What are the priorities for ECB Banking Supervision amid the pandemic?

Conversation between Kerstin af Jochnick, Member of the Supervisory Board of the ECB, and Tuba Raqshan, Journalist for Asset News, at L’AGEFI Global Invest Forum in Paris

9 October 2020

We could begin with your experience as a part of the ECB Banking Supervision team during the coronavirus (COVID-19) crisis. What were the challenges faced and measures employed during the unprecedented crisis?

As you rightly point out, this crisis was unprecedented. We knew that the banking system as a whole was well capitalised and on a stronger footing than before the 2008 financial crisis, but we had no clarity on the extent of the economic consequences of the pandemic.

From the outset, our goal was to help ensure that banks would be able to continue lending to the real economy – throughout the lockdown and the subsequent economic recovery. To this end, we gave banks significant capital and operational relief on a number of fronts.

On the capital side, for example, we eased our expectations on the quality of the capital and liquidity buffers that banks need to hold, and allowed them to operate below their Pillar 2 guidance, at least until we’ve overcome the most severe period of this crisis. So far, our measures have resulted in total capital relief of around €120 billion^[1] for banks.

On the operational side, our measures included suspending the implementation of some of our supervisory decisions for six months and extending the deadlines for the implementation of some remediation actions stemming from on-site inspections and internal model investigations.

While these extraordinary measures to help the banking sector were being devised and implemented, we had to adapt our own supervisory approach to accommodate a new reality of social distancing and travel restrictions. In this sense, the COVID-19 crisis has been a challenge for supervisors, too. For one, we had always exercised our supervisory scrutiny of banks through on-site inspections and meetings with the banks’ representatives, but the pandemic made these tools unavailable. So we then had to start conducting off-site inspections and off-site internal model investigations. And we requested regular updates from the banks on risks that may be particularly heightened during this crisis, so that pressing vulnerabilities are flagged early on and we are able to address them promptly.

These are just some of the many instances of how we have adapted. Overall, I am pleased to say that the Supervisory Board decided consensually on all of the supervisory measures, within a short time span and with most of us working remotely – thereby belying the frequent claims by critics of the European project that European-level decisions are cumbersome and time-consuming. If we want the banking union project to deliver on its promise, then institutional agility is clearly a necessary – if not sufficient – condition.

Euro area banks have been directed to hold out on dividend payouts and share buybacks beyond October 2020 – could you please touch upon the factors behind this decision?

We decided to prolong this recommendation in July 2020 for the same reason why we issued it in March 2020 in the first place: we are facing material uncertainty about the future and the extent to which the pandemic will hit the economy is still unknown; that has been preventing banks from accurately projecting their capital trajectory. We are aware of the differences in resilience across European banks, but we will gradually have a clearer picture of the banks’ situation and their deterioration in asset quality once moratoria measures in European countries have been lifted – until then, we prefer to err on the side of caution.

The goal of this measure has not changed – it aims to preserve banks’ capacity to absorb losses and ensure that they are able to take the economic hit from the pandemic and continue to lend to the real economy for the duration of the crisis. Prudent capital planning is absolutely essential in the current situation; better to be cautious today than sorry tomorrow should overall economic conditions deteriorate further.

We will adopt this stance until we consider that the uncertainty looming ahead no longer prevents banks from producing reliable estimates of how their balance sheets will be affected by the pandemic. We have been closely monitoring the economic environment, the stability of the financial system and the reliability of banks’ capital planning. Taking all these into account, we will decide on whether or not we would like to see banks continue to refrain from paying dividends or buying back shares beyond 2020. No decision has been taken yet.

Once we consider that this uncertainty is materially subsiding and that banks’ capital projections are reliable enough, banks with proven sustainable capital positions may consider resuming dividend payments.

Did stress tests play a key role in addressing the COVID-19 crisis?

In general, stress tests are an important supervisory tool because, among other things, they assess how much of banks’ capital would be depleted if the economy took a turn for the worse – and, ultimately, whether banks would be able to survive a shock such as the scenario that has played out during this pandemic.

In normal circumstances, the ECB would have conducted a fully-fledged stress test in 2020. However, after the outbreak of the coronavirus pandemic, we decided, together with the European Banking Authority (EBA), to postpone this exercise until 2021, because banks now need to focus their resources on coping with the serious challenges brought about by this unprecedented shock. At the same time, we should not lose sight of what is happening in the banking system, precisely when it is being subjected to a real-life stress test.

Ultimately, we decided to reconcile these objectives and conduct a focused vulnerability analysis of a sample of Europe’s largest banks, using the EBA stress test methodology as a starting point. This gave us an initial overview of the main and most immediate risks facing banks in the midst of this crisis. The aggregate results of this exercise, which we published in late July, suggest that while, in the most likely scenario, a number of banks will need to take action to remain compliant with their minimum capital requirements, the overall capital shortfall would not stop most of them from operating. However, we do see substantial differences across business models and banks, and the potential for material tail risks; some banks are bound to face serious difficulties in the future, once moratoria are lifted and the real effects of the pandemic start to materialise on banks’ balance sheets.

As the new normal sets in, how do you see banking supervision norms evolving? What are the key considerations?

We must bear in mind that, at present, banks’ balance sheets may be distorted by the moratoria which governments have extended to bank customers. For example, risk-weighted assets are expected to increase when moratoria expire and default rates rise, as a result of both the weaker economic situation and the heightened economic risks, but so far they have remained stable. As supervisors, we are concerned about these potential cliff effects which might ultimately affect bank capitalisation.

Bearing this important caveat in mind, the recent trends in bank performance may nonetheless indicate what could be in store for the banking system as a whole. For example, the structurally low profitability of European banks, which was already an issue before the outbreak of the pandemic, has taken a turn for the worse: European banks’ return on equity stood at zero in the second quarter of 2020, having decreased sharply in the first quarter due to higher credit impairments and lower net interest and fees and commissions income.

Given the build-up of expected losses, we have repeatedly encouraged banks to use their capital and liquidity buffers to absorb losses and extend credit to the economy during the crisis. The release of the buffers is perfectly in line with the spirit of the post-crisis reforms designed by the Basel Committee on Banking Supervision: banks have been required to build capital and liquidity buffers so that they can sustain the economy during a severe adverse shock, rather than acting procyclically by excessively restricting lending to preserve capital.

Looking beyond the question of buffer usability, we think that talk of the new normal following the pandemic is still premature. We are in the midst of the pandemic, so our view of the future is still clouded by uncertainty. We will remain vigilant and prudent in devising the path ahead and considering whether we should extend our recommendation that banks should suspend dividend payments and whether we should recalibrate some of the measures we introduced in March.

Non-performing loans (NPLs) are expected to rise – do you think this could affect the banks’ capital buffers? What is the ECB’s strategy?

We do expect a rise in non-performing exposures, particularly once the effects of the mandatory payment moratoria decreed by several euro area governments expire. We are already seeing the cost of risk increasing for many banks relative to 2019.

For now, many banks seem reluctant to formally recognise any significant increases in credit risk on their exposures. There is a risk of significant cliff effects at some point in the future; research shows that during the previous financial crisis, banks took a long time to fully recognise NPLs and NPL levels peaked at a much later stage. We also signalled to banks back in March that we will accommodate, to a reasonable extent, revisions of their NPL targets for the years ahead, in order to help them cope with the impact of the current economic downturn.

At the same time, it is especially important in crisis times for banks to have in place tight loan deterioration monitoring and management strategies which enable them to identify risks at an early stage. They should proactively identify and engage with potentially distressed borrowers. By acting in a timely manner, banks can minimise any potential cliff effects when the moratoria measures begin to expire. Let me underline here that the ECB had issued guidance to banks on how to deal with NPLs well before the start of the current crisis; in March 2017, to be precise. Now is the time for banks to consider our guidance and follow it closely.

Has COVID-19 made the case for a banking union much stronger?

The COVID-19 crisis has clearly shown the benefits of having pan-European structures to regulate and oversee banking activity in its different forms. By applying the stricter and more harmonised regulation that was put in place after the global financial crisis, and by developing practices and norms to bring the entire system to a higher common supervisory standard, ECB Banking Supervision has made sure that the European banking system as a whole is better poised to withstand severe crises such as this one. Needless to say, this time around our success is not only attributable to the ECB as supervisor, but also to the ECB’s monetary policy response, and to the fiscal response by governments, which has been larger and more coordinated than ever before.

However, there should be no room for complacency. The fact that the banking union has successfully weathered the challenges brought about by the COVID-19 crisis thus far does not necessarily imply that it will continue to do so indefinitely – whether in other stages of this crisis or in similar situations. And this is essentially because the pan-European architecture foreseen by political leaders when establishing the banking union remains incomplete. Let me mention a few areas where progress is still needed.

First, we should strive for consistent outcomes in resolution and liquidation within the euro area, by harmonising the framework for exits from the market by non-viable banks that are not subject to resolution measures. And second, in order to make the banking union fully operational, we need to put in place a European deposit insurance scheme. In addition to securing deposits at European level, EDIS will also make it easier for the European and national legislators to eliminate the remaining regulatory provisions trapping capital and liquidity within national borders. These are just a few of the areas in which we should strive for more progress.

Finally, what are the key challenges to banking supervision in the future?

This pandemic is likely to accelerate some of the trends which were already under way before the crisis. Let me give you a few examples.

First, the low profits of European banks will continue to be one of our biggest challenges. The performance of European banks in the first half of 2020 suggest that some banks’ persistent inability to earn their cost of equity will seriously compromise their survival in the future. Fundamentally, banks need to find the right business model and stick to it if they want to ensure both their sustainability and investor interest.

Second, digitalisation will become an integral part of banks’ business models; the pandemic has triggered a decisive push in the demand for digital products. Banks will need to revise their cost structures or consider other revenues that will allow them to take on higher investment in technology while keeping profits afloat. Consolidation could be one way of dealing with this dual challenge while also helping to reduce the current excess capacity in the European banking system. I am happy to see that consolidation seems to be picking up in Europe.

Interestingly, the response to the pandemic risks bringing back some ghosts from the not-so-distant past. Policymakers should guard against a revival of the bank-sovereign doom loop. Though appropriate for dealing with the current crisis situation, extending government guarantees to banks and decreeing payment moratoria for banks’ customers has temporarily reinforced the linkages between domestic banking systems and their respective sovereigns – which is the issue that the creation of the banking union was meant to tackle in the first place.

And as I have said before, completing the banking union will be fundamental to reaping the full benefits from any recovery avenues we choose to take. European history, both recently and in the more distant past, suggests that tackling shared challenges together yields better results than going at it alone.