ECB Banking Supervision’s post-pandemic priorities – the way forward

Keynote address by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, at the SmithNovak Global NPL Summit

Frankfurt am Main, 5 October 2021

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

In my speech today, I will share some reflections on the challenges and priorities that lie ahead for the banking sector.

In a nutshell, I will convey three main messages, namely that we need to avoid risk complacency, effectively incorporate climate risks into risk governance frameworks, and address structural challenges to the sustainability of European banks’ business models.

On the first point, let me say that, in this crisis, the banking sector has shown itself to be much more resilient than in previous crises of a similar magnitude. The results of the recent stress test exercise conducted by the ECB are indicative of increased banking sector resilience and suggest that euro area banks could cope with further adverse economic developments should they materialise. This is the result of regulation and supervision, which have pushed banks to build up greater capital and liquidity buffers, reduce their legacy stocks of non-performing loans and strengthen their risk management frameworks. It is also the consequence of the coordinated response by different authorities (monetary, supervisory, regulatory and fiscal) to the coronavirus (COVID-19) crisis. Their measures, which were complementary and unprecedented in scale, have helped to keep the credit channel to the real economy open.

Nevertheless, it is important to emphasise that a number of risks – both directly and 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COVID-19 shock has yet to materialise on banks’ balance sheets and may only do so once government support measures are withdrawn. This means 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. However, we have 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systems and procedures for assessing borrowers’ unlikeliness to pay are overly reliant on ineffective indicators, outdated ratings and backward-looking information. A striking example of this is the fact that two-thirds of the banks we reviewed earlier this year were estimating the probabilities of default in sectors heavily affected by the pandemic as being lower for new loans made today than they were before the crisis. This is clearly counter-intuitive and is no doubt the result of government support measures leading to the very low rates of default seen in recent months, and those low rates of default being automatically integrated in risk metrics.

We have also observed some “search for yield” behaviour in financial markets, including by banks. This can be seen in the exuberance in asset valuations in certain segments of the equity market, increasing leverage by banks, and the ever more complex and opaque financial products being traded by banks.

Our message here is clear, bank governance needs to address this immediately. These practices that lead banks to underestimate risk should be corrected today if we want to avoid turbulence tomorrow.

My second point also relates to an issue that requires urgent action. Banks need to make significant progress in including climate-related and environmental risks in their strategy and risk governance. ECB Banking Supervision carried out an extensive survey of banks’ self-assessments against our supervisory expectations on climate-related and environmental risks. The results are somewhat mixed. On the one side, banks are now clearly aware of the importance of this subject, with a large majority deeming these risks important for their business model. But, on the other side, 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. What is lacking, even in 80% of the banks that deem climate-related and environmental risks very important for their business model, is the definition of a clear strategic and operational framework to deal with these risks in their day-to-day operations. The underlying issue is mainly the unavailability of adequate data.

But the good news is that many pieces of the climate-related and environmental risk puzzle can already be found scattered across the banking union. Banks have started asking for more data from their customers and are also using proxies when data are unavailable. The progress that we have identified can be seen in banks from different countries, with different business models and different asset volumes. This confirms that what we are asking of the banks can be done. The ECB will see to it that every bank is making swift progress in embedding climate and environmental risks into their organisations. Next year we will conduct a full supervisory review of banks’ practices for incorporating climate risks into their risk frameworks, as we gradually roll out a dedicated Supervisory Review and Evaluation Process (SREP) methodology that will eventually influence banks’ Pillar 2 capital requirements. ECB Banking Supervision will also carry out a supervisory stress test focusing on climate-related risks, the methodology for which will soon be shared with the banks under our supervision. Let me clarify that the outcome of our supervisory exercises next year will be reflected in qualitative measures. A possible quantitative impact – if any – will be indirect, via the SREP scores on Pillar 2 requirements, and no bank-specific results will be published. But this is because it is only the beginning of the journey. Things may change in the years to come, given the prominence of the issue and the fact that all evidence points to the need to accelerate the transition to a greener economy. Banks need to be able to treat climate-related and environmental risks like any other risk. To do so, they must adapt their strategy and risk governance practices, and this needs to start now.

Finally, let me stress that the path out of the pandemic also needs to address the structural challenges to the stability of the banking system. These challenges were already present before the outbreak of the pandemic but have been exacerbated by the COVID-19 shock, making the need for action in this area all the greater. A major challenge is profitability: even though it is now returning to pre-pandemic levels after the shock of 2020, profitability levels before the crisis were lower than in other large banking systems, such as the United States, and lower than the implied market cost of capital . This makes raising capital difficult, which is an issue at a time when banks need to be able to invest, particularly in digitalisation.

During this crisis the sustainability of businesses – banks included – has hinged decisively on technology. But the trend towards digital 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 is therefore needed to face up to the competition generated by newly licensed and digitally savvy providers and to cut costs. This may prove essential as European banks try to further reap the benefits of the Single Market. A certain degree of consolidation within the European banking sector – which can help banks achieve the necessary scale to strengthen their business models – and organic growth through branches providing cross-border services should also help here. But investing in digitalisation will be key to ensure cost savings and revenue growth. As the full effects of this investment will only emerge in the medium term, the journey needs to begin as soon as possible.

I will conclude by sharing our overarching perspective on these three main points: the way out of the pandemic is an opportunity for the banking system to fulfil its role of financing the much needed transformation of the economy, which is essential to ensure its sustainability. To this end, it is vital that banks ensure their own path to sustainability, and this calls for effective and decisive action starting today.

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