The Single Supervisory Mechanism: Post-pandemic actions and expectations

Mon 20 Sep 2021

On 30 July, the European Central Bank unveiled the 2021 supervisory stress test results, which demonstrated that the region’s banking system is resilient in an unfavourable environment. The Common Equity Tier 1 (CET1) ratio has fallen 5.2% to 9.9% under the 3-year adverse scenario, while under the baseline scenario the CET1 ratio will reach 15.8% in 2023. Eighty-nine ECB-supervised banks, covering a bit over 75% of the total banking assets in the eurozone, were included in the exercise. Due to their success in Non-Performing Exposure (NPE) reduction and cost-cutting over past years, banks entered the stress test in better form than three years ago. Still, they experienced higher capital depletion because of the more severe adverse scenario compared to 2018.

Test results

While some banks will need to maintain their minimum capital if the adverse scenario materialises, the overall shortfall will remain controlled. The extra capital depletion of -5.2% was driven by higher credit and market risk losses, lower trading income, lower Net Interest Income (NII) and lower Net Fees and Commission Income (NFCI).  Furthermore, while representing only 35% of the overall exposure, unsecured corporate and retail exposures comprised 75% of all impairments under the adverse scenario.

Public guarantee schemes (PGS) and Covid-19 moratoria are both included in the test methodology. First, maturing PGS loans are expected to be always replaced with the guarantee, and, secondly, EBA-compliant Covid-19 moratoria are assumed to be out from 1 January 2021, and IFRS 9 stages will restate the starting exposure distributions. Loans worth a total of €241bn is guaranteed by PGS, with Spain, Italy and France having the most PGS covered exposures.

The pandemic has pushed forward sectoral vulnerabilities in the last year, further extending credit risk in corporate lending. The top three sectors reported by banks that had the largest exposures in 2020 included building construction, retail trade and accommodation.  

The stress test results will be integrated into the Supervisory Review and Evaluation Process (SREP). They will include both qualitative outcomes used by the Joint Supervisory Teams (JSTs) to assess institutions’ internal governance and risk management, and quantitative outcomes used in Pillar 2 Guidance (P2G) determination.

A new approach to P2G

As of 2021, the ECB Banking Supervision uses a new approach to determine P2G. Due to the new Capital Requirements Directive, CRD V, a new bucketing framework with a 2-step approach that would not include floors or caps anymore would be used to determine P2G for banks.

Step 1. Banks are placed in one of four buckets according to their max CET1 depletion in the stress test adverse scenario

Step 2. The JSTs set the final P2G for each bank within the range of the bucket, or exceptionally beyond that range, considering the institution’s individual situation.

This new approach directly links the stress test results to the banks’ capital decisions, hence influencing the banks’ management and dividend policies, and investors’ assumptions.

Banks directly supervised by the ECB must meet P2G with CET1 resources. Although the requirement is not binding, there could be supervisory measures against banks whose P2 capital falls below their targets.

It should be noted that the capital relief measures announced by the ECB in 2020 continue to apply, and banks may operate below P2G levels until at least the end of 2022. This would afford them adequate time to replenish their capital if P2G levels are increased. With this in mind, 2021 P2G identified through the new methodology should be considered by banks when planning their compliance after 2022.

When determining the P2G for banks that do not participate in the stress test, the supervisors would use a forward-looking assessment of the institution’s resilience and the potential impact of adverse scenarios on its solvency.

Dividend recommendation

Due to an improvement of the macroeconomic outlook, on 23 July 2021, the ECB announced its decision not to extend the recommendation that all banks limit dividends beyond September 2021. When Evaluating the benefits of euro area dividend distribution recommendations on lending and provisioning, the intended outcome is clearly visible; banks that followed the recommendation increased provisions by 5.5% and lending to the real economy by 2.4% compared to banks that did not follow or had already distributed dividends before the recommendation.

Still, banks are expected to remain prudent and keep their focus on credit risk management when determining dividends. Their credit risk process will be closely supervised to limit the increase in NPLs and loan losses once the public guarantees and moratoria are lifted. The ECB has clearly stated their expectations regarding banks’ classification of assets under the prudential and accounting frameworks according to their credit quality. Before banks finalise their capital distribution plans in Q4 2021, they will go through their standard supervisory dialogue with the legislator. The supervisors are returning to pre-pandemic ways of assessing banks’ capital and dividend plans, while credit risk management and capital position remain central.

Leverage ratio relief extension

Due to the continuing coronavirus pandemic, euro area banks directly supervised by the ECB are allowed to continue to exclude coins and banknotes, as well as central bank exposures from their total exposure until March 2022. Only central bank exposures accumulated since the beginning of the pandemic benefit from this relief measure, which effectively means that the level of resilience provided before the pandemic is maintained. A bank that decides to take advantage of this measure would recalibrate its 3% leverage requirement upward. 

Supervisors focus: the months ahead

There wasn’t much data before Covid-19 on the reaction of a global economy to a pandemic. This uncertainty and the strong public guarantees and loan moratoria were two of the most notable features of the year. Today, it seems that the worst phase of the Covid-19 pandemic is over and, based on forecasts, the economy is confidently moving towards a strong rebound. Due to this improved economic outlook, many banks started releasing their provisions, which resulted in increased reported earnings in the last quarter, as well as more significant earnings forecasts. Still, the Single Supervisory Mechanism (SSM) doesn’t let its guard down in anticipation of the moratoria and guarantees withdrawal. There is ongoing scrutiny on banks’ credit risk controls and management in an effort to prevent the unwelcome prospect of NPL increases due to a wave of bankruptcies and a massive deterioration in banks’ assets quality once public support is removed.

While aiding in the actual crisis, the government support measures have led to record levels of liquidity and a muted risk environment, which has elevated the market participants’ risk appetite for financial leverage and complexity. A concrete illustration of this is the growth of the leveraged loan and high-yield bond markets and the broader investor base interested in it.

The market extension in a search-for-yield environment has triggered increasingly loose loan underwriting standards that have generated leveraged loans structured with fewer covenants, underwritten to attract corporates with higher leverage levels. This could lead to weaker investor protection, hence higher supervisory focus in the future.

IT and cyber risk, which have been a supervisory priority for several years, have not left the legislator’s attention either. Banks went through lockdowns, branch closures, and staff working remotely, combined with an increased demand for online services. All of these further illuminated the importance of cyber risk. The increasing dependence of the financial sector on information technology and third-party IT service providers has maintained the use of technology in European banks as an ongoing supervisory task for the ECB.

As noted at the beginning of the year, credit risk, capital strength, business model sustainability, and governance are the four supervisory priorities for 2021. Based on the current economic situation, these will be on the supervisor’s radar for a lot longer than this coming December.

The regulators’ focus in the coming months will be to ensure the overall stability of the financial markets while navigating banks through the process of exiting the pandemic.