Building the financial system of the 21st century
Speech by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, at the EU-US Symposium, Harvard Law School
Frankfurt am Main, 23 September 2021
Thank you for inviting me to speak today. It is a pleasure to join this discussion, as the dialogue between the European Union and the United States is of the utmost importance to the global coordination of the regulatory and supervisory agenda. This is why I would like, first, to address the most pressing issue for this cooperation: finalising the transposition of the Basel III reforms. I will then follow on with the most urgent forward-looking issue: the development of a wide-ranging strategy to address emerging risks, in particular environmental risks. And here, I would like to comment on the ECB’s innovative approach to climate risk stress tests and the way ahead.
Basel III reform and the EU process
ECB Banking Supervision is very clear. The agreement reached in 2017 by the Basel Committee – the last component of the Basel III reform – should be fully and timely implemented without further delay or change in substance. It is in the interest of all stakeholders in prudential banking regulation. The agreement relates to promoting consistency and trust in the calculation of risk-weighted assets. It strikes a sound balance between standardised and internal model-based approaches.
The reform of Basel III also increases the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment risk and operational risk.
Following the onset of the coronavirus (COVID-19) pandemic, the Basel Committee decided to postpone the implementation date by one year – from the beginning of 2022 to the beginning of 2023 – to avoid contributing to business cycle disruption. This means that it will be at least 2028 before we achieve full phase-in. We thus support the European Commission’s intention to initiate the implementation process in 2021, through a legislative proposal, and it is important for the proposal to be launched as soon as possible in the autumn. This will enable the legislators in the Council of the European Union and the European Parliament to agree on the proposal later and pave the way for implementation in Europe in 2023. Looking at past negotiations, this timeline is certainly tight. But it is important the timeline is followed so the fully phased-in standards can be applied in 2028, after the five-year phase-in agreed by the Basel Committee. Some in the banking industry may oppose the timeline, as well as part of the substance of the reforms agreed by the Basel Committee, arguing that the impact may adversely affect banks’ capacity to support the recovery from the pandemic shock. We do not see any benefit in further delay. In fact, the effects of the pandemic are unlikely to coincide with the timeframe for the full implementation of the Basel III reforms. Let me underline three points that go in this direction.
First, the European banking sector is currently striking a positive tone in its forward guidance statements, as evidenced by plans for dividend distributions. Indeed, the economic outlook for Europe is favourable: real GDP in the euro area is expected to grow above its pre-pandemic level during the first quarter of 2022, and corporate profits are expected to return to pre-pandemic levels by the end of 2021.
Second, according to the European Banking Authority’s recently published Basel III impact study, while the impact of the reforms is heterogenous across the sample of banks, most are currently already able to meet the new requirements. So, it seems likely that banks would be able to maintain lending to the economy even if some further pandemic-related losses were to materialise in the short term.
Third and finally, the recent ECB analysis of the macroeconomic impact of implementing the last leg of the Basel III reforms, which uses alternative economic scenarios with varying effects from the pandemic, shows that the short-run phase-in costs of the reforms in terms of GDP growth losses are outweighed by long-term resilience gains. This conclusion does not change under the various pandemic impact simulations, and the one-year implementation postponement to 2023 helps neutralise negative effects on bank lending.
Some have nevertheless argued that the output floor runs the risk – given, in particular, the specific nature of the European transposition of Pillar 2 – of double-counting and thus hampering unduly the capacity of lending. For our part, we have communicated that the ECB is ready to mitigate any unintended effects arising from the accurate implementation of the output floor, which should be fully implemented at the consolidated level, in the European Pillar 2. When setting our Pillar 2 capital requirements, we will avoid any double-counting of model risk and unwarranted regulatory drag from the recalculation of risk weights linked to the floor. If risk-weighted assets for the Pillar 1 capital requirements increase as a result of applying the floor, we will not let Pillar 2 requirements automatically rise in absolute value terms in the absence of a corresponding increase in the underlying risks.
Transition issues aside, for the longer-term picture, we should keep in mind that Basel III was devised to pursue important long-term structural goals with two key objectives.
The first objective is to make the banking sector more resilient. There is no room for complacency on the need for resilience. In fact, the pandemic provides a case in point. We were able to deal with the effects of the pandemic precisely because regulatory reforms over the past decade had placed the banking sector in a strong enough position to manage the crisis – an external shock of a magnitude not seen before in Europe. And the second objective is to preserve an environment that supports credibility in the international banking markets. Multilateral agreements ensure a proper functioning of global financial markets and a level playing field among banks. Effectiveness relies on the commitment of all signatories to full and timely implementation in their jurisdictions. Postponing or watering down these last Basel III reforms in Europe will jeopardise this common good that is key in preventing risks worldwide. Let me therefore emphasise the need to mutually reinforce our commitment to it, by ensuring that both sides of the Atlantic will proceed in the same direction and as coordinated as possible.
Stress tests and environmental risks
I will now turn to the second point: how to deal with emerging risks. For this transatlantic audience, I would like to focus on an issue that is truly global: environmental risks. Given the potential major impact of these risks on a bank’s business model, ECB Banking Supervision has been taking steps to encourage the banks under its direct supervision to incorporate climate-related and environmental (C&E) risks into their risk management frameworks and decision-making processes. There are two sides to the situation we have today: on the one hand, almost all directly supervised banks have developed implementation plans for C&E risks, and many have started to improve their practices. On the other, all banks still have several blind spots and may already be exposed to material climate risks. The ECB’s May 2021 Financial Stability Review suggests that this is the case for around 80% of European banks.
Further progress needs to be made. For that reason, we have embarked on an exercise which we hope, given its unprecedented scope and ambition, will be a milestone on the way forward: a bottom-up, bank-specific climate stress test. It will be a unique opportunity to promote improvement in two key areas: the definition of a concrete, comprehensive strategy for C&E risks and progress in the collection and use of data, especially from customers.
Regarding the first area, one preliminary result of the recent ECB survey on banks’ self-assessment of their alignment with our supervisory expectations on C&E risks shows that too many banks have not yet defined a strategy to manage these risks. Moreover, some have not yet begun to define an approach for assessing the impact of these risks on their business model and outlook. The root cause of this is a lack of adequate data to carry out the assessment and define a strategy. In fact, only one-quarter of those banks that consider their environmental risks to be material have developed risk indicators to manage the risks. This situation clearly cannot be deemed compatible with the sound and prudent management of a credit institution. ECB Banking Supervision will therefore insist on the need to have operational measurement and monitoring instruments from a risk management perspective. And there are ways to address the real issue of the availability of relevant data.
First, banks should enhance their use of available data – whether public or from third-party providers – as many are still failing to do so. Second, and most importantly for the development of their business, banks should collect new data on C&E risks from their customers. These data are key to their business and strategy. Roughly half of euro area banks have started to integrate climate risks into their customer due diligence. They have developed dedicated customer questionnaires to better understand the climate risks to which they are exposed, and they use this information when deciding to grant credit. In some cases, a specialised climate risk function uses this information to advise the bank on riskier transactions and customer acceptance. Some banks have also been proactively trying to overcome the scarcity of C&E risk data by independently developing their own indicators – such as financed carbon emissions, financed technology mix and energy performance certificates – to identify corporate customers with high sensitivity to climate transition risks. They have then set limits at the portfolio level to manage those risks. Banks should build on these best practices, which the ECB will soon publish in a report. We clearly expect progress to accelerate in the coming months. The stress test next year will give all an opportunity to build an initial quantified approach, which will then be refined and further developed. It will just be a first test, a starting point. So, clearly, we do not intend to use this stress test in the same way as the usual European stress tests, which directly shape Pillar 2 capital guidance, but to push forward with this progress. A possible impact on Pillar 2 – if any – will be indirect, via our assessment of banks’ global scores in our annual supervisory review process. But the important message is that, in the coming years, it is unlikely this issue of the capital impact of environmental risks will stop here, so our supervisory action will be pursued with this objective of fostering banks’ preparation in mind.
At the ECB we firmly believe that the lesson for the 21st century drawn from recent crises is that we need a proactive supervisory approach. This means finalising the capital-strengthening reforms, which clearly improve global resilience, but also pushing for improvements in managing the risks that will shape the current century. For this, we need to make innovative use of our supervisory tools, just like we are doing for stress testing. This does not mean we do not encourage international convergence also in these areas. Far from it! We will always pursue that goal. But, in the area of environmental risk, for instance, we see the need for progress before we can hope for consensus on capital-based rules. This is because, first and foremost, we need a reliable, common base of data and indicators of measurement. That is why we should push ahead, since the greater risk for us all is the risk of doing nothing.