Start of the Single Supervisory Mechanism: from the comprehensive assessment to day-to-day supervision
Speech by Sabine Lautenschläger, Member of the Executive Board of the ECB,
at the Euro Finance Week,
Frankfurt, 18 November 2014
Many thanks for your kind introduction, Paul [Gordon],
Ladies and gentlemen,
Think of an athlete at the beginning of his career, who trained extremely hard and achieved an excellent result in his first major tournament. To turn this promising start into a track record of sustained high performance, he clearly cannot afford to rest on his laurels. Instead, he needs to go right back to the routine of constant training, to keep developing his skills and thus continue to build the foundation for future success on a day-to-day basis. This is the situation in which I see the SSM after the completion of the comprehensive assessment, which marks the start of the new supervisory regime.
The comprehensive assessment was a major milestone at the start of the SSM, not least because it proved that the new system can cope with a project of this magnitude and bring it to a successful end within a very demanding time frame. The exercise is meeting its key objectives of transparency, repair and confidence-building, even if it is still slightly early for a final assessment of this aspect. Finally, it has established a very good basis for cooperation between the ECB and the national competent authorities, which will be essential for effective supervision under the SSM. All this being said, I would like to make it very clear that we see these signs of success as the starting point of a longer journey, not as an end in themselves.
Today I would like to recap on some key aspects of what we found in this exercise, and then put them into the broader context of the next steps in our supervisory work.
Key findings of the exercise
As all parties involved know very well, the asset quality review (AQR) was a complex and laborious process. The granular bottom-up work to examine some 119,000 credit files and 170,000 collateral items individually paid off. The AQR results are reliable given that they can be traced down to the level of the individual debtor. Moreover, the granularity of the data collected made it possible to run quality assurance checks that served to establish the level playing field that we have emphasised so strongly all along.
As a result, the AQR’s achievements with respect to harmonising the information available on bank exposures are significant. The identification of €136 billion in additional non-performing exposures (NPEs), which represents an 18% increase vis-à-vis the previous stock, is certainly a key indicator in this respect. The fact that €55 billion of the increase in NPEs stem purely from the application of a harmonised definition reveals the magnitude of divergences at the starting point.
By publishing the AQR findings at a very granular level in the disclosure templates, market participants have been provided with an unprecedented wealth of data.
As regards the stress test component of the comprehensive assessment, we can conclude that it provided a sound check of banks’ ability to withstand shocks, given the severity of its capital impact. Under the adverse scenario, banks’ aggregate available capital was projected to be depleted by €216 billion – this corresponds to wiping out 22% of common equity tier 1 (CET1) capital held by the participating banks. The additional effect of risk-weighted asset (RWA) increases further reinforced this, leading to a total impact of €263 billion. It is reassuring to see that over 105 of the participating banks remained above all the capital thresholds we defined even when projecting a severe shock of this magnitude. In addition, it is also worth noting that 98 remain more than 100 basis points above each of the relevant thresholds. At the same time, we certainly also took note of those institutions which were very near the threshold levels, even if they did not fall below them. We also did the maths for the fully fledged CET1 ratio and will use it in our supervisory work.
Concerning the important aspect of balance sheet repair, I would like to point out that the observed frontloading of capital measures in itself was a very positive consequence of the exercise, which underlines its credibility throughout the process. Evidence of rigour and stringency in the conduct of a supervisory assessment can have a direct impact on a bank’s attitude towards remedial actions. Banks took our exercise very seriously all along, and this certainly contributed to the significant frontloading of capital measures that we saw. The €57 billion in CET1 raised by the participating banks in the first three quarters of 2014 alone are a necessary contribution to the safety and soundness of the system as a whole. Those banks where shortfalls were detected had already filled the gaps by no less than €15 billion at the time of disclosure, which is also an encouraging sign.
Next steps following the comprehensive assessment
I think the findings I just mentioned are worth highlighting, but they only cover a few out of a range of issues that we will follow up on. In general, many commentators have understandably put much focus on capital shortfalls and the question of how the banks that have not yet done so will fill the remaining gaps. This is important, but - from my perspective - too narrow – our follow-up work as supervisors will be much broader. Our immediate task at this stage is to incorporate the full spectrum of relevant findings into our regular activities. In the following I would like to give you an idea of the next steps on our agenda, and how the findings from the comprehensive assessment fit into the picture.
The overarching process that I would like to focus on first is the so called SREP, the Supervisory Review and Evaluation Process. The SREP is conducted on an annual basis, with the key purpose of ensuring that banks’ capital and liquidity, but also their internal governance, strategies and processes, are adequate to ensure a sound management and coverage of their risks. It is the main supervisory instrument to address the whole array of such risks based on the findings of ongoing supervision.
Under the SREP, supervisors have the power to impose a wide range of measures, including additional capital and liquidity requirements and changes to risk management practices. They are communicated to the banks in the so-called SREP decision.
The decisions for the current cycle will be taken in the remaining part of this year, and will incorporate not only the issues identified in ongoing supervisory but also the findings of the comprehensive assessment. This applies to all banks, not just those for which a capital shortfall has been identified.
Note that findings, as well as the respective measures required, can be of quantitative and qualitative nature. Quantitative findings of the comprehensive assessment are by now relatively well known and understood. Let me give you an example of our prudential follow-up work: We expect banks to incorporate the additional non-performing exposures identified in the AQR in their supervisory reporting of financial data. Putting myself into the shoes of a bank and its statutory auditor I would carefully assess how this should also be reflected in the level of provisioning.
While the SREP decision is of prudential nature, certain findings from the AQR will also need to be reflected prospectively in banks’ financial accounts for the year 2014. For instance, this is the case where the credit file review identified inadequacies in provisioning levels which derive from estimates which can no longer be considered as sufficiently conservative in light of the evidence gathered throughout the Comprehensive Assessment. Another example could be the collective provision: if the examination has identified weaknesses in the process to determine its value and the amount recorded by the institution is below the AQR estimation, then the institution should improve the procedures and reassess the amount of provisions, considering as well the view of the statutory auditor. The joint supervisory teams will follow up on such cases in a systematic fashion in dialogue with the banks and their statutory auditors to ensure that the findings are incorporated into the accounts as appropriate. In addition, we will arrange high-level meetings with major audit firms to discuss the AQR findings.
Turning to the qualitative findings, the AQR has in a number of cases revealed structural weaknesses in banks’ data systems, not only but in particular for some banks that had recently merged with or acquired other banks. There is an urgent need to improve those systems and banks will be required to do so.
The CA has provided the SSM with an unprecedented wealth of centrally quality assured data and insights into banks. I assure you that in addition to the issues I just mentioned all observations and findings of the CA including but not limited to weak processes, deficient internal models and wrong classification of assets will be reflected in our supervisory work going forward. The CA is a supervisory gold mine. We will fully exploit it.
A final issue that I would like to address here concerns the SSM’s overall objective of establishing a level playing field across banks in the euro area. As you are probably aware, the regulatory package of the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR) includes a large number of so-called options and discretions, which grant certain choices regarding the application of particular regulatory rules, either to the Member States, or to the relevant competent authorities. This implies that, so far, all of these choices have been made at the national level. In total, there are about 100 of these options and discretions, and some of them give rise to serious concerns from a level playing field perspective.
Let me use an example from the comprehensive assessment to illustrate what I mean. The exercise was carried out based on the legal framework in place, which implies that the discretions applied by the Member State or the national competent authorities in setting the phase-in percentages for deductions from CET1 capital were respected. The way in which those were set, however, has implications for the composition and quality of capital that we cannot ignore in our new role as central supervisor.
One key point is the strong divergences in the degree to which individual banks currently benefit from transitional adjustments in their CET1 calculation. The SSM will carefully examine both of the main drivers of such divergences:
Balance sheet composition, which is a bank-specific driver
Discretions applied at the national level, which are country-specific drivers
We will carefully review this matter and assess the banks’ overall capital situation. Our review will need to be broad and consider also all relevant items subject to phase-in rules, including goodwill and other intangible assets, holdings in financial institutions, deferred tax assets and the internal rating-based approach shortfall, to name some of the most important ones. On this basis, we can then determine appropriate actions to address their implications for the quality and composition of an individual bank’s capital, but also for the level playing field across all SSM banks.
As we, the SSM, want to fully exploit our broader spectrum, I like to briefly jump to another important supervisory priority. Level playing field issues are unfortunately not only limited to the quality and composition of capital. We will also have to take a close look at the denominator of the capital ratio equation and critically review the calculation of risk-weighted assets. That being said, we are not aiming for a return to a simple but also simplistic Basel I world. We want to reduce excessive variability, thereby restoring confidence in the calculation of risk-weighted assets and preserving risk sensitivity. Compared with other entities promoting greater harmonisation of internal models, such as the European Banking Authority and the Basel Committee on Banking Supervision, the ECB will use its position as a supervisor to gain in-depth understanding of internal model issues and exploit its cross-sectional overview of some of the world’s largest banks to address any inconsistencies in a very direct way.
Let me conclude by briefly stating where we stand now. The comprehensive assessment was an important milestone and provided us with an immense amount of information on the banks that will be subject to direct ECB supervision. Having concluded this major undertaking, we will move on to day-to-day supervision under the SSM, building on its findings and incorporating them into the broader range of our supervisory activities. This is a key area for us to focus on. In doing so, we will be using all the instruments at our disposal, always with the overarching goals of providing tough, intrusive and fair supervision of individual banks, establishing a level playing field across banks and safeguarding the robustness of the system as a whole. We have a full agenda and look forward to tackling it.
European Central Bank
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