Keynote speech by Anneli Tuominen, Member of the Supervisory Board of the ECB, at the 18th Banking Sector Industry Meeting “Banking: Navigating the Wave of Inflation”
16 May 2023
Thank you for inviting me to speak today. I look forward to discussing our supervisory expectations in the light of the recent bank failures.
These events were a timely reminder of the importance of strong regulation and supervision and effective crisis management. But above all, I think they underline that good governance needs to be the key focus area for banks going forward.
I will start by discussing some of the most relevant aspects of these events and their impact on European banking supervision. I will then focus on our supervisory challenges and regulatory reforms, before highlighting the lessons that can be learned from the recent market turmoil.
The current challenges in the banking sector
The European banking sector appears resilient to the challenges it has faced up to this point. Nevertheless, we must not forget that there is still a lot of uncertainty. The recent events show once more that we need to be well prepared, and the lessons learned are an opportunity to further reflect on banks’ vulnerabilities, our supervisory actions and dealing effectively with new crises that may emerge.
I know that recent events are probably still fresh in your minds but allow me to use Silicon Valley Bank (SVB) as an example and briefly summarise what happened before discussing the relevant risks.
Two months ago, on 9 March, SVB experienced deposit outflows of over 40 billion dollars. This bank run was caused by concerns about SVB’s solvency position and was seemingly exacerbated by a combination of social media and a concentrated depositor base. SVB informed its supervisors that it lacked sufficient cash or collateral to cope with the expected further outflows. One day later, on 10 March, the California Department of Financial Protection and Innovation closed SVB. As a follow-up to this and other US crisis events, the Federal Reserve System and the Federal Deposit Insurance Corporation conducted initial reviews of the market turmoil and their responses, which were published on 1 May and 28 April.
The Federal Reserve mentions in its review that, in some respects, SVB was an outlier because of its highly concentrated business model, interest rate risk and high level of reliance on uninsured deposits. Its failure demonstrates weaknesses that must be addressed. So what are these weaknesses, and are they also relevant for the European banking sector?
The Federal Reserve’s review presents four key takeaways, alongside specific supervisory and regulatory changes that should be considered. Let me highlight a few points.
The first takeaway is that SVB’s board of directors and management failed to manage the risks the bank was exposed to. SVB was highly vulnerable, with a highly concentrated business model, managerial weaknesses and a high reliance on uninsured deposits. This exposed it to the combined challenges of rising interest rates and slowing activity in the technology sector. Although SVB’s business model was unique and unlike that of any significant institution in Europe, we can still learn from the challenges faced by this fast-growing bank (SVB tripled in size between 2019 and 2021). In cases like this, a bank’s board and management need to be up to the task of steering a bank that has become much larger and much more complex. A strong governance structure is crucial to ensuring the sustainability of a bank’s business model, both during crises and in normal times, and to successfully adapting to ongoing trends.
In our supervisory priorities, we are focusing on strengthening banks’ governance arrangements and we expect banks to be able to identify new risks from emerging activities and changing environments and to put in place the appropriate management and controls. Specifically, banks must have a culture of checks and balances at all levels, effective risk management and control frameworks, and a well-defined organisational structure with clear reporting lines and responsibilities. Members of the management body in its supervisory function are expected to effectively assess and challenge the decisions of the management body in its management function. This is crucial for the effective oversight and monitoring of the management body’s decision-making and for providing a counterbalance to the executive members. Additionally, banks need adequate and efficient risk data aggregation and reporting frameworks in place to support efficient steering by management bodies.
Turning back to SVB, another central element of that crisis was that the bank’s funding relied on concentrated and largely uninsured deposits. In combination with broadly deficient liquidity risk management practices, this meant that the bank was not prepared for the acute liquidity event it faced in March, nor was it capable of responding to it. Let me highlight that, based on its size, SVB was not subject to liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) requirements. The Federal Reserve now considers it appropriate to have stronger standards that apply to a broader set of banks and plans to revisit its framework.
By contrast, here in Europe all banks are subject to LCR and NSFR requirements, and liquidity and funding risks are part of our supervisory priorities. One of the key vulnerabilities that we focus on is a lack of diversification in funding sources and deficiencies in funding – banks should have credible liquidity and funding plans in place that take into account the current uncertain outlook, and they should be ready to adjust these plans to the evolving risk landscape in a flexible and timely manner.
Euro area banks are subject to liquidity requirements and rules on quantifying and managing interest rate risk in the banking book (IRRBB). The Euro area banks show a lower average exposure to IRRBB than the US banks and we do not see any structural reasons for concern at the moment. Nevertheless, in our targeted review we identified some weaknesses in the management of IRRBB and pressed the banks to remediate these. Also, market sentiment remains fragile and we will continue monitoring the situation to identify any potential vulnerabilities, whether they be system-wide or at the level of individual banks.
As explained by the Chair of the Supervisory Board, Andrea Enria, we asked some banks to apply more conservative assumptions when stress testing credit spreads on financial securities. We also encouraged them to improve the calibration, validation and back-testing of their asset and liability management models so as to ensure that these models properly reflect their customers’ loan repayment and deposit withdrawal behaviours in line with the new interest rate environment. The banks we supervise do not exhibit the outlier features of extreme interest rate risk and predominant reliance on a concentrated, uninsured deposit base. Our banks generally operate with a more diversified customer base. Although uninsured deposits are an important source of funding in the euro area as well, they tend to be more relevant for business models which are well diversified on both the asset side and the liability side, including their depositor base.
Finally, I would like to highlight that the Federal Reserve’s review also mentioned the need to be attentive to novel activities, such as fintech or crypto activities, for which the Federal Reserve has begun to build a dedicated novel activity supervisory group. As you are well aware, we are also giving these topics our supervisory attention. This is a challenge for all of us as this field is constantly developing. For example, some of the other US banks that made headlines − including Signature Bank − were exposed to crypto risks. The crypto-related activities of the banks under our supervision are still limited and we have so far not observed any material exposure to stablecoins. Nevertheless, we need to continue carefully assessing these risks and working together to address them.
Risks in the financial system are continuously evolving, requiring constant evaluation of the supervisory and regulatory framework. At the same time, the recent market turmoil is no reason to undertake a major regulatory overhaul. As Mr Enria stated recently, we should instead focus on the effectiveness of supervision.
The Basel III framework provides us with good tools, and its rules should be implemented in a timely and faithful manner. So far, the improvements in capital and liquidity ratios have supported EU banks’ resilience during the recent turmoil and increased confidence in the system. Within the European Union, the Basel standards – through the Capital Requirements Regulation − apply to all banks regardless of their size.
The banks that failed recently had reported relatively high levels of capital and liquidity at the latest reporting rounds. However, they suffered from both a significant loss of trust and in some cases an unviable business model, which in turn contributed to large-scale simultaneous withdrawals, with shareholders and creditors being unwilling to provide extra liquidity. This leads us to ask whether we should be doing more.
These recent developments suggest that reassessing the calibration of the LCR − also in the light of how new technologies and social media may affect deposit outflows – could bring some benefits.
Regarding market sentiment, I would also stress that clear and transparent disclosure, both within banks themselves and towards investors, is essential. Internally, boards need reliable information for effective risk management, steering and sound decision-making. Externally, despite the overall resilience of banks, we have seen that contagion to other banks and markets can sometimes be caused by misstatements or other weaknesses in banks’ disclosures or in their risk management and controls. This is why it is important for banks to be transparent towards their investors. It is also important to be transparent about any exceptions to how to calculate the regulatory capital.
Moving on to new risks, such as crypto exposures, important steps have been taken. One is the Basel standards, which provide for a harmonised approach to banks’ crypto exposures and aim to balance responsible private sector innovation with sound bank risk management and financial stability. Another important step is the EU Markets in Crypto-Assets (MiCA) Regulation, which regulates the issuance of crypto-assets and the provision of crypto-assets services. While the MiCA is an important milestone, we will need to carefully learn from experience in determining what is still missing. For example, the MiCA will in many cases require supervision to be exercised at the entity level, while multiple services may be provided across several entities. Supervision and regulation at the consolidated level may therefore be necessary for obtaining a complete picture of the entities’ operation and preventing regulatory arbitrage.
Let us now look at crisis management. On the preventive side, let me highlight that banks have progressed significantly in their efforts to prepare for the unexpected, especially via their recovery plans. In this regard, we observe and appreciate that a lot of banks understand this as an integrated process strongly connected with internal risk management, emphasising the planning part in the first place, to be followed by a formal plan. In terms of crisis response, an important development was the publication of the European Commission’s legislative proposals for bank crisis management and a deposit insurance framework (CMDI package) on 18 April 2023.
The CMDI package expands the scope of banks subject to resolution to include small and medium-sized banks. The proposal aims to ensure adequate access to resolution funding, including by deposit guarantee schemes (DGSs) being able to contribute to meeting the loss-absorption threshold of 8% unlocking access to the Single Resolution Fund. Subject to several safeguards, it allows resolution funding to be drawn from DGSs rather than from the bailing-in of non-covered deposits in the cases where the failed bank’s deposit book is transferred to another institution.
The package introduces a single-tier general depositor preference, meaning all covered and uncovered deposits would be treated the same and would be senior to other unsecured claims in the creditor hierarchy. This enables a broader and more effective use of DGS funds, both in resolution and to finance preventive and alternative measures. In practice, it can help improve the stickiness of deposits. If deposits are treated the same, uncovered depositors should also have less incentive to withdraw their funds.
Overall, the ECB welcomes this package. It is a good step forwards in making the framework more effective in preventing and addressing the failure of banks of all sizes. and it is an important step towards strengthening and completing the banking union.
To conclude, looking at the recent market turmoil and the lessons learned, it is vital for banks to have a clear governance structure, with boards that can adequately address the challenges.
Other challenges we touched on today, are addressed through Basel III. While these standards need to be implemented in our regulation in a timely manner, there is no need for a major regulatory overhaul.
Finally, I welcome the proposed CMDI package and see it as a good step towards completing the banking union. With Spain assuming the Presidency of the Council of the EU for the second half of this year, I have no doubt we can make some further progress here.
Federal Deposit Insurance Corporation (2023), “FDIC Releases Comprehensive Overview of Deposit Insurance System, Including Options for Deposit Insurance Reform”, 1 May; Board of Governors of the Federal Reserve System (2023), “Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank”, 28 April.
ECB Banking Supervision (2022), “SSM supervisory priorities for 2023-2025”, December.
See footnote 2.
Enria, A. (2023), Exchange of views of the Committee on Economic and Monetary Affairs of the European Parliament, 21 March.
Enria, A. (2023), “A new stage for European banking supervision”, speech at the 22nd Handelsblatt Annual Conference on Banking Supervision, 28 March.
European Commission (2023), “Proposal for a directive of the European Parliament and of the Council amending Directive 2014/59/EU as regards early intervention measures, conditions for resolution and financing of resolution action”, 18 April.
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