A fresh take on risk and valuation

The ECB 2019 Regulatory Priorities

By Arvid Voormanns, Consultant,

Jean-Pascal Kretz, Senior Consultant

and Kristian Lajkep, Regulatory Compliance Officer


The ECB’s regulatory endeavours are motivated by trying to address the following challenges and risk drivers that the ECB has identified in its 2019 risk assessment:

  • geopolitical uncertainties,
  • the stock of non-performing loans (NPLs) and the potential for a build-up of future NPLs, cybercrime and IT disruptions,
  • the potential repricing in financial markets, 
  • the low interest rate environment,
  • the banks’ reaction to new and existing regulations,
  • the euro area economic and fiscal conditions,
  • cases of misconduct,
  • developments in real estate markets,
  • structural business challenges,
  • non-bank competition and
  • climate-related risks.


The severity of these risk drivers as well as their ECB projected likelihood to materialize can be seen in the graph below.



It is important to note that these risk drivers should not be seen separately. Some events may trigger more than one of these risk factors and the factors themselves may be self-reinforcing. What is more, the ECB notes that this list is non-exhaustive.

Following this, the ECB has identified three general risk categories. These categories are similar to those of last year, with the exception of the business models, which the ECB regards as having already been sufficiently tackled (This does not mean that the ECB will no longer supervise business models. It will, particularly through the JSTs’ day-to-day supervision.)

These categories are:

  1. credit risk;
  2. risk management; 
  3. activities comprising multiple risk dimensions.

Each of these points further subdivides into particular policies and approaches, many of which will span for well over one year. You will find more details about these below:


Credit risk

Follow-up on NPL guidance

The ECB will further seek to manage the thinning but still substantial (compared to the rest of the world) stocks of non-performing loans, particularly in southern Europe, but NPLs are a problem for the whole Union.  The remedies will address the need to provide banks with bank-specific supervisory expectations and harmonize the framework in which these expectations will be addressed. The goal is to provide a way to manage and mitigate the legacy risks from the time these NPLs were taken on, and the coverage of the bank’s stock and flow of NPLs.

Non-Performing Loans (NPLs) - or Non-Performing Exposures (NPEs) - are the major cause identified behind the lacklustre performances of the European banks, still representing EUR 780 BN on loan books in June 2018.

High NPE levels entail a negative impact on the net interest income and cost of funding, as well as an increase in servicing and management obligations, impairment costs and regulatory capital requirements. 

Additionally, they affect the lending capacities towards the real economy by strapping up deadweight exposures on the balance sheet of banks, limiting the capital available for households and companies. 

Starting in 2016, the European Union has tackled the issue of high NPEs quite extensively:

  • November 2016: introduction of a legislative package reviewing the Bank Recovery and Resolution Directive (BRRD), the Single Resolution Mechanism Regulation (SRMR), the Capital Requirements Directive IV (CRDIV) and Capital Requirements Regulation (CRR) in order to create the framework for a simpler NPL workout.
  • March 2017: ECB guidance on NPLs establishing clear supervisory expectations in terms of NPL reduction strategies, governance, recognition (of which NPE “vintage” counter) and effectiveness of forbearance; collateral valuation was a major focus point as well. 
  • July 2017: Action Plan from the European Council, among others formalizing secondary markets for NPEs and initiating a macro prudential approach to limit NPE build-up and blueprints for National Asset Management Companies (AMCs). Set-up of a compared analysis of insolvency regimes.
  • March 2018:
    • Addendum with a special focus on provisioning / write-off of NPEs at different time horizons for secured or unsecured exposures

    • Proposal for a directive on credit servicers, credit purchasers and the recovery of collateral

    • Proposal for a regulation amending the capital requirement regulation

    • Blueprint on the set-up of national asset management companies (AMCs).

This series of measures, as well as regulatory pressure of heightened capital requirements and growing interest from international distressed credit managers, brought NPE average ratios down from 4.58% in September 2016 to 3% in September 2018.

This “better” NPE level remains largely above NPL ratios in the US and UK banking sectors in 2016 (respectively 1.3% and 0.9%). Additional supervisory action is thus expected for 2019, aiming at fulfilling the July 2017 Action Plan for financial institutions in Europe:

  • The EBA Guideline on management of non-performing and forborne exposures (in force: 30/06/19)
  • The EBA Guideline on banks’ loan origination, internal governance and monitoring (Q2 2019)
  • The draft TS on management information systems (Q4 2019)


This will influence the governance and procedures, as well as the Data and IT systems of European banks, and should strengthen the internal bank NPE resolution capacity, to manage the legacy risks and prevent “new” NPE formation by allowing banks to recognise and act at an earlier stage of the NPE build-up process and provide solutions before the default.

Credit underwriting criteria and exposure  quality

The ECB is also going to take steps to improve the underwriting criteria for new loans. The lending practices, both with regard to the quality of credit risk modelling and the stringency of bank’s lending appetites, will undergo a review in order to reduce the potential risk. This may also be conducted bank-specifically. This will further be reinforced with on-site inspections, not only in banks, but also other commercial real estate, residential real estate and leverage finance institutions.

An answer found in the FAQs on the addendum to the NPL Guidance provides some glimpse of the path the ECB is going to take regarding new lending before the 2021 deadline to the implementation of the ECB Guidelines on NPEs:

“Banks should prepare themselves and use the next two years to review their credit underwriting policies and criteria with a view to reducing the emergence of new NPLs, particularly given the current benign economic conditions. A suitably gradual path towards provisioning is also important, starting from the moment of NPL classification.”

More details are in the SSM supervisory priorities for 2019, which explicitly mention the examination of the quality of banks’ lending practices and specific scrutiny of their lending standards to reduce potential risks, with possible bank-specific actions for shortcomings. Finally, it is pointed out that the quality of certain asset classes is considered to require dedicated on-site inspections, quoting the particular cases of commercial real estate, residential real estate and leverage finance.

In the light of the ECB Guidance on Leveraged Transaction from May 2017, highlighting:

  • the risk appetite governance requirements, the definition of the investment strategy and due diligence requirements and
  • the procedures for risk onboarding and long-term monitoring and management.


it is possible to have more than a rough idea of the general direction supervisory scrutiny will be taking.

Furthermore, in all Guidelines in the last years, a permanent expectation has been the requirement for senior management to be aware of - and responsible for – the appropriateness of the credit risk management practices. This covers many topics, from fully understanding the models in use to reviewing the strategy, policies and tools, as well as ensuring that an effective internal control system is in place and that internal audit can function properly, while adhering to sound underwriting principles.

Based on this long-standing trend, and the data and internal model scrutiny of the last 2 years, one could draw a tentative approach to ensuring preparedness for when the Supervisor comes knocking, which would include a proper documentation covering the following items: 

  • Reviews of the credit management processes and tools - including alignment of minimal requirements for Standard Approach with the minimal available requirements for internal models,
  • Risk appetite governance – including a precise level and segregation of risk types,
  • Lending strategies,
  • Data, IT and external and internal reporting procedures.

Risk management

Whilst Credit risk related policies concern almost exclusively enhancing the way banks are dealing with already issued bad loans and taking steps not to allow them to take on new ones, the risk management topic contains more diverse elements. The ECB identifies the assessment of Banks governance procedures as its ongoing concern, though among bigger topics it mentions:

Targeted review of internal models (TRIM)

TRIM on-site investigations started in 2017, continued to take place during 2018 and are going to carry on during 2019. This review intends to unify approaches towards risk-weighted assets and assesses the rigor of banks pillar 1 internal models. The modelling is of chief interest for the ECB inspectors, particularly with regard to assessing credit risk for exposures in medium-sized/large corporates and institutions and specialised lending. The ECB guide to internal models is also scheduled to receive an update.

TRIM in more detail

The ECB targeted review of internal models focusses primarily on methodologies, but will also include data quality, IT infrastructure, model governance and start-to-end documentation of all model-related processes. Its purpose is to check compliance with regulations (CRR, CRD), but also to harmonize the industry standard approaches towards IRB models. Currently, the ECB observes some degree of variability in the determination of risk weighted assets (RWA), which is due to the freedom banks have in setting their methodologies. This variability in RWA is undesirable as it means that banks with the same risk appetite may have large differences in their regulatory capital requirements. The ECB thus attempts to align methodologies across the industry to mitigate such differences.

Banks can expect to receive remedial follow-up instructions to adjust their methodologies and other processes as a result of the on-site TRIM reviews. For credit risk models (PD, LGD, EAD), a change in methodology will almost surely result in different model outcomes. These changes are then inherited by the final expected credit loss calculations, implying an imminent shift in the level of regulatory capital. The size of the shift depends to a large extent on the degree to which the models initially conform to industry practices. Banks that adhere to industry practices can expect to be impacted to a lesser extent than banks that deviate from industry practices. However, as there is no clear guidance on what the current industry standards are, it is very hard to accurately predict the impact. It is also difficult to make a statement about whether there will be an upward shift or a downward shift. As the aim of TRIM is to align approaches rather than to improve them, the impact on regulatory capital requirements can work both ways for individual banks.

ICAAP and ILAAP (Internal capital and liquidity adequacy assessment processes)

The ECB will carry on with the review of these management instruments quality in institutions throughout 2019. In 2019, the ECB also plans to release the finalised ECB guides on ICAAP/ILAAP for use. Furthermore, the ECB also promises more work done on risk-by-risk composition of the Pillar II capital requirements, but does not get more specific than this.

IT and cyber risk

Following numerous enquiries into IT, FinTech and associated risks, primarily by the FSB on the global level and by numerous institutions at the European level, the ECB will launch a number of on-site inspections on IT risk-related topics. In addition, under the SSM cyber incident reporting process, the significant institutions will keep providing the ECB with a detailed description of any cyber-related incident. Those will be used both for monitoring and policy-making purposes.

Liquidity stress test

Similarly to the 2018 stress test, which mirrored (or was based on) 2016 stress test, the 2019 stress test will do so from the 2017 one, which concentrated on the banks’ resilience against liquidity shocks. The outcome of the liquidity stress test will induce further regulatory moves with regard to SREP.


Multiple risk dimensions

Brexit preparations

In preparation to Brexit, which is currently scheduled to happen in March 2019, the banks are asked to create viable business plans for all possible contingencies that the EBA will go through. Given that the negotiations are currently stuck, the “all possible contingencies” means a truly large number of very different plans, with no-deal Brexit looking more and more probable each day. The banks are advised to finalise the preparation as March is fast approaching. Furthermore, the ECB has proclaimed itself ready to welcome under its supervisory wings any significant institution that would reallocate from UK to the continent as a result of Britain’s departure from the EU.

The Fundamental Review of Trading Books

The ECB will engage in a dialogue with the institutions regarding their degree of preparedness with regard to the Fundamental review of trading books – a Basel standard whose European form is at this stage still not officially codified. The purpose of this will be to make institutions ready for the new market risk regulatory requirements. On site missions are also planned. 

In the next months and years, we foresee an ever-increasing focus on valuation as a result of the requirements for accurate and fast valuation for FRTB and initial margin. For the institutions opting for sensitivity based approaches, a fundamental review and enhancement of their pricing architecture will be needed. It will not be the only needed review of the pricing system, as institutions will need to cope with new benchmarks with the LIBOR disappearing in 2021. Not to mention the already in force EMIR and MiFID.

Furthermore, numerous activities not depicted in this document are being carried out on an ongoing basis, such as:

  • those relating to the IFRS 9 implementation (IFRS 9)
  • and those relating to risk monitoring or the assessment of recovery plans (BRRD)


In addition, at bank level, different institutions may be discovered to require a different supervisory activity from the ECB.


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