Managing and supervising current and future risks
Introductory remarks by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at the 6th Single Supervisory Mechanism and European Banking Federation Boardroom Dialogue
Frankfurt am Main, 7 July 2022
I am very happy to be here today and would like to thank the organisers for inviting me.
As Andrea mentioned earlier, the dynamics are dramatically changed from just a few short months ago. The war in Ukraine has halted the positive momentum that the euro area banking sector had built up by the end of 2021. Short and medium-term risks are now rising on the back of a deteriorating macroeconomic situation, persistent supply chain bottlenecks and soaring energy prices.
One of the most immediate challenges facing banks is rising interest rates. While the banking sector can expect to see net gains from a gradual increase in interest rates, the downside risks must not be overlooked. If the interaction between market expectations, monetary policy and inflation dynamics leads to a disorderly rise in market interest rates, this may indeed have a significant negative impact on banks’ cost of funding and asset quality.
Both banks and supervisors therefore need to remain vigilant. The tail risk of a severe economic recession must sharpen our supervisory focus on priority areas such as credit risk management and counterparty credit risk towards non-bank financial institutions. At the same time, cyber risks and climate risks remain high on our supervisory agenda – as I will mention later.
But first I want to discuss credit risk. It has been well over two years since the start of the pandemic, and more than five months since Russia invaded Ukraine. As a result, asset quality is starting to deteriorate in the most vulnerable economic sectors.
Preliminary data for the first quarter of 2022 confirm this. Vulnerabilities that became apparent during the pandemic are now starting to materialise: the decreasing trend in volumes of non-performing loans weakened significantly in the first quarter of 2022, and even reversed at certain banks due to the rising corporate and household default rates.
The impact of the war will, of course, add to this pressure. The second and third-round effects of the conflict will put other sectors under strain, notably those most exposed to commodities, food and energy markets. And as Andrea already mentioned, the increasing cost of household borrowing, and the potential recession scenario, could threaten the residential real estate sector, where risks have been looming in some jurisdictions for some years now.
The prospect of a potential worsening in the credit risk outlook for banks in the short to medium-term serves only to heighten the relevance of our supervisory priorities for the next two years. Particularly in the area of credit risk, it is more important than ever that banks have in place effective provisioning and risk management practices. This will enable them to identify, assess and implement solutions to effectively support distressed debtors. We are now entering a period of uncertainty that could see an increase in default rates and non-performing loan (NPL) levels. This will warrant a shift in NPL strategies from a singular focus on reducing legacy NPLs to also preventing NPLs from accumulating in the future. As legacy NPLs are reduced, internal workout becomes increasingly important.
Early management of distressed debtors is key to containing the build-up of new NPLs, 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, that their assessment of new risks is comprehensive, and that they intensify their efforts to conduct “look-through” credit analysis on a more granular basis to gain the clearest insight into the effects on businesses and households. And we want to be sure that banks update their loss models to reflect the changed economic and business environment accordingly. Despite supervisory initiatives undertaken in recent years to help improve banks’ ability to cope with increasing asset quality deterioration, material deficiencies persist in the credit risk management frameworks of several banks. The ECB will continue to proactively engage with banks that have reported material deficiencies in this area and, where relevant, conduct targeted reviews, on-site inspections and internal model investigations.
We will also strengthen our supervisory focus on war-vulnerable sectors. While initially we concentrated on those industries hit particularly hard by the pandemic, such as commercial real estate, we are now also taking a closer look at those sectors and portfolios most affected by the war in Ukraine, such as those linked to commodities and energy markets.
Banks’ counterparty credit risk is also on the rise. Given the exponential growth in the non-bank financial sector and its connections to the banking sector through synthetic leverage and derivatives, there is a real possibility that market volatility, as we observed at the beginning of the pandemic, or as we are currently seeing as a result of the war in Ukraine, materialises into high counterparty credit risk at banks.
The pandemic has irreversibly accelerated and intensified the digitalisation of our economy. Consumer preferences have changed, fintech players have gained market share and banks’ reliance on IT and cloud services has grown.
These developments create both opportunities and risks. During the pandemic, there was a wave of coronavirus-related fraud attempts. And one of the consequences of the Russian invasion of Ukraine is an elevated risk of cyber attacks in retaliation to sanctions.
The good news is that there are several ongoing initiatives aimed at making the banking system more resilient to cyber risks. First, ECB Banking Supervision works with the national competent authorities to strengthen the tools that Joint Supervisory Teams use to assess banks’ cyber resilience. Second, the cyber incident reporting framework is in place, which requires all significant institutions to promptly report significant cyber incidents to the ECB. Third, in the context of the Supervisory Review and Evaluation Process, or SREP, ECB Banking Supervision annually reviews IT security risk at every supervised institution, following a common standardised methodology. Fourth, every year ECB supervisors frequently visit individual institutions to assess IT and cyber risk management.
Fostering international cooperation also helps prevent and mitigate the risks presented by these threats. ECB Banking Supervision works closely with its European partners, engaging with the European Commission and the Council, as well as at the international level, mainly in the context of the Financial Stability Board.
Last but not least, I would like to discuss climate risk.
The preliminary results of our thematic review on climate-related and environmental, or C&E risks show that, almost two years after we started implementing our supervisory agenda on climate, most banks have begun to adapt their practices to incorporate C&E risks into their daily business and to align with the ECB’s expectations in this area. This is a positive development.
However, some banks are still lagging behind and the approaches taken to tackle C&E risks are often inconsistent. For example, while more and more banks are recognising their material exposure to such risks in the short to medium term, some banks are yet to perform a materiality assessment.
In addition, we see that banks do not fully understand how the misalignment of their clients with the Paris Agreement affects their own risk exposures. Let me stress that, going forward, it is crucial that banks devise their own transition plans, using the many available and reliable data, and that they improve their ability to gather and use additional data about energy efficiencies in their lending portfolios. But they should also closely monitor the transition plans of their clients, especially those that are highly exposed to fossil fuel-intensive sectors, and they should ensure that viable plans for a smooth transition are in place.
Tomorrow we will publish the results of our bottom-up climate stress test. This was a learning exercise for both banks and supervisors, aimed at providing a better understanding of banks’ ability to measure physical and transition risks, including under stressed conditions. It has also enabled the ECB to benchmark banks against their peers in terms of stress testing capabilities, sustainability of their business models and their exposures to carbon-intensive companies. The results will be reflected in the recommendations to address relevant shortcomings in our SREP process. C&E risks are already an integral part of the SREP.
Let me conclude.
These are highly uncertain times. We can see a unique convergence of risks building up in front of us. Other risks not yet on our radar undoubtedly exist and we need to bring them into view.
If an economic recession were to occur, which cannot be ruled out, it would severely damage banks’ earnings through pressure on the cost of funding and asset quality deterioration. And even in the absence of a recession, excessive or disorderly increases in market interest rates can have an outsized negative impact on the risk profile of supervised institutions. All of these factors can have consequences for financial stability and seriously impair banks’ chances of emerging stronger from the pandemic.
We at ECB Banking Supervision remain vigilant and are reinforcing our supervisory focus on priority areas such as credit, cyber and climate risks, while zeroing in on our supervisory activities in the sectors most affected by the cumulative impact of the pandemic and the war. We are keeping our lines of communication open to monitor the evolving outlook and coordinate our actions to ensure that credit continues to flow to the economy in any scenario that materialises.
That is why events like this are so important. It is important to talk and to listen, and that is what I am looking forward to now.