Interview with Cinco Días

Interview with Elizabeth McCaul, Member of the Supervisory Board of the ECB, conducted by Ricardo Sobrino and Denisse López

2 October 2023

We are currently in a high interest rate environment which is boosting banks’ profits, although banks are facing more customer defaults. Is the ECB worried about another rise in non-performing loans?

We have been signalling to banks for quite some time that we are living in uncertain times. We have emphasised the need for them to remain vigilant and keep a close eye on their loan portfolios. We have asked them to review their provisioning levels with an eye to making sure they have a clear line of sight into potential deterioration in their portfolios. The time is now for banks to be investing in their credit risk management processes and in ensuring those governance processes are as robust as they can be.

Which credit segments are showing the greatest signs of deterioration?

So far we are not seeing signs of deterioration but in an economic environment like this one, with rising interest rates and geopolitical uncertainty, we are asking banks to implement robust credit risk management processes for all their portfolios. We have put particular emphasis on the mortgage and small and medium-sized enterprise portfolios, as well as commercial real estate. We are taking a cautionary stance and asking banks to have early warning indicators in place. This is important because it will enable them to get ahead of any difficult situations.

Are you concerned about the growth of non-bank financial institutions?

This is an area we are focusing on because this type of financing has been growing in Europe over the past ten years, as has its role in the global economy. Non-bank financial institutions (NBFIs) are not subject to banking regulation and it’s an area that is less visible to supervisors, so there are risks that are not monitored as closely. We are paying attention to this sector to gain a clearer understanding of it. Lending by this sector is one area of concern, since we don’t know which exposures on their books may correlate to those on banks’ balance sheets. There could therefore be a bigger risk concentrated in one specific sector or with some specific clients. We also need to better understand the interconnectedness between NBFIs and banks, as this can be a source of risk.

At the beginning of the year in the United States, a crisis affected some medium-sized banks that did not have enough liquidity to operate. Banks in Europe managed to avoid this crisis. Does this mean that the supervision of European banks is better than that of US banks?

We have learned several lessons from the turbulence in the US market, but there are very important differences between those examples in the United States and in Europe. I don’t think we have an institution in Europe that has a business model that resembles that of Silicon Valley Bank (SVB). The impact of the withdrawal of deposits at SVB triggered by social media is new and something that warrants close attention. One of the most important lessons we learned is about the need to ensure we implement all the Basel provisions, including those requiring strong liquidity ratios and capital requirements. The United States didn’t implement all of those provisions. And even though they have been more fully implemented in Europe, this is a wake-up call about the importance of faithfully implementing the Basel provisions and not watering them down.

In this respect, what are the ECB’s supervisory priorities to ensure financial stability?

Every year we take a close look at risks affecting the banks we supervise over a three-year forward horizon to inform the supervisory priorities we adopt. The priorities cover the themes that we see arising in the marketplace. Now we are in the process of thinking about the priorities for the next three years. We consider microprudential supervisory risk in the areas of credit and liquidity, as well as new risks related to the arrival of new entrants, such as fintechs, or new technology developments, such as artificial intelligence, as well as other risks, like climate risk. We also look at macro-market factors, such as the growth in NBFIs that can have an impact on counterparty credit risk.

In July the European Banking Authority published the results of its bank stress tests. On the whole, the results reflect that European banks have healthy levels of capital. Supervisors are nevertheless still calling on banks to be prudent. What worries you the most?

The stress tests are an important tool that enables us to see how banks are able to weather severe adverse scenarios under conditions they may have to navigate. The stress tests provide a very good view of whether a bank has enough capital or liquidity to withstand a certain shock. While there is significant uncertainty in the current market environment, European banks are very well positioned. Following the great financial crisis, the ECB and, here in Spain, the Banco de España, worked hard to establish strong capital and liquidity requirements that have enabled the banks to withstand the significant recent market impacts including the pandemic, Russia’s invasion of Ukraine and now the rising interest rate environment. So far, the operational resilience of banks has worked very well and bank balance sheets are proving to be resilient.

So why are supervisors so focused on capital conservation?

For supervisors, capital is king. We know that market forces can turn quickly in the current context of uncertainty, and supervisors always want to be sure that the banks are well capitalised and have solid balance sheets, especially in stress scenarios. Armed with strong balance sheets, ideally, institutions are positioned to communicate to the market that there won’t be a capital shortfall in times of turbulence and pressure. Keeping an eye on capital levels and making sure banks are ready for uncertainty is in our DNA.

As a result of the interest rate hikes, banks are doing well and have been distributing larger dividends. Are you worried that they are being too generous with their shareholders?

We ask banks to have strong capital planning in place that underpins their plans for their shareholders, and we review those plans. We analyse each bank’s core business and capital planning exercise so we can be sure that they are sufficiently robust. I think that process is working well, and we don’t have any specific concerns at the moment.

Last year, Spain announced an extraordinary tax on banks. Other countries, like Italy and the Netherlands, are also taxing the sector. Do you think these taxes are having a negative impact on bank balance sheets?

I can’t make specific comments about any of these countries because I’m not familiar with the details. But our priority is for the banks to pay attention to credit risk. If the tax eats into the interest margin on loans, this could have a negative impact as it would incentivise banks to make lower provisions because these would have been calculated with an incorrect cost of risk. So we do have a concern about the tax from this point of view. We also have to make sure that European banks are attractive to investors. And when there are new moves in this direction, it can have a dampening effect on investment, which we should also be worried about.

Some countries are considering the possibility of making these taxes permanent. Would that have a negative impact on banks’ capital?

If it lasts for a relatively long period of time, the tax could hit a bank at a time when its margins are at a cyclical low, which could have an impact on its overall balance sheet management. For loans made in the past, there wouldn’t be a clear line of sight into that down the road. From the supervisory perspective, our main concern is for banks to have a clear understanding of their net interest margins, and of their cost of risk when they are granting loans, to then incentivise them to make adequate provisions. I think that is a key ingredient. But, on the other hand, it’s not just about banks being attractive to investors. The banks also have to take some responsibility here. For example, they have dragged their feet in terms of increasing the remuneration of deposits.

So what challenges are banks facing?

In my view banks should be investing in technology for the longer term. Their operations need to be as efficient and cost-effective as possible in the future. And such investment, and the cost efficiencies it can bring, are a good thing for banks’ price-to-book value over the long term. In the short term it could be costly, but it will also bring benefits. I also think that we have work to do within the European Union – to enable and actually see more cross-border mergers come to fruition. We need to complete all aspects of the banking union and have a deposit insurance scheme that covers banks across the whole of the EU. This would also enable banks to become cost-effective by operating across borders and would make them more attractive to investors.

Claudia Buch was recently chosen as the candidate for the role of Chair of the Supervisory Board of the ECB, ahead of Margarita Delgado from Spain. What will she bring to the role and what challenges lie ahead of her?

Two candidates were put forward – Margarita Delgado and Claudia Buch – and they are both outstanding. As for Margarita Delgado, I’m sure great things lie in store for her and we’ll be hearing about her in the future. She is extremely well qualified. She is a committed public servant, leader and Deputy Governor of the Banco de España. One of the main challenges the new Chair will be faced with is steering the supervisory strategy through this time of economic uncertainty. Claudia Buch is also extremely well qualified and will be an excellent Chair. She is an expert on financial stability and macroprudential topics, so she is very well prepared for the current challenges. Additionally, she is taking the helm at a time when banks are in good shape. In general terms, capital levels are strong and liquidity is good.