Quarterly SSM briefing: spotlight on supervisory priorities, banking union and liquidity ratio

Fri 28 Jan 2022

Supervisory priorities 2022-2024

In December 2021, the European Central Bank (ECB) and the national supervisory authorities of the Eurozone countries published their supervisory priorities for 2022-2024. The three-year coverage enables the ECB banking supervision to achieve good progress in addressing the identified vulnerabilities while at the same time affording enough flexibility in any corresponding actions needed.

The European banking sector continues to operate under the impact of the Covid-19 pandemic. While the public guarantees have offered relief to banks and the macroeconomic conditions have improved, uncertainty remains. The withdrawal of the support measures could trigger dramatic changes in banks’ asset quality, as well as increased market volatility and overvaluation. As a result, the supervisory priorities in the next three years will be; to ensure banks emerge from the pandemic healthy, confirm that banks address the structural weaknesses they face via effective digitalisation strategies and enhanced governance, and require certain banks to tackle emerging risks.

Banks emerge from the pandemic healthy

The identified vulnerabilities by the supervisor concerning credit risk include banks’ deficiencies in credit risk management frameworks due mainly to a lack of timely identification and forward-looking measurement of the risks, exposures to sectors vulnerable to Covid-19, including commercial real estate, and exposures to leveraged finance with a focus on the supervisory expectations as noted in ECB Guidance. When considering market risk and interest rate risk on the banking book (IRRBB), the supervisor has identified banks’ sensitivities to medium-term interest rates and credit spread shocks as a weakness to be monitored over the next three years. As a result of these exposures, the ECB plans to maintain continuous joint supervisory team (JST) monitoring and assessment and perform targeted on-site inspections and internal model investigations. 

Effective digitalisation strategies and enhanced governance to address structural weaknesses

The pandemic has accelerated the adoption of technologies, so banks should ensure the existence of adequate arrangements which would push towards sustainable long-term business models using digital transformation. The supervisor plans to use digitalisation strategies’ surveys, benchmarking analysis, and on-site inspections in its approach. Additionally, supervised banks should focus on their governance structures and address any deficiencies in the functioning and composition of their management bodies. After running a public consultation on this topic in December 2021, the ECB published its Guide to Fit and Proper Assessment which outlines its expectations for supervised banks to develop and implement diversity policies and a risk-based approach to fit and proper assessments. As in other risk areas, the ECB plans to implement targeted reviews and on-site inspections.  

Emerging risks for banks are on the radar

The supervisory authorities outlined three evolving challenges and threats for the banks that they plan to focus on in the coming months and years. First, climate and environmental risks must become a part of banks’ governance, business strategies and risk management frameworks.  A bottom-up climate stress test and a thematic review evaluating banks advancement in this area so far will be performed by the ECB in 2022. Moreover, thematic on-site inspections and follow-ups on significant institutions’ data collection and disclosure practices are in the supervisor’s plans. The second major vulnerability faced by banks stems from their search-for-yield strategies in response to the low interest rate environment. Targeted reviews and on-site inspections evaluating the counterparty credit risks (CCR), arising from the increase in volume of capital market services provided by banks to non-bank financial institutions (NBFIs), will take place in the following months and years. Prime brokerage reviews would be finalised to clarify supervisory expectations regarding CCR exposures towards NBFIs. When material deficiencies are identified in banks, JST follow-ups will take place. The final emerging threat on the supervisor’s radar is banks’ increasing reliance on third-party IT providers, including cloud providers. The objective here is the development of adequate IT outsourcing arrangements and improved cyber threats resilience. Again, planned ECB actions include data collection, on-site inspections and investigations in areas showing material deficiencies. 

Banking Union

The completion of the EU banking union was again in the spotlight for EU regulators in the last quarter of 2021. John Berrigan, Director-General for Financial Stability, Financial Services and Capital Markets Union (FISMA), called it the “ultimate goal” in an interview published in the latest ECB Newsletter. In his last two interviews*, Andrea Enria, Chair of the ECB supervisory board, speaks about the urgency of reopening the discussions on the European deposit insurance scheme (EDIS) for bank deposits in the euro area. This last third pillar of the EU Banking Union has been on the sidelines for years due to controversial political opinions across Europe. However, developments such as a new German government taking the helm of the largest European economy in December 2021 and France taking over the EU presidency in January 2022 are both considered positive and hopeful by regulators for finally reaching a high-level agreement on the EDIS roadmap.

Liquidity coverage ratio relief is not extended

The ECB announced that the liquidity relief measure, which allowed banks to operate with liquidity coverage below 100%, would not be extended after 31 December 2021. The relief was initially allowed in March 2020 as a response to the pandemic, and the goal was to encourage banks to use their liquidity buffers to support the economy. The liquidity coverage ratio measures the proportion of highly liquid assets held by a bank to the cash outflow when meeting its 30-day obligations. The chart shows that the combined liquidity ratio for SSM supervised banks in the last quarter of 2021 was above 170%. This decision should not have come as a surprise for the industry, since the current number is well above the minimum requirement of above 100% as well as above the pre-pandemic level of 140%.

*Het Financieele Dagblad, 15th December 2021 and Les Échos, 10th January 2022