02 June 2020

SRB Board Member Laviola:The future of European Banking regulation in the aftermath of Covid-19

The sharp increase in the cost of debt has been a driving factor in the reduction of issuances of euro area banks. In 1Q 2020, banks under the SRB remit issued about €36.4 bn of MREL instruments, all in January and February. By comparison, in the 1Q 2019 SRB banks had issued €112 bn.

1. The impact of Covid-19 on the economy and financial markets

Covid-19 can be represented as an exogenous and symmetric shock for global and EU economies.

The Covid-19 shock has reverberated across financial markets; the Euro Stoxx 600 and the Euro Stoxx banks indices have respectively dropped by 20% and 41% since the third week of February. EU Bank share prices are currently priced 38% lower than in December 2019.

The sharp increase in the cost of debt has been a driving factor in the reduction of issuances of euro area banks. In the first quarter of 2020, according to preliminary estimations, banks under the SRB remit issued about  36.4 billion euro of MREL instruments, all in January and February. By comparison, in the same quarter of 2019 SRB banks had issued 112 billion euro of MREL instruments.

According to the European Commission’s 2020 baseline spring forecast, the euro area economy will contract by 7.7% in 2020 and will recover with a GDP growth of 6.3% in 2021. The ECB medium and severe scenarios are worse.  If this holds true, this would amount to a far deeper downturn compared to 2009, when euro area GDP had fallen by 4.5%.

Although the shock is a symmetric one, it will have asymmetric consequences. Each country has been hit differently. Each country faced COVID-19 with its own economic situation, be it strong or weak; and each country has had its own tailor-made response.

However, alongside these national responses, a coordinated European response from the various EU authorities is being put in place. Such a response is needed and will continue to be needed in order to maintain a level-playing field and find our way out of this crisis – together. 

In short, the situation is serious, but we are not taking the economic impacts lying down. Steps have already and are being taken to overcome the economic shocks - at national and at EU level.

Despite the severity of the crisis, we  also see signs of green shoots.  It is good to note that in more recent weeks bank issuances have restarted, although being in the bottom range of their “normal” values. We also observed a recent issuance of an Additional Tier 1 instrument, which was missing on the market since the end of February. So, now let us look at the policy response to help encourage these green shoots and overcome the challenges ahead.

2. The policy responses

An unprecedented number of policy measures at national and EU level have been put in place since March. The policy responses to the pandemic outbreak were essential to preserve financial stability and support economic recovery.

In the banking sector, there has been good coordination between regulators across the EU. The EBA and ECB banking supervision have played an important role; banks have been allowed to operate below the level of capital defined by the Pillar 2 guidance and encouraged to use their capital buffers. The SSM and EBA also recommended that, until at least October 2020, banks should not distribute dividends to shareholders for the 2019 and 2020 annual reporting periods, and refrain from share buy-backs aimed at remunerating shareholders. An amended approach in the application of the IFRS9 international accounting standard was also recommended, in order to avoid excessive volatility of loan loss provisioning.

Several macroprudential authorities have also provided capital relief so that banks can also maintain the supply of credit to the real economy. Besides the release of the Countercyclical Capital Buffer, other buffers have been lowered across the Banking Union, in particular the Systemic Risk and O-SII Buffers.

Furthermore, the European Commission recently proposed some modifications to the banking package aimed at facilitating lending during the Covid-19 crisis; a Communication clarified and encouraged the full use of the flexibility embedded in the regulatory and accounting framework as well as targeted amendments to the Capital Requirements Regulation.

Clearly, there is much work ongoing in order to deal with the economic fallout from the virus.

3. The SRB’s response

The SRB has also been playing its part. At the SRB, we have been carefully monitoring the impact of the Covid-19 outbreak on banks and financial markets and have joined European and national competent authorities in their efforts to alleviate the immediate operational burden on banks.

We have announced that we remain committed to working on the 2020 resolution plans and issuing 2020 MREL decisions according to the planned deadlines in early 2021. However, we have applied a pragmatic and flexible approach and postponed less urgent information or data requests, in line with the EBA’s recommendations.

The banking industry has achieved a lot in resolution planning in recent years and it is in our collective interest that this work continues. Good planning, the basis of crisis preparation, helps us to navigate the way forward and to continue making progress towards resolvability. In line with the new banking package, the 2020 planning cycle foresees that all SRB banks are subject to the same 12-month timetable. Notwithstanding the impact of the crisis and the remaining uncertainty, the 2020 cycle is well on track. 

Turning to the minimum requirement on own funds and eligible liabilities (MREL), the banking industry has made substantial progress in building up MREL and is overall in a good position today. At the same time, we are committed to ensuring that short-term MREL constraints do not prevent banks from lending to businesses and the real economy.

As regards existing binding targets, the SRB has announced that it will take a forward-looking approach to banks that may face difficulties in meeting those targets before new MREL decisions under the banking package take effect, with intermediate binding targets in 2022 and final targets in 2024. The SRB will continue to monitor carefully market conditions and will assess the potential impact on transition periods needed for the build-up of MREL. We are ready to use the flexibility allowed by the regulatory framework to adapt transition periods and interim targets applied to banking groups, as well as to adjust MREL targets in line with capital requirements, in particular with the changed capital buffers.

We believe that this approach provides banks with the flexibility they may need in the coming months, as well as ensuring a level playing field. At the same time, our collective work on resolvability should carry on to preserve financial stability and protect taxpayers.

4. Banks and regulators

Euro area banks entered this crisis in a much better shape than they were at the beginning of the previous one. According to a recent report by the EBA, at the end of 2019 banks’ common equity tier 1 was about 15% of risk weighted assets, from 9% in 2009; the liquidity coverage ratio (LCR) was well above the regulatory minimum of 100%, standing at around 150% on average; asset quality has constantly improved in the past years., with the Non-Performing-Loan (NPL) ratio decreasing to much lower levels. The progress made on MREL requirements provides banks with a greater degree of resolvability. Resolution plans have challenged banks to increase their crisis preparedness. Recent ECB data show that in this early phase of the crisis, banks, helped by their strengthened resilience, have faced the significant increase in the demand for loans without a sizeable tightening of credit standards compared with past crises[1].

Nevertheless, the fallout from the pandemic will likely determine significant losses and exercise pressure on banks’ profitability. A sensitivity analysis conducted by the EBA on the basis of the 2018 stress test indicates that credit risk losses could have an impact on EU banks’ CET1 ratios ranging between around 230 basis points and 380 basis points[2]. Based on these preliminary results, the banking sector would still have on average enough capital after loss absorption of about 1.1% of RWAs above the overall capital requirements. Government guarantees on bank loans coupled with supervisory relief measures are also expected to soften the impact on credit risk.

However, these results have to be interpreted with caution, given the overall uncertainty on the severity of the crisis, the length of the recession and the speed of the recovery, which will be uneven across countries and sectors. In particular, it is expected that NPLs will increase substantially notwithstanding all the support measures taken, although banks are certainly more resilient than in 2008. The impact of the crisis will also make more evident the problems of banks with unviable business models. We can say that this situation is not going to make banks that were already weak pre-Covid-19 any stronger. To be clear, the extraordinary support measures put in place by all the authorities are meant in the first place to support households and corporates, not to allow banks with unsound business models to survive. The requests to improve profitability, enhance cost efficiency, accelerate digitalisation become therefore even more important.

As concerns the implications for regulators, in line with the principles developed by the Financial Stability Board[3] and endorsed by G20 Finance Ministers in April, European authorities have shown a remarkable degree of coordination on the various measures taken to mitigate the impact of the crisis and facilitate the recovery; they have also exploited in the best way the flexibility embodied in the current regulatory framework. Another implication concerns the importance of not rolling back the regulatory reforms or compromising on the underlying objectives of existing international standards. Indeed, the progress made with the introduction of tighter banking regulation since the last crisis a decade ago has proven vital in the current one; the greater resilience of the financial system is also the result of the lessons learnt with the great financial crisis.

Conclusion    

Finally, I am hopeful that the occurrence of such a sudden economic crisis on a large scale will bring new momentum to addressing some of the remaining gaps in the framework, such as the completion of the Banking Union and a genuine Capital Markets Union. This would allow bank lending to circulate on a truly cross-border basis.

We need to establish a European deposit insurance in the first place. The present crisis, like the past one, again shows the need for decisive action towards harmonization to avoid ring-fencing and fragmentation along national lines. The enhancement of cross-border banking would improve private risk-sharing and access to low-cost banking services.

Furthermore, we still lack a credible solution for liquidity in resolution and the operationalisation of the common backstop to the Single Resolution Fund, as well as an alignment between resolution and insolvency frameworks, including a European bank liquidation regime for small and medium size banks, similar, for example, to the administrative regime in place in the US.

I am confident that by working together over the coming months we will keep our banking sector safe and sound.