Striking a balance: proportionality in European banking regulation and supervision
Introductory statement by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, at the panel discussion on “A proportionate implementation of Basel III” at the European Commission's DG Financial Stability, Financial Services and Capital Markets Union conference on the implementation of Basel III
Brussels, 12 November 2019
It is a pleasure for me to be here today, and I would like to thank the organisers for inviting me.
Proportionality is a key principle of the European Union (EU). Article 5(4) of the EU Treaty notes: “Under the principle of proportionality, the content and form of Union action shall not exceed what is necessary to achieve the objectives of the Treaties. The institutions of the Union shall apply the principle of proportionality as laid down in the Protocol on the application of the principles of subsidiarity and proportionality”. Proportionality thus applies to all EU acts and institutions and may be used to challenge Union actions. This includes the laws which underpin banking activity in Europe, and the institutions which oversee it.
My remarks will briefly outline how the principle of proportionality is at work in the sphere of European banking supervision, as regards both supervisory regulation and supervisory practice. In so doing, I hope to leave you with two lasting impressions: first, that the principle of proportionality is firmly embedded in the regulatory framework underpinning banking activity in the EU, including insofar as the implementation of Basel III is concerned; and second, that the European Central Bank (ECB) fully respects this important principle by taking a proportionate approach to the banks under its direct or indirect supervision.
Before describing how proportionality is applied in the banking supervision, however, it is worth reminding ourselves why we need it in the first place. In essence, it has to do with diversity. In many jurisdictions, including in Europe, banks tend to differ markedly in terms of business model, size and complexity. If there is no “one size fits all” approach to banking activity, it logically follows that the laws and supervisory practice overseeing such activity cannot apply in the same way and to the same extent to all parties concerned. This is why a proportionate approach is required in the application of these laws and practices, with bank size and risk being the main factors determining the intensity of their application.
Let’s see how this is applied in practice, both globally and in Europe.
At the global level, banking rules are articulated through the Basel framework, targeting primarily large and international banks that tend to exhibit a more diversified profile. Principle 8 of the Basel Core Principles calls on supervisors to “develop and maintain a forward-looking assessment of the risk profile of individual banks and banking groups, proportionate to their systemic importance”. With this scope in mind, the Basel framework provides a number of different approaches for banks to choose from when determining their risk-weighted assets. For example, large international banks can use either a simpler standardised approach or a more risk-sensitive approach that is also more complex. Systemically important banks, whether globally or in a domestic context, have to hold additional and larger capital buffers commensurate with the risks they pose to the economy relative to small banks. And small banks are not required to hold any additional buffers at all. Basel III also allows different jurisdictions to use different criteria and schemes for segmenting banks in recognition of national specificities, and it also allows for the possibility to use simplified approaches for some banks.
In Europe, the Basel standards apply to all banks, not just to the large entities. In my view, there are very good reasons for this, because partial or full carve-outs of capital and liquidity requirements for small banks may impinge on both prudential soundness and a competitive level-playing-field. These are important objectives for supervisors everywhere in a purely national context, but they acquire a critical dimension in a supranational set-up such as the euro area since the entire premise of the banking union rests upon the need to reduce financial fragmentation while subjecting banks to a higher common supervisory standard. The notion that a functioning banking union in Europe can be successfully reconciled with the existence of different prudential regimes for groups of banks across countries is therefore illusory, because the latter runs squarely counter to the objectives of the former.
However, the fact that all banks in Europe are subject to the Basel standards also implies that there is an increased, rather than reduced, need for a proportionate approach in their application, as is indeed the case in practice. Small banks can use the standardised approaches which, other things remaining equal, should result in the same level of prudence compared to large peers. It is also worth keeping in mind that Basel III will have a much greater impact on large and complex banks than on small ones, at least in Europe. For example, the total increase in Tier 1 capital for all banks should be around 24%, as compared to around 5% for small banks. Most of this impact is due to the introduction of an output floor on banks’ internal models – and since internal models are mostly used by large banks, it follows that such banks will be the most affected by these reforms. In fact, most small and non-complex banks won’t have to raise any additional capital at all in order to meet the new requirements under Basel III.
Looking beyond the Basel III framework and turning to the ECB’s supervisory practice on a day-to-day basis, it is important to note that the ECB is legally bound by the principle of proportionality. This principle features prominently in the key pieces of legislation which together form the EU banking framework, including the Capital Requirements Regulation (CRR), the Capital Requirements Directive IV (CRD IV) , and the Single Supervisory Mechanism (SSM) Regulation which confers supervisory duties to the ECB (known as the ‘SSM Regulation’), which states that the conferral of supervisory tasks implies a significant responsibility for the ECB to “use its supervisory powers in the most effective and proportionate way”. Proportionality is thus one of the key principles governing the functioning of European banking supervision, with supervisory intensity varying according to a bank’s size and complexity. Let me mention a few examples in this regard.
First, we are proportionate in our supervision of the large banks that are under our direct supervision. These are called “Significant Institutions” (SIs). We are more intrusive when supervising riskier, more complex and systemically more important SIs. This translates, for instance, into more and longer on-site inspections, as well as larger supervisory teams. This also means that supervisory outcomes are proportionate as well. The supervisory measures we take annually – the Pillar 2 capital add-ons in the context of our annual Supervisory Review and Evaluation Process (SREP) – are tailored to each bank, taking into account not only how much risk the bank has taken on, but also how important those risks are for the financial system as a whole.
Second, we are proportionate when indirectly supervising small banks, which are called “Less Significant Institutions” (LSIs). LSIs are classified as high, medium or low risk, depending on their own riskiness and on their weight in their domestic financial system. Banks which have been assigned a low or medium priority undergo less granular and less frequent supervisory assessments. These banks also submit fewer and less regular information about their capital and liquidity planning to the authorities.
Third, reporting is proportionate for all banks. As a general rule, small banks have to report fewer data points to supervisors than large banks: 600, compared to almost 40,000 for the largest banks. Still, I admit that this can be too much, which is why we are working together with other stakeholders to try to reduce this burden. We too want to make data collection simpler and lighter. However, without prejudice to the question of the granularity of reported data, we are not in favour of a system in which small banks would report at a lower frequency than their larger peers. Having regular access to updated data on small banks is the only way to ensure that our supervision and oversight of the system as a whole remains as effective as possible.
Fourth, the annual supervisory fees that banks have to pay in order to cover the costs of our supervisory tasks are also proportionate, as these are linked to the institution’s level of significance.
I hope my remarks thus far have convinced you that proportionality is a well-established principle of banking supervision, including in Europe, where it is enshrined in the Treaty and its application is governed by specific provisions in banking legislation. I have tried to show how proportionality informs many of our daily supervisory practices at the ECB. And there is more proportionality in the pipeline: thanks to the revised CRR and CRD texts, in future small and non-complex banks may enjoy lighter requirements for reporting, disclosure and remuneration. Such banks may also use simpler approaches to the calculation of some risks.
To conclude, I would like to emphasise something that has been implied thus far but that I haven’t discussed at length, namely that proportionality is firmly embedded in the organisational structure of the Single Supervisory Mechanism (SSM). This is because only the large banks are under the direct supervisory remit of the ECB, while the small banks are supervised by national supervisors and are only indirectly subject to the ECB’s oversight. But here I must add a word of caution, because the SSM is not and should never become a “two tier” system in which different supervisory styles apply on account of different risk tolerance thresholds. Direct and indirect supervision are different ways of achieving the same result, which is to safeguard the overall soundness of banks and the safety of the financial sector. Small banks can spell trouble too, for example in a “too many to fail” context, and they might play an important role in the local economy. Consequently, rules on capital and liquidity need to be based not only on size, but also, and most importantly, on risk. Simpler rules for small banks must not be tantamount to weaker rules, and proportionate supervision should not be equated with more lenient supervision warranting deviations from the single rulebook in Europe.