Supervisors’ risk tolerance: focusing on what matters most

16 August 2023

This year European banking supervision has implemented a new risk tolerance framework (RTF) to better focus its work on strategic priorities and key vulnerabilities. The new framework is playing a central role in moving towards a more risk-focused supervisory culture that empowers supervisors to tailor their activities to the individual situation of the bank they supervise, rather than applying a one-size-fits-all approach.

Since the start of European banking supervision in 2014, the approach to supervision has matured and developed. In the early years it was crucial to codify supervisory practices into detailed manuals and guidelines in order to ensure consistency and overcome initial national differences. This allowed for the creation of a common supervisory approach and supported a level playing field for European banks.

Over the years increased effectiveness, limited resources and changing external circumstances have also shaped the approach to supervision. In the pandemic, for example, supervisors temporarily adopted a pragmatic approach to the Supervisory Review and Evaluation Process (SREP). Furthermore, risks triggered by the energy price shock and the normalisation of monetary policy required supervisors to tackle risks that until recently had not been included among the priorities.

Given that economic conditions can change rapidly, supervisors are now striving to embed agility and the risk-focused approach in supervision for the longer term. A central element in this pursuit is the implementation of a supervisory RTF.

The RTF is designed to facilitate in particular the translation of the supervisory priorities into strategic planning and day-to-day supervision. For this purpose, the RTF combines top-down guidance issued by the Supervisory Board on prioritised risks and vulnerabilities with bottom-up relevance assessments for each individual bank. The bottom-up assessments are an important complement as some banks may deal with very idiosyncratic issues, which affect supervisors’ risk tolerance levels across risks and, consequently, the supervisory focus. Within the framework, supervisors are empowered to make full use of the flexibility embedded in the supervisory toolkit to focus on the most essential tasks. This means supervisors can intensify their efforts in areas where this may be most effective and assign a lower priority to areas that may not be as relevant for a bank’s specific circumstances. Ultimately, the RTF helps to pave the way towards a common supervisory culture that becomes less and less “tick-box”. Importantly, this supervisory culture also encourages supervisors to discuss openly about potential mistakes and to learn from them.

One of the core processes in which the RTF is being applied is the new multi-year approach for the SREP: it enables supervisors to plan their individual SREP activities in a more flexible way over a medium-term time horizon and to concentrate their scarce resources on those risks that most merit scrutiny and intervention. Results from a pilot exercise confirm that supervisory teams employing the RTF made a greater use of the flexibility embedded in the framework and were able to assign a higher priority to the most relevant risks in their assessments. Furthermore, results from consistency checks show that the increased prioritisation did not impair the consistency of the assessments across banks.

Streamlining supervisory activities should also reduce the burden for banks as the assessments become more focused. Banks may, for example, face fewer requests and a reduced reporting burden, or supervisory interactions on different parts of the SREP may be spread across multiple years instead of being completed every year.

Having a system that is less rule-based and allows supervisors greater discretion via the RTF increases the need to ensure that banks are treated fairly and in line with the risks they are facing. Therefore, alongside the RTF, ECB Banking Supervision has also strengthened centralised controls in order to preserve and enhance the degree of consistency in supervision. For example, in 2020 ECB Banking Supervision introduced a second line of defence function, which contributes to the consistent treatment of all banks via both ongoing and ex-post horizontal checks.

Over time the RTF should gradually be applied in more and more supervisory processes, equipping supervisory teams with the necessary flexibility to tackle new and emerging risks in a changing macro-financial environment. In this spirit, national competent authorities have also started implementing similar frameworks for the direct supervision of less significant institutions.