Interview with Market News International

Interview with Kerstin af Jochnick, Member of the Supervisory Board of the ECB, conducted by Jason Webb

18 September 2023

What is the outlook for eurozone banks as we move into this more downward phase of the economic cycle? And do we have any idea of at what point it is likely that asset deterioration will begin to outweigh the positive impacts of the higher rates?

Thanks a lot for the question. It’s really important to look to the future and see where we are going. But let’s start with where we are now: the banks under our supervision are well capitalised, they have good liquidity and low non-performing loan (NPL) levels. As you mentioned, banks have benefited from the normalisation of monetary policy and the upward turn in interest rates, here in Europe and globally. But just because banks are making good profits now doesn’t mean they will continue to do so when the economy takes a downturn. Having said that, European banks had low profitability for a rather long period. Our focus as supervisors has been to push banks to improve their business models so that they are viable and profitable during both economic upturns and downturns. We can see now that many banks have adjusted their business models – they have sold off parts that weren’t so profitable and have bought other parts that have been better for their interest margin and income.

We are of course aware that as the economy turns down, NPL levels may increase. We can see that there is this tendency but we have not seen any big shifts so far. As I said at the beginning, banks are in a much better position now than during the global financial crisis, and we think that they will be able to manage the problems they may face. Our 2023 stress test, the results of which we published in late July, also showed that banks would be able to cope with an adverse scenario.

Having said all this, as a supervisor we are of course conservative, and credit risk is one of our top priorities. We are really encouraging banks to be vigilant at this point in time, so that they identify new risks as early as possible and maintain a close dialogue with their customers.

What are the areas of greatest concern with credit risk?

This depends on the country, the bank and the business model. The real estate sector, particularly the commercial real estate sector, has for rather a long time been an area of focus for us, on which we have challenged banks. Higher interest rates are affecting borrowers, including regular mortgage customers, particularly if they have higher debt levels. So the scope of this issue has widened, as interest rates have increased significantly over a rather short period.

With regard to commercial real estate, I’m working from home now. Lots of people are working from home, this is something which was not a factor in the past cycle, it's something which has been accelerated by COVID. Is that a big shift in working patterns feeding into your calculations about commercial real estate?

In many countries, the demand for commercial real estate has fallen because people are working from home and, more generally, because they have changed their consumption patterns following the pandemic. For example, they are not going to shopping centres as regularly as they did in the past, while online shopping has increased. As a result, shopping centres have been suffering from a drop in demand. And as I have said, inflation has picked up, monetary policy has been tightened and higher interest rates have added to the pressure on the entire real estate sector.

This must be quite challenging to model because models are obviously based on historical precedent, and we’ve got a number of changes here, structural changes within the economy.

This is one of the objectives of our stress test, to make sure that banks have the capacity and the expertise to challenge their own assumptions. It is important that banks develop their own models and approaches to assess risk. This is getting more and more complicated, but our role is to make sure that banks are doing their job. The stress test is one tool for us to ensure that banks have a good risk management system.

There was a report that the ECB in its role as supervisor made a big upward adjustment to banks’ somewhat more optimistic view of their likely capital deterioration in the negative scenario. At the same time obviously banks have had their concerns about the Supervisory Review and Evaluation Process and other processes. How is this relationship with the banks and the supervisory bodies going? How can it be improved in the future, particularly given that this upward revision gives the impression that the ECB thinks that banks aren’t being completely honest with them?

I wouldn’t put it like that. The stress test is a cooperation between the ECB and the European Banking Authority; our role is mainly to carry out quality assurance. This is important to ensure that banks are using the methodology in the right way and that they have a broadly consistent approach, so that the final results are comparable. For example, it could be that a bank is not making as harsh an assessment of the future as we have requested. This quality assurance is a comprehensive process and we are not just deciding and telling the banks what they have to do. They always have the possibility to review their submissions to us another time in case of material deviations between their own projections and the “challenger view” provided by the ECB in a “comply or explain” discussion before we finalise the results. Perhaps we supervisors are by nature a little bit more conservative than the banks themselves. In any case, the quality assurance is very important because it lends credibility to the whole process and to the results. When we began doing the stress tests, critics said that they were too loose and that we weren’t challenging banks to the extent that the market wanted us to. Many were also saying that the US stress tests were much better than the European ones. This has changed and there is now a great deal of interest in the stress test results we publish. It’s important that this continues and that the market understands that we challenge the banks as much as necessary.

The ECB continues to reduce its balance sheet, so funding conditions are likely to become tougher for banks. What sort of risks do we have there? I know that in the Federal Reserve System there have been concerns that quantitative tightening could cause trouble for banks at some point and that the whole quantitative tightening process might even be potentially limited by the market reaction. But what’s the outlook in the eurozone? Is this at all a challenge? Is there some sort of feedback loop between financial markets and the banks and monetary policy in the sense that the banks might provide a constraint on quantitative tightening?

This has been on our radar for the past year and funding risk is one of our top priorities now. We have known for a while that the targeted longer-term refinancing operations (TLTROs) are being phased out, with a large repayment in June this year, so we have been in discussions with banks to make sure they have sufficient funding alternatives. We don’t want them to be too concentrated in one sector or just a few investors, so concentration risk is also part of this, to make sure that banks have a diversified funding model.

So far, we have not seen any major problems for banks, despite the ongoing phasing-out of TLTROs. That said, there are banks that can improve their funding situation, and this will be communicated to them with our yearly Supervisory Review and Evaluation Process at the latest. It is not necessarily that they need more liquidity – it’s also about risk management and ensuring diversified funding when they can’t get as much as before from the ECB.

Could this even have positive side effects for the banks? Could this be even though it might be harsh medicine? Could it be something which does them good in the long term?

Interest rates were low for a very long time and there was ample liquidity. So in that sense, it was maybe easier. Now banks may have to be more careful and develop better risk management models for liquidity.

With banks making more money and at a time when governments are feeling quite a lot of fiscal pressure with very high levels of debt, there have been attempts in different jurisdictions to grab quite a lot of money from banks. I think Spain imposed a windfall tax on banks, Italy, obviously had a made a recent attempt and then was forced to partially retract by the negative market reaction. How much of a concern is this sort of action to the ECB? And does it pose any risk to financial stability?

As you know, the ECB has published opinions on the special bank taxes in Spain, Lithuania and, most recently, Italy. From our point of view, there are two important considerations. First, we are concerned that such taxes will negatively affect banks’ incentives. For example, if a tax were to target net interest income without taking into account provisions and costs, it may be that banks record low profits or losses at the time when the levy is actually collected. Second, and perhaps even more importantly, such taxes affect investors’ views of banks, as we saw in Italy. We have been working for a long time on increasing capital, increasing liquidity and decreasing the level of non-performing loans. As a result, banks are now in a much better position to attract capital from investors. However, it would be detrimental if investors were to expect that from time to time governments or parliaments think that banks are earning too much and it's easy money to tax them. Banks also need to be attractive to investors, otherwise they cannot provide the support to the real economy that we all want them to. In the current circumstances, it is true that banks’ profits will be higher this year than they were in the past, but as the economy may now be entering a downturn, profits may not be as high next year. So we are perhaps in a transition period, and it would be a pity if this were a reason for governments to tax banks. So overall, we are a bit concerned about this kind of treatment.

A slightly different theme, but perhaps related, the Italian government is also looking at changes to NPL rules, what does the ECB think of that?

We are the European supervisor, and our goal is for the rules and guidelines on NPLs and on all types of practices in banks to be the same across all euro area countries. Reducing the stock of NPLs has been a key priority for the ECB in recent years. And in addition to our supervisory backstop, a prudential backstop for the provisioning of NPLs has also been introduced into EU regulation by the European legislator. This combined effort has proven to be very effective, as NPLs are now a fraction of what they were a few years ago and currently stand at their lowest level since the establishment of the Single Supervisory Mechanism. Therefore, from our point of view, it is important that national rules do not interfere with this successful approach.

Addressing the issue of distressed borrowers is of course welcome. But it is important that banks have functioning NPL markets that allow them to reduce the volume of these types of loans. In general, as a European supervisor we would like to have harmonised rules across Europe and harmonised supervisory practices, which will also help to enable more cross-border banking.

In terms of this desire for more cross-border banking, and of course, we get onto the somewhat frustrating progress towards banking union, particularly given the failure to agree on deposit guarantees. Do you have any assessment of the prospect for banking union? Are we going to see it at some point? Or will the eurozone banking system continue as this slightly hybrid animal?

I think we will see the full banking union up and running, but it will take time. When we look back over the past ten years, which is roughly how long European banking supervision has been in place, I think we have really done a lot. Previously, supervision was being handled by national supervisors, and we have merged everything together. There is now really good cooperation and we have managed to achieve a pretty good harmonisation of the European rules. The same holds true for the Single Resolution Board, which was established in 2015. So we have done a lot, but of course a European deposit insurance scheme is most desirable to make sure that we have the full institutional set-up. European banks would benefit from this, as it would enable them to go across borders more easily and achieve greater risk diversification. But this is not really in our hands, it is a political discussion. The European Commission recently published a proposal for improvements to the crisis management framework, and we very much welcome that, because it makes it easier to handle small and medium-sized banks in the same way as we do the larger banks. Achieving banking union has been a step-by-step process, and I think that is a little bit the way the EU works. It’s rather hard to take the really big steps in one go.

Would the crisis management proposals address the issue of making uninsured depositors less likely to behave in a panicked way?

The new framework is mainly focused on the small and medium-sized banks that will be covered or treated under the umbrella of the Single Resolution Board. The Commission also proposed some new tools that could be used in a crisis situation. Non-covered depositors may also indirectly benefit from the proposed changes, which would allow funds from deposit guarantee schemes to be used to support resolution strategies to protect depositors, subject to a least-cost test and other safeguards.

Referring to the issue of the Single Resolution Board and that framework, the continued delays in terms of the approval of the changes to the European Stability Mechanism Treaty in Italy, is that a problem for financial stability, given that this is delaying the backstop to the Single Resolution Fund?

It's not a problem for financial stability as such, but the more we manage to develop cooperation within the European Union, the more investors and customers will trust the banking system. So it would be better to have this settled. If we were to enter a crisis situation, it would be very good to have it in place.

Obviously we had a crisis situation, not in the eurozone, but in the United States and in Switzerland, earlier in the year. There are a number of lessons to be drawn from that. I think that Mr Enria has already spoken about issues regarding short-term liquidity and things like that, but one of the striking aspects was that both the ECB and the Bank of England were quite publicly critical of the action taken by the Swiss authorities with regard to the Additional Tier 1 (AT1) instruments. There was clearly a lack of coordination between jurisdictions in a crisis, and the eurozone and the United Kingdom felt that they were being infringed upon a little bit. What lessons can we draw about coordination between jurisdictions in crises, because the Swiss obviously acted in their own interests in this case?

We really strive to have good cooperation with authorities outside the euro area, with the Bank of England, for example, the Federal Reserve, the Swedish supervisors, and the Swiss authorities. The lessons learned from this spring are being discussed by the Basel Committee for Banking Supervision and the Financial Stability Board. I think that these discussions will also cover cooperation among authorities, because we really want to work efficiently during crisis situations. In most cases, it has worked and there has been a good exchange of information. In this specific case, we had different views on the treatment of AT1 instruments, and it was important for us to inform the market about our view and about how the AT1 instruments would be assessed in Europe.