The COVID-19 pandemic has exposed the weaknesses in the recovery plans of many banks in Europe, as they struggle to cope with the financial impact of the lockdowns and the economic slowdown. The European Central Bank (ECB) has urged banks to improve their recovery plans and make them more operational, as they face the risk of losing their liquidity and capital buffers.
What are recovery plans and why are they important?
Recovery plans are documents that outline how banks can restore their viability in a timely manner even in periods of severe financial stress. They are a key element of the European crisis management framework, which aims to reduce the need for taxpayer money to support the financial system in a crisis. They also help safeguard critical banking functions, such as lending to households and businesses.
Recovery plans should identify all the credible options that a bank has to survive a range of severe but plausible stressed scenarios. These options may include raising new share capital, selling assets or subsidiaries, reducing costs or risk exposures, or accessing alternative funding sources. A recovery plan should also specify the indicators that trigger the activation of these options, and the steps that need to be taken to implement them.
How does the ECB assess recovery plans?
The ECB is responsible for assessing the recovery plans of the banks under its direct supervision, which are the largest and most significant banks in the euro area. The ECB carries out regular benchmarking of the recovery plans submitted by these banks, and provides feedback and guidance on how to improve them. The ECB also conducts dry runs, which are simulations of crisis scenarios that test the effectiveness and feasibility of the recovery options.
The ECB has recently published a report on its experience with recovery plans, based on three successive cycles of assessments. The report presents the ECB’s lessons learned and some best practices observed in five key areas: recovery options, overall recovery capacity, recovery indicators, playbooks and dry runs. The report aims to help banks further improve their plans and make them more operational.
What are the main challenges and areas for improvement?
The benchmarking analysis of the 2019/20 recovery plan cycle shows that banks need to improve their recovery plans to adequately address the financial impact of extraordinary system-wide crises such as the COVID-19 pandemic. One key finding is that the pandemic stress could significantly reduce banks’ overall recovery capacity (ORC), which is the extent to which a bank’s recovery options would allow it to recover from situations of severe financial stress.
The chart below shows how certain pandemic-related market disturbances could reduce banks’ capacity to restore their capital position (presented here in terms of Common Equity Tier 1 (CET1)). If an individual bank is in a crisis, raising new share capital or selling subsidiaries can be effective recovery options. However, in a system-wide crisis capital markets could suddenly close, leaving banks unable to raise capital. Also, in the wake of a crisis, investors may be less willing to buy a bank’s subsidiary at a fair price. If these extreme scenarios were to materialise at the same time, banks would see a significant drop in the CET1 recovery capacity reported in their plans, by 60% on average.
Notes: Capital recovery capacity is measured in terms of the CET1 ratio. The originally calculated range of capital recovery capacity is shown on the left-hand side and the range of capital recovery capacity under pandemic stress conditions is shown on the right-hand side. The pandemic stress scenario assumes that capital increases and sales of subsidiaries are not possible owing to COVID-19-related disturbances.
Looking at liquidity recovery capacity, wholesale funding is the most significant recovery option for most banks. However, this option may also become less effective in a system-wide crisis, as market liquidity may dry up and funding costs may increase. Therefore, banks should diversify their funding sources and rely more on stable retail deposits or central bank facilities.
Another challenge for banks is to define appropriate recovery indicators that can signal when they need to activate their recovery options. The indicators should be forward-looking and sensitive enough to capture the deterioration of a bank’s financial situation in a timely manner. They should also be aligned with the regulatory requirements and supervisory expectations on capital and liquidity adequacy.
Moreover, banks should develop playbooks that provide clear and detailed guidance on how to implement their recovery options. Playbooks should include information on the operational steps, timelines, responsibilities, legal and regulatory implications, communication strategies and contingency measures involved in executing each option. Playbooks should also be regularly tested and updated to ensure their effectiveness.
What are the next steps for banks and supervisors?
The COVID-19 pandemic has reminded us of the importance of sound recovery plans as a crisis management tool. The ECB expects banks to take into account the lessons learned from the pandemic and the feedback from the supervisors in their next recovery plans, which are due by the end of April 2023. The ECB will continue to monitor the impact of the pandemic on banks’ recovery capacity and to support banks in their recovery planning.
The ECB also encourages banks to use their recovery plans as a strategic tool to enhance their resilience and to prepare for the challenges ahead. Banks should consider how their recovery options can help them address the structural issues that affect their profitability and sustainability, such as overcapacity, low efficiency, legacy assets or digital transformation. Banks should also factor in the potential impact of climate-related and environmental risks on their recovery capacity and options.
The ECB will keep working with the national authorities and the European Banking Authority (EBA) to ensure a consistent and effective application of the recovery planning framework across the European banking sector. The ECB will also contribute to the ongoing review of the Bank Recovery and Resolution Directive (BRRD), which is the main legal instrument that regulates recovery planning in the EU. The review aims to simplify and improve the BRRD, taking into account the experience gained since its adoption in 2014.
