The power of perception: COVID-19 and lessons in governance

Keynote speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at the Webinar for the presentation of the position paper on COVID-19 and Governance by the Italian Association of Financial Industry Risk Managers (AIFIRM) and Università La Sapienza

Rome, 30 October 2020

It is a pleasure to share my views with you today on the importance of solid bank governance in navigating the coronavirus (COVID-19) crisis. Though I am saddened by the fact that we cannot be together in person, I take some comfort in the fact that Italy and the state of New York, from where I speak to you today, are roughly on the same latitude.

And although they are both major tourist destinations, only in Italy can one admire Borromini’s Perspective while strolling through the gardens of Palazzo Spada, just a stone’s throw from La Sapienza. Borromini’s colonnade, built to appear twenty-five metres long, but actually measuring less than ten, with the columns on each side diminishing in size as one moves towards the small statue that stands at the end, offers a valuable lesson on the power of perception – and it is actually a fitting metaphor for our discussion on proactively managing the crisis ahead. What seems far away may well be closer than it looks. Banks would do well to bear that in mind when mitigating the adverse effects of the COVID-19 pandemic on the economy – and on their own balance sheets.

Let me elaborate by first recalling the extraordinary measures that ECB Banking Supervision has rolled out since the outbreak of the pandemic, and then discussing the impact of the COVID-19 shock on banks’ balance sheets and asset quality, as well as the decisive role of forward-looking strategies in mitigating the economic effects of the pandemic.

Supervisory response to COVID-19

The COVID-19 shock was unprecedented in our lifetime; but so was our response. Benefiting from the reforms undertaken since the last financial crisis, and armed with a common monetary policy and, for the first time, single European banking supervision, the ECB acted to contain the economic fallout where possible and to ensure that banks could continue lending to the economy through the most severe period of the lockdown and sustain the ensuing economic recovery. Our supervisory response is, I believe, well known to those of you who are listening to me today. We 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, such as Additional Tier 1 or Tier 2 instruments, to meet the Pillar 2 requirements. We gave guidance to banks on how to avoid excessive procyclicality when applying the international accounting standard IFRS 9. We provided banks with operational relief, too, by suspending the implementation of some of our supervisory decisions and recommendations stemming from both offsite and on-site supervision. And we granted banks temporary flexibility in their management of non-performing loans (NPLs), loan loss provisioning and loan classifications.

In a joint effort by many European countries to ensure that banks would be able to continue to support the real economy through this crisis without any major upsets, our supervisory action was accompanied by an extraordinarily accommodative monetary policy in Europe and the implementation of national loan guarantee and moratoria programmes. There is no playbook for what we are doing, but our collaboration in brainstorming and taking action has so far been a success. It is heartening to see the power of the banking union coming so strongly and effectively to the fore in this crisis. And I find it inspiring to see Europe acting so coherently to vigorously meet this health crisis by also taking steps to mitigate economic and financial disruption.

But owing to the measures that have been implemented, particularly the moratoria and the fiscal support, the full impact of the COVID-19 crisis will take some time to materialise on European banks’ balance sheets. Neither we nor the banks can afford to stand still, waiting and wondering, until then. Eight months into this crisis, with dismal data coming in and a second wave of infection upon us, helping banks to weather the current downturn is just as important as incentivising them to look to the future.

Immediate effects of the COVID-19 shock

Italian banks were on the front line of the crisis. Their impressive capacity for business continuity was emulated by banks in other European countries, thereby testifying to the banking union’s overall resilience.

But the recent trends in bank performance may indicate what is 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: the average return on equity of the significant institutions under our direct supervision fell to zero in the second quarter of 2020, after decreasing sharply in the first quarter of the year due to higher credit impairments and lower net interest and fees and lower commissions income. At the same time, European banks still endure excessive costs; for one, their branch structure is typically too large. In a scenario where remote access has become the norm, banks that had previously invested in digitising their processes and commercial channels have more easily adapted to the mobility restrictions of the COVID-19 reality. One way of addressing the dual challenge of investing in technology while keeping profits afloat is to explore options for business combinations. Experience in other countries shows that, in the aftermath of large shocks, healthy levels of orderly market exits are essential for a swift and successful recovery.

How banks deal with NPLs will also determine their ability to preserve profits. And although the level of NPLs has remained stable so far, we estimate that in an extreme – yet increasingly plausible – scenario involving a second round of lockdowns, NPLs could reach €1.4 trillion in Europe. This would be higher than the peak registered after the great financial crisis and would have material consequences for banks’ capital positions.

Regrettably – but not unexpectedly – the abrupt nature of the COVID-19 shock and the quick response it required weakened the governance of credit risk at some banks. We have seen staff being reallocated from the second to the first line of defence to manage increased workload. We have seen control functions clinging to irrelevant risk metrics and being slow to adapt to a new environment. And we have seen boards of directors that were too feeble to ensure effective internal management of the crisis. It is true that most of these issues are structural; indeed, our supervisory recommendations in last year’s supervisory cycle mainly concerned governance issues.^[1] But the current circumstances make it all the more urgent to address them.

Going forward, banks’ should be proactive in identifying and provisioning NPLs. And they should endeavour to preserve the independence of their risk management functions. These factors will be decisive in determining a bank’s ability to support the real economy and ultimately survive this crisis.

Lessons in governance

The good news is that, despite the continuing uncertainty, banks can already do a great deal to anticipate and start mitigating the effects of this crisis. This is where Borromini’s lesson comes in: perception is illusory; horizons can be closer than they appear, and the future may come sooner than expected. So banks must plan accordingly.

In practice, this means that all banks should start preparing for a worst-case scenario as soon as possible. Banks need to build up their operational capacity to process bad loans – particularly banks which have never had to deal with large volumes of NPLs before. They should be committed to identifying distressed borrowers and managing deteriorating assets as early in the process as possible, and definitely before moratoria expire. It is imperative that there be processes in place to differentiate weaker loans from less vulnerable ones, even though moratoria and government support may still be in place. To support this critical work, banks should ensure that their credit risk management is underpinned by robust governance. They need to be making adequate and timely provisions. All of this will help them prevent NPLs from piling up and should shed some light on the actual effects of this recession on banks’ balance sheets.

The impact of this crisis goes beyond specific types of lending and may spill over to entire sectors. Traditional approaches to credit processes and portfolio selection on a name-by-name basis need to be combined with more forward-looking methods, in particular by taking a sectoral perspective and analysing multiple scenarios. There are structural changes taking place in our real economy that may last longer than we would like, and it is time to recognise this.

Banks should identify vulnerable sectors, and then ensure that they have an aggregate view of their exposure to each of those sectors. They should also be quick to reflect any changes in the risk level of exposures under moratoria and of clients belonging to the most vulnerable sectors. The interplay between different management tools, such as early warning systems, watch lists, sectoral analysis and internal models, is crucial in anticipating unfavourable developments in loan and bond portfolios and detecting structural credit deterioration.

Only strong risk and control functions, supported by the management board, will be able to establish a forward-looking perspective and ensure adequate capital planning under various scenarios. Banks will only be able to continue to carry out their fundamental role of supporting the economy through these challenging times if they can effectively distinguish between viable and defaulting borrowers.

In a letter to banks’ CEOs in July^[2], we offered some suggestions on how they could manage their credit risk management functions during this crisis. For example, we advised them to quickly provide sustainable solutions to distressed but viable businesses. We also underlined the importance of banks paying sufficient attention to changes in the macroeconomic outlook and in the credit quality of their borrowers, and the need for them to devise metrics that provide a clear overview of emerging risks.

So far, banks seem to be behaving in one of three ways. Some have already started reassessing their clients’ default and bankruptcy risk. Others, while not reassessing individual loans, are nonetheless building up a general risk provision for their loan portfolio as a precaution. And then there are banks which still prefer to wait for a clear-cut indication that a client is going to go bust before they book any provision whatsoever. Deferring such a step until the last moment and waiting for moratoria to expire is unwise; if many of the bank’s clients subsequently fail to pay, everything will unravel at once.

Here, the experience of high-NPL banks in dealing with the legacy of the last crisis can offer a valuable lesson in perception to other banks across Europe which may now find themselves in similar circumstances. The NPL ratio in Italy has shrunk from over 16% at the beginning of 2016 to just below 8% in the first quarter of 2020, compared with the euro area average of 3.05%. Banks dealing with high levels of legacy NPLs have made impressive progress in operationalising their credit risk management processes. They have also set up NPL units that are dedicated to closely monitoring the quality of loans and ensuring they react quickly to any deterioration in balance sheet quality. Importantly, these dedicated units rely on high-quality data and thorough internal audit practices to assess the collateral and the quality of the credit line for each individual loan.

Beyond that, banks must also reflect on the implications of COVID-19 for their broader credit risk strategies. Both executive management and boards of directors must examine their existing credit risk strategy and consider ways of recalibrating it to operate in a COVID-19 and post-COVID-19 world. They should review the existing credit risk models, and their risk appetite framework more generally, to assess whether their underlying assumptions remain valid in the current environment and whether they still serve to monitor the bank’s risk profile in an effective way.

As the key persons responsible for measuring and monitoring risks, chief risk officers (CROs) must play a central role in this review exercise. They should ensure that internal models are well-connected to the business and to the market, and incorporate a range of different scenarios that reflect the current economic uncertainty. Forecasting and planning must take centre stage in banks’ governance frameworks. Banks must also enhance their risk data aggregation capabilities, their economic modelling know-how and the budgeting and planning processes they use in scenario analysis. Cutting-edge data management techniques will become essential. All this will enable CROs to have a far clearer overview of emerging risks. And finally, to make sure that banks keep their credit underwriting criteria in check and that their strategic planning remains adequate, CROs must have a direct line to, and regular contact with, both the chief financial officer and the board of directors. Independence does not mean expanding the distance between these critical functions.

The board of directors is the ultimate layer of quality control in a bank. The board must act as a compass for the whole institution and guide it through all situations, both good and bad. To live up to this task, boards of directors must not only be experienced and have the right expertise, they must also be diverse and attuned to the future as much as to the present. With this pandemic making the push for digitalisation stronger than ever, board members must be imaginative about the kinds of risk that are emerging, and there must be room for members that understand both the opportunities and the risks created by technology.

For a board of directors to be effective, it requires strong support structures. First, an effective board relies on an agile internal reporting framework that produces reliable information for the decision-making process. This can often be achieved by doing away with legacy IT systems and integrating the systems of all of a bank’s subsidiaries into the parent company’s infrastructure – streamlining, in other words. Second, an effective board has access to independent research and the right to request that such research be carried out, even outside the bank’s regular channels. Here, a dedicated and well-staffed secretariat or governance function can provide this support and help preserve the challenging power of the board, thus ensuring its decision-making is truly independent. In addition, a powerful internal function that manages the bank’s own organisational structure and changes its design to make it fitter for the most pressing priorities can significantly improve the strategic steering of boards. Such a function can prove particularly powerful in our current times.

ECB Banking Supervision represents the highest level of quality control for the boards of Europe’s largest banks. We work closely with national banking supervisors to ensure that the board members of European banks maintain minimum quality standards. While rigorous fit and proper criteria should be applied across all banks, and across all countries, some countries have implemented them in different ways.

So ECB Banking Supervision is going to go one step further and implement stricter and more intrusive fit and proper assessments. Let me give you a few examples. If our assessment finds that an individual is not suitable for the envisaged position, we will issue a negative decision in line with EU rules. We will also more closely scrutinise any relevant facts which may have a negative impact on the reputation of the individual in question, such as previous criminal convictions or ongoing judicial or administrative proceedings. We will examine the individual accountability of board members more closely – directors who are guilty of misconduct, or who turn a blind eye to the misconduct of their peers, will no longer be able to hide behind the collective responsibility of the board. In our revised Guide to fit and proper assessments, we will also clarify when and how the emergence of new material facts could result in us reassessing the suitability of existing bank directors. And we are making the necessary internal adjustments to supervise this issue more rigorously. We have strengthened our internal decision-making by creating a dedicated fit and proper department and an enforcement and sanctioning committee to strengthen independence and ensure due process.

Conclusion

Although the full impact of the COVID-19 crisis on the European banking sector will take some years to materialise fully, our projections of a severe, yet plausible, scenario suggest that we should expect the balance sheets and asset quality of banks to be seriously impaired.

Surviving this crisis will require decisive action from banks’ management boards and risk functions. The suitability of their board members and the effectiveness of their credit risk governance will ultimately determine whether they come out of it thriving.

Banks would do well to heed Borromini’s lesson on the power of perception: what seems far away may well be closer than you perceive it – and so, they must plan ahead. Getting through this crisis and the potentially massive increase in NPLs that it will cause will hinge on banks taking this lesson fully on board.