Credit risk

ECB lifts bank capital requirement amid credit risk and governance concerns

The European Central Bank (ECB) today published the results of its Supervisory Review and Evaluation Process (SREP) for 2021.

Findings from this annual assessment indicate that significant institutions have maintained strong capital and liquidity positions, with most banks operating at capital levels above those dictated by capital requirements and guidelines. Bank ratings remain broadly stable.

The results of the 2021 SREP cycle reflect both the resilience of the European banking sector, which has played an important role in the economic recovery of the euro zone, and the challenges ahead.

In particular, uncertainties remain about the future trajectory and evolution of the pandemic, with supply chain disruption currently weighing on trade and overall economic activity. There are also other risks on the horizon arising from a wide range of uncertainties, including the possibility of cyberattacks, climate-related risks, continued pressure on profitability and the possibility of a disruptive exit from the low interest rate environment.

The 2021 supervisory cycle marked a return to normal, following the pragmatic approach taken in 2020, when capital requirements remained stable due to the pandemic and supervisory concerns were addressed primarily through recommendations rather than requirements.

Therefore, the 2021 SREP cycle involved assessing banks’ capital, assigning SREP ratings to banks’ overall risk profiles and their main elements, and issuing formal decisions in addition to recommendations.

On average, banks have maintained strong capital and liquidity positions throughout the pandemic. Overall capital requirements and forecasts increased slightly for 2022, averaging around 15.1% of risk-weighted assets (RWA), compared to 14.9% in the 2020 SREP pragmatic assessment The average amount of aggregate capital requirements and CET1 forecasts increased to around 10.6% of RWA from 10.5%.

The marginal increase in total capital was driven by Pillar 2 (P2R) capital requirements, which increased to 2.3% from 2.1%. This is mainly due to the introduction of a specific requirement (a provisioning shortfall surcharge) imposed on banks that have not made sufficient provisions to cover the credit risk on non-performing loans (NPLs) granted before the April 26, 2019. Banks that close their provisioning shortfall relative to ECB expectations will be able to quickly reduce this new surcharge in the course of 2022 without waiting for the next SREP assessment.

Pillar 2 (P2G) guidance, which captures risks indicated by stress test results, rose 0.2 percentage points to 1.6% from 1.4%. Only six banks failed to meet their P2G at the end of 2021, and they did so due to structural issues predating the pandemic.

As part of the ECB relief measures, banks can fully utilize their capital buffers or P2G until the end of 2022. By January 1, 2023 – as stated in a separate press release – the ECB expects banks to operate above their P2G level.

“We are broadly satisfied with the way banks have operated so far during the pandemic. They have contributed to the resilience of the euro area economy and have continued to extend credit to households and businesses,” said Andrea Enria, Chair of the ECB’s Supervisory Board “However, the impact of the pandemic on the economy is not yet over. Banks need to remain aware of the possible consequences on their balance sheets and strengthen their frameworks risk control and governance in particular.

The 2021 SREP results show great stability in terms of scores. This is another sign of the resilience of the banking system, given that banks’ overall scores may well have deteriorated sharply during the pandemic.

In the 2021 cycle, credit risk and internal governance were the two main areas in terms of corrective measures requested from banks.

Supervisors have closely scrutinized the adequacy of institutions’ credit risk controls. Several banks were found to have insufficiently strong credit risk management practices, with some having inadequate provisioning processes. In these cases, the ECB lowered the credit risk ratings and demanded more follow-up action.

NPL inventories continued to decline, thanks in part to banks’ consistent implementation of NPL reduction and phase-out plans. Credit quality on banks’ balance sheets remained quite robust overall, partly thanks to exceptional public support measures. However, there are also some signs of deterioration in credit quality, particularly in the economic sectors that have benefited most from the support measures, and these developments will need to be watched carefully.

The findings in the area of ​​internal governance highlight the weak steering capacities of boards of directors and governance arrangements such as risk control frameworks. This can hamper risk management and compliance functions, as well as IT transformation plans, hampering the resolution of data aggregation issues. Many banks also need to take steps to improve the composition and collective fit of their governing bodies, as they continue to underemphasize diversity (e.g. in gender and professional expertise) . With this in mind, the ECB uses operational acts to compel banks to establish diversity policies and set gender-related targets.

At the same time, the evaluation of economic models shows that most banks still fail to generate returns above the cost of capital. Profitability recovered in 2021, but remains structurally weak overall. Supervisors’ concerns in this regard relate primarily to long-standing issues predating the pandemic, such as unsatisfactory strategic plans and/or inadequate execution of those plans.

The P2Rs applicable to individual banks in 2022 have been published on our website. Consent to the publication of this information has been obtained from all banks subject to a 2021 SREP decision.