Shifting challenges, stable priorities: euro area banks in times of war and interest rate normalisation
Keynote speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the 6th European Banking Federation Boardroom Dialogue
Frankfurt am Main, 7 July 2022
I am delighted to participate in today’s event so that we can exchange views and compare experiences, and I am really sorry that I am unable to be with you in person today. In these times of heightened uncertainty, such opportunities are all the more valuable.
I will argue today that banks had momentum on their side at the turn of the year, but now have to grapple with the macroeconomic implications of Russia’s war of aggression on Ukraine. While higher interest rates hold the promise of wider lending margins, spillover risks from a disorderly rise in market rates cannot be ruled out. And banks cannot rely exclusively on the normalisation of monetary policy to improve their profitability, they must tackle their structural issues. Although circumstances have changed dramatically, the supervisory priorities we set out last year are still well suited to the actions banks must now undertake to weather the current storms.
Euro area banks were feeling tailwinds at the start of the year
Let me first look back at the situation of European banks before Russia’s invasion of Ukraine. Prospects for the euro area banking sector were quite bright at the start of 2022, with the worst phase of the pandemic seemingly over and restrictions having progressively been lifted. Common Equity Tier 1 (CET1) capital levels stood at 15.5% and liquidity coverage ratios at 173.4% at the end of 2021, both close to the highest level ever recorded since the start of the banking union. The ratio of non-performing loans was at an all-time low of 2.1%, with the sale of NPL portfolios still key to improving asset quality for all banks in the euro area with high levels of NPLs. Despite the pandemic, overall NPL market activity has been stable over the past three years as the share of securitisations within it increased.
Not only did bank balance sheets look healthy at the turn of the year, profitability had rebounded as well. At 6.7%, return on equity was more than 5 percentage points higher than a year before. Much of this improvement was cyclical, though, as provisions were released when economic prospects were brightening. It was an encouraging sign that some banks diversified their incomes, for example by intensifying their fee and commission-generating business. And banks refocused their business models, for example through business line transactions, fintech partnerships and domestic mergers and acquisitions. But this reshaping of business models has yet to happen on a more system-wide level – a point I will come back to later on. Indeed, while some banks’ earnings projections approached their cost of equity at year-end, many still fell short.
These projections were buoyed by the benign macro outlook at the time. Robust economic growth was the baseline scenario, with positive growth expected even in the event of adverse developments. Inflation was projected to be only temporarily above its 2% target in the course of this year. This kindled expectations of a gradual normalisation of interest rates by as early as 2022, reinforcing the positive earnings outlook for banks. Against this backdrop, banks planned to resume distributions that had been restrained during the toughest phases of the pandemic, and their stock valuations recovered markedly.
The macroeconomic consequences of Russia’s war of aggression
Then, on 24 February, Russia invaded Ukraine. The direct and idiosyncratic impacts of the geo-political shock have remained contained because, as I explained earlier this year, the banking sector’s direct exposures to Russia, Ukraine and Belarus were limited in size and concentrated among a small set of institutions. Since the onset of conflict, most of those institutions have been moving towards exiting the Russian market, which from a supervisory perspective was, and still is, the right thing to do. The banks involved have therefore further reduced their direct exposures, at manageable costs. The exit process remains complex, however, and will continue to be monitored by supervisory teams.
But to our concern, the conflict in Ukraine has rapidly turned into a macroeconomic shock. Successive rounds of sanctions and retaliatory measures have compounded previously existing supply bottlenecks and materially driven up the price of oil, gas, food and metals, in particular. While inflation has surged substantially beyond the levels that had been caused by the pandemic, the outlook for growth has been steadily deteriorating, as evidenced by the macroeconomic forecasts which public institutions around the globe have been updating since March 2022. The June Eurosystem staff projections foresee real GDP growth in the euro area to slow down to 2.8% in 2022 and 2.1% in 2023, while inflation is expected to spike above target and only return close to it in 2024. Notably, for the first time since 2020, these projections envisage an adverse scenario of recession, with the economy contracting by 1.7% in 2023.
Adding to that, the gas supply decisions taken by Russia in recent weeks and the realistic scenario of a total disruption of energy imports from Russia in the near future have somewhat increased the probability that adverse scenarios and tail risks might materialise.
Against the backdrop of rising inflation across global markets, several central banks, including the ECB, have started raising policy rates, which underlines the global nature of the prevailing supply chain disruptions and the rise in commodity prices. Importantly, financial markets in the euro area have been anticipating further inflation rate and interest rate hikes. This has substantially accelerated the increase in market reference rates and market spreads which had started in the aftermath of the pandemic and which, in turn, may start to drive up the cost of borrowing for households and firms.
The first quarter results of the banking sector this year have been broadly positive in terms of profitability and have confirmed banks’ resilience both in terms of capital and liquidity. Nonetheless, the first quarter marked an uptick in both corporate and household defaults, an increase in loans classified as underperforming (or Stage 2 in accounting terminology) and an increase in banks’ cost of risk above pre-pandemic levels, reflecting enhanced uncertainty and the potential materialisation of vulnerabilities cumulated during the pandemic period.
The economic outlook has changed starkly since the turn of the year and uncertainty has risen. Investors are fully pricing in these developments in banks’ market valuations, which were markedly improving in the aftermath of the pandemic, but have been falling since the onset of the military conflict in Ukraine and have not shown any signs of recovery to date.
From a supervisory perspective, we find it encouraging that the baseline scenario remains benign and that, should adverse scenarios and tail risks materialise, the euro area banking sector would remain resilient overall. Earlier this year we performed a desktop vulnerability assessment in which bank balance sheets were confronted with a three-year recessionary scenario which was harsher than any adverse scenario currently foreseen. While asset quality and profitability would materially suffer under such a scenario, the sector as a whole would incur capital depletion levels which are noticeably lower than those seen in the most recent regular stress test exercise of 2021, with only very few banks potentially falling below their capital requirements.
At the same time, we are making every effort and can draw on the entire supervisory toolkit to keep banks highly focused on all the actions and transformations they need to undertake in order to navigate the current uncertain environment.
From the point of view of capital adequacy, we are asking individual banks to review their capital trajectories to include sufficiently conservative and updated adverse macroeconomic scenarios, notably including recessionary assumptions consistent with downside official projections. In line with our business as usual policy on bank-specific distributions, these capital trajectories should be used by banks when announcing distribution plans, after a dialogue with their supervisory teams.
From a broader supervisory perspective, we are continuing to work on the supervisory priorities for the medium term which we set ourselves prior to the conflict. The good news is that the priorities still represent the key areas for banks to work on to ensure that they appropriately tackle current and emerging risks and address structural weaknesses. I will spend what’s left of this intervention on this, starting from, and dedicating more time to, the importance of staying alert to the risks of a potential bumpy exit from the low interest rate environment.
Inflation dynamics, monetary policy and market expectations are on everyone’s mind these days. Banks are in the spotlight, too, for very good reasons. Interest rates are a primary driver of income and profits for banks, but they may affect, or be affected by, existing and new vulnerabilities along the adjustment path. The process of interest rate normalisation requires supervisory attention.
Interest rate normalisation
In a baseline scenario of positive growth, a gradual increase in interest rates will be beneficial for banks on balance, boosting profitability through interest margins. The capital costs associated with credit risk and asset valuations should remain very contained.
Increasing interest rates mostly affect banks’ balance sheets through earnings and capital adequacy. Banks should focus on these channels of impact when assessing the near-term consequences of interest rate changes. In particular, interest rate movements affect (i) net interest income, (ii) revaluation losses on securities and client revenues on trading, and (iii) asset quality and credit risk, mostly through provisions and changes in risk-weighted assets.
The economic value of equity is a more long-term measure of the impact of interest rate changes on banks. This value decreases whenever − as is the case, on average, in the euro area in the current environment − banks are able to adjust interest rates on liabilities more rapidly than they can adjust those on assets, as these are subject to the duration risk in the banking book.
The ECB recently focused on the earnings and capital adequacy dimensions of this problem and looked into the impact of two hypothetical “textbook” scenarios of an increase in interest rates over a three-year period. The shape and magnitude of those scenarios is in line with what international standard-setters and EU legislators require banks to look at when assessing interest rate risk in the banking book.
One scenario steepens the yield curve by increasing rates by approximately 200 basis points at the longer end of the curve, i.e. between five-year and 15-year maturities, while leaving the short end anchored to recently observed values. The second scenario is a parallel upward shift of the yield curve of approximately 200 basis points (between 150 and 250 depending on the maturity).
In both cases, and irrespective of whether the balance sheet is taken to be static or dynamic, increasing interest rates have a positive impact on banks’ earnings and profitability, with the return on assets, one of the measures of bank profitability, increasing materially above baseline values throughout the three-year horizon of the simulation exercise. Net interest income is the main positive driver of such an outcome, with trading income and credit risk deterioration contributing negatively, but for the second and third most important drivers respectively.
Banks’ capitalisation would remain resilient to both shocks, as CET1 ratios would decline only very marginally (by a few basis points) over the simulation horizon as a result of the revaluation losses banks need to recognise through capital and, where the balance sheet is dynamic, increasing risk-weighted assets, which would only be partially mitigated by some deleveraging.
These results do not change when the very robust macroeconomic growth baseline we were expecting at the beginning of this year is replaced with the economic slowdown forecast recently for the euro area, including when the textbook interest rate shocks are applied in addition to the interest rate increases currently embedded in market expectations.
In a positive growth environment, we expect an orderly exit from low interest rates to at last reverse the long-term trend of depressed bank margins dating back to at least 2014. Up until now, euro area banks have coped with this trend mainly by expanding lending volumes and, more generally, their holdings of interest-bearing assets. The first quarter results published by a sub-sample of listed significant banks provide us with a preview of this expected outcome: for the first time since the outbreak of the pandemic, interest margins have made a positive contribution to net interest income.
Ultimately, such a structural change should not only provide banks with additional resources to finance the long-awaited transformation of their business models, but should also pave the way for better pricing of risk by the lending business, thus correcting long-standing deficiencies in pricing practices and the unhealthy competition strategies observed in part of the sector.
However, if interest rates were to increase in the broader context of an economic recession, banks’ earnings would deteriorate not only as a result of a much more pronounced deterioration in asset quality, but also owing to a decline in net interest income: the pressure on banks’ cost of funding would dominate as targeted lending operations and other extraordinary monetary policy measures were gradually withdrawn.
Furthermore, irrespective of whether or not a recession occurs, the interaction between monetary policy adjustments, inflation dynamics and market expectations could lead to very pronounced or disorderly increases in market interest rates over and above the textbook interest rate shocks we have used in our assessment of bank balance sheets. Credit risk spreads could also widen to reflect increased risk aversion. Such disorderly scenarios could on the whole be detrimental to bank balance sheets and depress their profitability through transmission channels similar to those playing out during a recession. But they could also have particularly harmful spillover effects on specific pockets of vulnerability which we already identified in the wake of the pandemic. Let me elaborate further on these topics and the related priorities.
Continued focus on credit risk, leveraged finance and counterparty risk in the light of recent developments
The first supervisory priority we laid out at the end of last year was for banks to emerge healthy from the pandemic. This required a sharp focus on credit risk, particularly on credit risk controls, to ensure it was managed proactively. In a letter to banks, we spelled out our expectation for banks to use credit risk controls and this approach remains eminently suitable in the current situation. However, the sectoral focus has shifted slightly. While some sectors hit hard by the pandemic, such as the hospitality sector, are bouncing back thanks to a strong recovery in tourism, for example, other sectors, particularly those with supply chains most exposed to commodity, food and energy prices, are being put under strain and require proactive credit risk management. In addition, increasing financing costs for households combined with the scenario of a potential recession could threaten the residential real estate sector, where risk has been building considerably during the pandemic. Banks should also monitor developments very closely in this sector and use the appropriate risk controls.
In recent years, some banks have been pursuing search for yield strategies, including during the pandemic. Lending to structurally riskier counterparties has progressively increased in the leveraged finance segment, with leverage limits progressively lifted and investor protection covenants progressively lowered or disregarded despite dedicated supervisory guidance and related warnings. The increase in indebtedness associated with the pandemic may also have placed some corporate clients in the highly leveraged bucket who had never been in it before, thus increasing the disruptive potential of the portfolio. Unexpected increases in market interest rates have the potential to inflict severe losses on these counterparties. In March we instructed banks to define robust risk appetite frameworks and reduce the origination of highly leveraged transactions in order to adhere to supervisory guidance in place since 2017. Banks that persistently deviate from our guidance will face specific Pillar 2 capital charges as part of our Supervisory Review and Evaluation Process.
The non-bank financial sector has been growing over the last few years, with known and less-known connections to the banking sector. The sector as a share of the total financial sector grew from 25% in 1999 to 40% in 2020. It is exposed to high levels of synthetic leverage through derivatives, including with bank counterparties. Periods of volatility, such as those observed at the onset of the pandemic, can result in substantial levels of counterparty credit risk within banks, as seen with the Archegos case. We have impressed upon banks what is expected of them in these kinds of situations and we are following up with targeted reviews and on-site inspections in the areas of counterparty credit risk governance and management to identify any relevant deficiencies.
Tackling structural challenges: the green transition and digital technologies
Notwithstanding the risks highlighted so far, the baseline expectation is that the normalisation of monetary policy will prove benign for bank profitability.
But banks would be mistaken in thinking that this alone would be enough to lift their return on equity above their cost of equity. Instead, they need to focus on a much broader set of actions that could put their profitability and their business model on a sustainable path for the foreseeable future. My colleague Kerstin af Jochnick will build on this message later today. There are well-known, short-term challenges and broader, longer-term structural changes that banks have to keep in focus to address the structural weaknesses that have tainted their performance for so long.
The ECB has long reiterated the call on banks’ management to enhance their strategic steer, review their business mix, enhance their cost efficiency and consider consolidation as a possible component of their transformation agenda. Those banks that have taken steps in this direction are already well-positioned to become an attractive investment proposition. But all banks must consider the structural challenges raised by the green transition and digitalisation.
The ECB recently surveyed leading firms on the impact of climate change on economic activity and prices. The findings are noteworthy. Some 90% of those surveyed said that their firm needed to adapt to climate change, which would require investment in new facilities or processes and changes to their supply chain. They also said it would make inputs more expensive. More than three-quarters of firms surveyed confirmed that their insurance costs would rise because of climate change and that there was an increased risk of production being interrupted. In addition, one-third of companies in the sample feared that climate change would force them to relocate some operations. Given that bank balance sheets mirror the real economy, the results of this survey can only be interpreted as a call to action for banks as well.
However, around 40% of respondents also described business opportunities that the green transition might bring. These businesses have either already invested in alternative, low-carbon products, or would benefit because the goods and services they provide help other companies to reduce their emissions. This is in line with market analysts’ findings that the green transition also holds immense promise for banks, as the demand for green investments vastly outstrips the diminishing financing needs of non-green investments. On average, additional financing opportunities for global banks as a result of the green transition are estimated at USD 2.3 trillion a year. Banks that take the lead on climate-related and environmental risks will boost both their environmental and business model sustainability. European banks are well positioned to capitalise on this, not least because of the regulatory and supervisory demands placed on them. Later today, my colleague Elizabeth McCaul will expand on our supervisory activities on climate-related and environmental risks.
Digitalisation also holds great potential for bringing about a structural improvement in banks’ profitability. It can unlock value creation and cost reductions. As a result of the lockdowns, most people are now knowledgeable about online or mobile banking. This has broadened the potential customer base that banks can reach with digital products that incur little or no marginal costs. Similarly, banks may be able to cut back on expenses related to physical interactions with customers. In addition, they can harness digital technologies to provide more integrated platforms, data repositories and distribution tools across their groups.
There are obvious risks, notably operational, associated with digital technologies. Banks have already been on high alert in the last two years as coronavirus-themed fraud attempts became more common and Russia’s invasion of Ukraine raised the threat of cyberattacks in retaliation for sanctions. The potential disruption from cyberattacks carried out by state actors could even surpass the havoc wrought by private individuals and poses an unprecedented threat to social infrastructures, including financial ones. Authorities and firms alike must take all the cross-border steps required to combat these risks.
Let me conclude. Banks had momentum on their side as the headwinds of the pandemic were fading, but the macroeconomic developments stemming from Russia’s invasion of Ukraine have created new uncertainties and risks.
The supervisory priorities we identified at the end of last year remain valid to address the new challenges that have arisen. Credit risk was selected as a key area of focus to ensure a smooth exit from the pandemic, and it remains central in the light of the economic slowdown triggered by the war in Ukraine. While some adjustment to our supervisory focus might be warranted, for instance concerning the sectors that could be seen as the main drivers of heightened credit risk, the overall supervisory agenda on credit risk controls that we launched during the pandemic is still very relevant today. The risks of a bumpy exit from the low interest rate environment that has characterised the last decade remain more topical than ever, confirming the need to focus on certain areas of business, such as leveraged finance, exposures to non-bank financial institutions and counterparty credit risk. The structural challenges to rebuild banks’ profitability on a sustainable basis remain firmly on the radar of banks’ management and supervisors alike. They are becoming increasingly intertwined with the broader transformation of our economies spurred by digitalisation and the green transition, which from a prudential perspective also bring new risks we will increasingly have to grapple with.
Hopefully, this will give continuity to our efforts and our dialogue with banks.
Thank you for your attention.
Enria, A. (2022), “Invasion of Ukraine - euro area banks so far resilient to a second exogenous shock”, presentation at Morgan Stanley European Financials Conference, 15 March.
Enria, A. (2022), “Invasion of Ukraine - euro area banks so far resilient to a second exogenous shock”, 15 March.
Budnik, K., Panos, J., Pancaro, C. and Ponte Marques, A. (2022), Banks and their interest rate risk sensitivity: A two-tier analysis, VoxEU, Centre for Economic Policy Research, 20 June.
ECB Committee on Financial Integration (2022), “Financial Integration and Structure in the Euro Area”, Frankfurt, 22 April.
Kuik, F., Morris, R. and Sun, Y. (2022), “The impact of climate change on activity and prices – insights from a survey of leading firms”, Economic Bulletin, Issue 4, ECB.
Autonomous Research (2021), “Climate Risk: The Green Growth Opportunity”, 2 September.