2021 Banking Regulation Round-Up

Even regulators have noticed that there is a major business problem facing the banking industry. According to the ECB: “strategic thinking, action and follow-up [must be] employed to tackle the emerging risks as well as the structural challenges that banks face”. To quote McKinsey: “the industry’s outlook remains cloudy, particularly given that half of banks can’t cover their cost of equity”. We can’t solve banks’ financial woes, but we can review the regulatory challenges that banks continued to face in 2021 and look forward to the supervisory themes of 2022.

Balance sheet resilience and asset quality

The supervisory focus on banks’ non-performing loan (NPL) management continued in 2021. Irish NPL levels and portfolio trades are expected to increase due to:

• the impact of COVID-19
• the exit of Ulster Bank and KBC from the market
• Irish banks disposing of legacy NPLs, and
• investment cycles of early loan acquirers ending.

A BPFI report in February 2021 found that Irish risk-weighted asset requirements for residential mortgages are considerably higher than in other EU countries. This alone is likely to drive continuing waves of NPL sales for capital reasons. The ECB has flagged persistent weaknesses in banks’ credit risk management frameworks, including “unlikely to pay” classification and forbearance flagging, as areas of likely regulatory attention in 2022, which will give further impetus to loan sale efforts. Sadly, EU banks’ troubles are unlikely to be solved by NPL disposals alone. The ECB has identified overcapacity and long-lasting structural weaknesses as potential drivers of M&A activity in the sector. However, whether M&A would be sufficient to address poor ROE in the current low-interest rate environment is at best unclear.

The EU Commission proposed a review of the EU banking rules under the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD) in October 2021. This was done as part of its objective to ensure that EU banks are resilient to future economic shocks while contributing to the pandemic recovery and is widely referred to as “CRR III/CRD VI” in the industry. The package implements further Basel III reforms including the comprehensive review of the trading book, the output floor and revisions to the credit and operational risk frameworks. The package also gives enhanced powers to supervisors, streamlines arrangements for third-country access to the EU market post-Brexit and proposes amendments to the resolution framework including MREL/TLAC requirements. If this package of reforms is adopted in 2022, it is unlikely to come into effect until 2025.

Culture and Conduct

The Department of Finance approved drafting of the Central Bank (Individual Accountability Framework) Bill in July 2021. This will create Ireland’s first comprehensive senior executive accountability regime (SEAR). SEAR will introduce prescribed responsibilities for senior managers and strengthen firms’ obligations to undertake due diligence on staff. It will also impose more onerous conduct standards that can be enforced directly by the CBI against staff through fines and other sanctions. We discuss the introduction of SEAR in our publication here as well as in the context of other financial regulatory trends here.

The CBI gave notice to amend the list of pre-approval controlled functions (PCFs) in September 2021. It is expected to update the regulations in late 2021 or early 2022 and proposes expanding the current PCF-16 to include branch managers of Irish firms in non-EEA countries. This will be particularly relevant to Irish firms with branches in the UK post-Brexit, subjecting branch senior personnel to closer CBI scrutiny. Other proposed changes include the introduction of standalone PCFs for independent non-executive directors (INEDs); and the Head of AML/CTF. The introduction of a separate PCF for INEDs is potentially significant given the CBI’s continuing focus on INEDs as a key element of the control environment within regulated firms.

Environmental, Social and Governance Risk

In August 2021 the Commission published a study on the development of tools and mechanisms for the integration of environmental, social and governance (ESG) factors into the EU banking prudential framework and into banks’ business strategies and investment policies. Overall, the study found that integration of ESG factors within banks and supervisors’ practices is at an early stage and identified several obstacles to further progress. We consider the next steps to green banking and the management of ESG risk in the banking industry in our publication here.

The ECB published its first assessment of banks’ efforts to manage their climate-related risks in November 2021 and gave them a poor scorecard. No bank is close to meeting supervisory expectations, and this will be a major area of focus in 2022. The ECB has warned that, as it continues to integrate climate-related risk into the SREP process, this will ultimately lead to Pillar 2 requirements in this area. There will be a climate-risk related stress test in H1 2022 combined with SREP deep dives into banks’ risk management frameworks.

Combatting Financial Crime

The Commission presented a package of proposals to strengthen the EU’s AML/CFT regime in July 2021. The proposal aims to create a new authority to combat money laundering and a Single EU Rulebook which harmonises AML/CFT rules. The legislative procedure in the EU is ongoing and amendment to the current proposed text is likely. The Commission hopes that the new AML/CFT authority will be established by 2023 and commence activities in 2024. The Single Rulebook, including technical standards, will be in place and apply by the end of 2025.

Looking ahead

The focus on culture and conduct will continue through 2022 as the SEAR legislation proceeds through the Irish legislature. Climate risk will be a significant area of focus from both the ECB and the CBI, with the CBI setting out its expectations of regulated firms in November 2021. This was done in a “Dear CEO Letter” in tandem with its endorsement of the COP26 Glasgow Pledge. We can also expect to see a continued focus on technology, cyber and outsourcing risk, with the CBI having published in December 2021 its Cross-Industry Guidance on Operational Resilience. The ECB is also focused on outsourcing, having stressed in 2021 that banks need to tackle potential concentration effects stemming from their reliance on third-party service providers.

If you would like to discuss any of the points highlighted, please contact a member of the Financial Regulation team.

The content of this article is provided for information purposes only and does not constitute legal or other advice.