The banking union aims to restore confidence in the banking sector by ensuring that banks are subject to consistent prudential requirements, write Sarah Lane and Mark Kennedy.
The crisis that struck the European banking sector in 2009 prompted a variety of national approaches and responses. Such variety highlighted the weaknesses and interdependencies not only in individual banks and their national supervisory approaches, but inherent in the system that prevailed in Europe. The response of the European Commission (EC), European Central Bank (ECB) and member states was to create a banking union.
The concept dates back to 2012 but the banking union is now becoming a reality through the ongoing implementation of the single rule book, the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the European Deposit Insurance Scheme (EDIS). There is, of course, an element of uncertainty attached to the framework. No one can predict if confidence in the banking sector will be restored and whether cross-border spill-overs and contagion risk have in fact been reduced as intended. Against this backdrop, credit institutions and their boards must adapt their strategies to cope with a changed regulatory approach from both Europe and the national competent authorities (NCAs), accounting for the impact on operational risk and the risk appetite of each individual bank.
Single rule book
As the backbone of the banking union, the single rule book lays down the capital requirements for banks (Capital Requirements Directive IV and Capital Requirements Regulation); ensures better protection for depositors (the Deposit Guarantee Scheme); and regulates the prevention and management of bank failures (the Bank Recovery and Resolution Directive). These legal acts are at various stages of completion. The date of application of Capital Requirements Directive IV was 1 January 2014, with full implementation in line with the original EC proposal scheduled for 1 January 2019. The Deposit Guarantee Scheme was to be transposed by 3 July 2015, which 10 member states have done (not including Ireland). The implementation of the Bank Recovery and Resolution Directive, meanwhile, requires banks to document the means to wind financial institutions down in an orderly way. 16 member states have so far communicated to the EC full transposition measures, including Ireland in December 2015.
A common methodology for ongoing assessment
Since its implementation in November 2014, the SSM is responsible for the prudential supervision of all credit institutions (roughly 1,200 in all, according to the ECB) in participating member states and comprises the ECB and the NCAs. The SSM has developed a common methodology for the ongoing assessment of credit institutions’ risks, their governance arrangements and their capital and liquidity position including details of the Supervisory Review and Evaluation Process (SREP). The SSM strives to take adequate SREP decisions using a wide range of information from several sources. These include the credit institutions’ regular reports; Internal Capital Adequacy Assessment Processes (ICAAP) and Internal Liquidity Adequacy Assessment Processes (ILAAP); the institutions’ risk appetite; supervisory quantifications used to verify and challenge the credit institutions’ estimates; risk assessment outcomes including risk level and control assessments; the outcome of stress tests; and the supervisor’s overall risk priorities.
The Central Bank of Ireland’s Chief Economist, Gabriel Fagan, summarised the situation for Irish credit institutions in December 2015 at the second Sunday Business Post property summit: “With respect to new lending, the Central Bank and the SSM have a clear focus on the appropriateness of banks’ risk appetite with respect to new lending, and would review and challenge limits and metrics on a regular basis for appropriateness and monitoring purposes”.
Following implementation of the SSM, the focus moved to SRM which gives control of the management of the bank resolution to the Single Resolution Board (SRB) through use of the Single Resolution Fund (SRF). The SRM came into force on 1 January 2016, as agreed by the Inter-Governmental Agreement (IGA), to provide maximum legal certainty. The IGA was signed in May 2014 by representatives of all member states except Sweden and the United Kingdom. The signatories issued a declaration signalling that they would strive to complete the ratification process by such a time that would allow the SRM to be fully operational by 1 January 2016. The SRF will be progressively built up to a target level of €55 billion by 2024, and member states must provide an appropriate bridge financing mechanism until the SRF is built up. Work is ongoing in this regard.
European deposit insurance scheme
A common EDIS, as proposed in November 2015, is currently being debated in the European Parliament. It is intended to strengthen the banking union by improving bank depositor protection; reinforcing financial stability; and further reducing the link between banks and their sovereigns. The proposal is one of a number of steps set out in the Five Presidents’ Report entitled ‘Completing Europe’s Economic and Monetary Union’, which was published on 1 July 2015.
The EC’s EDIS proposal begins with a re-insurance approach, which would last for three years until 2020 after which it would become a progressively mutualised system known as “co-insurance”. By gradually increasing the share of risk that EDIS assumes to 100%, EDIS will fully insure national deposit guarantee schemes by 2024. This is the same year when the SRF and the requirements of the Deposit Guarantee Scheme Directive will be fully phased in. A European Deposit Insurance Fund would be created from the outset, financed directly by bank contributions; adjusted for risk; and managed by the existing Single Resolution Board (SRB). The EDIS proposals are being opposed by some countries, however – most notably by the German Finance Minister, Wolfgang Schäuble, who believes it does not have sufficient legal basis.
Elements of uncertainty
There is undoubtedly an element of uncertainty in the new framework as no one can predict how the SRB will handle an individual bank in crisis or the outcome of the ongoing EDIS debate. Some view European control of resolution as reducing the likelihood of a bailout for an individual credit institution and therefore, reducing the institution’s credit rating as the relative risk of the investment increases. However, ratings agencies also believe that increased regulation – through increased capital requirements – has improved banks’ financial statements, which may counteract the reduction in rating brought about by the SRM.
In this changing environment, it is important that banks incorporate the increasing regulatory requirements into not only their overall strategy, but also their risk management processes while maintaining a focus on sustainable business.
Operational risk, as well as sustainable profitability, will drive supervisory engagement this year as stated by Cyril Roux, the Central Bank of Ireland’s Deputy Governor of Financial Regulation, at the recent Banking and Payments Federation’s banking union conference.“Business model viability and sustainable profitability assessments will drive much of the supervisory engagement in the coming period as well as operational risk issues like IT and cyber risk,” he said.
Conclusion
The banking union aims to restore confidence in the banking sector by ensuring that banks are subject to consistent prudential requirements based not on location, but on business model, risk profile and governance arrangements. After the implementation of the single rulebook and SSM, and with the advent of SRM and EDIS, credit institutions are adapting to the full application of regulatory reform, which has resulted in a different style of supervisory approach from the Central Bank of Ireland.
2016 will be a challenging year for banks. It is important, however, to recognise that the boards and management teams that incorporate the changed supervisory landscape into not only their regulatory risk and operational processes, but into their strategic considerations also, will emerge as the strongest players in the new market.
Sarah Lane ACA is Director of Regulatory Assurance at Mazars. Mark Kennedy FCA is Managing Partner at Mazars.