**3. The SREP process and the holistic approach to supervision and management of the banking business**

Article 97 of the CRDIV (Directive 2013/36) requires supervisors to review the organisation, strategies, processes and methodologies that banks put in place to address the range of risks they face.

The Supervisory Review and Evaluation Process (SREP) is conducted annually by the supervisory Authorities to verify that each bank has implemented strategies, processes, capital and liquidity appropriate to the risks to which it is or might be exposed and that they have appropriate capital and organisational safeguards in place to address the risks they face, ensuring overall balance of operations and market resilience.

The SREP process is not new, as it has always been carried out before the SSM by national supervisors with different and non-homogeneous methodologies and practices. For this reason, the European regulation intended to standardise the SREP methodologies and practices used by the different Authorities at the level of the Banking Union.

SREP entered into force in 2016 for IS and only from 2018 became mandatory first for high priority LSIs and then for other LSIs. Following the harmonisation of the SREP process for LSIs, national authorities have been given full flexibility regarding the definition of Pillar 2 guidelines (P2G) [6]. Finally, one of the focal points of the MUV is the possibility for the ECB to take over the supervision of LSIs that are more vulnerable, for example due to a change in materiality profile or due to a choice by the Central Bank as a result of new assessments of the impact the institution might have on the financial system. Supervision of less significant institutions takes the form of periodic assessments conducted jointly by the ECB and the national supervisory authorities of the Member States, with the aim of making best use of the information available to the national authorities. Moreover, for high priority LSIs, the ECB examines the supervisory procedures and relevant draft decisions established by the NCAs themselves [6].

The SREP is a process by which the European Central Bank and the NCA specifically:


At the end of the process, the supervisory Authorities send the banks a letter (called a "SREP decision") specifying the objectives and areas to be addressed and corrected within a defined time frame16.

The SREP is an articulated process that develops through a continuous dialogue and confrontation between supervisor and supervised in order to make an overall assessment, from an integrated perspective, of the stability and resilience of the latter. The inspectors' findings and the on- and off-site supervision feed the subsequent SREP cycle. In this perspective, the SREP is not a control and assessment activity carried out by the Supervisor once a year, but rather a process of second-pillar prudential control, which unfolds continuously and starts from the identification of the category17 to which the bank belongs (with respect to which to calibrate the intensity of the supervisory activity) against which the intensity of the SREP assessment is established, the supervisory expectations and the information required during the data collection phase, calibrated according to the classes [7] to finally arrive at the so-called SREP decision*.* The classification is calibrated according to the systemic impact of the intermediary, based on: size, structure, internal organisation, type, purpose and complexity.

The classification of institutions is followed by monitoring of indicators for changes in financial conditions and risk with the objective of updating the assessment of SREP elements. If monitoring reveals a deterioration in the institution's risk, the Supervisor investigates the causes and may revise the assessments of the SREP elements. Vigilance develops different sets of ratios based on the different specificities of banks, including: ratios for all risks subject to SREP. All ratios used for regulatory requirements (see EU Regulation 575/2013 and Directive 2013/36/ EU), minimum requirements on own funds and eligible liabilities under Directive 2014/59/EU (bank recovery), market indicators (equity price, CDS spread, etc.), recovery indicators. The frequency of assessment of all items of the SREP process is calibrated according to the category that the financial intermediary belongs to.

The four central blocks covered by the SREP assessment are: business model analysis, the governance and risk management framework, the capital adequacy framework (ICAAP) and the liquidity management framework (ILAAP).

For each of the four main blocks covered by the SREP, banks are assessed by the Supervisory Authorities on a scale of 1 to 4.18 The outcome of the assessment constitutes the basis for the overall assessment of the SREP: the SREP decision, which

• Category 2: large-medium entities.

• Category 4: small entities.

<sup>16</sup> The normative sources of reference for the SREP process are: - *Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP) (EBA/GL/2014/13)* issued on 19 December 2014 – Applicable from 1 January 2016 - *Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing* issued 19 June 2018.

<sup>17</sup> Banks are divided into four categories:

<sup>•</sup> Category 1: Global systemically important institutions (Global SIFIs) and other systemically important institutions (article 131 of Directive 2013/36/EU.

<sup>•</sup> Category 3: small and medium-sized entities.

<sup>18</sup> For each block, the Authority is asked to assign a score on a scale from 1 to 4, with 1 being the best and 4 the worst.


#### **Table 4.**

*SREP process::Building blocks.*

is the basis for supervisory measures. The SREP decision is the final summary of the entire Pillar 2 supervisory review process, which reports the bank's overall score (compared to the assessment of the four main blocks) and, if anomalies are found, any corrective measures of an organisational, capital or liquidity risk containment nature or **other early intervention measures**. Interventions depend on the severity of the deficiencies, the need for timeliness, the degree of awareness, capacity and reliability of the corporate governance, and the availability of human, technical and capital resources at the intermediary. In the case of organisational deficiencies, additional capital requirements will be imposed if the bank does not appear to be able to ensure the removal of the deficiencies within an adequate period of time. The SREP decision is also a strategic moment of reconciliation between the MUV Pillar II process and the BRRD because it provides for the possibility of activating early intervention measures in case of trigger events foreseen by the BRRD.

Early intervention measures may be triggered by events that could have a significant prudential impact19 on the institution's financial condition. They should be considered if the institution's overall or individual SREP score is 4 and even if the SREP score inclusive was 3, but individual elements for governance and internal control, business model strategy, capital adequacy or liquidity score were instead 4. However, the early intervention measures are the result of ongoing monitoring of compliance with the requirements of the CRR and CRDIV with respect to the anomalous situations foreseen by the BRRD in the supervisory activity.

In the SREP decision the Authorities also define the so-called Pillar 2 Requirement (P2R), which **is applied in addition to the minimum** Pillar 1 **requirement in** order to cover all risks that are underestimated and not considered in internal risk governance. The P2R is one of the outcomes of the SREP and is legally binding. As part of the SREP process, an additional capital **requirement is** also identified, known as Pillar 2 Guidance or P2G, which is not legally binding, but which indicates to banks the level of capital deemed adequate to cope with stress situations and is defined by the Authorities downstream of the supervisory macro stress testing process (EU-wide stress test).

By its very nature, the entire process of Pillar 2 prudential supervision gives shape and content to the fundamental moments of intermediaries' strategic planning, business choices, capital and liquidity allocation, funding plan, governance

<sup>19</sup> For example, a severe operational risk due to improper business operations, fraud, natural catastrophes, severe cyber incidents, a significant deterioration of the minimum requirement for MREL eligible capital and liabilities, or rating downgrades.

and organisational structure. The SREP is certainly a holistic approach to supervision that calls for an equally integrated approach by individual intermediaries to business choices, risk, capital and liquidity management both in normal and stressed conditions (Crisis and Recovery Risk Management), governance and the overall Risk Management framework. In this perspective, the SREP certainly represents a regulatory "stimulus" to a significant qualitative leap in the functions that deal with risks, capital and liquidity in the bank, recognising them as having a primary role in the strategic planning of the bank, as well as a flexible and proactive integration of the corporate control functions (**Table 4**).
