Introductory statement by Andrea Enria, Chair of the Supervisory Board of the ECB, at the virtual meeting of the European CFO Network organised by UniCredit Group
Frankfurt am Main, 12 June 2020
Thank you for inviting me to share my thoughts with your network. I value our regular dialogue and I believe it is very important to touch base with you exactly at this time, given the extraordinary phase we are going through. I would first like to share with you our thinking behind the supervisory measures taken at the onset of the pandemic. I will then briefly discuss what we currently observe in terms of banks’ reaction to the fallout and provide you with some insights on how we look at the uncertain path ahead.
Swift and forceful supervisory measures are needed to mitigate procyclicality
No sooner were the first measures of lockdown adopted in the EU than it became apparent that a shock of unprecedented magnitude was ahead of us. In this context, we took three key decisions aimed at further increasing the euro area banking sector’s capacity to absorb losses and support distressed customers, while, at the same time, also mitigating procyclicality. First, we announced that we would make fully available to be used the capital and liquidity buffers under our control, namely the Pillar 2 Guidance, the capital conservation buffer and the buffer of high-quality liquid assets to comply with the liquidity coverage ratio (LCR) requirement. Second, we decided to frontload the 2021 reform on the composition of capital for the Pillar 2 Requirement (P2R), thus effectively releasing additional CET1 capital. Third, we recommended not to distribute dividends or buy back shares until October 2020, in order to form a better understanding of the magnitude of the shock and the likelihood of a fast recovery.
Our estimates are that those decisions, together with the decisions by national authorities to release some of the macroprudential buffers, made available around EUR 160 billion of extra CET1 capital in order to absorb losses and extend credit before prudential minimum requirements are breached.
Our measures on buffers and payouts are temporary and were taken with a view to better preparing the euro area banking sector as a whole to weather a potentially unprecedented storm. The release of the buffers is perfectly in line with the letter and the spirit of the post-crisis reforms designed by the Basel Committee and endorsed by the G20: banks have been required to build capital and liquidity buffers that can help withstand also a significant adverse shock. The use of those buffers during a sharp downturn is essential to prevent the banking sector from acting procyclically and excessively restricting lending to preserve capital during a recession: if all banks deleveraged at the same time, the recession might become deeper and have a stronger adverse effect also on the quality of bank assets and their capital position.
Also our recommendation to suspend dividends and share buybacks is aimed at preserving capital, given the current uncertainty regarding the depth and length of this very peculiar recession.
I am aware that this has been a controversial decision and I acknowledge that it may have played a role in the decrease of already depressed market valuations of European banks in recent months. Still, restricting dividends and buybacks was the right decision to take to keep within the system as much loss absorbency as possible.
It would have been imprudent to allow almost EUR 30 billion of capital to leave the sector while a storm of unknown magnitude is building up on the horizon. If the recession turns out to be milder than we expect today, nothing will prevent banks from paying back extraordinary dividends or buying back shares in the future, to compensate shareholders for their patience today.
If, instead, the crisis proves to be even harsher than we expect, shareholders will benefit from the resilience of the banks allowing them to preserve the value of their investment in the longer run. This argument has been made very forcefully by the Managing Directors of the IMF and the BIS. But let me stress that this measure is exceptional and temporary in nature, and we will repeal it as soon as the economic uncertainty is dispelled and the recovery is on sound grounds. We plan to provide more clarity on our stance towards distribution of dividends in July, reflecting also on the recommendation recently issued by the European Systemic Risk Board.
To complete the overview of the supervisory measures taken so far, let me mention here that we encouraged institutions to limit the procyclical implications of IFRS 9 accounting, we temporarily switched off a supervisory component of the market risk capital requirement in response to excessive market volatility, we deployed flexibility in the supervisory treatment of exposures within the scope of application of national support measures, such as moratoria and loan guarantees, and we provided banks with temporary operational relief from supervisory activity and decisions in several cases, to acknowledge their impaired working capacity during the lockdown.
Banks act as a shock absorber, not a shock amplifier this time
While in the last financial crisis banks were at the origin of the shock and their weak capital and liquidity position contributed to amplifying the impact of the crisis on the real economy, this time banks are positively contributing to helping the economy absorb a shock originated by the pandemic and the lockdown measures.
Banks significantly expanded lending during March, due to a surge in draw-downs of committed credit lines and, in some cases, re-intermediating business from other financial institutions under stress, such as money market mutual funds. The growth in lending to non-financial companies continued also in April. Lending survey evidence, dating back to end-April, shows that this increase in lending occurred with a very contained tightening in credit standards and conditions, especially compared with 2008. Banks expect the demand for corporate credit to increase further in the second quarter. They expect to relax credit standards considerably, probably due to the utilisation of national guarantee programmes.
The way ahead is marked by extraordinary uncertainty
Looking forward, though, significant uncertainties remain. Year-end capital projections published by significant institutions show that only a handful of them plan to dip into the capital buffer by the end of this year. Liquidity buffers have also been increasing, as banks benefited from the extraordinary liquidity support from the central bank. Our dialogue with banks signals a reluctance to use the buffers, or more precisely to be seen as the first using the buffers, also for fear of external ratings downgrades. Especially when approaching the thresholds for restrictions of payments to AT1 holders and variable remunerations banks might, instead, opt to deleverage, with potential adverse effects on the recovery. Although I acknowledge that the automatic rules for the suspension of payments might provide negative incentives, I remain puzzled by this reluctance to use the buffers. Let me ask you straight away: if not now, when? We are going through an unprecedented economic shock of systemic nature, which will hopefully be temporary but potentially damaging for banks’ balance sheets and the wider economy. Banks that were to use the buffers now would in fact be acting responsibly and in line with the expectations set out in our regulatory framework. I hear sometimes that banks might not be willing to use the buffers because of concerns that the ECB would abruptly switch off the flexibility granted so far and ask for a fast replenishment of the buffers. I want to reassure all parties that we will strive to put in place a well-designed and credible path to normality, taking into account evidence on the severity of the shock, bank-specific circumstances, and the need to preserve the sector’s fundamental lending role to the real economy during the recovery.
We observe high uncertainty and heterogeneity also in banks’ risk management choices. While some use what we consider overly optimistic macro scenarios in their year-end capital projections, others are not even in a position to produce scenarios. The cost of risk measured by banks has increased very little between Q1 2019 and Q1 2020, perhaps too little for a large proportion of institutions (less than 2 basis points for 40% of the banks under our supervision), whereas it has increased substantially for a smaller set of European banks (more than 20 basis points for 9% of the banks).
With our March 2020 communication on IFRS 9 we acknowledged banks would find it challenging to produce IFRS 9 estimates for the first quarter and explicitly recognised that projecting a V-shaped recession, with a relatively fast rebound to long-term trends, was a legitimate assumption, in the absence of reliable information. However, we are observing that the depth of the V shape projected by banks is in some instances too optimistic and that further assessments are needed on banks’ concentration of exposures towards the economic sectors that are proving most affected by the COVID-19 shock (e.g. retail and wholesale trade, manufacturing, hotels and restaurants, etc.).
In this regard, the recently published June 2020 Eurosystem staff macroeconomic projections are a call for prudence. They tell us that GDP in the euro area, in the central scenario, is expected to fall by 8.7 percentage points this year, and gradually approach again March 2020 values only by end-2022. These projections, which incorporate a very severe recession in the first two quarters of 2020, will offer banks a more reliable and conservative macroeconomic yardstick for their impairment measures in the second quarter results. There is however also a scenario whereby a severe resurgence of COVID-19 infections and related lockdown measures materialise after the summer. This scenario, which is a possibility according to health authorities, would lead to a much deeper fall in GDP and a much slower recovery path that would see the euro area still 5% below the March 2020 level at the end of 2022.
In order to assess the potential impact macroeconomic developments could have on banks’ balance sheets, we have recently started carrying out a vulnerability assessment. The exercise, performed without burdening institutions with additional data requests, aims to assess how banks would perform under the 2020-2022 ECB baseline macroeconomic projection. Also, and most importantly from a prudential perspective, we will check if currently available capital buffers would be sufficient to cover the losses stemming from the adverse developments of a second significant round of pandemic contagion and lockdown measures.
The exercise will also inform our supervisory assessment of banks’ risk management choices, and more generally our supervisory assessment of the prudential position of individual credit institutions.
I hope to be able to publicly discuss the outcome of the exercise around the end of July and, with it, provide you and all market participants with more clarity on the path which will lead us out of this environment of extraordinary measures and back to a much anticipated normality.
I am looking forward to our exchange of views.