The future of the SREP: how the ECB's annual supervisory assessment could evolve
At a glance:The ECB has published the report by an Expert Group looking at potential amendments to the SREP process. The Expert Group’s recommendations include making the SREP process leaner and more risk-based; taking a less ‘capital-centric’ approach and increasing emphasis on the qualitative elements of the SREP; and reforming the way Pillar 2 is calculated. The ECB has indicated that it will take forward some of the Expert Group’s recommendations in the 2023 SREP cycle, although it has not yet confirmed which ones. The ECB will also feed the Expert Group’s recommendations into a 2024 review of supervisory processes.
Banks subject to direct ECB supervision will need to understand the potential effects of the Expert Group’s recommendations for their ICAAP and SREP process; communication with supervisors will continue to be key to ensuring these processes run smoothly.
Audience: Board Members, CEOs, CROs, CFOs, Treasurers, ICAAP teams, Stress testing teams
Background
After almost a decade of marking European banks’ homework, in September 2022 the ECB asked an independent Expert Group (EG) to mark the ECB’s. In April, the ECB published the results of the EG’s seven month review of the ECB’s SREP process, identifying a number of development areas. While it remains to be seen which of the EG’s recommendations will be implemented, the ECB has said that it will take forward some of the recommendations as soon as the 2023 SREP cycle. The recommendations will also feed into a broader review of supervisory processes planned for 2024.
For SSM banks, the recommendations could prove to be the first signal of material changes to the way that they are supervised in the short to medium term. With that in mind, this blog summarises the key findings of the report, and gives our view on the potential implications for banks. Among the recommendations, we see two areas as being particularly important and consequential – increasingly ‘risk-based’ (i.e. proportionate) supervision and deployment of supervisory resources; and rebalancing of the capital and qualitative measures in the SREP, making it less ‘capital-centric’.
It is important to note that the report highlighted a number of strengths of the existing SREP process. These include:
- the overarching SREP principles of (a) consistency (b) synchronisation and (c) transparency;
- the SREP’s dynamism, evolution and adaptability;
- the SREP’s four level scoring system (1 – Low Risk, 4 – High Risk); and
- robust organisational and IT infrastructure for collaboration among staff in participating countries in the EU.
These areas are unlikely to be subject to significant change, so the remainder of this blog focuses on those development areas that we feel aremore likely to change, and potential effects on SSM banks. The annex to this blog sets out a wider view of the EG’s report.
Key Development Areas for the current SREP framework
Moving to a more efficient approach that is leaner and more risk-based
In recent years, the ECB has been developing a multi-year assessment (MYA) framework and a supervisory risk tolerance framework (RTF). The EG recommends that the ECB uses these new processes to improve the efficiency of the SREP, and the allocation of supervisory resources.
The MYA will allow supervisors to choose, on a bank-by-bank basis, which risk areas to look at each year – prioritising those risks regarded as most material,1 taking into account banks’ business, market and competition environment, history and culture, and in some cases deprioritising or not assessing less material risks every year. This would be underpinned by the RTF – which combines top-down guidance from the supervisory board and bottom-up assessment from joint supervisory teams.
The EG highlights that, by fully implementing the MYA in supervisory processes and systems, the SREP assessment could be streamlined – and shortened significantly.
Furthermore, the EG highlights that the SREP could be made more efficient by integrating better the outcomes of other supervisory activities into SREP assessments. This would mean that insights from other supervisory activities beyond the SREP (such as on-site inspections, horizontal reviews, internal model assessments, fit and proper assessments and stress tests) flow into and inform SREP assessments and measures.
Implications for banks
- Allocation of supervisory resources based on the materiality of risks should mean that certain banks face less onerous assessments each year, or at least assessments that focus on a narrower set of risks.
- Conversely, banks exposed to more material risks should see an intensification of supervisory scrutiny, as resources are re-routed from elsewhere.
Banks supervised directly by the SSM may be in favour of the proposal of a more streamlined approach, which could reduce the burden of SREP during its annual planning cycle. Banks will need to ensure they communicate well with the ECB and their supervisors to understand the extent to which their business model interacts with the MYA and RTF, in order to take a view on the likely level of scrutiny they will face through the SREP process.
Taking a less ‘capital-centric’ approach
The EG recognises that the SREP was designed at a time when SSM banks needed to increase their capital substantially to avert a ‘full-scale banking crisis’, and as a result the process was geared predominantly towards capital outcomes. This capital-centric approach is generally less relevant today, given the stronger capitalisation of the EU banking sector.
The EG therefore recommends changing the focus of the SREP so that qualitative outcomes have a greater influence on SREP scores. This would involve linking SREP scores less to risks to viability, and more to banks’ perceived ability to take specific actions to address supervisory concerns. Currently qualitative SREP measures are more commonly used to address low-risk findings. Under the EG’s proposed framework, binding qualitative measures would also be used to address severe deficiencies – likely coupled with strict remediation timelines, with embedded enforcement actions (such as restrictions on business or remuneration) that would be triggered if banks’ actions are not satisfactory.
SREP scores would increase or decrease based on whether banks had been able to address deficiencies and deliver expected outcomes. Accordingly, supervisors would need to communicate the expected management actions (and timelines) to banks more clearly.
Implications for banks
- Banks with long-standing, unaddressed weaknesses (in areas such as business model sustainability and governance) could see worsening SREP scores as a result of their inability to tackle deficiencies effectively.
- Equally, banks that take a proactive approach to addressing issues will likely see that reflected more substantially in their SREP scores.
- Although going forward capital may not be the primary tool through which weaknesses identified in the SREP are addressed, banks should not assume that SREP outcomes will be any less severe. The ECB will be keen to ensure that the SREP continues to create incentives for banks to address weaknesses, and will ensure that it has sufficient enforcement powers to do so.
Any change in the ECB’s approach toward more qualitative assessment will mean banks need to ensure that their delivery capability for regulatory change programmes is of the highest level. Banks where this is not currently the case will need to ensure they increase capability and capacity in programme management and delivery.
Reforms to the way that Pillar 2 Requirements are calculated
At present, the ECB determines Pillar 2 Requirements (P2R) using a combination of a ‘holistic approach’ (based on an overall risk assessment of the bank) and a risk-by-risk approach (derived from banks’ ICAAPs). The EG recommends that the ECB consider either a purely holistic approach or a purely risk-by-risk approach (although without relying on the ICAAP to the same extent).
The EG also suggests that the P2R should focus on risks not sufficiently covered by Pillar 1 – such as IRRBB, pension risks and sectoral concentration risks – which, in the current P2R determination process, do not necessarily receive a high weighting in banks’ overall risk scores. The ECB would need to develop internal methodologies for assessing those risks, which would need to be sufficiently flexible to capture new capital needs under specific circumstances and leave space for supervisory judgement. P2R would then focus on actual capital needs, rather than being linked to banks’ overall SREP scores.
The EG suggests that the ECB should aim to formulate in advance its expectations for the overall capital needs of SSM banks. This would then lead to the ECB taking a view on the relative contribution of P2R and P2G in achieving the desired level of capital. The EG further notes that the desired severity of the adverse scenario in the stress test is not currently subject to a consistent, agreed set of criteria. The EG recommends that the ECB should consider this, and also contemplate the possibility of some anti-cyclical adjustment to the scenario severity (making the stress less severe when conditions are already bad, and vice versa).
Implications for banks
- If the ECB adopts a more holistic approach, banks’ ICAAPs will play a less determinative role in supervisory capital setting – while the ICAAP would remain relevant as ancillary information, overall SREP scores would be the basis for Pillar 2R.
- If the ECB moves to a more risk-by-risk approach, an increased proportion of Pillar 2 capital may be devoted to idiosyncratic risks.
- Even if the ICAAP is less influential in driving banks’ P2R, the ECB will still expect banks to undertake a rigorous and complete ICAAP (and ILAAP) – as is the case in the UK, where risk-by-risk supervisory methodologies are used to determine Pillar 2A.
Reducing reliance on firms’ ICAAPs risks eroding some of the clear benefits they bring in terms of fostering sound risk management and closer self-scrutiny, where firms have a well-established ICAAP and continuous feedback loop to embed the outcomes. The ECB will want to avoid this potential consequence.
Conclusion
The publication of the EG’s report gives an indication of how the ECB may look to develop the SREP process. The EG has made a number of recommendations in its report; we have focussed in this blog on those we think are potentially most material.
Notwithstanding comments on feeding the EG’s recommendations into future amendments to the SREP process, the ECB will likely approach any action cautiously, particularly given the relative stability of the EU banking system through recent stress events including Covid and the US/Swiss bank failures. The ECB will also need to consider level playing field issues and whether changes it makes will lead to divergence between SSM and non-SSM supervised jurisdictions. Divergence may result in increased cost and effort for larger groups, which operate in both SSM and non-SSM Member States and could therefore face differing solo and consolidated requirements.
Banks should ensure they remain focussed on the production of high-quality, well-governed and robust ICAAPs, while maintaining a watching brief on changes to the ECB’s SREP process that may arise from the EG’s recommendations.
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