Understanding and preparing for the new flexible and more risk-based SREP approach

According to the EG, the existing SREP methodology aims at assessing many risk areas in detail each year, without clear prioritisation. However, the ECB recently introduced the concept of the multi-year assessment (MYA) and the risk tolerance framework (RTF).

The use of the MYA allows supervisors greater flexibility, enabling them to focus the SREP assessment on specific risks which are deemed material to each institution. In essence, this allows the ECB to better allocate resources to strategic priorities and critical vulnerabilities (i.e. some SREP modules may not necessarily be reviewed every year, allowing the ECB to dedicate resources and focus to higher risks).

To support the application of the MYA, the regulators will expand the use of the supervisory RTF. The RTF allows the ECB to understand and assess the materiality of risks for each institution, which in turn will drive supervisory activities and focus through the MYA.

The materiality assessment considers a number of factors such as: business model, market and competitive environment, and culture. This assessment allows for a more risk-focused supervisory culture that is tailored to each bank being supervised (as opposed to a ‘one-size-fits-all’ methodology).

The RTF is designed to enable the translation of the ECB’s supervisory prioritiesOpens in a new window into strategic planning, and day-to-day supervision by combining top-down guidance (issued by the Supervisory Board) with relevant bottom-up assessments for each individual bank.

With this approach, the ECB will continue to assess banks’ risks in a holistic manner whilst providing supervisory teams with greater flexibility to focus on material risks, which can vary year-on-year and from institution to institution.

• Focus on specific SREP modules each year (while spreading the supervisory assessments throughout the year) means that material risks (as perceived by the supervisors) are likely to receive additional scrutiny.
• Conversely, less material risks may not receive as much intensive review every year.

To ensure a more efficient and streamlined review process, the ECB will adopt a flexible risk assessment system (RAS).

The RAS affords supervisors more flexibility in conducting the review of certain SREP modules that are independent from financial data (e.g. business model, internal governance). These reviews and evaluations can now be performed throughout the year, at the discretion of the Joint Supervisory Team (JST).

In tandem with the objective of streamlining the SREP exercise, the ECB has also noted that proportionality will be increasingly applied to the overall process and, in particular, where [supervisory] risk assessments show no material change in the institution’s risk profile, SREP decisions can be updated every two years (under certain conditions)².

In addition, the ECB aims at implementing a more concise and clear decision making process (focusing on key supervisory concerns), which includes the leveraging of supervisory IT and analytical tools to transform and optimise the exercise (e.g. simplify ECB’s internal reporting for smaller banks, enabling a quicker turnaround).

Overall, this will enable the ECB to become more flexible and efficient in disbursing its supervisory duties.

• Banks with stable and sustainable business models, with appropriate level of controls could see SREP decisions being updated every two years.
• Smaller banks may see an increased benefit from the application of proportionality.
• Quicker turnaround processes could require that banks are appropriately prepared and resourced to ensure the delivery of potential supervisory measures.

The ECB is in the process of reviewing their supervisory methodology , in particular relating to the Pillar 2 Requirement (P2R). The overall aim is to ensure that the methodology to assign P2R is simpler and more transparent.

Having said that, the P2R will continue to be a key component of the SREP assessment and is not expected to be fully implemented until the 2026 SREP cycle.

Given that the ECB is still in the process of reviewing the potential changes to the supervisory methodology, implications are still unknown.

However, it is noted two elements of the EG report that could have an impact on banks across the EU.

Consideration 1: Greater focus on qualitative measures

The EG report highlights that the SREP has a perceived bias towards quantitative measures (i.e. capital add-on / P2R). This is understandable given that the SREP was designed at a time when banks needed to increase their capital. However, due to the current capitalisation profile of European banks, the focus on capital add-ons may not be as suitable as it once was.

To that effect, the EG recommended that the SREP methodology be reviewed to ensure a greater focus on qualitative outcomes, ensuring that these have a stronger link to the determination of the overall SREP score. 

The potential implications for institutions could be:

• Institutions with unaddressed weaknesses (or repeat issues) in areas such as business models and internal governance could see a worse SREP score.
• Conversely, those institutions taking the initiative to address issues as they arise may see a reduction in SREP scores.
  

Overall, if adopted by the ECB, this recommendation would see qualitative outcomes being more relevant in the determination of the SREP score.

Consideration 2: Less focus on banks’ ICAAP

The ECB currently determines the P2R based on a combination of a ‘holistic approach’ (i.e. overall risk assessment of the bank) and a risk-by-risk approach, which is largely derived from banks’ ICAAPs. The EG report notes that this methodology is “conceptually weak as it mixes two mutually incompatible approaches and makes the process operationally complex”³.

The EG’s recommendation is for the ECB to choose either the holistic approach or the risk-by-risk approach (albeit without placing too much reliance on banks’ ICAAPs). 

The EG also suggests the focus to be on risks that are not sufficiently covered by Pillar 1 requirements (e.g. IRRBB, concentration risk, CSRBB, etc.), which currently do not play a significant part in the SREP score determination.

The potential implications for institutions could be:

• Banks’ ICAAPs may play a less significant component in the determination of the SREP scores if the ECB adopts a purely holistic approach.
• A more risk-by-risk approach could see a higher proportion of P2R being allocated to idiosyncratic risks.
  
• Regardless of the approach chosen, the ICAAP may play a less significant part in the determination of SREP scores in the future. However, the ECB is likely to expect that the ICAAPs (and ILAAPs) will continue to be a rigorous and comprehensive exercise.

It is important to note that the ECB is likely to ensure that any perceived diminished usability of the ICAAP from a SREP perspective does not impact banks’ views of this prudential exercise. The ICAAP (and ILAAP) provides clear benefits as it fosters sound risk management and a higher degree of self-assessment, both of which the ECB would be likely keen to retain as part of banks’ ongoing risk management culture.