Interview with American Banker
Interview with Elizabeth McCaul, Member of the Supervisory Board of the ECB, conducted by Kyle Campbell on 9 December
19 December 2022
Let's just start with supervisory priorities right now in Europe: what are the top issues you're looking for in terms of bank supervision?
First of all, we have put a process in place which is quite good. There was always a very strong bottom-up assessment of risks across the Single Supervisory Mechanism, the SSM. Now we've introduced a better process that combines a top-down and a bottom-up approach. We are establishing the priorities for a three-year horizon. Then we have organised a whole planning process to connect what we established at the Supervisory Board as the priorities to the activities we're carrying out in inspections and in our supervision of the banks.
We have to talk about the current environment: it is an unusual one. Bank profitability has gone up quite a bit because of the interest rate environment changes, but we've seen an environment that has a lot of leverage, supply chain issues… Europe is very affected by Russia’s war against Ukraine – especially in energy markets and food prices.
We've got a lot of concerns about the underlying asset quality. We are concerned about risk that is outside the banking system, in non-bank financial institutions in particular. That growth has been exponential in the last ten years, and there have been warnings about that for quite some time. We're also concerned about other emerging risks: cyber threats, climate risk, operational resiliency. The IT infrastructure is something that we are quite focused on. Cyber risks are common both in the United States and Europe. There was an expectation with the war that there would be an uptick in cyber incidents. Indeed there has been an uptick but not to the extent that was expected. We're really asking our banks to be quite vigilant about that.
On climate risk, I'm pretty proud of what the ECB has been doing in this area. We have really been a leader, both in supervision and as a central bank, in making sure that within our mandate this risk is understood and is being managed. So we started back in 2020, even in the middle of the pandemic, asking our banks to do a self-assessment. Fast-forward to today: we've completed a thematic review to identify gaps in the banking system, with their oversight of climate risk. Now we've also conducted a stress test. This has been a learning exercise and what has really come out of this is that we've moved the discussion in the banks, and maybe the management of this issue in the banks, from government affairs offices, regulatory affairs offices, as something that is really a social policy, to bring about the understanding that it belongs in the risk management office and the CFO office. It's about the balance sheet.
This is a traditional risk. We're asking the banks to have clarity about their exposures, about their physical operational resiliency, and also about transition risk. Maybe I'll go back to where I started: the overall risk environment is very much top of mind, and the potential effect on asset quality in the institutions. This is a real priority for us. We've asked banks to be very cautious in their capital trajectory analyses. We've asked them to look carefully at their capital planning processes. While the industry is moving, for sure there is much more that needs to be done.
Do you find that you're having to have banks retain more capital against certain types of risks? What is the view from banks on those types of requirements, and how would you compare that culturally to the United States and Europe as far as capital requirements go?
Yes, the United States has a very strong stress testing process that it relies on to make the determinations about the capital levels. On our side, we have a strong supervisory process that builds up our view of what the capital levels should be and it's aligned with the Basel requirements of Pillar 1 and Pillar 2. Then we have a stress testing component that we add into the development of the capital demand that we make from the institutions. I would highlight, consistent with our priorities, that we're concerned about build-up of leverage. Recently we asked several institutions that had not adhered to our guidance to add additional capital for leveraged finance.
Are there specific areas of lending where that leverage is concentrated, or certain activities?
The leveraged finance market falls into two categories: one would be the financial players and the other would be the corporates, SMEs. Those are very different exposures and we are in a particular moment in the macroeconomic environment, owing to the pandemic, owing to rising interest rates, owing to the war. That means that a number of perfectly creditworthy corporates have had their revenues pushed out to the right because of supply chain issues etc. That is not what we're after and they've had increasing leverage as part of that, so we've made a differentiation here about the kind of leveraged finance that we're concerned about.
Is that leading to greater holdings against potential losses? Some of the regulators here who want to focus on that, current expected credit loss (CECL) of course, those standards are going to be applied to more banks, starting next year. It's a very uncertain time for that to be coming to the fore, so is there an equivalent standard that you're putting a lot of focus on right now?
We've focused on certain sectors that may have been more adversely affected by the conditions in the marketplace, so commercial real estate for example. We've just conducted a deep dive across the portfolios of our institutions, with a focus on commercial real estate so we can understand whether the provisioning levels are appropriate. We see a lot of the institutions putting overlays on their models. The models are not working the way that they did; that is not surprising. We're in something that hasn't historically happened for more than 100 years. So it's not surprising that the models are not working and we're pleased that the institutions are putting overlays in place.
These are judgemental. We are asking institutions to make sure they're doing look-through credit analysis and have a deep understanding of where there are structural changes in the economy that are affecting a credit that they have on their books. Or whether there are delays here. We want to make sure that they are building up the overlays in a robust way.
You mentioned non-banks as a focus. How do you compare the growth of non-banks, in the EU versus what we see here in the United States? Obviously it's also a focus but how do those compare to one another?
Yes, the growth in the non-bank financial institutions market in the United States has been well ahead of growth in Europe. That growth has been happening for a longer period of time. Having said that, the growth in the last five years in the European market has been exponential. So from a lower point, but a faster growth rate has occurred in Europe, vis-à-vis the United States. Our concern is that we don't have line of sight into that. We don't have oversight over the non-bank financial institutions market. If I look at the United States, more than 50 per cent of the lending market is now serviced by the non-bank financial institutions market. Those loans are put into funds that are then financed by the banks.
The other concern we have about growth in this market is the issue of covenant-lite. You see in particular the non-bank financial institutions market driving much lower covenant levels in areas that are important, like removing additional debt restrictions. So we really need to make sure that we are cognisant of this risk, that we get a line of sight and data about the developments in that risk, and that we understand the interconnectedness back to the industry, that we do have oversight of the banking industry.
I know this is a focus for the bank regulators in the United States as well; what sort of communication is happening between the US bank regulators and yourself at the ECB about how to handle these things? Are there new initiatives that are on the horizon that both sides are pursuing?
We have terrific colleagues in the United States and the United Kingdom and in other countries where we collaborate quite a lot. There is a process that we use called the College of Supervisors where we regularly compare notes about institutions that operate on a cross-border basis. I spent the beginning of this week in Washington at the Federal Reserve. Part of my portfolio now is the digital agenda, which has three components. One is the IT resiliency, the cloud, cyber component. The second is fintech, new entrants and how we supervise new entrants. The third is suptech: how we are arming our workforce, our supervisors to operate digitally.
At the ECB the team has won three – we'll call them “Oscars” – at the Central Banking Awards for the development and implementation of several tools that are now in the hands of the supervisors. So we had a two-day suptech conference with UK, Fed and ECB colleagues to talk about collaborating on the development and the use of the types of tools that we need.
I said before that we're very interested in being able to harness data. Supervision is, by its nature, backward-looking. We rely on historical information. We ask for financial and statistical information from the institutions that is dated. The world is moving so much faster and so I think there is a lot of opportunity to increase our ability to harness those data, mine the data, understand the data. To do that we need to develop tools.
What innovations were honoured?
So this is important: very particular tools that improve the ability of the supervisor to operate were honoured and one is a tool called Heimdall. This is a tool that we use in our fit and proper assessments, where we receive a lot of information about candidates for a management body or for a board of directors. That has to be analysed and Heimdall allows that to be done in a far faster way; that is one example. We have a project called Olympus for which we are also asking the national competent authorities for their ideas. We're asking them to consider IT developments that they can champion, that they can run and implement on behalf of the whole SSM. I think everyone knows there is a lot of pressure on IT – on the scarcity of IT resources – and so expanding the ability to get resources working on that across all of the SSM as part of the Olympus project will be very important for us as well.
As far as Basel III implementation, the final stages, I know it's something that's of great importance here in the United States that we're still building towards. What are you looking for as the United States finalises its implementation and other countries do the same?
Yes, in fact in Europe right now it's going through the legislative process, the final adoption of the Basel III rules. We are very much behind the timely and faithful implementation of Basel III, without deviations from the structural things that have been agreed at the Basel table. This is extremely important for a level playing field and for our international reputation. I think you would find supervisors on both sides of the Atlantic having a similar view; that timely, faithful implementation is important, is critical.
Are there any specific areas where things need to be hashed out? How it will be implemented, is that pretty much figured out?
Members of Parliament have proposed some of the deviations that, in our view, would lead to watering down Basel III. So deviations that would remove derivatives from the calculations. These are things that need to be kept in the framework so that faithful and timely implementation occurs, as agreed at the international levels.
Shifting over to the monetary side just a little bit, just to get your thoughts: obviously inflation is a huge focus around the world. We're starting to see maybe some signs of things easing up in the United States, and the Fed has acknowledged this and it seemed to be in a position to be adjusting their rate of interest rate increases accordingly. Are you seeing any easing up in Europe, and how do you see the correlations, monetary adjustments being made globally in impacting inflation?
The first thing I need to say is that I have no role in monetary policy and so it wouldn't be appropriate for me to comment on it. Having said that, inflation is certainly something we have a keen eye on as a supervisor. The good news is, we went into the pandemic with a banking system that was well capitalised and enjoyed substantial levels of liquidity. That is thanks to the reforms following the great financial crisis. It means that across the board, the European banking system is well placed to withstand adverse shocks.
Now we've sounded a cautionary note about the environment and the need for the institutions to be very vigilant, but we've got stable capital levels, strong liquidity, a safe and sound banking system and that is a good thing in these adverse scenarios with inflation, rising interest rates, parts of the market outside of the banking sector, supply chain issues. It is a fraught environment, it's the type of environment I've seen a lot in my career and it's the type of environment where you have the sense that there could be an accident. You don't know exactly where that accident will be. I would point to the gilt pension fund issue in the United Kingdom, FTX… So it means that you have to have your institutions very focused on strong risk management practices.
You mentioned FTX as of course part of a broader crypto and digital asset environment that has seen a lot of turbulence this year. From a regulatory perspective, how is the ECB looking at managing risk in that part of the financial ecosystem?
The good news is, there has been an agreement in Brussels to adopt legislation. It's called MiCA – that's Markets in Crypto-Assets. This is meant to have – after it comes into force in 2023 – a very strong supervisory oversight over the crypto-asset marketplace. So a regulatory framework is being introduced with European supervisory authorities given responsibility for technically developing the oversight and the supervision. There are components of MiCA that call for strong governance, strong internal controls. Segregation of assets would be required. From what we can read about FTX now we can understand that some of those basic governance internal controls – like the segregation of assets – are not in place.
The problem there seems to have been, they knew they were supposed to do it. There was no question that that was the rule they were supposed to follow.
Given the complexity of something like FTX, I have to say that every time I have seen a loss in the marketplace, we've been able to identify a gap in oversight. Where you have gaps in oversight, that is where risk increases and that is where accidents can happen. One area that I also have regularly seen as contributing to higher levels of risk is cross-border activity; where you don't have harmonisation of rules, that can lead to gaps. Now, I think FTX is based in the Bahamas. We don't know the story yet; it will probably be many months before we will know the whole story of FTX, but I guess that we'll be able to point to some gaps in oversight. So global harmonisation of oversight over crypto-assets is something that is very important.
There is still a lot of indecision in the United States about how or whether to regulate crypto. Does that raise concerns in the ECB of possibly being a large gap in coverage if the United States doesn't have a unified approach to this? Or if they do, they take one that's different from yours?
It's extremely important that there is oversight and supervision of crypto-assets that doesn’t lead to regulatory arbitrage on both sides of the Atlantic. The good thing about MiCA is that it establishes a single system for the entire euro area, with licensing procedures that will apply across the euro area. Where there is no oversight, that is where risk develops and financial stability itself can be threatened.
Are there any other specific concerns about financial stability that we haven't discussed yet? I know that's a big area of focus that our readers care about.
I think we've touched on the key areas – the growth in leverage across the market. Actually there is a point I would make here also: the complexity of the overall marketplace and the propensity to have opacity in some of the complex instruments that are out there. Opacity is never our friend when we think about the potential for systemic risk or for losses to occur. Continuing to promote transparency about interconnectedness in the system, about the construct of products that are being developed, this is very important.
But just as you think about capital requirements overall, how much of an impact is what's being done in the United States likely to have on banks that are present in both markets? Is that something that we should keep an eye on?
It's always a good idea to look at whether we have the right levels of capital on an institution-by-institution basis or across the system. So I welcome and look forward to hearing more about this. The key thing is the way that markets react: if one segment of the market is viewed as undercapitalised, that segment comes under pressure. So harmonisation of capital rules, which is why Basel was created in the first place, is also key to international financial stability.
Are there other big issues that we're not asking you about?
Yes, you didn't ask me about why an American is working at the European Central Bank!
It is interesting. Tell us why!
I'm the first American and I'm the only American and for me it's an enormous honour in my life to be serving on the Supervisory Board of the European Central Bank. It's a bit of a story, how I got there!
We touched on parts of it [note: before the interview started], but yes, fill in the dots for us, yes.
What you need to know is: I am from a poor family, I worked my way through college, student loans up to here and…
Where did you go?
I went to Boston University. I think you wouldn't be able to do today what I did then: paper round, waitressing, law library, three jobs the whole time − but I got a scholarship from the German Government to study abroad. Someone who had the financial constraints that I had, going through college, wouldn't ever have been able to study abroad. I went to the University of Freiburg, where I studied the common market and I went to see all of the European institutions. I learned about the free movement of goods and services across Europe, and how important that was for economic stability and economic growth. What I really learned was that the European project, as it's known, is about peace. I studied a lot about fascism as a student, and I became a passionate supporter of the European project.
Fast-forward: I started my career at Goldman Sachs. I had to pay off those student loans, as I mentioned. I've always had a big focus on the public sector; even at Goldman Sachs I was a public finance banker. Roads, bridges, resource recovery plans, climate risk – things like that – hospitals, were the things that I worked on when I was at Goldman. I went to the banking department as a public servant and I was given that opportunity to serve there for eight years. Then I went to Promontory as a consultant where I primarily served the Federal Reserve, Banco de España, the European Central Bank. I was hired as the consultant to put the organisational design of the Single Supervisory Mechanism for the banking union in place at the ECB before it existed. Then I applied for the position and it was the greatest honour in my life to walk into my first Supervisory Board meeting and see, though it's not even ten years old, the strong supervisory framework that grew out of the great financial crisis. And to see that it's the largest supervisor in the world, it is the most complicated portfolio, with so many different national competent authorities, also with oversight. To see that in operation is really something extraordinary, what has been built at the ECB.
As an American I'm not from a country that is around that table; I have a lot of training in supervision and I try to contribute an outside view about what the right thing to do is and how to strongly supervise the institutions. I come from a dual banking framework here in the States, with the Federal authorities and the state authorities. I was the Chairman of the Conference of State Bank Supervisors at one point in my life. I have enormous respect for the national competent authorities, they are me in many ways. So this development of a centralised framework working also with the national competent authorities is something I try a lot to contribute to.
You mentioned the focus of the European Project being on peace. How do you think it's held up to this current environment, especially with the Russian invasion of Ukraine, and how has the financial side of things contributed?
The war in Ukraine is just horrific. We brought into the ECB a group of Ukrainian trainees – refugees – who are now working as trainees, like interns, at the ECB. I had a chance to meet with them; we had a coffee morning last week. The stories that they have about their lives and what's happening in their villages and their cities and their families are just horrific. It's very front of mind in Europe. This is a close neighbour, a part of Europe, and it's a travesty that there is war on European soil once again. You see Ukraine is looking very much to join NATO, is looking very much to join the EU. I hope and pray that that happens and that it brings about peace.
Are these interns that you have people who were working in the banks in Ukraine?
They come from a lot of different walks of life. Some were students, economics students, some were in banks, some were working in communications in companies, and now they're working in our communications area at the ECB. They have a lot of different skills. Some are lawyers, so we've aligned them with projects across the ECB. We have one intern working with our office with the ECB representatives to the Supervisory Board: Svitlana, who is an attorney by training and is analysing some of the different sanctions programmes that are in place, as well as the different regimes for third-party supervision of foreign banks.
What is your assessment on the sanctions programme and the effectiveness thus far?
It's complicated. It seems that there's always a way to arbitrage the system. I only know what I read, but you read about ways that missiles are being developed with parts that are part of the sanctions programme; how is that happening? I'm very strongly in favour of strong enforcement over sanctions programmes.
You mentioned designing a framework for the ECB when you were contributing to Promontory. Did you at the time anticipate that you might be in a position where you'd be…
Never, no. In fact I worked closely with Tommaso Padoa-Schioppa. He was our Chairman of Promontory Europe. I was the CEO of Promontory Europe. He introduced me to a lot of policymakers during that time. One of the people I met was Andrea Enria, who was then the Chairperson of the European Banking Authority. Tommaso has passed away now, very sadly, and he was known as the father of the euro. He was a towering figure in the European project. He introduced me to Andrea and it was my great fortune to have dialogue with him over different years – just comparing notes about the market and the environment…
You mentioned having the similarities you see in the role now to what you've done in the past. Do you feel like it's been received well, having that – not just from the folks you work with directly – but at a national level by these different banking groups?
Yes, I would say in the beginning, probably it would be natural that there was scepticism like “she doesn't understand Europe”… Europe is an ancient society with thousands of years of history that I couldn't possibly understand to the level of native Europeans, some might have said. I'm sure there would have been scepticism about what I could contribute. The way I try to do my job is to support the people that work at the ECB, with anything that I know about different aspects of supervision to help them in their roles. I have to tell you, what an incredible workforce it is. I have really come to appreciate and enjoy my colleagues. It's a really smart group of people that help me to do my job, too.
How big is your team?
I'm a single person. I'm a Board member so you don't have a…
Staff who are designated or…
Yes, I have a wonderful counsellor and I have a management assistant and I work as part of an office of about a dozen people, and also with colleagues in the different divisions. My mandate includes the digital agenda, but also risk, capital liquidity, internal governance, our supervisory review and evaluation process (SREP). I am the diversity and inclusion sponsor at the ECB, so I've become very involved in those issues, also training. So as a result, I work with the teams that are involved in those areas.
What is diversity management like in Europe compared to the United States?
The United States is far ahead of Europe on diversity and inclusion, even though the United States still has more progress to make for sure. We mean to make a difference at the ECB, both inside the ECB as well as within our mandate and our oversight of our institutions. Diversity in boards brings about better risk management, greater shareholder value, diversity of ideas at that table and contributes to better management of risk. We are following through on the requirements in CRD IV that banks have diversity plans in place and, where the national regimes require it, that they're following through on that.
What additional challenges are there when you have to manage so many different cultures within Europe?
This is I think the beautiful thing about the European project. If you walked into the ECB, you would see colleagues from every nation across Europe. The official language is English and they all are working together. I've mentioned the first time I sat around that Supervisory Board table and how awestruck I was to see these colleagues supervising 119 institutions, I think this was the number at the time when I walked in, and working together with a European hat at that table. That's the goal. It's not always the case that that's achieved; national interests play a role at that table, but I've seen over the three years that I've been there a real development of that board and a real understanding of European oversight, which is a really critical thing. It is not “the United States of Europe”; it's an extremely different framework to the United States, and that has to be respected.
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