03 November 2020

SSM's Enria: Supervisory challenges of the pandemic and beyond

SSM’s countercyclical response to the pandemic. This year, ESM has responded rapidly and forcefully to the coronavirus pandemic. During this starkest of challenges, banking union has proved invaluable in enabling a swift and unified supervisory response across the whole euro area.

The work on building up bank capital during the last decade has been crucial. The fact that banks had stronger capital positions allowed us to launch a decidedly countercyclical response to the financial fallout of the pandemic. By releasing buffers and preventing capital from flowing out of the sector, we helped to avert the sharp tightening of credit standards that followed previous shocks. And by immediately and fully using our microprudential tools, we strongly contributed to overall financial stability across the banking union. Market-based evidence shows that the combined monetary policy and supervisory response has helped to ward off the bank-sovereign doom loop we have seen in the past. Considering the magnitude of the shock, this is in itself a remarkable result.

Banks need to proactively manage credit risks

Although financial stability has been maintained so far, the fallout of the pandemic has yet to show up on banks’ balance sheets. In the last few weeks, some of the loan moratoria put in place by national governments have expired. While we only have anecdotal information so far, we are seeing most borrowers resume loan payments, with only a small fraction showing signs of distress.

At the same time, the macroeconomic outlook is fraught with uncertainty, with coronavirus infections on the rise again. According to ECB estimates, in a severe but plausible scenario non-performing loans (NPLs) at euro area banks could reach €1.4 trillion, well above the levels of the financial and sovereign debt crises.

Banks must brace for the impact now. Early identification of arrears, case-by-case reclassifications and prudent provisioning choices are of the essence. Banks have to proactively distinguish viable distressed customers from non-viable ones by using borrower-specific debt restructuring and forbearance practices. ECB Banking Supervision will closely monitor banks’ preparedness for dealing with the impending deterioration in the quality of their assets. They need to align their capital projections to sufficiently conservative scenarios and move ahead with well-defined strategies for asset reclassification in the face of heightened risk.

No repeat of history with regard to asset quality

While banks have to do their part, we all have to guard against a repeat of history with regard to asset quality. Twelve years after the default of Lehman Brothers and nine years after the first private sector involvement during the Greek sovereign debt crisis, asset quality at euro area banks still remains below the levels we saw before the 2008 crisis. The European Banking Authority and the ECB have already issued practical guidance requiring banks to manage NPLs more actively and legislation has been introduced to ensure progressive write-downs of impaired assets.

But experience shows that asset management companies allow for a much quicker clean-up of bank balance sheets and are consequently very effective in restoring banks’ ability to lend.

A European network of asset management companies, if appropriately designed, could speed up the process of restoring asset quality. In my view, two elements of any such network would need to be firmly anchored at the European level: funding and pricing. Funding provided or guaranteed by a European body would allow each national asset management company to benefit from the EU’s credit standing and enjoy better market access. Common financial resources would of course require appropriately standardised and verified valuation methodologies and data to determine the transfer price of the assets. The low cost of funding and a carefully designed and verified common valuation methodology should ensure the right balance between the losses imposed on banks upon transfer of the NPLs and the medium-term profitability of the asset relief scheme.

Direct access to the scheme should be limited to those banks that, in the opinion of the supervisor, have a viable business model, enabling them to thrive as standalone entities when the crisis is over. For other banks, participation should be based on strict conditionality, including decisive restructuring measures. In the unlikely case such a scheme ends up making losses, we could dhttps://www.bankingsupervision.europa.eu/press/speeches/date/2020/html/ssm.sp201103~82fa2cb440.en.htmlesign a framework that limits or even prevents any mutualisation of credit losses across the EU: losses could be allocated in accordance with the nationality of the originating banks and the corresponding national scheme.

Setting up a European system of asset management companies is not about helping banks which took excessive risks and did not properly manage them. It is about enabling banks across the EU to support viable households, small businesses and corporates. And it is also to accompany the much needed structural transformation of our economies towards a greener and more technologically advanced future without being weighed down by impaired exposures to the economic sectors worst hit by the crisis.

Urgent need to address pre-crisis structural weaknesses

In tackling the challenges posed by the pandemic, we must not lose sight of the fact that the European banking sector was already beset by structural weaknesses when the crisis hit. Persistent low profitability, caused by excess capacity and low cost efficiency, has driven bank valuations to historic lows. The need to tackle these structural issues is now more urgent than ever.

One avenue to remove excess capacity and restore European banks as attractive investment propositions is consolidation. Experience in other countries and industries shows that, in the aftermath of large shocks, consolidation is often a key ingredient for a swift and successful recovery. Bankers and market analysts have indicated that the regulatory framework and supervisory practices, also at the ECB, were perceived as obstacles to consolidation. We tried to clarify our supervisory approach to consolidation and show that it is supportive of well-designed and well-executed business combinations. The draft ECB guide on the supervisory approach to consolidation in the banking sector has been submitted to public consultation and will soon be finalised. And targeted harmonisation could help make the European single market more integrated, for instance by identifying and removing territorial elements in the current rulebook that represent an obstacle to cross-border mergers and acquisitions.

But economic developments are shaped as much by technological innovation as by economic policy. While trade liberalisation has rightly been celebrated as a key driver of global economic welfare, technology played a part too. The invention of the container has dramatically reduced shipping costs – estimates suggest that current trade levels would decrease by about a third without container technology.^[1] By the same token, digitalisation might reinforce the impetus for business combinations to reap potential economies of scale.

By proactively confronting the challenges I have just mentioned, we can improve the health of the banking sector and support a speedy economic recovery. And I now look forward to our discussion!

SSM

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