On 19 December 2014, the European Banking Authority (EBA) published guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP)  in order to flesh out Articles 97 et seq of the European Capital Requirements Directive IV (CRD IV). The deadline for implementing these guidelines, directed at national supervisors, was 1 January 2016.

According to these guidelines, SREP comprises the evaluation of these four key elements:

• business model analysis,
• governance and risk management assessment,
• risks to capital,
• and risks to liquidity and funding.

Following the risk assessment, supervisors should determine whether an institution’s own funds and liquidity are adequate to ensure sound coverage of current or prospective risks to the institution. The process culminates in an overall assessment which forms the basis for further supervisory actions and guidelines for eliminating deficiencies.

One new development resulting from the implementation of the guidelines in Germany is that capital add-ons have been set as part of a comprehensive and systematic assessment of own funds adequacy. This process is termed SREP capital quantification. In this process, capital add-ons (Pillar 2 requirements (P2R)) are calculated for all risks which are not, or not sufficiently, covered by Pillar 1 own funds requirements.  
 

BaFin and the Bundesbank therefore conducted a full SREP assessment in accordance with the EBA guidelines, i.e. including capital quantification as a new component, for the first time in 2016 and 2017 for credit institutions pursuant to section 1 (1) of the German Banking Act (Kreditwesengesetz) which are directly supervised by German authorities. Going forward, the full SREP assessment will be conducted regularly for all credit institutions on a graduated and set schedule which will be described below. The results of the capital quantification will be communicated to the institutions. Irrespective of this, risk assessment for the four key elements and the overall assessment will still be conducted annually.

Capital quantification in accordance with the EBA SREP guidelines

Under the SREP guidelines, the SREP capital quantification shall be conducted regularly in a 12-month to three-year cycle, taking proportionality criteria into account. However, more frequent assessments are also possible.

In order to identify the proportionality criteria, the competent authorities shall classify all institutions in their jurisdiction into categories from 1 to 4 by size, structure and internal organisation, as well as by the nature, scope and complexity of their activities. This categorisation is intended to reflect the assessment of the risk to the financial system posed by these institutions, with category 1 comprising institutions posing the greatest risk to the financial system.

Capital quantification cycle for German institutions

In line with these guidelines, on which the European Central Bank also bases its actions, BaFin and the Bundesbank have categorised the institutions in their jurisdiction. The key factors here were the significance of the institution, especially in terms of size and complexity, and the risk situation.

The assignment of an institution to a category under the SREP capital quantification process is final for the respective cycle. There is no provision for an advanced SREP capital quantification unless the institution's risk situation deteriorates dramatically or a material change to the situation occurs, such as a merger.

The vast majority of institutions are currently in categories 3 and 4 and thus in a three-year capital quantification cycle. The competent authorities keep institutions informed of their cycle as part of their regular contacts.

(Non-binding) Pillar 2 guidance

The foregoing remarks cover only determination of the (binding) Pillar 2 requirements. The cycle for the (non-binding) Pillar 2 guidance is independent of this. Previously, this cycle was two years, a frequency which the German supervisory authorities will, in general, retain. Since the Pillar 2 guidance depends on the results of national stress testing, the supervisory authorities will also continue to perform the stress test every two years, in principle. The Pillar 2 guidance is merely an internal indicator used by the supervisors with no direct legal effect. 

Disclosure of (binding) Pillar 2 requirements

Given that the Pillar 2 requirements are a binding capital requirement, institutions are permitted to disclose their SREP capital add-on in per cent or in percentage points.