European banks – how have they coped with the crisis and what lies ahead?

Speech by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, at the Handelsblatt Banking Summit 2021

Frankfurt am Main, 8 September 2021

Introduction

It is a pleasure to be here and I would like to thank the organisers for inviting me.

In my speech today, I will first share with you some reflections on how European banks have fared to date during the different phases of the pandemic, before going on to discuss the challenges and priorities that lie ahead for the banking sector in a collective sense.

In a nutshell, I will convey three main messages. First, European banks have thus far emerged relatively unscathed from one of the most severe crises on record. In a further sign of increased banking sector resilience, our recent stress test exercise suggests that most banks would be able to withstand yet another economic crisis if this were to materialise in the period ahead. This strengthening of the banking sector, when looked at in aggregate terms, is partly attributable to the regulatory overhaul in the years since the great financial crisis. Together with an unprecedented policy response to the crisis, including by central banks, supervisors, and governments, this overhaul has enabled European banks to support the real economy through the hardest periods of the coronavirus (COVID-19) crisis.

Second, although the banking sector has been shown to be more resilient than in past crises of a similar magnitude, it is important to underline that a number of risks – both directly or indirectly related to the pandemic – still need to be addressed. The full impact of the COVID-19 shock has yet to materialise on banks’ balance sheets. This implies that proactive and advanced risk management tools will be crucial to keep credit risks in check and thereby safeguard the bank lending channel’s ability to support the real economy going forward. In addition, the “lower for longer” interest rate environment which the pandemic has prolonged has also been associated with increased “search for yield” behaviour in financial markets, including by banks. We have thus started to see exuberance in asset valuations in certain equity market segments, growing leverage in credit and financial markets, and ever more complex and opaque financial products being traded by banks.

Third, cyclical considerations aside, we should continue to be aware that several structural areas still need to be addressed, which will require the attention of both bankers and policymakers. These shortcomings are unrelated to the pandemic per se – they were already apparent before its outbreak – but some have been exacerbated by the COVID-19 shock. Insofar as bankers are concerned, investment in digitalisation, while costly in the near term, could serve as a potential avenue for banks to shore up both their business models and their financial bottom line.

Profitability issues aside, business model sustainability also implies that banks must put more focus on addressing climate-related risks. As regards policymakers, we must pursue the full implementation of Basel III to cement banking sector resilience. Rigorous global rules will foster robust banks and a global level playing field, which should help banks attract the investment they need to scale up and develop sustainable, future-proof business models.

From an institutional standpoint, work to complete the banking union should proceed in earnest. We should not think that the banking union is sustainable in its present, unfinished form just because it has successfully coped with the challenges brought about by the pandemic thus far.

In the remainder of my remarks, I will build on the narrative which I have just described, first by looking back, and subsequently by looking ahead.

Looking back: crisis response and banks’ resilience

Let’s start by looking back. Contrary to what occurred in the aftermath of the great financial crisis, the COVID-19 shock has not been associated with a deeply procyclical reaction by the banking sector. This can be attributed to three factors. First, the Basel III reforms implemented after the great financial crisis enabled banks to build greater capital and liquidity buffers, which they were able to use to withstand the COVID-19 crisis. Second, the response – unprecedented in scale and complementary in nature – by different authorities (monetary, supervisory, regulatory, and fiscal) to the COVID-19 crisis helped to stabilise the banking sector and keep the credit channel to the real economy open. Third, I would also put it to you – although it’s a conclusion I am partial to – that increased supervisory scrutiny by the ECB in recent years also contributed to this outcome, for example through our efforts to push banks to reduce their legacy stocks of non-performing loans (NPLs) and to strengthen their risk management frameworks.

The results of the recent stress test exercise conducted by the ECB are also indicative of increased banking sector resilience and suggest that euro area banks could cope with further adverse economic developments should they materialise in the period ahead. The Common Equity Tier 1 (CET1) capital ratio of the 89 banks in the stress test would fall from 15.1% to 9.9% if banks were exposed to a three-year stress period from 2021 to 2023 marked by challenging macroeconomic conditions. In this adverse scenario, capital depletion is driven mostly by credit risk (loan losses) and, for larger banks which are more exposed to equity and credit spread shocks, by market risk (losses stemming from asset repricing adjustments).

One and a half years after the start of the pandemic, we can say that a rebound in euro area activity is under way. The ECB believes that banks’ capital trajectories have become more reliable in recent months. For this reason, we have decided against extending our recommendation that banks limit their dividend payments and share buy-backs beyond the end of September 2021. After that date, we will resume our assessment of banks’ capital and distribution plans as part of our regular supervisory process.

Looking ahead: near-term priorities

If we look ahead, a near-term risk for banks is that, as government support measures for banks and their customers (through guarantees and loan moratoria, respectively) expire, additional losses may still have an impact on banks’ capital trajectory. Beyond the mitigating effect government measures have on banks’ balance sheets, which could reveal itself once such measures are unwound, our concerns in this area are also influenced by the experience during the great financial crisis, when delayed NPL recognition and resolution by some banks led to an excessive stock of legacy assets. In turn, the balance sheet rigidities introduced by such non-performing assets hampered those banks’ profitability and ability to support the economic recovery.

ECB Banking Supervision has thus taken a number of measures to avoid the risk that the progress achieved in recent years in reducing NPLs is undone, in part or in full, in the period ahead. For example, we sent letters to bank CEOs in July and December of 2020 stressing the importance of accurately and proactively managing credit risk. Over the past few months, we have also taken an in-depth look at banks’ credit management practices.

Results have been mixed: while most banks have adjusted their credit risk controls in line with our supervisory expectations and to reflect the specific features of this crisis, others have shown substantial gaps that need to be addressed. We also found that some banks’ early warning systems and procedures for assessing borrowers’ unlikeliness to pay are overly reliant on ineffective indicators, outdated ratings and backward-looking information.

Beyond credit risk, there are other cyclical vulnerabilities which banks should guard against in the near term. For example, the prolonged low interest rate environment, which has become “lower for longer” as a result of the pandemic, has pushed financial market participants, including banks, into a search for yield. We have thus started to see exuberance in asset valuations in certain equity market segments, increasing leverage in credit and financial markets, and ever more complex credit products which increase market opacity. Against this backdrop, banks remain vulnerable to a potentially abrupt correction in asset prices, both directly through their holdings of risky assets and indirectly through their connections to bond and equity funds and other non-bank financial entities.

To guard against this risk, we plan to continue with our supervisory scrutiny of leveraged finance, which we started back in 2017 with the publication of dedicated guidance on such transactions. The expectations published back then have not been met consistently by banks and we are currently considering whether the deployment of qualitative and quantitative supervisory measures is warranted on a bank-by-bank basis.

Focus areas beyond the pandemic

Let me conclude by outlining four focus areas for banks and their supervisors that are structural, rather than cyclical, in nature. The need to address these issues was already evident before the pandemic, but in some cases the COVID-19 shock has exacerbated the perceived shortcomings and hence the need for concerted action in these areas.

The first area concerns digitalisation. During this crisis, the sustainability of businesses – banking included – has hinged decisively on technology. But the trend towards digitalisation was already well under way in the banking industry long before this crisis: customers were increasingly using digital platforms to conduct their banking operations and attaching a higher value to convenience, customer-friendly apps and cheap banking products. Digitalisation offers a route for banks to cut costs as well as face up to the competition from newly licensed, digitally savvy providers. This may prove to be essential as European banks struggle with persistently low profits and try to find more sustainable, future-proof business models. In this regard, a certain degree of consolidation within the European banking sector could help banks achieve the necessary scale to embark on digitally driven cost savings.

The second area relates to the management of climate risks. ECB Banking Supervision is currently benchmarking banks’ self-assessments against our supervisory expectations on climate-related and environmental risks. While some banks have started adapting their practices, almost all of them still have a long way to go to be fully aligned with our supervisory expectations. In some cases, where banks are extreme outliers, the ECB will impose a qualitative supervisory measure as part of the 2021 Supervisory Review and Evaluation Process. A full supervisory review (as well as a specific stress test focusing on climate risk) will then follow in 2022.

The third area concerns Basel III implementation. The Basel Committee’s decision to postpone the introduction of these standards by a year (to January 2023) to help banks deal with the immediate fallout of the COVID-19 shock does not change the ECB’s position that Basel III should be fully implemented in the EU. As I outlined earlier, increased capital requirements introduced by Basel III are one reason why banks have been part of the solution to the COVID-19 crisis, as opposed to being part of the problem, like they were during the great financial crisis. The ECB thus firmly believes that a full and timely implementation of this last set of international standards is in the interests of all stakeholders. This will require only limited adjustments in the short term but will deliver the necessary structural improvements to our regulatory framework as well as sizeable and long-lasting benefits for our economies at large.

The fourth area relates to the completion of the banking union. While we are continuing to improve and further harmonise European banking supervision, the completion of the banking union via a clear path towards the introduction of a fully-fledged European deposit insurance scheme remains vital. There is also agreement that further progress needs to be made to strengthen the crisis management framework. This is essential to ensure that European banks can play their role in an interconnected and digital European economy and can compete at the same level as their global peers.

The common theme across most if not all four areas is the risk that both bankers and policymakers are lured into a false sense of security. The fact that the crisis has been well managed so far should not lead to inaction.

To dispel this misperception, my personal recommendation would be to recall the disclaimer in fine print which has long featured in the brochures of many investment products, namely that past success is not a guarantee of future performance.

Thank you for listening.