Implications of Covid-19 for the LSIs and the supervisory focus: an interview with Patrick Amis, ECB

On 19 January 2022, Mr Patrick Amis, the head of ECB Directorate General Specialised Institutions and Less Significant Institutions (DG/SPL) had a formal meeting with Mazars to discuss the implications of the pandemic for the LSIs and the supervisory focus. The main risks outlined by Mr Amis, were in the areas of NPLs, digitalisation, IRRBB, compliance, AML and governance.

European banks showed great resilience during the pandemic, and this was confirmed by the EBA/ECB 2021 stress tests results. What have you observed for LSIs? Have LSIs shown the same level of resilience or did they fall victim of their credit and/or operational vulnerabilities?

In broad terms, we have observed similar trends across the SI and LSI sectors over the course of the pandemic, with its impact on aggregate capital levels and core metrics of credit risk remaining notably moderate to date. In 75% of the SSM Member States, the aggregate NPL ratio for LSIs as of June 2021 was lower than it was as of December 2019, i.e. immediately before the pandemic, with increases in the remaining Member States being mostly negligible. Nevertheless, caution in monitoring and managing credit risk remains strongly warranted from our perspective and potential deterioration of asset quality going forward cannot be ruled out. This also implies that it remains imperative to pay close attention to banks’ asset classification and measurement practices, not only in the context of prudential reporting and risk management, but also in preparation and audits of financial statements.

Over the course of the pandemic, LSIs’ use of support measures has generally been lower than that of SIs in relative terms: the share of LSI loans subject to EBA-compliant moratoria has reduced from above 1.5% in the early phase of the pandemic to below 0.5% in the second half of 2021, persistently standing at about half the value observed for SIs, while the share of LSI loans subject to public guarantee schemes (just above 1% at the peak observed to date) has been moving at about a third of the SI level. Cross-country patterns in this regard have been consistent across SIs and LSIs.

Beneath the aggregate trends we have of course seen individual outlier LSIs on both ends of the spectrum – i.e. some that have been weathering the pandemic exceptionally well and others facing severe challenges. This is hardly a surprise given the sheer number of LSIs and their diversity in terms of size and business segments they operate in.

Is the ECB concerned about the less diversified business models of LSIs, especially in the context of their profitability?

Business models centred around traditional lending activities with a strong reliance on net interest margin as a source of income have obviously come under pressure in the low interest rate environment of the recent past, often exacerbated by low cost-efficiency and fierce competition. Those challenges continue to pose a concern from our perspective as supervisors. We have to recognise, however, that not every attempt at diversification ends in success, given that it implies entering new markets and taking on new risks. For that reason, we do not see diversification as superior to good customer selection and/or operating cost reduction as a way of improving long-term profitability. This may come in the form of purely internal effort or as a consequence of consolidation, and we have seen many successful examples. Technological change is another important factor in this context and the ability to adapt to it will surely become a key determinant of the medium-term prospects of numerous LSIs. 

Finally, we have also observed different niche business models in the LSI sphere that have continued to exhibit persistent high profitability over the last years, which suggests that, looking at the LSI population as a whole, diversity might actually be somewhat higher than commonly perceived.

The ECB’s supervision of LSI consists of different approaches between LSIs considered to be high priority (HP) against those LSIs that are not. What are the main elements that are considered when classifying a LSI as HP? What are the major differences between HP and non-HP LSI in terms of supervision?

For the purposes of ECB’s LSI oversight, the priority assigned to individual institutions is based on ‘impact’ and ‘risk’ criteria.  The former take into account size, importance for the national economy, business model, cross-border activities and whether the institution is potentially significant, while the latter factor in breaches of regulatory requirements, SREP scores and critical developments.  The oversight priority of an LSI as determined based on these factors influences not only the frequency and detail of institution-specific information which National Competent Authorities (NCAs) are required to report and notify to the ECB, but also the frequency and depth of supervisory processes such as the SREP as prescribed by harmonised SSM methodologies. Further detail on the classification of LSIs including a list of high-impact LSIs will be made available via the upcoming edition of the ECB’s Annual Report on Supervisory Activities.

What kind of flexibility might be given to NCAs, in terms of implementation, where the ECB’s guidance for SIs is extended to LSIs? Could there be a situation where NCA might object to ECB guidance?

The ECB is responsible for the functioning of the entire Single Supervisory Mechanism. Our task in the oversight of LSIs is therefore to ensure the consistency of supervision, both across and within the SSM countries, while respecting the proportionality principle. The striving for consistency is also reflected in the SSM practice of using the policies applied to SIs as a starting point for LSI policy discussions.

Proportionality is equally important and we achieve it by making supervisory activities less intensive for smaller, less complex and less risky institutions. This is true for both, SIs and LSIs, as well as different types of supervisory activities like offsite and onsite supervision. For example, in planning their on-site inspections, ECB and NCAs take those characteristics of the institutions into account when deciding on the scope, intensity and frequency of inspections.

Finally, regarding ECB guidance related to LSIs, while our policy documents are normally non-binding, decision-making on any SI and LSI policy initiative takes place in the Supervisory Board where the standpoints of all NCAs are represented. The preceding policy development process is also collaborative, often relying on working groups and other discussion fora in which all NCAs, or a subset comprising those for whom the issue at hand is most relevant, participate. These working modalities usually ensure high levels of buy-in, as experienced on projects such as the development of the LSI SREP Methodology.  

As far as the handling of individual LSI cases is concerned, NCAs in their role as direct supervisors of course remain responsible for all decisions, with the exception of the granting and withdrawal of licenses and qualifying holding procedures, which are subject to formal ECB decision-making. Frequent interactions between the ECB and NCAs on problematic cases, including via formal but non-binding ECB opinions on draft supervisory decision for high priority LSIs, also serve to ensure a high level of alignment in this remit.

2022: supervisory priorities and regulations. Beyond the SSM priorities for SIs, what would the specific focus areas for LSIs be? Are sustainability and ESG risks constitute areas of concern for LSIs? The EBA recently updated its guidelines on management of IRRBB – is this still a matter of concern for the ECB in particular for LSIs?

Our work programme for LSI oversight in 2022 is aligned with the overall SSM supervisory priorities. Accordingly, credit risk, different aspects of business model sustainability, and governance will remain key focus areas in which we will run joint initiatives with NCAs. Concerning the latter we aim to finalise a thematic review of LSI governance arrangements, focusing on the composition and functioning of the management body in its supervisory function and oversight on internal control functions of LSIs.

As far as ESG risks are concerned we envisage, together with the NCAs, targeted involvement of some LSIs in broader SSM exercises on climate risk and will analyse findings from additional initiatives run at national level. And of course, also IRRBB does continue to constitute an important risk from our perspective which we will keep monitoring for both SIs and LSIs via regular analysis.

What will be the next publications relevant to LSIs?

The ECB Annual Report on Supervisory Activities will be published in March, and, as usual, will contain a section on the indirect supervision of LSIs, where we will provide an update on the main trends among LSIs, as well as on the main supervisory activities.

Going forward we aim to further increase transparency on the work of the ECB and national authorities in this remit.

Are EU co-legislators planning to go further in terms of proportionality in prudential requirements for smaller banks in the 2021 banking package?

As you know, in June 2021, the EBA produced an array of recommendations aimed at reducing the reporting cost for Small and Non-Complex Institutions in particular, but not limited to them. Over the coming years, the EBA will implement those recommendations and the ECB has been included in this important project.

More generally, I would like to emphasise though that the SSM’s supervisory approach is already applying a significant degree of proportionality, also going beyond the obvious distinction between the supervisory approach for SIs and LSIs. Specifically for LSIs, this is structurally reflected in the use of concepts like the ‘Small and Non-Complex Institutions’ category and those applied in the abovementioned prioritisation of LSIs, which are key for operationalising the proportionality principle.

With the PRA applying a slightly different version of CRD5 in comparison with the EU following Brexit, and equivalence talks still a “work in progress”, how will the supervision of EU branches and subsidiaries of UK head-quartered banks be affected?

The assessment of the equivalence of a third country’s regulatory, supervisory and enforcement regime is the sole prerogative of the EU Commission, and hence this is outside the purview of the ECB. We will continue to monitor the developments in the UK carefully to assess the impact of a possible divergence on our supervision.

For subsidiaries of UK headquartered banks, it is worth noting that we have a regular dialogue with the NCAs to ensure we maintain maximum consistency in the approaches for SIs and LSIs. As you know, subsidiaries need to be authorised in the EU and are subject to prudential requirements as set out in CRR/CRD, as any other credit institution in the EU. As communicated over the last years, the ECB expects banks to be operationally self-standing and not overly reliant on group entities outside the EU. Each bank directly supervised by the ECB is expected to be able to independently manage all material risks that could potentially affect it at the local level in the EU, and to have control over its balance sheet and exposures. 

EU-Branches of third country groups are currently authorised and supervised by national authorities based on national legislation. The ECB is not involved in the supervision of these branches – Third country branches remain outside the scope of the SSM.

As illustrated in the EBA’s report on the treatment of incoming third-country branches under the national law of Member States, third-country branches carry out a significant volume of activities in the EU. The absence of harmonisation of these branches at European level means that their supervision and reporting requirements, which are governed by national law, might  vary (in some parts) considerably across Member States.

The current fragmented framework for third country access gives rise to regulatory arbitrage as firms may seek to circumvent the criteria for European supervision or shop around for lighter supervisory arrangements. Appropriate oversight and toolkits for EU regulators and supervisors is necessary to contain risks to financial stability in the euro area, especially considering that existing third country regimes were not developed to manage a substantial degree of cross-border provision of traditional banking services to EU clients without local establishments. In this regard, we welcome the EU Commission’s proposal to introduce in the CRD6 a new set of harmonised rules for branches of third country banks established in EU Member States. 

In many recent ECB publications, banks have been encouraged to take advantage of the increased digitalisation in the last years and improve their business models. How is this being addressed by the LSIs? Are there visible trends and/or issues compared to Sis?

Despite the fact that the LSI sector is generally aware of the digitalisation challenges and investing on digital tools and solutions, not all LSIs are comparable in that regard. First, it is worth noting that many LSIs are part of larger groups or networks, which allow them access to a wider pool or resources and development solutions. On the contrary, we see some LSIs operating in more traditional markets that might be lacking the necessary resources and impetus to continue investing in digitalisation. Then we have the newcomers in the system –FinTech companies that receive a banking licence, and the LSIs which have enough resources and drive to continue to invest. The Fintech companies who come and take a banking license have a strong IT and digital focus but tend to lack banking experience and invest into adapting to the necessities of risk management, customer identification and other banking risks.