Dentons

QuickTake: why this report matters

On March 14, 2019, the European Banking Authority (EBA) published1 its Annual Report on the Convergence of Supervisory Practices in the EU (the Convergence Report). Looking back at the progress made within the past three (or more in the context of the 2014 SREP Guidelines) years, it becomes somewhat easier to determine the overarching goals of the EBA and where these might lead to in the future. The EBA aims at fostering comparable supervisory approaches across the EU’s Single Market to ensure a level playing field, effective supervision of cross border groups and promoting supervisory best practices. For market participants, these goals are especially valuable in the context of structuring their operations across EU Member States. 

Supervisory convergence is comprised of three components: rules and their application (compliance), supervisory practices (comparability) and supervisory outcomes/measures (consistency). With supervisory convergence still being one of the primary supervisory priorities of the EBA’s “sister” European Supervisory Authorities (ESAs), i.e. ESMA and EIOPA, as well as of the European Central Bank (ECB) in its lead in the Banking Union’s Single Supervisory Mechanism (SSM), the outcomes set in the Convergence Report point to areas where the ESAs and the authorities in the SSM may continue to focus. As such, this Client Alert should be read in conjunction with coverage by our Eurozone Hub of ESMA’s 2019 Supervisory Convergence Work Programme2 as well as our “Navigating 2019” supervisory outlook publication3 as it adds to the non-exhaustive outline of supervisory priorities of various EU institutions and European Supervisory Authorities (ESA) for Banking Union Supervised Institutions and other regulated market participants. 

Looking back and ahead

Highlighting the EBA’s activities in 2018, the Convergence Report provides a summary of the EBA’s observations on the current state of convergence of supervisory practices. It focuses on the EBA's assessment of its tools on how to promote supervisory convergence but also the application of the supervisory review and evaluation process (SREP) as well as the operationalization of ongoing supervision, recovery and resolution at individual and group level. Overall the EBA concludes that good progress has been made on the implementation of the 2014 SREP Guidelines with a number of issues remaining such as challenges in converging capital adequacy assessments and determining institution-specific additional own funds requirements as well as the link between ongoing supervision, early intervention and resolution, for example. 

By way of summary, the 2018 assessment of the convergence of supervisory practices focuses on two main areas:

  • Convergence in ongoing supervision and the supervisory review and evaluation process: Most of the areas highlighted as in need of further work in the 2016 and 2017 assessments as reflected in the EBA’s policy work on Pillar 2 have led to the publication of the revised SREP Guidelines4 in 2018; and
  • Convergence in the continuum between ongoing supervision, recovery and resolution: This is a new consideration given the relatively new entry into force of the Bank Recovery and Resolution Directive (BRRD). More work remains to be done in the area to ensure that institutions who do not benefit from a waiver have developed a recovery plan. It is certainly conceivable that the Banking Union authorities, notably the ECB-SSM and Single Resolution Board will continue to act as these remain core supervisory priorities for 2019 through to 2021 for all types of Banking Union Supervised Institutions regardless of whether they are directly or indirectly supervised. The 2018 bilateral convergence visits also led to creating a more comprehensive view on how the BRRD framework applies to those firms in the SSM that are categorized as Less Significant Institutions (LSIs) and which are thus only indirectly supervised by the ECB in the SSM.

For 2019, the EBA aims to review the approach applied by competent authorities in monitoring and assessing the key supervisory topics with a focus on areas in which EBA policy products have recently been developed. In terms of core business, the development and application of the Single Rulebook remains at the forefront for the coming years as well, especially in light of the EBA’s regulatory work in relation to the endorsement of the “Banking” i.e. CRD V-CRR II-BRRD II package and the preparation for the implementation of the last elements of the Basel III framework. This is outlined further in the EBA’s 2019 Convergence plan.

EBA’s 2019 Convergence plan – setting a clear tone

Key topics identified for the 2019 convergence plan focus on four areas. 

a. Internal governance

After the financial crisis, internal governance has been a major point of attention of the regulators. The CRD reinforces the governance requirements for institutions and stresses the responsibility of the management body for sound governance arrangements. In 2019, the EBA aims to review the approach followed by the competent authorities to monitor and assess the adequacy and robustness of the institutions’ internal governance arrangements. As part of its plan, the EBA aims to examine the compliance of this approach with the revised EBA Guidelines on internal governance (EBA/GL/2017/11) and the EBA-ESMA joint Guidelines on the assessment of the suitability of members of management bodies and key function holders (EBA/GL/2017/12), both of which entered into force on June 30, 2018.

b. ICT risk and operational resilience

As a result of the increasing importance of ICT in the banking industry, the EBA has identified some recent trends, including the emergence of (new) cyber risks and increased potential for cybercrime and cyber terrorism; and the increasing reliance on outsourced ICT services and third-party products, often in the form of diverse packaged solutions resulting in manifold dependencies and potential constraints and new concentration risks.

With relation to these, in 2019, the EBA aims to review the approach followed by the competent authorities to monitor and assess the IT risk and operational resilience as well as to integrate the outcomes of this assessment into the overall SREP. In particular, the EBA will examine the compliance of this approach with the Guidelines on ICT risk assessment under the SREP.

c. Non-performing exposures

In 2019, the EBA aims to review the approach followed by the competent authorities to monitor and assess the reduction of NPLs in institutions’ balance sheets. The EBA plans to examine the level of compliance of this approach / the degree of preparation of the competent authorities to comply with the Guidelines on management of non-performing and forborne exposures.5

d. Use of benchmarking exercise for internal models

In 2016, the EBA published an Opinion on the implementation of the regulatory review of the internal ratings-based (IRB) approach.6 In 2019, the EBA assessment will review the approach followed by the competent authorities regarding the review of the IRB approach to evaluate the progresses made since the publication of the 2016 Opinion and the use of the outcomes of the 2018 benchmarking exercises, in particular for credit risk internal models, in order to assess the quality of the institutions’ internal approaches used for the calculation of own-funds requirements.

The EBA plans to fulfil these aims using the tools at its disposal, especially in light of the fact that achieving comparable supervisory practices across competent authorities that are based on compliance with the EU’s “Single Rulebook” for financial services is vital for achieving consistent regulatory and supervisory outcomes.  

EBA tools for pursuing supervisory convergence and its monitoring

The EBA’s tools promoting convergence are built around three main elements—regulatory and policy products; training; monitoring and assessment. The Single Rulebook is also aimed at aiding competent authorities via covering various aspects of supervisory work and is supported by a Q&A tool providing a common interpretation when needed. With regard to the latter category, by way of summary, the tools contained in there can be split into four main categories—college monitoring, peer reviews, desk-based reviews, staff reviews of supervisory practices (bilateral convergence visits). These in turn mean:

  • College monitoring – the college of supervisors play a role in the effective and consistent supervision of financial institutions across borders. The EBA monitors the colleges and has observed an improvement in their functioning over the years.
  • Peer reviews – these are reviews of competent authorities, conducted by the EBA on a regular basis. Reviews aim to assess the implementation and application of the EBA guidelines and technical standards.
  • Desk-based reviews – these combine the EBA stocktakes with open discussions in the EBA’s standing committees on different topics.
  • Staff reviews of supervisory practices (or bilateral convergence visits) contribute to the building of a common supervisory culture and the convergence in supervisory practices. They allow for more in-depth bilateral discussions with the authorities and thus support both the EBA and the national competent authorities. The 2018 bilateral convergence visits and discussions focused in particular on the recovery planning for LSIs, recovery planning, the application of early intervention measures, the approach used for the determination of failing or likely to fail (FoLTF) and the cooperation and exchange of information between competent authorities and resolution authorities. 

Generally, the report covers the EBA’s activities focused on promoting and supporting convergence, such as the SREP practices; the internal governance on specific aspects such as remuneration for example; the internal models; the continuum between ongoing supervision, recovery and resolution. 

Convergence in ongoing supervision and the supervisory review and evaluation process (SREP)

a. Status of the implementation of the SREP Guidelines

The EBA has set out the comprehensive common European SREP framework in its Guidelines on common procedures and methodologies for SREP.

In 2014, the viability scoring concept was introduced as an indication of the risk to the institution’s viability and its proximity to the point of non-viability. Although significantly improved and now increasingly incorporated into the authorities’ frameworks, challenges remain, especially concerning the procedural aspects and assessment criteria as well as the link with the actual determination of the ‘failing or likely to fail’ status of an institution.

i. Detailed observations on capital adequacy assessment

With regard to capital adequacy assessment and total SREP capital requirements (TSCR), the below areas are still found in need of further convergence:

  • Interplay between the TSCR and the restrictions on distributions. Here, the report is of the opinion that actual implementation takes time because of the legislative process to ensure the binding nature of the P2R.
  • The development of supervisory benchmarks to assess capital needs and determine institution-specific prudential requirements and to challenge banks’ internal capital adequacy assessment processes (ICAAPs). Here better progress is deemed to have been achieved, as some authorities have developed supervisory benchmarks for credit concentration risk, credit risk and IRRBB. 

The concept of P2G was introduced in the revised SREP Guidelines in 2018. The guidelines outline how competent authorities should establish and set P2G based on supervisory stress-test results. The setting of P2G is an area of focus for the EBA convergence work in 2019. 

ii. Link between SREP, early intervention and determination of failing or likely to fail

Increasing convergence is observed in the areas of implementation of viability scores that provide a link between the ongoing supervision under SREP and early intervention, recovery and resolution. However, some authorities have not yet fully implemented the EBA FoLTF Guidelines.7 Despite that, progress has been made in implementing the automated monitoring of key risk indicators and organizing crisis simulation exercises to test communication lines in case an institution would be considered to be ‘failing’.

b. Focus on specific SREP element: business model analysis

The implementation of the business model analysis (BMA) component of the common SREP framework remains a point of particular attention for the EBA. Introduced in 2014 by the SREP Guidelines, the BMA is one of the main SREP elements requiring competent authorities to form supervisory views on business and strategic risks by assessing the institution’s business model viability and sustainability. BMA is also important for embedding a forward-looking perspective on supervisory work. In 2017, the common approach to BMA was broadly implemented by competent authorities in their methodologies and practices despite some differences observed in the approaches adopted. 

c. Branch supervision

In 2017, the EBA published its own-initiative Guidelines on the supervision of significant branches,8 aiming to facilitate cooperation and coordination between competent authorities involved in the prudential supervision of significant branches of EU institutions established in another Member State. These guidelines apply from January 1, 2018 and focus on the largest and systemically important branches, so-called ‘significant-plus’ branches, requiring intensified supervision.

To gauge whether a branch which is considered significant in accordance with Article 52 of Directive 2013/36/EU would also be considered ‘significant-plus’, competent authorities are encouraged to carry out a common assessment and endeavour to reach a common conclusion on its outcomes. 

d. Passport notifications

One of the goals of the Capital Requirements Directive IV (CRD IV) is to ensure the observance of the right of establishment and the freedom to provide services for credit institutions within the EU. Thus, the EBA is mandated to develop regulatory technical standards (RTS) and implement technical standards (ITS) to establish forms, templates and procedures for such notifications in accordance with Articles 35, 36 and 39 of the CRD.

In 2018, a peer review assessed the competent authorities’ compliance with the RTS. It revealed globally developed consistent and robust passporting processes to comply with said requirements but also showed inconsistencies in practices related to the cooperation between competent authorities when dealing with branch or services passport notifications.  Competent authorities were also given the chance to raise their concerns in relation to the RTS and ITS.

Some competent authorities considered that further clarifications should be introduced to reflect better the interlinkages between the RTS and the ITS with other pieces of legislation dealing with passporting (e.g. the Markets in Financial Instruments Directive II, the Payments Services Directive and the Mortgage Credit Directive). While a viable comment, it cannot be denied that the EBA is usually very diligent when it comes to updating its documents in line with the current developments, with most recently Brexit developments being a case in point. 

e. Benchmarking exercises for internal models

This concerns an exercise for credit and market risk models, in accordance with Article 78 of the CRD. The article requires that (i) competent authorities conduct an annual assessment of the quality of internal models and (ii) the EBA produces reports to assist competent authorities in this assessment. The exercise covers the entire population of institutions authorized to use internal models for calculating own funds requirements. The EBA publishes two horizontal reports on the outcomes of the yearly benchmarking exercises—one with respect to credit risk and one for market risk. The 2018 reports outline the outcomes of the analyses on benchmarks for both low default portfolios (LDPs) and high default portfolios (HDPs), as well as for market risk.

Convergence in the continuum between ongoing supervision, recovery and resolution

As a foreword, the EBA stresses that SREP is considered a fundamental element in this convergence stream.

a. Recovery planning for less significant institutions – approach to simplified obligations and assessment of the LSI’s recovery plans

In mid-2017, half of the competent and resolution authorities had granted simplified obligations or waivers to institutions under their jurisdictions. The eligibility assessment for simplified obligations showed a significant variation in practices across the EU. The EBA has addressed these divergences in the final draft of the EBA RTS on simplified obligations.9

The EBA observed the development of comprehensive internal procedures on simplified obligations; however, some competent authorities have not imposed uniform requirements on institutions under the simplified obligations regime because of the diversity of the LSI population in their jurisdiction.

Competent authorities rely on the BRRD and the relevant EBA products such as the Supervisory Handbook module on the assessment of recovery plans and its template for the assessment of recovery plans. 

b.Selection and calibration of recovery indications

A recovery plan should be activated in a timely manner. As such, institutions should have a set of quantitative and qualitative indicators to reflect adequately the size and complexity of the bank so they can monitor risks properly. The competent authorities must examine indicators when assessing recovery plans. “Regarding the calibration of the recovery indicators, which is also a focal point for competent authorities, the EBA has detected that the thresholds applied are sometimes too low, meaning that the institutions’ management would not have sufficient time to implement corrective actions.”

c.Application of early intervention measures

Competent authorities have identified triggers for the decision on whether or not to apply early intervention measures. These triggers are based on “(i) the scores supporting the outcomes of the assessment of various SREP elements and the overall SREP assessment or (ii) material deterioration in the key financial and non-financial indicators monitored by the competent authorities or (iii) significant events, in line with the EBA Guidelines on triggers for use of early intervention measures.” An escalation process is applied when triggers are breached, and then a further analysis is carried out to determine whether early intervention measures need to be applied or not.

d.Approach for determination of failing or likely to fail

The determination that an institution is FoLTF is necessary to start any resolution process. For the purpose of making this determination, the competent authorities and the resolution authorities might follow different practices. The EBA applauds as one of the best practices the development/implementation of comprehensive internal procedures. These procedures take into account the EBA FoLTF Guidelines and include specifications regarding the detailed circumstances of when an institution is FoLTF as well as operational aspects of the process to follow when determining that an institution is FoLTF. 

e.Cooperation and exchange of information between competent authorities and resolution authorities

The EBA is of the opinion that a close cooperation and exchange of information has been ensured between the competent authorities and the resolution authorities. Done on an ad hoc basis, it happens when the conditions for early intervention have been met or in the context of important decisions to be taken, such as decisions regarding early intervention measures or FoLTF determination for example. The EBA also observes that the resolution authorities were always provided with the recovery plan of each institution and had the opportunity to examine it in order to identify the recovery actions that may adversely impact the resolvability of the institutions. Regarding the formalization of the organizational provisions for the exchange of information, the EBA notices that some authorities have set up internal procedures or are already in the process of doing so.

Convergence in colleges of supervisory

The action plan for 2018 included key topics such as (i) NPL cleaning, (ii) business model and profitability, (iii) IT risk and operational resilience, (iv) internal governance, (v) Brexit, (vi) structural changes and (vii) IFRS 9. The EBA monitoring of the 2018 key topics shows that, in general, all of them have been taken into account in the college works in 2018.

For 2019, a convergence plan has been established to assess the degree of convergence in supervisory practices using key topics on which the EBA has recently developed guidelines. The ‘2019 EBA Colleges Action Plan’, which will be included in the 2018 EBA report on supervisory colleges, will refer to the ‘2019 Convergence Plan’.

EBA policy work supporting supervisory convergence

Evaluation in this area focuses on the following deliverables

i.Revision of the SREP Guidelines

The guidelines are applicable from January 1, 2019 and aim to further enhance convergence in the SREP process. The changes introduced aim to enhance the requirements for supervisory stress testing and explain how stress testing outcomes will be used in setting P2G. These include “(i) a section on P2G, (ii) supervisory stress testing requirements, (iii) guidance on the supervisory assessment of institutions’ stress testing, (iv) a clarification of the scoring framework, (v) an explanation of the interaction between the SREP elements and the articulation of TSCR and OCR and the communication of supervisory capital expectations to the institutions and (vi) consistency checks with relevant revised EBA standards and guidelines, in particular in the areas of internal governance and IRRBB.”

ii.Revision of the IRRBB Guidelines

IRRBB is an important financial risk for credit institutions that is considered under Pillar 2. The IRRBB Guidelines10 have been revised and published in July 2018. The supervisory framework assumes that banks develop their own methodologies and processes for identification, measurement, monitoring and control of this risk. The aim of the guidelines is to set out supervisory expectations regarding the management of IRRBB. 

Listed as main changes to the IRRBB Guidelines are: (i) the inclusion of high-level guidance for the monitoring of credit spread risk in the banking book, (ii) requirements for model validation, (iii) a number of changes to the existing supervisory outlier test including the removal of the zero bound floor and the inclusion of NPEs as general interest rate sensitive instruments, and (iv) the introduction of an ‘early warning signal’ in addition to the existing supervisory outlier test.

iii.Revision of the Guidelines on institutions’ stress testing11

These are applicable from January 1, 2019 and update the 2010 Committee of European Banking Supervisors (CEBS) guidelines on this topic. They aim to achieve convergence of the practices followed by institutions for stress testing across the EU. They reflect industry practices and the incorporation of recovery planning. 

iv.Revision of the Guidelines on internal governance

In 2017, the EBA published its revised Guidelines on internal governance.12 They aim to improve the status of the risk management function, enhancing the information flow between the risk management function and the management body and ensuring effective monitoring of risk governance by supervisors. 

The EBA is of the opinion that competent authorities should ensure that institutions comply with these guidelines on an individual, sub-consolidated and consolidated basis. The guidelines set out how competent authorities should establish effective and reliable mechanisms to enable institutions’ staff to report to competent authorities any relevant potential or actual breaches of regulatory requirements.  These EBA Guidelines in the Banking Union should be read in conjunction with rules of the ECB-SSM. 

v.Revision of the Guidelines on ‘fit and proper’

In September 2017, the EBA and ESMA published their joint Guidelines on the assessment of the suitability of members of the management body and key function holders (‘fit and proper’).13 As per the Guidelines, competent authorities are required to assess all members of the management body. For significant CRD-institutions, competent authorities should assess the heads of internal control functions and the chief financial officer (CFO), where they are not members of the management body. For significant CRD-institutions part of a group but not subject to prudential consolidation by a significant consolidating CRD-institution, this should be done at the highest level of consolidation and at the individual level, if the significant CRD institution is not part of a group. A description of these assessment procedures should be publicly available. Competent authorities should also provide each other any information they hold about a member of the management body or key function holder for the performance of a suitability.  These EBA Guidelines in the Banking Union should be read in conjunction with rules of the ECB-SSM.

vi.Revision on the Guidelines on outsourcing14

These guidelines are applicable to competent authorities across the EU, as well as to financial institutions. They set out specific provisions for the institutions’ governance framework with regard to their outsourcing arrangements. The aim is that competent authorities should be satisfied that they can supervise institutions effectively, including those outside the EU/EEA, and that institutions have ensured within the outsourcing arrangement that service providers are obliged to grant the competent authority and the institution audit and access rights. These EBA Guidelines in the Banking Union should be read in conjunction with rules of the ECB-SSM.

Outlook

While much of what the EBA is committing itself to do as part of its identified lessons learned from 2018 is of course welcome, past delivery timelines of what is already a full task list on the desks of the EBA have proven that market participants may want to consider timing and project delivery fallbacks so as to remain agile.  

As a number of the priorities discussed above impact not only on documented policies and procedures, including those that are refined, supplemented or amended by the ECB-SSM, but also possibly on documentation in place between market participants and/or their own counterparties, taking early action is recommendable, as is having contingency plans with staged (mutually agreed) fallbacks, to identify, mitigate and manage any adverse Brexit effects or any other operational continuity concerns. In summary, the EBA’s Convergence Report and Plan demonstrate a much more confident authority cooperating with its sister ESAs aiming to deliver on its supervisory priorities in respect of its “part” of the Single Rulebook as well as to coordinate that with the wider European System of Financial Supervision.


1. See here.
2. See here
3. Download the Guide here.
4. See 2018 Guidelines here
5. Full text here
6. Full text of the opinion here
7. See Guidelines here
8. See Guidelines here.
9. The RTS can be found here.
10. See Guidelines here
11. Full text here
12. See Guidelines here
13. Full text here
14. Full text here.

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