Current risks and vulnerabilities in the European banking sector

Article by Elizabeth McCaul, Member of the Supervisory Board of the ECB, for Eurofi Magazine

13 September 2023

The sound policy decisions implemented following the great financial crisis have brought undeniable benefits. The euro area banking sector remains resilient^[1], and thanks to prudential regulation and supervision, banks are in a good position to withstand the three major macroeconomic challenges we now face: rising interest rates, inflationary pressures and subdued GDP growth, and the economic fallout from the pandemic and Russia’s war in Ukraine. The aggregate Common Equity Tier 1 ratio of banks directly supervised by the ECB stood at 15.5% in the first quarter of 2023, compared with 15.0% the previous year, and the aggregate liquidity coverage ratio was 161.3%, up from around 140% before the pandemic.

The significant macroeconomic uncertainty has been reflected in financial market tensions, with credit risk, liquidity risk and funding and interest rate risk key areas of concern. The ECB is addressing these issues as part of its supervisory priorities.

The supervisory strategy underpinning our priorities assesses both cyclical and structural challenges amid a risk landscape shaped by three medium-term trends.

• Persistently high inflation, the unprecedented pace of monetary policy tightening and the difficult geopolitical situation could lead to new shocks and, in turn, further asset price corrections, while the uncertain economic outlook may give rise to asset quality concerns.
• The digital transformation of the financial sector is challenging banks’ business models, underscoring the need to strengthen governance. With the ongoing geopolitical uncertainty and banks relying more heavily on third-party providers for their digital strategy, cyber risk is on the rise.
• Climate risks have become more pronounced since the start of the war, with Europe facing an “energy trilemma”, i.e. how to make energy secure, affordable and sustainable.

We are keeping a weather eye on the potential for market dislocation effects. The fast-paced normalisation of monetary policy is leading to asset price adjustments and higher debt servicing costs. This may result in further market corrections and/or increasing credit, market liquidity and funding risks. Short-term fiscal pressures remain contained, but the outlook for sovereigns may deteriorate if financial conditions tighten and additional fiscal support is needed.

The recent market turmoil highlights how important it is for banks to be able to withstand unexpected short-term liquidity shocks and to have sound and prudent asset liability management (ALM) frameworks. Even if a bank has excess liquidity, it could still fail owing to shortcomings in ALM practices. A bank runs a reputational risk if its management and internal controls are perceived to be weak. And when there are also doubts about the business model, market confidence may erode, potentially exposing the bank to capital and liquidity vulnerabilities.

Asset quality concerns rise as the economic cycle weakens, making credit risk one of the most pronounced risks. Inflation and interest rate increases have not resulted in a material deterioration in asset quality, but there have been growing signs of this over the last three quarters. We have observed a – so far orderly – turn in the real estate cycle, particularly in commercial real estate markets. Our recent stress test also showed that leveraged finance exposures carry a high degree of credit risk and market risk which could materialise in a downturn.

We are also keeping a close eye on emerging risks in the non-bank financial intermediation (NBFI) sector. In the current environment, if liquidity risks in this sector were to materialise, it could lead to a drop in the funding NBFI entities provide to banks. As this type of funding is relatively more sensitive to the credit quality of banks, and since market sentiment remains fragile, the strong links between banks and the NBFI sector could amplify banks’ funding pressures if the soundness of their fundamentals was somehow called into question by the market.

Changing customer preferences and increasing competition from new entrants is another area of attention. Banks are under increased pressure to speed up their digital transformation strategies and rethink their business models, and they also face fierce competition for IT talent. Moreover, surging cyber and IT-related risks stemming from the geopolitical situation and banks’ increasing reliance on outsourcing are also considered among the most pronounced in our assessment.

Finally, amid the current energy trilemma, banks face medium-term transition risk as they shift to a green economy. Tackling climate-related and environmental risks must be a priority, and banks need to incorporate these risks adequately within their business strategy, governance and risk management frameworks.

The risk landscape is constantly evolving, and we will adapt our supervisory strategy in line with it.