What lies ahead for the European banking sector?

Conversation between Anneli Tuominen, Member of the Supervisory Board of the ECB, and Kian Abouhossein, Managing Director at JP Morgan, at the inaugural European Financials Conference hosted by JP Morgan

London, 22 November 2024

From a supervisory perspective, how do you see the state of European banks today, a decade since the Single Supervisory Mechanism was put in place?

The banking sector remains resilient overall, as proven by its ability to withstand large and sudden external shocks in recent years. This resilience has been built up over time, and although it is not the only factor, the active role played by the single supervisor should be recognised. The decision to grant supervisory powers to the European Central Bank (ECB) came at a time when there was not a great deal of clarity concerning the true state of banks’ balance sheets. Part of the problem was one of institutional design: the global financial crisis had shown that it was no longer tenable to have a set-up with monetary policy managed at European level but banking supervision and resolution remaining in national hands. The establishment of the Single Supervisory Mechanism as the first pillar of banking union was meant to redress these weaknesses, not just by applying a common supervisory standard to all banks, but also by placing them under a higher level of scrutiny.

Ten years on, we can say that the days are behind us when European banks were regarded with suspicion by both market participants and the wider public . Today, the ECB is a trustworthy and well-respected supervisor. Various initiatives have been instrumental to restoring confidence in the banking sector, including progressively lifting the capital bar faced by banks, reducing legacy non-performing assets and reviewing banks’ internal models. Nowadays, banks have robust capital and liquidity buffers in place, and their headline level of bad loans is still low overall. Thus far, European banking supervision is fulfilling the promise on which it was established ten years ago, which is to ensure that banks stay safe and sound.

This brings me to a broader point, that is, the regulatory framework we have developed to underpin banking activity in recent years. Competition and growth are currently at the forefront of the political agenda in Europe – for good reason. However, I would caution against heeding the calls made by some in the banking industry, who argue that capital requirements should be relaxed so that banks can be more competitive in the business of financing the economy. There have been around 150 banking crises since the 1970s^[1]. These have come at a high economic and social cost to the people affected, so we should not risk repeating the mistakes of the past. However, there is a case to be made for streamlining the overall banking regulatory framework, which is currently complex. The ECB is participating in discussions on this, together with other stakeholders such as the European Banking Authority.

What are some of the key areas of focus for the ECB’s Supervisory Board in the short to medium term?

The collective challenge for us as supervisors is to make sure that banks are well prepared to deal with a changing risk landscape. I am referring here to issues such as operational resilience and risk management, and the need to deal with hybrid threats, digital and IT-related challenges and dealing with the green transition. These risks come on top of the long-standing ones that banking supervisors tend to look at in a traditional sense, such as credit and market risks and governance issues. Moreover, geopolitical risks remain high in the current environment, and these have the potential to affect both traditional and emerging risks in a multifaceted way that cuts across established categories. That’s why we are asking banks to factor in these additional risks for the purposes of scenario planning and business model viability.

All these factors suggest that we need to make sure that our supervision is more efficient and risk-based going forward. Earlier this year we announced a number of reforms to our supervisory processes, which are designed to make this happen. For example, in the context of the Supervisory Review and Evaluation Process, our annual health check for banks, our supervisors will now have more flexibility to prioritise areas that may be more important for the specific banks they cover at a given time. As the supervisor, we should practise what we preach. If we are telling banks that they should be agile in adapting to the realities of the changing macroeconomic and financial landscape, we should do the same.

There is some discussion about bank mergers in Europe at present. From a supervisory perspective, what are some of the key factors you look at when deciding on applications for mergers and acquisitions?

Our role as banking supervisor is to assess merger proposals from a prudential perspective. This means that we need to make sure that the combined entity that would result from the merger has a sustainable business model, an adequate level of capital which is consistent with its risk profile, and sound governance and risk management arrangements in place. We therefore need to see a credible group-wide integration plan if we are to make such assessments in an informed way.

The prudential approach to these and other elements that are important in merger transactions, such as the treatment of badwill, are all laid out in a guide we published a few years ago.^[2] To firmly dispel any misperceptions that the supervisor was standing in the way of bank mergers, we felt that it was important to clarify our stance on consolidation in the banking sector. Parts of the European banking system appear overbanked in certain market segments, and recent trends suggest that the decline in the number of credit institutions in the euro area has slowed, with mergers and acquisitions activity remaining sluggish^[3] Business combinations could be one way of improving efficiency. However, we see bank consolidation as a market-led process, regardless of whether it takes place within national boundaries or across borders. Given that the assessment of proposed merger transactions in terms of aspects such as competition and consumer protection does not fall within our prudential remit, this is a call for other (national) authorities to make.

Turning to cross-border mergers more specifically, what is your view on the extent to which the lack of provisions in EU banking regulation for fungibility of capital and liquidity across countries, and the fact that there is still no common insurance scheme for bank deposits in Europe, are hindering such transactions?

Banks looking to expand beyond national borders have to deal with different regulations across European countries, including on tax, accounting and insolvency regimes, as well as securities markets. Fostering cross-border bank integration would therefore require more harmonisation on these fronts. But I agree with you that perhaps the single largest deterrent to cross-border mergers is to be found in European rather than national legislation. This is because cross-border capital waivers are currently not possible under EU law, so banking groups cannot freely move capital between their subsidiaries in different jurisdictions. EU law does provide for cross-border liquidity waivers, and the ECB has tried to create an environment in which banks can use the limited leeway provided in the legislation to this end.

However, the take-up of this initiative has been lukewarm, as some host-country authorities still fear that local subsidiaries could be put at a disadvantage compared with their parent entities if the latter experience financial distress. This is where the lack of progress on the third pillar of banking union – a common insurance scheme for bank deposits – appears to be a major obstacle. It is safe to say that if a common deposit insurance scheme were in place at European level, some national authorities would be more likely to allow the free movement of capital and liquidity across borders, which would in turn increase banks’ appetite for cross-border mergers.

From a supervisory perspective, how important is it to make progress on a European deposit insurance scheme?

I would say that progress towards a European deposit insurance scheme, or EDIS, is important for at least three reasons. The first has to do with achieving a more unified banking market. Overcoming the fragmentation of the financial system along national lines was one of the main objectives political leaders had in mind when they decided to establish a banking union. However, despite the progress made in other areas in recent years, the European banking system is still closer to being a collection of national banking sectors than a truly integrated market. As I have just mentioned, there are several different factors standing in the way of cross-border bank mergers at present. This explains why, in contrast to domestic bank mergers, such transactions have been more the exception than the rule over the past decade. Progress towards an EDIS could therefore help host authorities provide added flexibility for group-wide risk management and increase overall reassurance.

The second reason has to do with improving our crisis management framework. A common scheme for insured deposits in Europe would allow for a smoother transfer of assets and assumption of liabilities for banks in resolution and liquidation. These “purchase and assumption” transactions could be carried out more efficiently across the entire banking market, rather than being confined to a domestic solution, which is the situation at present given the national character of deposit guarantee schemes. This would therefore be a welcome addition to the EU crisis management toolkit.

The third reason has to do with buttressing financial stability. It is important to realise that a common deposit insurance scheme would be a useful tool for managing a crisis in the event of bank failure. But we must also recognise that it would make a crisis less likely to occur in the first place. Advances made in supervision and resolution under the first two pillars have helped weaken the links between banks and their sovereigns. However, as long as the third pillar – a common insurance scheme for bank deposits – is missing, it is possible that the doom loop between governments and banks could resurface. In my view, progress on an EDIS could also help forge a convergence of views on the regulatory treatment of sovereign exposures. This would help sever the remaining links inherent in the sovereign-bank nexus and thereby cement banking sector resilience even further.

The EU’s crisis management and deposit insurance framework is currently under review. Could you say a few words about the framework’s importance from a supervisory perspective?

The current crisis management and deposit insurance framework was introduced in response to the global financial crisis of 2008, so it has been in place for some time now. At the ECB we think that the framework has been working well overall, and that the reforms implemented over the last decade have significantly strengthened the effectiveness of our collective crisis management capabilities in the EU. However, our practical experience with cases of possible or actual bank failures in recent years has also shown that certain aspects of the framework could be refined.

For example, the process for unviable banks exiting the market could be improved. The scope of resolution could be expanded to ensure that the failure of small and medium-sized banks is addressed in a harmonised manner across EU countries. Making resolution work for a broader range of banks would minimise the probability of taxpayers’ money being needed to cover losses. However, bank resolution often requires funding. If the range of banks for which resolution may be in the public interest is to be widened, then we also need to make sure that such banks have sufficient access to funding sources in order to make them resolvable in a practical sense. This is why we are in favour of national deposit guarantee schemes playing a stronger role in resolution, so that they are empowered to provide a wider range of crisis management options for addressing potential, or actual, bank failures. For instance, instead of paying out covered depositors, national deposit guarantee scheme funds could help facilitate the transfer of assets and liabilities to an acquiring bank. They could also help banks meet bail-in conditions, so that these banks can access Single Resolution Fund resources.

Overall, at the ECB we believe that the European Commission’s proposals^[4] to reform the crisis management and deposit insurance framework go in the right direction in terms of strengthening the resilience of the framework, and we have published an official opinion to that effect.^[5] Discussions on this matter are ongoing within EU forums, and there are important issues on which consensus hasn’t yet been reached, such as funding in resolution. But we hope that these open issues will be favourably resolved during the upcoming negotiations, which will take place at meetings (known as “trilogues”) bringing together representatives of the European Parliament, the Council of the European Union and the European Commission.

The financial market turmoil we saw in the United States in spring 2023, associated with the failure of Silicon Valley Bank, put the spotlight on banks’ management of their interest rate risk and their asset and liability management frameworks. What steps are you taking to ensure that banks are adequately prepared to deal with risks in these domains? And how are you thinking about liquidity in a digital environment where bank deposits can quickly be withdrawn with a few clicks of the mouse?

The financial market turmoil of spring 2023 in the United States and Switzerland showed how quickly markets could shift their assessment of bank valuations from a balance sheet view to a mark-to-market view. Following this turmoil, we adjusted our supervisory practices in a couple of areas. First, we increased our scrutiny of banks’ unrealised losses. Our work in this area suggests that the amount of unrealised losses for banks that are directly supervised by the ECB remains manageable in aggregate terms, and is significantly lower than is the case for banks in the United States.^[6] However, such losses could still be problematic when combined with weaknesses in individual banks’ asset and liability management strategies. So we have been emphasising the need for banks to have robust arrangements in place in this domain.^[7] Our supervisors have been conducting targeted activities to review banks’ governance and strategies for asset and liability management, and they have also been assessing the adequacy of the assumptions underpinning the behavioural models of some banks. A targeted review is also assessing the reliability and soundness of banks’ funding plans, the results of which will feed into the outcome of our Supervisory Review and Evaluation Process, to be published later this year.

We also asked banks to step up the frequency with which they report their liquidity positions to us. While the indicators used to gauge liquidity requirements under the Basel framework (such as the liquidity coverage ratio and the net stable funding ratio) are available on a monthly basis, the financial market turmoil of spring 2023 suggested that such metrics may be of limited value for flagging issues in fast-moving situations where deposits are being withdrawn quickly. We therefore asked banks to send us their liquidity data on a weekly rather than a monthly basis to improve our regular monitoring of their positions. Our supervisors use this to complement their analysis of banks’ counterbalancing capacity, gauging banks’ preparedness to face sudden liquidity shocks.

This brings me to a broader point concerning liquidity in the digital age. A recent report by the Financial Stability Board, looking into the lessons from the March 2023 turmoil, finds that technological advancements have made it easier for bank customers to transfer their deposits, and that there is evidence that social media had a bearing on some recent bank runs amid a concentrated depositor base.^[8] So, while it has always been the case that if all of a bank’s customers were to suddenly show up unannounced to withdraw their funds, that bank would almost certainly go bust – both the means and the speed by which this may be done nowadays have been amplified.

However, the turmoil last spring was also a reminder that one should not forget the bread and butter of sound bank management and supervision. A report by the Basel Committee on Banking Supervision, also looking into this turmoil, puts the onus on issues that have long been familiar to banks and their supervisors, such as shortcomings in the management of traditional banking risks, unsustainable business models, poor risk culture and failures to adequately respond to supervisory recommendations.^[9] These features are far from new and have been at the root of many banking crises in the past. To anchor supervisory expectations more firmly in these areas, the ECB has developed a guide on governance and risk culture, which was recently issued for consultation and will be published in early 2025.^[10]

The pandemic underlined the need for banks to become increasingly digital, while geopolitical risks have arguably been on the rise in recent years. Both of these factors have a bearing on banks’ operational resilience. Could you tell us how you are approaching these issues in prudential terms?

The degree of bank digitalisation varies significantly across regions and business models, but it is fair to say that we see this as a critical matter for banks going forward, regardless of their business model. As supervisors, our overarching aim is to ensure that banks are in a strong position to not only take advantage of the opportunities offered by the digital transformation, but also to manage the risks associated with it. As a first step in this regard, we conducted a digital transformation survey in 2023, the results of which revealed a mixed picture for banks directly supervised by the ECB.^[11] We found that while almost all banks have a digital transformation strategy, these strategies vary in terms of how developed they are. Most banks do not yet have a dedicated digital transformation budget, even though they spend on average a fifth of their IT budget on digitalisation. The results of the survey also showed that banks are aware that having an effective internal control framework is key to enabling the digital transformation. Our supervisors have been following up on these results via on-site inspections and targeted activities.

Once we accept that both digitalisation and artificial intelligence are here to stay, the next question to tackle is whether banks will remain operationally resilient so they can make the most of new technologies going forward. I would like to highlight two issues in this regard.

The first concerns the potential for banks to be on the receiving end of cyberattacks. The incidence of such events has significantly increased in recent years, nearly doubling for banks directly supervised by the ECB between 2022 and 2023.^[12] This underscores the need for banks to invest in cyber resilience. We conducted a cyber resilience stress test earlier this year and found that, while banks tend to have response and recovery frameworks in place, improvements are needed in a number of areas.^[13] These include business continuity, communication and recovery plans, and estimating losses from cyberattacks. Improvements are also needed on banks’ assessments of their (increasing) dependencies on (a few) critical third-party IT service providers. In this regard, earlier this year the ECB released a guide on outsourcing to cloud service providers, which has already undergone consultation.^[14] The final version will be published in 2025.

The second issue relates to geopolitical risk. This is not a novel risk for supervisors, but I agree with you that it has been on the rise in recent years. As I mentioned at the beginning of our conversation, we see this as a multifaceted risk-type with the potential to affect both traditional and emerging risks. Operational resilience is certainly included among the areas that could be affected by cyber risks, disinformation, physical threats and various forms of hybrid influencing. We are aware that geopolitical risks are difficult to measure and that they can have different implications for banks depending on the channels through which they emerge, but that is exactly the point. Traditional risk models do not capture the uncertainty around adverse geopolitical events, yet banks still need to be sufficiently resilient to withstand unexpected shocks. So we are asking banks to make an effort to account for geopolitical risks in their scenario planning through the channels which they consider most relevant for their own franchise, and to make contingency arrangements for their risk management and governance practices accordingly.

There has been a lot of talk lately about developing securitisation in Europe, both in Mario Draghi’s report on competitiveness and in the European Commission’s targeted consultation on the functioning of the EU securitisation framework. What is your view, from a prudential standpoint, on whether this market needs to be revived?

This is a worthwhile debate, especially because it has several nuances. I think that everyone can agree on the fact that a more developed securitisation market could play a role in transferring risks away from banks and enabling them to provide more financing to the real economy, while also creating opportunities for investors.^[15] This would also be one way, although by no means the only way, to contribute to the capital markets union – promoting equity financing would be at least as, if not more, important.

In my view, the question is therefore not so much whether we want to promote securitisation in Europe, but rather how to go about this in a practical sense and what objectives we want to pursue while doing so. And this is where the nuances start to appear, because trends in EU securitisation markets in recent years have been more complex than they might appear at first glance. While the European true-sale (cash) securitisation market appears to have stabilised at issuance volumes considerably lower than those observed in the run-up to the global financial crisis, issuance volumes of synthetic securitisation have grown significantly in recent years. The evidence suggests that banks have adapted their use of available products, including both securitisation and covered bonds, to best fit their needs. Banks use true-sale securitisations mainly for secured funding with the ECB. They use synthetic securitisations to transfer risk and release regulatory capital, for example, in the context of management strategies for non-performing loans.

Assessment of the need to further support (or revive) securitisation markets should therefore take a comprehensive view, including both supply and demand factors. In my opinion, any review of the prudential treatment of securitisation should put market safety first, so as not to risk a repetition of past mistakes associated with a lowering of regulatory standards, such as those we saw during the subprime debt crisis. We should also keep in mind that, even in a best-case scenario involving genuine transfer of risk outside the banking sector through securitisation, this risk still remains in the financial system as a whole, for example in non-bank financial institutions where the supervisor does not have the complete picture. So we must be sure that risk transfers apply to a diversified pool of investors that can manage the inherent risks appropriately. And we also need to have a good grasp on the extent to which securitisation markets can develop in a sustainable manner without leading to an unintended build-up of risks, so we need to set realistic objectives in this regard.

I therefore welcome the European Commission’s targeted consultation on the functioning of the EU securitisation framework^[16] because it provides us with a good platform to start discussing these different aspects in a coherent manner.

The growth of non-bank financial institutions has been staggering in the aftermath of the global financial crisis. As a supervisor, how do you ensure that these largely unregulated entities do not pose a risk to banks, especially in the form of counterparty credit risk?

As you say, the growth of the non-bank financial institution – or NBFI – sector has been phenomenal since the global financial crisis. In the euro area, the sector has more than doubled in size, from €15 trillion in 2008 to €32 trillion in 2024. At a global scale, the growth of the sector has been even larger, from €87 trillion in 2008 to €200 trillion in 2022.^[17] From a supervisory perspective, this raises a number of concerns. One of these is the private credit market. Banks’ exposures to private credit funds have significantly increased and risk management approaches appear not to have caught up with the developments in this market segment. The results of an exploratory review of bank exposures to private credit funds which we conducted earlier this year suggest that banks are not able to systematically identify transactions where they are co-lenders to portfolio companies alongside private credit funds.

More broadly, data gaps and market opacity are another source of concern. As supervisors we do not have a full picture of the levels of exposure and correlation between NBFI balance sheets, bank lending arrangements and lines of credit or derivatives to and from NBFIs. This makes it challenging for us to gauge the full extent of risks that banks may be facing, and it limits the capacity for market participants and regulators to assess systemic risk. We would thus favour further harmonising and expanding reporting requirements in this domain, also with the aim of making information sharing between authorities easier at the global level.

From a prudential standpoint, we have been focusing on counterparty credit risk as the main channel through which risks from the NBFI sector may spill over to banks. We have implemented a number of initiatives in this domain since we identified counterparty credit risk as a broader supervisory priority back in 2022. For example, we performed a targeted review of counterparty credit risk for a larger group of banks, which confirmed that some progress has already been made by certain banks and identified several good industry practices. But the review also identified areas where only a few banks have adopted sound practices and where further efforts are needed to address several material shortcomings. These include: customer due-diligence procedures for NBFIs; early warning indicators specific to derivatives and securities financing transactions; and risk appetite statements for banks with material or complex counterparty credit risk exposures. To help guide banks in this area, last year we published a report on sound practices in counterparty credit risk governance and management, describing sound practices in areas such as counterparty credit risk governance, risk control, management and measurement, stress testing, and the watchlist and default management process.^[18] The Basel Committee for Banking Supervision has also developed some guidelines on counterparty credit risk management, whose final version will be published soon^[19]. We are also currently conducting a quantitative survey on counterparty credit risk exposures to NBFIs among the largest trading banks directly supervised by the ECB, which are likeliest to have exposures to NBFIs.