17 February 2021

SSM: “We are not out of the woods just yet”

Kerstin af Jochnick, Member of the ECB’s Supervisory Board, looks back at the road travelled by banks and supervisors during the pandemic – and is confident that the resoluteness shown so far will stand European banks in good stead for the challenges of the year ahead.

2020 was certainly a busy year for crisis management but, at the micro level, there was little news about banks in financial distress. Is the worst yet to come in 2021? Are banks’ credit risks adequately reflected in banks’ balance sheets?

I would like to highlight two points in response to this question. First, euro area banks began 2020 with significantly higher capital levels and far greater resilience to economic deterioration than was the case in the great financial crisis. This meant that the banking system as a whole was well-poised to deal with the immediate economic fallout from the outbreak of the pandemic.

Second, the scale of the direct or indirect measures taken by different stakeholders to support the banking sector has been extraordinary and unprecedented, consistent with the magnitude of the shock.

The combination of these two reinforcing factors has meant that this time, banks have been part of the solution to the crisis, rather than part of the problem. Banks have been a stabilising force in the economy by avoiding procyclicality and continuing to lend to corporates and households to the extent possible. In its role as supervisor, the ECB has tried to facilitate this effort: we have recommended that banks restrict dividend distributions to enhance their loss absorption capacity, and we have released their capital buffers to increase their lending capacity.

However, we are not out of the woods just yet. Several European countries are currently grappling with the third wave of the virus, and many of the measures taken by national authorities to support the banking system, such as payment moratoria for bank customers and loan guarantees for the banks themselves, are still in place. So the impact of the crisis on the European banking sector has not yet fully materialised. Our main concern is that, as the economic shock continues to reverberate, bank customers may find it more difficult to repay their loans. This is why credit risk has been a major focus of supervisory attention up to now and will remain a key priority in the future. Banks need to proactively manage their emerging non-performing exposures, assess the evolution of borrowers’ unlikeliness to pay, and be able to forecast how the crisis is most likely to affect the overall quality of their capital and provisioning of their exposures.

One year on from the start of the coronavirus (COVID-19) crisis, what is the key lesson learned for recovery planning?

The main lesson is that banks’ recovery plans still have some way to go to show that their recovery options are credible and can be implemented in a timely manner in times of stress. In this respect, the pandemic has reminded us of the importance of sound recovery plans as a crisis management tool. Let me mention two areas where improvements are needed.

First, our analysis of banks’ recovery plans suggests that banks’ overall recovery capacity (ORC) – in other words the amount of capital and liquidity that banks can generate via their recovery options – can be significantly compromised in times of financial stress. Some options, such as raising capital or selling a subsidiary at a fair price, may be difficult to implement during a crisis. Moreover, we found that a substantial number of banks relied on just one or two recovery options for most of their ORC. This means that banks’ ability to recover, in terms of this metric, could be severely hampered if one of these options was not available.

Second, we also found that the calibration of some recovery indicators was not sufficiently robust to the stress caused by the pandemic. There have been numerous breaches of recovery indicators since the start of the pandemic. This is not too concerning in itself, because these breaches alert banks to a possible crisis and trigger a review mechanism within each bank that should enable them to respond swiftly. However, our analysis suggests that the macroeconomic and market-based indicators which are supposed to trigger these internal reviews were too backward-looking, and the thresholds for triggering the activation of recovery options were too lenient.

It is worth noting that our benchmarking exercise to assess banks’ ability to respond to an extraordinary event was based on their recovery plans from 2019, when the COVID-19 shock was not yet on the radar. Following the outbreak of the pandemic, we took steps to reduce the operational burden on banks associated with producing recovery plans for 2020, while reminding banks of the need to monitor and update the core elements of their plans. Looking ahead, our main task is to encourage banks to include more robust, forward-looking indicators in their recovery plans so that they are more effective in crisis situations.

The doom loop between sovereigns and banks has been strengthened during the pandemic owing to the massive government support packages. Will this create a problem in the coming years and how can we stop the link between governments and banks getting stronger?

This question can be tackled from two different time perspectives. The short-term perspective is that, yes, measures such as granting payment moratoria for bank customers and extending government guarantees to banks have reinforced the linkages between domestic banking systems and their respective sovereigns. However, the silver lining is that these measures were taken specifically to deal with the current situation, so they are temporary in nature. Here, our task as supervisors is to ensure that the problem the banking union was designed to address is not exacerbated by the crisis. This calls for close monitoring of the situation once the payment moratoria and loan guarantees expire. We also need to focus on banks’ exposures to local or central governments in the context of rising public debt issuances.

Turning to the longer-term perspective, the pandemic has revealed that the banking union is a vulnerable construct because its institutional architecture remains incomplete. Again, there is a silver lining because there is no denying that, since political leaders first endorsed the idea of a banking union in 2012, the sovereign-bank nexus has been significantly weakened with each milestone of the project, particularly the establishment of a single supervisor and a single resolution authority. However, the European banking market remains fragmented along national lines and the third pillar of the banking union – a European deposit insurance scheme, or EDIS – is still missing. The fact that the banking union has successfully weathered the challenges caused by the COVID-19 crisis until now does not necessarily mean that it will continue to do so indefinitely – whether at other stages of the crisis or in similar situations. This is why it is important that work to complete the banking union proceeds in earnest.

In your view, is EDIS the only outstanding topic to complete the banking union, or are there other areas that need to be addressed?

There has been little progress on EDIS since it was first discussed in 2015. So obviously this is the issue to be fixed. EDIS is important for so many reasons: it is key to securing confidence in the banking union and creating trust between home and host authorities, which in turn helps to further challenge the ring-fencing attitude to cross-border capital and liquidity management that has to some extent persisted since the great financial crisis. EDIS would also level the playing field and reduce the risk of bank runs. And finally, EDIS would further weaken the link between domestic banks and their sovereigns.

But there are other, less talked about areas of the banking union where progress is also needed. As I already mentioned, the European banking market remains fragmented along national lines. Pending the establishment of EDIS, we have recently put forward a number of innovative proposals to make progress on this front. These include introducing adequate incentives and safeguards to enter into group support agreements and linking those group support agreements to recovery plans. There are also persisting discrepancies between national bank insolvency regimes, which lead to differences in the way that crises for small and medium-sized banks are managed across countries. And while harmonising insolvency regimes across Europe would be desirable, we know that this is difficult to do and would take years to accomplish. This is why we would favour additional liquidation powers for resolution authorities, as this would lead to a more consistent European framework for the exit of weak banks from the market.

Therefore, the to-do list for European policymakers involved in the banking union project is still rather long, but I am hopeful that we will get it done. If we compare the current institutional and regulatory set-up for banking activity across Europe with the one in place during the great financial crisis, we can clearly see that a lot has been accomplished in a relatively short period of time. And the pandemic has shown that there is value in having pan-European structures to regulate and oversee banking activity in its different forms, as it allows, for example, the single supervisor to act swiftly to roll out a very sizeable relief package for banks across the euro area. So from this perspective, I remain hopeful.

Macroprudential supervision is important for European banking supervision. How does macroprudential supervision interact with day-to-day banking supervision?

Microprudential and macroprudential policies are mutually reinforcing in that they are complementary parts of a common policy framework to preserve financial soundness and financial stability. Microprudential policy primarily targets the safety and soundness of individual banks while the macroprudential policy safeguards the stability of the financial system as a whole. These are two sides of the same coin.

In practice, the Governing Council and Supervisory Board of the ECB regularly combine the two perspectives in the Macroprudential Forum, a body which brings together policymakers from the microprudential and macroprudential realms. At the staff level, there is a continuous exchange between the ECB’s macroprudential and microprudential functions on financial stability risks, policy measures and regulatory issues. And ECB Banking Supervision actively contributes to the European Systemic Risk Board, which is responsible for overseeing the EU financial system and counts national macroprudential authorities among its members.

How would you characterise the cooperation between microprudential and macroprudential authorities during the COVID-19 crisis?

The pandemic has put the cooperation between the different macroprudential and microprudential stakeholders to the test and while there is certainly room for improvement, my overall sense is that this has worked relatively well. Let me mention two examples in this regard.

The first example concerns the decisions on capital buffers. ECB Banking Supervision moved quickly to help banks to cope with the stress caused by the outbreak of the pandemic. In March 2020 we announced that banks would be allowed to temporarily operate below the applicable capital and liquidity buffers, including the capital buffer known as Pillar 2 guidance, which is set for each bank by the supervisor. Buffers are specifically designed to be used in situations like the COVID-19 crisis, and releasing them helps to avoid the regulatory framework having a procyclical impact, enabling banks to absorb losses and keep lending to the real economy. The measures taken by national macroprudential authorities had similar goals, with several countries releasing their countercyclical capital buffers in preparation for the economic downturn.

However, although the logic behind banks’ capital buffers has worked largely as intended, the system can still be improved. Many banks have not made use of their buffers, in part or in full, despite our reassurances that they will have ample time to replenish them should they decide to use them. Their reluctance may be due to residual stigma, financial market pressure, or the fact that use of certain buffers can activate automatic triggers limiting remunerations and distributions, including coupons on capital instruments other than common equity. In this regard, it is evident that Additional Tier 1 instruments are not working to absorb bank losses on a going concern basis as was originally intended. And while there is a broader debate among policymakers on the split between the cyclical and structural components of banks’ capital, it is also clear, with hindsight, that cyclical buffers were not sufficiently built up during the “good times” to be released during a sharp downturn. Microprudential and macroprudential policymakers should work together to address these aspects, once the pandemic is over.

The second example concerns the actions we have taken around dividends. On the microprudential side, the ECB first recommended that banks refrain from distributing dividends or engaging in share buy-backs in March 2020, as a temporary and exceptional measure to keep precious capital resources in the banking system at a time of considerable uncertainty. On the macroprudential side, in June the ESRB also recommended that the relevant authorities ask all banks, insurers and other financial institutions to temporarily suspend distributions. The two recommendations therefore complemented each other. The ECB and ESRB modified their respective recommendations in December 2020, with this complementary approach in mind.

From a microprudential perspective, the ECB assessed that the level of uncertainty over the impact of the crisis on banks had decreased, but considered that a continued prudent approach to dividend distributions remained necessary. So, banks were asked to consider not distributing any cash dividends or conducting share buy-backs, or to limit such distributions, until the end of September 2021. In this regard, we clarified that only profitable banks with robust capital trajectories should consider making dividend distributions. The ESRB modified its recommendation in a similar direction and with an identical time horizon, envisaging that limited distributions could be resumed if they were appropriately discussed with the competent authority.

SSM

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