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Banking Union: navigating through Europe’s shifting landscape of bank supervision

Banking and capital markets Print

In November 2014, banks across the Eurozone entered a new world. Barely recovered from the financial crisis, they found themselves answering to a new “tough but fair” supervisory regime: the Single Supervisory Mechanism (SSM). Led by the European Central Bank (ECB) from Frankfurt, the SSM was positioned as the “new sheriff in town,” remote from local influence and laser-focused on preserving the stability of Europe’s financial system.

Today, as the SSM regime beds in, it’s already clear that it is significantly more intrusive and impactful than Europe’s banks have historically experienced in their local markets. As they adjust to the new realities, banks are discovering that the SSM is not only creating unprecedented challenges — it’s also opening up new opportunities for differentiation and competitive advantage. 

A bumpy ride

How do you cut through the sometimes overwhelming array of regulations to achieve clarity? And zero in on those issues that really matter in practical terms? To build a stable platform for the future, it’s vital that you are able to prioritize your responses to the SSM.

Put simply, the transition to the SSM has not been an easy ride, and the industry’s adjustment is still taking place. While prior to the crisis banks were often seen as leaving their supervisors trailing with their riskier initiatives, it now appears that that the SSM is setting the supervisory pace, with many banks struggling to keep up. The drive to reduce NPLs is a case in point. Add to this the ongoing stream of new regulations, and it’s clear why the challenge of adapting to the SSM has been so significant for Europe’s banks.

A brief history of the Banking Union

However, banks are only one part of the new supervisory landscape, and it’s also important to have a clear view of developments on the ECB side. In fact, in recent years the ECB has been leading an impressive exercise in institution-building, scaling up into a respected and efficient pan-European bank supervisor in an extremely short timeframe. While challenges remain, the positive impacts are already clear, with the move to apply the same high standards across all Eurozone banks leading to improved trust in the quality of supervision and the stability of banks. 

As part of the changes it’s implemented, the SSM has already launched and established a number of instruments that are setting new standards for supervision globally. Together with the regular Stress Tests, the Supervisory Review and Evaluation Process (SREP) framework has become the cornerstone of banking supervision. The SSM’s other notable achievements include its Options and National Discretions (OND) harmonization initiative and recent guidance on NPLs. As banks absorb and address the flow of requirements and guidance, evidence across the industry is pointing to an improvement in solvency ratios.

Chart 1: Solvency ratios of directly-supervised ECB banks

In addition to the new supervisory framework, a new resolution mechanism has recently taken over as the European entity charged with preventing and addressing the solvency issues of problematic banks. The Single Resolution Mechanism (SRM) started operating at full mandate in January 2016 and, together with the new regulatory requirements, is here to stay as one of the main pillars of the Banking Union. Other initiatives include the more recent CRD 5/CRR 2 package, which is the latest in a series of regulations that have reshaped the industry’s management of risks. All of this shows that the “tsunami” of post-crisis regulations and changes is not yet over, although the end may soon be in sight.

Chart 2: Selected timeline

Looking beyond compliance

To do its job effectively, the management of any European bank — especially a significant one — will need a well-balanced view of the new supervisory environment, even before it starts worrying about the right business model. Even then, the business model itself will be thoroughly scrutinized as part of banking supervision — as we have recently seen in the SSM’s thematic review on governance.

However, as the initial shock of the new paradigm gradually subsides, banks now need to shift the focus back to their business. Directing too much attention towards coping with evolving regulatory requirements can cause management to get distracted from commercial realities, resulting in a loss of market share to challengers or competitors. Several industry indicators underline this point: the average cost-to-income ratio in Eurozone banks is above 65%, total NPLs amount to more than EUR900 bn [1], and interest rates have been close to zero. Such figures clearly reinforce the pressure on banks to review their business models and accelerate their efforts to tackle their legacy problem loans. 

The SSM’s agenda for this year emphasizes the assessment of profitability, as it continues to review banks’ business models and profitability drivers while also considering factors such as the impact of FinTechs and Brexit. Another major focus area is interest rate normalization, with the ECB running a Stress Test on interest rate risk in the banking book, focusing on interest rate shocks. Credit risk is becoming ever more prominent, as NPLs are a major drag in several major economies.

The ECB will follow up on its NPL guidance as it seeks to enforce NPL reduction plans and scrutinizes banks’ strategies and processes to reduce impairments. The review of internal models is a massive exercise already started by the ECB, focusing not only on credit risk but also on market risk, with all fair value instruments expected to be reviewed.

EY Banking Union Centre: helping you stay informed

Amid this fast-changing environment, EY Banking Union Centre is committed to helping you stay ahead and up-to-date on the most recent and relevant prudential matters in European banking. We are coordinating a network of regulatory experts and technical specialists across Europe who continually analyze and translate the Banking Union agenda. For more information, please read our series of viewpoints on key topics, closely aligned with the latest supervisory and regulatory priorities.

This new series of thought leadership articles supplements our already expanding series of initiatives aimed to build a Banking Union community, including our Banking Union conferences and quarterly client calls. We will soon launch more two-way initiatives as we look to increase the level of interactivity in the program. Stay tuned.

 

[1] Risk Dashboard Data as of Q4 2016, European Banking Authority, http://www.eba.europa.eu/documents/10180/1804996/EBA+Dashboard+-+Q4+2016.pdf