Proportionality in banking supervision

Panel intervention by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the BIS-IMF policy implementation meeting on proportionality in banking regulation and supervision, Basel, 9 May 2019

“Proportionate banking supervision: the ECB’s approach”

Introduction

Proportionality is a key obligation for all bank supervisors. After all, none of us in any jurisdiction is aiming to achieve “disproportionate” supervision.

Moreover, legislators have explicitly enshrined proportionality as a key objective for banking supervision. For European banking supervision, this is baked into our founding legal texts – the Treaty, the single rulebook and the SSM Regulation.

However, proportionality is an inherently subjective concept. What seems proportionate to me may not immediately seem proportionate to you.

In my remarks today I will seek to unpack how this subjective concept should be understood in the banking supervision context. I will then explain the day-to-day reality of how we at the ECB implement proportionate supervision.

What does “proportionality” mean for banking supervisors?

For banking supervisors, proportionality means adapting the nature and intensity of supervision to the specifics of the bank – its risk profile, its business model and its size. In deciding how best to adapt their approach, supervisors must be guided by the other primary objectives of banking supervision.

First and foremost, banking supervision is about preserving prudential soundness. Adapting supervisory practices and intensity to bank specifics must not in any way compromise financial stability.

This implies that proportionality is not a crude matter of reducing prudential standards for all small banks, irrespective of the risks that this would generate. Nor does proportionality involve the supervisor forgoing any of the information requests that are required to assess riskiness.

Within the supranational structure of the ECB’s Single Supervisory Mechanism (SSM), banking supervision also involves creating a level playing field across jurisdictions to support financial integration – this is a substantial part of our work.

Creating a level supervisory playing field supports financial stability and the integrity of the internal market. It also helps maintain a level competitive playing field for banks across the market. Of course, the ECB is not a rule-maker, and nor are we a competition authority – so primary responsibility for maintaining a competitive level playing field does not lie with us.

Nonetheless, we are careful to ensure that the costs and benefits of our supervisory activities are balanced across banks of different sizes and with different business models. Applying exactly the same supervisory approach to small banks as we do to the very largest banks is unlikely to be proportionate.

Complex supervisory approaches and demanding information requests tend to be disproportionately costly for smaller banks. As smaller banks tend to pose a smaller risk to the systemic functioning of the sector, the benefits of such intensive supervision are also likely to be smaller.

To achieve proportionality, then, supervisors must hone their practices so that they get the information they need to safeguard prudential soundness, while avoiding excessive burdens on particular banks or classes of bank.

Achieving this proportionality in banking supervision is, however, something of a balancing act. How much information and supervisory intensity is needed to ascertain that banks are sound? How far should supervisors go in honing their practices to take account of differing bank sizes and business models?

There is room for judgement in responding to these questions. Each supervisor has to decide what response is most suited to the specificities of their jurisdiction.

The SSM approach to proportionality

Structure

The structure of the Single Supervisory Mechanism is itself designed to enshrine proportionality.

The ECB directly supervises 117 significant banking groups, with these institutions accounting for over 80% of the banking assets across the euro area. All other euro area banks are supervised day-to-day by the national competent authorities (NCAs), with the ECB providing an indirect oversight function for the NCAs’ supervision of these less significant institutions, or LSIs.

This split of roles and responsibilities between the ECB and NCAs allows the same supervisory objectives to be pursued efficiently in both large and small banks. That efficiency is one of the key elements of proportionate supervision. Supervisors must achieve the same good prudential outcomes in their interactions with all banks. However, supervisory approaches must be tailored so that these good results can be delivered in the best possible way.

LSIs tend to focus on the domestic market of the country where they are based. This makes the local expertise and geographical proximity of the NCA supervisors particularly useful in ensuring the efficient monitoring of prudential soundness.

Significant institutions more often span multiple countries and are more likely to generate the types of risk that spread easily across borders. The ECB is best placed to efficiently analyse and mitigate these types of risk, which is why it leads the supervision of significant institutions.

Proportionate supervision of significant institutions

The first step in arranging our supervisory work is to set a minimum level of supervisory engagement that applies to all banks. This allows us to ensure that all banks are held to the same standards, and that supervisory intensity is, in all cases, sufficient to demonstrate that these standards are met.

This concept of a minimum level of engagement itself includes an element of proportionality. The quantum of supervisory work involved to achieve this minimum engagement level is not the same for every bank. Minimum engagement levels are higher where the impact of failure is greater. In particular, larger banks and banks with more complex business models will be subject to a higher starting level of supervisory intensity.

From this minimum engagement level, extra layers of supervisory requirements are added in a proportionate way. These layers vary depending on the risk profile of the bank in question. If our analysis shows that a bank is more likely to get into difficulty, we invest more of our time and energy in providing deeper and more intrusive supervision.

The calibration of the additional layers of supervision is captured in a detailed annual supervisory examination plan. This plan sets out the supervisory activities to be undertaken for each of the significant institutions in the coming year, including risk-based decisions on what on-site inspections and internal model investigations to pursue.

At the end of our supervisory analysis, proportionate supervisory measures must be applied. Our key tool for applying proportionate supervisory measures is the Supervisory Review and Evaluation Process, or SREP. Within this process, ECB Banking Supervision takes advantage of its broad market coverage to benchmark banks’ riskiness across many metrics. Such quantitative inputs are then combined with the supervisory judgement of our experts in the application of tailored supervisory measures to each institution.

These supervisory measures have become more proportionate over the five years since the Single Supervisory Mechanism was set up. One way of measuring this is to look at the correlation between the SREP scores of significant institutions and the Pillar 2 capital requirements that the ECB imposes on them. Five years ago this correlation was below 30%, and now it is steady at around 80%.

This demonstrates the extent to which the banking union has already managed to level the playing field for banks across our jurisdiction.

Contributing to the proportionate supervision of less significant institutions

As I mentioned, the direct supervision of less significant institutions is performed by the NCAs, with the ECB overseeing that supervision. The ECB takes care to be proportionate both in its oversight function and in how it designs guidance for NCAs regarding their day-to-day supervisory activities.

The main way in which the ECB ensures that its oversight of the NCAs’ supervision is proportionate is by ranking the LSIs. The LSIs are categorised as high, medium or low priority, and this categorisation is reviewed each year in cooperation with the NCAs.

The LSIs are prioritised according to, first, the impact their failure would have on the domestic financial system and, second, their intrinsic riskiness. Greater riskiness and a larger potential impact on the financial system imply more intensive supervisory attention. The ECB uses this prioritisation of LSIs to apply the principle of proportionality in a number of its oversight tasks.

For example, when developing supervisory standards and policies for LSI supervision in coordination with the NCAs, the ECB takes the prioritisation of LSIs into account to ensure that the envisaged approaches are proportionate to the specific supervisory objectives. These standards allow the ECB to ensure that the NCAs are consistent and rigorous in their supervisory approach and that there is a continuum between the supervision of significant and less significant institutions.

Our common SREP methodology for LSIs is gradually being applied by all NCAs in their supervision of the smaller banks in their domestic environment. This methodology sets different levels of supervisory intensity for LSIs in different priority categories, in particular in terms of the frequency and granularity of supervisory assessments.

Generally speaking, the supervisory requirements for high-priority LSIs are more stringent or more detailed than those for low-priority LSIs.

For instance, the SSM Framework Regulation provides that NCAs send certain ex ante notifications and fulfil certain ex post reporting requirements vis-à-vis the ECB to ensure that the ECB can adequately exercise its oversight of the functioning of the SSM.

In the interests of proportionality, NCAs are only required to submit ex ante notifications for material supervisory procedures and material draft supervisory decisions concerning high-priority LSIs. The principle of proportionality is also an important criterion for the ECB when assessing incoming ex ante notifications and determining the intensity of the review to be performed. The ECB assesses the impact of the planned measures from a supervisory and risk perspective and also examines whether the measures themselves are proportionate.

As regards regular ex post reporting requirements, the ECB requires NCAs to submit institution-specific information and information related to their supervision of LSIs only if it is deemed material and proportionate. Hence, the depth and frequency of ex post reporting are adapted to the priority rank of the LSI.

The ECB’s framework for the institution-specific oversight of LSIs is also based on the prioritisation of institutions. A less granular and less frequent assessment is normally conducted for those banks which have been assigned a low or medium priority. However, this is not always the case. For example, if a thematic review were to indicate that a lower-priority institution was more risky and complex than expected, the principle of proportionality would require a stricter and more intrusive approach to be taken.

Conclusion

To conclude, I would like to briefly reiterate the main points I have made today.

First, pursuing proportionality is a natural fit with preserving a competitive level playing field. The two concepts go hand in hand.

Prudential soundness sets limits on the way that supervisors apply proportionality in practice. However, different supervisory techniques can be used to ensure that specific types and sizes of banks are handled in the best possible way.

The largest and most complex institutions are supervised in the most intense manner. Simpler banks with a smaller systemic footprint are subject to a somewhat less intense supervisory focus.

The aim is to conduct supervision at a level that is no more and no less than what is needed to ensure that prudential soundness is maintained across the board.