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  • Speech

Supervisory priorities and securitisation

Keynote speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at the 26th Annual Global ABS Conference

Barcelona, 14 June 2022

Introduction

I am very honoured to be invited to deliver this keynote address at the Global ABS conference in Barcelona.

I would first like to start by looking at the current state of the banking sector. After that, I would like to discuss how our supervisory priorities which we spelled out last year not only remain valid but are now more relevant than ever given current developments. I will conclude by reflecting on the role of securitisation in Europe’s financial architecture.

State of the banking sector

The war in Ukraine is on all of our minds. Before I talk about its impact on the European banking system, I think it’s important first to express our continued support for the people of Ukraine as they pursue their right to freedom and sovereignty. The war has brought about historic unity for Europe. We pray for peace.

While the war has changed the dynamics going forward, let’s first appreciate the underlying fundamentals as we brace for some headwinds. After almost two years of pandemic and lockdown measures, the outlook for the European banking system was quite bright at the end of last year. Capital and liquidity positions were strong, and banks’ asset quality and profitability improved over the course of 2021.

The average ratio of non-performing loans at our supervised banks has continued to decline, reaching 2.06% in the last quarter of 2021, and the return on equity rose to 6.72%, the highest level in five years (on an end-of-year basis).

The Russian invasion of Ukraine in February 2022 has repeatedly been described as a watershed moment for Europe. Its impact on the European banking sector cannot be ignored either.

That said, the banking sector’s direct exposures to Russia and Ukraine are limited. Banks active in these markets are already containing local banking activities and are in the process of unwinding their positions. Even in a scenario where European banks had to write down all their cross-border exposures to these countries or had to “walk away” from their subsidiaries in Russia, the losses generally seem to be manageable.

While the direct impact of Russian’s invasion of Ukraine appears to be contained, some near- to medium-term risks have risen. Above all, these include a worsened macroeconomic outlook, the indirect effects of elevated commodity prices, combined with supply-chain disruptions, including on food supply, and concerns about increased corporate and household credit risks as well as heightened volatility in financial markets.

So, what does this mean for our supervisory priorities?

Banking supervision in times of uncertainty

Every year we publish our supervisory priorities, which set out what we see as the most important supervisory focal points and activities for the next three years.

When confronted with a geopolitical shock such as the Russian invasion of Ukraine, it was only natural for us to consider the impact on our supervisory priorities for 2022-2024. However, when we took a closer look at them, we realised that they are not only still valid but potentially even more relevant than before.

Let me walk you through these priorities.

The first of our supervisory priorities – ensuring banks emerge healthy from the pandemic – focussed primarily on banks’ credit risk controls, ranging from risk identification and classification practices to provisioning policies. Initially, we concentrated on those sectors particularly hard hit by the pandemic, such as commercial real estate, but now we are also taking a closer look at those sectors and portfolios most affected by the war in Ukraine such as the ones linked to commodities and energy.

Indeed, looking ahead, the credit risk outlook for banks may deteriorate. For this reason, banks need to have in place effective provisioning and risk management practices to identify, assess and implement solutions to better support distressed debtors. Early management of distressed debtors is key to containing the build-up of new non-performing loans which could otherwise have a significant impact on the recovery of the economy once the crisis is over. We want to be sure that banks are well prepared and that their assessment of new risks is comprehensive, and also that they update their loss models to reflect the changed economic and business environment.

This brings me to a more general point and that is the uncertain growth and inflation outlook, together with heightened financial market volatility. With this in mind, another important supervisory focus for us is the impact that potential sudden interest rate shocks could have on banks’ balance sheets.

On the one hand, banks’ profitability benefits from higher net interest margins, just as lending volumes would benefit from an economic recovery. On the other, lower economic growth, or higher-than-anticipated inflation, could have a negative impact on banks’ asset quality if customers struggle to repay their debt. Not only that, banks could sustain losses on the fixed-income assets on their balance sheets if interest rates rise quickly.

This is why we are planning targeted activities to make sure banks are well prepared to withstand the potential adverse effects of rising interest rates and credit spread shocks. Looking ahead, banks should monitor risks related to inflation, carefully monitor their lending portfolios, mitigate cost pressures and live up to the enhanced supervisory standards developed over recent years.

As our second set of supervisory priorities, we identified structural challenges which predate the pandemic and the current uncertain geopolitical situation. These challenges continue to be as relevant as ever. For example, banks should continue to invest in digitalisation to put their business models on a more sustainable footing and to resolve long-term governance deficiencies. Achieving structural profitability serves as a buffer against deteriorating economic growth prospects, and good governance allows for strong strategic and tactical steering of the business plans. It also allows for faithful implementation of sanctions, thus mitigating potential reputational risks.

Our third supervisory priority is to tackle emerging risks which are, as we see it: i) IT and cyber security; ii) counterparty credit risk management; and iii) climate-related and environmental risks.

Cyber-attacks have been on the risk radar of banks and supervisors for some time already but the war in Ukraine has certainly increased cyber risks and the need for banks to improve their operational resilience.

Now, as the second emerging risk we have identified, counterparty credit risk has certainly become even more relevant as financial market volatility – especially in commodity prices – has increased. The prices of futures on commodities rose rapidly in March 2022 and this was accompanied by corresponding increases in margin calls.

Finally, to conclude this explanation of our priorities and before I turn to securitisation, I would like to say a few words on climate risk. The fallout from the war in Ukraine may lead to a temporary increase in the use of fossil fuels, potentially putting the global climate agenda at risk. However, it also brings into sharp relief the need to accelerate the green transition: Europe is pivoting to be less reliant on Russian gas and oil and is frontloading many of its energy objectives.

In any case, today it is more important than ever to put all our effort into sticking to the climate commitments made. Since physical and transition risks already pose substantial challenges to banks already in the near term, banks must adequately incorporate climate-related and environmental risks into their business strategy, governance and risk management frameworks.

In 2021, we conducted a review of banks’ approaches to managing these risks based on their own assessments. Most banks which did a thorough analysis acknowledged the materiality of these risks. But we also saw that most banks still have a considerable way to go in developing their risk management capabilities. In fact, 90% of banks’ practices are only partially or not at all in line with ECB supervisory expectations.

The availability of data is one of the most relevant issues in this regard. To give you a concrete example, in our recent targeted review of commercial real estate, we observed that many banks were unable to provide comprehensive and accurate climate data on each specific property held as collateral and that the majority of them were relying on proxies. Even if it is challenging to collect Energy Performance Certificates or “EPC” data for commercial properties and more time is needed, it is important that banks establish robust procedures to collect accurate information and integrate climate risk into credit risk management in the commercial real estate sector. Without accurate EPC data, banks cannot set their strategy and targets based on quantitative targets, nor can they progress in loan pricing, classification and credit risk management cycle. In spite of the structural issues that come into play, it is crucial for banks to do all they can to collect these data as soon as possible. Lastly, while the use of proxies is unavoidable in the short term, it is preferable to already establish processes to collect actual data on each property so that over time, reliance on proxies can be reduced. And while we recognize that there are difficulties in obtaining EPC data for loans that have been on the books for some time, for new lending banks can make progress relatively quickly to collect the needed data, allowing for considerable future benefits.

Securitisation: friend or foe

Climate change is not only a risk for banks, it is also financing opportunity. It is estimated that to achieve Europe’s climate and energy targets by 2030 around €330 billion of annual investment are needed every year. This comes on top of around €125 billion every year to carry out the digital transformation.

While public investment of course plays an important role here, the private financial sector has to contribute too, including banks and non-banks alike. As the discussions on a completion of the banking union are not looking promising at all, the importance of deeper European capital markets can hardly be overstated. Well-functioning and integrated capital markets can play a crucial role in fostering the green transition. In parallel with the ambitious implementation of the European Commission’s capital markets union action plan, we urgently need to make progress on the EU’s sustainable finance agenda to build a green capital markets union.

I would now like to focus on the specific role securitisation can play as a bridge between banks and the capital markets to contribute to the financing of the green transition, and also the ECB’s role in securitisation. I will conclude with some observations on the functioning of the current securitisation framework.

Potential of securitisation and recent developments

A well-functioning securitisation market is an important element in Europe’s financial architecture. Securitisation can boost banks’ capacity to channel lending to the real economy, providing banks with additional funding and enabling the risk to be transferred to investors. Of course, these risks do not disappear just because they are transferred outside of the banking sector and we should not close our eyes to that.

Securitisation is a tool which can be used to support various objectives. It might be useful to distinguish between securitisations of performing assets which pursue capital relief and securitisation of non-performing assets which are geared to clean the balance sheet of the bank. A significant majority of performing asset transactions is done in synthetic form, while most non-performing transactions are accomplished via cash transactions.

Looking at the banks we directly supervise, over the past four years, we see that around 29 banks were active in performing asset transactions and 13 banks in non-performing asset transactions. The notional volume of performing asset securitisations reached €136 billion in 2018 and €124 billion in 2019. Owing to the pandemic, issuances declined to €95 billion in 2020 but picked up again in 2021, reaching €104 billion. Synthetic securitisation accounted for around 70% of performing transactions, with a capital benefit of €4 billion, which is 40% higher than in 2020.

While the market for securitisation has somewhat picked up over the last years, the market is still only a fraction of the market in the US. According to the ESM[1], the size of the European securitisation market, including the United Kingdom, was 75% that of the US in 2008. In 2020, it was just 6%.

I will come back to some of the possible reasons for these differences later on but it is clear that they have consequences for banks’ balance sheets. If we take mortgage loans as an example, US banks function more as originator and distributor of these loans, while euro area banks hold them on their balance sheet.

Aside from the potential of securitisation to free up lending capacity, I also want to acknowledge the role of securitisations in some European countries in cleaning up banks’ balance sheets – also with the help of government guarantees. Non-performing securitisations reached a record high of €60 billion in notional volume in 2021.

Our role in significant risk transfer for securitisation or “SRT” transactions

Just over a year ago, we announced our decision to start ensuring that the banks we directly supervise comply with the requirements for risk retention, transparency and re-securitisation, as set out in Articles 6, 7 and 8 of the EU Securitisation Regulation. At the same time, we formed a new SSM hub on securitisation which became operational on 1 April this year. The hub is a new form of collaboration between the ECB and the national competent authorities (NCAs). The hub is led by staff from a “coordinating NCA”, with staff from volunteering NCAs and additional ECB staff operating as a “Joint Team”. This allows us to pool resources and be more effective in our supervision of the requirements for risk retention, transparency and resecuritisation.

So what is our role specifically?

As mentioned, securitisation allows banks to transfer the risk of certain exposures and free up lending capacity, as regulatory capital may be released and used for loans to the real economy. But this capital can only be released if the securitisation transaction meets SRT criteria, as laid down in prudential regulation, and our supervisors check on banks’ compliance with these criteria. Concretely, banks are required to notify transactions to the ECB at least three months in advance of the expected closing date. We published our new Guide on the notification of securitisation transactions[2] in March, following a public consultation. The Guide explains what kind of information banks are expected to submit to the ECB, both at origination and during the lifetime of securitisation transactions. After supervisors have received this notification, they start to assess whether the SRT criteria are met. Once exposures are securitised, banks may be able to release regulatory capital and, in this way, continue lending to the real economy.

I would argue that the supervisory dialogue on SRT transactions has matured over the past few years and that banks understand the assessment process well. At the same time, we have also managed to reduce the time needed to assess these transactions considerably, particularly for repeat or standard transactions. This means that banks can plan their securitisation programmes more predictably and can count on SRT transactions to optimise their capital positions.

I should like to draw your attention to one other key supervisory focal point which is directly related to SRT resilience. It is crucial for securitisations to meet the SRT criteria not only at origination but also over the life of the transaction, even in a crisis. The EBA Guidelines on SRT require originators to put in place the appropriate systems and governance for the ongoing monitoring of significant risk transfer. Meeting the SRT criteria throughout the life of the transaction supports the capital integrity of the bank. The structural features that require particular scrutiny include granularity, amortisation, call options, excess spread and early termination events.

Functioning of the securitisation market

I said earlier that the securitisation market has perhaps not fully lived up to expectations. That said, it is undeniable that we have come a long way since 2014.

There is probably not just one reason why the depth and breadth of the European securitisation market is lagging so far behind the US market but many. To give you an idea of the size of this market: According to a recent research paper by the New York Fed[3], the US mortgage-backed securities (MBS) market alone has more than $11 trillion of securities outstanding and nearly $300 billion in average daily trading volume. Of course, the MBS market in the US is rather special due to the government-backed credit guarantees by the housing agencies Fannie Mae, Freddie Mac and Ginnie Mae which make the situations not directly comparable to the EU but still the difference is striking. There are other reasons as well such as structural features of the European market including the role of covered bonds, a continued stigma of securitisation as well as regulatory features.

Among the structural features is also the well-known fragmentation of European financial markets, the differences in national insolvency and taxation laws, which make it more difficult to pool and securitise assets across borders. This also limits the potential for private cross-border risk-sharing.

As for the regulatory side, it could be considered to introduce a more risk sensitive methodology. This would help to differentiate between the actual risk profile of underlying asset pools, the structural features and the model and agency risks stemming from information asymmetries and ultimately lead to more resilient SRT structures.[4]

Conclusion

Let me conclude. While the risks related to the pandemic have declined for now, the economic outlook is surrounded by high uncertainty. At the same time, our supervisory priorities remain highly relevant and we will continue to closely monitor the situation and push banks to prepare for more adverse scenarios.

At the macro level, Europe is facing various challenges, among them the financing of the green transition. However, a challenge can also be seen as an opportunity. Banking and capital markets will have to contribute to manage the investment needs of the twin green and digital transition. Securitisation as a bridge between banks and capital markets could play an important role in this regard.

Thank you very much for your attention.

CONTACTO

Banco Central Europeu

Direção-Geral de Comunicação

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