Boosting banking resilience to adverse external shocks
Article by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, published in InforBanca, the quarterly magazine of Instituto de Formação Bancária (Portuguese Bank Training Institute)
10 January 2023
Within the past three years, European banks were hit by two large and adverse external shocks: first, the outbreak of the COVID-19 pandemic and second, and more recently, the Russian invasion of Ukraine. The banking system as a whole has withstood these shocks so far, though as the Russian aggression against Ukraine is still ongoing, great caution about future developments continues to be warranted. In this article, I will first outline the factors which contributed to banks’ solid performance to date. I will then discuss the risk outlook for banks and touch on the issues which should be high on the agenda for both bankers and supervisors to increase our collective resilience to crises in the future.
Banking performance amid macroeconomic uncertainty
The euro area banking sector remained resilient and able to support the economy despite the severe negative fallout from the pandemic, with banks under ECB supervision exhibiting capital and liquidity buffers which remained broadly unchanged at comfortable levels. By contrast, during the 2008 global financial crisis, euro area banks were caught off guard and forced to deleverage in a bid to repair their balance sheets, thereby exacerbating the magnitude of the economic downturn.
The scale of the countercyclical policy response to the pandemic by both European and national authorities, which was significantly larger than their response during the global financial crisis, was clearly a key contributing factor to maintaining financial stability. However, it is also hard to argue against the notion that the differentiated scope of the policy response to the COVID-19 crisis – aiming to stabilise the real economy rather than just the banking sector – also stemmed from the banking sector being in comparatively better shape to begin with. Banks would otherwise have been unable to fulfil their critical role of keeping the lending channel afloat as a lifeline for economic activity during the pandemic. This suggests that the Basel III reforms agreed by supervisors to enhance banking resilience in the aftermath of the global financial crisis have paid off. However, our experience with crisis management also indicates that no two crises are the same and that past successes are not necessarily reliable predictors of continued sound performance. This is why the elements of those global reforms that are still pending should be implemented in Europe without further delay.
As the banking sector emerged from the COVID-19 crisis, its stability was again tested by the outbreak of the war in Ukraine. Banks have been coping well so far. The direct impact of the war seems to have been manageable, including for those banks with large direct exposures to Russia. As for its indirect impact, the macroeconomic shock provoked by the war has yet to have any discernible effects on banks’ balance sheets. On aggregate, capital and liquidity ratios mildly declined from the end of 2021 to the second quarter of 2022, but they were still robust, in both cases remaining above pre-pandemic levels and close to their historic highs. Over the same period, the total non-performing loan ratio of banks under ECB supervision continued to edge down to an all-time low of 1.9%. Banking profitability as measured by return on equity, which was already on the mend amid the initial rebound in economic activity in the latter stages of the pandemic, has been further buttressed by the positive effect on net interest margins associated with the turning of the interest rate cycle. Overall, the return on equity of banks under ECB supervision climbed to 7.6% in the second quarter of 2022, the highest recorded value since ECB Banking Supervision became operational. Although data for the remainder of 2022 are not yet available, we expect bank profitability dynamics to have remained robust on account of the positive contributions by lending volumes and margins to net interest income growth.
Market participants seem to anticipate that the dynamic momentum in bank profitability will extend well into 2023. However, this confident sentiment seems to have taken hold despite the fact that, since the outbreak of the war in Ukraine, real growth expectations of both public and private sector analysts have been revised down significantly. Private sector forecasters now expect the euro area economy to grind to a halt in 2023. For its part, the ECB already warned in September of a possible recession scenario caused by euro area energy supply disruptions should downside risks materialise.
A changing risk outlook for banks
Markets thus seem to be betting that, in a context of still high inflation, the beneficial effect of higher interest rates will more than compensate for the drag stemming from increasing loan loss provisions, lower loan volumes and higher operating costs amid a weaker economy. However, there are three reasons to exercise some caution with this wager.
First, the benefits of interest rate increases are not evenly distributed across our supervised banks. These depend on factors such as business model and balance sheet structure, as well as on the sensitivity of those variables to the underlying strength of the economic cycle. From a supervisory perspective, it is therefore important to understand that even presuming the system-wide effects associated with rising interest rates are positive, idiosyncratic factors may influence outcomes across individual banks.
Second, the current risks to the outlook are clearly tilted to the downside. This means that any deviations of actual growth relative to the baseline may further affect the abovementioned “winners and losers” from rising interest rates. In this regard, a potential deterioration in asset quality is the main concern. As mentioned, the stock of non-performing loans of banks under ECB supervision has kept going down in 2022, but there are signs of this possibly reversing if interest rates continue rising and the macroeconomic outlook keeps deteriorating. Beyond a weakening of economic activity in general, there are also concerns about the potential effect of rising interest rates on specific market segments where banks may be particularly exposed, such as residential and commercial real estate markets, consumer and leveraged finance and energy-intensive corporate sectors. That is why we at the ECB are emphasising the need for banks to monitor the downside risks to the outlook and to proactively manage the associated risks.
Third, the changed macroeconomic environment also conditions the public sector response which may be reasonably expected should downside risks to the outlook materialise. While the pandemic postponed the exit from a low interest rate environment, the war in Ukraine has hastened it. The fight against inflation, and in particular the need to bring it back to levels consistent with the ECB’s primary objective to maintain price stability, is therefore a limiting factor to the public sector’s potential policy measures for supporting economic activity. From a supervisory perspective, this implies that banks’ balance sheet management strategies should not incorporate expectations of future public sector interventions, as these will have to be more targeted than was the case during the pandemic.
The supervisory agenda going forward
The key task for bankers and supervisors in the near term is thus to keep a close eye on the risks stemming from the current environment, and to manage them accordingly. We are asking banks to be proactive in guarding against the materialisation of credit risk and to bridge any gaps with our supervisory expectations. While supervised institutions have made some progress in recent years, shortcomings persist in their risk controls, especially in relation to loan origination and monitoring, classification of distressed borrowers and provisioning frameworks. We will continue to engage with banks on these aspects, focusing on those sectors most affected by the consequences of the war in Ukraine (such as energy-intensive industries) and by the prevailing macroeconomic environment (such as commercial real estate). We are also following up with banks to better understand both their sensitivity to the interest rate cycle – for example due to changes in consumer behaviour – and the potential implications of the downside risks to the outlook for capital planning.
In the medium term, the main task is to tackle those challenges which, while predating the pandemic and the war in Ukraine, have now risen to the forefront of the supervisory agenda as a result of these crises. First, the pandemic highlighted the need for banks to fully embrace digitalisation. In addition to responding to customers’ demands, investing in digitalisation could be one way to boost efficiency. However, this entails short-term costs for banks before they can reap the technological benefits. What is more, greater reliance on IT systems opens the door more permanently to operational and cyber risks. We are therefore engaging with banks regarding their digital transformation activities through several initiatives, including dedicated surveys, targeted reviews and on-site inspections.
Second, the repercussions of the war in Ukraine for global energy markets will likely build collective momentum towards the green transition. Banks therefore need to address the challenges but also seize the opportunities that this transition also offers. In this issue of InforBanca, my ECB Supervisory Board colleague Frank Elderson describes all we are doing to incorporate climate-related and environmental, or C&E risks, in our day-to-day supervision. The overarching message from these initiatives is that, while banks are making progress in managing C&E risks, this trend is not uniform and laggards remain in all areas. At the same time, these exercises also revealed that some banks have already adopted state-of-the-art governance for the management of C&E risks. We have published these good practices in a guide to foster supervisory convergence in this area, and have set individual deadlines for institutions to fully align with our expectations by the end of 2024. Our goal is to treat C&E risks in the same way as any other material risk that may affect banks’ capital requirements.
As supervisors, we always have to look around the corner to make sure that banks remain resilient and are able to support the real economy through the financial cycle. The shockwaves unleashed by the war in Ukraine – quite different from the confluence of risks which we faced during the pandemic – call for vigilance and prudence from all of us, bankers and supervisors alike. And although the turning of the interest rate cycle has been beneficial for banks so far, they need to know that this would be insufficient to offset any structural weaknesses that could re-emerge if and when downside risks to the economic outlook materialise. In order to further strengthen our collective resilience to potentially adverse future developments, the ECB calls for the prompt implementation of the Basel III standards and the completion of the European banking union.
In fact, standard indicators of banking health tended to improve during the pandemic. In aggregate terms, the Common Equity Tier 1 (CET1) capital level of banks under ECB supervision rose from 14.9% in the second quarter of 2020 to 15.6% in the fourth quarter of 2021. Banks’ liquidity coverage ratio rose from 165% to 173% over the same period, while the total non-performing loans ratio for banks under ECB supervision dropped from 2.9% in the second quarter of 2020 to 2.1% in the fourth quarter of 2021.
The CET1 capital level of banks under ECB supervision dropped from 15.6% in the fourth quarter of 2021 to 15% in the second quarter of 2022; this compares to a ratio of 14.4% in the first quarter of 2020. Banks’ liquidity coverage ratio dropped to 165% from 173% over the same period, as compared to a ratio of 146% in the first quarter of 2020. In both cases, the highest ratios recorded since ECB Banking Supervision started operations were posted in the second quarter of 2021 (with a 15.6% CET1 ratio and a 174% liquidity coverage ratio).
ECB Banking Supervision (2022), “Supervisory Banking Statistics: Second quarter 2022”, October.
ECB (2022), “Financial Stability Review”, November.
See ECB (2022), “ECB staff macroeconomic projections for the euro area”, September; and ECB (2022), “The ECB Survey of Professional Forecasters: Fourth quarter of 2022”, October.
ECB (2022), “A downside scenario related to the war in Ukraine and energy supply cuts”, ECB staff macroeconomic projections for the euro area, September.
ECB Banking Supervision analysis suggests that, in a hypothetical scenario of a 200 basis point interest rate shock amid a baseline scenario of sluggish growth, bank profitability would increase overall and total capital adequacy would only deteriorate mildly (stemming from losses in bond portfolios, increases in risk-weighted assets, and increases in the cost of risk respectively. However, the distributional effects of such relative gains and losses may still matter – for example, promotional and development banks would tend to see higher capital depletion compared with other banks. For a full discussion of the potential implications of rising interest rates for euro area banks, see Enria, A. (2022), “Monitoring and managing interest rate risk along the normalisation path”, speech at the Deutsche Bundesbank symposium “Bankenaufsicht im Dialog”, Frankfurt am Main, 8 November.
In this regard, bad loans in certain market segments have recently been on the rise, as have loans subject to impairment review as a share of total loans. Stage 2 loans rose from 8.9% in the third quarter of 2021 to 9.7% in the second quarter of 2022. The ECB’s latest bank lending survey also shows that, in response to the deteriorated outlook, credit standards applied for lending to households and firms have tightened substantially. See ECB Banking Supervision (2022), “ECB publishes supervisory banking statistics for the second quarter of 2022”, press release, 7 October and ECB (2022), “October 2022 euro area bank lending survey”, press release, 25 October.
Enria, A. (2022), “The risk outlook for euro area banks”, presentation at the Cumberland Lodge Financial Services Summit, London, 4 November.
Enria, A. (2022), “Better safe than sorry: banking supervision in the wake of exogenous shocks”, speech at the Austrian Financial Market Authority Supervisory Conference 2022, Vienna, 4 October.
ECB Banking Supervision (2022), “SSM supervisory priorities 2023-2025”, December.
ECB Banking Supervision (2022), “Good practices for climate-related and environmental risk management: Observations from the 2022 thematic review”, November.
Elderson, F. (2022), “Delivering on the Glasgow Declaration: actions by the ECB on the road through Sharm El-Sheikh to a Paris-compatible path”, panel contribution at the Euro-Mediterranean Economists Association COP27 side event on “Investing in and financing the acceleration of sustainable development in a net zero scenario” in Sharm El-Sheikh, 9 November.