Interview with Market News International
Transcript of a conversation between Andrea Enria, Chair of the Supervisory Board of the ECB, and Jason Webb, at an MNI event
25 April 2023
Hello everyone and welcome to this seminar and webcast. I am Jason Webb, Deputy and Global Managing Editor at MNI. I'm delighted to be your host on this occasion. I would like to extend a particularly warm welcome to Andrea Enria, Chair of the Supervisory Board of the European Central Bank, who kindly joins us for a very timely discussion on the topic: euro area banks, risk outlook and supervisory priorities. In March, the collapse of Silicon Valley Bank and other banks in the United States, and the absorption of Credit Suisse into UBS here in Europe sent a shockwave through global financial markets. As central banks press on with their tightening course to combat inflation, these developments continue to pose the question: where else do the financial stability risks lie, and on what scale? What is in the bank supervisors' toolkit to resolve these risks without them becoming systemic?
We very much look forward to hearing Mr Enria on his assessment and outlook insofar as the eurozone is concerned and also the broader risks posed by our interactive financial world. Our speaker today has a peerless track record, with a lot of firsts. Andrea Enria took up his current position for a five-year term at the start of 2019, having been the first Chairman of the European Banking Authority from 2011. Prior to that he served in several banking analysis, regulation and supervisory roles at the Banca d’Italia and the ECB. He became the first Secretary General of the Committee of European Bank Supervisors based in London. Thank you once again, Andrea, for being with us today. This seminar and webcast is fully on the record. Our speaker will make some introductory remarks for around five to ten minutes. I will then raise questions we've collated. Some were kindly submitted by our audience during today.
We also invite you to raise questions as we go along by submitting them via the chat box. I will be monitoring this and can raise some of the personal entries. This seminar and webcast is scheduled to run for up to one and a half hours in total, and I now hand over to Andrea Enria for his opening remarks: Andrea.
Thank you very much, Jason, and thank you for the invitation and to all of you for joining. I will keep my remarks as concise as I can. It's clear that the first point for me is the recent turmoil in the banking markets at the global level, starting in the United States. I think this has been a powerful reminder of the challenges of a fast-adjusting monetary policy framework and fast-adjusting interest rate environment in a situation in which debt is still at a very high level from all types of counterparts. The events of recent months have not highlighted surprising areas for supervisory attention, to some extent. Interest rate risk in the banking book was one of the areas of focus that was called to our attention by the events at the Silicon Valley Bank and other regional banks in the United States, and a lot of focus also went on unrealised losses on portfolios held at amortised cost. These have been for quite a while already a point of supervisory attention for us.
We started focusing on interest rate risk in the banking book at the end of 2021. During 2022 we ran quite an in-depth targeted review of interest rate and credit spread risks at our banks. We focused very much also on the issue of the economic value of equity, so the impact that increasing interest rates could have not only on the earnings of banks, which is generally a positive – especially for European banks – but also on their net worth. So, on their long-term perspectives, linked especially to the performance and valuation of their assets and liabilities, irrespective of the accounting books in which they are held. Sectors of course also attracted a lot of attention; exposures to sectors which are particularly sensitive to the increasing interest rates, like commercial real estate and residential real estate. The focus on commercial real estate was particularly high also following the turmoil in the US markets.
These have been other areas of supervisory priority for us. We ran targeted reviews and on-site inspection campaigns for a while. We focused a lot also on other sectors such as consumer finance, leveraged finance and on counterparty credit risk because the amount of increasing indebtedness that we have experienced in the last decade has been to a large extent also fuelled by non-bank financial institutions. So, the areas of focus were not surprising or new. What was surprising and new to some extent has been the extraordinary size and speed of deposit outflows. In these days we have seen publication of data for Credit Suisse and other banks in the United States, also First Republic today. This has been definitely something that needs further focus and further reflection, also in the supervisory community.
Let me say upfront however, that sometimes there is this reaction when you have a crisis and turmoil, that you need to jump the gun and move to regulatory reforms. I don't think this should be the case at this time. There might be areas in which we want to review and maybe fine-tune the calibration of some of our requirements, but in general I think that the overall framework has shown that it is robust. The key point is that supervisory attention needs to be paid to some specific business models that have extreme features and that we deploy our supervisory tools to maybe find a better coverage of these issues. For instance, in the case of Silicon Valley Bank and Signature Bank there was a particularly concentrated depositors’ base. So, in those cases you might need to deploy your supervisory tools to deal with the specific situation rather than recalibrating international standards to fit a very extreme business model.
All in all, we have argued for a long time that we don't see a direct read-across from events in the United States to banks in the euro area. There were some outlier features of those business models that were core to the turmoil that we don't find in our environment: banks that were very concentrated on high-tech companies both on the asset side and also on the side of shareholders and depositors, a very concentrated depositors’ base and extreme exposures to unrealised losses; also this dual system that I understand is under review now in the United States, in which international standards are applied only to a bunch of larger systemically important banks but not to smaller banks – which is not a feature, as you know, of our framework. So, there are a lot of issues that do not appear.
So far we have seen that increasing interest rates have played a very positive role in European banks' profit and loss and balance sheet. To some extent, it was a long-awaited moment to beef up interest margins and bring profitability and also valuations of European banks in a better space. So, there are indeed risks – as I mentioned – on which we are also focusing from a supervisory perspective, but our assessment is that on average, the increasing interest rates remain a positive for European banks. Let me just conclude by saying that another important aspect which is being debated as a result of the current developments is the framework for the management of crisis. We have had two issues. The first one is the deployment of the tools that we have in allocating losses in a situation of crisis; there was this very specific decision taken by the Swiss authority, which I of course respect and I am convinced is perfectly in line with contractual and regulatory features of that regulatory environment.
At the same time, the allocation of losses to additional Tier 1 investors which had been totally wiped out in the case of Credit Suisse, while equity holders maintained value on their investment, is something that created turmoil in the overall market. We asserted strongly that this supervisory trigger feature, which is in the Swiss additional Tier 1 instruments, is not present in any Additional Tier 1 (AT1) contract of European banks, and that we would by law respect in resolution the hierarchy of claims. We also committed to respecting it, if there were to be – which I don't think will be the case – any crisis management outside of resolution. The Commission has recently issued proposals on crisis management, which are important and do not target systemically important banks but more mid-sized small banks. We are strongly supportive of these proposals. We think they could be an intermediate step towards the completion of the banking union. I am sure we will have plenty to discuss on that topic. I will leave it here – thank you.
Thank you very much for these very useful remarks, Andrea. Interesting. I know we're awaiting the results of a stress test with a high interest rate scenario later this year. So it is interesting that you provide an initial assessment of rising rates as a net positive for the European banking system. Nonetheless you mentioned a lot of this wasn't a surprise, and of course you have been pointing to risks from rising rates and commercial real estate for some time. But you did single out the speed of the outflows, particularly the deposit outflows. We had further news from First Republic overnight about that, particularly given the capacity for digital transactions, the way that news is transmitted across social media. In the past I think you've linked this to the liquidity coverage ratio. Whilst you're not saying we need any significant regulatory reform, what sort of parameters, what sort of calibrations could be adjusted to take account of this surprising and slightly alarming development?
Thanks for the question, Jason. I would say that, as I mentioned before, we need to be careful in moving on adjusting the liquidity coverage ratio. The liquidity coverage ratio I think is a very good metric. Let's remind ourselves that the objective of this metric is to give authorities time. So to create a window – ideally one month – to prepare solutions in case the crisis becomes entrenched, to find solutions and plan for a smooth exit from the market if need be. Now, if you roll back for instance to the first episode of deposit outflows at Credit Suisse last year, the liquidity coverage ratio fulfilled its role. So it enabled the bank to have time to bridge to a capital issuance that eventually for some time restored stability at the bank. Then there was further news and further developments, and the situation deteriorated further. But in that situation the liquidity coverage ratio worked properly.
There are some features of some specific business models, like a high concentration of deposits. There were cases of investors that had more than three billion in deposits at Silicon Valley Bank. That I think should not be covered by rules; it should be covered more by supervisory intervention. So, if you see as a supervisor that there are specific features, you should maybe ask for higher liquidity buffers. You can do it – the Basel standards are minimum standards and you can do more than that. Maybe the issue we should investigate a bit further – and I don't have answers yet – is whether there are some types of depositors that showed a much higher outflow rate than calibrated in the international standards. For instance, I am told by my US colleagues that venture capital firms were particularly fast in running.
So, it might be that we need to look at different types of investors. But one point I want to make which for me is the most important, and that I learned with some concern, is that there are a number of institutional and corporate treasurers that look at triggers for deposits such as stock prices or credit default swap (CDS) spreads. There could be many drivers behind a depreciation in stock, in equities and not necessarily something that puts at risk deposits. But these triggers have been particularly strong in some cases, especially if you look at the CDS market. I mentioned it during the turmoil in March. Sometimes you have single-name CDS transactions, very small transactions, that can cause very sharp moves in illiquid and shallow markets, and then trigger adjustments in stock prices. Then eventually it can even contaminate outflows of deposits.
These types of dynamics concern me quite a bit, and I raised the point that sometimes these CDS transactions are not very transparent, they might be taken also jointly with short positions on the equity, so there could be dynamics that might be difficult to contain and could accelerate financial instability. As supervisors, as authorities I think we should focus a bit on these aspects as well.
So, the main focus there will be looking at the CDS market. You mentioned the link between equity prices and deposits, but what as a supervisor you could look at more is – or as authorities what you can look at more – is how the CDS market works and reforming it as well.
Yes and we can also think about, as supervisors, using more – and to be honest, so far we have not used that possibility very much – the possibility of asking for additional liquidity buffers when we see that the liability structure of a particular bank requires probably more liquidity buffers because deposits might flow out faster than for other business models.
So, if they've got a high concentration of venture capital depositors or something like that?
Yes, something like this.
I see. Also, Andrea, before I go on to the questions – and I see we're getting quite a lot of those – before I go on, you mentioned the issue of the Swiss response on the AT1s and the hierarchy. Obviously, the Bank of England was also not thrilled by that development. Were there lessons in terms of coordination between international authorities in the response to a crisis to be learned here? Or is it just the case that when these crises occur, the best-laid plans always have to be adjusted in the heat of battle, as it were, because I don't think anyone anticipated that the Swiss authorities would handle the AT1s in this way.
Well, I understand that you cannot have large international debates during a weekend in which you are trying to manage a complex crisis. I think the core of the issue is in the international collaboration beforehand. I am somebody who has always believed a lot in international cooperation, in the Basel Committee and in the international structures for cooperation. I think we need to strengthen these aspects a bit more. For instance, in the European Union, even before the start of the banking union, we had at the European Banking Authority (EBA) a strong collaboration; a team of experts, a network of experts that was reviewing exactly the contractual features of additional Tier 1 instruments to make sure that for all the contracts that were issued in Europe, we had a common understanding. They were good quality, they ensured flexibility of payments, loss absorbency, but also to look at the possibility that these instruments behaved in predictable ways for all the banks under the responsibility of different authorities.
So, I think these types of mechanisms are very useful, ex ante, to create a common understanding on how losses should be allocated if something bad happens. I think these mechanisms were very useful at the European level. I would advocate that something similar maybe should be established also at the international level.
I'll move now to some questions that I'm getting from our attendees because there's already quite a number. One person says: the link between CDSs and banks was also regarded as a problem during the global financial crisis, so 15 years ago. Why are we still talking about that problem now? Were there not lessons learned then? How would you respond to that one, Andrea?
Well, it's a difficult question. I would say that in general the reaction to the great financial crisis focused very much on the banking sector because the banking sector was the core of that crisis. It was a major shock amplifier to some extent, so it's clear that the reforms put a lot of attention on that. You can see if you go back to the debates from those days, there was a lot of attention also to other markets, to other institutions and which were maybe not followed up as strictly as was the case for banks. I think the ECB has been very vocal recently in requesting that more attention is paid also to these markets and to non-bank financial institutions. So, I think that times are ripe to step up the regulatory cooperation internationally on those topics.
Going back to the question of the effect of rising rates, I've got a question on the effect of bank profitability in a two-year horizon when the next interest rate margin could be compressing as banks have to raise deposit rates, to compete for deposits while also facing a deterioration in their assets. I'm not sure if the stress test looks at it over a two-year horizon but how would you respond to that one?
Yes, the stress test has a three-year horizon indeed. In general I'll say in the stress test there are also quite demanding assumptions on pass-through of the increasing interest rates to depositors. Actually, the banks were quite vocal in criticising the harshness of these assumptions so I think it will provide some interesting reading into the question. In general I think that when we look at the projections of banks and we look at our own projections with our own models, the positive effects of increasing interest rates on the earnings are generally prevailing. We are also seeing an uptick in asset quality problems. It's clear that with increasing interest rates we will have at a certain point some materialisation of credit risk in the balance sheets of the banks. But at the moment we still have for the next couple of years projections that give a positive impact.
Again this relies on the assumption that banks are particularly disciplined and effective in tackling asset quality problems as fast as possible. That has been something that we have been calling out banks on like a broken record in the last year. So, we had been fearing an increase in credit risk and in non-performing loans already starting from the pandemic. That increase didn't materialise but we still have asked banks to beef up and strengthen their credit risk controls and to be able to identify problems very early, manage them proactively very early, providing solutions for customers and avoiding a pile-up of asset quality problems, as in the past. If there is a disciplined approach to managing credit risks we think that still the trajectory should be positive. That is the baseline. Of course we will see from the stress test what would happen in a very adverse scenario.
I am getting a few more questions regarding bank profitability – which of course is an entire subject in the eurozone, as you're aware. A question on the unwind of TLTRO liquidity, particularly in the peripheral banking system; whether there's a mismatch of excess liquidity vis-à-vis TLTRO borrowing. How do you see the unwinding of TLTROs which is coming up and how might that affect banks?
That is not a surprise, is it? It's something which has been announced with a great prior time lag. Banks have had time to plan how to start reimbursing the TLTRO funds and find alternative funding sources. We have placed again – already starting last year – a lot of attention as supervisors in reviewing the funding plans of the banks, with a particular focus on the TLTROs. We have seen that the process so far has moved pretty orderly, so we have not seen major hiccups and we will keep following this closely. But at the moment, there is no “flashing light” that we have seen in that direction.
More broadly on this subject of profitability, it's been a long-standing problem for eurozone banks since the financial crisis. I think that the forecasts for return on equity are at about 8% assuming credit losses remain contained. This is obviously far below what we've seen in the United States. How far are banks on the road towards healthier business models, and how do you see the challenges remaining? How far are the eurozone banks on the road towards revising their business models to make them healthier? How do you see that?
I don't want to provide an excessively rosy picture here, but I've seen progress, honestly. We have been very harsh also in criticising the lack of long-term sustainability of banks' business models since 2017, when the ECB made the first review of business model issues. We identified a lack of focus in investing in new technologies, issues in terms of cost efficiency, inability to focus, downsizing, so getting out of business lines that were not ensuring sufficient remuneration of the capital invested. So, I think that in recent times there have been important positive developments. For instance we have not seen, maybe as I would've expected, more full-blown mergers in the European landscape but we do have seen a lot of business line transactions with banks that were exiting some lines of business and other banks that were trying to achieve more scale in those lines of business, so, in asset management, in custody business, in leasing, also in some lines of investment banking business, structured equity.
There has been quite a lot of reshaping of business models. We have seen more forceful actions on costs and with the change in the interest rate environment, we see that many banks are, in their three-year plans, projecting – rather credibly I would say – to go to double digit return on equity, and to finally earn their cost of equity which has unfortunately not been the case since a long time. So, 8% return on equity you mentioned – I am not sure but in any case we have seen already in 2022 the highest return on equity on record since the start of the banking union. So, the trajectory is OK. The first quarter of this year - banks are announcing results in these very days - has been another positive quarter. The drag on profitability that was exercised by asset quality, by the legacy of non-performing loans, is now basically dealt with. We have an average NPL ratio at 1.8%, which is the lowest ever recorded. Even banks which had much more significant legacy issues have continued dealing with the topic and securitising also during the pandemic and during the crisis.
So, I am pretty positive. Since I started at the ECB we had a pandemic, a war, a fast-accelerated adjustment in the interest rate environment. So, everything is moving so fast. We cannot rule out there might be other shocks that once again create difficulties, but I think the direction of travel is positive.
In terms of the shocks, one shock – it's not a shock at all – but something which you'd been actively working on, which was the final implementation of Basel III with the nickname Basel IV. What are the implications of that for banking profitability given that banks will be a little bit constrained in some of the more creative use of their internal models?
Well, to be honest, I think that the impact for the banking sector as a whole cannot be but a positive. If you had some banks that are creatively – as you mentioned – using their models to portray an inaccurate and excessively rosy picture of risks, having a reform that puts every bank on a level playing field and makes sure that the function of internal models is more robust, more reliable and more comparable across banks – I think this should be saluted as an improvement by everybody. In general there is also this narrative, that the banks manage to pass in the general debate, that an increase in capital requirements is always a negative for bank profitability, for lending, for growth, for jobs – for everything, basically. I would strongly challenge this. There is plenty of very serious research that argues quite in the opposite direction.
What happens is when you transition from one level of capital to a higher level of capital, of course you have an adjustment which might be costly and might also be driving some reduction in the risk-taking by the banks. But once you have achieved the new steady state level, the bank is actually in a better position to withstand shocks, which is what we want. What we saw is that in 2008 banks had a poor capital position. A shock arrived. Major knee-jerk risk aversion and massive impact on our economies for years, which brought the growth path on a much lower level. The pandemic arrived. Basically, banks did not behave like that. They continued lending, they supported their customers. Of course there were also a significant amount of government guarantees that helped throughout the process but still they managed to work as shock absorbers, not as shock amplifiers.
So, having a higher level of capital eventually helps the role of the banks in the economy and once you are there at the higher level, their profitability will be driven by their revenue generation capabilities, their cost efficiency and the normal drivers for that. Let me stress that this package was not about increasing the capital levels for all. This package is about increasing the capital levels for those banks that inappropriately benefited from use of internal models that put them at an advantage vis-à-vis other banks. So, distributional effect is what matters more than the average. Everybody is always focused on the average but actually it's resetting the level playing fields across banks which is the most important point for a regulator.
On the subject of creativity in the banking industry: I think in the past you've accused – it was a while ago admittedly – banks of gaming stress tests. Do you think there is still some of that going on?
Well, I hope not. I have not yet seen the results of this year. I know the team is still engaging with the banks after the first submissions. But in general it is important that in this repeated game that we now are having regularly with the banks, that banks really do not low-ball the first submissions, maybe looking at each other, and that they play fairly. This is an instrument also for them to have proper feedback from their supervisors on their risk profile and the risks which are on the horizon. I think I am confident that banks will positively interact with our teams throughout the stress test and we will come out with a reliable result in July.
Just before moving on to some more questions from our audience. This is a bit beyond your remit but we're now implementing the final part of Basel III. The eurozone banking system, with much lower NPLs than a few years ago, much more closely regulated and there's still some uncompleted pillars of banking union but it's in a much stronger way. How worried are you that the risk is simply being squeezed into one part of the financial system, and outside… So, with all the debt which you referred to earlier in your comments, a very high debt environment, you squeeze the risk out of banks, it just pops up like a balloon somewhere else. Then it affects the banks. How do you think about that broader issue of a very high debt world?
OK, before we move away from the Basel discussion let me use this opportunity to launch another plea for our colleagues later to stick as much as possible to the Basel standards. Now, if there is a lesson also from the case of the regional banks in the United States, it's that it might seem a good idea in good times to have maybe some banks which are not under the remit of Basel, as was the case for regional banks in the United States, or to have banks like in the EU, which are under the remit of Basel but the Basel rules being watered down somewhat here or there to address supposed specificities of this or that banking sector. I think eventually when there is a crisis there will always be somebody saying: “oh, that bank would've fared much better if it had been in line with the Basel standards”. This will come back and haunt regulators and legislators if you don't stick to the Basel standards. I am not saying they are “the Bible” – but still they are the best that we managed to construct as a regulatory community globally. It is important that we strive to stick as much as possible to that in all jurisdictions, including especially for me the European Union.
Your point is absolutely spot on. It is clear that if you look at the overall level of leverage of the finance sector – so households, corporates and governments – in 2010 and you do the same snapshot now, the level of debt has increased significantly. The level of leverage of the banking sector has decreased so it means that some of this leverage has been fuelled, financed by non-bank financial institutions. So, the issue of the potential role that this sector could have in a new crisis is something which is really still unchartered waters for us. So, from my perspective I know that our colleagues on the central banking side are focusing a lot on the potential for systemic risk in the non-bank financial institutions sector. As supervisors our entry point in this debate is counterparty credit risk, so the interface between banks and non-bank financial institutions of course especially in the counterparty credit risk area. This is where we have made a huge significant supervisory effort both in terms of reviews and alongside the inspections.
We have identified some issues both in terms of origination and monitoring of counterparts in terms of stress testing of these positions. So, we have done a lot to also strengthen these safeguards but this is indeed an area where maybe also globally the Financial Stability Board should focus more, as they have announced recently.
Right, I'm just going to turn to a few questions from our audience. This is more of a philosophical one. You say the United States has a dual system and European euro area doesn't, but only larger banks are supervised centrally in the eurozone and smaller ones nationally. Is that not effectively a dual system as well?
Well, in terms of regulatory framework, no. The same legislation applies to all. We have the capital requirements directly in our regulations. The Capital Requirements Regulation where the bulk of the prudential requirements are, is legislation binding for all banks in the European Union of all sizes. So, there isn't this type of difference. We have the concept of proportionality which is a sort of constitutional concept in the European Union, so we do have a number of areas where we apply lighter processes for smaller banks, but all the international standards – liquidity coverage ratio, net stable funding ratio, the capital requirements –are applied across the board to all authorities.
Also in the banking union I would say that although it is true that we are focused directly and supervise directly 113 banks, if I remember well at the last count, while the others are supervised by the national authorities, we do have a number of functions also for smaller banks. We do have an oversight function at the ECB and we work very closely with the national authorities, also for the supervision of what is called less significant institutions. So, there is a much more unified framework I would say in that respect.
Turning to a broader question of banking union and also crisis management. The ECB has welcomed the Commission's proposed legislative changes to the crisis management and deposit insurance framework. How far does that take us and how much still remains to be done for the eurozone to be as strong as it can be in a crisis? How far do the European Commission proposals go towards what you would like to see? Do you have any reservations about them?
Yes, I think the European Commission proposals are a good step forward. It's not in itself the end game in terms of the process towards the banking union, but it has some important features that I would like to stress. First of all let me stress that we are not in a situation in which we would need to repair something that is now dysfunctional. We don't have a system that has proven not to work in a crisis. Unfortunately, we have had our fair share of banking crises in the last years. Admittedly, mostly small but also medium-sized banks like Banco Popular, so to some extent the system works. But there is the issue that we have a fully European system for the larger banks that go into resolution but for the small and mid-sized banks that are now going into liquidation under national regimes, we have very different approaches.
This is also a problem for us as a supervisory authority because sometimes we declare a bank failing or likely to fail and this bank is not considered as ticking the box in terms of public interest assessment for resolution. So it's left to the national liquidation processes and there you have the wildest variety of practices in terms of the possibility to deploy the deposit guarantee scheme, to fund a solution to the crisis in terms of the possibility to trigger liquidation. We have had cases in which a bank was declared failing or likely to fail, but the Court didn't consider that it satisfied a liquidation test, so we had a bank that was in limbo, not failing but not to be put into liquidation. We have had banks for which resolution was not considered to be in the public interest at the European level, but was however considered to be so at the national regional level, and the banks therefore benefited from liquidation aid in liquidation.
This has created, in my view, a lot of practical problems but also fuelled the lack of trust among Member States as to how their neighbour would manage a crisis compared to how they themselves would manage it. I think more harmonisation in the rules on how to deal with the exit from the market of a small or medium-sized bank is an important step towards restoring this trust and building a common framework that could be a stepping stone towards the finalisation of the banking union.
When you step into the discussion of crisis management arrangements, there are a lot of differences in preferences. I myself would like to see in the legislation things which are missing, and maybe I would have liked some to have been drafted differently. But I would now like everybody to focus on the main objective of this package, which is to put together three very closely intertwined tools and objectives. The first one is to ensure the possibility of deploying deposit guarantee scheme funds more widely in funding the solution of a a crisis.
So not only in paying out depositors when a bank is defaulting, but also in financing solutions − for instance, sale of business, bridge banks, etc − and using deposit guarantee schemes in order to support a smooth exit of banks from the market. The second point, which is linked to the first, is that if you want to do that, you need to get rid of the super priority for deposit guarantee schemes. Otherwise it would not work. You need to introduce a general depositors' priority and harmonise the hierarchy across Member States, which is also an important point in moving towards the completion of the banking union. The third point, linked to the first two, is that once you do that, you can also use the deposit guarantee funding to bridge the gap to the 8% that would trigger the access to the resolution fund.
We have a big pot of money there, which is contributed by the banks themselves and which has so far never been used to finance positive solutions to a crisis. So, using deposit guarantee schemes to do that would be an important step forward. If we take the sum of the Single Resolution Fund and the national deposit guarantee scheme, we have the same ballpark figures as the Federal Deposit Insurance Corporation (FDIC) in the United States. But they use this fund much more proactively to manage crises, while we never use this fund. The final point is the least cost test. It's a key principle of international standards that you should always deploy deposit guarantee funds on a least-cost basis. So, when it is convenient to do so compared to paying out the insured depositors. It is important that this principle is harmonised at the European level and exercised in the same way across the Union.
If you take these four principles, you cannot take out one and keep the other three so you need to have the “full monty”. They are closely related to one another, so it is important in negotiations that we don't jeopardise this unity of intent that would deliver for us a much stronger and more effective crisis management framework.
Just in terms of the third pillar of banking union, which is still delayed, which is the European deposit guarantee: what is your reading on when we're likely to see that, if ever?
Well, I had hoped that we would have achieved last year, with the effort of the President of the Eurogroup in this direction, a clear roadmap with a timeline to get there. We don't have it, so at the moment nobody can answer your question. What is important for me to say is that the reluctance of governments or ministers of finance to sign up to EDIS, to the European Deposit Insurance Scheme, is that from the politicians' point of view, you have the impression that you are signing up to a sort of joint and several guarantee on seven trillions of insured deposits. That makes finance ministers hesitate a bit. So, why do I think that the reform that the Commission put on the table is important also in that perspective? Because if you have a well-functioning deposit guarantee scheme and crisis management framework, as is shown in the United States by the FDIC, you never use the fiscal backstop.
Throughout the great financial crisis, the FDIC managed to close down more than 500 banks in the United States, deploying the funds they had, doing purchase and assumption, then selling these franchises to the investors, banks, sometimes in other states, and helping the consolidation, rationalisation, restructuring of the sector, without ever triggering the fiscal guarantee. So the fund was used eventually and is now being replenished by the contributions of the banks themselves. If you had a common framework for crisis management that enables finance ministers to understand that this can work effectively, favouring the smooth exit from the market without weighing on the public finances, then I think that they could sign up to EDIS with less hesitation going forward. I hope so at least.
Turning again to a question from the audience, quite a straightforward one for you: how are supervisors dealing with unrealised losses on banks' books, and is there a concern there?
Let me stress some differences in the setting that we are in right now and the setting that we have seen at play, for instance in the Signature and Silicon Valley Bank case. First of all, in the case of regional banks in the United States, there was a possibility not to reflect on capital the depreciation of assets held in the available-for-sale book. That was an option, and the banks that we are talking about did not map the unrealised losses on the available-for-sale assets into capital. For all our banks this is not possible, so everything in the available-for-sale book goes to capital through fair value through other comprehensive income. That is a first important difference. Take the overall size of unrealised losses at US banks and European banks, I think there was a chart published by the IMF recently. If you were to map all these losses into capital in the United States it would have a median impact of more than 250 basis points, whereas in the case of the European banks it would be below 50 basis points. That is one of the big differences in our regulatory frameworks.
The second point is on the liquidity coverage ratio (LCR); when we calculate the LCR we assess these assets at market value, so the computation of the liquidity coverage ratio already includes a market valuation. The banks need to have a buffer that is on mark-to-market terms that fulfils the requirements; that is another important difference. The banks we're discussing in the United States did not have actually have the application of the LCR. So the unrealised losses aspect is in a different ballpark; that was my first part. But still it is there, so we do have a significant amount of assets which are held at amortised cost. For European banks, 75% of the sovereign portfolio in the banking book is held at amortised cost. This means that if the banks were forced for liquidity reasons to liquidate this portfolio, they would have to realise these losses.
This is a point of attention. That is why we conducted a number of shocks throughout last year. We asked the banks to give us their feedback on how a standard 200 basis points shock on the interest rate would have mapped into their economic value of equity. We monitored that throughout the year as the interest rates were hiked up. Along with the European Banking Authority (EBA), we are now also collecting additional information within the framework of the stress test. This is also because sometimes we do have the amounts but we don't have very detailed information on the hedging practices, for instance, of banks on the interest rate risk on these particular assets. The information that we are gathering will enable us to have a better, more granular picture of the interest rate risk in the banking book through that channel.
It will enable us also to do some sensitivity analysis, to see in different scenarios – including the scenario of the stress test – how the unrealised losses would move for different banks. It's something we have now been focusing on for more than a year and on which we are engaging in strong discussions with our banks.
We have a related question from the audience concerning the potential losses in bank securities holdings. How does the maturity of these compare with US banks?
I don't have a clear picture of the maturity in the US banks, so this is a question that should be addressed to the IMF or other international organisations. But again the type of exercises that we do are generally these 200 basis point shocks. We have a parallel shift in the yield curve, we have tilting upwards, downwards. We have the whole configurations of increases which enable us also to challenge banks which have a different maturity distribution of their books at amortised cost.
Going back to the subject of banking union and the fact that European banks are still quite segmented along national lines, when are we going to see changes in that? Does this segmentation in itself provide some sort of risk? Back in the eurozone, back in the crisis in 2012, talk was of the doom loop and of the exposure of banks to government bonds and sovereigns and vice versa. Is there still any danger of that, and how concerned more broadly are you in systemic terms about the continuing national segmentation of the eurozone banking system?
You can keep me going for a while on this question! I think there would be huge benefit from achieving a greater integration of banking markets in the banking union, for a number of reasons, also in terms of profitability for banks, honestly. But I am a supervisor so what I look at are the tail risks. Having a more integrated market would improve the resilience of our banking sector in the face of shocks. If you look at the banks in the United States, at banks that operate in different states, if you have a real estate crisis in one state − as happened in Nevada some time ago − then the banks which have diversified portfolios across states would be able to withstand the losses in Nevada by compensating with profits in other real estate markets across the overall federation.
In the European Union we don't have that. If their portfolios are very much concentrated in one national market or even regional market, the banks are going to suffer more deeply if there is a major real estate shock. It is interesting because it is also a shock absorber in terms of the possible solution to the crisis. If you have a shock in one Member State you would like to be able to fund solutions to this crisis by finding potential buyers for the assets and liabilities of these banks, also from other states. The lack of what is usually called private risk sharing is indeed an issue. In my view, we don't have sufficiently effective private risk-sharing elements in the banking union because of this segmentation of the banking market in some national pools.
We have tried to give a lot of attention to – not favouring – but at least not hampering additional integration. For instance, we set out clear guidance supportive all in all for mergers and we say clearly that we would have used the same metrics for domestic or cross-border mergers within the banking union. We have seen some domestic mergers; we have not seen a lot of cross-border mergers so far. I think that the case for cross-border mergers will become stronger if profitability becomes more crystallised and stable going forward but for the moment, that is where we are. We said, and it is still an open possibility for banks to consider, that we can open up to branchification, for instance. It was interesting because we saw that most of the banks that moved to the banking union, to the euro area, after Brexit from the United Kingdom, use the branch structure. They used the central entity in the euro area and then they integrated. They merged all the subsidiaries in the other Member States into this unit, distributing products through a branch network. This would avoid any segmentation of capital and liquidity when operating in the banking union. It's an option which is also open to incumbent European banks, so we stand ready to assess this as an avenue as well. So far we have not received any application. One of the stumbling blocks in this is the fact that there is no portability of the deposit guarantee scheme. Once you pay the deposit guarantee scheme in one Member State, if you branchify, you cannot move the funds that you contributed to the local scheme back to the other state. You can only bring the payments of the last year. We asked the European Commission to take care of this aspect in the legislation. Unfortunately we didn't find this element in the recent package.
Third, there is limited space for liquidity waivers that would enable banks to pool more liquidity for cross-border groups. We stand also ready to look into applications from banks in this area. So far, not much has moved. I think banks right now are overly focused on returning capital to shareholders and lifting their valuations. They are not that much into the mindset of expanding their franchise in other Member States. I hope that once profitability becomes more stabilised, we can see more push from the European banks in terms of integration.
On the point that you were making on the doom loop: the doom loop has two drivers. One is the contamination from the sovereign to the banks, so the sovereign spreads widening and these affecting negatively banks in one area worse than banks in others. To some extent, the diversification I was discussing before would already be an important safeguard, but in general I would say that the institutional safeguards that were put in place after the sovereign debt crisis − so the outright monetary transactions (OMTs) and more recently, the Transmission Protection Instrument − have enabled going through a number of shocks without seeing massive shifts in sovereign spreads. So, this element is much less relevant today than it was at the time of the sovereign debt crisis.
The other element is the contamination from the banks going through a crisis into the sovereigns. This is the national nature of the safety net. We have done a lot to remove this channel too. We now have a Single Resolution Fund so for the large banks, the funding comes from a common fully-mutualised fund that will be fully funded by the end of this year. We also have a common backstop, that has been agreed at the Council level, from the European Stability Mechanism (ESM) to the Single Resolution Fund, so we are getting there in terms of completing that institutional set-up.
We do have the national part of the deposit guarantee schemes for the small and medium-sized banks, as we were discussing before. This honestly will not be fully addressed until we move into EDIS. But having common criteria is already an important step forward there as well.
How important is the portability of the national guarantee schemes compared to EDIS, the European scheme? Would that in itself make a huge difference and encourage more cross-border activity?
Well, the portability is relevant only in a specific case, which is the branchification, so if you decide to transform the subsidiary into a branch. It depends very much on the amount of funds that you paid, the amount of deposits you are taking. It may differ from bank to bank, for some banks it might not be that relevant, while for some other banks it could be killing the deal. It would have been helpful but it's not so material. EDIS, however, is on a much different scale in terms of providing the support that would be needed to foster the integration of the euro area banking market.
We have a question from the audience on EDIS. It seems we cannot get EDIS before banks diversify the sovereign debt holdings, and governments appear unwilling to force that. How do you respond to that one?
Well, my first reaction is that we no longer see in the banks' balance sheets the same amount of concentration on domestic sovereigns that we saw back in 2011. So this has changed already to some extent. Banks have learned, there has been some diversification. There are less extreme cases of concentration than we have seen in the past. In the past I have also supported institutional initiatives that favoured this diversification or creation, also of European synthetic assets that would have helped this process. But besides that I would say that – and this is also a reflection on the developments in recent times – the most important step towards making this issue less relevant would be having more mark-to-market in the sovereign portfolios of European banks.
I understand that banks keep a significant part of their sovereign bond portfolios at amortised cost. I understand that they could still use these assets for monetary policy operations and get the liquidity they need through that channel without having to sell the assets in the market. But I would like to move in a different setting in which banks were to hold their liquidity buffers at market values; that would already be a major improvement that would make this issue less relevant. Banks would be incentivised to manage the risk in a more proactive fashion so diversification would also be more in their interest.
You mentioned the TPI and the OMTs so we're getting close to some of the other functions of the ECB beyond your department. Obviously one enormous concern of the monetary policy section – which isn't your section of the ECB, but which regards the banks − is the tightening of financial conditions. What sort of evidence are you seeing of banks pulling in their lending in the eurozone?
What I've seen in the bank lending survey is that indeed in the first quarter of this year, banks were planning to tighten their lending standards. I expect that also in light of the turmoil that has happened in March, this has indeed occurred to some degree. Obviously I don't monitor these data very closely. I would expect that there has been some tightening. We already saw at the end of last year that in some markets, for instance the residential and the real estate markets, the lending conditions in some Member States were massively tightened. So the tightening is occurring. It's a natural element when you are in a monetary policy normalisation framework. I am not dealing with monetary policy issues, as you correctly pointed out, but it seems to me that the tightening process is occurring in line with the expectations of our colleagues on the other side of the building.
In terms of the cycle we find ourselves in, you mentioned commercial real estate earlier on. Could you say a little bit more about the risk to banks from commercial real estate, particularly as the monetary cycle continues to tighten?
We have had an intense supervisory focus on commercial real estate, also because we thought – already starting during the pandemic – that there would be a structural impact on the sector coming − especially in the office segment − from the increased reliance on remote working at most firms, and a more conjunctural impact coming from the tightening cycle in interest rates. So this sector was one of the first on which we focused our attention. We looked extensively at the risk management practices of banks in this area. We identified some issues in the origination, for instance the very extensive reliance on balloon and bullet loans, and sometimes also the lack of skin in the game asked of the sponsors of these projects. We saw some weaknesses in the monitoring of the conditions of the counterparts, some weaknesses in the valuation of the collateral. We have put a lot of effort into ensuring good internal controls and good risk management in this area. This is one of the sectors that will need to continue being at the centre of supervisory focus. I notice that in the United States there is now a lot of attention on exposures to this market, but what is important is to look at the risk management practices by banks which have been significantly involved. We should especially focus our attention on the extensive use of balloon and bullet loans. Having said that, I must say that the market so far has been surprisingly resilient. For some time we have noticed that real estate investment trusts − which are usually used to predict future price developments − have pointed to a downward adjustment in valuations. This downward adjustment in commercial real estate has not yet materialised, especially not to the extent foreseen. For the moment we don't yet see the risk materialising but I think it is important to keep a focus on that.
I'm just getting another question from the audience: referring to your appearance before the European Parliament, there was a report suggesting that you were encouraging banks to mark-to-market sovereign debt holdings used for liquidity coverage ratios. Is that accurate?
I would say that banks should be ready to sell all the assets that are included in liquidity buffers at short notice. In my view, this should be carried at market value. However, I recognise that the setting which has been designed right now is sustainable in a sense, because you have to mark to market for the calculation of the liquidity coverage ratio, but the asset would be still held at amortised cost, basically. Also because the banks would still use these assets as collateral in central bank refinancing operations, so the system now works. I remain convinced that a much better way of addressing the concern, also on unrealised losses, would be if all these portfolios which are earmarked for the liquidity coverage ratio were to be carried at market value. That is a personal opinion. Nobody is listening to me so I don't think you should take any indication from what I say in terms of what is likely to happen on the regulation side.
Where do you see the risks coming from the non-bank financial sector − real estate investment trusts?
Well, it's not my line of business. The Bank of England, for instance, also has responsibility for non-bank financial institutions whereas we are only focused on banks, so I don't see these entities. I know that in some areas of non-bank financial institutions, our colleagues in the European Insurance and Occupational Pensions Authority (EIOPA) and in the European Securities and Markets Authority (ESMA) are monitoring risks and also conducting stress tests from time to time, so they are focusing more on that. I am not in a position to indicate anything. Our colleagues on the Central Banking side have indeed recently identified investors in commercial real estate as one potential element of scrutiny from that point of view.
A big issue we haven't mentioned so far is exposure to Russia. The conflict has been going on for quite a while now. How is the exposure to Russia going?
Taking a purely prudential point of view, so how much are the exposures of European banks towards Russian counterparts, these exposures are manageable. We already came out in the weeks after the Russian invasion of Ukraine showing that basically, if you were to write down to zero all these exposures, this would not have rocked the boat for any European banks, so they would have still been able to fulfil the capital requirements. Having said that, we have been quite clear in our message to the banks that we expect these exposures to be downsized and to be significantly reduced. Ideally banks should also consider exiting from that market, also because of reputational risk. If you are in a market which is involved in such a nasty war of aggression − although I know that many banks operating there are very careful and engage mainly with the western counterparts still operating in Russia − the optics could be that you are to some extent involved in financing the war effort.
So, there is a reputational issue, there is an issue of compliance with the sanctions regime, which again I'm sure our banks are particularly careful to respect. But all in all, I think that at this juncture maintaining a significant presence in Russia raises more risks than it should. I have not been particularly pleased by the speed of reaction of banks to these recommendations coming from our side. The downsizing, the winding-down of operations there has been pretty slow, but banks have made positive communications more recently. Many of them are really moving towards a wind-down type of mindset, and some are also trying to find buyers for their franchises. I would encourage them to accelerate their progress in that direction.