Elderson On Escalation
The SSM Vice-Chair evokes Cold War theory to reiterate the ECB's willingness to act against non-compliant banks
Enforcement Toolkit
Frank Elderson spoke again about enforcement last week. In a speech to lawyers in Frankfurt, the ECB Supervisory Board Vice-Chair affirmed that sanctions are a key part of effective supervision.
Reprising remarks from last December, Elderson once again described the ECB’s extensive enforcement ‘toolkit’. This includes the power to require banks to improve their internal controls, restrict banks’ businesses, remove board members, and impose financial penalties – as well as the more familiar power to increase banks’ minimum capital ratios.
Escalation Ladder
Elderson vowed that the ECB would use all the tools at its disposal to compel banks to address deficiencies, for example in governance and risk management. This, he said, was a key lesson from the sudden collapse of US regional banks last spring. Then, supervisors had identified problems but did not effectively intervene. That allowed weaknesses to persist – with catastrophic consequences.
Learning from that experience, Elderson committed to more intrusive supervision. The ECB will require banks to address problems within a specified timeframe, he said. If they do not, supervisors will follow an ‘escalation ladder’ and impose increasingly tough sanctions to compel compliance.
Elderson’s invocation of an ‘escalation ladder’ is intriguing. The term was popularised in the 1960s by Cold War strategist Herman Kahn, to describe an intensifying sequence of actions by rival powers reacting to each other in a crisis. The ladder’s rungs mark escalating diplomatic, political or military interventions culminating in all-out (nuclear) war. Moving through these intermediate stages allows states to respond to different levels of provocation and signal their core interests, commitments and red lines to an adversary.*
The idea of escalating regulatory/supervisory action is nothing new. Elderson’s ‘escalation ladder’ is very similar to the ‘enforcement pyramid’ proposed by Ian Ayres and John Braithwaite in 1990s. This model of graduated sanctions – with penalties calibrated according to the seriousness and intentionality of an infringement – has been adopted by regulators around the world. And its key insight that a tiered system of sanctions can make regulatory intervention both more predictable and more credible lies at the heart of proportionate enforcement regimes.
But despite endorsing gradual escalation, Elderson did not spell out the various stages of intensifying supervisory intervention – the rungs on the ladder. Kahn’s Cold War ladder famously comprised 44 steps from ‘Ostensible Crisis’ to ‘Spasm/Insensate War’ set out in precise order. By contrast, Elderson did not arrange the ECBs tools on a single escalation spectrum. Rather, he suggested that some enforcement tools are better suited to tackling some problems than other (echoing comments by former SSM Chair Andrea Enria last September). He also reserved the right for the ECB to skip over intermediate sanctions and deploy more intrusive measures at an early stage in cases of serious breaches.
What emerges is therefore less a straightforward, unilinear escalation model and more a flexible multi-track framework – more an escalation scaffold than a ladder. For supervisors this has the advantage of maximising flexibility to respond to the specificities of each situation. But it also makes the ECB’s ‘enforcement reaction function’ harder for banks to understand and predict.
Climate Warning
The most prominent recent ECB enforcement action – and the one most closely associated with Elderson – relates to climate and environmental risk. Elderson reminded his audience that the ECB threatened to impose periodic penalty payments (PPPs, i.e. daily fines) on 18 banks if they did not improve their assessments of the materiality of climate risk. And he repeated his previous comment that ‘most banks have now submitted a meaningful materiality assessment.’ As I wrote in May, this implies that some banks have not and so will soon be fined. So far, however, the ECB has not publicly announced any sanctions.
Looking beyond the materiality assessments, Elderson confirmed that supervisors will follow a similar enforcement approach for the next stage of the climate risk process. The ECB has told banks to include climate and environmental risks in their governance, strategy and risk management by December 2023. Those not meeting supervisory expectations may again be given a fixed deadline to remedy any shortcomings, or risk daily fines.
That the ECB should reach again for the PPP tool is unsurprising. Indeed the logic of escalation requires the ECB to be at least as intrusive as during the first stage of the climate risk journey – or risk sending the message that it no longer cares as much. Which means banks cannot take much comfort at having passed the first stage of Elderson’s climate test.
See you in Court
Finally, and conscious that he was addressing an audience of lawyers, Elderson affirmed the ECB’s confidence in the legality of its enforcement actions. Ever since the ECB first imposed PPPs late last year rumours have circulated that some banks might challenge the decision in court.
Elderson’s message was simple: bring it on.
The ECB takes pains to ensure it abides by the requirements of EU law, he said. It follows a coherent methodology in line with the principle of proportionality, and gives banks a right to be heard before decisions are taken. This makes the ECB confident that its decisions will be upheld in court – as they have, Elderson said, in most of the 100+ cases brought to the European Court of Justice. So the ECB ‘will not stop using our toolbox for fear of litigation’.
* Interestingly, Herman Kahn is also often credited as the first proponent of scenario analysis – a tool that ECB Supervisory Board Chair Claudia Buch has said banks should use to supplement their traditional risk models. Curious how far the ECB has apparently been influenced by this theorist of thermonuclear war.