The resilience of the European banking sector
Keynote speech by Anneli Tuominen, Member of the Supervisory Board of the ECB and designated ECB representative, at the Florence School of Banking and Finance’s Annual Conference “The future of finance – Finance for the future”
14 June 2022
One of ECB Banking Supervision’s main priorities for the coming years is to ensure that banks emerge from the pandemic healthy. But how are we getting on?
Overall, data for the fourth quarter of 2021 confirm that banks remain resilient at this stage of the coronavirus (COVID-19) pandemic and have strong capital and liquidity positions. Their profitability outlook at the end of 2021 was also good. Nevertheless, there is still uncertainty about the overall impact of the pandemic, as some support measures are still in place. We will only be able to see the full impact in the medium term, once most of the government and central bank relief measures have been withdrawn.
However, the situation has changed dramatically since Russia’s brutal and inhuman aggression towards Ukraine. The war has led to deteriorating economic forecasts and unforeseen inflation and has forced a total rethink of our energy supply. Higher interest rates will hit indebted households particularly hard as they are already struggling with the rise in prices. To add fuel to fire, the war has increased the threat of cyberattacks on critical infrastructures, including in the financial sector. It has also increased the awareness regarding the greening of our society, which - although as such a positive development - comes with inherent transition risks.
The impact of the COVID-19 pandemic
Before I talk more about the impact of the war in Ukraine, I would like to briefly return to the effects of the COVID-19 health crisis. The pandemic made certain risks to the European banking system all the more pressing, owing to the lockdown measures and associated travel restrictions, the closure of businesses deemed “non-essential” and supply chain disruptions. These challenges highlighted two key issues for banks: the importance of adequate credit risk management and – for some banks – the need for further digitalisation. I would like to talk a bit more about each.
Banks need to ensure that they adequately assess, classify and measure the credit risk on their balance sheets. This became increasingly important during the pandemic as certain sectors – such as services and commercial real estate – were more vulnerable to the fallout from the crisis. As a result, the ECB strengthened its supervisory focus on banks’ exposures to vulnerable sectors and carried out a dedicated assessment of how banks were identifying and measuring credit risk during the pandemic.
Following its assessment, the ECB informed banks that - for several banks - there were still material deficiencies in their credit risk management framework. The main areas of concern related to the identification and classification of distressed borrowers, collateral valuation and the adequacy of provisioning practices.
Up to now, the impact of the pandemic on banks’ credit risk has been more manageable than expected, with non-performing loans having fallen further. However, a possible deterioration in asset quality related to the withdrawal of relief measures and new pressure emerging from the war could lead to a rise in defaults. Sectors considered vulnerable during the pandemic, such as commercial real estate and residential real estate, also still need to be monitored. This further highlights how important it is for banks to address the shortcomings detected in their credit risk management frameworks. The ECB is proactively engaging with the banks that reported material deficiencies in this area to ensure sound credit risk management.
The second issue, digitalisation, is not a new one. Banks have been offering digital services for decades. But the demand for digital services has increased during the pandemic, including in previously less digitalised countries, and these services have also expanded to new areas. Moreover, digitalisation has made it easier for people to work remotely and has made operations more efficient overall. However, while some banks already had the infrastructure in place, others needed to speed up their implementation of technology.
Aside from the impact of the pandemic, digital transformation is crucial for banks to keep up with customer preferences and the related changes in the competitive landscape. Banks are facing increasing competition from new market entrants such as fintech firms and big tech platforms. These new entrants are able to provide services in an efficient and user-friendly manner, are less affected by regulatory burden and the cost of office space, and can offer customers a wide range of choices, leveraging on their customers’ data.
Digitalisation also presents an opportunity for banks to tackle cost inefficiencies and excess capacity by improving their internal processes through technology. Examples would be using a robot instead of a person to advise a customer on investments, automated programs for the detection of money-laundering activities or fraud and algorithms to authorize trading. However, smaller banks may not have the capacity to develop such digital services in house. As an alternative, these banks might use cloud computing from third parties, to offer digital services.
There are of course risks associated with these developments. An increasing reliance on technology will make banks more dependent on the availability of IT services and, in the case of outsourcing, on third-party providers. Banks are expected to manage these risks effectively and have contingency plans in place to avoid disruption should a third-party provider not be able to deliver its services. Banks should also manage cyber risk. Through its cyber incident reporting framework, the ECB found that the most frequent cyber incidents at banks during the first years of the pandemic were distributed denial of service attacks, in which perpetrators interrupt banking services by flooding (and clogging) bank servers with fake requests. There was also an increase in attacks on third-party service providers.
The impact of the war in Ukraine
As I explained earlier, banks appear to be resilient at this stage of the pandemic. But we must also look closely at the impact of the war in Ukraine and the changes it could cause in the banking sector.
The challenges related to credit risk, that I mentioned before, are even more relevant today in the context of the war in Ukraine. But we have seen a shift in the drivers of credit risk from services-related sectors to commodity trading, energy and raw material-intensive.
Although the full impact of the war is not yet known, it may further intensify the pressure on asset quality in the coming quarters. Drivers of a potential deterioration in asset quality include disruptions to supply chains and increased costs for corporates for energy, commodities and other imports. At the same time, the increase and volatility in commodity and energy prices, together with ongoing global supply chain pressures, could prolong the period of elevated inflation. Higher inflation combined with an increase in interest rates – which is generally positive for bank profitability – could lead to defaults by borrowers. The ECB will therefore continue to focus on banks’ risk management practices.
As I mentioned, the ECB and banks alike were on high alert for cyber risk before the war in Ukraine. IT outsourcing and cyber risk were already part of the ECB’s supervisory priorities. After all, the financial system has always been an attractive target for attackers. The war has led to an increase in cyber risk, but it has also changed the nature of this risk. While before the war, the motives of those behind cyberattacks seemed to be primarily financial in nature, a new type of cyber threat seeks to focus on the destruction of critical infrastructure and causing as much disruption as possible.
We have not yet seen an increase in the overall number of significant incidents in the financial sector, and the impact on banks has been limited. However, potential disruptive cyberattacks pose an unprecedented risk to critical infrastructure, including financial services. Banks are therefore expected to establish and test response and recovery mechanisms, and to adapt them to the evolving threat situation. The ECB is monitoring the situation closely and has launched several initiatives to step up its supervision in this area. One of these initiatives is the cyber incident reporting framework that I mentioned earlier. This framework requires banks to confidentially report significant cyber incidents to the ECB as soon as they are detected. This helps the ECB to identify and monitor trends and to react quickly if a major cyber incident affects any of the banks under its supervision. At the same time, the ECB fosters cooperation with other authorities at the European and international levels.
Lastly, I would like to talk about climate-related and environmental risks. As ECB President Christine Lagarde observed at the IMF Spring Meetings, the recent volatility in energy markets is a stark reminder of the need to speed up the energy transition. The paths to achieving energy and climate security now point firmly in the same direction. This means that banks should also take action and increase their capacity to deal with climate-related and environmental risks. As the economy changes, banks will have to adjust how they operate and respond to these developments.
Addressing these risks will be one of the main challenges for banks in the years ahead. Considering the outcome of the self-assessments carried out in 2021: 90% of banks reported that they are only partially aligned or not in line with the ECB’s supervisory expectations in this area. In this context, it is crucial that banks develop mitigation strategies to soften the long-term impacts of climate-related and environmental risks and adjust their business strategies, governance and risk management frameworks to adequately incorporate these risks. And banks should have a clear overview on the “green” performance of their customers if they are to manage their risks properly. The proposed Corporate Sustainability Reporting Directive could support this by asking large banks and their corporate clients to disclose transition plans.
Moreover, the ECB is currently carrying out a climate stress test to assess how prepared banks are to deal with climate risks, as well as a full supervisory review of banks’ risk management and disclosure practices. This is seen as a learning exercise for the ECB and the banks alike. The ECB will also perform a thematic review to assess banks’ progress towards meeting the ECB’s supervisory expectations. The ultimate aim is for climate-related and environmental risks to be managed like any other risk and for banks’ transition plans to become part of their risk management practices.
Let me conclude.
So far, the banking sector appears resilient to the challenges it is facing. But there is still a great deal of uncertainty, and banks need to be prepared for worsening conditions. For some banks, this means further strengthening their capital base and mitigating operational risks. The ECB will continue to closely monitor these risks and will take further initiatives similar to those I described today. Our goal here is that banks remain resilient, including in these turbulent times.
European Central Bank (2020), “Identification and measurement of credit risk in the context of the coronavirus (COVID-19) pandemic”, December.
Hakkarainen, P. (2022), “The digital transformation of the European banking sector: the supervisor’s perspective”, speech at the Institute for Financial Integrity and Sustainability, 13 January.
European Central Bank (2021), “IT and cyber risk: a constant challenge”, Supervision Newsletter, August.
Enria, A. (2022), “The euro area banking sector, one quarter after the start of the war in Ukraine”, presentation to the Italian Banking Association, 18 May.
Lagarde, C. (2022), “IMFC Statement”, statement at the forty-fifth meeting of the International Monetary and Financial Committee, 21 April.
European Central Bank (2021), The state of climate and environmental risk management in the banking sector, Publication, November.
Elderson, F. (2021), “Overcoming the tragedy of the horizon: requiring banks to translate 2050 targets into milestones”, speech at the Financial Market Authority’s Supervisory Conference, Vienna, 20 October.