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A pragmatic SREP delivers appropriate supervision for the crisis

Blog post by Elizabeth McCaul, Member of the Supervisory Board of the ECB

12 May 2020

Today’s balance sheets are significantly strengthened since the Great Financial Crisis thanks to many decisions taken since then by global economic leadership and banking supervisors. In response to the coronavirus disruption, governments and central banks around the globe have been delivering liquidity, moratoria and public support measures of unprecedented magnitude and reach. ECB Banking Supervision and our counterparts in the EU, UK and US have announced unprecedented supervisory flexibility in response to the economic shock.

ECB Banking Supervision’s flexibility is reflected in a number of actions taken over the last few weeks and has several objectives.

First and foremost, our actions seek to alleviate the immediate operational burden on banks. This burden is not small. While protecting the health and safety of their employees and customers by moving in many cases to off-site working arrangements, banks also need to provide sustainable solutions for temporarily distressed debtors amid the current coronavirus outbreak. We want to enable banks to focus on the continuity of their core operations so that they can be part of the solution to this crisis.

Second, we are keenly aware of the wide variety of risks facing banks in this challenging macroeconomic environment. While the crisis is certain to cause economic damage, much is yet unknown about the depth and breadth of the harm. For now, we are striving to ensure that our actions today recognise uncertainties, are balanced and avoid procyclicality.

And, third, drawing on some of the most important lessons of the last crisis, we are keeping a firm hand on the supervisory tiller to avoid any hidden build-up of risks.

Here are a few examples of actions taken recently:

  • We are fortunate that past experience during the great financial crisis led to a prudent build-up of capital buffers for when the worst comes. We recently instructed banks to take advantage of the current regulatory flexibility in using their capital buffers. In these stressed circumstances, banks may operate temporarily below the level of capital defined by the Pillar 2 guidance and also are allowed to recompose the capital buffer that is needed to meet Pillar 2 requirements with capital instruments that absorb less core equity. We expect banks will then be better able to absorb losses as well as free up their balance sheets for lending to households and firms[1]. We believe and expect that markets should not penalise banks for using the flexibility we have provided.
  • On 19 March the European Banking Authority (EBA), the ECB and the other competent authorities in Europe postponed the EU-wide stress test exercise to 2021 so that banks can focus on the continuity of their core operations. At the same time, the EBA decided to carry out an EU-wide transparency exercise in order to provide market participants with updated information on banks’ exposures and asset quality.
  • In response to the recent disruption in financial markets, the ECB – like other banking supervisors around the world – is applying greater flexibility in the use of internal models to calculate capital requirements for market risks. The Basel regulation acknowledges that even well-designed internal models may fail to anticipate exceptionally high market volatility of the kind we are currently witnessing. To preserve the capacity of banks to provide liquidity and continue their market-making activities, the ECB is permitting banks to temporarily reduce the qualitative market risk multiplier. This multiplier is set by supervisors and is used to compensate for banks’ potential underestimation of their market risk capital requirements. The aim of this move is to stabilise the impact of increased market volatility on capital requirements for market risks.
  • We have written to all significant institutions about the implementation of the IFRS 9 international accounting standard, recommending that they avoid procyclical assumptions in their provisioning models and apply the IFRS 9 transitional rules in full.

We have also asked the banks we supervise to take certain steps to be sure they are well prepared with enough fuel for the voyage ahead. In a move that was echoed by our UK counterparts, the ECB recommended that no capital leave the banking sector through dividend distributions or buybacks until we have a clearer picture of the consequences of the crisis. Policymakers are playing their part to ensure that banks are in a position to be reliable lenders to households, small businesses and large corporations alike in the weeks and months ahead.

However, our job is not yet done. In many ways, I think the role we will play in identifying risks in the system as the crisis unfolds will be just as important if not more so than the work we have done within European banking supervision in the last few weeks.

We are also considering carefully how best to extend our supervisory flexibility to the annual Supervisory Review and Evaluation Process (SREP). Our deliberations about how to strike the right flexible balance for this cornerstone of our supervisory work have been extensive and reflective of the importance SREP has in enabling us to understand the state of the banks under our supervision.

The SREP involves a comprehensive review of the sustainability of a bank’s business model, the effectiveness and quality of its internal governance, and the risks and control measures for managing its capital and liquidity positions. The annual SREP process is an intensive exercise for both supervisors and banks, requiring the management board and the risk functions of each bank to provide a broad range of information, for example through internal capital and internal liquidity adequacy assessment processes (known as ICAAP and ILAAP, respectively) in line with EBA guidelines.

We need to be pragmatic and take a simplified approach this year. At the same time, we very much need to continue to assess the health of the banks in a relevant, rigorous and transparent manner.

The ECB Supervisory Board took note of the main features for conducting a pragmatic SREP in 2020 at its meeting on 27 March. The SREP 2020 will:

  • Focus on how banks are handling the challenges and risks to capital and liquidity arising from the ongoing crisis. We intend to maintain the previous supervisory assessment for many elements of the SREP. Joint Supervisory Teams will instead focus on providing a supervisory outlook on the resilience of banks and their capacity to absorb the potential impact of the crisis over time, with particular emphasis on internal governance and risk management.
  • Maintain stable Pillar 2 requirements and Pillar 2 guidance, unless changes are justified by exceptional circumstances affecting an individual bank[2].
  • Have a significantly condensed ICAAP and ILAAP assessment that focuses on aspects relevant to managing the coronavirus crisis. The ICAAP/ILAAP submission deadline remained end of April 2020. However, banks are exempt from a number of formal requirements and should instead focus on showing how they are managing capital and liquidity during this challenging period, including by providing information on the flow of information within the bank, its decision-making structure and the materialised and expected impact on capital and liquidity planning. We sent a letter to banks clarifying our supervisory expectations for the submission of ICAAP and ILAAP documentation in April 2020.
  • Have an adjusted timeline to allow banks to deliver reliable estimates of the impact of the coronavirus crisis on the various risks to capital and liquidity. Under the revised timeline, we intend to communicate any recommendations resulting from our SREP assessment in letters in November and December 2020.

At the time of writing this blog post, we are still refining aspects of the SREP assessment in 2020. For example, we are working closely with the EBA as it coordinates a European approach on a simplified joint decision-making process for the SREP in 2020. We are also coordinating with the relevant competent authorities for banks operating in countries outside the European Union.

In short, our guiding objective is to reduce the burden on euro area banks while maintaining a clear and accurate view of their soundness. We are currently working to ensure that we deliver a SREP that is pragmatic while meeting our objectives for rigor, relevance and transparency.

As the coronavirus crisis unfolds, ECB Banking Supervision will continue to be flexible and vigilant, keeping a weather eye on the horizon for potential build-up of risk using tools such as a pragmatic SREP and other supervisory assessments.

We need a strong banking system that can support the economy through this crisis, and we look forward to the day we enter “new” normal times, when ECB Banking Supervision can return to normal supervision.

  1. For further clarification of the relief measures regarding capital requirements, please check Section 3 of the FAQ on ECB supervisory measures in reaction to the coronavirus.
  2. See this reference for the Pillar 2 Requirements (P2R) for the 2019 SREP decisions taken for 2020. These decisions will remain stable for 2021, unless there are exceptional individual bank circumstances.