“Two wrongs don’t make a right”

Interview with Kerstin af Jochnick, Member of the Supervisory Board of the ECB, Supervision Newsletter

14 August 2024

During your time at the ECB, you have always pushed for us to be more transparent and communicate more effectively with banks and the financial industry. Are you satisfied with what has been achieved in recent years and, specifically, with the level of transparency that ECB Banking Supervision currently provides?

Transparency is an important concept for the conduct of banking supervision for reasons of policy accountability and effectiveness. The ECB is required to report to the European Parliament and other EU bodies, so we need to be transparent in our decisions and processes if we want the dialogue with these counterparts to be a fruitful one. We are also accountable to the millions of European citizens who are trusting us to help keep their money safe by adequately scrutinising the banks under our remit. We therefore need to communicate our supervision in a way that allows the broader public, and not just financial industry participants and institutional stakeholders, to understand how and why we supervise banks. Essentially, the more forthcoming we are about our supervisory actions and expectations, and the clearer we communicate about them, the more likely we are to successfully ensure that the banks we supervise remain safe and sound, which is what the European legislator has asked us to do.

This is why I have been a strong advocate of increasing transparency in supervision during my term at the ECB, and I think we have made good progress in recent years. Concerning disclosure and comparability, we now publish more detailed aggregate results from our annual health check on banks – the Supervisory Review and Evaluation Process (SREP). We also disclose Pillar 2 capital requirements for all banks, and we are working on a revised methodology for setting these requirements, which will be published by the end of this year. And we now release stress test results for all individual banks under our supervision rather than just for a subset of banks, as was the case before. As regards communication and outreach, we have established the Banking Supervision Market Contact Group as an important forum for exchanging with market professionals who deal with banks but who are not bankers themselves. We also make use of different channels to share our messages with the wider public, like blog posts and podcasts. And we have continued to clearly set out our supervisory expectations in novel areas for banks’ risk management, such as climate-related risks or outsourcing arrangements to cloud service providers.

Do you see any risk that striving for transparency could jeopardise confidentiality?

There is no denying that confidentiality is a critical element of the day-to-day activities of banking supervisors. It is therefore important that we preserve this going forward. We need to keep in mind that supervisory decisions on individual entities can have distributional effects on people or groups (like bank shareholders), which is why decisions are subject to data protection rules and legal recourse. But confidentiality is not just a legal obligation. Confidentiality in the conduct of banking supervision is an operational necessity – there can be no supervision without confidentiality.

But we also need to recognise that there have been growing calls from external stakeholders − by this I mean legislators, banks, financial markets and the general public − for supervisors to be more transparent about what we do and how we do it. Society's preferences about the transparency of institutions and their communication in the digital age have clearly changed, and as the banking supervisor, we need to keep up with these trends.

This results in a constant friction between confidentiality and transparency when carrying out banking supervision. Moreover, the relationship between confidentiality, transparency and financial stability may also vary depending on the circumstances. So striking the right balance here is more art than science. I think it is fair to say that supervisors rank among the most risk-averse policymakers around, in the sense that they are naturally inclined to keep their cards close to their chest. In spite of this, I have been pleased to see that the Supervisory Board has found ways to overcome this inertia and take steps to enhance the transparency of our supervision.

Supervisors need to understand bank-specific risks as well as the competitive and macroeconomic environment that banks operate in. Is the current SREP equipped to capture macroeconomic and geopolitical developments?

Although we now often take it for granted, we should remember that developing a new risk assessment methodology like the SREP that is common to all banks under our supervision is a great achievement in itself. The SREP aggregates all known risk factors and combines quantitative and qualitative information which is then distilled into scores measuring the overall riskiness of banks. The SREP makes the process of setting banks’ capital and liquidity requirements objective and systematic, promoting a level playing field and thereby facilitating the understanding and acceptance of supervisory decisions. So it very much exemplifies the added value of the Single Supervisory Mechanism compared with a set-up in which banks are exclusively supervised by national authorities.

This risk assessment methodology has served us well over the first ten years of European banking supervision, allowing our supervisors to effectively measure the pulse of our banks in very different economic and financial circumstances, including in the face of large and unexpected external shocks. Based on this experience alone, I would say that the SREP is equipped to deal with anything that is thrown at it. However, we should also take into account that the environment in which banks operate has changed significantly in recent years on the back of structural changes in the banking market, the more palpable presence of risks related to the green and digital transformations, and recurring macroeconomic and geopolitical shocks. This has made the risk assessment process more complex.

The changes to the SREP which we announced earlier this year aim to make our supervision more efficient and effective in this fast-evolving risk environment, for example by giving our supervisors more flexibility to prioritise areas that may be relatively more important at a particular time for the specific banks which they cover. As the supervisor, we should practice what we preach, so if we are telling banks that they should be agile in adapting to the realities of the changed macroeconomic and financial landscape, we should do the same.

Growing macro-financial and geopolitical risks also make crisis preparedness essential. You witnessed the bank resolution cases in the United States and Switzerland last year. What’s your take on the current state of the crisis management framework in Europe?

We have established a very good platform for crisis prevention and crisis management in Europe through single mechanisms for supervision and resolution. I was the Chair of the Committee of European Banking Supervisors back in 2008 and I vividly remember the difficult discussions we had around fostering supervisory convergence across different EU Member States. Shortly after that, the global financial crisis of 2009 showed that setting monetary policy at the supranational (European) level while handling supervision and resolution at national level was untenable. The euro area sovereign debt crisis of 2011 further reinforced this impression.

We have come a long way in a short period of time. On a personal note, let me say that it has been a great pleasure to be part of the European project for the past five years as a Member of the Supervisory Board of the ECB. The times of market participants and the general public viewing European banks with a degree of suspicion are behind us. In aggregate terms, our supervised banks are now in much better shape than they were when they first came under the ECB’s supervision back in November 2014. Banks have shown their resilience to the large and sudden external shocks which have hit them in recent years. And these events have been a significant test, not just for the banks, but also for the regulatory framework which underpins their activities and for the institutions which oversee them. So from this perspective, I think that we can be pleased with what has happened so far. The overhaul of the Basel framework in the aftermath of the global financial crisis was key in enabling the ECB to subject the European banking system to high common supervisory standards over the past decade. And the importance of having union-wide institutions and structures to effectively deal with crisis situations in a coordinated manner became clear during the pandemic. In this regard, the contrast with respect to the fragmented policy response of national authorities to the global financial crisis, including in supervisory terms, is rather sobering.

However, a key lesson from our experience with crisis management in recent years is that no two crises are the same, so past success is not a reliable bellwether for future performance. This is why we support the proposals tabled by the European Commission last year to enhance the EU crisis management framework. They would allow stakeholders to effectively deal with the failure of mid-sized and small banks in a more harmonised manner, while at the same time preserving financial stability, protecting depositors and saving taxpayers’ money. But perhaps the single largest step which could be taken to further cement the resilience of our banking system would be to establish a true safety net for bank deposits in Europe under a common insurance scheme. This is why the ECB has been underlining the importance of completing the banking union as originally envisaged.

You have been the link between the ECB’s macro- and microprudential work. What is your view on developments on this front in recent years?

The pandemic brought the question of the usability of banks’ buffers to the top of the policy agenda. The lessons from that episode appear to have been partly heeded, as national macroprudential authorities have tended to take a more proactive stance towards building up banks’ buffers in recent years so that they can be released in a countercyclical manner.

However, this increased policy activity has brought some new challenges. First, there are level playing field concerns, as banks of a similar size and footprint for the banking union may be subject to different buffer requirements by their home macroprudential authorities. And second, the framework is becoming more complex, because some countries have opted to activate systemic risk buffers, either country-wide or only for specific sectors, while others have not. This has raised some difficult questions about the degree to which macroprudential measures taken in one country should be “reciprocated” by other countries for cross-border banking exposures or exposures through bank branches.

Therefore, the macroprudential framework must have a union-wide perspective to ensure a consistent approach across Member States and to minimise any overlaps. This can be done without altering the existing balance of competencies between the national authorities and the ECB, for example by updating the commonly agreed methodologies for determining banks’ macroprudential buffer requirements.

The ECB’s Governing Council recently called on national authorities to maintain current capital buffer requirements and supported an increase of those requirements in countries whose authorities saw a need to do so. Could higher buffers shrink banks’ lending capacity at a time when financial conditions are already quite tight?

At the micro level, we should always consider banks’ lending ability throughout the cycle, rather than at a single point in time. There is plenty of evidence to suggest that better capitalised banks are in a stronger position to perform their lending function relative to poorly capitalised peers. This was one of the key lessons from our experience with European banks during the global financial crisis, when credit rationing by capital-constrained banks amplified the real effects of the economic downturn. The fact that the capital bar for banks was subsequently raised in the revised Basel framework is part of the reason why, in more recent crisis episodes, banks have been part of the solution rather than part of the problem.

At the macro level, macroprudential policy needs to be countercyclical by design, because its ultimate purpose is to help preserve financial stability by limiting the build-up of vulnerabilities and thereby mitigating systemic risk. In practical terms, this means that buffers need to be built up on sunny days so that they can be deployed on rainy days. As I said before, this was an element of policy that was not always applied in the run-up to the outbreak of the pandemic, and many national authorities discovered that there were insufficient releasable buffers relative to the magnitude of the shock. This has since been partly redressed.

The Governing Council’s assessment, which I share, is that the conditions are not ripe enough for macroprudential buffers to be released. If we look at the macroeconomic picture, the outlook for euro area GDP growth in 2024 was revised up in the June Eurosystem staff projections compared with the March ECB staff projections. While it’s true that both the demand for and supply of bank credit have taken a hit in recent quarters, this was to be expected amid the normalisation of monetary policy and a more sluggish economy. The latest ECB Bank Lending Survey shows that loan demand from firms continued to decline in the second quarter of 2024, but demand for housing loans and consumer credit to households increased for the first time since 2022. So there are some signs of recovery here too. And at the micro level, we know that banks are on aggregate exhibiting robust levels of profitability and solid capital positions that are comfortably above regulatory requirements. Coupled with the fact that there are lingering vulnerabilities in some areas for example in certain real estate market segments, this explains the Governing Council’s view that gradual buffer increases in those countries that might need it would not significantly affect lending.

European banks have repeatedly stressed that regulation and supervision in the EU inhibit their business, especially compared with their peers in the United States. What is your view?

Before I entered the realm of supervision, I was head of the Swedish Bankers’ Association, so let me say that I am very familiar with these sorts of claims. It would certainly be surprising if bankers argued for tighter rather than laxer regulation of their activities or asked for their entities to be required to hold more rather than less capital. So the fact they are arguing the opposite should be seen as part of the healthy debate which needs to take place between banks and their supervisors in a “business as usual” fashion.

With this in mind, let me make three additional points. The first is that we heard similar arguments in the aftermath of the global financial crisis, when the Basel III framework was overhauled and banks were required to hold more, higher-quality capital. Events since then have shown that fears of the purported negative macroeconomic consequences were unfounded. In fact, we have seen the opposite, with larger buffers of loss-absorbing capital reducing the likelihood of banking crises and smoothening the negative impact of economic downturns by allowing banks to lend through the cycle in a more sustainable manner. Second, we know that comparisons of capital requirements on each side of the Atlantic are sensitive to sample size and methodological assumptions. So if we were to compare only global systemically important banks, the US entities would be subject to higher capital requirements than their European counterparts. However, if we take the other significant banks in the banking union and compare them to their US peers of a similar size, then the reverse would be the case. There is also evidence to suggest that if European banks were to be subject to the current US prudential framework, their average capital requirement would be somewhat higher than they are today.

This brings me to my third and perhaps most important point, which is that only the largest US banks are subject to full Basel standards, unlike in the EU where the rules apply to all banks. The demise of Silicon Valley Bank in the United States in the spring of 2023 was a prominent example of the limitations of the approach for US banks. The need to avoid our banks being exposed to the same weaknesses which we have seen in other jurisdictions is one reason why we at the ECB do not favour a loosening of our rulebook compared with the Basel III standards. So while I understand the concerns expressed by some industry participants concerning level playing field issues and believe we should strive to make things as even as possible on a global scale, my ultimate conclusion would be that “two wrongs don’t make a right”.