Quarterly SSM briefing: stable supervisory priorities and the ECB’s green agenda

The last few weeks have been marked by an ongoing review of the supervisory priorities initially listed by the Single Supervisory Mechanism (SSM) for 2022-24, and developments in the climate agenda outlined by the European Central Bank (ECB).

ECB’s supervisory priorities for 2022-24 remain stable despite geopolitical instabilities and challenges

At the beginning of 2022, the European Commission’s outlook for the EU economy was for continued and healthy growth. However, the picture is quite different four months after Russia’s invasion of Ukraine. Higher commodity prices, supply-chain disruptions and surging uncertainty have squeezed anticipated growth potential in the EU, while inflation continues to surge. This evolving economic landscape has been a focal point and a theme of concern for both the financial industry in the Eurozone and its regulatory and supervisory agencies. The SSM has maintained a clear and stable position regarding its expectations towards banks in the region, which is recognised in its latest review.

Original priority – Banks emerge from the pandemic healthy

The focus here has been on banks’ credit risk management practices, which encompass risk identification and classification practices, as well as provisioning policies. While the initial attention fell on the commercial real estate sector as being hardest hit by the pandemic, the commodities and energy sectors’ banking portfolios affected mainly by the war have now started to receive centre-stage attention. The importance for banks to improve their loss models to reflect a worsening macro-outlook in the region has been reflected by the issuance of a Dear CEO letter on leveraged transactions. In recent speeches, Andrea Enria and Elizabeth McCaul have mentioned their concern about the risks of a “bumpy exit” from the low-interest rates environment. In general, higher rates are beneficial for banks’ profitability. Still, high inflation, in combination with slow economic growth in the area, would cause asset quality deterioration when debtors struggle to repay. Banks, therefore, should closely monitor risks related to inflation and their influences on lending portfolios and costs.

Original priority – Addressing banks’ structural weaknesses

The current uncertain geopolitical situation gives further weight to the importance of banks’ investment in digitalisation as a route to more sustainable and improved business models. In addition, resolving governance inadequacies in banks’ management bodies would lead to the proper execution of recent sanctions on Russia, and alleviate reputational risks.

Original priority – Tackling emerging risks

The supervisor’s focus on IT and cyber risk has amplified since the war started. Furthermore, the surge of market volatility for commodity prices has heightened the relevance of counterparty credit risk. Last but not least, the war has highlighted the rush towards the green transition and reaching net zero objectives as dependence on Russian gas in Europe declines. Integrating climate-related and environmental risks into banks’ strategy and governance frameworks is now crucial.

The green agenda

On 8 July 2022, the ECB published the results of its first formal climate risk stress test initiated earlier in January. The test collected quantitative and qualitative information from 104 significant banks in the Eurozone, which will be fed into the Supervisory Review and Evaluation Process (SREP). This information will be used as guidance on best practices which the ECB will publish in the last quarter of 2022. As initially noted, these results will have no impact on banks’ capital through Pillar 2 guidance in the current year, but feedback was shared with each participating bank and reciprocate actions are anticipated from them.

Banks had to provide information regarding their stress-testing capabilities, reliance on carbon-emitting sectors, and performance under different macro-financial scenarios. The table below outlines findings of relevance listed by the supervisor.

A week before the stress test results came out, the governing council of the ECB announced its decision to include climate change in its monetary policy framework. In a formal letter to the Chair of the Committee on Economic and Monetary Affairs of the European Parliament, ECB President Christine Lagarde listed four concrete aspects of this decision:

1. The corporate bond holdings issued by companies that have (i) lower greenhouse gas emissions exposure, (ii) more ambitious carbon reduction targets, and (iii) better climate-related disclosures will increase as a share of the Eurosystem’s balance sheet. This will apply as of October 2022, and the ECB will start disclosing climate-related information on corporate bond holdings as of the first quarter of 2023.
2. The share of collateral from entities with a high carbon footprint will be limited when borrowing from the Eurosystem. This should be in power before the end of 2024, and, initially, it will only apply to marketable debt instruments issued by non-financial corporations. Also, as of this year, the ECB will consider climate change risks when haircuts applied to corporate bonds used as collateral are reviewed.
3. Through its engagement with the relevant authorities, the Eurosystem will back the requirement for better and harmonised disclosures of climate-related data from banks as part of the Corporate Sustainability Reporting Directive (CSRD), which would start applying in 2026.
4. Last but not least, the ECB will include climate-related risks in risk management. It will urge rating agencies to be more ambitious in their disclosure requirements on climate risks and more transparent about how they incorporate such risks into their ratings. There is an ongoing close dialogue with the relevant authorities on this matter. By the end of 2024, an approved set of common minimum standards for how climate-related risks are supposed to be incorporated by central banks in their in-house credit assessment systems will enter into force.