**Abstract**

The book is based on Supervisory Review and Evaluation Process (SREP) is conducted annually by the Supervisory Authorities to verify that each bank (Significant/Less Significant) has implemented strategies, processes, capital, and liquidity assessment process appropriate to the business model and overall planning activity and risk governance system. Analysis of the aims, the features, and the different phases of SREP and the proportionality principles on which the Single Rulebook is based. Some reflections about proportionality principle of Single Rule Book and new skills required to Risk Management function. The research emphasised the need for a holistic approach also in Risk Management and the bank's business activity.

**Keywords:** SREP, PILLAR 2, Business Model Analysis, Risk Management

#### **1. Introduction**

The *Single Supervisory Mechanism*<sup>1</sup> *(*SSM), the *Single Resolution Mechanism*<sup>2</sup> (SRM) and the *European Deposit Insurance Scheme*<sup>3</sup> (EDIS) are the three pillars of the European Banking Union, which together form a single set of rules that must be applied to all EU Member States. The European Banking Union is the response to the international financial crisis (first subprime crisis, then liquidity crisis of financial markets and sovereigns) aimed at establishing a single market for banking services and safeguarding financial stability, helping to overcome tensions (mainly fuelled by the intertwining of banking and sovereign risks), restore confidence in the European banking sector, strengthen integration and support economic growth. This objective has yet to be achieved and has been pursued with a massive amount of regulations, guidelines and technical principles (Single Rulebook), which have undoubtedly burdened the cost structure of financial intermediaries in their quest for stability. The three pillars of the Banking Union are closely interrelated and

<sup>1</sup> Council Regulation (EU) no. 1024/2013 of 15 October 2013 conferring specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions.

<sup>2</sup> Regulation (EU) no. 806/2014 establishing uniform rules and procedures for the resolution of credit institutions and certain investment firms under the Single Resolution Mechanism and the Single Resolution Fund.

<sup>3</sup> Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on Deposit Guarantee Schemes.

interdependent. However, a single supervisory system could not have been imagined without building a system capable of intervening in crises when they occur. Similarly, where a crisis cannot be resolved without bank failure and liquidation, a common deposit protection system is needed for all EU Member States. The keystone of the Banking Union, the pillar of change in terms of profound changes in policy and law, is the latter. The pursuit of financial stability has become even more urgent during the COVID pandemic because of the global health emergency's impact on the economic and financial system.

As defined in the Guide to Banking Supervision, the European Central Bank (ECB) has identified three objectives to be achieved by the *Single Supervisory Mechanism* (SSM):


The Single Supervisory Mechanism (SSM) has no legal personality and its purpose is the prudential supervision of banking activities. It consists of the ECB, which also plays the lead role, and the national competent authorities (NCAs) of the participating countries. Although the ECB has the ultimate responsibility for decision-making, it carries out its supervisory tasks under the MVU in close cooperation with the NCAs. Working with the NCAs, the ECB performs direct supervision of institutions defined as Significant (SIs). On the other hand, the supervision of Less Significant institutions (LSIs) is carried out directly by the NCAs in a unified supervisory approach guided by the general guidelines and instructions given by the ECB. In addition, all supervisory tasks that are not conferred within the MVU, such as consumer protection or anti-money laundering, remain with the NCAs. The criteria for determining whether banks can be considered significant – and therefore subject to direct ECB supervision – are defined in the MVU Regulation.

To qualify as significant, banks must meet at least one of these criteria4 :


The ECB may decide at any time to classify a bank as significant to ensure that high supervisory standards are applied consistently, and conducts periodic reviews of all licenced banks within the SSM. The classification of banks may be changed due to the normal operations of credit institutions or as a result of extraordinary

<sup>4</sup> Regulation (EU) no. 468/2014 of the European Central Bank of 16 April 2014.

#### *Basel IV: The Challenge of II Pillar for Risk Management Function DOI: http://dx.doi.org/10.5772/intechopen.96929*

events such as mergers or acquisitions. In such cases, the ECB and the national supervisory authorities involved coordinate the transfer of supervisory responsibilities. The purpose of balancing the regulatory requirements for institutions of different sizes is to promote the stability of the financial system and to ensure a level playing field within the financial system and an appropriate comparison of risk, capital and liquidity profiles between intermediaries of different sizes and operational complexity.

For significant institutions, the ECB carries out its supervision through a specific methodology, the periodic assessment of their economic and financial situations, the verification of compliance with prudential rules, the adoption of any necessary supervisory measures, and the performance of stress tests. All of this is done by the Joint Supervisory Teams (JST) composed of staff from the ECB and the NCAs of the significant institutions' countries of establishment. The JST is responsible for drafting and organising the supervisory review programme, as well as for performing day-to-day supervision at consolidated, sub-consolidated and individual levels (assessments of the institutions' risk profiles, business models and strategies, risk management and control systems and internal governance). JST members may also participate in on-site inspections and investigations of internal models.

In our country, the supervision of less significant banks and banking groups is instead exercised directly by the Bank of Italy with a view to unitary supervision under the guidelines and general instructions given by the ECB. Among the less significant banks are the so-called "High Priority" banks for which the exchange of information between the BoI and the ECB is more intense. (These are the first banks "below the threshold" of €30bn in assets.) However, the BoI retains full and autonomous competence in the areas of consumer protection, combating money laundering and terrorist financing, supervision of payment services and markets for financial instruments, and supervision of non-banks and branches of non-EU banks.

As regards SIMs and OICR managers, the Consolidated Law on Finance (TUF) assigns to the Bank of Italy supervisory tasks for risk containment, stability and sound and prudent management, and to Consob those for the transparency and propriety of the conduct of these intermediaries in offering investment products.

The First Pillar of the MUV (SSM) is based on the so-called Basel framework, or rather on the following regulatory sources:


Starting from 2021, the two regulatory packages will be gradually replaced by the new CRR II and CRD V, whose regulatory changes define the final structure of the new "*Basel IV".* This expression, replacing the previous *"Basel III",* indicates the important process of change that has taken place over the last three years to the current regulatory framework. The changes, which affect several areas of prudential supervision of the banking sector (credit risk, market risk, operational risk, liquidity, leverage ratio, etc.) will become fully effective in 2027. The regulatory texts that make up Basel IV are as follows:

<sup>5</sup> In Italy, CRD IV has been implemented by Circular No. 285 of the Bank of Italy.


The prudential supervisory framework for risk and capital (Basel IV) has always been ideally divided into three pillars:


In general terms, the MUV is based on the European single rulebook, which therefore consists – in addition to the Regulation and the Directives (Directive 2013/36/EU-CRD IV, EU Regulation no. 575/2013 - CRR, Directive 2014/49/EU - *Deposit Guarantee Schemes Directive*, Directive 2014/59/EU -*Bank Recovery and Resolution Directive*) – also of the binding technical standards and guidelines of the EBA. The chapter want to analyse the aim, the features and the different phases of Supervisory Review Process.

#### **2. Is proportionality enough?**

The entire structure of the Single Supervisory Mechanism is based on a principle of proportionality aimed at achieving a uniform application of the rules while respecting the diversity of banks' business models, identities, size and operational complexity. However, the operational implementation of this principle does not always seem to have been able to fully achieve these objectives, which is why the application of this principle continues to be a priority on the agenda of European authorities.

However, the approach of European supervision has historically been oriented towards the definition of a set of rules equal for all, in order to ensure homogeneity of treatment for different banks: the principle of "one size fits all". However, this approach*,* while further tightened in the immediate post-crisis years, has been revisited from a proportional perspective (at least in theory) with the introduction of the current CRR and CRD IV and the future entry into the scene of the new CRR II and CRD V.

The application of the principle of proportionality within the Single European Supervisory Mechanism is therefore substantiated by the application of the same

<sup>6</sup> Update of the CRD 4 Directive and the CRR Regulation by the EU Commission, made through a first proposal on 23 November 2016, and which will address market risk, interest rate risk, leverage ratio, Net Stable Funding Ratio, TLAC/MREL requirements, large exposures, counterparty risk, SME support factor, exposure to CCPs.

<sup>7</sup> The Regulation will amend certain aspects of securitisation procedures carried out by banks.

<sup>8</sup> It must be calculated and reported quarterly to the Supervisory Authorities.

*Basel IV: The Challenge of II Pillar for Risk Management Function DOI: http://dx.doi.org/10.5772/intechopen.96929*


#### **Table 1.**

*Classification of LSIs into priority classes.*

rules to all banking intermediaries, but with a "depth" and an articulation proportionate to the significance and/or operational complexity. The significance of an intermediary is relevant to the identification of the competent Supervision Authority, even though, in this regard, an intense collaboration between the European Central Bank and the NCAs is foreseen to guarantee the harmonised application of the Community rules. Specifically, the SSM provides that, with regard to the supervision of the *Significant Institutions*, the ECB presides over working groups technically defined as *"Joint Supervisory Teams"* (which are composed of both representatives of the ECB and representatives of the NCAs), while for the supervision of the Less Significant Institutions it is the NCAs that calibrate the regulatory requests on the banks they are responsible for. The method used by the ECB, in its capacity as a harmoniser of EU supervisory practices, to ensure the proper application of the proportionality principle by national authorities is based on the classification (reviewed annually in cooperation with the NCAs) of LSIs into9 priority classes that, based on their impact on the financial system and their inherent riskiness, consist of (**Table 1**).

Based on this classification, the NCAs establish the intensity of Pillar II assessments, supervisory expectations and information requirements at the data collection stage, calibrated according to the classes.10 Supervisory activities for less significant institutions consist of regular assessments conducted jointly by the ECB and the NCAs of the Member States, with the aim of making the 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 themselves11.

The subject of the proportionality of the rules of supervision and surveillance in the European banking system is of strategic importance, also due to the fact that the LSIs represent a pillar of the European real and financial economy, even though 80% of these institutions are concentrated in nine countries (primarily Austria, Germany and Italy, but also Croatia, Denmark, Luxembourg, Poland, Slovakia and Slovenia).12 It is interesting, in this context, to observe how the principle of proportionality is implemented overseas.

<sup>9</sup> The objective is to determine an order of priority of individual LSIs to be applied in the allocation of supervisory resources within the MVU, both for NCAs and the ECB.

<sup>10</sup> MVU's SREP methodology for LSIs. ECB, 2018.

<sup>11</sup> MVU Supervision Manual. ECB, March 2018.

<sup>12</sup> As of 2016, the average size of European LSIs stood at around €1.5 billion, with German institutions accounting for a large part of this with €5.5 billion in assets (ECB, 2017). Moreover, the business models of less significant European intermediaries, although predominantly oriented towards a retail banking approach, are characterised by variety and by the market segments concerned. In fact, they are also present in sectors such as real estate or private banking, depending on the national context of reference.

In fact, US banking regulations basically implement the Basel standards for large banks, while the provisions of the reform known as the "Wall Street Reform" or also the "Dodd-Frank Act"13 establish a series of rules tailored to the size of small and medium-sized banks, which make up about 95% of US credit institutions. From the outset, the main objective of the definition of new common rules was to guarantee greater stability to the US financial apparatus and above all to avoid the spread of systemic risk. Although this objective was perfectly consistent with that of European legislators, the approach used on the other side of the Atlantic was more oriented towards defining more stringent rules for large banks (identified as those with total assets of over \$50 billion), and therefore by definition carrying systemic risk, while a set of new, less onerous rules proportionate to their operations was envisaged for community banks. In addition, in 2018, the Dodd-Frank Act was revised and amended with a view to further calibrating it towards a more pervasive application of the proportionality principle. For example, while initially the more stringent rules on stress testing, MREL requirements and the weakening of the role of advanced internal models were only applicable to institutions with assets in excess of \$50 billion, from 2019 they would be limited to institutions with assets in excess of \$250 billion. In the case of smaller banks, the legislature instead focused its attention on the need to hold high capital requirements, which – especially initially – resulted in the closure of smaller, underperforming banks [1].

With regard to Community banks, however, the principle of proportionality does not take the form of applying the same regulatory requirements with a different degree of depth, but rather provides for total exemption from certain supervisory standards (this is the case for banks with assets of less than \$10 billion, which are not subject to the macroprudential stress tests that are mandatory for all larger institutions, including those with assets of between \$10 and \$50 billion). The application in the United States of the regulatory standards envisaged by Basel III applies, with due differentiation, to two categories of credit intermediaries: *internationally active* banks, identified as banking institutions with at least \$250 billion in assets or an amount of foreign exposure of at least \$10 billion; and *global systemically important banks* (G-SIBs), whose identification is based on a comparison of key indicators of systemic risk.

**Table 2** summarises the regulatory capital and liquidity requirements for different types of banks operating in the US system.

A comparison of the regulatory indicators in the US and European systems reveals some differences in the proportionate application of supervisory rules with respect to bank size. First, while US regulation provides for a full exemption from stress testing for community banks, in Europe this exemption does not apply to LSIs. With respect to capital requirements, however, the main difference is that while the EU framework allows NCAs to require even smaller institutions to hold an additional countercyclical capital buffer in good times, this only applies to banks with assets greater than \$250 billion in the US. Ultimately, evidence of different application of the proportionality principle can also be found with respect to liquidity requirements. Specifically, while in the US full compliance with the LCR

<sup>13</sup> The Wall Street reform known as the Dodd-Frank Act is a complex intervention sought by the Obama administration to promote a stricter and more complete regulation of US finance while encouraging a protection of consumers and the US economic system. Source: Borsa Italiana.


*Source: U.S. Treasury (A Financial System That Creates Economic Opportunities - Banks and Credit Unions. Pag.41. www.treasury.gov).*

#### **Table 2.**

*Breakdown of the main regulatory obligations in the US system.*


**Table 3.**

*Differences between the US and the EU in the application of the principle of proportionality.*

(Liquidity Coverage Ratio14 [2]) and NSFR (Net Stable funding Ratio)15 [2] is only required for banks with assets greater than \$250 billion, and less stringent application is demanded of institutions with assets between \$50 billion and \$250 billion, in Europe compliance with an LCR of at least 100% is mandatory for all intermediaries. In addition, as of 2021, compliance with an NSFR of at least 100% will also be mandatory for all intermediaries, although a simplified version will be available for small and less complex institutions. **Table 3** below summarises the differences just discussed.

Finally, the application of the principle of proportionality in the US banking system manifests its effects also in the phase of resolution of banks in crisis, contrary to what actually happens in the European Banking Union. In Europe, in fact, as highlighted by Masera [3], while the SSM provides for the assignment of the tasks of supervision on the LSIs to the NCAs, the performance of this activity is effectively limited only to the banks in ordinary administration, and as highlighted in paragraph 3.2, in the cases in which a Less Significant bank shows signs of vulnerability, the ECB has the right to take over the supervision of the institution, making the principle of subsidiarity prevail over that of proportionality. In the US, on the other hand, resolution interventions are led by the Orderly Liquidity Authority for banks subject to *enhanced supervision* (i.e. less than 5% of credit intermediaries), while small and medium-sized banks are subject to a special procedure coordinated by the Federal Deposit Insurance Corporation, which is entrusted with the necessary powers for proportionate interventions according to the characteristics of the institutions in crisis. The greater operational flexibility of the aforementioned US authorities compared to the European authorities is also accompanied by the lack of a single deposit insurance scheme for the resolution of small banks and by the provision of a limit of \$250,000, well above the €100,000 envisaged by the future CDGS (which the ECB is also considering modulating over time for interventions

<sup>14</sup> The LCR rules for European banks are defined in the CRR (Articles 411 to 416). The concept and requirements of LCR were devised by the Basel Committee of Banking Supervision in 2009 as a response to the 2008 financial crisis, which was caused by banks issuing risky loans and other egregious banking activities. Liquidity coverage ratio or LCR refers to the percentage amount of cash, cash equivalents, or short-term securities that large banks are required to hold as reserves to meet their short-term financial obligations during a crisis event. The LCR is calculated by dividing a financial institution's most liquid assets by its cash outflows over a 30-day period. Banks must maintain a ratio of 100% to satisfy the requirement.

<sup>15</sup> NSFR is a liquidity ratio requiring banks to hold enough stable funding to cover the duration of their long-term assets. For both funding and assets, long-term is mainly defined as more than one year, with lower requirements applying to anything between six months and a year to avoid a cliff-edge effect. Banks must maintain a ratio of 100% to satisfy the requirement.

#### *Basel IV: The Challenge of II Pillar for Risk Management Function DOI: http://dx.doi.org/10.5772/intechopen.96929*

limited to institutions in countries in financial difficulty), for the guarantee of depositors in the banking system.

In this context, it should be noted that the definition of the identification threshold for banks to which size-related measures are to be applied is not straightforward and can hardly be standardised. The difficulty lies primarily in defining criteria that are adaptable to the financial systems of different jurisdictions, which are different from each other. Policymakers and the literature have provided much food for thought [3–5] on the effective application of a two-tiered approach to less complex institutions identified through parameters such as:
