ECB supervisory focus for significant institutions
Significant institutions will be focused on a series of recent publications from the European Central Bank including the 2021 Supervisory Priorities and February's Supervision Newsletter. We have identified that recovery planning, maintenance of capital, business model sustainability and governance are key supervisory concerns for the regulator and this article takes a closer look at each of these issues.
There is an understandable focus on recovery plans at the moment. The ECB has stated that supervisors are paying particular attention to challenging banks’ recovery options and recovery.
Recovery plans must be credible and capable of being implemented in times of stress, particularly where plans rely on raising capital or selling assets. Such contingencies must take in to account stressed market conditions. Significant institutions should have a suite of options for their overall recovery capacity, with the ECB calling out that having just one or two recovery options leaves the institution severely compromised if one of these options is not available in a crisis.
The ECB has also commented on recovery plans developed in 2019 that were the subject of a recent benchmarking exercise that found that banks need to improve their recovery plans to adequately address the financial impact of extraordinary system-wide crises such as the pandemic.
Management of Credit Risk
The ECB have stated that robust credit underwriting standards are crucial to ensure that banks remain resilient. Where credit underwriting standards are relaxed this must be adequately supported by capital resources and risk management practices.
Interest rates banks charged on loans don't always adequately reflect the underlying credit risk of those loans. This lack of risk-based pricing may undermine banks’ ability to cover future loan losses.
A key finding recently announced by the ECB is that most of the banks surveyed found it difficult to retrieve data on key credit risk indicators and where data was retrieved the ECB were dissatisfied with data quality. This feeds in to concerns about IT capabilities and overall risk governance.
Banks must have adequate risk management practices in place in order to manage the anticipated increase in distressed exposures. Banks should focus on identifying deteriorating asset quality and making timely and adequate capital provisions in response. Resourcing should be increased where necessary to appropriately manage arrears and non-performing loans.
Dividends, buy backs and variable remuneration
In March and July 2020 the ECB recommended that banks suspend their cash dividends and share buy-backs. In December the ECB updated its recommendation, calling on banks to remain cautious by keeping their distributions within certain levels and setting the expectation that extreme moderation should be exercised in deciding on variable remuneration. The ECB has stated that the dividend recommendation will remain valid until the end of September 2021.
The ECB have announced that banks will not be required to replenish their capital buffers before the peak in capital depletion is reached, and in any case not before at least 2022. The ECB will decide on the exact timeline for rebuilding capital after the 2021 EU-wide stress test. Banks will be given until at least the end of 2021 to meet the liquidity coverage ratio requirement.
Business model sustainability
The ECB's SSM Supervisory Priorities for 2021 indicate that the pandemic along with low interest rates, excess capacity and competition are putting pressure on business profitability and business model sustainability for banks. Supervisors will challenge strategic plans and interrogate actions taken to overcome existing shortcomings, where identified and will focus on the oversight of business strategies.
The ECB has flagged in its 2020 SREP assessment that it envisaged a more active role for Non-Executive Directors in decision making during crisis response and this will be something for institutions to address going forward. The ECB would also welcome improved 'bottom-up' reporting in order to improve management information during a crisis. Certain banks have been asked to make their critical services less dependent on outsourced arrangements and must resolve flagged IT issues.
For more information on any aspect of supervisory engagements please contact Dario Dagostino, Kevin Allen, Patrick Brandt and Mark Devane, Financial Regulation and Investigations Partners and Sinéad Prunty, Financial Regulation and Investigations Knowledge Lawyer.
Date published: 2 March 2021