SSM supervisory priorities for 2023-2025

The growth outlook for the euro area has significantly deteriorated over the course of the year as a result of high inflation and the consequences of Russia’s war in Ukraine. Uncertainties remain high for the months ahead. The rebound in economic activity observed in the first half of 2022, resulting from, among other things, the progressive lifting of pandemic-related restrictions, has slowed down. Russia’s invasion of Ukraine triggered a series of Western sanctions, followed by retaliatory measures from Russia, leading to surging energy, food and commodity prices as well as disruptions of energy supplies. Inflationary pressures increased as a result, with euro area inflation reaching record highs. These effects, together with a resulting confidence shock, exacerbated pre-existing supply chain bottlenecks and led to a deterioration in the economic outlook. In an environment of highly elevated uncertainties, the main downside risks to the growth outlook include a longer than expected war in Ukraine, an escalation of geopolitical tensions, rising energy costs and inflation which, combined with further energy supply disruptions and rationing, could lead to recession in Europe.

High inflation levels around the globe have led major central banks, including the ECB, to accelerate the pace of their monetary policy normalisation. After public and private debt-to-GDP ratios expanded during the pandemic, the combination of tighter financing conditions in the wake of increasing policy rates and a deteriorated growth outlook is expected to further challenge the debt servicing capacity of banks’ counterparties. Corporates, particularly in the high-yield segment or energy-intensive sectors, are also expected to be challenged by higher financing, input and operating costs, as well as by the weaker growth outlook, potentially leading to a rise in default rates. Finally, households with higher levels of indebtedness, lower incomes or variable rate mortgages may also see a deterioration in their creditworthiness in the future, although fiscal measures, savings accumulated during the pandemic and an overall resilient labour market may help cushion at least partially the impact of inflation and higher interest rates.

Heightened geopolitical tensions, rising interest rates and fears of economic recession in Europe are weighing on financial markets dynamics. Interest rates around the globe have followed the pace of central bank decisions and exhibited episodes of volatility in 2022 as a result of uncertainties concerning the timing and magnitude of policy rate adjustments. After experiencing a sharp drop in valuations in the first half of the year, equity markets have recovered somewhat but remain susceptible to further price corrections. Going forward, high uncertainty may translate into increased market turbulence and episodes of high volatility, which may in turn lead to a further repricing in financial markets and subsequent mark-to-market losses on banks’ balance sheets or lower earnings from market-related business.

The SSM supervisory priorities include the strategic objectives that ECB Banking Supervision is committed to pursuing over the next three years to tackle prioritised vulnerabilities and the supervisory activities planned to achieve those objectives. The following sections outline these priorities for 2023-2025.

High uncertainties and downside risks associated with the current macro-financial and geopolitical environment are materially affecting the outlook for the European banking sector. Supervised institutions need to be prudent in developing and planning their business strategies, to keep monitoring closely the risks associated with the fast-changing financial environment and to focus their efforts on risk management. This includes developing sound and credible capital, liquidity and funding plans that take into account the current uncertain outlook and being ready to adjust them to the evolving risk landscape in a flexible and timely manner.

Against this background, ECB Banking Supervision’s primary objective for the coming months is to ensure that banks under its direct supervision strengthen their resilience to immediate macro-financial and geopolitical shocks. The 2023 EU-wide stress test exercise, coordinated by the European Banking Authority (EBA), will support this effort and feed into the outcome of the next SREP cycle, contributing to the supervisory priorities for 2023. Other supervisory activities that are more focused on specific risks are described in the next section. Also included are follow-up activities in relation to certain priorities from last year that are being performed as part of the regular supervisory work.

Strategic objective: Banks should effectively remedy structural deficiencies in their credit risk management cycle, from loan origination to risk mitigation and monitoring, and address in a timely manner any deviations from regulatory requirements and supervisory expectations.

Banks should be in a position to swiftly identify and mitigate any build-up of risks in their exposures to sectors that are more sensitive to the current macroeconomic environment, including sectors affected by the war in Ukraine and real estate portfolios.

While issuances of leveraged loans have slowed down in recent quarters, with issuers and investors adjusting to macroeconomic uncertainties, supervised institutions’ outstanding volumes and underlying vulnerabilities remain high given the nature of the counterparties (high-yield/low credit rating and/or high leverage) and the instruments (typically floating rate and covenant-lite loans). This year ECB Banking Supervision has increased its efforts to strengthen banks’ adherence to the supervisory expectations laid down in ECB guidance. Going forward, supervisors will follow up on banks’ responses to this exercise with a view to closing outstanding gaps relative to the corresponding supervisory expectations. ECB Banking Supervision stands ready to impose additional capital charges on supervised institutions showing insufficient progress in addressing these gaps.

While substantial supervisory work has been undertaken in 2022 to tackle vulnerabilities stemming from banks’ material sensitivities to interest rate and credit spreads and from their exposures to counterparty credit risk, the related risks have not receded and the likelihood of observing further episodes of high volatility and repricing in financial markets in the months to come remains high. Against this background, supervised institutions are expected to continue to closely monitor and prudently manage the underlying risks, which are still highly relevant and material in the current context. Supervisory efforts will be pursued accordingly, with a targeted follow-up by JSTs expected in 2023 based on the outcome of the targeted reviews conducted this year.

Strategic objective: Banks reporting a high concentration of funding sources, in particular less stable ones, should diversify their funding structure by developing and executing sound and credible multi-year funding plans, taking into account challenges stemming from changing funding conditions.

During the first half of 2022, on average, supervised institutions reported comfortable liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs), which is a clear sign of resilience to the materialisation of potential liquidity and funding shocks. Nevertheless, a lack of funding diversification makes some institutions more vulnerable to market disturbances. The exceptional monetary policy measures introduced at the onset of the pandemic led some banks in particular to increase their central bank funding (e.g. via the third series of targeted longer-term refinancing operations, TLTRO III) and consequently to downscale the share of market-based funding (e.g. via commercial papers and covered bonds). The expected repayments, at maturity or upon early redemption, will require banks to further diversify their funding sources and replace part of their central bank funding with more expensive and possibly shorter-term alternatives, which will put pressure on their prudential ratios and profitability, particularly in an environment of increasing economic risks and progressive monetary policy tightening. Risks stemming from banks’ high reliance on TLTRO III funding and their related exit strategies require continued supervisory scrutiny, as highlighted by some JSTs in this year’s SREP. In this context, supervised institutions will be asked to develop, execute and adjust as needed a sound and reliable liquidity and funding plan, covering exit strategies and mitigation of rollover risks and concentrations in funding structures.

• Targeted review of TLTRO III exit strategies for selected banks which have a material reliance on this funding source and are more vulnerable to increases in market funding costs. This targeted review will be complemented by a broader analysis of banks’ liquidity and funding plans aimed at identifying weak practices and more vulnerable institutions, including targeted OSIs where appropriate. JSTs to follow up on the findings of these exercises and enquire about the development and execution of sound remedial action plans, including via targeted OSIs.

Supervised institutions should keep a strong focus on addressing structural challenges and risks stemming from the digitalisation of their banking services with a view to ensuring the resilience and sustainability of their business models. While strong internal governance and effective strategic steering by management bodies are key for the development and execution of successful digital transformation strategies, banks also need to tackle vulnerabilities and risks stemming from a greater operational reliance on IT systems, third-party services and innovative technologies. At the same time, banks are operating in a highly volatile and uncertain environment. Taking decisive steps towards achieving strong strategic steering, sound governance and proper risk data aggregation and reporting capabilities can help banks to support the sustainability of their business models against the challenges ahead.

Strategic objective: Banks should develop and execute sound digital transformation plans through adequate arrangements (e.g. business strategy, risk management, etc.) in order to strengthen their business model sustainability and mitigate risks related to the use of innovative technologies.

Supervised institutions are continuously developing, executing and adjusting strategies to support the digitalisation of their banking services and practices to address continuously evolving consumer needs and preferences. At the same time, the adoption of new technologies can also support efficiency gains which contribute to improving banks’ profitability. Although supervised institutions have recently reported stronger profitability on the back of higher interest rate expectations, an intensification of competition with digital champions in the banking sector and digital natives from outside the sector – e.g. financial technology (fintech) and bigtech players – may put banks’ business models at risk if they fail to adapt in time to the evolving landscape. Against this background and following this year’s prioritised initiatives aimed at better understanding and benchmarking banks’ practices, ECB Banking Supervision will continue its efforts in this area and will conduct targeted OSIs and targeted reviews of specific aspects of banks’ digital transformation strategies and use of innovative technologies. JSTs will also follow up outlier institutions identified in these exercises with a view to complementing the overall strategy and inducing banks to address any structural deficiencies found.

Strategic objective: Banks should have robust outsourcing risk arrangements as well as IT security and cyber resilience frameworks to proactively tackle any unmitigated risks which could lead to material disruption of critical activities or services, while ensuring adherence to the relevant regulatory requirements and supervisory expectations.

The digital transformation taking place in the banking sector and the increased reliance on technologies and third-party service providers for delivering banking services have brought additional complexity and interconnections within the financial system, leading to heightened operational resilience challenges for banks around the globe. While supervised institutions have demonstrated strong resilience during the pandemic, with limited operational losses reported in a context of heightened risk, the war in Ukraine is bringing new challenges. Some of the concrete concerns, also raised by a number of JSTs in the context of the 2022 SREP exercise, relate to heightened risks stemming from the outsourcing of certain activities or critical services to countries adversely affected by sanctions regimes (or facing higher geopolitical risks) which may be more vulnerable, for instance, to a possible increase in retaliatory cyberattacks in response to Western sanctions against Russia.

Furthermore, high reliance on third parties for critical IT services and deficiencies in IT outsourcing arrangements continue to present a material vulnerability which could result in increasing losses owing to the unavailability or poor quality of outsourced services. Against this background, ECB Banking Supervision will continue to review banks’ outsourcing arrangements and cybersecurity measures and will conduct targeted reviews and OSIs to follow up on any identified deficiencies.

• Data collection and horizontal analysis of outsourcing registers to identify interconnections among significant institutions and third-party providers and potential concentrations in certain providers.
• Targeted reviews of outsourcing arrangements, cybersecurity measures and IT risk controls.
• Targeted OSIs of outsourcing and cyber security management.

Strategic objective: Banks should effectively address material deficiencies in the functioning, oversight and composition of their management bodies by developing and swiftly implementing sound remedial action plans, adhering to supervisory expectations.

Sound internal governance arrangements and effective strategic steering are crucial in ensuring the sustainability of banks’ business models, both during crises and in normal times, and in successfully adapting to ongoing trends, such as digitalisation and the green transition. The collective suitability, including adequate collective knowledge, skills and experience, and the diversity of banks’ management bodies strengthen their risk oversight role and are essential to their effective functioning.

Banks have made progress in adapting their diversity policies, including as a consequence of the supervisory follow-up in early 2022 of banks which did not have such policies in place or internal targets for gender diversity at board level. Some areas still require attention, such as compliance with internal or national gender representation targets in management bodies or insufficient skills diversity on boards, including, but not limited to, IT/cyber risk expertise. Moreover, there are still weaknesses in the succession planning process and in the capacity of boards to provide oversight and challenge management functions, including within the related committees. This may also be linked to persistent weaknesses in the area of formal independence in the management bodies of some institutions.

ECB Banking Supervision will continue to strive to achieve progress in these areas through targeted reviews, OSIs and targeted risk-based fit and proper (FAP) assessments and reassessments. In addition, supervisors will also update and publish supervisory expectations on governance and risk management.

Strategic objective: Banks should effectively address long-lasting deficiencies and have adequate and efficient risk data aggregation and reporting frameworks in place in order to support efficient steering by management bodies and to address supervisors’ expectations, including in times of crisis.

• Refinement and communication to banks of supervisory expectations related to the implementation of risk data aggregation and risk reporting principles.
• Targeted engagement and horizontal analysis across JSTs and/or OSIs for banks with persistent shortcomings.
• OSI campaign on risk data aggregation and reporting (extension from 2022).

Strategic objective: Banks should adequately incorporate climate-related and environmental (C&E) risks within their business strategy and their governance and risk management frameworks in order to mitigate and disclose such risks, aligning their practices with current regulatory requirements and supervisory expectations.

• Targeted deep dives to follow up on shortcomings identified in the context of the 2022 climate risk stress test and thematic review.
• Review of banks’ compliance with new ITS reporting and Pillar 3 disclosure requirements related to climate risk, and benchmarking of banks’ practices against supervisory expectations.
• Deep dives on reputational and litigation risk associated with climate-related and environmental strategies and risk profiles for selected banks.
• Preparatory work for reviews of banks’ transition planning capabilities and readiness for environmental, social and governance (ESG) related mandates expected in the sixth Capital Requirements Directive (CRD VI).
• Targeted OSIs on climate-related aspects, either on a stand-alone basis or within reviews of individual risks (e.g. credit risk, governance, business model).