform those two approaches either in terms of simplicity or consistency.

The Report highlights the approach of other jurisdictions, notably of the United Kingdom (UK), which have adopted a risk-by-risk approach which relies predominantly on internal methodologies (as opposed to ICAAPs). That approach requires tools and judgement criteria capable of estimating potential losses not sufficiently covered by Pillar 1 for each risk category. Correspondingly, such methodologies provide for an estimation of additional capital needs in a risk-by-risk manner, leading to a derivation of the P2R (P2A in the UK) for each bank, after properly applying supervisory judgement.

The Expert Group therefore in its Report encourages the ECB to consider whether the current compromise adds any net value compared with a purely holistic approach. It also suggests that the ECB should consider developing the methodology in a way allowing it to focus more directly on risks that are not sufficiently covered by Pillar 1 but with only limited ICAAP intervention. It suggests that transitioning towards a more direct focus of the P2R determination on actual capital needs would also disentangle the process of the determination of capital requirements from the risk assessment process. Ultimately, this would contribute towards more flexibility of the ECB-SSM and streamlining the SREP timeline.

Outlook and next steps

The need to target specific risk areas during the SREP as well as the prioritisation of follow-up actions has already been underlined extensively by the ECB-SSM. This resonates well with the recommendations reflected in the Report and could well be implemented as early as the 2023 cycle.

This is also confirmed in the ECB-SSM press release accompanying the Report’s release stating that: “supervisors will apply a new risk tolerance framework to all significant banks to better focus on strategic priorities and key vulnerabilities, with more flexibility in planning activities based on a multi-year SREP”. ECB welcomes expert group recommendations on European banking supervision, published in April 2023, available here.Show Footnote In the same vein, the Supervisory Board of the ECB has expressed its intention to evaluate the Report’s input as part of a review of supervisory processes planned for 2024. ECB welcomes expert group recommendations on European banking supervision, published in April 2023, available here.Show Footnote

Given the above, the specific actions flowing out of reforming how SREP is to be applied by the ECB and other stakeholders in the SSM in the context of Banking Union and how that might differ or, alternatively, in whole or part otherwise influence how SREP is applied by national competent authorities in respect of the wider set of financial services activity that is outside of the Banking Union will remain important as an area to monitor and take appropriate preparatory measures.

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