The ECB banking supervision has mandated slightly higher capital buffers for the institutions under its oversight next year compared to 2023. The total requirements and the so-called pillar 2 recommendations, which have to be met in the form of common equity tier 1 capital, will increase from an average of 10.7% of risk-weighted assets (RWA) this year to 11.1% next year. This was announced by the supervision on Tuesday. If additional requirements are included alongside the common equity tier 1 capital ratio, the benchmark rises to 15.5%.

The ECB has thus presented the objectives from the Supervisory Review and Evaluation Process (SREP) for the coming year and has also outlined its focus areas in supervision for the years 2024 to 2026. In total, the supervision oversees 109 major banks in the Eurozone, including 21 banks from Germany.

The increase is attributed only to a lesser extent to the elevation of pillar 2 requirements for common equity tier 1 capital by the ECB: these requirements rise from an average of 1.1% to 1.2%. A more substantial portion of the increase comes from the growth of countercyclical capital buffers, set by national supervision to counteract overheating in lending. In Germany, this includes a countercyclical capital buffer of 0.75% and a sectoral risk buffer for mortgage loans of 2%.

ECB Chief Supervisor Andrea Enria, who has been succeeded by the former Vice President of the Bundesbank, Claudia Buch, at the turn of the year, attested resilience to banks. However, he noted that the downside risks are increasing. "European banks were able to withstand the macroeconomic challenges in 2023 well." He specifically mentiones confrontations such as inflation, rising interest rates, low economic growth, Russia's invasion of Ukraine, and the pandemic. Capital ratios and liquidity positions are robust, and profitability has significantly increased this year. In the second quarter, profitability reached double-digit values for the first time in almost ten years at 10.04% thanks to higher net interest margins.

Despite the accomplishments, European banks are cautioned not to be complacent amid significant uncertainty and economic challenges. "Economic prospects are marked by substantial risks and uncertainties," states Enria. "Banks will have to face challenges of more restrictive financing conditions, permanently elevated inflation, and ongoing geopolitical tensions."

The supervision expects interest margins to narrow, and refinancing costs to rise, putting pressure on profitability. At the end of November, the Bundesbank had already forecasted a renewed decline in net interest income for smaller and medium-sized German institutions not directly supervised by the ECB.

Enria states that 20 institutions received capital surcharges in the SREP due to non-performing risk positions. The supervisors had criticized that the resulting risks had not been adequately covered with capital. Additionally, eight banks received surcharges for their leveraged finance activities, six banks must meet higher leverage ratios, and seven banks received pillar 2 recommendations for the risk of excessive leverage. Recommendations, unlike requirements, are not legally binding, but the supervision expects them to be followed.

Qualitative measures are imposed by the supervision primarily due to weaknesses in governance, credit risks, and inadequate capitalization, as explained by Enria. Governance remains a focal point for banks, with three out of four institutions being advised to take measures to address deficiencies.

Measures related to liquidity risk and interest rate risk have also increased significantly. A focal point in the SREP was to delve into the reasons behind weak business models. As such, poor strategic planning and insufficient diversification were identified, further exacerbated by weaknesses in internal governance.

The banking supervision assesses business models, governance and risk management, capital risks, and liquidity and refinancing risks in the SREP. Each of these categories is given a score from 1 to 4 (good to poor), from which an overall score is derived. Depending on the score, the ECB imposes institution-specific capital surcharges beyond the minimum requirements (Pillar 1). The ECB also sets qualitative requirements that banks must meet.

According to Enria, the SREP scores assigned by the ECB have remained stable for years. The overall score is currently 2.6, the same as in 2015. Most banks (71%) have maintained their respective ratings over the year.

As supervisory priorities for the period 2024 to 2026, the ECB has emphasized improving resilience against macro-financial and geopolitical shocks, quicker remediation of deficiencies in governance and environmental risk management, as well as the digital transformation of banks.