The Single Supervisory Mechanism (SSM) is the arm of the European Central Bank (ECB) whose main aims are to:
- ensure the safety and soundness of the European banking system;
- increase financial integration and stability; and
- ensure consistent supervision.
In order to achieve the above aims, the supervisory priorities for 2021 are drawn from the key risks and vulnerabilities assessed in the banking sector. Due to the pandemic, the overall risk landscape has undergone a rapid change over the past number of months; therefore, the SSM has outlined four major areas of focus for 2021:
- Credit Risk Management
- Capital Strength
- Business Model Sustainability
Additional supervisory activities relating to medium and longer-term structural risks to European banks, beyond the COVID-19 pandemic, will be carried out. These activities include: (i) banks’ alignment with expectations set out in the ECB Guide on climate-related and environmental risks, (ii) prudential risks ensuing from money laundering, cyber and digitalisation risks and (iii) banks’ preparedness for the final stages of implementing Basel III.
1. Credit Risk
The COVID-19 pandemic crisis has triggered an extraordinary challenge across all sectors of the economy, affecting banking functions ─ particularly credit risk, with a direct correlation on banks’ asset quality. As assets credit quality further downgrades, an increase in distressed borrowers and impaired collateral values will likely materialise in the EU markets. Banks should be prepared to recognise and differentiate between: (i) temporary financial difficulties due to the pandemic versus (ii) credit deterioration which threatens the economy in the medium to long-term is essential. Therefore, it is important for banks to discern the two elements to provide a holistic approach to credit risk and in particular the implications on the design of specific scenarios for ICAAPs and Recovery Plans.
In this context, credit risk is considered one of the main challenges for the banking sector and supervisors over the coming months. It is imperative that banks have adequate and effective risk management practices in place to recognise, measure and alleviate the impact of credit risk, as well as the operational capacity to manage the expected increase in distressed borrowers.
2. Capital Strength
Banks’ capital ratios may be impaired due to the enhanced level of credit risk along with potential market adjustments. It is imperative that banks’ capital positions are maintained and bank-specific vulnerabilities are identified at an early stage, facilitating management specific actions or the potential deployment of pre-defined recovery options.
Recommendations to enhance banks capital planning, in the context of the frequent ICAAP and Recovery Planning activities are evident, therefore ensuring reliability in these frameworks is imperative for supervisors. At the forefront of this priority area is the planned HY2 2021 EU-wide stress test coordinated by the EBA, as it will assess and determine banks’ capital resilience and capital planning capabilities.
3. Business Model Sustainability
Banks’ business models have been evolving over time; however, the extremely low interest rate environment and the competition brought by the various challenger banks will pose an additional risk when questioning the viability of the traditional banking business model. Taking this impact into consideration, banks’ business model is an integral part of the Supervisory Review and Evaluation Process (SREP) and the assessment of banks’ business model sustainability will be a key focus activity of the SSM in 2021.
Strategic overhauls, such as the digitalisation of internal processes, have been significantly accelerated following the onslaught of the pandemic, posing challenges for some banks. As the scope of the banking market continues to shift, it is vital to restructure business models which are better fit for the future.
Internal governance plays a crucial role for banks to demonstrate they are adequately addressing the challenges stemming from the current crisis; to this extent, as outlined in our previous publication, the EBA is in the process of publishing the revised Guidelines on Internal Governance to capture the amendment of the fifth Capital Requirements Directive (‘CRD V’) and their implications for banks.
Notwithstanding the progress made in recent years, the COVID-19 pandemic has highlighted a number of pre-existing vulnerabilities in banks’ governance frameworks. This includes long-standing difficulties with risk data aggregation and accuracy of reporting, hampering the strategic decision making and the effective and timely monitoring of material risks during the pandemic (e.g. credit risk developments and capital projections).
What will be expected of banks?
Why Grant Thornton
Grant Thornton’s Financial Services Risk, Consulting and Advisory teams are comprised of dedicated experts who are experienced in supporting banks with these regulatory challenges outlined in the 2021 supervisory priorities.
In particular, our industry-leading Prudential Risk team understands that regulation continues to drive the strategic agenda for banks. They specialise in assisting clients across the financial services sector in navigating through the maze of regulation and support clients to identify regulatory obligations and work towards full compliance balanced with your business needs.