Priorities to help banks withstand headwinds

Blog post by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, and Mario Quagliariello, Director of Supervisory Strategy and Risk

Frankfurt am Main, 16 January 2024

We recently published our supervisory priorities for 2024 to 2026, which we based on our outlook for the banking sector and on the findings of our annual assessment of banks, the Supervisory Review and Evaluation Process (SREP). In this blog post, we would like to stress the importance of these priorities, as they clearly reflect the existing and emerging risks supervised banks are facing. Having derived these priorities from our risk assessment, we then have to ensure that action is taken to contain and manage the risks identified. By clearly outlining our medium-term priorities every year, we provide not only strategic direction for our own supervisors, but also clarity to banks about what we will be focusing on and what we expect them to do.

In recent assessments, we welcomed the resilience shown by the banking sector in weathering several crises in the last few years. This resilience was supported by comfortable liquidity buffers, low levels of non-performing loans (NPLs) and improving profitability. At the same time, we advised banks to remain vigilant, as the headwinds of past years have not yet subsided: the economic outlook is still weak, geopolitical tensions are still high and financial stability remains vulnerable.

Although asset quality has remained strong so far and the aggregate NPL ratio is at record-low levels, we expect some deterioration in banks’ asset quality due to weaker growth, sustained inflation and higher borrowing costs. This is weighing on households and firms and some early signs of stress are already visible. Early arrears, which give an indication of loans that are likely to default, increased significantly over the past year, although they remained below pre-pandemic levels. We are seeing growing pressure on households’ capacity to service debt, particularly in the consumer loan segment. Loans for house purchases have slowed, while house prices have started to fall. Rising borrowing costs are weighing on the corporate sector’s refinancing capacity, and bank exposures to commercial real estate are particularly vulnerable given that the sector remains in a downturn amplified by structural shifts, economic uncertainty and higher interest rates.

Banking sector remained strong in 2023

Supervised banks continued to display sound capital ratios, comfortable liquidity buffers, low levels of NPLs and improving profitability during the first three quarters of 2023. These sound fundamentals allowed them to withstand the headwinds stemming from a weaker economic outlook and heightened geopolitical tensions. The aggregate Common Equity Tier 1 (CET1) ratio stood at 15.6% in the third quarter of 2023, near its record-high level, driven mainly by the increase in the absolute capital level, while risk-weighted assets remained broadly stable.

Moreover, positive margin effects from higher interest rates continued to boost banks’ profitability in the third quarter of 2023, and return on equity (ROE) stood at 10%.

The strong position of banks enabled them to successfully weather the fallout from the financial market turmoil that occurred in March 2023. While US mid-sized banks faced strong risk-off sentiment, contagion to the European banking sector remained relatively limited and temporary in nature. This was also reflected in price-to-book ratio dynamics and resulted in the narrowing of the valuation gap between euro area and US banks, which remains material.

Managing credit, asset and liability risks

While asset quality has remained strong so far, with the aggregate NPL ratio of supervised banks standing at 1.85% in the third quarter of 2023 (2.27% excluding cash balances at central banks), we expect some deterioration in banks’ asset quality owing mainly to a weaker growth environment, still high inflation and higher borrowing costs, all of which are weighing on households and firms. Some early signs of this are indeed visible. Some sectors, such as the commercial real estate sector, remain particularly vulnerable to macroeconomic dynamics and structural shifts.

The turn in the interest rate cycle could also pose a challenge to banks offering prime brokerage services to non-bank financial institutions (NBFIs), especially if the latter are highly leveraged. In addition to being a potential source of counterparty credit risk for banks, these NBFIs may also pose indirect risks by amplifying negative market movements. This would be especially true if financing conditions were to tighten further and these institutions were forced to abruptly unwind their positions.

Taken together, these developments explain why addressing structural deficiencies in banks’ credit risk management frameworks will remain a key supervisory focus in the future. Our targeted reviews, deep dives conducted by Joint Supervisory Teams and on-site inspections will largely continue from last year. We will make certain adjustments in order to focus on the portfolios that are more sensitive to macroeconomic factors, such as residential and commercial real estate, and small and medium-sized enterprises. We will continue investigating banks’ provisioning practices under the IFRS 9 framework. We also plan to strengthen our engagement with banks on counterparty credit risk management by accelerating the remediation of findings from last year’s targeted horizontal review and on-site inspections and monitoring how banks meet our supervisory expectations.^[1]

A potential further tightening of financing conditions might significantly alter the liquidity environment, raising banks’ funding costs and thereby testing how prepared they are to manage liquidity risks. On aggregate, banks exhibited a comfortable liquidity and funding position after the repayment of funds under the ECB’s targeted longer-term refinancing operations (TLTROs). In the third quarter of 2023, the liquidity coverage and net stable funding ratios stood at 159% and 126% respectively. In future, we will check banks’ resilience to short-term liquidity shocks and the credibility of their liquidity contingency plans, while also continuing our review of the feasibility and reliability of banks’ funding plans.

The financial market turmoil in spring 2023 in the United States, unleashed by the failure of Silicon Valley Bank, was a reminder that banks need to properly manage the risks posed by rising interest rates. Having already identified this issue in 2021, we were able to identify the most vulnerable intermediaries at an early stage. Banks’ exposure to interest rate risk in the banking book seems to be relatively contained so far. Higher interest rates have boosted profitability and rate increases have a rather limited impact on the economic value of equity in the current situation. Looking ahead, we will pay attention to banks’ sensitivity to changes in credit spreads, as some of their exposures to those spreads are unhedged and could lead to significant losses in certain situations. Analysis by our supervisors suggests that unrealised losses in the amortised cost portfolios are much smaller than those of their US counterparts.^[2] At the same time, however, banks should be aware that with the turning of the interest rate cycle, any deficiencies in asset and liability management frameworks will appear in a different light than they would have during the period of historically low interest rates known as the “low for long” era. We need to increase our scrutiny of banks’ asset and liability management governance and strategy, including the calibration of their models to reflect changes in customer behaviour.

Addressing governance, data reporting, climate and digitalisation challenges

Near-term risks to the banking sector stemming from macro-financial developments often take the spotlight. But banks and supervisors should not lose sight of the need to buttress banks’ resilience in the medium term by remedying the more structural shortcomings identified in previous supervisory cycles.

For several years now, we have been pointing out banks’ lingering weaknesses in internal governance, particularly in the functioning of their management bodies. Banks have also failed to fully address long-standing issues around risk data aggregation and reporting capabilities. Given their slow progress overall, many of our banks have continued to score poorly in governance in their annual SREP, even though their risk profile has improved in other areas. Our supervisors will deploy their entire toolkit, ranging from issuing qualitative measures with clear remediation deadlines to imposing capital add-ons or periodic penalty payments if such deadlines are not met.

We have already started applying enforcement measures so as to foster banks’ compliance with our supervisory expectations^[3] for banks’ C&E risk management practices by the end of 2024. A number of banks have not complied with our first interim deadline of March 2023, which focused on the materiality assessment of the impact of C&E risks on banks’ activities. For such banks we have issued binding supervisory board decisions providing for periodic penalty payments should they fail to comply with the requirements by a given date.^[4] We will take a similar approach to the rest of our implementation deadlines for banks.

Digitalisation trends affect banks’ operational resilience frameworks, also because banks are becoming more dependent on a handful of − in some cases large − third-party service providers. The higher number of cyber incidents reported by banks in recent months is an additional challenge, also in the light of the mounting geopolitical tensions. We will therefore continue identifying and assessing deficiencies in banks’ outsourcing arrangements and cybersecurity management. And in 2024 we will conduct a system-wide cyber resilience stress test.^[5]

Towards a more effective and risk-focused supervision

As European banking supervision has entered a more mature stage, we are gradually enhancing our risk-based, agile and effective supervisory approach. The introduction of an explicit risk tolerance framework (RTF) in 2023 was a major step in this direction. The framework defines institution-specific risk tolerance levels for each risk issue by combining the top-down guidance embedded in the SSM supervisory priorities with bottom-up assessments of their relevance for each individual bank. It empowers our supervisors to adjust their activities to the banks’ individual situation and devote more time to addressing the main priorities and vulnerabilities of the bank in question.

By outlining and specifying our priorities every year, we encourage effective and consistent supervision and promote efficient deployment of our resources. At the same time, we clarify our supervisory expectations for banks and help national supervisors set their own priorities for the banks they directly supervise. As we have already said, the European banking sector is generally in good shape. Alongside actions taken by banks themselves, we can help strengthen the sector’s resilience even further by following through on our priorities with supervisory guidance and measures to ensure that banks remain a healthy cornerstone of the European economy.