THE SUPERVISION BLOG

Supervising the new normal

Blog post by Kerstin af Jochnick, Member of the Supervisory Board of the ECB

Frankfurt am Main, 7 July 2020

From the outset of the current crisis, ECB Banking Supervision has taken extraordinary measures to address the initial economic fallout from the coronavirus (COVID-19) pandemic. The overriding goal of these measures has been to ensure that banks remain well placed to absorb losses and continue to lend to the real economy.[1] Safeguarding the bank lending channel is particularly important in the euro area, where banks, rather than capital markets, provide the bulk of financing to corporates and households.

But the effectiveness of the measures taken, as well as the need for additional ones, can only be assessed accurately in the coming months, as the full extent of the economic fallout from the crisis comes into view.

In the meantime, supervisors must turn their attention to two key questions. First, in the near term, how can we maintain effective supervisory engagement with banks during the crisis? And second, as the immediate effects of the crisis fade away and a new normal sets in, which aspects will be crucial in determining the shape of the European banking sector in the medium term? As an ECB policymaker in the field of banking supervision, I will share some of my thoughts on these questions.

Maintaining supervisory engagement

This crisis has redefined what constitutes meaningful supervisory engagement, in both a conceptual and an operational sense.

From a conceptual point of view, the supervisory flexibility provided by the ECB has meant that some of the indicators normally associated with banks’ financial deterioration in the pre-COVID reality – such as breaches in banks’ combined buffers – may no longer hold the same signalling value, and therefore need to be reconsidered. The extent to which this supervisory flexibility regarding bank buffers is warranted, the degree to which banks will make use of it once granted, and the pace of replenishment of such buffers once they have been exhausted are all issues that are still being debated in supervisory policy circles.

Banks are concerned that reporting lower capital ratios by dipping into their buffers would be a red flag to investors. However, ECB Banking Supervision has reassured them that they will be given sufficient time to replenish buffers that they have drawn on in order to maintain an adequate pace of lending while absorbing losses resulting from the COVID-19 pandemic. The Basel Committee on Banking Supervision has also reiterated that a reasonable drawdown of capital and liquidity buffers in the current period of stress is appropriate.[2]

These messages of reassurance from the official sector are important, because supervisory flexibility in the context of crisis measures will only be effective if it is well understood by the market and accepted as a temporary, but necessary, step to ensure that banks continue to perform their critical lending function. The ECB is also contemplating whether its recommendation that banks suspend dividend payments and share buybacks should be extended beyond October 2020. We will be communicating on this topic soon.

From an operational point of view, social distancing rules and travel restrictions precluded the use of many of the tools and practices that are part of the supervisory toolkit during both normal and crisis times, such as on-site inspections or internal model investigations. The ECB has therefore had to adapt its supervisory approach. Our engagement with banks has become leaner and more focused, so as to help banks deal with the immediate fallout from the crisis, while allowing us to monitor emerging risks. Let me mention a few examples.

First, we have made up for less on-site supervision by conducting more off-site supervision. Our Joint Supervisory Teams receive frequent updates from the banks on their key risk indicators and on crisis management aspects. In addition, we are performing a number of off-site inspections and off-site internal model investigations, which should help us continue to identify and remedy banks’ critical deficiencies.

Second, we are carrying out a vulnerability analysis of the banks under our supervision to assess the potential impact of this crisis on their balance sheets, considering different scenarios. This assessment will shed light on banks’ weak spots, their ability to withstand credit losses and the main risks that lie ahead, thereby also helping to inform our supervisory approach for the future.

We have also adopted a pragmatic approach towards our annual process for setting banks’ capital and liquidity requirements – the Supervisory Review and Evaluation Process (SREP) – for 2020, with a specific focus on how banks are handling the challenges and risks to capital and liquidity arising from the ongoing crisis.

Third, we have strengthened our efforts in the area of crisis prevention. We have revised the early warning framework we use to gauge whether supervisory action towards specific banks is warranted on the basis of likely financial deterioration. Our monitoring of banks’ liquidity positions has become more focused and more frequent, and we have introduced regular dedicated reporting on other material risks, such as IT risks, that may be heightened in the current crisis. This should allow us to identify pressing vulnerabilities early on and take appropriate action promptly.

And finally, we have incentivised banks to review and strengthen their recovery plans, which are crucial tools in their crisis management. We have advised them to increase their monitoring of recovery indicators and to step up their efforts to identify all recovery options that could be quickly implemented if the current crisis were to deteriorate. In order to free up banks’ resources and allow them to thoroughly and quickly identify these options, the ECB, in line with the guidance issued by the European Banking Authority[3], granted substantial relief to banks for other, non-core parts of their recovery plans.

Looking ahead, we stand ready to further adapt how we engage with banks to enable them to continue to lend to the real economy and help make the forthcoming recession as short-lived as possible.

Designing the new normal

Beyond the immediate response to the initial phase of the crisis, both banks and supervisors should reflect on what the business of banking will look like in a post-COVID-19 reality.

Just as health authorities have devised a path to a new normal for social interactions once restrictions on people’s physical movement are fully lifted, supervisors will need to design a new normal for the business of banking. And this thought process should start now, because the ultimate impact of this crisis on banks will partly depend on our initial policy response. I would like to highlight four important aspects in this regard.

First, banks need to maintain the efforts to repair their balance sheets. Experience from the previous financial crisis suggests that well-capitalised banks that were free of balance sheet rigidities were more likely to continue to lend through the cycle, and thus support a faster economic recovery, than those dragged down by high volumes of non-performing loans.[4] We can expect a similar dynamic to take hold in the aftermath of the COVID-19 crisis.

Non-performing loans are very likely to increase in the future, particularly once the effects of the mandatory payment moratoria decreed by several euro area governments expire. We have signalled to banks that we will exercise flexibility across several aspects when implementing the ECB Guidance on non-performing loans, so as to help them cope with the impact of the current economic downturn. At the same time, it is especially important in crisis times that banks have in place tight loan deterioration monitoring and management strategies which enable them to identify risks at an early stage. We will continue to keep a close eye on how effective banks are in implementing such strategies during this crisis, and we will maintain our engagement with banks to devise ways of swiftly disposing of impaired bank assets.

Second, the COVID-19 shock is likely to accelerate some of the trends which were already under way before the crisis. This includes digitalisation as an integral part of banks’ business models[5], and more acute challenges to profitability. Consolidation could be one way of successfully dealing with this dual challenge.[6] Consolidation can also help reduce the current excess capacity in the European banking system and it can deepen the banking union by fostering private risk-sharing.[7]

We recently published a draft guide clarifying our supervisory approach to consolidation in the banking sector, focusing in particular on how we intend to use existing supervisory tools when assessing key prudential aspects of consolidation projects. We have made it clear that we will not penalise credible integration plans with higher capital requirements and guidance, and that we will recognise, in principle, duly verified accounting badwill from a prudential perspective, with the expectation that it is used to increase the sustainability of the business model of the newly created entity. We have also clarified that we will allow the newly formed entity to temporarily use existing internal models for calculating capital requirements, subject to a to clear model mapping and a credible internal models roll-out plan to address the specific internal model issues created through the merger, as well as other conditions where appropriate.

Third, the crisis management and resolution framework for banks still needs to be strengthened. The lessons from the functioning of the framework during the first years of the banking union should not be forgotten. The process through which non-viable banks exit the market needs to be improved, in particular for banks that are not subject to resolution and are liquidated under different national insolvency regimes.[8]

We need to have coherent outcomes in both resolution and liquidation across the banking union in order to ensure a level playing field, but a liquidation tool is not yet available at the European level, and national liquidation regimes still provide domestic authorities with different tools and powers for dealing with failing banks.

And finally, policymakers should remain vigilant to guard against a potential revival of the bank-sovereign doom loop. Though appropriate for dealing with the current crisis situation, extending government guarantees to banks and decreeing payment moratoria for banks’ customers has temporarily reinforced the linkages between domestic banking systems and their respective sovereigns. Yet the banking union was conceived with a view to weakening precisely this sovereign-bank nexus.

It is important that these distortions to the level playing field do not become entrenched, and that the exit from these national measures is carried out in a coordinated manner, so as to avoid prudential externalities for banks and further financial fragmentation in the euro area. And for this same reason, work on completing the banking union must proceed, including the creation of a common insurance scheme for bank deposits.

Conclusion

In its role as banking supervisor, the ECB had to act swiftly to provide capital and operational relief to banks, with the overriding aim of limiting the economic damage arising from the COVID-19 pandemic to the extent possible. In so doing, we have also had to adapt how we engage with banks in order to cope with the demands of the new reality.

In the future, we will likely need to show the same speed and agility in devising a supervisory approach that meets the demands of this new normal while also building on the lessons of the recent past. While many open questions remain, any sustainable future for the business of banking will most certainly need the support of a more integrated system. For this reason alone, the need to complete the banking union remains as pressing now as it was before the COVID-19 pandemic.

[2]See Basel Committee meets; discusses impact of Covid-19; reiterates guidance on buffers, Basel Committee on Banking Supervision, 17 June 2020.
[4]See Ari, A., Chen, S. and Ratnovski, L. (2020), The dynamics of non-performing loans during banking crises: a new database, Working Paper Series, ECB, No 2395, April.
[5]See, for example, Pentti Hakkarainen, Member of the Supervisory Board of the ECB, The first lesson from the pandemic: state-of-the-art technology is vital, The Supervision Blog, ECB, 8 May 2020.
[6]See Interview with Andrea Enria, Chair of the Supervisory Board of the ECB, Supervision Newsletter, 13 May 2020
[7]See Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, Clarifying the ECB’s supervisory approach to consolidation, The Supervision Blog, ECB, 1 July 2020
[8]See also speech by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, Banking performance, competition and financial stability: a supervisory view, 15 November 2019.