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, 28 June 2023
The year got off to a tumultuous start, but the European banking sector has shown remarkable resilience. This is testimony to the progress made by our banks in their long journey to addressing the disruptive legacy of the great financial crisis and the sovereign debt crisis. It also confirms the effectiveness of the enhanced regulatory and supervisory reforms implemented over the last ten years. But this resilience should not be cause for complacency. Rather, it should remind us of the need to continue our efforts to adapt our framework to an ever-changing risk landscape.
Outlook for the banking sector
The euro area banking sector continued its generally positive performance in the first quarter of 2023.
Banks’ capital positions remain strong, with preliminary data suggesting that banks’ Common Equity Tier 1 ratio has increased by 50 basis points compared with the first quarter of 2022, to now stand above 15.50%. However, asset quality developments show a mixed picture. While both the non-performing loan ratio and the stage 2 loans ratio decreased further, arrears have increased across the board.
The increase in arrears is not unexpected in the current monetary policy tightening cycle. While the rapid increase in interest rates has helped to boost interest margins and overall bank profitability, this effect is expected to fade away as the higher interest rates are passed through to depositors and some downside risks – mainly credit, valuation, and liquidity risks – start to materialise.
We have been looking at interest rate and credit spread risks since late 2021 through several off-site and on-site activities. Where our teams identified weaknesses in the management of these risks, they have asked banks to take swift remedial action. The 2023 stress test designed by the European Banking Authority will also assess banks’ vulnerabilities to very harsh macroeconomic scenarios, including further changes in interest rates.
Following the banking turmoil in the United States, we also sharpened our scrutiny of unrealised losses. The significant banks directly supervised by the ECB have around €70 billion of unrealised losses, net of hedging, on debt securities held at amortised cost. Although not material in aggregate terms, these losses can become problematic when combined with weaknesses in banks’ asset and liability management. Nevertheless, unlike Silicon Valley Bank, the banks we supervise do not have extreme exposures to interest rate risk or a predominant reliance on a concentrated, uninsured deposit base.
With respect to funding and liquidity risks, we have just completed a targeted review of banks’ exit strategies from the targeted longer-term refinancing operations (TLTROs). This sought to assess which banks have a material reliance on this funding source and are more vulnerable to ongoing increases in market funding costs. The findings show that all the banks we reviewed have a strategy in place to replace their TLTRO funding, although some may face challenges in the currently fragile market environment. This review will be complemented by an analysis of banks’ liquidity and funding plans later this year.
In parallel, we are continuing to look at the sectors that are more sensitive to interest rate hikes, namely commercial and residential real estate. We concluded targeted reviews on banks’ related risk management practices at the beginning of the year and are providing concrete recommendations to banks.
As regards profitability effects, when measured on an annual basis, banks’ profitability increased on the back of growing net interest income. However, on a quarterly basis, net interest income is actually decreasing for a constant sample of significant banks. In the first quarter of 2023, for the first time since interest rates started to increase, the rise in banks’ funding costs exceeded the increase in interest income. It is therefore crucial that we remain prudent, as we can expect increasing interest rate competition between banks to further narrow their interest rate margins.
Lastly, we should not forget that some of our banks still face structural weaknesses in their business models and many are grappling with the challenges presented by climate-related and environmental risks and the digital transformation. Long-standing shortcomings, such as poor strategic planning, revenue concentration and deficiencies in the steering capabilities of management bodies, continue to pose a clear threat to the overall sustainability of banks’ business models. In our view, progress in these areas is still insufficient. For this reason, in our supervisory dialogue with banks we are continuing to push them to actively tackle these enduring structural weaknesses.
The need for strong supervision
The challenges posed by the monetary policy tightening cycle and the recent turmoil in the banking sector underline the constant need for us supervisors to question whether we are focusing on the relevant risks. While we should always be open to reviewing and adjusting our regulatory framework based on the experience we have gained, it would be inefficient, if not plainly wrong, to constantly seek to amend the rules to capture those risks created by bank-specific weaknesses and outlier business models. Those weaknesses should be addressed by effective, intrusive, and risk-based supervision. Supervisors should be empowered and willing to step up pressure on banks to ensure that they promptly remedy their shortcomings. This is possibly the most important lesson to be learned from the US authorities’ reports on the recent failures.
ECB Banking Supervision had been looking at ways to enhance our supervisory effectiveness before the recent turmoil. In 2022 we tasked a high-level group of experts with reviewing our supervisory processes, and they published their report in April 2023. More recently, the European Commission and the European Court of Auditors also published reports on our supervision. We take the recommendations made in these three reports very seriously and will work hard to implement them as soon as possible. In fact, several of the recommendations refer to weaknesses that we had already identified and are in the process of remedying. For example, we had already started to strengthen the effectiveness of our supervisory processes by increasing the risk-based focus of supervision and by defining clear escalation actions for our supervisors. Further efforts are under way to enhance our efficiency, transparency and predictability, and the three reports will serve as valuable input to our continuous endeavour to improve our supervisory work. With due respect and consideration for the observations made in the European Court of Auditors’ report, we remain convinced that our comprehensive and proportionate approach – which is tailored to the specific situation of each bank – was the best course of action available and has contributed meaningfully to the significant decrease in non-performing loans in the banking union in recent years.
The need for a strong regulatory framework
Strong supervision is, of course, also a product of strong regulation, and co-legislators have some crucial dossiers on the table.
The review of the crisis management and deposit insurance framework is an important opportunity to improve and harmonise crisis management at European level. We strongly support the Commission’s proposal, which draws on recent experience and aims to address practical issues that complicate the authorities’ efforts to ensure that failing banks can smoothly exit the market. We support extending the use of resolution tools to a broader spectrum of banks. This requires realistic solutions to facilitate access to funding in resolution. We therefore welcome the Commission’s proposals to allow deposit guarantee schemes to contribute more in resolution. This improved use of deposit guarantee schemes would be aided by a clarified and harmonised least cost test and a single-tier depositor preference. We encourage the co-legislators to make swift progress on the file and we consider it important for an agreement to be found before the end of the current legislative cycle.
Completing the implementation of the final Basel III reforms is another key component that will strengthen the regulatory framework for EU banks. We welcome the political agreement reached in trilogues yesterday, which paves the way for implementation by 1 January 2025. We will consider the details of the agreement before taking a final view on the package but let me say it again: only strong banks can sustainably supply the necessary lending to the economy, also in times of stress. Therefore, we should remain particularly vigilant about the pockets of risk which may be left unaddressed owing to deviations from the Basel standards. With this in mind, deviations should be reviewed against their stated policy objectives.
Let me also say that we very much welcome the new rules and powers that will derive from the Capital Requirements Directive (CRD VI). Among the many positive elements, I would highlight the new provisions on environmental, social, and governance activities, the harmonisation of the fit and proper framework and the minimum requirements applicable to branches of third-country banks. The agreement reached on the latter topics has been very much welcomed by us as the recent events have emphasised the necessity of a good governance in banks and an effective supervisory cooperation for third country groups activities.
Thank you very much for your attention. I now look forward to your questions.
This refers to early arrears, meaning arrears between 30 and 90 days past due.