Snakes and (escalation) ladders: the ECB’s new SREP is coming

At a glance:

• The ECB is making a number of significant changes to its Supervisory Review and Evaluation Process (SREP). 
• The SREP will become less “capital-centric”, with strengthened qualitative measures and more expeditious use of the supervisory escalation ladder (including periodic penalty payments).
• The ECB has made clear that the new SREP “will not mean less supervision or a light touch approach”. In practice, in some areas (such as business model sustainability and governance) we expect the opposite. The ECB sees deficiencies in those areas as being the root cause of broader capital and liquidity issues.
• Given the ECB’s increased emphasis on effective remediation of identified weaknesses, senior management will need to put in place the right resources and internal incentives to make remediation programmes more effective.
• Banks should also consider how the ECB’s new approach affects ongoing implementation programmes. The economics of tactical or partial day 1 implementation of regulatory and supervisory requirements could change if the costs of ECB enforcement measures outweigh the cost savings of "just in time” compliance.

The ECB has set out its plan for implementing the Expert Group’s recommendations on reform of the SREP process.

We wrote about the potential amendments to the SREP here: The future of the SREP: how the ECB's annual supervisory assessment could evolve | Deloitte UK.

Although more detail is still to come, the key message is that the ECB is taking forward many of the recommendations made by the Expert Group, and banks will begin to feel the effect of changes as early as the 2025 SREP assessment cycle. As we highlighted in our original blog, this means that the SREP will become less “capital-centric”, with increasing emphasis on qualitative elements (which are often best addressed by non-capital measures); and more streamlined, in terms of the process, areas of focus each year, and communication to firms.

Although the ECB is a “first mover”, it is not alone among supervisors in major financial centres in reviewing its supervisory approach, not least in the wake of the banking turmoil in 2023. The PRA has stated its plans to revisit its Pillar 2 methodology, and the US Government and Accountability Office (GAO) recommended that US regulators clarify their escalation and enforcement procedures. In Switzerland, the new CEO of FINMA recently gave a speech calling for stronger qualitative supervision and early intervention. At the global level, the BCBS recently revised its Core Principles for Banking Supervision, reflecting lessons learned from the past decade and covering new risks that have emerged such as operational resilience, business model sustainability and climate change, while also strengthening principles around the corrective and sanctioning powers of supervisors.
 

What will change in the ECB’s SREP?
 

The ECB will reform the SREP in six areas, listed below. (1) to (4) will change in the 2025 SREP assessment cycle, while (5) and (6) will change in the medium to long term.

1. Focused risk assessments

• Building on the multi-year assessment and supervisory risk tolerance frameworks deployed by the ECB since 2023, supervisors will focus on certain priority risks each year. SREP decisions can be updated every two years if there is no material change to an institution's risk profile (from 2025 cycle).

2. Better integration of supervisory activities

• Enhanced use and integration of on-site inspections, targeted analyses, and horizontal thematic reviews.

3. Using the full supervisory toolkit

• Full and more intrusive use of the ECB’s supervisory toolkit, faster moves up the escalation ladder, legally binding qualitative requirements, and stronger enforcement measures.

4. Enhancing communication

• SREP decision letters to be more concise, focusing on key supervisory concerns, expectations and actionable measures.

5. More stable methodologies

• Revised methodology for setting Pillar 2 Requirements, to be published by end-2024, with the aim of improving stability and enabling supervisors to focus conceptual work on new issues and emerging risks.

6. Making better use of IT systems and analytics

• Investment in and use of supervisory technology to improve efficiencies, access to data, risk analytics, consistency of decision-making and collaboration. The ECB will explore use of Generative AI and Large Language Models.
   

More detail still to come

The ECB also plans to revise its approach to calculating Pillar 2 Requirements (P2R) by the end of 2024, with the new methodology fully applied in the 2026 SREP assessment cycle. There is no detail yet on what will change in the new methodology, but the ECB’s stated objective is to make Pillar 2 requirements “more stable and, where possible, simpler and more transparent”, with “increased stability” allowing supervisors to focus conceptual work on new issues and emerging risks.

The Expert Group made a number of recommendations on how the process for determining P2R could be improved, including using a more “operationally efficient” methodology, focusing exclusively on risks requiring additional capital and reducing the role of ICAAPs in the process. It is not yet clear which of those recommendations will be taken forward, although the ECB has said that it P2R will “remain anchored to the SREP and reflect the supervisors’ comprehensive view of a bank’s risk profile”.

An additional longer-term question is how the ECB uses technology in its supervision. The ECB has previously set out its view that technology such as AI can enhance the work of banking supervisors, including by analysing large quantities of data and identifying risks. It will be important for banks’ digital transformation journeys to keep pace with supervisors’, in order to remain on the front foot.  Banks may find that the volume of supervisory data requests increases as supervision becomes more data- and technology driven. An ongoing joint initiative between the ECB and EBA to improve the efficiency of bank data reporting may eventually help to reduce the burden of fulfilling those requests.
 

What does the increased emphasis on qualitative measures mean for SSM banks?
 

Banks will have already started to feel the effect of the ECB’s new supervisory strategy. More qualitative topics such as governance and business model sustainability have become more prominent in the ECB’s priorities in recent years, with governance issues accounting for a large portion of the ECB’s SREP decisions.

However, the ECB’s pledge that the reformed SREP will make supervision “more effective and intrusive by using the full range of supervisory tools that the law makes available” indicates that failing to address qualitative supervisory concerns will become increasingly consequential. The economics of tactical or partial day 1 implementation of regulatory and supervsisory requirements could change if the costs of ECB enforcement measures outweigh the cost savings of ”just in time” compliance.

The ECB has already made clear its readiness to use “periodic penalty payments” as an enforcement measure (requiring banks to pay a daily amount, up to 5% of average daily turnover, for every day the infringement continues during a maximum period of 6 months).

ECB communications around periodic penalty payments have focused in particular on banks’ management of climate and environmental risks, but banks with longstanding deficiencies in internal governance are also likely to be particularly at risk of enforcement action. Unaddressed weaknesses in risk data aggregation and reporting, the effectiveness of management bodies and the effectiveness of internal control functions will remain in the spotlight, with scrutiny potentially intensifying for some banks as supervisory resources are re-routed from other banks with no material change in their risk profile.

Qualitative findings, such as those relating to governance and business models, are in some respects harder to address than quantitative issues.  They are often more complex and it is more challenging to demonstrate a "quick fix". It will often take time for a bank to evidence that its new governance arrangements are effective or that its business model is on a sounder footing. Firms will need to focus on demonstrating tangible and lasting improvements and outcomes rather than treating remediation as a “box ticking” exercise.

More concise SREP letters that set out clearly expected actions will be welcomed by banks. Additional clarity around the consequences of inaction may also make it easier to mobilise resources and investment for regulatory change programmes.

Senior executives will need to ensure they create the right incentives to enable effective remediation programmes.

Conclusion

The ECB has made clear that the new SREP “will not mean less supervision or a light touch approach”. In practice, in some areas we expect the opposite. The ECB is clearly losing patience with banks’ failure to remediate qualitative issues that it sees as the “root cause” of risks to capital and liquidity effectively and promptly, and will not shy away from bringing topics back to the top of its priorities if they remain unaddressed for long periods – BCBS 239 is a case in point. Banks should expect to come under pressure to shorten the time between issues being identified and remediated, and should work with their supervisors to understand the changes and how expectations are likely to evolve over the coming years.