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Flexibility in supervision: how ECB Banking Supervision is contributing to fighting the economic fallout from the coronavirus

Blog post by Andrea Enria, Chair of the Supervisory Board of the ECB

27 March 2020

In this blog post, I will try to explain the rationale for the supervisory flexibility measures and distribution restriction recommendations we announced over the past two weeks in response to the economic shock from the coronavirus (COVID-19) outbreak.

From the outset our supervisors have been collecting intelligence on a continuous basis from the banks on the effects of the current severe shock. Our response to events will be reviewed and adjusted as they unfold to keep pace and ensure that banks continue performing their vital function of servicing the real economy.

We are in the midst of an unprecedented crisis generated by a totally unexpected event. The coronavirus outbreak is threatening the lives of many people around the globe and is pushing the economies of many countries into recession. We expect households, small businesses and corporates in the euro area to face extremely challenging economic and financial conditions.

Unlike in the 2008 financial crisis, banks are not the source of the problem this time. But we need to ensure that they can be part of the solution. To this end, our mitigation measures aim to allow banks to keep providing financial support to viable households, small businesses and corporates hardest hit by the current economic fallout. Likewise, our recommendation on dividend distribution restrictions is intended to keep precious capital resources within the banking system in these difficult times to enhance its capacity to lend to the real economy and to support other segments of the financial sector as they come under stress.

It is worth mentioning that our supervisory measures should not be considered in isolation. In fact, important synergies exist between what we have decided and the policies announced in parallel by monetary and fiscal authorities. The ECB, as central bank of the euro area, has provided banks with increased sources of cheap funding supplemented by an extraordinary asset purchase programme. As the banking supervisor, we have eased capital and liquidity constraints to increase the ability of banks to lend and absorb losses in this challenging environment. Euro area governments have taken noteworthy decisions to temporarily relieve the difficulties of debtors with payment moratoriums and guarantees on bank loans, and in response we have increased supervisory flexibility regarding the regulatory treatment of loans receiving such public support.

First of all, our supervisory guidance has focused on delivering a more flexible application of the unlikely-to-pay classification for borrowers that are recipients of ad-hoc governmental guarantees or for which moratoriums are enacted. In addition, loans that have government guarantees and turn non-performing will receive favourable treatment in terms of coverage requirements for a period of seven years following their deterioration.

However, prudential rules are not the end of the story. Our supervised institutions expect the current turmoil to heavily impact their capital and published financial statements through accounting outcomes. Within our remit as a prudential supervisory authority, we have asked banks to smooth the procyclicality embedded in their IFRS 9 loan loss provisioning models as much as possible. For the same reason, we recommended all institutions that have not done this so far to start applying the IFRS 9 transitional calendar available under the Capital Requirements Regulation. This will prevent the volatility in IFRS 9 valuations during the current shock having a significant impact on banks’ capital.

Let me be clear that, in these trying times, we will perform our ongoing supervisory actions with great consideration for the operational burden they could create for banks and supervisors, both of which are relying extensively on teleworking during this period. We have suspended, for a period of at least six months, the finalisation or implementation of various supervisory decisions, which would increase the regulatory burden for many supervised entities. And we have communicated to banks that we will use full flexibility in evaluating the implementation of the ongoing plans for reducing past non-performing loans.

Last but not least, we have instructed banks to take advantage of all of the regulatory flexibility allowed by current legislation in using capital and liquidity buffers under stressed circumstances, including full usage of the Pillar 2 Supervisory Guidance and re-composition of the quality of capital for the Pillar 2 Requirement with less equity absorption. The capital relief provided via these measures is substantial; it can be used to absorb losses in the deteriorated macroeconomic environment, without triggering any supervisory action, and to continue lending to customers, especially small and medium-sized enterprises, severely hit by the crisis.

For all of the supervisory initiatives that are already in place, we have reassured banks that we will not make any negative supervisory assessment on the basis of their implementation at the current juncture.[1]

Extraordinary liquidity measures, very large public guarantees, historically high support for households and firms and, last but not least, unprecedented flexibility in supervision. This is truly a panoply of public initiatives that will play their role in helping banks absorb the shock, remain sound and keep providing vital support to the real economy.

I am convinced, however, that this should not be a one-way road.

As everything around us is being put on hold to focus all the efforts of our communities on the fight against the coronavirus, a contribution is also required from banks and their shareholders.

Credit institutions’ own funds are the most effective tool to enable them to withstand shocks that materialise unexpectedly. Unfortunately, we have now clearly been forewarned: the economic shock resulting from this crisis cannot be considered unexpected anymore. We still do not know how large and long-lasting the contraction in economic output will be. While we hope for the best, we must be ready for the worst.

Moreover, we observed during the last financial crisis that, as the economic outlook worsens, the liquidity of non-bank financial intermediaries may be put under strain as investors redeem their investments and fly to the safety of cash. If that happens, banks’ support to other financial intermediaries could help contain liquidity strains in the system. A prudent capital conservation strategy by banks could also be beneficial in this regard.

All this considered, ECB Banking Supervision has recommended that, until at least the end of September 2020, all credit institutions not distribute dividends to shareholders for the 2019 and 2020 annual reporting periods.

Compliance with this recommendation would allow a total €30 billion of additional capital of the highest quality (retained profits classified as Common Equity Tier 1) to be kept within the system. This will give banks additional capacity to lend or absorb losses at a time when it is particularly needed.

At the same time, ECB Banking Supervision has extended this recommendation also to share buy-backs and will act accordingly when assessing buy-back applications from banks as required by EU legislation.

While I consider these supervisory recommendations and actions to be extremely appropriate from a prudential point of view, I also think that withholding distributions in these exceptional times is entirely appropriate from the point of view of social corporate responsibility.

I have heard arguments that such interventions by and recommendations from the supervisory authority will actually spook equity investors and, in the end, diminish the lending capacity of credit institutions.

While I understand that we all need to be cognisant of immediate market reactions, I believe that these measures are in the long-term interest of the banks and their shareholders. By preserving their critical functions and enhancing their support to households, small businesses, corporates, and other financial institutions, banks are effectively protecting the value of their franchise and enhancing their reputation.

Europe and its citizens are facing an extraordinary challenge. We must rise to this challenge and act quickly and decisively to address the most urgent issues. At the same time, we must also take into account the longer-term consequences of our actions, to make sure that the European banking sector remains strong and can support the rapid recovery of our economies after this unprecedented shock.