Martin Noréus: Capital and AML - current topics in bank supervision

At a conference today, Deputy Director General Martin Noréus shared his views on capital adequacy in Swedish banks and how capital adequacy will be impacted by forthcoming regulations. Mr. Noréus also gave a process update on ongoing AML investigations and concluded that money-laundering risks will become a bigger consideration in prudential supervision.

  • Date: 2019-09-05
  • Speaker: Martin Noréus
  • Meeting: UBS Nordic Financial Services Conference

Some perspectives on capital adequacy

The first question I want to address today is this: Do Swedish banks have enough capital? There are several ways to answer this question. One is to take a regulatory approach, where we state that "we currently assess the Swedish banks to have satisfactory resilience overall". This is a rather formal way to respond to the question in our legal role as supervisors continuously assessing risks. It is also possible to take a more theoretical approach to capital in banks, drawing on macroeconomic assessments such as the trade-off between economic activity and reducing the costs to society from banking crises. And, finally, there are market-based assessments, where conclusions are drawn from the pricing of bank credit and equity. Combined, our assessment is that the overall level of capital in Swedish banks is satisfactory.

Resilience due to sound business models

However, I would argue that the key question is really broader than merely capital adequacy: are banks' business models sound? From a forward looking perspective, the sustainability of profitable business models is the most fundamental element of resilience. Securing or improving the soundness and sustainability of your business model is what secures or improves the ability to adapt to new challenges, whether these challenges stem from market evolution or even regulation. Many European markets have been struggling with unsustainably low profitability in banking, whereas the Nordic banks overall have had a better ability to build resilience.

When supervising banks, our main task is to evaluate and assess the risks facing the banks and their business models and whether these risks are sufficiently covered by the banks' forward-looking capital planning. As a basis for our supervisory decisions, we are tasked by EU directives and Swedish law to perform continuous risk assessments.

Addressing credit risk in commercial real estate

There is one area of risk assessment which has drawn some attention lately: How do we view the risks in the commercial real estate market? This lending segment is always an important part of the supervision of the Swedish banking system due to its size and boom-bust cyclical nature. Over the past year, we have performed more in-depth studies of banks' exposures, downturn scenarios for the real estate market, and how the banks' credit risk models work for this segment. What we concluded and communicated before the summer was that capital levels derived by internal (IRB) models result in insufficient risk coverage for commercial real estate.

To bridge the gap until IRB models have improved, we are now designing a supervisory measure to secure sufficient coverage, and we are targeting our measure on the IRB banks' corporate exposures to Swedish commercial real estate. We will issue a consultation paper in November specifying what action we intend to take. This means that, if we decide to introduce bank-specific Pillar 2 capital add-ons, these add-ons can be applied from early next year in the annual Supervisory Review and Evaluation Process, where we set capital requirements for individual banks.

Securing buffer functionality in new regulatory regimes

One question in particular is often posed to us: How will Swedish banks be impacted by forthcoming changes to regulation? Particularly in regard to capital and balance sheet composition overall, there are significant changes that have been agreed upon but not yet implemented. The changes will primarily come in two waves in the form of two new editions of the Capital Requirements Directive, which is the EU's main legislative package for banks. I will try to provide a very general illustration of the dynamics. The first wave, CRR2/CRD5, will be transposed into Swedish law next year. This will mainly impact capital buffers and Pillar 2 add-ons, which will become more harmonised in design and calibration within the EU.

Historically, but also currently, we have placed major emphasis in Sweden on the functionality of loss-absorbing capital. For us, high capital buffers and Pillar 2 add-ons have offered high functionality in terms of securing the usability of capital, which is valuable in particular from a systemic risk perspective. The capital stack in Sweden has been high but narrow from a European perspective, and harmonisation will lead to a wider but lower capital stack, where more is made up of minimum requirements. We have already made changes in this direction by moving the risk weight floor on mortgages from Pillar 2 to Pillar 1 minimum requirements (while retaining the buffer functionality).

Even more standardisation and harmonisation is set to come with the second wave of regulation, CRR3/CRD 6, which transposes the latest Basel standard into EU and Swedish law from 2022 onwards. Here, the intention is to reduce unwarranted variability in risk weights and, hence, capital requirements. However, a consequence of using a more standardised approach is that capital requirements will generally become somewhat less risk-sensitive. The impact for Swedish banks will again be a change to the design of the capital stack – wider from more standardised (normally higher) risk weights and lower as a percentage to the extent risks are instead covered by the higher minimum requirements. The primary impact on capital from both CRD5 and the Basel-led changes will be on the composition of our requirements, whereas the impact on the overall size—the krona amount of capital for banks to hold—is less clear. We have stated that higher REA from these regulatory changes should not mechanically lead to higher capital requirements, although we cannot rule out an increase in order to ensure that some buffer functionality remains.

But it is not only the design of capital requirements that are being harmonised; bank supervision more generally is increasingly converging in the EU; partly from regulatory changes, but also from more interaction with the ECB in the supervisory colleges that are coordinating supervision of large cross-border banks in the Nordic region.

AML risks specifically considered in prudential supervision

Finally, there is one question that has been asked most frequently this year: What is happening in the area of anti-money laundering? During the summer, we concluded the first phase of our investigations into the control of AML risks in the Baltic operations of SEB and Swedbank. The banks are now responding to our initial assessments, and the final decisions from our side will be communicated early next year by the latest. These supervisory investigations are being coordinated with the national authorities in Estonia, Latvia and Lithuania. The Swedish investigations are evaluating the risk control frameworks at the banking group level both historically and at present based on detailed information, whereas the authorities in the Baltics are investigating the national subsidiaries' compliance with AML regulations.

I think it is fair to say that AML is not a regional topic, but an area that will remain in the spotlight of regulation and supervision on a more global level for the foreseeable future. Evidence of malpractice and wrong priorities has been revealed in many banks across Europe. Tighter regulations and standards are being introduced, which will have a meaningful impact on both banks' risk management and AML supervision. At Finansinspektionen, we have already significantly increased the resources dedicated to AML supervision, and we expect this to continue. We have also strengthened the cooperation with our Baltic and Nordic colleagues and aim to significantly increase the exchange of information and the coordination in AML supervision.

In addition, the EU is strengthening the link between AML and prudential supervision. In Sweden, AML is already integrated into our ongoing supervision, but for us, and all other supervisors in the EU, AML risks will from now on be more specifically considered in the ongoing review of risks in prudential supervision. This will be the case in particular when making decisions on authorisations, acquisitions of qualifying holdings and fit and proper assessments of management.

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