The third annual SREP since the SSM's launch should be the most effective yet. We expect `SREP 3.0' to deliver closer harmonisation and better risk sensitivity within the Single Supervisory Mechanism (SSM). This reflects ongoing improvements to input data, and an ECB drive to enhance transparency. But banks cannot afford to relax. Understanding the SREP's potential impact on capital planning - and communicating this to investors - remain vital.

The annual Supervisory Review and Evaluation Process (SREP) is a core element of the SSM, and an important component of European banking union. The SREP cycle of 2017 (“SREP 3.0”) will be the third to take place since the SSM's launch in November 2014.

Each SREP differs from the previous year, as the SSM becomes more sophisticated and supervision grows more harmonised. SREP 3.0 will also aim to address complaints about the transparency of 2016's SREP. Some banks felt that the process was too much of a `black box'. In particular, changes to the composition of Pillar 2 capital requirements and the introduction of non-binding Pillar 2 guidance made it hard for banks to gauge the SREP's impact on capital planning.

In response to these concerns, we expect SREP 3.0 to be characterised by better input data and enhanced transparency. In our view these factors should further improve the SREP and make the `best yet'.

First, the enhanced quality of input data reflects the SSM's growing maturity. Joint Supervisory Teams (JSTs) benefit from continuing improvements in the range and quality of data at their disposal; in the standard of their analytical tools and processes; and in their own insight and understanding. Some specific improvements include:

• The ability to draw on the thematic reviews into business models and profitability drivers, compliance with BCBS 239 and the impact of IFRS 9.
• Access to increasingly sophisticated benchmarking tools, which now include pan-European peer group comparisons [refer to Business Model article].
• Using observations from last year's comprehensive EBA stress test to improve JSTs' risk assessments. SREP 3.0's particular focus on interest rate risks in the banking book (IRRBB) should also help JSTs to provide banks with detailed feedback.
• New guidance from the ECB in a number of areas including NPLs, leveraged transactions and the ICAAP and ILAAP processes.

Second, the ECB is working to address banks' transparency concerns, even if the need for subjective judgements means that perfect transparency will never be possible. For example:

• The ECB is actively focused on improving the transparency of the SREP process, and is expected to provide banks with a `comprehensive SREP communication package' during two SREP supervisory dialogues and when explaining decisions taken.
• Banks should receive more detailed information than before about their peer group benchmarking. This represents a significant step towards achieving truly pan-European supervision.
  

So far, so good - these changes should make SREP 3.0 less demanding for banks, while achieving a more risk sensitive outcome. But what about the “1 million Euro question”: Will SREP 3.0 lead to higher Pillar 2 capital requirements?

Overall, we expect core equity Tier 1 (CET1) requirements to remain broadly stable, although individual banks may experience variations as a result of their SREP scores. However, the devil will be in the detail.

• The calculation of Pillar 2 requirements and guidance should be more predictable - and more risk sensitive - than in previous years. Average levels of Pillar 2 requirements and Pillar 2 guidance will remain close to 200bps. Given the narrower focus of this year's IRRBB stress test, SREP 2016 levels should represent a fairly good indicator for most banks.
• The make-up of the capital stack will continue to change as the Capital Conservation Buffer (CCB) is phased in. The CCB's gradual introduction could slightly increase overall CET1 requirements, especially for banks that are close to 2016's minimum Pillar 2 guidance of 100 bps. However, the ECB has suggested that most banks should expect relatively little impact.
• EBA reviews its SREP guidance. The interplay between the various buffers (P2R, P2G, capital conservation buffer, etc.) and especially the quality of capital which can be used to meet the requirements will remain a moving target. The most crucial question will centre on the use of AT1 capital instruments.
  

In summary, we believe that SREP 3.0 should be the most harmonised, most risk sensitive and least onerous since the SSM's inception. But that does not mean that Significant Institutions can afford to underestimate its challenges. Banks need to closely monitor the ECB's communications around SREP 3.0, including the ongoing evolution of the Pillar 2 framework. They will also need to pay particular attention to the impact of the various factors which influence their capital planning, e.g. phase in of CCB or forthcoming regulation such as CRR2 or Basel IV - and to communicating this effectively to investors and creditors.