COVID-19: making decisions in uncertain times
17 February 2021
As vaccines are rolled out across the EU, citizens and businesses are asking when and how things can get back to normal. Banks are, quite rightly, also asking this question. Although this is understandable, banks and their supervisors are still facing considerable uncertainty, especially as regards the further spread of the coronavirus (COVID-19) and its macroeconomic and financial consequences. In addition, once the current fiscal support measures end, the banking sector will no longer be shielded, directly or indirectly, from the full impact of the pandemic.
The state of the economy and the financial system is an important consideration when it comes to deciding when and how to withdraw support measures. At the same time, these support measures are key drivers of that economic and financial state. Therefore, the supervisory response to the pandemic must not be seen in isolation – the interaction between the support measures adopted by public authorities should also be taken into account. Last year’s experience of dealing with the pandemic showed that successful coordination is possible, and should now guide the debate on withdrawing the current measures, while respecting the mandates of the various authorities involved.
So, how should the supervisory authorities respond to the unprecedented uncertainty?
First, supervisors should, as much as possible, reduce uncertainty by gaining a better understanding of banks’ risk profiles. That is why ECB Banking Supervision wrote to the CEOs of the banks under its supervision in December 2020 to underline the ongoing need for banks to identify, measure and manage their credit risk in a timely manner. The ECB highlighted that banks should forecast – and share with their supervisors – the most likely impact of the crisis in terms of the credit quality of loans, provisioning and capital. The better banks understand the crisis, the better they will be able to fight it.
Second, supervisors should be flexible and agile so that they can adjust their response to any changes in circumstances. For example, ECB Banking Supervision recently revised its recommendation on dividends, updating its previous stances from earlier in 2020.
In March last year, in the wake of the COVID-19 outbreak, the ECB recommended that banks suspend their cash dividends and share buy-backs. This recommendation, which was extended in July, reflected the extraordinary uncertainty that the banking sector and supervisors faced at that time. The ECB then updated its recommendation in December, calling on banks to remain cautious by keeping their distributions within certain levels or “guardrails”, as they were described. It also reiterated that banks are expected to exercise extreme moderation in variable remuneration. The update took into account new macroeconomic projections, which showed a lower level of uncertainty over the economic impact of the pandemic. While challenges remain, forecasts are close to the central scenario used in the ECB’s analysis of the banking sector’s vulnerability to the pandemic stress. This analysis showed that the banking sector is sufficiently resilient to withstand a stress such as the one we are currently witnessing.
At the same time, continued prudence remains necessary. Loan defaults will materialise with some delay, owing in particular to the broad use of moratoria and public support measures. Therefore, it remains necessary to safeguard banks’ capacity to absorb losses. Banks need to book sufficient provisions and, at the same time, their lending ability needs to be protected so that they can continue supplying liquidity to the economy. The ECB’s dividend recommendation will remain valid until the end of September 2021. At that time, in the absence of materially adverse developments, the ECB will repeal its recommendation and return to assessing banks’ capital and distribution plans within the normal supervisory cycle.
Third, supervisors should enhance the effectiveness of the measures taken by providing clear and transparent forward guidance to banks and explaining its underlying principles. ECB Banking Supervision therefore continues to encourage banks to use their capital and liquidity buffers for lending and loss absorption purposes. Banks will not be required to replenish their capital buffers before the peak in capital depletion is reached, and in any case not before at least 2022. The ECB will decide on the exact timeline for rebuilding capital after the 2021 EU-wide stress test. As usual, it will do so on a case-by-case basis according to the individual situation of each bank. Similarly, banks will be given until at least the end of 2021 to meet the liquidity coverage ratio requirement. ECB Banking Supervision will determine the precise timeline for rebuilding liquidity buffers on the basis of both bank-specific factors (e.g. access to funding markets) and market-specific factors (e.g. demand for liquidity from households, businesses and other market participants). This will allow the ECB to respond flexibly to the economic and financial environment.
Fourth, supervisors should make it clear that the supervisory relief measures were adopted in exceptional circumstances and will be reversed once appropriate. There should be no doubt that the underlying prudential framework remains intact, which is essential to maintaining the necessary trust in the financial system.
ECB Banking Supervision will continue to carefully assess the situation and stands ready to act as appropriate. It will seek to avoid excessive procyclicality – i.e. an excessive tightening of lending criteria coupled with shrinking lending capacity during an economic downturn – while ensuring that banks continue to properly identify and manage their risks.