Despite improvements in the SREP process, Single Supervisory Mechanism banks face a rapidly evolving capital challenge.
As predicted, 2017's SREP was the most transparent and risk sensitive so far. The calculation of Pillar 2 Requirement is becoming clearer, even if the banks see room for further improvement. In contrast, banks still see the determination of Pillar 2 Guidance as a `black box'. At a time when demands on Pillar 1 and Pillar 2 are growing, this opacity poses an increasing challenge for capital planning and investor communication.
Recent developments appear to confirm these expectations. For example:
Even so, many banks feel they are still a long way from a clear understanding of how the SREP affects their capital planning activities.
On the upside, there is no question that the transparency and risk sensitivity of the Pillar 2 Requirement (P2R) continues to improve - even if some banks feel the link with the ECB's supervisory measures could still be made clearer. More specifically:
On the downside, many banks feel that the calculation of non-binding Pillar 2 Guidance (P2G) is opaque. Our SREP survey did not detect any obvious pattern for P2G based on banks' sizes, business models or home markets. Quantitative stress tests also appear to have a limited impact on P2G - similar to the findings of our 2016 SREP survey. That contrasts with the EBA's consultation on revised SREP guidelines.
In short, the determination of P2G appears to remain a `black box' process dominated by supervisory discretion. Furthermore, while P2G is not legally binding, the ECB's expectation that banks will operate above this level means it is de facto mandatory. In effect, P2G is therefore a confidential capital target that banks cannot disclose to investors or other external stakeholders.
This combination of P2R transparency and P2G opacity will make it hard for banks to carry out internal capital planning, let alone to explain to investors how their capital is being put to use or project funds are being allocated. The picture is further complicated by the different capital buffers, the growing number of measures and supervisory expectations affecting Pillar 1 and Pillar 2. Some notable examples include Basel IV where for example, it is unclear how changes of the Pillar 1 requirements in Operational risks will be reflected by ECB's Pillar 2 requirements, Non-performing loans (link to be included), Resolution planning, internal governance or leveraged transactions.
Despite the improvements in the SREP process, it is clear that SSM banks face a rapidly evolving capital challenge.