European banking supervision after year one: what lies ahead?
Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB,
Handelsblatt conference – European banking supervision,
Frankfurt am Main, 10 November 2015
Ladies and gentlemen,
I am very honoured and pleased to speak at this distinguished event dedicated to European banking supervision. I believe that such conferences, together with the in-depth work of journalists, greatly contribute to the public’s understanding of what we are doing as banking supervisors. And this is actually much needed, as I am convinced that the better people understand us, the more they will support us in accomplishing our tasks. So, thanks to the organisers of the event for giving me this opportunity to speak about the first year of the Single Supervisory Mechanism – or SSM for short.
One year ago, the Single Supervisory Mechanism was born. We had just released the results of our comprehensive assessment and we were taking over the supervision of the 122 largest banking groups in the, back then, 18 – now 19 – SSM countries. So what have we achieved in this year? What are the main challenges ahead? What will be our priorities for the year to come?
1. Where did we start and what have we achieved in our first year
Let me start by reflecting a few minutes on where we started. This is always important to keep in mind, especially for such a young and innovative institution as the SSM.
One of the founding fathers of the European Union, Jean Monnet, predicted that “Europe will be forged in crises and will be the sum of the answers provided to these crises”. I think the banking union is the latest illustration of this theory. What we learned from the financial crisis in 2008 is that a monetary union without a banking union is fragile. This was further proven by the subsequent sovereign debt crisis, with the emergence of the sovereign-bank nexus, which amplified the seriousness of the crisis in the euro area, destabilising our economies and ultimately our single currency. Europe had many supervisory authorities holding similar responsibilities, but operating in different national jurisdictions. This was problematic: supervisory authority stopped at national borders, but banks’ operations did not. Under this imperfect system, the costs of any failures were ultimately borne by taxpayers and vicious cycles developed.
Against this background, it is fair to say that the financial crisis was a catalyst for the creation of a European banking union in order to safeguard economic and financial stability in the euro area. This led to the concept of the Single Supervisory Mechanism, focused on one major objective: to achieve a consistent euro area banking system, independent from national bias and therefore more resilient.
Rather than a revolutionary decision, the creation of the banking union was more of an evolution, albeit an “evolution at the speed of light”. The single rulebook, which has been built up since 2008 and provides a common set of regulation for the European banking sector, paved the way for the establishment of a single supervisor within the euro area. The same is true for the frameworks for cooperation between national supervisors such as the Committee of European Banking Supervisors, which was active from 2004 until 2010 when it was replaced by the European Banking Authority.
The first year
This first year of operational existence has been full of unprecedented and quite remarkable achievements; so much progress was made in such a short period of time. But the greatest achievement is the most obvious one: to have set up a fully functional and efficient mechanism, based on the cooperation between the ECB and the 19 national competent authorities, that manages to consistently supervise the 122 largest banking groups – representing around 1,200 banks – in the euro area. To make this happen, we have worked very hard and we have brought together the experience and energy of supervisors from all over Europe.
We have recruited experienced and highly skilled staff from the national authorities, from within the ECB and from beyond. For each banking group, we have set up one Joint Supervisory Team, which is headed by an ECB staff member and includes a majority of staff from the national supervisors. The Joint Supervisory Teams are the core of our supervisory approach and practice. We have established horizontal functions to develop common methodologies, provide quality assurance and produce in-depth analysis on risks and supervisory policies. We have a directorate general dedicated to the indirect supervision of less significant institutions and the harmonisation of their supervisory practices. The direct responsibility for the supervision of these smaller banks remains with the national authorities.
Before the launch of the SSM, we conducted a thorough “health check” of the banks we were going to supervise: the comprehensive assessment, which was an unprecedented mix of a stress-testing exercise and an asset quality review. The nine-month exercise was in itself a major challenge that was successfully mastered by the ECB and the national supervisors together. It helped us to start the SSM on a credible footing and provided us with a very valuable set of additional data on the banks’ balance sheets.
Perhaps even more important than the success of the exercise itself was the quality of the follow-up. For banks with a shortfall, we monitored the full implementation of their capital plans; for all other banks, we ensured that the findings of the asset quality review were taken into account. Last April, the ECB estimated that about two-thirds of the additional write-offs required by the asset quality review were recorded in 2014 financial statements, the remaining third of the balance sheet adjustments being treated as prudential requirements, notably in the context of the Supervisory Review and Evaluation Process or SREP. This resulted in a general increase in provisioning for non-performing exposures.Besides these quantitative adjustments, the ECB – shortly after the publication of the comprehensive assessment’s results – informed banks of around 1,300 findings on the deficiencies in processes and procedures. Over the first nine months of 2015, the banks directly supervised by the ECB have implemented more than three-quarters of the required remedial actions on these qualitative points. In some cases, it was necessary to initiate more complex projects involving medium and long-term timelines, which are being closely monitored by the SSM.
The overall conclusion we draw from this – and I must say it is a real source of satisfaction for a new supervisor – is that the affected banks accepted the quantitative and qualitative results of the comprehensive assessment. This is an important signal that our action as a European supervisor is both powerful and recognised.
Another major milestone we achieved in our first year is the development of a common methodology for the day-to-day supervision of banks. This has been an ongoing and work-intensive project conducted in full cooperation with the national supervisors. It resulted in the drafting of our Supervisory Manual, which provides our hundreds of supervisors across Europe with a common set of work procedures and practices. This manual is, of course, a living document, which will be updated as we gain experience.
Thanks to this methodology, we were able to conduct the first round of the common SREP in 2015. For the first time, all significant institutions in the euro area were assessed against a common yardstick. Quantitative and qualitative elements were combined through a constrained expert judgement approach, which ensures consistency, avoids forbearance and accounts for institutions’ specificities. Extensive peer comparisons and transversal analyses were possible on a wide scale for the first time, thus fully promoting the goals of the banking union.
More specifically, in preparing the Pillar 2 capital decisions, the supervisors first took into account persisting and developing risks faced by banks due to economic and market conditions in the euro area such as credit and liquidity risk. Second, they pursued the objective that banks transition smoothly from current capital positions towards a fully-loaded Basel III environment in 2019; and, third, they did all the above while maintaining the level playing field, both within the SSM and with other major jurisdictions. The SREP decisions will be finalised later this year but we can already say that the Pillar 2 capital requirements envisaged for the SSM significant institutions in 2016 are slightly higher than in 2015 – by circa 30 basis points on average. In addition to Pillar 2, the phasing-in of buffers requires around 20 additional basis points of capital.
The JSTs began holding meetings with the banks in July to inform them about their SREP ratios. I believe that, once approved, the final results, together with the information on the most important aspects of the SSM’s methodology, will provide an indication of what SSM Pillar 2 requirements are likely to be in steady state.
We have also played a key role in managing the financial turmoil in Greece, which was triggered by a deadlock in the negotiations on the Greek programme last June. This had an immediate effect on Greek banks, which again suffered an intense stress episode. We monitored the situation closely and were always prepared to take supervisory action when necessary. Under the final political agreement reached early in the summer, we were given a role in contributing to the determination of the recapitalisation needs of the Greek significant institutions. For this purpose, we conducted a comprehensive assessment of these banks, the results of which were recently released.
We are proud of the milestones we have reached and of our standing as a supervisor. At the same time, we are aware that important challenges still lie ahead of us.
2. The main challenges ahead
Challenging macroeconomic and financial environments
Let me start with an overview of the developments in the banking sector. Banks are still facing a number of challenges, among which I would name weak profitability and the persistence of non-performing exposures on their balance sheets.
As regards the first, looking at recent developments, bank profitability improved moderately in the first half of 2015 and capital positions have been strengthened further. Nonetheless, the euro area banking system continues to struggle with low profitability and many banks’ return on equity is hovering below their corresponding cost of equity. This is due to a conjunction of factors. In particular, these include the low and uneven growth levels in the euro area and globally, which notably implies subdued loan growth; an environment marked by persistently low interest rates; and the high level of provisioning. While some banks may be capable of adjusting to these challenges without having to reshuffle their activities, a number of others have to revamp their business models towards activities that rely less on traditional interest income-generating business.
Second, non-performing exposures still represent a serious prudential challenge in some countries. The underlying reasons for this problem include general economic conditions; a large stock of legacy problem assets, particularly in countries most affected by the financial crisis; and flawed legal frameworks for debt recovery. We as supervisors can address some of these causes, while others go beyond our remit. In some countries, improvements have been made towards a legal framework that is more conducive to effective non-performing loan resolution. The ECB has launched a dedicated workstream on this issue and is working with banks in developing and implementing tailored action plans.
Still important regulatory developments to come
Important regulatory developments will be implemented or finalised in 2016. For example, the requirements for total loss-absorbing capacity (or TLAC) as developed by the Financial Stability Board (FSB). This will enable us to deal with the “too-big-to-fail issues” at globally systemically important banks. The TLAC requirements will mean that the biggest banks will have to comply with an additional set of requirements and it will be our job to ensure their smooth introduction. Within Europe, the Bank Recovery and Resolution Directive (BRRD), which will come into force in January 2016, has established a new minimum requirement for own funds and eligible liabilities (MREL). For the latter, the cooperation between the SSM and the Single Resolution Board, which is already well established, will be of the essence. The strategic review of the Basel capital framework will continue, with a view to finding the right balance of simplicity, comparability and risk sensitivity. The Basel Committee has also initiated reflections on how to deal with sovereign exposures. The impact of the entry into force of the new accounting standard IFRS 9 on banks’ provisioning will also have to be assessed.
Another important challenge for us is to foster more harmonisation of the regulatory framework. Of course, the implementation of the European Capital Requirements Directive or CRD IV was a major improvement on the patchwork of national banking legislation. However, the European framework has not fully erased national differences: in transposing CRD IV into their national legislation, Member States have sometimes interpreted several provisions differently. This poses a challenge to the SSM, as in some cases it forces us to judge similar situations in a dissimilar way. Of course, this is mostly an issue for the legislators to resolve. However, we have some room for manoeuvre within our remits and given that this situation impacts on our daily supervisory work, it is our role to make the legislators aware.
In some cases we can, and do, take the initiative. Here, I am referring to the national options and discretions or ONDs that are included in the European framework and that are left to the discretion of the supervisors. These ONDs were inserted to cater for specific national features, but many of them merely reflect unquestioned traditions, pure national interests and regulatory capture. That is why we seek to harmonise their treatment where we can. We cannot cover all ONDs with our harmonisation, because some ONDs can only be exercised by Member States. However, the High Level Group which we set up for this purpose identified about 100 ONDs – out of more than 150 ones in the CRD4/CRR –, which we could address during the first phase of the harmonisation project. These ONDs cover a wide range of topics such as the treatment of deferred tax assets, large-exposure intragroup exemptions and intragroup liquidity waivers. In developing a proposal for their common treatment, we have taken a conservative approach while acknowledging the new regulatory reality that supervision is now being exercised on a European level. This is a major step forward. We will start the public consultation on our proposed treatment of ONDs tomorrow and I encourage you to let us have your views.
3. Our priorities to make SSM banks stronger and more resilient
I have just given you a quick overview of the main challenges facing us: the uncertain environment poses challenges to banks; both the banks and the supervisors will have to implement new regulatory developments such as TLAC and MREL: and we as a supervisory authority still have a significant amount of work to do to foster more harmonisation within the SSM.
It will therefore be no surprise to you that these topics are reflected in the five high level priorities the Supervisory Board has set for this year. These priorities are:
1) business models and profitability drivers;
2) governance and risk appetite;
3) capital adequacy;
4) credit risk;
5) cyber risk and data integrity.
How have we taken action on these priorities and what lies ahead?
With respect to business models and profitability drivers, as I said, the comprehensive assessment we carried out prior to the start of the SSM has provided us with valuable information on the specific situation at each bank. This has given Joint Supervisory Teams a good starting point for their follow-up. They have been engaging in firm discussions with banks’ senior management to set the bar high regarding the SSM’s supervisory expectations and to challenge the viability of business models and profitability drivers. To better equip us for challenging the banks, we developed a business model classification tool with which we can conduct peer group analyses. We have also conducted a survey on banks’ profitability forecasts. In 2016 we will try to gain deeper insights, by looking at profitability drivers at the level of individual banks but also across business models. This is clearly an important area of supervisory focus. Of course, it is up to the bank’s management itself to ensure that its business is profitable. But having a sound business model that leads to profitability is essential from a prudential perspective too.
The governance and risk appetite of banks is another priority for us. We have performed a review of banks’ governance, for which the Joint Supervisory Teams assessed the organisation and composition of the management of the banks. We looked at the profiles of board members to ensure that all relevant knowledge about the business of the bank was represented within the board. We attended some meetings of the banks’ executive boards to gain knowledge of the governance from the inside. We reviewed the quality of the decision-making process and the documentation used by the banks. We have also looked at policies on practices, such as the setting of risk limits at banks. Here our goal is to be able to assess whether the management of the banks is “in control”: whether it knows what is happening in its business and whether it receives the right information on which to base its decisions. From this perspective, we are also looking at conduct risk, which can have a significant negative impact on the profits and reputation of banks. We will continue with this work in 2016.
Of course capital adequacy remains a supervisory focus too. Here we try to make sure that the banks have an adequate buffer against potential losses and shocks. The work on ONDs is proving to be extremely useful for assessing the quality of capital that banks have on their balance sheet. In implementing the common SSM stances on the various ONDs, we will also make sure that the banks are following a reasonable timeline to reach fully-loaded capital ratios. With the arrival of MREL and TLAC requirements, we will have to broaden our perspective from “going concern” to “gone concern”, as banks will have to prepare compliance with “gone concern” scenarios.
We will also look into the banks’ internal models, to foster comparability and improve model quality. This is a challenging task for us in view of the wide diversity of internal models that require specific expertise. We will therefore carry out a targeted review of internal models, which will help us to ensure that their implementation complies with the regulatory framework and will foster more harmonisation of supervisory practices.
Credit risk is still at the core of our supervision, since it remains key for banks’ activities. I have mentioned the creation of the Task Force that will develop a consistent supervisory approach to banks with high levels of non-performing loans. The Joint Supervisory Teams will use this approach when following-up on the individual cases. In addition, we will focus on concentrations of risk that we deem to be excessive, in certain cases for example in real estate exposures.
I defined cyber risk and data integrity as our fifth and last supervisory priority. This is a relatively new area of supervision, and one that needs a completely different kind of expertise. Cyber risk is by no means less important than any other prudential risk, given the dependence of banks on IT systems. Some banks have to deal with a patchwork of legacy systems, which is a source of difficulties. Previously, banks dealt with the risk that failures of those systems would hamper their daily operations, trigger operational losses and cause damage to their reputation. But in today’s world, cyber risk also includes cyber-attacks, constituting the digital version of a classic bank robbery. These attacks can be the work of individuals, but also of criminal organisations. Rightfully so, banks have demonstrated increased awareness of their cyber risks. In order to assess the cyber risk profiles of our banks, we launched a cyber-security review of significant institutions and performed a benchmarking exercise. Based on the outcome, we identified the banks at which we wished to carry out on-site inspections, which we launched in the second half of this year. We are setting up a process to closely monitor significant IT incidents at the banks we supervise. This will provide us with a good overview of trends and developments relating to cyber risk.
I have given you an overview of our priorities and the work we are doing in these areas. As you will have noticed, many of the supervisory reviews and on-site inspections are ongoing. The findings will feed into our more detailed supervisory priorities for next year, which are currently under preparation. The priorities not only steer our supervision, but also enhance our accountability. In our Annual Report published next year, we will explain in detail how we followed up on the priorities we set for 2015.
Banking supervision in Europe has come a long way since the outbreak of the financial crisis in 2007. Today, we have a regulatory framework that requires banks to do more to protect themselves against financial shocks, and that gives us, the supervisors, more effective tools. The harmonisation of prudential supervision within the SSM contributes to the resilience of the euro area banking sector and shows that we have learned the right lessons from the crisis.
But the world keeps turning and new challenges have emerged for banks: low growth levels, persistently low interest rates and high levels of provisioning put pressure on banks’ profitability. Banks will have to review and adapt, where needed, their business models in order to survive in this challenging environment. At the same time, we in the SSM also have work to do. Already in our first year we have proved our added value, but we still have a long way to go in further strengthening and harmonising the euro area banking system. This is what we will focus on in the near future.
Thank you for your kind attention.