Smart Supervisory Response is a must

By Matthew WESTON – Eurogroup Consulting

In November 2018, the European Banking Authority (EBA) published the results of its most extensive stress test performed on EU banks since 2009. None of the 48 CIBs tested failed to meet the minimum requirements (capital ratio above 5.5%). However, Italian banks and, more surprisingly, Barclays and Lloyds, were among the worst performers, due to their exposure to riskier credits and bad loans. According to the EBA the core equity capital ratio of the pool of tested banks fell by 395bps. Overall the health of European banks, compared to their US counterparts, remains worrying due to their credit risk problems previously stated but also lower profitability and cost discipline. As a result, the region’s banking index SX7P declined 20% in 2018. This was echoed by the ECB’s 2019 supervision priorities as its Single Supervisory Mechanism (SSM) defined the following themes as “high-level priority areas for 2019”: credit risk; risk management; activities comprising multiple risk dimensions. European CIBs’ poor intrinsic health relative to international competitive standards, combined with heightened European regulations that causes increased costs to comply, makes it all the more vital for them to prepare a new Smart Supervisory Response urbanized and industrial set-up across departments going forward.

Indeed, various factors call for short term potential remediation but also a medium-term strategic response to prudential supervision. A heavy and increasing ECB regulatory agenda has appeared around the Supervisory Review and Evaluation Process (SREP) components (e.g. risk appetite, risk identification, stress tests, capital planning) which induces numerous supervisor investigations within a tight timeframe. For example, a supervisor investigation on market risk components can require an average workload of 2,000 ECB man days which on average necessitates 6,000 man days internally for a bank. Also, the ECB’s TRIM (Targeted Review of Internal Models) is designed to assess whether the internal models currently used by banks comply with regulatory requirements and to determine whether they are reliable and comparable (e.g. calculating their Risk Weighted Assets). In addition, recent data regulations potentially steering in opposite directions (e.g. GDPR restraining B2C actors to access data whilst PSD2 allows more access to data for B2B banking) could increase the existing complexity. This intricate set of different regulations can prove treacherous and severe penalties could occur if supervisor responses are not prepared accordingly. Finally, banks are encountering an economic value added destruction threat, mainly due to an increase in capital requirements of impacted business lines due to regulatory shortcomings and Opex/Capex overrun to meet regulatory requirements. Many CIBs are overlooking these potential significant problems and could face a double penalty, as follows:

Regulatory Charges + Capex Increase = Double penalty

Regulatory Charges. Do not “do the right thing” (e.g regulatory compliance) and face additional regulatory charges / fines

Capex Increase. Do not “do it right” (e.g efficient supervisor response) and create Capex erosion, e.g. too many man days, to remediate the regulatory responses

Double penalty. According to estimations, due to net income being adversely impacted by these 2 factors, a bank’s Return on Equity could decrease by 25 – 75 bps.

CIBs should address this challenge through 3 levers across SREP items (recurring and non-recurring) and dimensions (e.g. geographies, business and functional lines):

  • Effectiveness (doing the right things): Positioning the ambition “bar” in terms of regulatory response (e.g. investigating convergence of concepts, optionality in regulatory response). Integration of “forward looking” value creation / risk metrics (revenue / liquidity / risk)
  • Efficiency (doing things right): Reducing complexity induced by ‘fragmentation’ across dimensions (e.g. geographies, business lines, IT, data etc.) and enforcing “smart governance” with an urbanized and industrial set-up. Containing direct Opex / Capex via legitimate optimization levers (e.g. non-disruptive and disruptive)
  • Fostering enablers: Raising full awareness on SREP stakes throughout the CIB organization (e.g. harsh penalties could be imposed). Empower people to remediate in an agile fashion (i.e. new ways of working, “auto-repair”) and plan for tomorrow (i.e. big and integrated forward-looking picture). Create the right set-up to manage their relationship with regulators regarding their compliance challenges.

Therefore an innovative Smart Supervisory Response, via the creation of a dedicated urbanized and industrial set-up and team with suitable talent across functions, is a must for European CIBs to avoid short term supervisory shocks whilst being able to strategically navigate regulations in the mid and long terms. A few CIBs, mainly non-European, have embraced this dedicated urbanized supervisory response and this has been proven successful so far.

EU-wide stress testing 2018, 2nd November 2018, eba.europa.eu

ECB Banking Supervision: SSM Supervisory Priorities 2019, 30th October 2018, www.bankingsupervision.europa.eu