An essential ingredient for the euro area’s recovery is a stable banking sector that serves the economy. And the key lesson we have learned from the crisis is that strong regulation and effective supervision are essential ingredients for a stable banking sector. In fact, excessive deregulation was among the causes of the global financial crisis. So, stronger rules for the financial sector and better supervision actually belong to the growth agenda. And major progress has been made at European and global levels. In November 2014, European banking supervision was established. This was a decisive step, and it has laid the foundations for a more stable banking sector and a more integrated Europe.
Over the past few years, European banks have become more resilient in terms of capital, leverage, funding and risk-taking. Consequently, they have been able to withstand the economic crisis in emerging markets, the collapse in oil prices and the immediate consequences of Brexit. Healthier banks are also able to continuously provide credit, which is much needed to support the economic recovery in the euro area.
European banking supervision has played an essential role in ensuring the sector’s resilience. By introducing tough and fair banking supervision – exercised according to the same high standards across the entire euro area – it has instilled trust in the quality of supervision and, consequently, in the stability of banks.
Challenges remain, however. The banking sector’s capacity to fully support the euro area’s recovery is curtailed by its low profitability. Overcapacities, inefficiencies and legacy assets contribute to banks’ low profitability. It is up to the banks themselves to find appropriate answers to these challenges. And for the sake of a strong recovery in the euro area, they must do so quickly.
European banking supervision greatly contributes to a more stable banking sector in the euro area. At the same time, it ensures a level playing field, which is necessary for a single banking market to emerge. However, to ensure that the integrity of the single banking market remains unquestioned, we need to finalise the banking union. Just as we have created common supervision and resolution in the euro area, we have to ensure that depositors are equally safe everywhere.
Frankly, I am very proud of what we have achieved. Within a very short time, we have created an institution that helps to ensure the stability of the entire European banking sector. European banking supervision is of course very young, and there is still room for improvement. But it works, and it works well. People from all across Europe are working together towards one common goal: a stable banking sector. Some of them work here at the ECB while many more are working at the national supervisory authorities. Together, they form a truly European team of banking supervisors. And it is their dedication that drives our success. I cannot thank them enough; for me, it is a pleasure and an honour to work together with all these people: the staff at the ECB, the national supervisors and, of course, the members of the Supervisory Board.
Three things come to mind: first, we began to effectively address the issue of non-performing loans. We had already set up a task force to deal with this issue in 2015. In 2016 we produced draft guidance for banks on how to deal with high levels of non-performing loans. That has been a major step forward. Second, we continued to improve the solvency of the euro area banking sector. And finally, we further harmonised banking supervision in the euro area with the goal of supervising all banks according to the same high standards.
European prudential law offers a number of options and discretions which give supervisors some leeway in applying the rules. In 2016 we agreed with the national authorities to exercise these options and discretions in a harmonised manner across the euro area and, subsequently, issued an ECB Regulation and a Guide. Another important means of harmonising supervision is the Supervisory Review and Evaluation Process, the SREP. The SREP ensures that all euro area banks are supervised according to the same methods and standards. In 2016 we further refined and adapted the SREP. As a result, our supervisory capital add-ons are now much more closely correlated with the individual risk profile of each bank.
We have made good progress towards that goal. However, there are still some uneven patches. Regulation, for instance, remains somewhat fragmented in the euro area. Some of the rules for banks take the form of EU directives, which still have to be transposed into national law. The actual rules differ therefore from country to country, making European banking supervision less efficient and more costly. So if policymakers are serious about the banking union, they must further harmonise the rules. One option would be to rely less on directives and more on regulations as these are directly applicable in all EU Member States. The recent legislative proposal by the European Commission, which revisits many important aspects of the rulebook, presents a good opportunity to further harmonise banking regulation in the EU. We have to make sure this chance is not missed. The final legal text should also ensure that the supervisor has all the necessary tools and flexibility to carry out its duties adequately.
The ECB directly supervises the 130 or so largest banks in the euro area, the significant institutions. The remaining banks (around 3,200), referred to as the less significant institutions, or LSIs, are directly supervised by the national competent authorities. The ECB plays an indirect role in the supervision of LSIs. Together with the national supervisors we support the establishment of uniform standards for supervising LSIs as well. In 2016 we developed a number of such standards. We also extended our approach to options and discretions to smaller banks, and we are working on a harmonised SREP for LSIs. Naturally, we adhere to the principle of proportionality when dealing with LSIs. We adjust the level of supervisory engagement to the risks borne by smaller banks.
Well, the good news is that they have become much more resilient over the past few years; their capital buffers have increased significantly. At the same time, however, they still face risks and challenges. Besides having to work out how they can raise profits in a challenging environment, how they can dispose of legacy assets and how they should deal with cybercrime and other IT risks, they currently face a number of other questions. Will competition from non-banks intensify? Where is the euro area economy headed? How will Brexit affect banks in the euro area? How will other geopolitical issues play out? Banks are operating in a world characterised by risk and change; they have to manage these risks and adjust to the change. Only then will they be able to remain profitable over the long term.
For large banks in the euro area, interest income makes up more than half of their total income. So interest rates are indeed an issue and low interest rates are a challenge. In 2017 we will further explore banks’ interest rate risk. For instance, this year’s stress test will consist of a sensitivity analysis focused on effects of interest rate changes on the banking book. Regarding regulation, rules invariably impose a burden on those who have to comply. But we have to look beyond the banks in this case. Stronger rules help to prevent crises. And we have learnt that financial crises are costly to the economy, to taxpayers and, ultimately, to the banks themselves. Against that backdrop, it would be most welcome if the global regulatory reform were to be finalised as foreseen. Walking back on the global regulatory reform is the last thing we should do. The financial sector transcends national borders, and so must the rules that govern it – that is a major lesson from the financial crisis.
The risks and challenges I just mentioned are reflected in our supervisory priorities for 2017. First of all, we will further analyse banks’ business models and go on exploring their profitability drivers. To that end, our Joint Supervisory Teams will thoroughly examine their respective banks. And we will also assess how developments such as FinTech and Brexit might impact the business models of banks in the euro area. However, at the end of the day, it is of course not our job to prescribe new business models. But we can and will challenge the existing ones. Our second priority is risk management. In the current environment of low profitability and high liquidity, banks might be tempted to embark on a dangerous search for yield. In that context, risk management is more important than ever. And our third priority is credit risk. This mainly refers to non-performing loans – I already mentioned this important issue.
Banks and supervisors have certainly accomplished much already. Nonetheless, non-performing loans, or NPLs, remain a big issue. They are like dead weight in banks’ balance sheets: they curb profits, and they limit the capacity of banks to extend credit to the economy. The guidance we devised will help banks to clean up their balance sheets. It fosters consistent forbearance, recognition, provisioning and disclosure for NPLs. And it urges banks with high levels of NPLs to define and implement specific reduction targets. The best practices defined by the guidance constitute our supervisory expectations. Our Joint Supervisory Teams have already started to actively engage with banks on how they plan to implement the guidance. But the issue of NPLs is not just one for banks and their supervisors. How quickly a bank can resolve its NPLs also depends on the national legal and judicial systems. And in some countries, these systems hamper the speedy resolution of NPLs. Here, national policymakers could help the banks. They could make judicial systems more efficient, increase access to collateral, create fast out-of-court procedures and align fiscal incentives.
It is clear that banks always and everywhere need sound risk management – after all, they are in the business of taking and allocating risks. But sound risk management is complex, and it requires a number of elements. First of all, it requires the right culture – a culture where risk management is valued and not seen as a roadblock on the way to higher profits. More formally, sound risk management requires sound governance structures – risk managers must be given a voice that is heard by those who take decisions. In June 2016 we published the results of a related review which showed that many banks still need to improve in this regard. Finally, sound risk management requires good data. That is why in 2017 we will assess how banks comply with relevant international standards. As a related issue, we have launched a major project to assess the internal models that banks use to determine their risk-weighted assets. These internal models are important because risk-weighted assets form the basis for calculating capital requirements. And finally, we will initiate a thematic review to take stock of banks’ outsourced activities and scrutinise how they are managing the associated risks.
For banks, supervision is like a counterweight that improves stability: banks tend to see the returns, supervisors tend to see the risks; banks tend to care about profitability, supervisors tend to care about stability. By playing their role, banking supervisors prevent banks from excessive risk-taking, thereby helping to prevent future crises. They protect savers, investors, taxpayers and the entire economy. European banking supervision has the additional benefit of a dedicated European perspective. Looking beyond national borders, it can spot risks early on and prevent them from spreading. Acting independently from national interests, it can be a tough and fair supervisor for all banks in the euro area. So it helps to create a level playing field, with everyone sharing the same opportunities and the same responsibilities. This is the foundation on which a truly European banking sector can grow for the benefit of the entire economy.
In 2016 euro area banks posted stable profits, but at low levels. At the same time, their risks and challenges remained mostly unchanged compared to those in 2015. The main risk lay in the sustainability of banks’ business models and profitability; other major risks included high levels of non-performing loans and geopolitical uncertainties, such as the medium and long-term impact of Brexit. European banking supervision set its supervisory priorities accordingly.
European banking supervision also continued to improve its main tool, the Supervisory Review and Evaluation Process (SREP). As a result, banks’ capital requirements were more closely matched to their individual risk profiles. Overall, the capital demand resulting from the SREP 2016 remained broadly stable.
In 2016 European banking supervision made good progress in dealing with non-performing loans. In September it published draft guidance for public consultation. The recommendations and best practices set out in this guidance will help banks to effectively reduce non-performing loans.
Main risks for the European banking sector remain unchangedThe risks identified in 2016 remain relevant, for the most part, in 2017. Banks in the euro area are still operating in a business environment characterised by low economic growth. The bleak economic performance impacts on interest rates and economic recovery and is driving the main risks faced by the euro area banking sector depicted in Chart 1.
The prolonged period of low interest rates supports the economy and reduces the risk of defaults. However, it also puts pressure on banks' business models as low interest rates squeeze interest income in a context where the overall profitability is already low. Risks to the sustainability of business models and low profitability continued to be one of the main concerns for the euro area banking sector in 2016.
Banks need to reduce high stocks of non-performing loansAnother source of concern is high stocks of non-performing loans (NPLs) in a number of euro area banks. Besides diminishing profitability, they leave the affected banks more vulnerable to shifts in market sentiment. Banks therefore need sound and robust strategies to clean their balance sheets, including active management of the NPL portfolios.
Brexit poses a geopolitical risk for banksGeopolitical uncertainties are on the rise. Particularly in the context of the UK referendum on Brexit, ECB Banking Supervision was in close contact with the most exposed banks to ensure that they were carefully monitoring the situation and the risks and preparing for the possible outcomes. During this period of time, no material liquidity/funding or operational risks in the banking sector were identified. However, recent political developments may delay investments, leading to sluggish growth.
Risk map for the euro area banking system
Source: ECB; arrows indicate potential transmission channels from one risk driver to another (only main first order effects are represented); NPL: this risk driver is only relevant for euro area banks with high non-performing loan ratios.
Notwithstanding the benefits of a safer and more resilient financial system, ambiguity surrounding future regulation is also an issue. The completion of the Basel III review, the determination of minimum requirement for own funds and eligible liabilities (MREL) targets will reduce regulatory uncertainty and make the banks’ operating environment more stable. In the meantime, banks are also preparing for the implementation of IFRS 9, which will enter into force at the beginning of 2018. On the whole, certain banks may still find it challenging to meet stricter requirements while maintaining adequate profitability.
In 2016 ECB Banking Supervision conducted the EU-wide European Banking Authority (EBA) stress test for euro area banks and the ECB Banking Supervision SREP stress test. The EU-wide stress test covered 37 large significant institutions (jointly representing roughly 70% of the banking assets under European banking supervision). Stress test results for these banks were published by the EBA on 29 July 2016. The SREP stress test covered an additional 56 significant institutions in the euro area. Broadly the same methodology was used in both exercises to assess the resilience of financial institutions to adverse market developments and to provide input to the SREP.
The stress test outcome showed that:
A team of roughly 250 members from the ECB and from NCAs/NCBs subjected the stress test results, as calculated by the banks, to a robust quality assurance process. This process drew on the bank-specific knowledge of Joint Supervisory Teams (JSTs), peer benchmarking, the ECB’s own top-down calculations and NCA expertise.
Supervisory priorities for 2016 and 2017
1 Targeted review of internal models
2 Internal Capital Adequacy Assessment Process
3 Internal Liquidity Adequacy Assessment Process
Note: Thematic reviews are highlighted by a dark blue border.
The quantitative impact of the adverse stress test scenario is one factor in determining the level of Pillar 2 guidance (P2G). The qualitative outcome of the stress tests is included in the determination of the Pillar 2 requirement (P2R). Moreover, in addition to risks already identified through the ongoing supervisory assessment, the stress test pointed to key vulnerabilities of euro area banks in the event of an adverse shock. For instance, most loan losses came from unsecured retail and corporate exposures. The stress test also identified lending to certain geographies such as Latin America as well as Central and Eastern Europe as a driver of credit losses.
The SSM supervisory priorities set out focus areas for supervision in a given year. They build on an assessment of the key risks faced by supervised banks, taking into account the latest developments in the economic, regulatory and supervisory environment. The priorities, which are reviewed on an annual basis, are an essential tool for coordinating supervisory actions across banks in an appropriately harmonised, proportionate and efficient way, thereby contributing to a level playing field and a stronger supervisory impact (see Figure 1).
Profits of significant institutions in the euro area remained stableThe results of the first three quarters of 2016 show that the profitability of significant institutions remained stable in 2016. The average annualised return on equity for a representative sample of 101 significant institutions stood at 5.8% in the third quarter of 2016, slightly decreasing year on year (6.0% in the third quarter of 2015). However, it should be noted that, behind these aggregate figures, we observe a great variety of developments.
Recurring revenues contracted in 2016: the aggregate net interest income of significant institutions decreased by 3%, despite a slight increase in loans (+0.5% year on year), particularly in corporate loan volumes (+2.8%). The decrease was concentrated in the first quarter of 2016. Thereafter, interest revenues stabilised. Fee income also decreased (-2.8% year on year), largely reflecting a decline in commissions from asset management and capital markets activities during the first three quarters of 2016. The trend may have been reversed in the fourth quarter of 2016 as capital markets activities picked up again.
Stable level of return on equity in 2016 due to lower impairment charges offsetting the decline in operating profits
(All items are weighted averages displayed as a percentage of equity)
Data for both years are shown as Q3 cumulated figures annualised.
Source: FINREP framework (101 significant institutions reporting IFRS data at the highest level of consolidation).
The negative impact of decreasing revenues was partly mitigated by lower operating expenses (-1%). The cost reduction was particularly pronounced for staff expenses (-1.4% year on year). In view of the restructuring measures recently undertaken by several euro area banks, the trend may continue in the coming quarters.
Improving macroeconomic conditions had a positive effect on impairment charges, which were lower than in 2015: impairments on loans and other financial assets dropped from 5.5% of aggregate equity in the third quarter of 2015 to 4.4% in the third quarter of 2016. Most of the improvement was concentrated in a few jurisdictions, while credit losses had already been at historically low levels in some of the other countries. Past experience suggests that banks tend to book higher impairments in the fourth quarter, which could affect profitability results over the full year.
Extraordinary sources of income supported banks’ profitability in 2016 (3.4% of aggregate equity in the third quarter of 2016). However, one-off gains were lower than in 2015 and may not be repeated in the coming quarters.
Owing to improvements in the SREP methodology, the correlation of banks’ risk profiles with their capital requirements increased
Based on a common methodology for the largest banking groups in the euro area, European banking supervision carried out the SREP for the second time in 2016. Again, the objective was to promote a resilient banking system that is able to sustainably finance the euro area economy. The harmonisation already achieved in the 2015 supervisory cycle led to tangible results in this regard. Building on these achievements, the SREP assessment has been enhanced. The enhancements are reflected in an increased correlation of capital requirements with banks’ risk profiles (from 68% after the SREP 2015 to 76% after the SREP 2016). At the same time, the general approach of combining quantitative and qualitative elements through constrained expert judgement has been maintained. In addition, the SREP methodology has been further complemented in order to incorporate the results of the 2016 EU-wide stress test.
Figure 2 gives an overview of the SREP methodology. An update of the relevant SSM SREP Methodology Booklet was published in December 2016.
SSM SREP methodology 2016
The JSTs delivered the key input for the SREP by assessing, for their respective banks, each of these four elements: business model, governance and risk management, risks to capital and risks to liquidity and funding.
The SSM SREP methodology was enhanced in 2016In 2016 the SREP methodology for assessing governance and risk management was enhanced, on the basis of the extensive thematic review on risk governance and appetite performed by the JSTs in 2015.
P2G is not included in the calculation of the MDA
1) Most common case; specific calculation may occur depending on implementation of CRD IV Article 131(15) by Member State
2) Systemic risk buffer
Notes: Scale not meaningful; implementation of the EBA opinion on MDA and 1 July 2016 press release.
Moreover, in 2016, Pillar 2 guidance (P2G) was introduced as set out by the EBA in July 2016. P2G is complementary to Pillar 2 requirements (P2R) and constitutes a supervisory expectation for banks’ capital above the level of binding capital (minimum and additional) requirements and on top of the combined buffers (see Figure 3). As a supervisory expectation, P2G is not included in the calculation of the maximum distributable amount (MDA) laid down in Article 141 of the Capital Requirements Directive (CRD IV).
When drawing up P2G, the following elements are taken into account in an holistic approach: in general, the depletion of capital in the adverse scenario of the stress test; the specific risk profile of the individual institution and its sensitivity towards the stress scenarios; interim changes in the institution’s risk profile since the stress test cut-off date; and measures taken by the institution to mitigate risk sensitivities.
Although banks are expected to comply with P2G, a failure to comply with it does not trigger automatic restrictions. Should a bank fail to meet its P2G, ECB Banking Supervision will adopt corrective measures that are finely tuned to the bank’s individual situation.
SREP CET1 demand remains stable for 2017The results of the 2016 SREP have kept the overall SREP Common Equity Tier 1 (CET1) demand for 2017 at the same level as in the previous year. All things being equal, the current capital demand in the system also provides an indication for the future. In a number of individual cases, the SREP CET1 demand changed to reflect the evolution of the risk profile of the respective institutions. In the 2016 SREP, capital shifted from the 2015 Pillar 2 to the newly introduced P2G and the inclusion of the non-phased in part of the capital conservation buffer was eliminated. As P2G is not factored into the respective calculations, the MDA trigger decreased from an average of 10.2% to an average of 8.3%.
In addition to capital measures, more use has been made of qualitative measures to address specific weaknesses of individual institutions. The likelihood of these measures correlates with the risk profile of banks: the higher the risk, the more likely the use of qualitative measures.
SREP 2017 – no substantial changes expectedThe SSM SREP methodology is not expected to change substantially in 2017. Nonetheless, ECB Banking Supervision will continue to refine it in line with its forward-looking approach to adequately monitoring banking activities and risks.
The objectives and the set-up of TRIM have been laid down in detail
In 2016 conceptual work on internal models focused on the targeted review of internal models (TRIM), which starts in 2017. In preparation for TRIM, ECB Banking Supervision:
Most internal model investigations in 2016 focused on credit risk
Over the past year, 109 internal model investigations were launched at significant institutions, and 88 ECB decisions concerning internal models were issued. These numbers are likely to increase in future when additional investigations are performed in the context of TRIM.
Further progress has been made regarding the harmonisation of assessment practices of internal models. ECB and NCA staff represented European banking supervision in European and international fora on issues relating to internal models and participated in various exercises, such as the EBA benchmarking of internal models.
Levels of non-performing loans have increased significantly since 2008Non-performing loans (NPLs) pose a particular challenge to banks. NPLs have increased significantly since 2008, particularly in Member States that underwent significant economic adjustment processes over the past years. Large amounts of NPLs contribute to low bank profitability and constrain the ability of banks to provide new financing to the economy.
As of the third quarter of 2016, the weighted average gross NPL ratio of significant institutions stood at 6.49%, compared with ratios of 6.85% in the first quarter of 2016 and 7.31% in the third quarter of 2015. Aggregated data for significant institutions show that the stock of NPLs decreased by €54 billion between the third quarters of 2015 and 2016 respectively (of which €15.59 billion in the third quarter of 2016). As of the third quarter of 2016, the stock had reached €921 billion.
Beginning in 2014 with the comprehensive assessment, the ECB has continued to support the resolution of NPLs through constant supervisory dialogue with affected banks.
The ECB supports banks in resolving legacy NPLs and preventing the build-up of new NPLsIn order to address the challenge of NPLs in a determined and forceful manner, European banking supervision set up a dedicated task force on NPLs in July 2015. The task force, which comprises representatives from NCAs and the ECB, is chaired by Sharon Donnery, Deputy Governor of the Central Bank of Ireland. The objective of the task force is to develop and implement a consistent supervisory approach towards institutions with high levels of NPLs.
Drawing on the work of the task force, the ECB published guidance on NPLs to banks, for consultation in the period from 12 September to 15 November 2016. A public hearing was held on 7 November. More than 700 individual comments were received and assessed by the task force during the formal consultation process. The final guidance was published in March 2017. This guidance is an important step on the journey towards a significant reduction of non-performing loans.
Ratio of non-performing loans in the euro area