As predicted, 2017's SREP was the most transparent and risk sensitive so far. The calculation of Pillar 2 Requirement is becoming clearer, even if the banks see room for further improvement. In contrast, banks still see the determination of Pillar 2 Guidance as a `black box'. At a time when demands on Pillar 1 and Pillar 2 are growing, this opacity poses an increasing challenge for capital planning and investor communication.

In the October edition of KPMG's ECB Update, we predicted that the 2017 SREP process would be the most transparent and risk sensitive to date (Read SREP 3.0 online here).

Recent developments appear to confirm these expectations. For example:

• KPMG's 2017 SREP survey shows a sample median Pillar 2 Requirement of 225bps for 2018, similar to the 2017 figure, and a sample median Pillar 2 Guidance level of 156bps, down from 200bps in the prior year.
• MDA triggers appear to have increased on average by 90 basis points (bp) compared to SREP 2016, mainly due to the increase of P2R (~20 bp), the phasing-in of capital conservation buffer (~50 bps – less than 62.5 bps due to more front loading in certain EU countries) and the introduction of systemic buffers (~20 bp).
  
• As part of its Pillar 2 Roadmap, the EBA has also published revised guidelines for the 2019 SREP. The planned changes include the use of supervisory stress testing results for setting P2G; an assessment of institutions' stress testing frameworks; and a new distinction between viability scores and risk scores. However, we believe that these amendments will not fundamentally change the ECB supervisory approach in 2018.
  

Even so, many banks feel they are still a long way from a clear understanding of how the SREP affects their capital planning activities.

On the upside, there is no question that the transparency and risk sensitivity of the Pillar 2 Requirement (P2R) continues to improve - even if some banks feel the link with the ECB's supervisory measures could still be made clearer. More specifically:

• The impact of each SREP element's score (the assessments of Business Models, Governance & Risk Management, Risks to Capital and Risks to Liquidity & Funding) on the final P2R figure has become much clearer.
• That makes it easier for banks to conduct business driver assessments, helping them to understand how decisions over their business models could affect their P2R.
• This is demonstrated empirically by the increasing correlation between SREP scores and P2R. According to the ECB, correlation increased to 76% in 2016 from just 40% in 2014.
  

On the downside, many banks feel that the calculation of non-binding Pillar 2 Guidance (P2G) is opaque. Our SREP survey did not detect any obvious pattern for P2G based on banks' sizes, business models or home markets. Quantitative stress tests also appear to have a limited impact on P2G - similar to the findings of our 2016 SREP survey. That contrasts with the EBA's consultation on revised SREP guidelines.

In short, the determination of P2G appears to remain a `black box' process dominated by supervisory discretion. Furthermore, while P2G is not legally binding, the ECB's expectation that banks will operate above this level means it is de facto mandatory. In effect, P2G is therefore a confidential capital target that banks cannot disclose to investors or other external stakeholders.

This combination of P2R transparency and P2G opacity will make it hard for banks to carry out internal capital planning, let alone to explain to investors how their capital is being put to use or project funds are being allocated. The picture is further complicated by the different capital buffers, the growing number of measures and supervisory expectations affecting Pillar 1 and Pillar 2. Some notable examples include Basel IV where for example, it is unclear how changes of the Pillar 1 requirements in Operational risks will be reflected by ECB's Pillar 2 requirements, Non-performing loans (link to be included), Resolution planning, internal governance or leveraged transactions.

Despite the improvements in the SREP process, it is clear that SSM banks face a rapidly evolving capital challenge.