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Supervision in times of uncertainty

Keynote speech by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, at the European Confederation of Institutes of Internal Auditing (ECIIA) Banking Forum

Brussels, 29 October 2020

It is a pleasure to be here today and I would like to thank the organisers for inviting me. Fifty one years ago to this day, the first computer-to-computer connection was established through ARPANET, the early forerunner of the internet. This first host-to-host node has evolved into the vast global network which makes our virtual gathering possible today, with speakers and audience members tuning in from all over Europe.

In my remarks today, I will discuss the challenges that the coronavirus (COVID-19) pandemic has posed for banks and banking supervisors alike, and I will highlight the instrumental role that internal auditors can play in navigating this crisis. I will first recap the supervisory measures that ECB Banking Supervision has taken since the start of the pandemic and stress how important it is that banks actually make use of the regulatory flexibility provided for in the law. I will also outline the intricacies hidden behind the clouds of uncertainty that currently surround the macroeconomic outlook. I will then discuss how banks can play a part in clearing some of the haziness ahead and plan for a sustainable future by considering digitalisation and consolidation strategies and by proactively enhancing their credit risk management. Finally, I will look further ahead and consider some of the challenges that are likely to lie in store for banks, including some old issues that will persist, regardless of what the future may bring.

Supervisory measures and challenges during the pandemic

Let me start by outlining our supervisory response to the crisis. Since the outbreak of the pandemic, ECB Banking Supervision has been keen to communicate to markets, banks and other stakeholders the rationale behind the extraordinary measures we have taken. Our ultimate goal has been to help create the conditions for banks to be able to keep the flow of credit to the real economy as steady as possible. This, in turn, should allow for the seeds of the recovery to be sown at an early stage. To this end, we gave banks significant capital and operational relief.

On the capital side, we have allowed banks to operate temporarily below the level of capital defined by the Pillar 2 guidance, the capital conservation buffer and the liquidity coverage ratio. Banks have also been allowed to partially use capital instruments that do not qualify as Common Equity Tier 1 capital, for example Additional Tier 1 or Tier 2 instruments, to meet the Pillar 2 requirements.

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. We also granted banks temporary flexibility in relation to their management of non-performing loans (NPLs), loan loss provisioning and loan classifications. Our goal is to help smoothen the implementation of the loan guarantee and loan moratorium schemes that have been adopted by national governments. Finally, to keep capital within the system, we recommended that banks suspend dividend payments and refrain from buying back shares until end of this year.

At the same time, we have repeatedly encouraged banks to take advantage of all of the regulatory flexibility allowed by current legislation and use their capital and liquidity buffers to absorb losses lend to the real economy. Banks should not be concerned about being stigmatised for using these buffers or needing to quickly replenish them, as we have also repeatedly reassured them that they will be given enough time to rebuild their buffers once the most severe period of the crisis is over. ECB simulations show that using the buffers would support higher GDP growth and, as a result, credit losses would be lower, leading to higher bank profits. The positive effect on credit quality and profits would almost completely compensate for the effect of balance sheet expansion, so that the overall capital position of the sector would be broadly similar both when buffers are used and when they are kept intact.[1]

But banks must be cautious and also play their part. I presume that there are many internal auditors in the audience today. With this in mind, I would like to highlight the instrumental role that banks’ internal audit functions play in keeping the risk profile of banks in check. As the people in charge of providing independent assurance of the quality and effectiveness of banks’ internal control, risk management and governance frameworks, it is your responsibility to inform the board of directors and senior management of any material issues identified. During testing times such as these, the primary focus needs to be the risk areas most affected by the COVID-19 crisis, namely credit risk, liquidity and capital planning, and IT and cyber risk. Furthermore, it is fundamental that, as internal auditors, you remain agile in reprioritising tasks and are able to adapt your practices to a reality in which internal audits are performed mostly off-site and online.

Let me reassure you that, as supervisors, we are firmly committed to ensuring that the adjustments banks have had to make in response to the pandemic shock follow a risk-based approach. These adjustments must not jeopardise the activities of the internal control function and its key role as an independent third line of defence. We expect banks’ internal control functions to continue to have full access to the board, including in a remote working environment. In these critical times, our joint supervisory teams very much count on internal auditors maintaining an open dialogue with them, so that, together, they can ensure that banks’ critical weaknesses and heightened risks are identified in a timely manner, and that risk mitigation measures are duly implemented.

ECB Banking Supervision is also playing its part in terms of risk identification. In April we created dedicated task forces to assess the most pressing risks from this crisis and to identify emerging ones. The aggregate results of this vulnerability analysis were encouraging to the extent that the overall capital shortfall in the most likely scenario would not stop most banks from operating. However, we identified substantial differences across business models and banks, which suggest that some banks are bound to face serious difficulties in the future – even if the future is still clouded by a high degree of uncertainty. I will turn to this issue next.

Near-term uncertainties

As the supervisors of the system, we knew that the euro area banking sector was, on aggregate, on a stronger footing at the start of this crisis than it was at the start of the great financial crisis of 2008. The fact that European banks were able to survive the first, most severe hit from the crisis seems to confirm this notion. However, this does not mean that we are out of the woods. Let me explain why.

First, although expectations of the euro area’s future macroeconomic performance have recently stabilised[2], we must keep in mind that the overall macroeconomic environment is still subject to a high degree of uncertainty. The baseline scenario of our projections cannot be taken for granted and the possibility of a double-dip recession cannot be ruled out yet, as the new restrictions being implemented across the euro area to curb the current resurgence of COVID-19 cases will again increase uncertainty for households, corporates and banks.

With such uncertainty clouding the macroeconomic picture, it is not surprising that the outlook for the banking sector itself is still unclear. The latest data on banking performance is dismal, with banks’ return on equity averaging zero in the second quarter of 2020, down from 6% a year earlier. But it is difficult at this point to make an accurate prognosis on future euro area bank performance, as banks’ balance sheets remain somewhat distorted by the loan moratoria and the loan guarantees that governments have extended to bank customers and to banks themselves.

Second, we must remember that the euro area banking sector has itself been the beneficiary of unprecedented measures taken by different stakeholders to keep the economy afloat during the pandemic. In addition to our supervisory response, banks have also benefited from an extraordinarily accommodative monetary policy, as well as from other measures taken by fiscal and macroprudential authorities in different countries. It is difficult to disentangle bank performance from the combined influence of such measures, and academics may wonder about the resilience of the banking sector had these not been deployed. From a policy point of view, however, the main question going forward is whether the pace at which these extraordinary stimulus measures are withdrawn will result in severe cliff effects rather than the desired soft landing outcome for the banking sector as a whole.

Although banks are at the receiving end of decisions by policymakers in different domains, there are still a few areas where the banks themselves could do more to ensure they are better prepared for the uncertainties which lie ahead. A number of European banks are highly exposed to the hardest hit economic sectors: as of August 2020, roughly 10% of all loans to the most vulnerable sectors were covered by EBA moratoria and other COVID-19 forbearance measures. Of course this does not mean all these loans will go sour, but it does highlight the importance of banks being pro-active in guarding against potential cliff-effects in the future.

Thus, one area of focus going forward must be credit risk management. A number of European banks are highly exposed to the hardest hit economic sectors. In the second quarter of the year, however, there was only a slight increase in NPLs and the share of loans classified as being at risk. Of course, when government loan moratoria expire and defaults materialise, we expect non-performing exposures to increase significantly. In an extreme scenario involving a second round of lockdowns, which is not the baseline foreseen at the moment, NPLs could reach €1.4 trillion in Europe. This would be higher than the peak registered after the great financial crisis.

It is therefore important that banks complement the operational flexibility granted to them in relation to their NPL management with effective strategies for monitoring loan deterioration that allow them to identify risks at an early stage. By engaging with potentially distressed borrowers in a timely manner, distinguishing viable distressed customers from non-viable ones and adopting prudent provisioning practices, banks can help to minimise potential cliff effects when moratoria are lifted. This would also provide greater clarity on banks’ balance sheets, particularly as regards the trajectory of asset quality – a key indicator used to inform realistic and reliable capital planning by banks. Having such elements in place would help us in our review of the recommendation to suspend dividend payments, which we will complete in December.

Navigating the more distant future

Although the pandemic has clouded the outlook for the banking sector and near-term developments are still subject to high uncertainty, it has also shed light on some stark realities which are likely to be permanent features of the European banking sector in the medium term. Let me give you some examples.

First, the structurally low profits of some European banks and their persistent inability to earn their cost of equity will compromise their survival in the medium term. The COVID-19 crisis has exacerbated this challenge, but the underlying principle still applies: banks will need to continue to adapt their business models to the new circumstances if they want to ensure their sustainability, including by securing sustained investor interest and, through it, access to capital.

Second, it is also very likely that the trend towards digitalisation becomes an underlying assumption in banks’ planning. Any viable strategy for the future has to consider significant investment in technology as essential for a bank to not only survive, but also thrive. The pandemic has triggered a decisive push in the demand for digital products. Some of the expected unbundling of traditional services is already occurring, and powerful new competitors are entering the market: non-bank competition and competition from newly established credit institutions with specialised business models have never been higher, with the number of applications submitted by institutions with fintech-oriented business models increasing again in 2019, for the fourth year in a row. Taken together, this implies that banks must pursue ambitious digital transformation plans. In order to sustain this, banks will need to thoroughly 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 – a new wave of mergers is taking place among Europe’s largest banks, while consolidation among less significant institutions is also continuing. The number of less significant institutions has decreased by around 800 since the start of the European banking supervision in 2015.

Third, the nature of the relationship between banks and their governments will require continued attention by policymakers. 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. It was precisely this close association that took a particularly pernicious form during the euro area sovereign debt crisis of 2011-12, and it is the very issue that the creation of the banking union was meant to tackle in the first place. With governments increasing their supply of sovereign debt amid the pandemic and banks searching for yield and investing in sovereign bonds, this problem might become worse in the period ahead. This could be an issue for smaller banks in particular, which suffer from a lack of asset diversification.

Fourth, the COVID-19 crisis has shown the benefits of having pan-European structures to regulate and oversee banking activity in its different forms. This is true for significant institutions, which are directly supervised by the ECB, and for less significant institutions, which are directly supervised by the national competent authorities with the ECB in an overall oversight function. Since the onset of the pandemic, the ECB and the NCAs have acted together in a swift and coordinated manner. In so doing, we have been able to refocus part of our supervisory attention on the immediate mitigation of the fallout from the crisis, without losing sight of the medium-term challenges that are likely to remain relevant for the banking sector as a whole. This outcome is testament to the validity of the banking union in Europe, but we must acknowledge that this structure is still incomplete, and that progress in some of its constituent pillars is still lacking, especially as regards a common deposit insurance scheme. Work to finalise the banking union as political leaders foresaw it back in 2012 must therefore continue.


In conclusion, I hope to have persuaded you that, although banks were on a sounder footing going into this crisis and supervisors took action from the outset, the full consequences of the pandemic for both banks and banking in general remain to be seen. It is undeniable that, in the near term, we will continue to wrestle with this uncertainty when devising our path to the future. In this regard, I have outlined that there is a case for coordination among different stakeholders, so that the eventual withdrawal of the extraordinary stimulus measures provided to the banking system is as smooth as possible.

I have also argued that banks need to provide greater visibility on realistic asset quality and capital path trajectories to help supervisors make informed decisions. And here, internal auditors have a role to play in promoting efficient and fair processes within banks.

Lastly, while there are many known unknowns in this crisis, some elements are as familiar as ever – these include the need to restore bank profitability, overcome the challenge of digitalisation, redress the relationship between banks and their sovereigns, and complete the banking union. All of these topics are likely to be an integral part of any medium-term policy agenda from a supervisory point of view.

Regardless of what the future may bring, I am convinced that we will be better able to address the challenges that lie in store if we do so through strong, pan-European structures rather than self-standing national solutions.

  1. ECB Banking Supervision (2020), Buffer use and lending to the real economy, July.
  2. ECB (2020), ECB staff macroeconomic projections for the euro area, September.

European Central Bank

Directorate General Communications

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