Interview at Festival dell’Economia

Transcript of a conversation between Andrea Enria, Chair of the Supervisory Board of the ECB, and Mariangela Pira at Festival dell’Economia, held in Trento on 26 May

19 June 2023

What is the current situation for banks in Europe and how healthy are they? You once said that it is not quite right to equate US banks, European banks and Swiss banks with each other. How healthy are European banks at the moment?

European banks are in good shape. If we take a snapshot today in terms of their capital strength, liquidity and profitability, the situation is very good.

As you were rightly saying, a comparison – which would project the problems that US regional banks and Credit Suisse have faced onto European banks – is not actually appropriate, because the US banks that were in crisis had very extreme and very specific business models. They held lots of uninsured deposits and had a high concentration of government bonds and technology stocks. There are no banks like this in Europe, but this doesn’t mean we should suddenly not be at all concerned. There are still high levels of risk. Rising inflation, the rapid exit from negative interest rates and the rapid change in interest rates are also risks. European banks must remain very vigilant and manage these risks as actively as possible.

We have seen that the rise in interest rates is generally good news for European banks. But they also need to keep their eyes on the ball, because when there is market turbulence – as there has been recently – investors and markets do not look at profitability alone, they also look at the market value of banks’ assets, which can of course be negatively affected by the increase in rates. It is still a risky time, so it’s crucial to be vigilant at all times.

If you were to look ahead and were asked what risks you could see on the horizon, what would your answer be?

March was a difficult month. What we saw were very destructive dynamics, with deposits starting to move really quickly, much more so than in the past. One thing that worried me about those cases in the United States, but also with Credit Suisse, was how quickly deposits started to flow out of the banks. This is due to digitalisation, to the fact that moving funds is much easier with a mobile phone than it used to be. It may also be due to social media, which offers a much faster channel for spreading news, including fake news. Depositors therefore react much quicker. I have also been concerned about how jumpy the markets are, which has been triggered by the rapid change in interest rates. Investors tend to adopt speculative positions, sometimes on shares or sometimes on credit default swaps (CDSs) or on hedging instruments, which then also feed through to deposits. One thing that struck me was that during the crisis, firms and institutions that held deposits with banks tended to look at share prices and CDS spreads as what led them to withdraw deposits. This turbulence, which affects the stock, hedge funds and deposit markets, is something I find very worrying.

I agree with what you say. People often say to me, “look at how such-and-such a CDS is rising; watch out, because it is generating market tension”. I believe it happened the other day with US government credit default swaps. We need to always pay a lot of attention to this.

A point that I made recently, and one that is very important to me, is that these markets are very illiquid, there aren’t that many transactions taking place on them, and it is very easy to move prices. Sometimes there may also be cases of manipulation. We need to be very careful. The authorities regulating the markets must also strive to ensure transparency in the functioning of these markets. ESMA, the European authority, is working on this, which I believe is very important.

Before moderating this event, an analyst said to me, “the banking problem seen recently in the United States and Switzerland will lead to even tighter regulations for European banks”. In other words, we will somehow suffer tighter regulations, given what is happening to banks. But in the end this didn’t happen, did it? What do you think about the measures put in place, during a crisis on top of everything else, because banking supervision began during a crisis – both Greece and Lehman Brothers spring to mind. In your opinion, are such measures currently sufficient?

Every time there is a crisis, the almost automatic response is to say that there is a gap in the regulations and we need to reform them. I honestly don’t believe that this has been the case with respect to the events that we have seen in recent months. The US authorities produced very interesting and open reports on the lessons to be learned from these crises. I believe that it is becoming clear that the two fundamental problems were governance – banks’ internal controls – and, as the US authorities openly admitted, a few weaknesses on the banking supervision side. So I think that we must concentrate more on these two areas. Maybe we need to recalibrate some of our requirements. For liquidity requirements, for example, there is an estimate of how quickly different categories of depositors can withdraw their deposits, to give the relevant authority a certain amount of time to react. This shows that maybe these estimates are already a bit obsolete and perhaps they need to be revisited. However, I don’t think there is a need for major reform at this juncture. On the one hand, banks must concentrate much more on keeping their risks under control and on having good risk management practices. They must have good governance and properly functioning boards capable of challenging management and raising more issues. On the other hand, supervisory actions should perhaps be more specific and targeted. Another thing I’d like to say is that banks have sometimes criticised us here in Europe, saying that we are a bit too intrusive on the governance side because we provide guidelines on how a bank should be organised, how its internal controls should be organised, and saying we interfere with how a board functions, which is a bit like interfering with its inner sanctum and workings. But I believe that recent events have shown that we need to be demanding. If a bank’s governance doesn’t function properly, the bank runs the risk of failing.

Among other things, it was implicit in the analysts’ question that they were saying to me: look, lots of people may criticise these kinds of interventions and rules but, in the end, the only banking system that has held up is the European one, which did not ring any alarm bells compared with what happened in the United States. So it had positive rather than negative implications with respect to supervision. But if we turn now to the European Court of Auditors, which audits the ECB, it turns out they did find some shortcomings. My question is this: on the one hand you have been open and transparent with the external authorities. But how do you respond to the shortcomings that were found?

I’m glad you’ve brought this up because it’s something I really care about. When I arrived at the ECB in 2019, there was a lot of tension between the European Court of Auditors and the ECB, because in order to protect the ECB’s independence, the Treaty contains very restrictive provisions on the Court’s and other entities’ capacity to carry out full audits. The audits they can conduct are essentially limited to issues related to managerial efficiency. But I felt that a supervisory authority should be held accountable, it should be able to account for its actions. So it’s important to be open and transparent and let what we do be scrutinised. We then signed an agreement with the Court – what we call a memorandum of understanding – which allows it to conduct more detailed audits. The audit you are referring to was the first audit the Court conducted after the agreement was signed. I am also proud of another thing: when we look at other countries, reports are drafted after a crisis to see what didn’t work well. Instead of taking this approach, we asked an international group of supervision experts to analyse how our supervision process is working. Their report was published just a few weeks ago and we are now following up on both this report and the report produced by the Court.

There are lots of useful things in the Court’s report. We were already making improvements to some of our internal processes to make them faster and more efficient. We know that our processes are a bit cumbersome – the banks themselves have said as much. In short, we are trying to fine-tune and increase the efficiency and transparency of our activities; this is something we are really focusing on. We are a bit less sure about the Court’s observations in other areas. For example, they think that we have not been strict enough with our capital requirements for banks that have very high levels of non-performing loans. They also think we have not sufficiently increased the capital requirements for banks that have very high levels of non-performing loans, which are therefore exposed to higher levels of risk. But there was a reason we did this, a very good one in my view: these banks – we are basically talking about banks that had more than half of their loans that were underperforming – were engaged in a complicated process of selling and securitising these loans. To do this, they needed adequate resources, what we refer to as “capital space”. They had to be capable of absorbing the losses resulting from the sale of these loans at prices below the carrying amount. If we had significantly raised the capital requirements, banks would not have had the space they needed to sell their non-performing loans and the reduction in these loans would not have been as fast or as effective as it has been in recent years. So with all due respect to the Court, we may not follow up on its observations in this area.

Another question I’d like to ask, the question of all questions, is what do you feel is missing from the banking union?

The third pillar, in the guise of a European deposit insurance scheme, is missing from the banking union. This is a serious shortcoming. Mario Draghi rightly said that the lack of a common deposit insurance scheme is also a problem for the single currency, because if we look at monetary aggregates, more than 90% of “money”, as defined by economists, is made up of retail bank deposits. We have little cash in our pockets, which is a central bank direct liability. If €1 deposited in a bank in Cyprus has a different value from €1 deposited in a bank in Helsinki, there is clearly a problem related to the lack of integrity of the single currency, and this is a fundamental institutional problem. During the great financial crisis, we saw that deposits were starting to be moved from one country to another due to concerns about the effective guarantee provided by deposit insurance schemes in some countries by their national deposit insurance funds, which reimburse depositors in the event of a crisis. This is a fundamental factor that will help to complete the process of separating banks from sovereign states. To truly break this bank-sovereign vicious circle, which we witnessed during the sovereign debt crisis, we need a European guarantee fund, but we still don’t have one, which is a pity.

I don’t want to say that the banking union we have is not functioning or functional. The banking union works. We could make much more progress towards banking union with the rules we already have, but sometimes Member States hesitate or adopt policy positions which unfortunately hinder this process.

It is a bit of a complicated process. I’ll try to explain it as quickly as I can. Take the US banking system. Let’s imagine a bank fails in Nevada and there is a real estate crisis there. First of all, there are banks in Nevada from all the other US states. This means that they can absorb the losses they incur in Nevada using the profits they make in Illinois, so they are less likely to face a crisis. By contrast, the problem in Europe is the geographical diversification of risk. Moreover, if a bank in Nevada is in crisis, the US federal guarantee fund can sell that bank’s assets and liabilities to banks from other states. This makes it possible to resolve the crisis more easily and without causing any damage. In Europe, the markets are much more fragmented along national lines. Is Banco Popular in crisis? Santander can buy it. Is Sberbank in crisis? The Croatian bank can buy the Croatian part and the Slovenian bank can buy the Slovenian part. We still aren’t able to have a system that truly works at the European level.

We can do a lot with what we have. We have sought to encourage cross-border mergers through the transformation of subsidiaries into branches, which could help with this process. We have tried to facilitate the pooling of liquidity at group level. But the banks, perhaps put off sometimes by their national authorities, have not made great progress in this area. I hope that in future years there will be a new drive towards consolidation.

It is interesting though, because when you explain it like that, naturally we also understand what the advantages are. On the one hand, it is probably a very political issue at individual Member State level, so we really need to overcome this political aspect as well as a certain amount of populism. Because otherwise, you end up asking, “why do you want this to happen? What do we have to do? Why do we have to help Germany?” These are examples of the things you hear. But on the other hand, if you have losses in one Member State, you can absorb them because you are also present in another Member State. It’s really obvious, it’s self-evident that there’s an advantage. It’s as though additional political will is needed in Europe for banking union to become a reality sooner rather than later.

Let’s try to put ourselves in the shoes of those who are more affected by it. One of their concerns is that if something goes wrong, there will be an impact on their national deposit guarantee fund, which is of course protected by the safety net offered by the national tax authorities, so they want to have more control over this. But basically, this reasoning is a bit short-sighted, because by taking that view, the likelihood of this negative event happening actually increases, as does the likelihood of it having an impact on the national insurance funds. The whole process (which is now very complicated) of integrating this national safety net to make it part of a European safety net is hampered precisely by these processes.

To tell the truth, I believe that banks are unfortunately still seen as being very closely linked to national policies. And this is a bit of a problem that we should try to sort out in the coming years.

If there were a scheme covering the whole of Europe, we could then say, “Okay, there’s no longer that rule linking a loss outside your borders to the tax authority of your home country”. Do you see this as a possibility, and would it be a selling point for the strongest sceptics?

Yes, of course, but we already have the Single Resolution Fund, which is the only part of the union that has been completely established.

Which is not something that is very popular with the general public either...

That surprises me because, at the end of the day, it is funded by the banks. That means that no-one in this room pays a single euro for this fund. The banks pay to manage crisis situations that may affect them collectively. In addition, all the legislation was drafted to minimise the impact on this fund, by trying to have the losses absorbed in the first instance by shareholders and creditors, and only to call on the fund as a third option if this were not possible, which is also a plus. The fund’s very existence is a way of reducing our collective risk. I see it as something that is extremely positive. To tell the truth, everyone thinks in terms of how many insured deposits (i.e. less than €100,000) European banks have in the euro area, in the banking union. Broadly speaking, it now stands at around €7.5 trillion. When a finance minister looks at this figure, he or she thinks that if they create a common fund, they are signing a guarantee for €7.5 trillion. In reality, if you look at how insurance schemes work in the United States, even after all the crises of the great financial crisis, you realise that the US Treasury did not spend a single dollar to reimburse the fund. When an event occurred, the fund was triggered, it took the losses by reducing the funds at its disposal, then charged the banks fees to replenish these funds. This worked extremely well, to such an extent that in the United States, following the crisis, and after more than 500 banks left the market within three years, the system became profitable again, while for ten years we wondered why European banks were much less profitable and had much lower market values than US banks. The reason is that the US system used its insurance fund to clean up the market, restructure, reorganise, consolidate and start again. And they did this very quickly. We got there in the end – our banks are now strong – but it took us 12 or 13 years to get there. In short, it was a bit more laborious.

Of course, that is absolutely clear. Now let’s talk about the floods, because I wanted to bring our meeting into the present a little. We can’t ignore recent events in Emilia-Romagna. I know that you and your colleagues are also doing many things related to climate change, so I also wanted to take this opportunity to talk about how you are dealing with climate change, because maybe you are seen as an institution that almost doesn’t look at that side of things at all. Is that true?

Frank Elderson, who is Vice-Chair of the ECB’s Supervisory Board, rightly said that we are not policymakers in the field of climate change. The real stakeholders are to be found elsewhere. We are policy takers. Our approach is as follows: given that there is a climate crisis and the European Union is currently drafting very ambitious policies in the field of climate change, this generates significant risks for the banking sector. As a supervisory authority, we therefore have to encourage banks to measure, manage and – with full transparency – give account of how they handle and respond to these risks. We already provided banks with guidelines in 2020 on our expectations for what they should do in terms of delegating responsibilities at board level, defining a risk appetite framework (the risk levels they are willing to assume in relation to climate change), their capacity to conduct climate-related stress tests, and disclosing their exposures in a transparent manner.

Banks have openly admitted that they are some way off meeting our expectations. So we have devised a plan for each bank to ensure they are fully in line with our expectations by the end of 2024, and this is currently under way. If banks are not able to do this, they will obviously be penalised from a supervisory perspective, and we have made this very clear. Banks are complaining a lot, saying, “but we don’t have the information, we don’t have the data, our customers don’t give us the data we need to measure our exposure to climate risk”. Take, for example, how the energy certificates for buildings and apartments put up as collateral are classified. Lots of banks do not have this information, but it’s fundamental! If you grant a 25-year loan, you have to know how much this type of collateral will be worth in 25 years. Encouraging banks to obtain this information is very important. We have therefore published best practices that should be followed in the sector. There are banks that have been able to estimate and better manage this risk, even without the data. We have taken steps to disseminate best practices and have done so at banking union level, which is an advantage, because some stakeholders in the smaller countries may not have any information on the best examples that exist across the entire European sector.

In fact, banks are perhaps among the few firms to have an immense amount of data. If managed well, these data can be a very good source of information. And given the technology available today, including artificial intelligence, my next question is this: when you talk to banks, does it seem like they are aware of this problem? On the climate change front, should banks be acting faster to tackle this?

In this respect, I believe that European banks are much further ahead than banks in other parts of the world at the moment. At the beginning they were a bit slow to react and were surprised, and even criticised us for being a bit too demanding. But I think they are now more aware of the issue, and many of them have also developed their own policies. They have understood that there is, ultimately, even an element of competitive advantage in dealing with this issue. Climate change also represents a big opportunity for banks. There will be massive funding required to sustain the necessary change, and banks are gearing up for this change. Things are moving quite slowly, but with a little bit of a push from us, I believe that at the end of next year the landscape will have changed.

I agree. It has to be something that involves everyone. Big businesses must encourage smaller ones, and institutions must encourage the banks.

I think it is also a question of attitude. Banks – and through the banks, their clients – must take ownership of the concept of planning the transition, of planning how to reach net-zero emissions by 2050. Everyone must do this and banks must assess their clients’ ability to have viable plans for reducing their environmental impact. This will be a fundamental task which will also allow banks to bring added value to the whole community.

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Are there any questions or comments from the public?

I would like to ask Mr Enria a question on derivatives, a topic that you haven’t covered. In their balance sheets, European banks have accounted for derivatives in a specific way. Are we sure that there aren’t any problems with the valuation?

You ask a very important question, because in many cases lots of derivatives – not all of them, but many – are in illiquid markets, so there is actually no reliable valuation for these financial instruments and the banks make valuations based on their own models. At the end of the day, sometimes these models have not been up to scratch, so it is a serious problem. We carried out a round of bank inspections focusing on this. Inspections are the best way of going about this, because our inspectors go on-site to the bank, they look at each individual instrument, each transaction, revalue it, and they try to identify any potential weaknesses in the bank’s valuation process. We did therefore conduct a very thorough and detailed round of inspections to look at this. Naturally, the risk remains and this is also one of the reasons why one of the priorities we identified for European banking supervision last year, which we are continuing to look at this year, is what we call counterparty credit risk. This is one example of the contact between banks and some non-bank institutions, such as hedge funds and other entities, that are taking very significant risks in quite risky markets. We are trying to put significant pressure on banks to strengthen their practices for measuring and managing this risk.

Let me start by congratulating you for your work in European banking supervision, because we have seen what happened in the United States and Switzerland in recent months, and I think we have done well in this respect. My question is about competition in the banking world. How much competition is there? Current account rates in Italy are 2.91% at the moment, almost a year after the ECB started to raise interest rates, and the deposit facility rate is 3.25%. Is there enough competition? It doesn’t seem so to me.

You are right, there is probably not enough competition. I touched upon one of the points earlier. The market remains very fragmented, even at the national level. I visit all the national authorities, and in recent weeks was in the Baltic States, where they were exploring the idea of introducing additional taxes on banks – in Lithuania, it seems they had just done so – because they are seeing a very strong rebound in profitability. They are even projecting a return on equity in the range of 35-40% this year. The authorities there are asking, “how come banks from other countries never come here to open branches?”. In reality, this process did not work well enough for a host of reasons, which would take too long to explain. But I think that digitalisation will shake things up. Big banks are also ramping up, opening digital banks at the European level to offer services to the whole market. One has run a pilot scheme in the United Kingdom offering rates of over 3% and is gaining a very significant market share as a result. However, it is important to mention that when there is a monetary tightening cycle, it is normal for margins to grow at the start of it. Even when interest rates became negative, banks avoided passing these negative rates on to customers for several years. So maybe it is also quite normal that there is an initial period when there is not full monetary policy transmission. But you are right, there has to be a moment when competitiveness starts to push rates up, and perhaps that time has come.

Even Apple is offering yields of 3.78%, but only in the United States, not in Europe.

What role do you think banks that are primarily regional will play? We live in a country where this is relevant, because historically our banks play a predominantly regional role. Tools have been provided through a banking group to oversee the stability of the individual components through a guarantee agreement. But how do you see the future of this particular component of the banking sector in a region currently seeing strong economic and banking/financial health?

Very quickly, two things. First, size is clearly becoming important. Many regional banks are part of networks of cooperatives or savings banks, allowing them to grow to a scale which they probably need to deal with the current challenges, while maintaining their regional foundations. I think this is a positive outcome. However, especially in the light of what I was just saying, these regional beginnings must not be looked upon as offering permanent protection against competition. Banks that have also forged a strong relationship with their regional clients could in the future face strong competition from the digital services on offer. So there is a need for banks, including small ones, to gear up for this and develop a digital agenda. I think that doing this as part of a network is very important. It will probably help them overcome the problems of scale they will face in this area.

The other day you said that you were a bit disappointed because your mandate was nearing its end and you had failed to ratify a large cross-border operation. Everything has become very complicated. Mergers destroy value. Why should mergers go ahead? Is it possible that we still might not see mergers for many years?

What I said the other day was a bit of a scolding for the banks, because I think they have sometimes not been brave enough in taking risks to ramp up consolidation at the European level. At the same time, they did not respond positively to a series of opportunities the ECB provided. But the main thing hampering banking consolidation so far has been banks’ very low market valuations, i.e. their price-to-book ratio. European banks’ ratios were depressingly low for many years. This meant that banks had almost no economic incentives and few opportunities to pursue a merger. Now that profits have finally recovered and market values are improving, I believe that the opportunities are growing for the most successful banks with the strongest growth prospects to merge with other banks. So far, the consolidation options – there have been cases in Spain and Italy, with the Intesa-UBI and Caixa-Bankia mergers – have remained mostly national, because the aim was to reduce costs. I believe that in the future, after a phase of returning value to shareholders through buybacks, banks will start to invest in their own activities. I think we will start to see the benefit of risk diversification, even at the regional level. I fully expect that in only a few years’ time, cross-border mergers will be inevitable.

You referred to the illiquidity of securities on the market. Banks are keeping a close eye on this, and we really appreciate that, but does this not mean that we are underestimating the possibility of this financial risk hitting other areas, such as pension funds, insurance or savings?

The short answer is yes. If we take a snapshot of financial flows and stocks during the great financial crisis of 2008-2010 and now, we see that the debt level of end-borrowers (e.g. households, businesses and governments) has actually increased significantly. Banks’ leverage levels have fallen. So this increase was clearly financed primarily by non-bank entities not subject to prudential regulation, because many of them have comprehensive codes of conduct, but there is little coverage on the prudential front. The ECB has raised this issue. The Financial Stability Board is considering increasing the monitoring and regulations for this part of the financial sector, which I welcome.

Could you say a few words on corporate management, specifically cyber- and crypto-assets?

Cyber risk, or IT risk, is probably identified by banks as the most significant risk. We even listed it as one of our priorities for last year and this year. It is a difficult and complicated topic. Let’s just say that next year, for the first time, we will carry out a cyber risk stress test and this will focus primarily on banks’ recovery capacities. There will be [cyber]attacks. There will be vulnerable moments, but the important thing is how quickly banks can restore their key functions. That will be our focus. It would take too long to talk about crypto-assets, so I’m afraid I won’t be able to answer that question.