“Strengthening bank resilience is priority”

Interview with Claudia Buch, Chair of the Supervisory Board of the ECB, Supervision Newsletter

21 February 2024

In addition to weak economic growth, Europe is facing significant geopolitical risks. Do banks take these risks into account sufficiently when managing their business?

We are indeed facing heightened uncertainty. The new macro-financial environment, geopolitical risks, climate change and the risk of cyber threats are all highly relevant challenges for banks. This is why strengthening banks’ resilience is one of our priorities.

European banks are now better capitalised, which is good news. But there are still deficiencies in internal governance and risk controls and, in this new environment, these need to be addressed. In a fast-changing risk landscape, it is important that both financial and non-financial risks are managed effectively.

One issue is that standard risk models are often not the most suitable for analysing new risks. Banks need to work with different scenarios to ensure that they would also remain resilient under adverse circumstances. We have, for example, reviewed prudential overlays and found that some banks do not sufficiently take new risks into account in their provisioning practices. Our supervisory teams will therefore continue to focus on provisioning practices, particularly in relation to vulnerable portfolios. We have also stepped up our efforts to ensure that banks take climate-related risks into account and make progress in adapting internal information systems and improving risk data aggregation practices. To tackle cyber risk, we are currently conducting a cyber resilience stress test.

We are seeing an uptick in corporate insolvencies. This is already having an effect on the banking sector, for example through an increase in loans classified as underperforming. What can and should be done to prevent a new surge in non-performing loans in the coming years?

Corporate insolvencies are increasing in many countries. Insolvencies were quite low until recently and even fell during the pandemic, also owing to the fiscal support that many firms received. This was certainly needed to prevent scarring effects, but it makes risk measurement more difficult. Past data may not show the typical correlation between economic downturns, rising insolvencies and loan losses.

We are already seeing that asset quality is starting to deteriorate. Up to the end of 2022, we had 32 almost uninterrupted quarters of declining non-performing loans (NPLs). But this trend has since reversed. The volume of NPLs has increased modestly since last year. Underperforming loans, particularly in the consumer lending business, are also increasing. Still, the cost of risk that many banks report – in other words their loan loss provisions as a share of total loans – remains relatively low and stable. This suggests that there could be some misalignment between emerging risks and banks’ own risk assessments.

Banks therefore need to be particularly vigilant with regard to credit risk management. They need to strengthen their capacity to deal with distressed debtors. And they need to closely monitor credit risk, particularly in relation to real estate portfolios, firms affected by the energy transition and firms exposed to weaknesses in global supply chains.

In general, how do you expect the banks to prepare for all these uncertainties?

Given the high uncertainty that we are facing, I can only urge all banks to be as prudent as possible with regard to their investments and capital planning. Banks’ profits have increased across the board – thanks also to the significant increase in interest rates. This gives the banks an excellent opportunity to increase their buffers against future shocks and to invest in their IT systems. And this will ultimately pave the way for sustainable future profitability, while also strengthening their resilience in times of stress.

The ECB has undertaken several initiatives to ensure that banks look at climate-related and environmental risks. Is this becoming an integral part of European banking supervision?

Yes, dealing with climate-related and environmental (C&E) risks has become a priority for European banking supervision. The work of banks and supervisors is no substitute for action at the political level, but it is important that climate-related risks are properly taken into account. A lack of preparedness on the part of the financial sector certainly shouldn’t stand in the way of good climate policies.

In 2020 we published supervisory expectations on how C&E risks should be embedded in banks’ risk management practices. We reviewed banks’ disclosure practices and, in 2022, we carried out a climate risk stress test. These exercises allowed us to identify best practices for C&E risk management and share them with the banks. Several banks still have deficiencies with regard to assessing C&E risks across their portfolios, while the assessment is a precondition for managing these risks. We are currently following up on these findings.

Shadow banking is now a very real systemic risk. Non-bank financial intermediation has grown considerably, but regulation and supervision are yet to catch up. What does supervision need to do to get up to speed?

The share of financial assets outside the banking sector has increased globally. This is partly the result of tighter regulation on banks. Non-banks can play an important role in our economies, for example by helping to finance the green and digital transformation of our economy. But if non-banks are not properly regulated, financial stability risks can increase, with negative implications for banks. A high degree of interconnectedness between banks and non-banks, exposure to liquidity risks and high financial leverage at non-banks require attention. Given the global reach of these non-bank entities, I strongly support the work that the Financial Stability Board is doing on this topic.

To ensure banks remain resilient, a more active use of the macroprudential toolkit could also be considered. The European Systemic Risk Board checks for dangers in the non-bank financial sector and has found problems that the current rules don’t fully address. These gaps in the rules might be making it easier for large financial risks to grow in areas outside of traditional banking, and they need to be addressed.

As supervisors, we look closely at banks’ exposure to non-banks and ensure that they remain vigilant. Banks offer a range of services to non-banks in financial markets. Therefore, having effective counterparty credit risk management in place is an essential safeguard against risks from the non-bank financial sector.

Various initiatives are under way to advance European integration in the areas of financial supervision and crisis management. How long can Europe live with an incomplete banking union?

The banking union is still incomplete, and I believe that a lack of progress here is becoming increasingly costly over time. We are missing out on opportunities to share risk more efficiently and to reap the benefits of a single capital market to finance the transformation of our economy. We are missing out on the chance to better protect against local shocks.

In my view, the banking union was the right response to the financial crisis. It reduces risks and improves crisis management. Its three pillars are closely connected. Strong supervision limits the probability and severity of bank distress. A credible resolution framework curbs moral hazard within banks while preserving financial stability and protecting taxpayers’ money. And common deposit insurance is key to maintaining depositor confidence and weakening the bank-sovereign nexus.

While the first two pillars of the banking union are well established, progress on a European deposit insurance scheme has been slow, and is hindering financial integration. But concrete initiatives to improve the framework do exist and they can be implemented. The crisis management and deposit insurance legislative package is one example. It offers a more effective framework for managing distress in smaller and medium-sized banks, ultimately safeguarding taxpayers’ money. For that reason, it must be swiftly adopted by the EU legislators.

The lack of progress towards a capital markets union is another factor hampering financial integration in the EU. With the Markets in Crypto-Assets Regulation and the Digital Operational Resilience Act, Europe is showing that it can respond to new risks. But, ultimately, Europe’s ability to confront global challenges will also depend on the completion of the banking union and the capital markets union.