Hearing of the Committee on Economic and Monetary Affairs of the European Parliament
Introductory statement by Andrea Enria, Chair of the Supervisory Board of the ECB
Brussels, 1 December 2022
The banking sector maintains strong capital and liquidity positions. According to third-quarter results available for listed banks, the sector continues to record good levels of profitability. However, the euro area economic outlook has further deteriorated. We face a period of lower growth and possible recession, with significant uncertainty over energy supplies. While higher interest rates and margins are boosting banks’ profitability right now, they also affect the ability of highly leveraged customers to pay back their debts or fulfil margin calls and may trigger sharp adjustments in volatile financial markets. Banks need to prepare for the potential adverse impacts of the uncertain environment on their business.
The new risk environment warrants some adjustments to our supervisory approach. Today, I will outline how we are asking banks to prepare. We also expect to publish our updated supervisory priorities for 2023-25 in the coming weeks.
Supervisory risk outlook
Our key focus is that banks remain resilient to the challenges stemming from the current uncertain macro-financial environment. We collected banks’ updated capital trajectories at the end of October to identify any vulnerabilities in their capital adequacy to the energy shock and the heightened risk of recession. Based on our preliminary assessment, a number of banks seem to use relatively mild macroeconomic assumptions in their adverse scenarios, which translates into a moderate impact on their capital ratios. Consequently, supervisors will closely scrutinise capital planning and challenge management actions to ensure an appropriate level of conservatism.
Credit exposures to energy-intensive corporate borrowers are a particular area of supervisory attention. Despite limited signs of distress so far, many energy-intensive sectors are at the beginning of the value chain, where disruptions can trigger chain reactions. Since earlier this year, we have been focusing our attention on credit and derivative exposures to the largest energy commodity traders. We also looked at exposures to the energy utilities sector and are keeping a close eye on developments in energy derivatives markets. Exposures to energy utilities increased by around 14% in the first three quarters of the year, and further credit extension might bring banks closer to their internal risk limits. The focus on the risk management of these exposures is particularly warranted in light of the recent temporary relaxation of margining requirements, enabling the use of uncollateralised bank guarantees as eligible collateral for non-financial corporates accessing central clearing services.
The fast-paced normalisation of interest rates is highlighting vulnerabilities in other sectors, such as residential and commercial real estate markets, consumer finance and leveraged finance. At an aggregate level, leveraged finance exposures account for over 60% of euro area banks’ Common Equity Tier 1 capital. A large share of these are exposures to highly leveraged corporates. This is the riskiest category of an already high-risk asset class, and banks still continue to originate loans of this kind. We will therefore pursue targeted follow-up. In this year’s supervisory assessment, we intend to apply Pillar 2 capital add-ons to a handful of banks, due to substantial deficiencies in their risk management frameworks for leveraged transactions.
Together, these underlying risks point to a likely deterioration in asset quality in the coming months. While over the last few quarters the headline non-performing loan (NPL) ratio has continued to decline, NPLs in the consumer loans segment and early arrears, both for households and corporates, are increasing. Reducing legacy NPLs and preventing an excessive build-up of new NPLs continues to be a priority for ECB Banking Supervision.
Our analyses suggest that for most banks the expected increase in interest rates should enhance profitability. Some business models, however, could suffer as interest rates further normalise. This could happen either because the repayment capacity of their borrowers is particularly sensitive to the level of interest rates – as is the case for instance for consumer lenders – or because due to their assets and liability management strategies, banks fail to reprice assets to the extent needed to offset higher funding costs. We have reviewed banks’ risk management practices in relation to interest rate risk in the banking book. Banks should enhance their focus on monitoring and measuring how interest rates affect the economic value of their net worth in the medium to long term, as this metric affects their profit generation capacity, long-term capital adequacy and attractiveness vis-à-vis investors.
We also remain attentive to fragilities in the non-bank sector. Recent market events, such as the 2021 default of the family office Archegos Capital Management and the liquidity shock to UK pension funds have highlighted the vulnerability of non-bank financial institutions (NBFIs) to abrupt market adjustments. These vulnerabilities not only affect banks via their direct exposures to NBFIs. They may also give rise to damaging asset price correction spirals, which have an impact on banks’ balance sheets beyond direct exposures. We performed a targeted review and an on-site campaign on the governance and risk management practices in the area of counterparty credit risk. We plan to soon communicate publicly the results of these reviews and how we intend to follow up.
The crypto-asset market may pose considerable challenges to European regulators and supervisors in the years ahead the recent failures of exchange platforms and stablecoin providers demonstrates the inherent riskiness and volatility of the crypto markets. We will need to remain vigilant to ensure the regulatory framework is adequate to address both current and emerging risks and challenges. For now, the level of interconnectedness between banks and providers of crypto-assets remains low and banks have not been adversely affected by the significant correction in valuations of crypto-assets or by the defaults of major crypto players.
Last, digitalisation and IT challenges remain a key supervisory focus. We will follow up on banks’ digital transformation plans to ensure they adapt their risk profiles. We are also conducting activities on banks’ operational resilience frameworks with a focus on IT outsourcing, IT security and cyber risks.
Stepping up banks’ efforts to address climate change
We also maintain a focus on climate-related and environmental (C&E) risks. With the climate risk stress test we conducted earlier this year, we encouraged banks to actively collect data and develop proxies on their climate exposures.
We also carried out a thematic review that thoroughly examined banks’ strategies, governance and risk management practices to incorporate C&E risks. We concluded that although banks have become better at incorporating C&E risks in their risk management framework, they need to collect granular data and develop more sophisticated methodologies to quantify them. While most banks have devised basic practices at policy and procedural levels, over half have not yet proved their ability to implement them effectively.
To support banks on this journey, we have released a compendium of good practices that we identified through the exercise. It helps banks to improve their frameworks while sharing advice with a wide audience on how to address the risks posed by climate change. These good practices also demonstrate that supervisory expectations can indeed be implemented swiftly. We have set deadlines for banks to progressively meet all supervisory expectations by the end of 2024.
Legislative developments: EU banking package
Supervision and regulation should go hand in hand to ensure a strong banking sector that can maintain its function as a shock absorber in the economy. This is why we reiterate our plea for a faithful implementation of the Basel III rules via the banking package. Each deviation implies a pocket of risks against which European banks will be less protected. Empirical evidence shows that capital discounts resulting from such deviations do not in practice lead to more lending in corresponding portfolios. They also make the framework more complex to enforce, resulting in higher costs and risks for banks, market participants and supervisors. Some of the most impactful deviations would be granted at the discretion of individual Member States, which could result in additional fragmentation of the Single Market and potential level playing field issues for banks under European supervision.
The banking package should also strengthen the supervisory toolbox in specific areas: supervisors need more tools to assess banks’ transition plans to address environmental, social and governance (ESG) risks; minimum rules and requirements for third-country branches should be harmonised; and we should put in place a consistent approach to fit and proper assessments for top management of all supervised banks.
For 2023, we look forward to engaging on the upcoming legislative proposal on reforming the EU crisis management framework. We also hope for a timely agreement on the EU-level anti-money laundering authority, so that it can begin its direct supervision in 2026 as planned.
Thank you very much for your attention. I now look forward to your questions.
ECB (2022), “2022 climate risk stress test”, July.
ECB (2022), “Walking the talk: Banks gearing up to manage risks from climate change and environmental degradation”, November.
European Banking Authority (2022), EBA report on the application of the infrastructure supporting factor, November.