Banking Reform Updater 10

On 4 November 2014, the European Central Bank (ECB) assumed its supervisory role under the single supervisory mechanism (SSM). In this updater we take a look at some of the key issues arising from the SSM and what the new regime actually means for banks operating in the EU.

The SSM is a system of banking supervision composed of the ECB and the national competent authorities of participating member states.

The legal basis for the SSM is Regulation No 1024/2013 of 15 October 2013 conferring specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions (the SSM Framework Regulation). The SSM Framework Regulation governs the relations between the ECB and national supervisors and includes the rules that apply directly to banks.

Within the SSM, the ECB will be responsible for the direct supervision of significant banks, whereas national competent authorities of participating Member States will be responsible for the direct supervision of less significant banks.

The ECB will also be responsible for the effective and consistent functioning of the SSM. The ECB will be able to issue general instructions to the national competent authorities of participating Member States with regard to the supervision of less significant banks and will retain investigatory powers over all banks.

It is worth noting that the SSM is one of the two pillars of the EU banking union, the other being the Single Resolution Mechanism (SRM).

The SSM automatically applies to all Eurozone member states. EU member states that are not in the Eurozone may choose to participate. The Czech Republic, United Kingdom and Sweden have chosen not to participate in the SSM. Banks established in the United Kingdom will also not be subject to the SRM.

For the non-participating EU countries and countries outside the EU, the ECB and the relevant national supervisory authorities can conclude memoranda of understanding describing how they will cooperate in carrying out supervisory tasks. However, at the time of writing the United Kingdom and Sweden had not entered into such memoranda.

The Capital Requirements Regulation provides that the ECB is the ultimate supervisor for all banks established in those member states that are participating in the SSM.

Banks that are deemed to be significant will be subject to direct supervision by the ECB. The day to day supervision of these banks will be conducted by joint supervisory teams comprising of staff from both the relevant national competent authority and the ECB. All other banks within a participating member state will generally remain under the supervision of the national competent authority. However, it is worth noting that the ECB can take on the direct supervision of a less significant bank if it is necessary to ensure the consistent application of high supervisory standards.

The SSM Framework Regulation sets out a definition for those banks that are to be considered less significant, which by implication provides a definition for those banks that will be deemed significant. In brief, a bank will be deemed to be significant where:

• its assets exceeds EUR30 billion or, unless the total value of its assets is below EUR5 billion, exceeds 20% of national GDP;
• it is one of the three most significant banks established in a participating member state;
• it is a recipient of direct assistance from the European Stability Mechanism; or
• the total value of its assets exceeds EUR5 billion and the ratio of its cross-border assets/liabilities in more than one other participating member state to its total assets/liabilities is above 20%.

Notwithstanding the above on 4 September 2014, the ECB published a document¹ containing the list of banks classified as significant and the list of less significant banks. The ECB intends to update these lists regularly.

For those banks that are established in non-participating member states that provide banking services in participating member states through branches or on a cross-border basis (i.e. passporting under the CRD IV Directive) the ECB acts as the host supervisor.

Importantly, the ECB has the power to grant and withdraw the authorisation of any bank in a participating member state and to assess the acquisition of holdings in such banks. This is done jointly with the relevant national competent authority.

The SSM Framework Regulation contains a number of procedures that are known as “common procedures” which are decided on by the ECB, regardless of whether the bank is significant or otherwise. These are the procedures for authorisation to take up banking business, withdrawal of such authorisation and the assessment of acquisitions of qualifying holdings. The SSM Framework Regulation sets out how the ECB and the national competent authorities are involved in these common procedures.

The common procedures are governed by certain key principles including:

• applications for authorisation and notifications of an acquisition of a qualifying holding are to be sent by the applicant bank to the relevant national competent authority: for the granting of authorisation, this is the national competent authority of the member state where the new bank is to be established; for intended acquisitions of qualifying holdings, the relevant national competent authority is the national competent authority of the member state where the bank being acquired is established;
• the national competent authority notifies the ECB of receipt of an application for authorisation within 15 working days. In relation to a notification of an intention to acquire a qualifying holding, the national competent authority notifies the ECB of such notification no later than five working days following its acknowledgement of receipt of the applicant; and
• once applications have been submitted and their completeness verified, they are subject to a complementary assessment by the receiving national competent authority, the ECB and any other relevant national competent authorities. The assessment will cover all the criteria set out in relevant national and EU laws.

The ECB and the national competent authorities of participating member states where a bank is established have the right to propose the withdrawal of a banking licence. The relevant national competent authority can propose a withdrawal upon the request of the bank concerned or, in other cases, on its own initiative in accordance with national legislation. The ECB can initiate a withdrawal in instances set out in EU legislation. The ECB and the relevant national competent authority will consult on any proposals to withdraw a bank’s authorisation.

The ECB's supervisory responsibilities for significant banks include:

• assessing passporting applications made by banks established in a participating member state that want to establish a branch or provide cross-border services in a non-participating member state;
• imposing prudential requirements on banks in the areas of own funds requirements, securitisation, large exposure limits, liquidity, leverage, and reporting and public disclosure of information on those matters;
• imposing requirements on banks to have in place robust governance arrangements, including the fit and proper requirements for the persons responsible for the management of credit institutions, risk management processes, internal control mechanisms, remuneration policies and practices and effective internal capital adequacy assessment processes, including internal ratings based (IRB) models;
• carrying out supervisory reviews, including stress tests;
• carrying out supervision on a consolidated basis over banks’ parents established in one of the participating member states, including over financial holding companies and mixed financial holding companies, and participating in supervision on a consolidated basis;
• participating in the supplementary supervision of a financial conglomerate in relation to the banks included in it and assuming the tasks of a co-ordinator where the ECB is appointed as the coordinator for a financial conglomerate; and
• carrying out supervisory tasks relating to recovery plans, and early intervention where a bank does not meet or is likely to breach the applicable prudential requirements.

Day-to-day supervision of significant banks will be conducted by joint supervisory teams comprising of staff from both the ECB and the national competent authorities in which the bank operate. Each joint supervisory team is led by a coordinator at the ECB who is responsible for the implementation of supervisory tasks and activities.

National competent authorities in participating member states retain direct supervisory responsibility for less significant banks although the ECB can issue regulations, guidelines or general instructions to them regarding the performance of these responsibilities. ECB staff may also participate in certain activities, for example on-site inspections.

The SSM Framework Regulation also sets out a regime concerning the deployment of capital buffers and other measures designed to address systemic or macro-prudential risks. Essentially before introducing these measures a national competent authority of a participating member state must first notify the ECB. The ECB may also take the decision to introduce macro-prudential measures, either at its own initiative or at the request of an national competent authority or designated authority in a participating member state.

The ECB may require banks established in participating member states to report any information that is necessary for it to carry out its tasks, including information to be provided at recurring intervals and in specified formats for supervisory and related statistical purposes. On 23 October 2014, the ECB published a consultation paper concerning a draft ECB Regulation on the reporting of supervisory information. The consultation closed on 4 December 2014.

The SSM Framework Regulation gives the ECB certain investigatory powers which includes the ability to request all relevant information from banks and persons involved in their activities, related or connected to those activities or carrying out operational functions on their behalf. The ECB is also given the power to conduct all necessary investigations, including on-site inspections.

Where a bank established in a participating member state breaches regulatory requirements the ECB may impose enforcement measures and sanctions. Such measures include periodic penalty payments (i.e. fines applied for each day of non-compliance for no longer than six months).

The ECB can also impose administrative penalties on banks. In general, these are calculated at up to twice the amount of the profits gained or losses avoided because of the breach, or up to 10% of the total annual turnover in the preceding business year.

The ECB Regulation on supervisory fees sets out the arrangements under which the ECB will levy an annual supervisory fee for the expenditures incurred in relation to its new supervisory role under the SSM. The Regulation was published in the Official Journal of the EU on 31 October 2014, and entered into force the next day.

The Regulation sets out:

• the arrangements for calculating the total amount of the annual supervisory fees to be levied in respect of supervised entities and supervised groups;
• the methodology and criteria for calculating the annual supervisory fee to be borne by each supervised entity and each supervised group; and
• the procedure for the collection by the ECB of the annual supervisory fees.

In preparation for assuming supervisory responsibility under the SSM, the ECB conducted a comprehensive assessment of the resilience and positions of the 130 largest banks in the Eurozone. The comprehensive assessment consisted of:

• an asset quality review (AQR) which examined whether assets were properly valued on banks’ balance sheets as on 31 December 2013; and
• a stress test which involved a forward looking examination of the resilience of banks’ solvency to two hypothetical scenarios. A novel element of the stress test was that information acquired from the AQR was incorporated in banks’ balance sheet starting points and in related stress test projections.

On 26 October 2014, the ECB published the results of the comprehensive assessment which found a capital shortfall of €25 billion at 25 banks. Twelve of the 25 banks have already covered their capital shortfall by increasing their capital whilst the remainder have nine months in which to cover the shortfall. The AQR uncovered a number of important issues including that banks’ assets need to be adjusted by €48 billion, which will be reflected in their accounts or prudential requirements. In addition, using a standard definition for non-performing exposures (any obligations that are 90 days overdue, or that are impaired or in default), the ECB found that banks’ non-performing exposures increased by €136 billion to a total of €879 billion.

The comprehensive review also found that a severe scenario would deplete the banks’ top quality, loss-absorbing common equity tier 1 (CET1) capital by about €263 billion. This would result in the banks’ median CET1 ratio decreasing by 4 percentage points from 12.4% to 8.3%. This reduction is higher than in previous similar exercises and is a measure of the rigorous nature of the exercise.

On 18 November 2014, the ECB published a speech by Sabine Lautenschläger (Member of the Executive Board of the ECB) entitled Start of the Single Supervisory Mechanism: from the comprehensive assessment to day-to-day supervision.

At the beginning of her speech Ms Lautenschläger stated that the comprehensive assessment was an “important milestone” that had provided the ECB with an immense amount of information on the banks that will be subject to direct ECB supervision. Having concluded this major project the ECB is now focusing on its daily supervisory role under the SSM, building on its findings and incorporating them into the broader range of its supervisory activities.

In relation to the ECB’s next steps Ms Lautenschläger mentioned that the immediate task is to incorporate the full spectrum of the review’s findings into its regular supervisory activities. In particular, as an example of its prudential follow up work the ECB expects banks to incorporate the additional non-performing exposures identified in the AQR in their supervisory reporting of financial data. Banks and their auditors should also carefully assess how this should be reflected in the level of provisioning.

Turning to the qualitative findings of the review, Ms Lautenschläger noted that the AQR has in a number of cases revealed structural weaknesses in banks’ data systems, particularly where banks had recently merged with or acquired other banks. Ms Lautenschläger stated that there is an urgent need to improve those systems and that banks will be required to do so.

Another issue that Ms Lautenschläger raised was that there were strong divergences in the degree to which individual banks currently benefit from transitional adjustments in their CET1 calculation. She added that the drivers of such divergences will be carefully examined as will banks’ overall capital situation.

The European Commission is required to publish a report by 31 December 2015, and every three years after that, on the application of the SSM Framework Regulation. The report will evaluate, among other things:

• the functioning of the SSM and the impact of the ECB's supervisory activities on the interests of the EU as a whole;
• the division of tasks between the ECB and national competent authorities of participating member states;
• the interaction between the ECB and the European Banking Authority;
• the interaction between the ECB and national competent authorities of non-participating member states; and
• the possibility of further developing the SSM.

The ECB’s assumption of supervisory responsibilities is an important moment in EU banking regulation. The next 12 months will be critical for the ECB in which it must take forward its supervisory work initially armed with the information obtained from the comprehensive assessment. During this period the ECB will be evaluated and a report will be issued by the Commission setting out its successes and failures to meet its main objectives of ensuring the safety and soundness of the European banking system and increasing financial integration and stability.

As stated at the beginning, the SSM is one of the two pillars of the EU banking union, the other being the SRM which will be the subject of our next updater.