Interview at the Mediobanca 8th Italian CEO Conference

Interview with Andrea Enria, Chair of the Supervisory Board of the ECB, conducted by Andrea Filtri on 21 June 2022

21 June 2022

[The amount of funds was updated from “68 trillion” to “68 billion” on 24 June 2022 at 17:45 CET to correct an error.]

This session will be composed of a fireside chat with some questions and then a Q&A session. So, let's start at a macro level. That seems to be the favourite topic of the moment. The market seems to be polarised over two alternative scenarios for European banks: on the one hand, the benefits of higher rates after ten years of abstinence, and the risk of stagflation on the other. How do you see each of these, and is asset quality deterioration a risk to you here?

Indeed, the increase in interest rates is a welcome development for the European banking sector. From the point of view of profitability, we have seen scenarios in which you have a significant increase in interest rates, up to the textbook 200 basis points – an upward shift or steepening of the yield curve. This would definitely be a positive for profitability, and the impact on capital would, basically, be almost neutral. There would be a slight deterioration in terms of re-evaluation of fixed income portfolios and inflation of risk-weighted assets, but in general it would definitely be a positive. So, the whole question of the development of the banking sector in the coming months hinges on the macro outlook. If you look at the baseline scenario that we have in front of us right now – the ECB published its projections a couple of weeks ago – the baseline scenario is still positive. Of course, there is a deterioration in the outlook for growth, but it's still positive growth: 2.8%, 2.1% and 2.1% in 2022, 2023 and 2024, if I remember well. That's still a positive. In terms of these baseline scenarios, for banks' profitability and capital generation, we are still in a positive scenario.

Of course, we also need to look at tail risks, and those same projections that I have just referred to also envisage a possible recessionary scenario in 2023, which is linked to the potential for sharper shocks on the energy side, in particular as regards the availability of gas supplies from Russia. We ran a stress test – a desktop stress test; a top-down stress test – at the ECB, and the results were published in the Financial Stability Review at the beginning of the month. That showed that even in the most extreme scenario – three years of recession in a row, basically – European banks would have aggregate capital depletion of around 360 basis points. That's a lot, but still less than what was envisaged last year, where we had a scenario in the stress test that was a sharp recession coupled with a low-for-longer interest environment. So, to some extent, the overall framework is still showing resilience – a good capital position for banks – but of course, that scenario would not be a walk in the park, and the asset quality outlook would be a concern. So, what are we doing now as supervisors? We are asking banks to focus on credit risk controls. That has been our key focus for a year now. We have shifted a bit from the service sectors that were most impacted by the pandemic to the more energy-intensive sectors (such as manufacturing) and rate-sensitive sectors (such as residential real estate), with a strong focus on credit risk. Of course, there is also a focus on those segments of the financial markets which are characterised by high leverage, and maybe high concentration of exposures, such that they could suffer particularly badly from dislocations in the case of sharper than expected increases in interest rates. So, these are the areas of greatest focus right now – the areas which we are trying to keep our banks’ attention on.

Clearly, the fact that banks are better capitalised should be a defence mechanism. So, continuing on from what you have just said on natural defences, banks are often flagging the large defensive cushion represented by overlay provisions accumulated during the pandemic. While this could be true for macro models, it may be less true for sector-specific ones and Stage 2 positions. In practice, how do you look at this aspect in the context of the current macro uncertainty – i.e. how do you account for overlay provisions?

You are right in saying that European banks have been relatively conservative. They released some provisions in 2021, but they have maintained a significant buffer of overlay provisions. As I mentioned before, there has been a sort of changing of the guard. The sectors for which these provisions were designed – like accommodation, food services and transport – are now, basically, booming to some extent, and there are other sectors which are entering into a more tense situation. So, the overlays have been a good approach, because they can be redirected and remain relevant in the new growth outlook. Still, what we are seeing is that there has already been – in the fourth quarter of 2021; in the first quarter of 2022 – an uptick in defaults, especially corporate defaults, SME defaults and household defaults. And in the first quarter of 2022 there was also an uptick in Stage 2 loans. So, to some extent – from our perspective, of course – it's still a moment to remain prudent and avoid excessively optimistic approaches in terms of provisioning.

So then, moving on, capital returns is a little bit the positive that the sector wants to propose. Amid the current geopolitical turmoil, several banks are maintaining their very generous capital distribution policies, while calls for further government support are re-emerging. How do you look at these aspects, given your very clear prior statement that you did not want the dividend ban to enter the SSM's toolbox?

Let me start with the last point. I've stated clearly – I can reiterate it here – that the recommendation to suspend dividend payments and buybacks that we made in 2020 was an exceptional decision, justified by an exceptional situation in which we had a shock that prevented any visibility as regards the capital trajectories of banks and any possibility of differentiating across banks, because our economies were basically put on ice by the distancing measures. So, that was the rationale for that measure, which was unprecedented and is not something that we intend to do again. We have also been asked by Members of the European Parliament whether we want to have in legislation the power to introduce these sorts of constraint on a discretionary basis, and I have said clearly that I don't want it, because we would basically be the only jurisdiction in the world where the supervisor had discretionary power to curb overall dividend payments. We have moved, let's say, back to the old normal, to some extent. So, in terms of the way in which we look at distributions, the points we made – I think I made them in March – are still, let's say, our Pole Star. First of all, we are neutral when it comes to choosing between dividend payments and buybacks; for us, what matters is what is returned to investors, not the way in which this is done. There is a difference in procedure, because buybacks need to be authorised, while dividend payments do not, but still, from the point of view of the prudential situation of the banks, the two things are totally identical, so we don't have any bias. The way in which we look at banks’ distribution plans is by asking them to develop capital projections under baseline scenarios, but also under severe stress scenarios, and to reassure us (and we will, of course, challenge these projections by the banks) that even under stress scenarios they will be able to respect not only the minimum requirements and buffers, but also the management buffers – the targets that banks themselves have set. If this is confirmed, there are no constraints from our side.

Of course, in the current situation, in which the macro outlook is deteriorating fast, we've seen a downward trend in official projections – not only from the ECB, but also from the IMF, the OECD and the Commission. Since February, the next projections have always been worse than the previous ones. We would ask banks that have significant distributions or are planning ahead for the next year to update their capital trajectories in light of the new macroeconomic outlook.

Moving on to the institutional framework, we are in a situation where Europe is, essentially, trying to make strides ahead, talking about a defence or energy union, or even considering getting rid of veto powers. Yet, at the same time, many years down the banking union road, we're still awaiting the implementation of the European deposit insurance scheme, which you have been quite vocal about. How do we live with such contradictions and, most of all, how do we justify them to the global markets?

Well, Andrea, am I frustrated that we are not moving towards the completion of the banking union and the establishment of a European deposit insurance scheme? Indeed, I am. It is clear to me – I have made it clear several times – that a European deposit insurance scheme is a key ingredient of the banking union. Actually, I would go even further and say that it is a key ingredient for Monetary Union, because, as you know, monetary aggregates are composed predominantly of commercial banks' deposits. If a €1 deposit held in one country is not worth the same as a €1 deposit held in another country, just because the safety net in that country is not equally strong, then you jeopardise the integrity of the single currency. So, it's a no-brainer: we need to move in that direction, and we need to do it fast. And, unfortunately, this is not happening.

Having said that, we should not jump to the opposite conclusion – that the banking union is dysfunctional. I mean, the banking union is functioning well. It has a strong, very integrated supervisory arm, which has driven significant de-risking in the European banking sector in the last few years. And we do now also have the resolution arm, which is actually nearing completion. The Single Resolution Fund will complete its transitional phase next year, reaching almost €80 billion of funds that can be deployed in the case of a banking crisis, and we do have, pending ratification in a couple of Member States – including Italy, by the way – the backstop to the Single Resolution Fund, which is another €68 billion that should be finalised very soon. If you take the overall amount, including also the national deposit guarantee schemes, we are in the same ballpark as the United States, basically. So, we do have a strong safety net in place. Let me also say that the deposit guarantee scheme is not so crucial for managing a crisis affecting a major cross-border group. A major cross-border group would go under the Single Resolution Fund, so we do already have all the tools to deal with a potential crisis that has a Europe-wide dimension.

So, what needs to be fixed as a matter of urgency? I think that there are two issues which need to be fixed. The first one is the very thing that was in the Eurogroup statement of last week, which is crisis management and deposit insurance legislation. There, the issue is how to have a setting that also enables us to manage crises at middle-sized banks that do have a strong deposit base, where you don't actually want to go into the bailing-in of deposits. So, the point is to have a common approach to ensure that deposit guarantee schemes can intervene on a least-cost basis, to prevent or manage crises affecting these banks in a harmonised fashion across Europe. The other one, which unfortunately is a bit frustrating for me, is the ability of banks to manage capital and liquidity in a more integrated fashion – so, removing some of the obstacles to integration within the banking union.

Here, I think that there is an old approach that is still predominant, which is that Member States tend to put safeguards, in terms of legislative constraints, in legislation. This was the approach that prevailed before the banking union. And now we have institutions in the banking union, we have the ECB, so the legislation should give the supervisor responsibility to decide how capital and liquidity should best be allocated between parents and subsidiaries within the banking union. We are the supervisor of both the parent and the subsidiary, so we would definitely be neutral and tailor these requirements and the distribution of capital and liquidity between parents and subsidiaries to the different business models of different banks. I think that there is a need for a cultural shift in that respect, which, unfortunately, is not there yet.

Do you think banks are scared of turning subsidiaries into branches to get around this legislation?

That's an interesting question, because I mentioned recently that if you look at banks that have relocated business post-Brexit to the euro area – especially US banks, but also, let's say, Swiss banks – most of them have been looking at the banking union as a single market. They have adopted European company statutes, so they have a corporate structure which is European; they have used the Cross-Border Merger Directive to merge subsidiaries into the parent company, so they are actually branching out across the single market, they don't have any constraints in terms of capital and liquidity requirements locally in each Member State, and they can operate in a very integrated fashion across the banking union. While our banks, the European banks – the European‑headquartered banks, let's say – are not there yet. I suggested that banks switch to having branches. I mean, that's an option that is available. Actually, it was the idea behind the original single market – the possibility to branch out and increase competition in the single market. I perceive that there is some reluctance to move in that direction, for a number of reasons, but I still think that banks should carefully consider this option if they want to develop their retail business in particular in a more integrated way.

This leads perfectly to the next question, which is about consolidation – the usual evergreen, I guess. You have made no mystery of your desire for more consolidation, both in-market and cross‑border. We have had some reluctance regarding domestic deals and not much luck across borders. The Commission is proposing to make it very attractive for banks to buy insurance companies. Is this to make up for the bad luck regarding cross-border consolidation between banks?

Also in this area, let's start by looking at the part of the glass which is half full. To some extent, when I joined the ECB three-and-a-half years ago, there was a perception that the supervisor was against consolidation; that it would jack up capital requirements in the event of consolidation; that there was no clarity on the treatment of bad-will or internal models. So, we provided clarity, and we saw a significant rebound in consolidation. 2020 had more than €300 billion of deals, which was the highest level since 2008. These deals were predominantly domestic but, to some extent, this makes sense. If consolidation is, to a large extent, driven by excess capacity, by cost-efficiency objectives, of course the more you have overlapping in the distribution network, the more you can reap the benefits of consolidation.

It's not that the supervisor is in favour of consolidation just because it wants to see big banks; this is not my objective. The key point for us was to push banks to rethink their business models, refocus their business models. And there have been deals – not full-blown mergers, but a number of business-line deals – in asset management, in the custody business, in structured equity trading. I mean, there have been a number of deals – cross-border, by the way; many of them cross-border – even for payment platforms and car leasing, in which banks have started to refocus their business models, and this is, in my view, also a positive. Insurance and partnerships with insurance are also an important element of this strategy. Partnerships with fintechs have also been an important element. So this, in our view, is another aspect of consolidation which is positive.

Full-blown cross-border mergers in retail are not on the table at the moment. I mean, when I talk to the CEOs of banks, they argue that buybacks at the moment trump mergers by a big distance. I understand it; with valuations where they are right now, that's unfortunately the configuration. For me, to put it in perspective, having cross-border mergers is important for what we call private risk sharing. So, if you look at the United States, if you have a shock hitting a single state, having banks which are more distributed across the United States means that they can shoulder the hit in one state thanks to the profits in other states. In Europe, unfortunately, it's much more concentrated, and this creates these sorts of loops that we have seen in the past, which are not healthy for financial stability.

Following on from the prior question, how do you look at M&As, between buying more branches, staff, and legacy IT systems, in the context of the relentless digital transformation? Where is Europe on investments versus where it should be, in your view, and how much does scale have to do with it? So it's a business model type of question.

Well, first of all I would say that I don't see a contrast between growing scale and investing in digitalisation. Sometimes, there is this idea that scale is too expensive and resource-intensive, IT integration; a lot of challenges: why don't you go digital, set up a challenger bank, and you reap benefits in terms of cost efficiency? I think that that's a little bit – I mean, there could be, of course, also these aspects – but I think that the best comes if you see the two things as complementary, if you see both consolidation as a real transformative opportunity for business models, and digitalisation and IT as an important ingredient in this strategy. For instance, I've seen banks that are deploying more and more artificial intelligence for mass production, automation, let's say, of the processes for retail and SME portfolios. Of course, you can buy the customer relations, and then apply these types of tools also to achieve the scale which is needed.

My impression is that with the green and digital transformation of our economy, which is part of the Next Generation EU plans, scale is a relevant dimension. So that's an area where scalability is important, and that's why I see with some concern, again, the fact that due to the current depressed valuations, European banks tend to view/look more at the return of capital to investor, so, this means they are shrinking, to some extent, rather than finding investment opportunities. If you compare the investment in IT of European banks with US banks, you are definitely on a totally different scale. So it's clear that there is a challenge there.

Then, saving the best for last, we first wrote about the inevitability of the digital euro and the potential repercussions for European banks. How are banks preparing for it, what have they got to lose, and what are the opportunities, in your view? Is there a plan B?

I think, first of all, there is a need to understand that the rationale for a digital euro is the fact that in the payments area the preferences of customers are shifting. I mean, there is a need – and if you look, let's say, ten years ahead, probably the preferences will be even more radically changed. So there is, indeed, a preference for digital forms of payments which is increasing, so that's an area in which the European Central Bank cannot leave the field and leave it to external parties, because that would mean, also in terms of interaction between central bank money and private money, that it would destabilise these long-established relations. There is also the issue that, again, whatever we decide to do – the ECB, or actually whatever my colleagues on the central banking side decide to do – there are already developments under way. I mean, other central banks are already developing – or in some cases, like China, have already developed – digital currencies. There are already also initiatives by private parties; so the alternative is not between having a digital currency and not having it. The alternative is having Europe, the European Union and Monetary Union, involved, or not; and in the alternative scenario in which it is not involved, I think the challenge for our banks and for financial stability would be steeper, because still there would be a potential supply, or international supply, of means of payments from either other central banks or private parties, such as stablecoins or other unbacked digital offers. So, I think that this makes a strong case, in my view. Looking at it from the banking perspective, it makes a strong case for central bank involvement. Again, the ECB has always made clear that it would not be managing the front-end with the customers, it would be the banking industry that would manage these relationships, and that the features of the digital currency would be designed in such a way as to prevent a destabilising effect on the banking industry. So if you have a moment of stress, of course, what you don't want is people just stepping out of commercial bank deposits to move fast to the safety of a central bank digital currency.

So design features, such as limits or renumeration features, in terms of increasingly disincentivised renumeration the higher the stock, are key features that would probably make part of the design. There is dialogue under way right now. Of course, this will be a change also for the banks. I mean, it's not saying that introducing a digital currency will leave things as they are. There will be changes. What is important is that we don't want these changes to be disruptive. Quite the opposite.

I've just noticed how many times you have mentioned in the different questions the issue of valuations of European banks. Although this should not be a direct concern of the supervisor, you're keeping it under consideration for secondary or third effects. What is your view there? What's the path to higher valuations for European banks?

We have this market contact group with investors, analysts, rating agencies that we meet with. In January we had a meeting in which, let's say, there was a very bullish attitude towards banks. I think that at that moment, the prospect of a gradual smooth exit from the negative rate policy, a robust growth outlook, and a clear distribution strategy by banks were the three ingredients that were creating a sort of magic circle for European banks, driving valuations closer to book value, which is, let's say, unfortunately, the target that we have to set for ourselves right now. So at the moment, the key drag is the macroeconomic outlook, let's be honest, and that's not something that banks can do a lot about, but, again, I've always argued that banks need to pull the levers that they have under their control. So business models’ sustainability, cost-efficiency, investments in digitalisation, possibly scale, are the key ingredients on which bankers should focus their attention right now.

We're actually ahead of schedule, but we can open the Q&A session. Who wants to start?

Thank you, Andrea, for the comments. I just wanted to clarify. I think you said that where you have banks which are already making substantial distributions, you are asking them to update their capital projections. I just wanted to clarify that's the correct understanding. What would the consequences be of that re-examination if you found that those capital distributions were now looking, maybe, excessive?

The point is simply to enforce the policy that we have already announced, which is, I think, and I hope, clear. Basically, when you have a bank approaching us and our supervisory team with their distribution plans, what we ask of them is to give us its capital trajectory under the baseline scenario and the severe adverse scenario, and then we look at it. Of course, sometimes we challenge it if we are not convinced that it is conservative enough, and if some parameters are not in line with our expectations; but in general, let's say, we enter into dialogue with the bank on this basis. This happens both if you have plans to pay dividends, or if you have a request for authorisation for a buyback. So the only point is that, basically, we collected the capital projections in March, if I remember well, and they were based, of course, on the macroeconomic scenario that was available back then. Now, the scenario, of course, has changed a lot. So, if tomorrow a bank wants to go to the market and announce its dividend plans or buyback plans for the next year, we would recommend that banks come to us with their sort of updated projections of their capital trajectory, so enabling us to check that this is in line with our expectations. That's all we will do, under any circumstances.

Can I raise a question about the risk – and I don't see it referred to much – of clearing? I mean, the clearing of the euro is still done in a country that is now not even part of the European Union – it was never part of the euro area, and now is not even part of the European Union. I mean, in the Lehman scenario, if I'm transferring – me, BNP – to Intesa Sanpaolo, and if something happens, it's still through LCH clearing, which is based in London. I know that they come up with a solution saying that the subsidiary in Paris, which probably has five people, is conducting it. I mean, to what extent is this a concern for the ECB, that still most of the clearing of the European currency is done outside of Europe?

The policy objective is clear, from the European Union and from the ECB, and it is to have a shift of the bulk of these activities onshore to the euro area; but we realise that in terms of this – I mean, when there was a proposal from the Commission to accelerate this path – there was also a strong pushback, especially from the banking industry. Because, of course, moving from a very liquid market, with a very well-established set of industry practices, to a reality in which you don't have yet a robust and liquid enough infrastructure for this type of business, was and still is a challenge. So it needs to be something that cannot be, from one day to the other, created by edict, by law, but a gradual process that is driven also with the collaboration of the industry. At the moment, of course, when CCPs are considered systemically relevant, we do already have a sort of extraterritorial responsibility for ESMA to run its checks and to intervene, and we do have, of course, very strong connections and cooperation agreements with the UK authorities for matters which are of our concern. So, we are trying to use as much as possible the current setting to keep, in any case, an eye on the risk that can emerge from these types of activities, but indeed, let's say, it's an anomaly, and is something for which there is a strong policy objective from the European Union’s side to move towards reshoring in the European Union a part of this business at least.

Can I ask another one on top, this one that I never yet referred to? The other question, I know that it's not directly under the ECB’s influence, because it's financial services. It reminds me a bit of the time of the financial crisis, when the Commission, the only thing that it could think about was financial transaction tax. I think that if I want to trade in a country that has a financial transaction tax, I can trade through CFDs or whatever, and avoid that transaction tax. In terms of most, even after Brexit, financial products that are consumed in mainland Europe, they are produced or are manufactured in the United Kingdom. Although, the domicile can be Ireland or Luxembourg, the manufacturing of the products is still done in the United Kingdom. I know that this was not under the Brexit negotiations, but it was supposed to be after that. I mean, is there any view from the ECB on how this should be conducted? Is it going to be just the passporting-equivalent rules, or will there be a wish from the ECB that actually mainland Europe manufactures more of its financial services which are being consumed in European countries?

I want to be clear on this. I don't think that we should now have the ambition of creating the euro area or the European Union as a sort of self-contained place. I mean, we should be an open economy, an open financial market, and if there are foreign providers which are more efficient and more effective than our providers are to service our industry, our investors, I think that we should be open to that, and we should not be erecting barriers in the Channel to the provision of services from the United Kingdom. Also, for that matter, from any other jurisdictions. So we should be open to third countries entering the market and providing business. Within the Brexit debate, our position at the ECB has been very much, of course, that if you want, you don't have a single passport anymore if you are providing services. So, you cannot provide services from London to European customers; you need to have an establishment or a branch or a subsidiary, and you need to be supervised accordingly. We have achieved with banks that have been relocating their businesses a clear agreement on a target operating model as to how businesses should have been shifted, and we recently conducted what we call the desk-mapping review to make clear what the activities should be – there should be risk-management capabilities which are commensurate for the type of risk which are generated locally within the banking union. So we should remain open, and we should activate our prudential and investor protection tools in a way that ensures that if business is done within the banking union, within the euro area, within the European Union, it is in accordance with our law. The equivalence criteria, of course, are important, and, let's say, on this we have to wait and see a bit. At the beginning, there was a clear vibe from the United Kingdom that there would be no bonfire of regulations, that there be clear consistency in rules going forward, and if this is the case, of course, equivalence will not come into question. Of course, if the United Kingdom were to decide to deviate significantly, this will need to be reconsidered according to the choices that the UK legislators and regulators make.