The European Central Bank (ECB) published the results of its Supervisory Review and Evaluation Process (SREP) for 2022, which provides an overall assessment of the challenges facing significant institutions, together with the corresponding capital requirements and other supervisory measures that banks are expected to comply with.
- SREP results show banks have solid capital and liquidity positions and increased profitability, with scores broadly unchanged
- Common equity tier one (CET1): weighted average of Pillar 2 requirements set at 1.1%, unchanged from last year
- CET1: weighted average of overall capital requirements and guidance in CET1 rise to 10.7%, up from 10.4%, reflecting impact of macroprudential policies
- Credit risk and internal governance remain key areas for supervisory action
The SREP was conducted amid deteriorating economic conditions and financial market dynamics following Russia’s invasion of Ukraine. Despite the outlook worsening throughout the year, rising interest rates led to improved profitability and capital generation. On average, banks maintained solid capital and liquidity positions, with the vast majority holding more capital than the levels dictated by capital requirements and guidance stemming from the previous SREP cycle. SREP scores have also remained broadly unchanged overall.
“Banks have done well in withstanding the economic impact of the Russian invasion of Ukraine, thanks to their strong capital and liquidity positions, increased profitability and continued improvement in asset quality,” said Andrea Enria, chair of the ECB’s Supervisory Board, in a statement. “However, challenges will remain as long as the war drags on, and the effects of rising interest rates warrant careful monitoring. Banks need to address persistent weaknesses, particularly in their risk control and governance frameworks, and to assess future developments in a prudent way”.
Year ahead
The weighted average of Pillar 2 requirements (P2R) set by the ECB for total capital remained in line with the requirements set out in previous years, at 2.0% of risk-weighted assets (RWA) after 1.9% in 2022. The P2R for CET1 also remained broadly unchanged for 2023, at 1.1%. Given that no single supervisory mechanism (SSM)-wide capital stress test was performed in 2022, Pillar 2 guidance (P2G) remained largely unchanged at an average of 1.3%.
The 2022 SREP resulted in P2R add-ons for non-performing exposures for 24 banks that fell short of ECB coverage expectations related to non performing loans (NPLs) granted before 26 April 2019. Institutions have been encouraged to close these gaps. The aggregate shortfall in NPL provisions amounted to 7 basis points of RWA at the end of the SREP cycle.
Banks that actively address the shortfall in their coverage compared with ECB expectations will be able to swiftly reduce the new add-on in the course of 2023, without having to wait for the next SREP assessment. A capital add-on was also included in the P2R for a few banks with very high exposures to leveraged transactions or highly deficient risk controls in this line of business.
For the first time, the ECB assessed the risk of excessive leverage in a SREP exercise. The aim was to identify banks that need to apply qualitative measures or P2R for the leverage ratio. The ECB issued qualitative measures for four banks as a result.
For the period ahead, the overall capital requirements and guidance have been increased, on average, to 15.0% of RWA, from 14.7% in the previous SREP cycle.
The average amount of overall capital requirements and guidance in CET1 increased to around 10.7% of RWA for 2023, up from 10.4% in 2022. At the end of the third quarter of 2022, the average amount of CET1 held by significant institutions totalled 14.7% of RWA.
The increase in overall capital requirements and guidance mostly reflects the impact of macroprudential policies set by national competent authorities. During 2022 several announced increases in countercyclical capital buffers and systemic risk buffers, applicable from the start of 2023, taking the average combined buffer requirement from 3.6% of RWA in the first quarter of 2022 to 3.8% of RWA in the first quarter of 2023.
2022 in review
The average overall SREP score in 2022 was broadly unchanged, with 92% of the banks covered receiving the same overall SREP score as in 2021.Half of the remaining 8% saw their score worsen.
The ECB imposed qualitative measures primarily in the areas of internal governance and credit risk. This is where supervisors looked at the broader quality of banks’ internal risk control frameworks and the effectiveness of banks’ management bodies, in line with the supervisory priorities set for the years 2022-24.
Findings on internal governance highlighted concerns about the effectiveness and composition of management bodies, their collective suitability and their oversight role. The main concerns in the area of risk management related to the fact that banks lack clarity about their risk appetite and have inadequate practices to assess and manage climate-related and environmental risk.
The ECB also found that many banks had insufficient resources across all their control functions (risk management, compliance and internal audit). At the same time, many banks had failed to sufficiently improve their capabilities in risk data aggregation and reporting. This in turn had a negative effect on data quality and the banks’ ability to produce non-standardized reports. Many IT landscapes continued to be fragmented and not harmonized, which impeded data aggregation and reporting.
The war in Ukraine had also led to an increase in operational and IT/cyber-related risks, pushing banks to tackle deficiencies in their outsourcing arrangements and in their IT security and cyber resilience frameworks.
Despite the continued reduction of NPLs, the credit risk scores of more than half of the banks involved were unchanged. Signs of latent credit risk emerged, with Stage 2 ratios and forbearance remaining above pre-pandemic levels, while Stage 2 coverage dropped below pre-pandemic levels for many banks. In 2022 scores were still underpinned by persisting risk control deficiencies, particularly in the area of loan classification and in the implementation of the EBA’s Guidelines on loan origination and monitoring.
The ECB introduced a number of initiatives in 2022 aimed at fostering banks’ response to medium-term structural transformations, such as the digitalization of the financial system and the transition to a green economy. These initiatives were designed to incorporate the thematic review on climate-related and environmental risk and climate stress test results in the SREP. The ECB also launched a knowledge-gathering project across the banking sector to monitor the adoption of digital transformation and the adaptation of business models.