Challenges and priorities for banking supervisors

Speech by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, at the 7th Biennial European Supervisor Education Initiative Conference hosted by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin)

Berlin, 17 October 2023

Introduction

I am delighted to be here today and would like to thank the organisers for their kind invitation. The title of the conference is “Crisis! – The new normal for the financial system?”. To answer this question, I would like to convey a message that is both cautious yet optimistic.

Let me start with the cautious part. There is no denying that the banking system has in recent years been hit by several external shocks in quick succession. I am of course referring to the coronavirus (COVID-19) pandemic and to Russia’s invasion of Ukraine. While the pandemic delayed the exit from a low interest rate environment, the fallout from Russia’s invasion of Ukraine hastened it. Banks have therefore had to adjust to the changed economic environment and, as the financial market turmoil unleashed by the failure of Silicon Valley Bank showed earlier this year, the path from “low-for-long” to monetary policy normalisation can be a bumpy one. This adjustment process is still ongoing, so although not part of a baseline scenario, we cannot rule out the possibility that the banking sector may face renewed challenges on this front in the future, or that it might have to deal with other risks from sources currently not on our supervisory radar.

From a policymaking perspective, the experience of recent years has been both humbling and comforting. Humbling because we have had to deal with very severe and, for the most part, completely unexpected negative shocks. But also comforting because the banking system showed its resilience when these shocks materialised. In my view, this resilience can be largely attributed to two main factors. First, the reforms to underpin banking activity agreed by global standard setters in the wake of the global financial crisis, commonly known as the Basel reforms, have proven their worth. And second, when confronted with challenges of an unprecedented scale and scope, both European and national policymakers have shown that they can act quickly in a mutually reinforcing manner, each within their own institutional remit, to find a commensurate response to the severity of the situation at hand. Taken together, these factors help explain why the European banking sector has recently been able to cope with challenges that in the past would have almost sunk it. And this brings me to the optimistic part of my message: better regulation, well-capitalised banks and strong institutions have yielded a more stable banking sector on the whole, and banks have been able to support the European economy.

In the remainder of my speech, I would like to expand on this cautiously optimistic note by talking about the challenges currently faced by the European banking sector and the priorities we as supervisors have identified to inform our work in the future. Let me start by looking at the issues brought to the top of the supervisory agenda as a result of the financial market turbulence that occurred in the spring of 2023.

Addressing interest rate, liquidity and funding risks

Events surrounding the failure of Silicon Valley Bank in the United States earlier this year showed that financial market sentiment remains volatile amid tightening financial and credit conditions. In a phase of the cycle where monetary policy is adjusting rapidly, banks may be affected by changes in financial agents’ perceptions of their management of interest rate, valuation and liquidity risks.

It is worth mentioning that these risks were already on the ECB’s supervisory radar well before the above-mentioned events. In 2022, our supervisory priorities already included topics such as interest rate risk in the banking book, credit risk in specific areas more sensitive to turning points in the interest rate cycle, such as commercial real estate and leveraged finance, and counterparty credit risk. Work in these areas continued into this year. For example, we conducted targeted reviews of banks’ risk management practices in commercial and residential real estate and have been making concrete recommendations to banks in this area. The results of our 2023 stress test unveiled in July^[1] also provided us with further insight, confirming that banks’ ability to generate net interest income under an adverse scenario with increasing interest rates largely depended on the nature of their business model and related balance sheet structure. That is why banks with a larger share of variable rate loans benefited more from rising interest rates than those relying mostly on fixed rate loans.

Concerning liquidity and funding, we asked banks at an early stage to prepare for the fact that the ECB’s targeted longer-term refinancing operations (TLTROs) would fall due, as widely anticipated by the market, so that the increase in funding costs would be duly accounted for in banks’ individual plans. The work done in this area thus far shows that banks have an exit strategy to replace their TLTRO funding, but that some of them may nonetheless find the current financial market environment challenging. We are also conducting a broader analysis of banks’ liquidity and funding plans, which will be finalised later this year. Pending this review, the market turmoil in the spring suggests that some elements of the framework used to monitor the risks to which banks are exposed may need to be fine-tuned. While the indicators used to gauge liquidity requirements under the Basel framework (such as the liquidity coverage ratio and the net stable funding ratio) are available on a monthly basis, the events in the spring revealed the limited ability of these metrics to flag issues in fast-moving situations where deposits were being quickly withdrawn. We have long been using our own metrics, such as the counterbalancing capacity, to assess banks’ preparedness to face sudden liquidity shocks. We are now looking to upgrade our analytical capabilities in this area by asking banks to send us their liquidity data on a weekly rather than a monthly basis.

In addition to this, following the events of the spring, we increased our supervisory scrutiny of banks’ unrealised losses. Our work in this area suggests that banks directly supervised by the ECB have around €70 billion in unrealised losses^[2] on debt securities held at amortised cost. Here, it is worth mentioning that the banks we supervise do not share the same business model features as the banks that came under pressure in the United States, especially the high dependence on volatile funding sources and material unrealised losses in securities portfolios held at amortised cost. Coupled with the fact that the scope of regulation for banks in Europe also differs from that in the United States^[3], this explains why we at the ECB do not believe there is a direct read-across between the bank failures in the United States and the banks under our supervision. However, while we are not overly concerned about the amount of unrealised losses of the banks we supervise in aggregate terms, such losses could still be problematic when combined with weaknesses in individual banks’ asset and liability management strategies. This brings me to my next point concerning governance and internal controls, where the experience from the events in spring is also relevant.

Maintaining the focus on banks’ governance

The market turmoil in the spring showed that weaknesses on the risk management side are often associated with deficiencies in banks’ governance frameworks. In the case of Silicon Valley Bank, the report released by US supervisory authorities following the bank’s demise^[4] clearly states that the bank’s Board of Directors and management failed to manage their risks. As regards Credit Suisse, the bank was beleaguered by a series of corporate governance and internal control setbacks which, coupled with its business model deficiencies, clearly had a bearing on its eventual collapse.^[5] These deficiencies are also echoed in the Basel Committee on Banking Supervision’s report on the banking turmoil, which identified the main fault-lines^[6] as fundamental shortcomings in the basic risk management of traditional banking risks, inadequate and unsustainable business models, a poor risk culture and a failure to adequately respond to supervisory recommendations. These common features of the banking failures that occurred in the United States and Switzerland are of course far from new and have been at the root of many banking crises in the past.

Good governance and sound risk management by banks is thus critical as a first line of defence to guard against sudden shifts in market sentiment. As the events in the spring also showed, it is very difficult to restore confidence in banks exhibiting severe weaknesses in their business model and governance once that confidence has been lost. And if governance mechanisms and related internal controls are inadequate, there is almost no level of capital that would be enough to prevent a bank’s demise once the market tide has definitively turned against it.

That is why I believe bankers and supervisors should continue to focus on bank governance and risk management in the period ahead. The record shows that here in Europe, we still have plenty of work to do in this area. For example, 73% of banks assessed in our 2022 Supervisory Review and Evaluation Programme were assigned a score of three out of four for internal governance, indicating that most banks we supervise still need to improve on this front.^[7] A major driver behind the enduring weaknesses in governance is the lack of management bodies’ effectiveness in terms of their composition, collective suitability and oversight role. We have been engaging with banks to remedy shortcomings in these areas for quite some time now, but it is fair to say that progress has not been as steady as we would have liked.

There is a careful balance to be struck from a prudential point of view. While banks’ management and boards obviously need to take ownership of their governance and business model strategies, supervisors should intervene when it is clear that changes are required. Again, the market turmoil we saw last spring was instructive, because the report produced by US authorities shows that, even when vulnerabilities in Silicon Valley Bank were correctly identified, supervisors did not take sufficiently prompt action to ensure that the problems were solved in a timely manner. This is why, as Chair Andrea Enria recently emphasised^[8], in future we need to find ways to be more effective on the governance front to ensure that shortcomings in this area are not allowed to fester.

Managing the economic slowdown

Thus far I have talked about the need for supervisors to keep a close eye on not only liquidity and funding issues but also on banks’ risk management and governance frameworks. Weaknesses in these areas could be especially sensitive to this phase of the interest rate cycle. Beyond these concerns, the main task for us as supervisors in the near term will be to ensure that banks are able to handle the consequences of the forthcoming economic slowdown, especially as regards credit risk. Compared with the June 2023 Eurosystem staff projections, the September 2023 ECB staff macroeconomic projections for the euro area contain a downward revision of 0.2 percentage points in 2023 and 0.5 percentage points in 2024 to the outlook for GDP growth, bringing it to 0.7% and 1% respectively, including on account of tighter financing conditions.^[9] In a similar vein, the ECB’s latest euro area bank lending survey^[10] shows that credit supply conditions have tightened significantly since the turn of the year and loan growth has decreased sharply. A more sluggish growth outlook means that some deterioration in banks’ asset quality is to be expected in the future, as already signalled by early arrears (meaning arrears between 30 and 90 days past due), which have increased across the board.^[11] Coupled with the slowdown in the pace of credit extension, this also implies that the positive contribution of interest margins to bank profitability is likely to wane in the period ahead, as higher interest rates are passed through to depositors and some downside risks materialise.

However, the banking sector as a whole appears well placed to deal with the challenges posed by a slightly deteriorated outlook. Banks supervised by the ECB have ample capital and liquidity buffers, with the aggregate Common Equity Tier 1 (CET1) ratio and the liquidity coverage ratio standing at 15.7% and 158% respectively in the second quarter of this year. And while some worsening of asset quality is to be expected in the period ahead, we still see no sign of this in headline terms, with the non-performing loan ratio of banks supervised by the ECB standing at a near-record low of 1.9% in the second quarter of this year. In addition, profitability has been steadily improving in recent quarters, supported by the normalisation of monetary policy, with banks’ return on equity edging up to 10% in the second quarter of this year.

Moreover, the results of this year’s ECB stress test also show that banks could withstand a more severe economic downturn than the one we currently foresee. In particular, the CET1 ratio of the 98 stress-tested banks would fall by 4.8 percentage points on average, to 10.4%, if they were exposed to three years of stress under a very adverse scenario, assuming a prolonged period of low growth, elevated interest rates and high inflation. The negative impact on capital in the adverse scenario was driven by credit risk and market risk, coupled with lower income generation by banks. Capital depletion in 2025, at the end of the three-year horizon, was lower in this exercise than in previous stress tests. This was mainly owing to banks being in better shape overall going into the exercise, notably thanks to higher-quality assets and stronger profitability.

Dealing with the digital and green transitions

Looking further ahead, there are at least two areas in which banks will need to improve regardless of their business model, and which will therefore warrant continued supervisory attention in the medium term.

The first of these is digitalisation. Our overarching aim is to ensure that banks are in a strong position to manage the risks stemming from the digital transformation and the related implications for the sustainability of their business models. We are fully aware that investment in digital and IT technologies and infrastructure entails a sizeable sunk cost, but we also believe that banks can thrive on the opportunities offered by the digital transformation. For this to be the case, however, banks need to show that they have governance and risk management frameworks in place that are capable of dealing with the challenges related to strategic and execution risks, technology-related and operational risks and potential emerging threats, among other things.

The results of our digital transformation survey, which we conducted among supervised banks earlier this year,^[12] paint a mixed picture. While almost all banks have a digital transformation strategy, their degree of maturity differs, with most strategies focused on improving customer experience and offering digital services and products. And while banks spend on average a fifth of their IT budget on digitalisation, most of them do not yet have a dedicated digital transformation budget. However, the results also show that banks are fully aware that setting the right tone from the top down and having an effective internal control framework are key to enabling the digital transformation. We are now following up on these results through on-site inspections and targeted reviews, which will help to shape our supervisory expectations on digital transformation in the period ahead.

The second area in which banks will need to make progress is climate-related and environmental risks (C&E risks). As you know, the ECB has taken several steps to include C&E risks in its ongoing supervision. We have made it clear that it is not up to the ECB to tell banks how green their lending policies should be. However, we have also emphasised that failing to take into account the transition towards a more sustainable economy would be incompatible with sound risk management. This is why we want supervised banks to manage their C&E risks in the future in the same way they manage any other material risk today.

The results of the various C&E initiatives that the ECB has taken in recent years suggest that banks have made progress in their treatment of C&E risks but that they still have some way to go to properly incorporate these risks into their risk management frameworks.^[13] That is why we have set intermediate and bank-specific deadlines for banks to align their frameworks with our supervisory expectations in this area by the end of 2024. We will be following up on this to ensure they do so, imposing periodic penalties or requiring bank-specific capital add-ons if necessary.

Conclusion

Let me conclude. We can safely say that the European banking sector remains solid overall, having successfully weathered the challenges brought about first by the pandemic and, more recently, by Russia’s invasion of Ukraine. These and other recent events, such as the market turmoil that occurred in the spring of this year, have seriously tested the Basel regulatory reforms. I think we can be satisfied with the results, in that the framework has largely worked as intended. However, we should not lose sight of the fact that certain aspects, such as the prompt integration of the remaining Basel III standards into European law and the completion of the European banking union project, would cement the resilience of our banking sector even further. We would therefore welcome further steps in this direction.

While the framework underpinning banking activity is not in need of major reform, banks need to pay close attention to credit, valuation and liquidity risks in the current financial market environment. Recent experience suggests that, while being a helpful means for banks to buttress their financial bottom line, rising interest rates entail a number of risks for banks. These risks need to be appropriately managed as the pace of economic activity is set to slow. From a prudential perspective, we will continue to challenge banks’ business models and risk management capabilities to ensure they remain viable in the medium term, and to assess banks’ preparedness to deal with both the digital transformation and the green transition.

Overall, we remain hopeful that with the cooperation of all stakeholders concerned, we will make further inroads into building a robust banking sector that enjoys the confidence of all Europeans and is able to serve their needs in an efficient manner.