21 June 2021

SSM's McCaul: Emerging risks for the European banking sector in the post-pandemic era

This period of unprecedented coordination of supervisory, monetary and fiscal policies which have supported the economy for our citizens is also an opportune moment to identify any risks that are lurking beneath the surface.

It is an honour to be invited to the Salzburg Global Finance forum to take part in such a timely discussion about emerging risks. I say “timely” because we are meeting at a moment when we can be hopeful that the worst of the coronavirus (COVID-19) pandemic will soon be behind us, as vaccine campaigns are well underway.

Let me start on a positive note. European banks are performing well and show resilience during the pandemic. This is thanks to the extraordinary coordinated public policy measures and the efforts to strengthen their fundamentals since the Great Financial Crisis through regulatory reforms as well as banks’ own strategies to reduce their legacy stock of non-performing loans (NPLs) since 2015. Even during the first year of the pandemic, the NPL ratio of euro area banks fell from 3.1% end March 2020 to 2.5% end March 2021. The economic outlook has improved considerably and the recovery seems firm and widespread. So, it is not surprising that there is a positive sentiment among markets and analysts reflecting expectations of enhanced bank profitability, also driven by gradual release of precautionary loan loss provisions. The drop in euro area bank cost of risk from 70 bps end June 2020 to 64 bps end March 2021 illustrates this point.

Looking at the bigger picture, however, we should not ignore the warning lights on the dashboard that call for caution over emerging risks: low interest rates are forcing search for yield, easier access to credit is available which of course is good unless it becomes excessive and contributes to an untenable credit risk environment. We also see exuberance in asset valuations in certain segments of the equity markets; increasing leverage; ever more complex credit products containing market risk attributes increasing opacity in the markets, increasing lending via derivatives to the non- bank financial sector. These warning lights may sound familiar. Some were features of the subprime crisis leading to the Great Financial Crisis. They also played a role in the recent Archegos case which is not dissimilar to the Long Term Capital Management debacle.

Opacity is a familiar culprit. It confounds the ability of market participants to assess overall notional and risk level of exposures. Opacity also contributes to growing risks from interconnectedness in the financial markets that intersect with bank balance sheets. Opacity is our enemy for any number of reasons. As Andrea Enria, Chair of the ECB Supervisory Board once said, it “is a powerful crisis accelerator.”^[1]

Today, I will focus on some market and balance sheet trends that warrant attention for different reasons: some represent: (1) warning lights, and others (2) pose risks and offer rewards.

Warning lights

Non-bank financial institutions

Non-bank financial institutions (NBFIs) have been a feature of the US markets for some time, but we have seen tremendous growth globally in the so-called shadow banking market since the Great Financial Crisis. The NBFI sector – comprising mainly pension funds, insurance corporations and other financial intermediaries – has grown faster than the banking sector over the past decade. The financial assets of the NBFI sector amounted to USD 200.2 trillion in 2019, accounting for nearly half of the global financial system at the time, up from 42% in 2008. The expansion of collective investment vehicles such as hedge funds, money market funds and other investment funds are a key driver of NBFI growth. Assets of this diverse range of entities grew by an average annual rate of 11% between 2013 and 2019 to make up 31% of the NBFI sector, reflecting both sizeable inflows and valuation gains^[2]. Behind this massive increase there could be areas of high leverage and concentrated exposures in opaque entities in less regulated parts of the markets. These warrant attention from bank risk managers.

The Archegos case is just one in a series of individual episodes of extreme price volatility in financial markets where lack of transparency and excessive leverage have been recurring themes. The true extent of the use of leverage, particularly synthetic leverage, is largely unknown and that is worrying from a financial stability perspective.

From a banking supervision perspective, the lessons of the Archegos case are not new. Banks should strengthen their credit risk management approaches for certain types of non-bank financial institutions, especially where counterparty risk exposures contain market risk attributes. Banks should place greater emphasis on requiring clarity about overall leverage when dealing with opaque counterparties and on avoiding risk concentrations.

Greater transparency will reduce the risk of accidents.

Asset quality and profitability

When looking at bank balance sheets, heeding the warning lights is also warranted in the areas of asset quality and persistently low profitability. The upcoming gradual withdrawal of COVID-19 government support measures could have a negative impact on asset quality and translate into an increase in NPLs. There may also be an increase in NPLs once public support measures are completely lifted. This impact typically materialises with some delay and, owing to the prevailing uncertainty, it is still difficult to estimate the timing and size of a potential increase in NPLs. There are discussions in the market about releasing provisioning in the light of the nascent recovery and emerging positive economic data but rushing to release provisions before the full effects of pandemic are known would not be prudent.

One lesson from the Great Financial Crisis is that a lack of transparency about asset quality on bank balance sheets hampers the proper functioning of the banking system.

History shows that economic recoveries are threatened when NPLs are allowed to pile up on bank balance sheets, creating a debt overhang which mutes the economic recovery. So, it’s crucial that banks anticipate, accurately recognise and address early any difficulties that borrowers may have in making repayments when support measures are ultimately withdrawn. Responding with sound and timely restructurings requires robust risk management practices that contribute to both helping borrowers and avoiding cliff effects for the bank. This is why in ECB Banking Supervision we remain focused on the need to strengthen credit risk management and identify credit deterioration and asset quality as swiftly and accurately as possible.

Structurally low profitability was a characteristic of many European banks even before the pandemic, underscoring the need for banks to review their business strategies and take advantage of technology transformation and consolidation opportunities. Banks need to implement ambitious initiatives to improve the sustainability of their business models and boost cost efficiency, hopefully taking on board some of the lessons learned from harnessing technology during the pandemic-induced lockdowns. On a positive note, European banks have made progress since the Great Financial Crisis, and technological changes have helped reduce branch footprints by almost a third, leading to a leaner and more efficient aggregate banking system. Banks are also partnering with technology companies to simplify products and processes, reduce the costs of maintaining IT systems and offer services to clients on new technological platforms....

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