In cooperation with national supervisory authorities, the European Central Bank (ECB) supervises 110 “” banks--including four in Luxembourg--in 21 member states in the European Union--20 countries that use the euro and Bulgaria. Together, these banks hold approximately 82% of banking assets in the banking union, explained Mihails Kozlovs, member of the European Court of Auditors (ECA) in charge of the report, during a press briefing.

The ECB carries out risk assessments in terms of credit exposure, governance, liquidity and how banks manage these risks. It can also impose additional capital requirements and corrective measures to reduce risks. “EU action to strengthen supervision of the banking sector represents an important commitment and responsibility that requires adequate external oversight,” said Kozlovs.

Good quality risk assessments, but tools not used efficiently

“The ECB stepped up its efforts in supervising banks’ credit risks, and, in particular, of non-performing loans,” said Kozlovs. “However, the ECB needs to do more, in order to gain increased assurance that credit risk is properly managed and covered by banks. And also secondly, to enhance transparency of the whole process.”

This is important not only for the banks, but also for policy makers, financial markets, and citizens and taxpayers, “whose resources are very often on the line in case of turmoil in the financial sector.”

“Our overall conclusion is that the ECB assessments of credit risks are of good quality,” said Kozlovs. “But it does not efficiently use its tools for ensuring sound management and coverage of credit risk.”

Details from the report

The ECA’s report focuses on credit risk, and more specifically, on the risks posed by non-performing loans, which is when borrowers are unable to repay loans to banks.

“The first part of our findings is about a comprehensive annual assessment of significant banks, known as supervisory review and evaluation process.” The auditors checked the risk assessments, and found that the assessments of banks’ credit risk levels by the ECB in their sample were of “good quality.”

However, “we also checked the supervisory review and evaluation process, and found that the ECB did not use its existing tools and supervisory powers efficiently to ensure that the credit risk is appropriately covered by additional capital.”

The ECB’s methodology for “determining the additional capital requirements did not provide assurance that banks’ various individual risks were appropriately covered,” Kozlovs continued.

“Moreover, the application of this methodology by the ECB did not lead to consistent results.” The ECB, for example, did not impose proportionally higher Pillar 2 capital requirements for high-risk banks, found the auditors. In fact, for the highest-risk banks, it selected “requirements at the bottom of the pre-defined ranges,” said an ECA press release.

Findings on the ECB’s supervisory measures

The auditors also found that “the ECB did not efficiently use its supervisory measures to instruct some banks to better manage credit risks,” said Kozlovs, “even in the presence of evidence of high and sustained credit risk and persistent control weaknesses.”

In addition, the ECB did not escalate the supervisory measures when needed--for example, measures were taken with delays, did not lead to visible improvement, or additional capital requirements remained stable or even decreased, elaborated Kozlovs. The ECB has powerful measures to address these issues, but has instead relied on “softer” recommendations.

The auditors had two additional criticisms regarding supervision: timing--the supervisory cycle was “very long,” and took longer than in previous years--and a lack of staff, both of which could lead to outdated assessments.

Non-performing loans

The ECB was inconsistent in its treatment of banks with regards to non-performing loans, noted the ECA. “Those with higher shares of non-performing loans were given relatively more time than other banks,” said Kozlovs. That being said, the auditors also recognised that the ECB’s actions had contributed to the reduction of non-performing loans over the last five years.

Major recommendations to the ECB

Based on their findings, the auditors recommended improving the efficiency of the supervisory assessment process by improving a guidance and benchmarking process for supervisors and implementing a quality assurance process, as well as staffing the ECB’s supervisory function independently from the ECB’s central banking staffing strategy.

Kozlovs also noted that the ECB should improve their efficiency and issue final decisions within 10 months of the reference date.

The auditors’ last recommendation was to apply supervisory measures that would ensure better coverage and management of risk by banks by amending its Pillar 2 calculation methodology, using the full range of supervisory powers when required and publishing its methodology for generating Pillar 2 requirements.

Find the full “EU supervision of banks’ credit risk: the ECB stepped up its efforts but more is needed to increase assurance that credit risk is properly managed and covered” report published by the European Court of Auditors .