25 November 2022

SSM's af Jochnik: Banking stability amid macroeconomic uncertainty

...euro area banks have proven themselves to be resilient to adverse and severe macroeconomic shocks characterised by high uncertainty in recent years, unlike during the global financial crisis.

It is a pleasure to be here in Milan today and introduce our discussions on credit perspectives for a sustainable recovery. In order to set the stage for the discussions that you will be having over the rest of the day, I would first like to talk about the performance of the euro area banking sector in the wake of the COVID-19 pandemic and the altered risk outlook brought about by the war in Ukraine. I will then outline the issues related to the banking business which will warrant the attention of both supervisors and bankers in the near to medium term.

To anticipate the thrust of my remarks, I would like to highlight three key messages.

First, euro area banks have proven themselves to be resilient to adverse and severe macroeconomic shocks characterised by high uncertainty in recent years, unlike during the global financial crisis. This shows, among other things, that the reforms enacted in the aftermath of the global financial crisis are working, and that the elements of those reforms that are still pending should be implemented without further delay.

Second, in a collective sense, bankers and supervisors need to carefully monitor the risks stemming from the current macroeconomic and financial environment and manage them accordingly. Banks need to be proactive in the early recognition and management of credit risk. They need to incorporate downside scenarios into their capital planning and be mindful of both the risks and benefits of rising interest rates. Banks would also be ill-advised to incorporate their expectations of future public sector interventions into their balance sheet management strategies, especially because these will necessarily have to be more targeted in nature than was the case during the pandemic.

Third, in the medium term, previously existing vulnerabilities, some of which have also been put in the spotlight due to the pandemic and the war in Ukraine, will continue to demand the attention of bankers and supervisors. In this context, addressing the challenges posed by digitalisation and making progress in preparing for the green transition are “must-haves” for banks, regardless of their business model.

Let me elaborate on these messages.

The impact of macroeconomic shocks on banking dynamics

The euro area banking sector proved to be resilient throughout the pandemic, with banks supervised by the ECB exhibiting capital and liquidity buffers which remained broadly unchanged at comfortable levels.^[1] Banks were therefore able to support the economy in spite of the severe negative fallout brought about by the COVID-19 shock. In contrast, during the 2008 global financial crisis, euro area banks were caught wrong-footed and forced to deleverage in a bid to repair their balance sheets, thereby exacerbating the magnitude of the economic downturn.

It is undeniable that the scale of the countercyclical policy response to the pandemic by both European and national authorities, which was significantly larger than the response by the same parties during the global financial crisis, was a key contributing factor to maintaining financial stability. However, it is also hard to argue against the notion that the differentiated scope of the policy response to the COVID-19 crisis – aiming to stabilise the real economy rather than just the banking sector – also stemmed from the fact that the banking sector was in comparatively better shape to begin with. Had this not been the case, banks would not have been able to fulfil their critical role of keeping the lending channel afloat as a lifeline for economic activity during the pandemic.

The banking sector’s differentiated response to these two crises therefore suggests that the Basel III reforms agreed by supervisors to enhance banking resilience in the aftermath of the global financial crisis have paid off. However, my experience with crisis management also suggests that no two crises are the same and that past successes are not necessarily reliable predictors of continued sound performance. This is why the elements of those global reforms that are still pending should be implemented in Europe without further delay.

As the banking sector emerged from the COVID-19 crisis, its stability was again put to the test with the outbreak of the war in Ukraine. Thus far, banks have coped well. In direct terms, the impact of the war seems to have been manageable, including for those banks with large direct exposures to Russia. In indirect terms, the macroeconomic shock provoked by the war, which is still ongoing, is yet to have any discernible effects on banks’ balance sheets. In aggregate terms, capital and liquidity ratios mildly edged down from the end of 2021 to the second quarter of 2022. However, they were still robust, in both cases remaining above pre-pandemic levels and close to their historic highs.^[2] Over the same period, the total non-performing loan ratio of banks supervised by the ECB continued to edge down to an all-time low of 1.9%. Banking profitability as measured by the return on equity metric was already on the mend amid the initial rebound in economic activity in the latter stages of the pandemic. It has been further buttressed by the positive effect on net interest margins associated with the turning of the interest rate cycle. As a result, most banks have posted profits in recent quarters that were above market expectations. Overall, the return on equity of banks supervised by the ECB edged up to 7.6% in the second quarter of 2022, the highest recorded value since the operational start of ECB Banking Supervision.^[3]

The profitability outlook for the remainder of 2022 remains optimistic on account of the positive contributions by lending volumes and margins to net interest income growth. Market participants seem to anticipate that the dynamic momentum in this regard will extend well into 2023.^[4] However, it is striking that this confident sentiment seems to have taken hold in spite of the fact that, since the outbreak of the war in Ukraine, real growth expectations by both public and private sector analysts have been revised down significantly. This is particularly true for 2023, with private sector forecasters now expecting the euro area economy to grind to a halt next year^[5]. And although the September 2022 ECB staff macroeconomic projections still foresaw a modestly positive real GDP expansion as a baseline scenario for the euro area in 2023, a recession scenario caused by euro area energy supply disruptions was also considered a possibility, should downside risks materialise.^[6] In this context, the ECB further warned in October that “the likelihood of [a] recession [was] looming much more on the horizon and the probability of it [had] increased”, and this assessment was also echoed in its November 2022 Financial Stability Review.^[7]

SSM

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