Response to consultation on guidelines for common procedures and methodologies for the supervisory review and evaluation process (SREP)
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• SREP’s proposed proportionate approach is adequate to adapt regulatory expectations to the complexity of institutions supervised
• SREP linkage to G-SII denominations for Category 1 institutions is also welcome to ensure consistency with other global regulatory expectations for systemic institutions
Potential Areas for Enhancement
• SREP proposed proportionate approach would benefit from a more explicit quantitative and qualitative criteria definitions for categories 2, 3 and 4 institutions that are consistent with those criteria elements used for category 1 selection (G-SII denomination criteria)
• Proposed quarterly frequency for indicator monitoring may fall short to spot potential weaknesses and emerging risks. An alternative solution is to regularly monitor market indicators on a more frequent basis to potentially identify idiosyncratic emerging risks that might require immediate supervisory attention. Examples of indicators that might be useful would include stock prices, CDS spreads, bond spreads, rating downgrades, etc.,
• SREP monitoring granularity of indicators needs to be specified (by business line, geography, legal entity or product type). Tracking indicators at the bank holding level might result in non-meaningful comparisons given multiple bank business models and idiosyncratic risk profiles.
• Proportionally is largely achieved through frequency of assessment. The guidelines should also clarify the depth of assessment as systems and controls will reflect the nature, scale and complexity of the institution
• Explicit integration of knowledge and understanding of business strategy, risk appetite and business plans into supervisory process is a positive development. List of drivers included in SREP guidelines to conduct BMA analysis is comprehensive.
• The concepts introduced in the BMA of viability vs. sustainability provide a sound framework to differentiate between supervisory short term priorities and longer term vulnerabilities
Potential Areas for Enhancement
• Business model analysis will benefit from adding the following considerations:
• Business and geographical diversification when assessing sustainability
• Incorporate measures that evaluate business risk-reward trade-offs such as risk-adjusted returns, RAROC, ROE through the cycle (after incorporating stress test results), etc.
• Reliability of business plan forecasts (back-testing of forecasting accuracy between projected estimates and actual financial numbers)
• Performance measures used by banks to evaluate success to ensure they incorporate a dimension of risk
• Operational and human talent metrics particularly those related to oversight functions and how they interrelate to business growth plans
• While business risks are considered as part of the business model analysis in SREP they are not explicitly considered as a risk in the proposed capital and liquidity assessments
• Some jurisdictions incorporate business risk as a Pillar 2 consideration
• Business risk is also be captured in forward looking stress tests when projecting pre-provision revenue under adverse conditions
• SREP proposed risk categories and sub-categories are generally comprehensive and consistent with other risk assessment supervisory approaches and industry practices
• Credit & Counterparty
• Market risk
• Operational risk
• Interest rate risk
Potential Areas for Enhancement
• EBA and other regulatory bodies should consider harmonizing risk taxonomies used for supervisory purposes (SREP, Basel, Comprehensive Assessment, Concurrent Stress Tests, capital buffers, etc.,). The lack of consistency in risk taxonomies might lead to:
• Double counting
• Investor confusion in interpretation of capital and liquidity adequacy metrics and buffers
• Lack of comparability across different capital and liquidity assessments (static vs. forward looking measures)
• Comparability of capital adequacy processes across jurisdictions, particularly relevant for banks with global operations
• Performance indicators should ideally be mapped to risk taxonomy used
• Risk categories not explicitly mentioned or considered in SREP guidelines include:
• Wrong way risk
• Sovereign
• Pension
• Insurance
• Business
• Interrelationships among risks
• Definitions of capital measures and buffers are in principle consistent with Basel III and largely consistent with capital and liquidity adequacy supervisory frameworks used in other jurisdictions such as the UK.
Potential Areas for Enhancement
• Over-reliance on supervisory benchmarks when ICAAP not deemed reliable has the risk of discouraging banks to improve their risk and capital management practices. In addition, depending on how supervisory benchmarks are constructed, they might not be granular or specific enough to capture bank idiosyncratic risks. SREP guidelines should provide more explicit standards in the area of construction and usage of supervisory benchmarks including detailed considerations around benchmarks applicability, granularity, weight relative to internal estimates, calibration and soundness.
• Supervisory ability to change confidence level and time horizon of risk estimates can discourage banks to develop their own internal risk and capital models. It might also contradict one of the intended principles of ICAAP, which allows banks to define their own level of model conservatism based as a function of their target rating levels. SREP guidelines that allow and promote the use of internal models, and that counterbalance such usage with strong model risk management standards, is an alternative solution.
• Not allowing for inter-risk diversification highly penalizes groups with global diversified operations. Furthermore, compliance with SREP assessments at the subsidiary standalone level might exacerbate the effects of ignoring diversification benefits. Understanding and measurement of inter-risk diversification at the holding company and across subsidiaries is important when setting risk appetite setting and capital allocation targets at banks with global operations.
• Providing further granularity of how own funds requirements add-ons will be calculated would be beneficial to understand capital requirement expectations, allow firms for proper capital calibration/planning and promote transparency of SREP standards:
a. Model add-on – uncertainty of model estimates can be evaluated through the following steps:
i. Model inventory impacting risk, capital and liquidity assessments which includes purpose, materiality, past performance, validation results and controls to allow for an evaluation of intrinsic and residual risks by model
ii. Uncertainty buffer calculations for medium or high risk residual models based upon factors such as sensitivity analysis, backtesting, performance monitoring and benchmarking results
Figure 2 – A&M Model Uncertainty Framework
b. Process and governance add-on - deficiencies of process and governance can be evaluated through the following steps:
i. Identify process and governance deficiencies including assignment of materiality and criticality of identified weaknesses
ii. Evaluate qualitatively potential impact of process / governance weaknesses in capital estimates through scenario analysis and business judgment overlay
Figure 3 – A&M Process and Governance Uncertainty Framework
c. Funding risk, including potential double counting of incorporating funding risks in forward looking stress tests (more adequate way of capturing funding risks relative to static capital measures)
• EBA and other regulatory bodies should consider harmonising capital buffer methodologies for static capital / liquidity adequacy measures and forward looking stress tests
• Static and forward looking capital adequacy measures being considered in the US, Europe and UK differ in implementation especially guidelines related to supervisory buffers and minimum post-stressed capital ratios
• The guidelines propose that the additional capital requirements should be binding requirements, always applied in additional to the CRD IV capital requirements. The guidelines do not however specify how the SREP add-ons will interact with the Capital Buffers and maximum distributable amounts (MDA). With the EU developing a sustainable market for Additional Tier 1 capital, the EBA should provide clarity in this area in order to allow sufficient transparency and investor protection.
• It would also be helpful if the EBA could provide information on whether the SREP add-ons will be incorporated into the hurdle rate of the ECB stress-tests going forward
Figure 4 – Comparing capital adequacy across jurisdictions
• RWA consistency is not addressed under SREP guidelines. Providing more detailed guidance in this area would be beneficial to understand capital requirement expectations, allow banks for proper capital calibration/planning and promote transparency of SREP standards.
• Transitional periods are adequate to allow for proper capital and liquidity planning
• The liquidity requirements introduce both firm specific and supervisory stress tests. This will be material undertaking for both firms and National Competent Authorities in many jurisdictions, so the EBA should carefully consider the appropriate transitional arrangements.
Q2. Do you agree with the proportionate approach to the application of the SREP to different categories of institutions? (Title 2)
Positive Feedback• SREP’s proposed proportionate approach is adequate to adapt regulatory expectations to the complexity of institutions supervised
• SREP linkage to G-SII denominations for Category 1 institutions is also welcome to ensure consistency with other global regulatory expectations for systemic institutions
Potential Areas for Enhancement
• SREP proposed proportionate approach would benefit from a more explicit quantitative and qualitative criteria definitions for categories 2, 3 and 4 institutions that are consistent with those criteria elements used for category 1 selection (G-SII denomination criteria)
• Proposed quarterly frequency for indicator monitoring may fall short to spot potential weaknesses and emerging risks. An alternative solution is to regularly monitor market indicators on a more frequent basis to potentially identify idiosyncratic emerging risks that might require immediate supervisory attention. Examples of indicators that might be useful would include stock prices, CDS spreads, bond spreads, rating downgrades, etc.,
• SREP monitoring granularity of indicators needs to be specified (by business line, geography, legal entity or product type). Tracking indicators at the bank holding level might result in non-meaningful comparisons given multiple bank business models and idiosyncratic risk profiles.
• Proportionally is largely achieved through frequency of assessment. The guidelines should also clarify the depth of assessment as systems and controls will reflect the nature, scale and complexity of the institution
Q3. Are there other drivers of business model / strategy success and failure that you believe competent authorities should consider when conducting the BMA? (Title 4)
Positive Feedback• Explicit integration of knowledge and understanding of business strategy, risk appetite and business plans into supervisory process is a positive development. List of drivers included in SREP guidelines to conduct BMA analysis is comprehensive.
• The concepts introduced in the BMA of viability vs. sustainability provide a sound framework to differentiate between supervisory short term priorities and longer term vulnerabilities
Potential Areas for Enhancement
• Business model analysis will benefit from adding the following considerations:
• Business and geographical diversification when assessing sustainability
• Incorporate measures that evaluate business risk-reward trade-offs such as risk-adjusted returns, RAROC, ROE through the cycle (after incorporating stress test results), etc.
• Reliability of business plan forecasts (back-testing of forecasting accuracy between projected estimates and actual financial numbers)
• Performance measures used by banks to evaluate success to ensure they incorporate a dimension of risk
• Operational and human talent metrics particularly those related to oversight functions and how they interrelate to business growth plans
• While business risks are considered as part of the business model analysis in SREP they are not explicitly considered as a risk in the proposed capital and liquidity assessments
• Some jurisdictions incorporate business risk as a Pillar 2 consideration
• Business risk is also be captured in forward looking stress tests when projecting pre-provision revenue under adverse conditions
Q4. Does the breakdown of risk categories and sub-categories proposed provide appropriate coverage and scope for conducting supervisory risk assessments? (Title 6)
Positive Feedback• SREP proposed risk categories and sub-categories are generally comprehensive and consistent with other risk assessment supervisory approaches and industry practices
• Credit & Counterparty
• Market risk
• Operational risk
• Interest rate risk
Potential Areas for Enhancement
• EBA and other regulatory bodies should consider harmonizing risk taxonomies used for supervisory purposes (SREP, Basel, Comprehensive Assessment, Concurrent Stress Tests, capital buffers, etc.,). The lack of consistency in risk taxonomies might lead to:
• Double counting
• Investor confusion in interpretation of capital and liquidity adequacy metrics and buffers
• Lack of comparability across different capital and liquidity assessments (static vs. forward looking measures)
• Comparability of capital adequacy processes across jurisdictions, particularly relevant for banks with global operations
• Performance indicators should ideally be mapped to risk taxonomy used
• Risk categories not explicitly mentioned or considered in SREP guidelines include:
• Wrong way risk
• Sovereign
• Pension
• Insurance
• Business
• Interrelationships among risks
Q5. Do you agree with the use of a standard approach for the articulation of additional own funds requirements to be used by compete authorities across the Union? (Title 7)
Positive Feedback• Definitions of capital measures and buffers are in principle consistent with Basel III and largely consistent with capital and liquidity adequacy supervisory frameworks used in other jurisdictions such as the UK.
Potential Areas for Enhancement
• Over-reliance on supervisory benchmarks when ICAAP not deemed reliable has the risk of discouraging banks to improve their risk and capital management practices. In addition, depending on how supervisory benchmarks are constructed, they might not be granular or specific enough to capture bank idiosyncratic risks. SREP guidelines should provide more explicit standards in the area of construction and usage of supervisory benchmarks including detailed considerations around benchmarks applicability, granularity, weight relative to internal estimates, calibration and soundness.
• Supervisory ability to change confidence level and time horizon of risk estimates can discourage banks to develop their own internal risk and capital models. It might also contradict one of the intended principles of ICAAP, which allows banks to define their own level of model conservatism based as a function of their target rating levels. SREP guidelines that allow and promote the use of internal models, and that counterbalance such usage with strong model risk management standards, is an alternative solution.
• Not allowing for inter-risk diversification highly penalizes groups with global diversified operations. Furthermore, compliance with SREP assessments at the subsidiary standalone level might exacerbate the effects of ignoring diversification benefits. Understanding and measurement of inter-risk diversification at the holding company and across subsidiaries is important when setting risk appetite setting and capital allocation targets at banks with global operations.
• Providing further granularity of how own funds requirements add-ons will be calculated would be beneficial to understand capital requirement expectations, allow firms for proper capital calibration/planning and promote transparency of SREP standards:
a. Model add-on – uncertainty of model estimates can be evaluated through the following steps:
i. Model inventory impacting risk, capital and liquidity assessments which includes purpose, materiality, past performance, validation results and controls to allow for an evaluation of intrinsic and residual risks by model
ii. Uncertainty buffer calculations for medium or high risk residual models based upon factors such as sensitivity analysis, backtesting, performance monitoring and benchmarking results
Figure 2 – A&M Model Uncertainty Framework
b. Process and governance add-on - deficiencies of process and governance can be evaluated through the following steps:
i. Identify process and governance deficiencies including assignment of materiality and criticality of identified weaknesses
ii. Evaluate qualitatively potential impact of process / governance weaknesses in capital estimates through scenario analysis and business judgment overlay
Figure 3 – A&M Process and Governance Uncertainty Framework
c. Funding risk, including potential double counting of incorporating funding risks in forward looking stress tests (more adequate way of capturing funding risks relative to static capital measures)
• EBA and other regulatory bodies should consider harmonising capital buffer methodologies for static capital / liquidity adequacy measures and forward looking stress tests
• Static and forward looking capital adequacy measures being considered in the US, Europe and UK differ in implementation especially guidelines related to supervisory buffers and minimum post-stressed capital ratios
• The guidelines propose that the additional capital requirements should be binding requirements, always applied in additional to the CRD IV capital requirements. The guidelines do not however specify how the SREP add-ons will interact with the Capital Buffers and maximum distributable amounts (MDA). With the EU developing a sustainable market for Additional Tier 1 capital, the EBA should provide clarity in this area in order to allow sufficient transparency and investor protection.
• It would also be helpful if the EBA could provide information on whether the SREP add-ons will be incorporated into the hurdle rate of the ECB stress-tests going forward
Figure 4 – Comparing capital adequacy across jurisdictions
• RWA consistency is not addressed under SREP guidelines. Providing more detailed guidance in this area would be beneficial to understand capital requirement expectations, allow banks for proper capital calibration/planning and promote transparency of SREP standards.
Q6. Do you agree that competent authorities should be granted additional transition periods for meeting certain capital and liquidity provisions in the guidelines (Title 12)?
Positive Feedback• Transitional periods are adequate to allow for proper capital and liquidity planning
• The liquidity requirements introduce both firm specific and supervisory stress tests. This will be material undertaking for both firms and National Competent Authorities in many jurisdictions, so the EBA should carefully consider the appropriate transitional arrangements.
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