04 October 2022

SSM's Enria: Better safe than sorry: banking supervision in the wake of exogenous shocks

Today I will focus on the risk outlook for the euro area banking sector at this delicate juncture and on the approach taken by the ECB to ensure banks remain focused on risk management and on prudently monitoring the multi-faceted downside risks emanating from a fast-changing economic environment.

Banks’ first half results portray a strong euro area banking sector with a robust capital position, abundant liquidity buffers and relatively good profitability. Banks and analysts alike project into the near future the beneficial impact of rising interest rates on profits that we have observed in the last few quarters and consider this effect powerful enough to outweigh the adverse impact of a likely deterioration in asset quality, negative valuation effects on securities portfolios and increasing funding costs.

I sense that an increasingly optimistic attitude is spreading, which generates a certain reluctance on the part of banks to seriously engage in supervisory discussions on the downside risks underlying the macroeconomic and financial outlook.

I believe a root cause of this attitude lies in the warning we, along with other institutions and public bodies, issued at the onset of the COVID-19 pandemic in 2020, when we expressed our concerns about a massive deterioration in asset quality. Our estimates of the possible increase in non-performing loans (NPLs) in hindsight proved, to say the least, overly pessimistic in the light of the faster than expected rebound of the economy. Hence, we might be suffering the same fate as the boy who cried wolf in Aesop’s Fables, and a tendency might be spreading among banks to dismiss their supervisors’ calls for prudence as unjustified conservatism. Worryingly, this is occurring at the same time as Russian invasion of Ukraine is developing into a persistent and fully fledged macroeconomic shock.

It is my belief that exogenous shocks to the economy and the banking sector require supervisors to exercise extreme caution and that, when facing events of this kind, in banking supervision or elsewhere, it is generally better to be safe than sorry.

Also, I believe the events of the last decade should lead both supervisors and banks to be humble regarding the predictive capacity of their models in a world subject to major structural shifts. Supervisory projections in 2020 undoubtedly underestimated the increased liquidity and efficiency of the secondary market for NPLs, which enabled banks to continue cleaning their balance sheets during the pandemic. Similarly, banks should now take care not to blindly project into the future the exceptionally low default rates we have experienced in the last two years when they estimate their capital trajectories in the face of a rapidly worsening economic outlook. A wise and balanced combination of all sources of evidence and expert judgement are warranted to prudently safeguard the safety and soundness of the banking sector.

Second, no two exogenous shocks are alike, which is why no specific monetary and fiscal support pattern can or should be taken for granted as we leave the pandemic shock behind us and look at the future economic impact of the war in Ukraine.

Given the different backgrounds and trajectories of these two shocks and the different role public support measures may end up playing in both, we cannot simply assume that euro area banks will find navigating the geopolitical shock as smooth as the recovery from the pandemic...

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