A European watchdog with more bark than bite

Financial watchdogs can be fearsome beasts, though they often tend to have more bark than bite.

Take the European Central Bank. A recently released report on its Supervisory Review and Evaluation Process (Srep) for 2020 reveals this particular watchdog favoured issuing warnings over imposing prudential sanctions. Whether or not this was a smart approach may only become clear later down the line.

The ECB issued a bucketload of “qualitative recommendations” last year – essentially requests to address specific concerns that banks are obliged to answer in good time. The number of recommendations on credit risks increased 79% versus 2019, and those relating to business model risks jumped 105%. Alarmingly, 50% of all qualitative recommendations on the latter concerned the ongoing sustainability of supervised banks in the medium to long term.

Other recommendations focused on issues that, left unresolved, could causes banks trouble in the here and now. Several firms were asked to patch up their compliance control functions, for instance. Others were taken to task on IT and cyber security issues. Still more were interrogated on their capital planning.

All these requests stuffed bank in-trays already loaded with unanswered recommendations issued in 2019, before the Covid pandemic hit. The ECB said 46% of the recommendations it made that year on the topic of internal governance alone remain outstanding. One reason for the backlog is that the agency extended the deadline for banks to address these recommendations by six months, to give them time to deal with the more immediate problems unleashed by the crisis.

Still, this means a number of banks went into the pandemic with unresolved issues concerning their credit risk management, business models and capital planning. Some of these may be festering to this day, having been neglected in the midst of last year’s mayhem.

Knowing the banks it supervises have yet to address issues critical to their survival, the ECB could have chosen to punish them with capital add-ons in the form of higher Pillar 2 requirements and guidance (P2R and P2G). Such sanctions would incentivise the recalcitrant lenders to patch up their operations in line with the qualitative recommendations sent their way. But the Covid recession convinced the agency to dismiss this option. Instead, the ECB elected to freeze banks’ P2R at 2019 levels.

As an emergency measure, the logic was sound. But it may store up trouble for the future. Coming out of the pandemic, European banks will have looser capital requirements along with a host of unresolved profitability and business model problems to address. In addition, if European authorities give their say-so, lenders will be able to pay out dividends this year after a Covid-induced suspension. The confluence of these three factors may give the ECB reason to worry about the capital adequacy of a handful of especially shaky lenders.

One danger is that the agency then pushes too hard on the Pillar 2 lever, slapping higher discretionary charges on select banks in 2022 to compensate for the mass of unaddressed qualitative recommendations in their in-trays. This could prompt some to rein in their lending, reducing the provision of credit and slowing the post-Covid recovery.

Another is that the ECB simply adds more questions to the pile, burying problematic banks in a slew of supervisory requests that add to their existing regulatory costs and burden teams that otherwise could be working on helpful innovations.

It’s impossible to say which outcome firms would dislike more: the eventual bite, or the constant barking. But it’s one or the other. Banks better brace themselves.