Interview with Börsen-Zeitung
Interview with Elizabeth McCaul, Member of the Supervisory Board of the ECB, conducted by Bernd Neubacher
26 July 2022
Ms McCaul, how would significant institutions in the banking union be affected by a cut-off of Russian gas supplies?
There’s a realistic scenario of a disruption to oil and gas supply in front of us. So we’re asking the banks to look at what such adverse scenarios mean for their balance sheets.
The scenario of a total cut-off is kind of binary – either it will happen or it won’t happen. How does the ECB deal with that? Do you ask banks to price in the worst scenario or to make a judgement?
We always ask banks to look at adverse scenarios and medium-risk scenarios. That’s what forward-looking risk management is about. The reason for considering an adverse scenario is to find out what changes you might want to make to your risk profile or how you might want to adjust your strategic plan. There are lots of steps that you can then take. An adverse scenario is not about making predictions. It’s not a requirement for an outcome. It’s a tool for analysis.
How does the overall picture look at the moment, with the war in Ukraine and soaring energy prices?
Generally speaking, the banking sector entered 2022 with strong capital and liquidity positions, and direct exposures to Russia and Ukraine are quite limited. At the same time, the crisis has definitely put additional pressure on the commodities market. We’ve seen a lot of volatility and we’ve had concerns about margin calls and effects on the overall working of the marketplace. That really came to the fore when we saw some of those margin calls taking place. That volatility has somewhat receded, but prices are still quite elevated.
A few days ago Andrea Enria, the Chair of the ECB’s Supervisory Board, mentioned that banks should look closely at their capital trajectories. Is there a possibility that the ECB will once again be asking banks to refrain from dividend payments, like it did two years ago?
We put such a recommendation in place at the very start of the pandemic. We decided not to extend it and we returned to business as usual, and by this I mean that we always analyse the capital trajectories of our banks in a forward-looking manner when we assess their distribution plans. And that’s exactly where we are now. It’s business as usual.
Apart from the risk of being cut off from Russian gas supply, there has been a quick rise in market interest rates while monetary policy has just been tightened and there is political uncertainty in Italy, driving up government bond spreads and affecting banks’ balance sheets. Is this something you look at closely or is it more on the back burner compared with the issue with Russian gas supply?
I don’t think I’d like to make any sort of prioritisation here. One of the vulnerabilities we identified in our supervisory priorities is sensitivities to shocks in interest rates and credit spreads. We are following up on that as a high priority. So we are conducting targeted reviews and we are in close contact with the banks regarding their sovereign bond positions where relevant.
Before the war in Ukraine and interest rate hikes became reasons for concern, the ECB looked carefully at the leveraged loan market too. Do you see some interaction between these factors?
The leveraged finance market has grown exponentially over the last decade and it is an area that requires very strong risk management practices. We have sent a “Dear CEO” letter highlighting our concerns about banks’ risk appetite frameworks and this year we are following up on this with the banks that are most affected by leveraged transactions. Since the Russian attack on Ukraine, there has been a significant change in the leveraged finance market. We have seen quite a pulling back of additional issuance in that area. So it’s really about making sure that the institutions understand what they have on their books. Where will they be able to offload holdings? How are they gaining an understanding of that? We are asking them to do “look-through” credit risk analysis to understand where possible adjustments may be needed and to make those adjustments.
Does a pulling back in the leveraged loan market increase or diminish the risks for banks and financial stability?
I wouldn’t say it’s either one of those things. It’s two things: first, the growth in the overall leveraged finance market has been of concern because it’s a high-risk activity that requires a concomitant risk appetite framework and detailed risk management. And second, a lack of investor appetite means that the banks are less able to offload the holdings of leveraged finance. That has to be carefully understood.
Do you have the impression that the big players in the market – names like Deutsche Bank and BNP Paribas come to mind – are capable of doing that?
I would not want to comment on any specific institution. I think we take a lot of comfort in the fact that we are in a very good shape, by and large, across the banking union thanks to the banks’ strong capital and liquidity positions as we went into the pandemic and now the war.
On the same day that Russia launched its invasion, the Russian bank VTB sold its 46% stake in the Cypriot bank RCB to the remaining shareholders, two investment firms from Cyprus, obviously without obtaining prior qualifying holding approval from the ECB. Will you authorise this transaction or will RCB be sanctioned as it is in breach of regulation?
We never comment on individual banks. But as in every case, the applicable rules will apply.
The current crisis might lead to a rise in non-performing loans (NPLs). The ECB has been advocating secondary NPL marketplaces for years. Why?
I don’t see any downside to it but only an upside. Creating a European-wide vehicle would result in a more liquid market. If you can create a single vehicle, you can homogenise the credit risk in that overall portfolio. You can expand the investor pool and probably improve pricing, transparency and information.
The market does not seem to get it. What can the ECB do about it?
We can only point to the market advantages that would be available to banks. But it’s not that we need something because we have such a bad situation. In fact, the situation with NPLs is really quite a victory for Europe. The banks were able to reduce the total stock of NPLs from around €1 trillion at the start of ECB Banking Supervision in 2014 to €369 billion in the first quarter of 2022.
The ECB and the banks have just finished their first climate stress test. What’s your assessment?
The results of the stress test suggest that we need to insist on putting in place better data, better information and better risk management processes. There are some statistics that are quite important to understand. Around 65% of the banks scored poorly and they showed significant limitations in their stress test capabilities. We found that most banks have not yet included climate risk in their credit risk models. Banks are lacking actual data regarding emissions, and around 70% of them are reporting emissions relying on proxy data, not actual energy efficiency data. And these are data that are going to be fundamental in understanding the credit risk management aspect of climate risks.
The results of the climate stress test will feed into the Supervisory Review and Evaluation Process (SREP) later this year and indirectly into the capital requirements for banks. Is the same on the cards for aspects of diversity, which is playing an increasingly prominent role in the fit and proper process? Will banks with a lack of diversity in their board members get a capital surcharge at some point?
Diversity is completely fundamental for understanding risk. A lot of research tells us that if everyone brings the same background to problem-solving and strategic planning, you end up with the same point of view – and this limits the ability to see other types of risk. That’s the first point. The second is that diversity is also a requirement according to CRD IV. Last year we explained how we are also going to look at fit and proper decisions in the context of diversity. We are asking our Joint Supervisory Teams to periodically assess how and to what extent diversity policies, including those on gender balance, are being implemented and maintained by the banks. And that is part of the governance element of the SREP. But the SREP is not just about a capital requirement. It’s about the strength of the frameworks that are in place in the business model, the governance structure, liquidity and capital management. It’s not only about quantitative capital requirements, but also the qualitative strength of the banks’ operations and risk management.
You have recently put forward the idea of hybrid stress testing, which means combining a more top-down approach with the original bottom-up structure. Why is that?
When ECB Banking Supervision started, the bottom-up approach and the assumption of static balance sheets were necessary for us to launch a stress-testing programme of this scale across Europe in the first place. But as we mature, we understand that these two principles may have an impact on the results of the stress tests. We also see that stress testing is very resource-intensive for both the supervisors, conducting all of the quality assurance, and for the banks, which do the modelling. So there are discussions in the European supervisory community about trying to improve on our ability to recognise dynamic balance sheet implications as banks naturally react to shocks.
The design of the climate stress test was already different from the run-of-the-mill stress tests in the past because it dealt with dynamic balance sheets.
The climate stress test is a good example. We had 41 banks submit bottom-up projections and the ECB projected impacts for the others. There’s a real value in bottom-up stress tests. They act as a catalyst for banks to improve their own processes. So there’s a role for both: the top-down and the bottom-up approach, the use of static and dynamic balance sheet assumptions.
How will the design of stress tests develop?
I wouldn’t want to predict that. Things are moving very rapidly. The best I can do is tell you we’re continuing to evolve.
In 2026 the EU anti-money laundering authority (AMLA) is supposed to be up and running. Seeing as cooperation between the ECB and the Single Resolution Board was not always without friction in the past, how do you envisage cooperation this time?
AMLA is an extremely welcome structure and we are looking forward to cooperating with them as observers. Cooperation is absolutely essential to eliminate gaps in oversight, and that is precisely where big accidents happen in the banking sector. We are identifying deficiencies that need to be remediated to strengthen the banks. These deficiencies are often in the area of internal controls, risk management, governance, etc. When you have information about weaknesses in those kinds of structures, it’s very likely to apply to the money laundering compliance structures and vice versa. And if there are weaknesses in AML structures that become visible to the AML supervisors, that information is also very important for the prudential supervisors so we don’t have franchise risk that begins emerging. Eliminating these gaps is not just about creating a safer banking sector. It’s about stopping the use of the financial system by terrorists, drug traffickers and human traffickers. It’s about making our society safe. I was a supervisor in New York during the days of 9/11 and the lessons couldn’t be clearer to me.
Apart from weaknesses in AML structures, crypto-assets might also become important for prudential supervisors. How is the ECB looking at this?
In my view, this is an area that is in need of regulation and oversight, as recent market conditions have underscored. So the ECB welcomes the mandate that the European Commission has in this area.
The Basel Committee on Banking Supervision has recently put forward a second consultation on capital requirements for crypto-assets.
The proposal divides crypto-assets into two groups according to their risks, setting out capital requirements and risk weights. Regardless of the type of exposure and prudential treatment, a specific risk management framework (e.g. operational risks, liquidity, leverage) would be required to cover the specific risks entailed in crypto-asset activities. I would expect that following the Basel proposal, financial institutions undertaking crypto-asset investments or activities will be subject to disclosure requirements and will need to set up governance, internal control arrangements and reporting that are adequate for reflecting the specific nature and the risk profile of the activities. And then the ICAAP…
…the internal capital adequacy assessment process, part of the SREP…
…should also be enhanced so that the risk inherent in crypto-assets is taken into account.
Do you see banks wanting to dive into that area yet? Is it a topic in their dialogue with you?
This is interesting. We’ve seen lots of developments in this area, especially internationally. But largely speaking, I think that the crypto-asset activity has been outside of the traditional banking system. You do have several cases in the EU where banks have started to offer crypto-asset services but, by and large, most of this activity sits in investment vehicles, payment-enhancing vehicles and similar. But there are lots of questions. We’ve just seen another bankruptcy of one of the crypto-asset companies.
…that of crypto lender Celsius…
You know, there is investment risk here. And there could be balance sheet risk if banks become more involved in this activity. So it’s something that needs to be regulated, ultimately, in my opinion.