If you have ever worked at a bank, you might have come across a process called Supervisory Review and Evaluation Process (SREP). A “baby” of the Global Financial Crisis (GFC) and the European debt crisis, this process is an essential element in ensuring that banks remain safe and reliable. The SREP allows the European Central Bank (ECB), either directly or indirectly via the National Competent Authorities (NCA), to assess a bank’s ability to manage and control the factors which can impact its capital and liquidity positions.
At this point, almost 10 years since its inception, the process is well ingrained into the EU supervisory framework and has proven its effectiveness and flexibility in the face of uncertainty and market turmoil (i.e., COVID-19, Russian Invasion of Ukraine). However, even good processes require periodic reviews and assessments to ensure they stay effective and in line with regulatory and business model changes. The latest of such reviews was performed in 2022 and completed in March 2023 by an Expert Group (the Group) comprised of heads of central banks as well as other regulatory bodies. Their work resulted in the report, “Assessment of the European Central Bank’s Supervisory Review and Evaluation Process”, which outlines several findings and recommendations to the Chair of the Supervisory Board of the ECB.
The remainder of this article is comprised of a summary of the report along with key points extracted from the seventeen recommendations, with additional commentary from Avantage Reply’s point of view.
What is SREP’s purpose?
The Single Supervisory Mechanism (SSM) was created in 2013 as part of EU banking regulation and supervision reforms aimed at increasing financial resilience, reducing fragmentation and reinforcing the monetary union. The SSM is comprised of the ECB and NCAs from 21 countries and directly supervises 111 banks (as of Jan. 2023) and oversees the supervision of over 2,000 smaller banks in 21 EU countries. The SREP helps to set capital and liquidity requirements and establish measures to improve internal controls and risk management practices for in-scope banks. The process includes four elements: business model, internal governance and risk management, risks to capital, and risks to liquidity. A risk assessment score (RAS) is produced for each element and an overall SREP score (OSS) reflects supervisors' view of each bank's viability.
After completing the supervisory assessment, the ECB communicates the results of the SREP to significant institutions. The decision outlines the mandatory requirements stemming from the assessment, as well as detailed risk assessments and findings for each element of the SREP. The decision is a legal act adopted by the ECB Governing Council and may also contain non-binding recommendations.
What are the key recommendations of the report?
The report groups the findings and recommendations into three main sections. The summarised version of the recommendations, by group, is listed below along with Avantage’s Reply commentary:
The report points out several recommendations pertaining to the SSM culture, SREP process, communication of management actions, technology and use of analytics. In particular, the Expert Group suggests defining the supervisory culture and making it publicly available for all NCAs.
When it comes to the SREP process, the report recommends several actions. First, to consider leveraging the risk-based approach during the process to avoid “all-encompassing reviews” and instead perform targeted assessments of key risks of the bank. In order to do this effectively, the report also recommends to use the data gathered during other supervisory activities, beyond SREP, which should provide insights during the SREP assessments.
Additionally, the SREP timeline should be further shortened and made more efficient. When it comes to the SREP communication, it can be further improved by making SREP letters clearer - by pointing out key strategic risk drivers and major supervisory concerns - and actionable - to create an accountability for banks and supervisors to follow-up on open measures.
Finally, the last two recommendations address the Information Management System (IMAS) and ask to make it more streamlined, flexible and better integrated, while the second focuses on further development of the data analytics and tools to extract, aggregate and analyse data.
Avantage Reply’s Commentary:
Directly supervised banks would surely welcome a shorter and more efficient SREP process. The current length of time (sometimes more than 12 months) is not only very taxing on the time and resources for banks, but also reduces the impact of supervisory actions, which can sometimes refer to underlying issues or risk exposures that are no longer relevant. Similarly, performing targeted risk assessments would provide banks with a clear link between supervisory actions and material risk types. We often hear from banks that it is sometimes difficult to understand the relationship between Pillar II capital requirements and their material risk exposures. More targeted risk assessments, combined with SREP letters which clearly point out strategic risk drivers and main supervisory concerns, would go a long way towards alleviating these concerns.
In this section of the recommendations, the Group focused on the SREP score, the rationale behind it, limiting the use of the ICAAP and setting of the average P2R for the euro area banking sector. The report points out the importance to consider non-quantitative measures when deriving capital add-ons and suggests to consider 1) the importance of the management actions as well as 2) the actual performance of banks in addressing their deficiencies and delivering the expected actions. When communicating the final score, the report also suggests to be transparent in the rationale behind the scores and clear in the actions the bank needs to implement to address each identified weakness. One recommendation urged to restrict the reliance on the bank’s ICAAP in the P2R determination process, arguing that it brings higher operational complexity with potentially limited upside. Finally, the last recommendation suggests to schedule annual discussions within the Supervisory Board, “…formulate preliminary expectations on the average P2R, the calibration factor for the P2G and the desired severity for the adverse scenario in the stress test used for the determination of P2G.”
Avantage Reply’s Commentary:
The recommendations in this section, consistent with those elsewhere in the report, focus on improving the transparency of SREP scores and the actionability of supervisory recommendations. One of the most interesting recommendations suggests that the ECB should significantly reduce the role that ICAAP plays in the SREP and especially in the determination of Pillar 2 capital requirements. One common piece of feedback from directly supervised institutions is that the ICAAP has become less an internal risk management process and more of a supervisory-defined exercise. One interpretation of such a radical shift in supervisory philosophy could indeed be an attempt to put the “I” back into “ICAAP”.
Restricting the role that the ICAAP plays in setting capital requirements would align supervisory practices with those observed at some other supervisory authorities, including the Federal Reserve System in the US (i.e., the Fed). In America, capital requirements are based primarily on the results of the Fed’s bank-wide supervisory stress testing, C-CAR, rather than an ICAAP-like assessment. If this recommendation is eventually adopted by the ECB, it would be interesting to see whether they would take a similar approach by, for example, basing Pillar 2 capital requirements on the results of the bi-annual EU-wide supervisory stress test.
The last section of the recommendations further elaborates on some of the points listed earlier while adding additional proposals. For instance, for qualitative measures mentioned earlier, the Group also suggests to identify, design, prioritise and deploy such qualitative measures to allow 1) for strengthening the link with the SREP score and 2) the banks to remediate their weaknesses in a targeted manner. When it comes to preparing for the SREP, the Expert Group advises to establish an inventory of all outstanding supervisory measures at the beginning of each SREP cycle, which may be shared with each bank, to enhance transparency. When communicating the results, the Expert Group also suggests to do it via the Joint Supervisory Teams (JSTs) and not directly to the bank. Finally, when it comes to follow-ups, the report suggests to develop a platform for the banks to provide their updates on on-going basis to avoid ad hoc submissions.
Avantage Reply’s Commentary:
Consistent with other recommendations in the report, these recommendations focus on increasing the clarity and transparency of qualitative measures applied by the SSM. We expect that banks will welcome any attempt to make qualitative measures clearer and more targeted in order to reduce ambiguity experienced in current practices. Similarly, any measures to improve the frequency and quality of feedback on remediation actions would likely have the positive impact of improving the dialogue between banks and supervisors. It is interesting to note that these recommendations echo some of the findings and recommendations recently published by the European Court of Auditors (ECA) in its recently published special report 12/2023 on the ECB’s supervision of credit risk
(Report | European Court of Auditors (europa.eu) particularly in relation to transparency, where it recommends that the ECB look at “publishing its methodology for generating pillar 2 requirements”. This is similar to the recommendations related to transparency here, where it is suggested that the SSM should provide banks with a stronger, clearer link between the outcome of the SREP assessment, summarised in the SREP scores, and the issuance of qualitative measures.”
In summary, the report provides a good overview of the current practices utilised by the SSM and the ECB while also recommending further improvements. From our conversations with market participants in Luxembourg and other EU member states, the SREP timeline and communication clarity are some of the key topics where further improvements would be appreciated. Another welcomed recommendation surrounds the use of ICAAP. More specifically, its return to the true “internal” process and less of “a supervisory-defined exercise”.
Time will show if and how many of the proposed recommendations will be implemented in the SREP in the future. However, the fact that such a review has been requested and performed signals a desire from the ECB to step back and potentially readjust its supervisory philosophy. It shows a willingness from the ECB to constantly evolve and where possible, enhance the supervisory process. No matter one’s views on the recommendations in the report, we think that all market participants can at least agree that this is a welcome ambition.
Avantage Reply Luxembourg will continue to follow these developments and stand ready to provide expert advice to clients on these and other supervisory topics.
For the full report, please click on the following