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INTERVIEW

“We can’t afford to drag our heels when it comes to risk”

Interview with Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, Supervision Newsletter

19 May 2021

Frank Elderson

Frank Elderson, Vice-Chair of the ECB’s Supervisory Board, talks about monitoring credit risks during the pandemic, addressing current and future climate change risks, and the suitability and diversity of banks’ boards.

 

The ECB has been looking closely at banks’ asset quality and credit risks. What have you found so far? What are the next steps?

We started our examination of credit risk in 2020, and the first preliminary results are now coming in. The fallout from the pandemic is still not fully reflected in indicators of distress, but we are beginning to get a clearer picture of credit risk, and signs of increased credit risk are becoming apparent.

Some banks still have work to do in terms of classifying and measuring their credit risks. Around 40% of the banks we examined need to address significant gaps if they are to meet our supervisory expectations on credit risk management. Also, there are major differences in how banks flag their exposures as forborne, suggesting that some banks might not be taking an adequate approach here. We are also concerned about the large share of exposures that appear to go straight from being considered performing without significant signs of distress to being seen as credit-impaired, skipping the stage where an increased credit risk has been identified. This could be a sign of ineffective early warning systems. We mustn’t forget that credit risk has not yet peaked, so we can’t lower our guard. We have to remain cautious. It is still too early to relax provisions. We are taking a close look at banks’ provisioning policies and if we have concerns about how prudent banks are being, we will delve deeper.

One of the benefits of European supervision is that we can compare banks competing in the same markets. And we are currently carrying out in-depth analyses in a number of areas, including provisioning practices, banks’ compliance with supervisory expectations and their exposures to vulnerable sectors. This work on credit risk will keep us busy for the rest of this year and will likely continue into 2022.

You have stressed the need for banks to address climate-related and environmental risks and, more specifically, biodiversity risks. How will you make sure they do?

Climate-related and environmental risks cannot just be an afterthought – they pose a very real challenge today and could have serious implications tomorrow. A safe and sound banking sector is essential to financial stability, so we must ensure that banks adequately address any risks that could pose a threat to this stability. And this goes beyond purely climate-related risks. Biodiversity loss is also emerging as a material source of financial risk – fewer bees means less pollination and that leads to poorer harvests, to give a simple but telling example.

You may remember that we published the ECB Guide on climate-related and environmental risks last November. The Guide makes it clear that these risks should be embedded in all relevant bank processes, ranging from the definition of business and risk strategies to public disclosures. Based on this Guide, we asked banks to assess their current practices against our expectations and to share action plans to address any identified gaps. We are critically reviewing their submissions at the moment. If we see that a bank is not adequately managing its exposure to climate-related risks, we will of course step in and ask the bank to correct its course – just like we do for any other material risk.

Will climate change risks become a permanent feature of your annual supervisory work plan?

Most definitely. We have already started to incorporate climate-related risks into our supervisory methodologies and they will also be regularly assessed as part of our Supervisory Review and Evaluation Process (SREP). This year’s assessment of climate risks is not expected to be taken into account when determining bank-specific capital requirements, but we may need to impose qualitative or quantitative requirements in some specific cases. In a way, the 2021 SREP will lay the groundwork for a full supervisory review in 2022.

2022 will be a key year for our work on climate-related risks as we will be carrying out a bottom-up stress test, based on information provided to us by banks. Preparations are underway and we are currently developing our scenarios and methodology. We will test what impact climate change could have on banks’ portfolios, mapping the developments over the next 30 years. The stress tests will help us form a clearer picture of where banks stand – are their balance sheets resilient to climate change risks, for example, and do they adequately manage these risks? What’s more, the exercise will allow us to gather crucial data that we are currently lacking. Not only will this help us to identify any supervisory reporting needs for these types of risk, it will also inform the general supervisory approach to climate change.

I have said it before, and I will say it again: the risks from climate change, be they physical or transition risks, are material. And we will use a wide range of supervisory tools to make sure that banks adequately address them. This has an added benefit because if banks know how climate risks can affect their balance sheets, they can price them more accurately. And accurate risk pricing is central to securing the investments needed to transition to a net zero economy.

In addition to your role as Chair of the Network for Greening the Financial System, you also co-chair the Basel Committee on Banking Supervision’s Task Force on Climate-related Financial Risks. What has this task force achieved so far, and what climate change topics will it be working on in the future?

The Basel Committee on Banking Supervision (BCBS) acknowledges that climate change may have an impact on the safety and soundness of financial institutions and broader financial stability implications for the banking system as a whole. Climate-related financial risks will therefore be among its main priorities over the coming years. In this context, the task force was set up specifically to explore how to best mitigate risks to banking institutions and the banking system arising from climate change. It’s a large group, too – participants come from over 40 BCBS member authorities and include central banks and supervisors.

We have been very busy since we started in February 2020. In April last year we published a stocktake of existing initiatives on climate-related financial risks. And just last month we published two analytical reports: one on risk transmission channels and the other on measurement methodologies for climate-related financial risks.

These two reports offer some good news. We concluded that the traditional risk categories – such as credit risk, market risk and liquidity risk – can be used to capture climate-related financial risks as well. This means we have a solid foundation for the BCBS’s future approach to climate issues: instead of treating climate-related financial risks as a new separate risk type, we can look at how to tackle these risks within the current structure of the Basel framework. This will considerably speed up our action in this field. However, the task force also concluded that there are still challenges in terms of data availability and measuring climate-related financial risks. Over the coming months, we will be identifying potential gaps in the current framework and considering possible ways to address them. As part of this work, we intend to carry out a comprehensive review of current regulation, supervision and disclosure practices.

Given the urgency of the topic, we can’t afford to drag our heels. We won’t be deterred by the current analytical constraints and will consider the full suite of available tools. The clock is ticking!

You have identified major deficiencies in banks’ governance, and there were some long-standing issues already. What urgent changes are needed?

When it comes to governance in banks, some issues do take a long time to resolve, and the pandemic has aggravated problems we had already flagged. In a way, the pandemic has highlighted several pre-existing vulnerabilities. For example, some banks have issues with risk data aggregation and the accuracy of their reporting. This hinders strategic decision-making and has made it difficult for these banks to properly monitor material risks and their impact during the pandemic, including on credit risk developments and capital planning. Moreover, a number of banks have not been proactive enough in adapting their control functions to the crisis environment in order to adequately identify, monitor and manage risks. There have also been cases where the management body has not provided effective oversight of operational and risk management decisions to deal with the crisis. Governance has long been one of the areas with the most significant shortcomings, practically since the start of ECB Banking Supervision in 2014. This is why it has always ranked high in our priorities, and 2021 is no exception.

Banks’ board members are under close supervisory scrutiny. What are the ECB’s plans for 2021 in this regard?

This year we will focus on the composition of banks’ boards and update our approach to fit and proper supervision, that is, the criteria we look at when assessing or, where necessary, reassessing candidates for the boards of Europe’s largest banks. We are planning to hold a public consultation on our supervisory expectations regarding the suitability of board members and hope to publish our revised guide to fit and proper assessments later this year.

In concrete terms, we want to place more weight on boards that are sufficiently diverse in terms of expertise, professional background and, of course, gender. Diverse boards tend to be better at anticipating customers’ needs, innovating, weighing risks, and challenging the decisions taken by the management. We are also considering a requirement for bank boards to include members who have relevant experience in areas that are becoming increasingly prominent, such as IT, cyber and climate-related and environmental risks.

Another idea we are considering is to encourage banks to provide us with their suitability assessments for executive board members before making appointments, which will enable us to give our supervisory input early on in the process. We will also clarify how we intend to reassess board members if new material facts that could affect their suitability emerge after they have been appointed. With money laundering risks becoming increasingly relevant for prudential supervision, we will explain how findings relating to this topic could be considered in fit and proper reassessments from a prudential perspective.

This work is particularly important for two reasons. First, stronger boards mean stronger governance in banks, and that will ultimately translate into a safer and sounder European banking system. In this respect, the Joint Supervisory Teams will continue assessing the effectiveness of the management body as part of their ongoing supervision. The second reason – which is perhaps less talked about, but just as important – is that this is an area where there is a pressing need to finally complete the banking union. European banking supervision has been in place for almost seven years now, but we are still working with 21 different national frameworks for assessing members appointed to banks’ boards. We are doing our part to close existing gaps through stricter and more intrusive fit and proper policies, but this process would also greatly benefit from further harmonisation of national laws and, ideally, directly applicable EU regulation on the matter. 

You welcome the European Commission’s proposals on a single supervisor being responsible for anti-money laundering and combating the financing of terrorism (AML/CFT). Should the ECB be this supervisor?

The Commission’s Action Plan lays out some very important considerations for the development of a comprehensive EU policy on preventing money laundering and terrorism financing. It acknowledges that further harmonisation of the AML/CFT rulebook could address possible divergences in the current transposition of AML directives by EU Member States. By offering clear regulatory guidance and harmonised, stronger supervisory powers, an improved rulebook could also strengthen the enforcement of AML/CFT compliance. The Action Plan also recognises that conferring related supervisory tasks to an existing or new EU authority or body could help address supervisory fragmentation. I very much agree that the single rulebook should be enhanced, and I believe an AML/CFT supervisor should be as strong as possible and established as soon as possible.

But the ECB cannot be this supervisor, as its mandate explicitly excludes AML/CFT supervision of banks. The Treaty on the Functioning of the European Union does not empower the ECB to carry out this task either. That being said, money laundering and terrorist financing risks pose a danger to the sustainability of banks, and they can seriously damage people’s trust in the banking sector. This is why we will continue, within the remit of our supervisory functions, to look at any risks that are flagged to us by the national AML/CFT supervisors. We have improved the way we communicate with these authorities and have updated our supervisory methodologies in order to better incorporate AML/CFT-related concerns into our work. For example, the prudential implications of the risks flagged by the AML/CFT authorities, or in other warnings from different sources, are now accounted for in the SREP and considered in authorisation procedures and fit and proper assessments.

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