Interview with Milano Finanza

Interview with Andrea Enria, Chair of the Supervisory Board of the ECB, conducted by Francesco Ninfole

22 July 2023

[A sentence in the tenth answer of this interview was corrected to reflect the intended meaning on 25 July 2023 at 12:30.]

What are the main supervisory tasks between now and when your mandate finishes at the end of this year?

We will continue to closely monitor market developments in this delicate phase. We are still experiencing the repercussions of Russia’s aggression in Ukraine, the jump in inflation and the rapid increase in interest rates. All this creates challenges for banks in terms of interest rate risk, liquidity risk and funding risk. We will focus intensively on these risks in the stress tests and in the Supervisory Review and Evaluation Process (SREP), which will be completed by December.

What have you learnt from the recent Silicon Valley Bank (SVB) and Credit Suisse crises?

When there are banking crises, the usual reaction is to start thinking about regulatory reforms. I think that in this case the main lesson is about the effectiveness of supervision and banks’ internal controls, rather than regulations. I know that there will also be discussions in international fora, but I don’t believe that it would be wise to recalibrate liquidity requirements on the basis of such an extreme business model as that of SVB. Likewise, it wouldn’t be right to reach the conclusion that, as Credit Suisse was complying with the capital and liquidity requirements before it failed, these requirements are wrong. In reality, Credit Suisse had a serious problem with its business model and governance. This led to the crisis. So, the lessons are about how to make supervision more effective in order to intervene early and effectively, and how to strengthen banks’ internal controls.

What’s the best way to manage liquidity risk?

There are liquidity requirements, based on indicators like the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), which are harmonised at the international level. They are still important. The LCR is designed to give the authority sufficient time to intervene in the event of a liquidity shock that risks leading to the bank failing. But these indicators alone don’t provide enough visibility for phenomena that could appear very quickly, which was what happened with the deposit outflows from SVB and Credit Suisse. It’s important that the authorities also develop their own metrics. We have various metrics, such as counterbalancing capacity, which looks at the quantity of assets that banks can use as collateral with the central bank or can sell on the market and what other measures they can take to deal with a liquidity shock. The problem also concerns the data. For example, LCR data are available on a monthly basis, with a lag of a few weeks.

What steps will you take in this regard?

It will be useful to review the frequency of supervisory reporting, as the EBA recommended in a recent report. Following this suggestion, we decided to send banks, starting in September, a request for information on a weekly basis, in order to have more recent data to allow us to better monitor liquidity developments. It’s a question of sending, with greater frequency, the information on liquidity that banks already send us on a monthly basis, which includes maturities, types of counterparties, collateral and refinancing operations with the central bank. This will be useful for observing developments in the most liquid assets and liabilities, like deposits. While waiting for the EBA to modify the regulatory reporting requirements, we will also request a quicker and regular submission of these data, which banks already have to make available immediately on request.

Will you intervene in the SREP with more requests for liquidity add-ons?

Liquidity is one of the priorities this year, so supervisory teams have been asked to pay greater attention to this risk in the SREP. It’s in line with the idea that intervention should not necessarily take the form of regulation but that it is preferable to look at specific risks of individual banks. If some banks have liquidity profiles with high levels of risk in terms of certain currencies or geographical areas or business lines, qualitative and, in some cases quantitative, recommendations will be issued.

What was the role of social media and digital banking in the recent deposit outflows from SVB and Credit Suisse?

It’s an issue that we must discuss. The US and Swiss authorities raised the point that the outflows from some deposit categories were much faster than expected. That said, I am yet to be convinced that digital banking is a source of disruption for banks’ liquidity in times of stress. The deposits that were withdrawn more quickly were those that were uninsured, especially those of non-financial corporations and financial institutions. I don’t think that the treasurers of these companies use smartphones to move deposits. So, I believe that it’s more a question of financial market conditions rapidly changing in response to the rapid normalisation of monetary policy, rather than a structural issue related to digital banking.

After the SVB and Credit Suisse crises, it seemed like the next weak link would be in Europe. Was this the most difficult moment for you in your time as Chair? 

There have been many complicated moments. The start of the pandemic was also a time of heightened stress, with no idea of what could happen. The economy was frozen, and our supervisory tools were also affected – we could no longer carry out inspections. Of course, the crisis period in March was very difficult. It also showed the positive effects of European banking supervision and of the reforms over the last decade, although it clearly showed that there is still a lot of volatility in the markets, with high anxiety, and that the risk profile can change very quickly.

What did this crisis reveal about European banks?

The European banking system regained a good level of stability in this context. Capital levels are satisfactory, liquidity levels are robust, asset quality is better than ever. Profitability, which has been the European banking system’s weakness, has begun to grow and is returning to healthy levels. We are starting to see European banks in a position to achieve returns above the cost of capital in the coming months and years. Some banks have already reached this point. The situation has normalised to a great extent and has improved a lot, although we are still in a very delicate context. This requires us, and especially banks, to continue to pay very close attention to risks.

Are banks vulnerable to interest rate risk?

We carried out a very detailed analysis of interest rate risk and the widening of credit spreads in the second half of 2022. There’s an exposure to interest rate risk, and this is normal. What counts is understanding how banks manage it. Our analysis shows that, in terms of unrealised losses (the loss of value of securities held at amortised cost whose market value would be reduced owing to an increase in interest rates), the impact would not be particularly large at the sector level. There would be €73 billion in unrealised losses, compared with $620 billion for US banks.

For most European banks, the increase in rates is good news, because it has a positive effect on their margins. But if we look at the economic value of equity (how the balance sheet is affected by the market valuation of assets and liabilities) then there is a negative impact on many banks conducting maturity transformation. So, banks must also properly manage this risk, and that’s what we have asked them to do.

Isn’t it dangerous to mark to market government bonds included in the LCR liquidity indicator? The EU is going against the Basel III regulations.

Indeed, legislators don’t seem inclined to follow the recommendations I’ve given on this subject. I understand that there’s the issue of volatility that it could cause on banks’ balance sheets. That said, the problem can always emerge, as seen in the case of SVB, which chose not to apply market valuations to government bonds held in the available-for-sale bonds portfolio. When there was a significant interest rate shock, SVB had a significant amount of losses and then it failed. Therefore, it would make sense to hold at market value, as a minimum, bonds that are calculated in the liquidity buffers. Indeed, the LCR serves to allow banks to address sudden liquidity needs by selling bonds on the market. If these bonds are held at amortised cost, there’s a clear tension between the objective of the supervisory requirement and the accountancy classification.

But there are not many European banks that are like SVB. The disadvantages of this proposal risk outweighing the benefits.

To be honest, my main reference point is not SVB, but Dexia. In 2011 we conducted stress tests at the EBA, at the onset of the sovereign debt crisis. Markets were paying very close attention to government bonds. Dexia did well in the tests but lost access to funding in two weeks and entered a crisis, because valuing its assets at market value led to the erosion of the capital level. The recent crisis teaches us an important lesson. In normal times, the markets monitor metrics of capital, liquidity, profitability and so on. But in a period of stress, investors look at banks primarily in terms of market value – that is, at their earning potential and at the value of immediate liquidation. All banks encounter difficulties in times of stress, but those that are most exposed to this type of risk are considered weak links and come under attack more quickly. Therefore, it would be better to further strengthen banks’ balance sheets and liquidity position ex ante, by having enough assets at market value.

In 2011 you were already criticised for the write-down of government bonds in the stress tests. Would you change this?

I would take the same decisions, absolutely, but these decisions were not so relevant since it was the investors themselves who had switched to a market value assessment. Banks’ capital adequacy was being monitored, with particularly close attention being paid to the market value of sovereign portfolios, because there was a very significant widening of spreads. The lesson I drew from this is that supervisory authorities can’t ignore how the markets monitor banks in a period of stress. 

Banks are accusing you of being too demanding in the stress tests.

I’m convinced that it’s important to maintain the bottom-up aspect – that is, stress tests based on assessments made by the banks themselves using their models. This more effectively links the stress tests to credit institutions’ risk management. However, the bottom-up approach has the drawback that banks are sometimes tempted to initially present us with overly optimistic results, as they know the stress test result will determine the level we set for the capital requirements. Then there is a period of discussion. In the past and also this year, it seems to me that we have eventually achieved credible and high-quality data.

What results can we expect from the stress tests?

The outcomes will be published in a few days. The results will reflect the better starting point of European banks, with much higher levels of capital and a much stronger and reliable quality of assets. This puts banks in a stronger position.

The adverse scenarios were more severe than ever before.

We devised a scenario that remains very relevant even now, with persistent inflation and lower than expected growth, resulting in a stagflation situation that would be very challenging for banks.

What do you think the results of the coming SREP will be? Do you expect capital requirements to remain stable, as in the last few years, or to be higher owing to the recent crises?

There is no macro-calibration for capital requirements. We assess banks individually and there is always some change in the scores. For both the stress tests and the SREP, it will be more interesting to see the distributional effects, namely how the banks evolve, rather than the average level of the capital requirements. The current risks have very differentiated impacts.

Do you expect there to be consequences for the repayments of the targeted longer-term refinancing operations (TLTROs)? Do you see risks of a credit crunch?

It has long been known that the TLTROs would fall due. We asked for plans well in advance and so far this planning has paid off. There has been only a very slight deterioration in liquidity requirements. When monetary policy is tightening, it is normal for banks’ credit standards to become more stringent, both in terms of prices and in terms of volumes. Already in advance we have seen a significant reduction in demand for credit in some segments, such as for mortgages and real estate lending. The banks are also reducing the supply somewhat.

What factors have hindered cross-border consolidation in Europe?

A more integrated market at the level of the banking union would be beneficial, because it would be more capable of withstanding possible shocks. There would be greater risk diversification, as in the United States, where the management of the banking crises was simpler. My primary concern has been to eliminate what are perceived to be obstacles to consolidation posed by the supervisory authority. It is then for the management and shareholders to decide whether or not to go ahead. It is true that we have not had any high profile cross-border mergers, but we have had many transactions involving business lines, asset management, leasing and custody business.

So what is needed?

What is still missing is a more positive attitude towards cross-border consolidation, including on the part of national authorities. There is still great reluctance to allow capital and liquidity to be managed in a pool at the banking group level. There are very stringent restrictions, particularly on capital, but also on liquidity. This is a crucial factor. And perhaps up until now the banks have also been very preoccupied with securing a recovery in profitability based on cutting costs and reviewing their business models. Now they should also summon up a little more courage to develop their business on a European basis. I understand that, based on current assessment, conducting share buy-backs and improving shareholder remuneration was a sensible course of action, but I hope that in future they also find the means and the will to invest in the development of their business within a truly European domestic market.

Would mergers be beneficial in Italy, too? Would it be beneficial to have a third large entity alongside Intesa and Unicredit?

I don’t have any industrial policy objectives neither at the European level nor for Italy, which has already undergone a significant consolidation process. I would not wish to overlook the importance of what occurred in the cooperative banking sector, with the establishment of the Iccrea and Cassa Centrale groups. In Italy, as in other countries, there could be further scope for consolidation, but I leave it to the banks to assess this.

What is your view on the Italian banking sector? Is there a risk of an increase in non-performing loans?

Interest rates are rising and the economy is slowing. It would be surprising if asset quality didn’t deteriorate. However, what has been done in terms of the supervisory rules and in terms of banking practices should prevent an increase in non-performing loans on the scale that we saw after the great financial crisis. Banks are now also subject to legal obligations to reduce non-performing loans and to establish provisions by the deadlines laid down in the provisioning calendar. Moreover, our supervision is very far-reaching. Therefore, I believe that the next recession will not bring an avalanche of non-performing loans, as in the past. With regard to other risks, Italian banking groups, like other European banks, should keep a close eye on interest rates, liquidity, funding and more structural issues, such as digitalisation, cyber risks and climate risks.

Do you expect dividend restrictions for some banks?

The one key factor for us is the capital trajectory. If banks show us that their dividend distribution plans are compatible with maintaining sufficient levels of capital and with continued compliance with the supervisory requirements, including in stress situations, we will raise no objections. Conversely, if some banks were to find themselves in more difficult situations in these capital projections, then our discussions would indeed include the suitability of the levels of dividend distributions.

Has the ECB been more focused on credit risk than on market risk?

ECB Banking Supervision started work at a time when we had more than €1 trillion in non-performing loans. The priority then was to clean up banks’ balance sheets, in part to increase banks’ capacity to support the recovery of the European economy. That said, we don’t give preference to any one risk. The priorities are defined each year on the basis of the configuration of the markets and development trends in Europe. Recently, for example, we have concentrated our attention on counterparty risk and on prime brokerage and leveraged finance activities, which are focused on the capital market.

How would you respond to bankers who say that you are overly intrusive in board meetings?

We started operations at the European level, based on different national practices. In Germany, the supervisory authority regularly sat in banks’ board meetings. In France, this was extremely unusual. We take a sensible approach. We do not regularly attend board meetings, we allow great freedom, and we interact with the chairs. From time to time we conduct analyses to look at how a board is functioning and how effective it is. This cannot be seen just by reading the minutes, it requires some understanding of the dialogue and interaction between the managers and between the non-executive directors. Therefore, attending board meetings is a useful instrument, which is also widely employed by other global authorities, and we intend to continue using it.

Are capital requirements higher in the euro area than in the United States?

We are still in the process of conducting a more detailed analysis of this issue, but the preliminary result is clear. Compared with the United States, the capital requirements applicable to European banks are lower on average. There is of course a difference between the types of bank. The larger US banks, the so-called global systemically important banks (G-SIBs), have to comply with capital requirements that are much higher than ours, while medium-sized and small US banks have much lower requirements, as we have seen for the regional US banks.

On the banking union, the ECB has suggested that the Commission should be more ambitious with regard to the crisis management rules, by activating a bail-in exemption clause to safeguard financial stability. Do you think that a bail-in can be too rigid an instrument in crises?

We strongly support the Commission’s proposal. The key innovation lies in allowing more flexible solutions in crisis management, including the use of private funding. We already have the Single Resolution Fund and 21 national deposit insurance funds. If they are added together, the amount of resources is equal to, if not more than, the resources of the Federal Deposit Insurance Corporation in the United States. But we have much less leeway in using these funds. The most important thing is to make crisis management more flexible, in part because this is instrumental for the next step, namely the common deposit guarantee. With regard to a systemic exemption clause, what happened in the United States shows that in certain situations this type of instrument can be useful.

But the restriction on using the Single Resolution Fund was precisely the fact that 8% of liabilities needed to be bailed in first. Such a move frightens investors and savers. Do you think it is useful for protection funds to be able to fill the gap up to 8% if necessary?

This is a positive proposal by the Commission. Increasing the possibility of using deposit guarantee funds is an essential element. However, the requirement for banks, including in the most recent reforms, is also important: they should maintain debt placed on the market, and not with retail investors, so that it can be converted or absorbed in crises (Ed.: the minimum requirement for own funds and eligible liabilities – MREL). The fact that the regional US banks were not subject to these requirements also meant that they were too dependent on sight deposits.

However, the Commission is extending the resolutions and bail-in to include medium-sized and small banks that find it more difficult to issue these riskier debt securities on the market.

That is why it is necessary to allow guarantee funds to be used for banks whose liability structure is focused on retail deposit-taking, on the basis of the least-cost principle.

Is it right to impose capital requirements for climate-related risks? Areas where environmental risks are greater could be penalised, as was the case for the Romagna region, for example.

I have seen a map of Europe that shows all the areas at risk from wildfires or floods, and it was hard to find any place that was free from climate risks. One should not emphasise the capital aspect. We ask banks to assess and manage these risks, if, for example, the value of collateral in a certain location is not being assessed accurately.

But you have said that you will start to look seriously at climate risks from 2024.

In the longer term the aim of this debate is to reach a situation in which banks measure these risks and capture them in the capital requirements for credit risk, market risk and operational risk. In this transition phase, it is also possible for supervisory instruments to be used. We have asked the banks to meet our expectations within a certain period. If some are not in line, we would have to ask ourselves what type of action to take, but it is not a given that this will be an increase in capital requirements. Enforcement actions, sanctions or other measures could be implemented. It is important that banks understand the urgency of complying with the guidance on these physical risks. Then there are also transition risks They entail a major challenge and this is only just beginning. Banks and firms should draw up transition plans to meet the legal requirements. There will be a process involving the whole economy and in which the banks will play an important role.