ECB report on LSI supervision

Introduction

The ECB this week published a report on Less Significant Institutions’ (LSI) supervision. According to the report, the average total assets of an LSI bank supervised by the SSM is Eur1.5bn, Malta and Cyprus being lowest (both Eur0.4bn).

The report emphasises the fact that LSIs can expect increased supervisory harmonisation following successful harmonisation for significant banks. The report also sheds light on the SSM's focus areas as far as LSI oversight is concerned, being the assessment of business model and profitability drivers, credit risk and NPLs, and risk controls and internal governance.

Below is a breakdown of risks covered by on-site inspections in 2016:

Although business model and profitability risk was only covered in 3% of inspections, this is expected to increase in the coming year.

Business models of LSIs tend to be diverse, however they face a number of common risks in the current environment, for example:

• Intense competition;
• A prolonged period of low interest rates;
• Poor asset quality; and
• Weak credit demand.

These factors have contributed to the squeezing of LSIs’ profits, which makes it difficult to generate capital internally. The ECB therefore expects further consolidation of LSIs, resulting in leaner cost structures and improved business synergies. In 2016, market consolidation lead to a decrease of 5.1% in the number of banks falling under SSM supervision.

The report cites an Italian example of market consolidation. In Italy, credit cooperative sector reforms promote consolidation as a means of enhancing capacity to manage risks, improve operational efficiency, and enhance governance frameworks.

A focus on internal governance

Banks will need to comply with the new EBA guidelines on internal governance, and the EBA/ESMA suitability assessment guidelines (June 2018). Additionally, internal governance is perceived to be a risk existent throughout the industry. We expect internal governance to be a focus area of onsite inspections in the coming year.

Upcoming developments

Substantial progress has been made on the harmonisation of standards and practices with regard to LSIs. However, a variety of challenges still need to be addressed.

Among the statistics presented in the report, one which stood out is the number of capital add-on decisions imposed during 2016: a total of 827 cases, increasing from 612 in 2015.

A positive note is that a number of supervisory developments appear to be on the horizon, including an LSI SREP manual and IFRS guidance for LSIs. Such developments should enable better application of proportionality.