Presentation of the ECB Annual Report on supervisory activities 2016 to the European Parliament’s Economic and Monetary Affairs Committee

Introductory statement by Danièle Nouy, Chair of the Supervisory Board of the ECB, Brussels, 23 March 2017

Mr Chair,

Honourable Members of Parliament,

It is my pleasure to present to you today the 2016 ECB Annual Report on supervisory activities. I will focus on the following themes mentioned in the report. First, some key developments in the banking sector; second, the results of the 2016 Supervisory Review and Evaluation Process, or SREP; third, the progress made in tackling non-performing loans; and fourth, our work on smaller euro area banks, the less significant institutions. I will then highlight some key issues regarding the current EU banking reform package from a supervisory perspective, before giving an overview of our priorities for 2017.

General developments in the banking sector

Let me start by looking at the developments in the banking sector. In 2016, euro area banks posted stable profits, albeit at still subdued levels. The average annualised return on equity for a representative sample of significant institutions stood at 5.8% in the third quarter of 2016, a slight decrease compared with 6.0% in the third quarter a year before.^[1] This slight decrease in return on equity was caused by an increase in equity capital levels of 3.5%.

The relatively low levels of profitability are cause for concern as they may hamper banks’ ability to build up capital through retained earnings and lead to additional risk-seeking. For this reason, the SSM identified banks’ business models and profitability drivers as a supervisory priority in 2016 and launched a thematic review to assess banks’ ability to earn at least their cost of equity in the long run.

A number of structural challenges also continue to weigh on banks’ longer-term profitability prospects, including high levels of non-performing loans, or NPLs, in some regions and overcapacity in certain markets. Therefore, the supervisory priorities we identified in 2016 also included work on credit risk, with a focus on NPLs.

The existing overcapacity in the banking system also means the sector is not operating as efficiently as it could, which is one reason why cost-to-income ratios remain high in some countries. This suggests that there may be some scope for efficiency gains from consolidation, although we must be mindful not to contribute to possible “too-big-to-fail” problems. The banking union, while not yet completed, paves the way for banks to capitalise on opportunities for cross-border mergers and acquisitions. This development needs to be driven by the market and so far we have not seen significant consolidation. However, in specific cases consolidation may also take the form of the unwinding of banks if they become unviable, as anticipated by the BRRD and the SRMR.

The 2016 Supervisory Review and Evaluation Process

Let me now discuss the 2016 SREP exercise. Our in-depth evaluation of the banks under direct ECB supervision revealed that the distribution of risks in the system remained broadly stable, with some idiosyncratic changes. The overall supervisory demand for the highest quality of capital, known as CET1 capital, for 2017 remained at the same level as last year.

As a key input to the SREP, we conducted an EU-wide stress test and a SREP stress test for the banks under our direct supervision. The results of the EU-wide stress test show that the banking sector today is more resilient and much better able to absorb economic shocks than in 2014.

Despite applying a more severe scenario and a more stringent stress test methodology, the final average CET1 ratio of 9.1% in the adverse scenario was higher than that of 8.6% in 2014, reflecting significant capital increases and additional balance sheet repairs over the past two years.

For the SREP 2017, our objective is to stabilise the SREP methodology and process. Some fine-tuning of the methodology will continue, but no major change – such as the introduction of Pillar 2 guidance last year following the clarification by the European Commission – is foreseen.

All other things being equal, capital demand can be expected to remain broadly stable. With the phasing-in of the capital conservation buffer, the guidance is expected to decrease, though credit institutions will be expected to continue to have positive Pillar 2 guidance in the future.

For the future, we need to be mindful of possible significant changes to the Pillar 2 framework resulting from the amendments to the Capital Requirements Directive recently tabled by the European Commission, which I will come back to later on.

Work on NPLs

Next, I would like to focus on our work on non-performing loans. As you know, we published our draft guidance to banks on NPLs for consultation in September 2016. A public hearing was held on 7 November, and more than 700 individual comments were received and assessed by our NPL high-level group during the consultation process. The final guidance was just published on Monday.

The key policy message of the guidance is that high levels of NPLs should be addressed by relevant banks as a matter of priority, in a comprehensive manner, by focusing on their internal governance and by setting their own ambitious but realistic targets. The “wait-and-see” approach we have often seen in the past cannot continue.

The banks’ own targets need to be properly reflected in incentives for their managers and need close monitoring by their management bodies. The banks themselves are responsible for implementing adequate strategies and managing their NPL portfolios across a range of strategy options, such as NPL workout, servicing and portfolio sales. The guidance will hence serve as a basis for our ongoing supervisory dialogue with individual banks.

Joint supervisory teams will follow up shortly with relevant banks on the implementation of the guidance. Some banks need to move faster than others to address their NPL problems and work intensively to put in place credible and properly resourced plans to tackle this issue. The ECB will review, benchmark and, as part of its supervisory process, ascertain whether banks have responded appropriately. Of course, we will apply the principle of proportionality. This means that the level of our intrusiveness will differ depending on the level of NPLs.

The guidance and the supervisory follow-up work are very important steps on the journey towards a significant reduction in non-performing loans. But let me emphasise that addressing NPLs requires determined action from all stakeholders, not only supervisors. The resolution of NPLs is hampered by a variety of factors, requiring a combination of supervisory activities and legal and institutional measures, notably in the areas of insolvency and judicial processes.

The ECB’s work on less significant institutions in 2016

Let me also report on our work with regard to the smaller euro area banks, the less significant institutions, or LSIs. The ECB, in cooperation with the national competent authorities, the NCAs, continued to develop its framework for indirect LSI supervision in 2016. It comprises the development of joint supervisory standards and common methodologies, as well as a range of day-to-day activities.

The joint standards for LSI supervision completed in 2016 cover four highly relevant aspects of supervisory work:

• supervisory planning;
• recovery planning;
• on-site inspections; and
• supervision of car financing institutions.

In addition, an LSI crisis management cooperation framework for the ECB and the NCAs was established and work started on a joint standard for the licensing of LSIs with FinTech business models.

The ECB and the NCAs are also making significant progress in developing a common methodology for the SREP applied to LSIs.

The principle of proportionality is strongly embedded in indirect LSI supervision, based on a dedicated prioritisation framework. This differentiates LSIs based on their intrinsic riskiness and their potential impact on the domestic financial system.

The risk-reduction package

The risk-reduction package, which aims to revise the single European rulebook, is of vital importance to our work as the supervisor of the banking union. Therefore, we have invested quite some time in analysing the Commission’s proposal and looking into its possible implications for us.

In broad terms, we think the Commission proposal is a step in the right direction and has substantial potential to reduce risk in the banking sector. Therefore, it is important to move quickly on this legislative package.

We welcome in particular the provisions which will facilitate a closer prudential supervision of financial holding companies and of third country institutions located in the EU, although some modifications will be needed to close possible loopholes. Finally, we think the proposal to further harmonise the creditor hierarchy will facilitate resolution by reducing the risk of no-creditor-worse-off problems.

However, some of the topics in the proposal pose concerns for us. Most prominently, the proposal may frame supervisory action too tightly. It does so by constraining the flexibility required by the supervisor in taking action in cases not foreseen in the legislation and in determining the composition of the Pillar 2 capital requirements. In our view, supervisors should retain the discretion to require that Pillar 2 requirements are fully satisfied with CET1 capital in order to ensure going-concern loss absorbency. Requiring additional supervisory reporting from institutions is also constrained, rendering the supervisor unable to perform a proper assessment of risks.

We also think that supervisors should have the power to impose, on a case-by-case basis, individual supervisory deductions, provisions or filters, if the applicable accounting framework allows flexibility. Such supervisory power will help, in particular, to effectively prevent the build-up of high levels of non-performing exposures in the future.

Also, we believe some of the proposed deviations from internationally agreed standards might make institutions more vulnerable to certain risks, and may make it harder for investors to compare institutions across and outside the EU. Moreover, the transition to IFRS 9 should be implemented using a static approach – meaning that only the initial CET1 impact at day 1 should be subject to transitional arrangements. We do not support a dynamic approach whereby actual changes in provisioning levels are also phased in over time. Finally, the proposal lacks ambition regarding further harmonisation within the EU prudential framework. We would like to see more progress towards reducing unwarranted options and national discretions in order to achieve a truly single rulebook, which is the necessary foundation of our banking union.

Priorities for 2017 and conclusion

Allow me to conclude by giving an overview of our activities for the remainder of 2017. Our current supervisory priorities comprise three high-level areas:

1. business models and profitability drivers;
2. credit risk with a focus on NPLs and concentrations;
3. risk management.

These priorities reflect our view that the key risks identified in 2016 remain, for the most part, relevant in 2017. Correspondingly, some of our activities build on and develop work already started in 2016.

This is true, for instance, for the thematic review on business models and profitability drivers, where our Joint Supervisory Teams will move forward with more in-depth assessments, benefitting from new tools developed last year. It is also true in the area of credit risk, where we will leverage on the NPL guidance and intensify our supervisory dialogue as I explained earlier.

We will also conduct a sensitivity analysis of interest rate risk in the banking book, which will examine how hypothetical changes in the interest rate environment would affect banks.

As part of the priority area of risk management we will conduct a targeted review of internal models, also referred to as TRIM, to level the playing field for banks by reducing unwarranted variability in risk weights. In other words, we will review whether banks have correctly and consistently implemented their Pillar 1 internal models for the calculation of own funds requirements. In February, we provided comprehensive information on the topic to banks, the media and the public. This includes a guide on TRIM that sets out the ECB's supervisory views and expectations in key areas. A large number of TRIM-related on-site inspections will start from the second quarter of 2017 onwards. These inspections will continue throughout 2018 and may extend into 2019 as well.

Overall, our activities aim to continue to deliver tough and fair supervision. This also means that we will keep following up on topics needing continued attention, while at the same time scaling up our efforts related to important new initiatives such as TRIM.

I thank you for your attention.