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Looking ahead, even beyond the pandemic, is exactly what we should all be doing at this juncture, banks and supervisors alike. The sooner we start the better off we will be, once we finally get there. “Never let a good crisis go to waste” – Winston Churchill’s famous dictum, which he coined while working to set up the United Nations after the Second World War, surely applies here. The programme of today’s dialogue is therefore very timely, in my view, and I thank you for this opportunity to share some thoughts on the evolving supervisory response to the pandemic, as we brace for the impact of the shock and prepare for a “new normal”.
What I consider to be the first two phases of ECB Banking Supervision’s response to the pandemic have been widely covered in the public domain. But let me briefly summarise them again here and, in so doing, set the scene for the discussion on what comes next.
Our immediate response to the coronavirus (COVID-19) shock saw rapid and unified action across the euro area, something that would have been quite unthinkable before the banking union was set up. We had two main guiding principles: supervisory relief and capital conservation. By releasing buffers and preventing capital from flowing out of the sector, we helped to avert the sharp tightening of credit standards that characterised the response to previous shocks. Not only did we give banks capital and operational relief, but we also granted them temporary flexibility in relation to the management of non-performing loans (NPLs), loan loss provisioning and loan classifications. These measures were intended to accompany and smoothen the implementation of national loan guarantee and loan moratorium programmes on an unprecedented scale. We have seen the value in making full use of microprudential tools during the first phase of our response to contribute to overall financial stability across the banking union. This is no small development. Market-based evidence shows that the combined monetary policy and supervisory response helped to keep at bay the sorts of bank-sovereign doom loop dynamics we have seen in the past, which, in itself, is a remarkable result. Of course, the flip side of capital relief is capital conservation: to ensure that no capital is flowing out of the banking sector in this situation of profound uncertainty, we recommended that banks refrain from dividend distributions and share buy-backs.
In a second phase, we moved on to assessing risks, vulnerabilities and the potential impact of the pandemic on banks’ balance sheets. We conducted a desktop analysis to assess the potential vulnerability of significant institutions under two scenarios: one central and one severe. Both scenarios were based on the June 2020 Eurosystem staff macroeconomic projections. The severe scenario envisaged a significant increase in COVID-19 infections in the autumn and renewed containment measures. The results of this vulnerability analysis showed that the banking sector was resilient overall and well positioned to withstand the deep and abrupt recession caused by the pandemic. But the results also indicated the potential for material tail risk. Under the more adverse scenario, which remains plausible in the light of recent developments, capital depletion could be material (a decline of 5.7 percentage points in the Common Equity Tier 1 ratio, on average) and NPLs could soar to around €1.4 trillion. Perhaps more importantly, we observed a very high level of uncertainty prevailing over the banking sector. This was reflected in very diverse capital planning assumptions used by banks, estimates of the cost of risk that were too dispersed and sometimes optimistic, and a widespread tendency to refrain from reclassifying assets. In a letter to banks in July, we asked the sector to focus more on proactively identifying distressed borrowers and managing deteriorating assets at an early stage. With the same precautionary stance, we also extended our blanket recommendation that banks should refrain from dividend distributions. A choice of prolonged capital conservation which, in our view, has proven to be effective and underpins banks’ stated intentions to expand, on aggregate, their loan books and risk-weighted assets by the end of 2020.
But let us turn to the present and look ahead. The September 2020 ECB staff macroeconomic projections do not show a worsening with respect to the June projections and provide broadly comparable results, including in terms of overarching uncertainty around the outcomes. Economic activity remains far below pre-pandemic levels and the recovery is asymmetric across sectors and countries. The economic, financial and social costs associated with a severe scenario remain very high. At the same time, consumer spending and business investment have rebounded somewhat over the summer.
Let me be clear that, at the current juncture, our supervisory strategy has moved into a new phase. On the one hand, it is time for banks to brace for the impact that will likely materialise as the system-wide moratoria are lifted. On the other hand, a proactive attitude is needed on all sides for the pandemic not to act as a mere amplifier of long-lasting and well-known structural deficiencies.. Rather, it should serve as a catalyst for a stronger banking sector in the future.
While we still cannot see the impact of the shock materialising in current supervisory data, we believe that no bank should postpone any longer the fundamental risk management duty intrinsic to its own mandate. Early identification of arrears, case-by-case reclassifications and prudent provisioning choices are now crucially important. Borrower-specific debt restructuring and forbearance practices must be used to distinguish viable distressed customers from non-viable ones. The available flexibility and tolerance were justified when the impressive moratoria measures were first being introduced, in the light of all the operational challenges they entailed. But as most of those programmes will soon be expiring, every effort should be made to avert costly cliff effects in time.
We are currently reviewing the banks’ responses to the letter we sent in July and we plan to gradually intensify our scrutiny of banks’ preparedness to deal with the impending deterioration in the quality of their assets. Solid credit risk management practices and prudent provisioning outcomes are particularly important here. A clearer picture on the trajectory of asset quality will also be needed to inform our review of the recommendation to suspend dividend payments, which we will complete in December.
When I hear that some people are using the pandemic to question the implementation timeline of the forthcoming standards on the definition of default or to propose reviewing the legislative backstop on NPL coverage, I am inclined to think that too many of the lessons of previous crises may unfortunately not have been learnt.
The sooner NPLs are identified and provisioned for, the faster and smoother the NPL resolution and disposal process will be, averting damaging hangover effects down the road. Delayed recognition and poor management of deteriorating asset quality could easily clog up bank balance sheets with NPLs for a fairly long period of time, making it more difficult for the banks to support viable customers and underpin a faster economic recovery. Moreover, portfolio quality is one of the main drivers of value creation at banks in the current environment. Analysts and investors expect there to be material adjustments in the cost of risk in 2020 and have revised down their profitability expectations for the sector accordingly. Postponing the adjustments won’t help banks to re-establish themselves as attractive investment opportunities as quickly as they need to, with all the consequences that this entails.
In my view, we have good rules and policies in place to deal with NPLs more quickly and effectively this time around. Banks need to focus on effective implementation, and the right time to do that is now.
Of course, with banks playing their part in tackling the deterioration in asset quality, authorities will have to play their part too. In this vein, I more than welcome the debate relaunched by Valdis Dombrovskis on further improving the functioning of the secondary markets for NPL sales and NPL securitisations, as well as on promoting a more integrated use of asset management companies in the EU.
Moreover, we must remember that, when the pandemic struck, the European banking sector was already suffering from several structural weaknesses. Persistent low profitability, caused by excess capacity and low cost efficiency, has driven bank valuations to historic lows. The need to address these structural issues has become even more urgent in the light of the likely impact of COVID-19 and the policy responses from authorities.
First, following this shock, a low interest rate environment might prevail for a longer period of time. Taking into account a further deterioration in asset quality, banks may need to take more decisive action to reshape their business models. Recent ECB analysis shows that, besides asset quality, the ability to boost activities generating non-interest income has been essential to maintain profitability and remain resilient as this crisis has unfolded. This effort to refocus business models could require investment in new technologies, which the pandemic may have already made more attractive owing to customers’ increased interest in digital banking solutions during the lockdown. Second, to tackle cost efficiency and transformation issues, banks may build on the experience gained in managing staff, premises and branches during the lockdown. In particular, as working remotely and serving customers digitally proved a feasible alternative overall, banks may consider further exploiting technology to consolidate cost-efficient strategies in that direction. We will duly take these elements into account when analysing business models in the context of our Supervisory Review and Evaluation Process.
In this quest to restore profitability, banks should also consider the possible benefits of business combinations. Reducing overcapacity via consolidation would, among other things, reduce unhealthy competition focused on volumes and the race-to-the-bottom type of behaviour, thereby helping to re-establish sustainable levels of profitability. The experience of other jurisdictions shows that, in the aftermath of large shocks, healthy levels of orderly market exits are a key ingredient for a swift and successful recovery. Here too, as banks play their part, supervisors and legislators alike should play theirs. The recently published draft ECB guide on the supervisory approach to consolidation in the banking sector was intended to be a step in this direction. Targeted harmonisation could further the integration of the European single market, for instance by identifying and removing territorial elements in the current rulebook that represent an obstacle to cross-border mergers and acquisitions. In my view, it is also essential that legislators work towards an integrated crisis management framework that is more conducive to facilitating smooth exits from the market, including for mid-size banks that would currently be subject to very diverse national arrangements.
Finally, the COVID-19 pandemic should not be seen as an opportunity to question the validity of the recently finalised international prudential framework. The Basel III reform is addressing weaknesses in the current regulatory framework that have been identified first and foremost by European authorities. It has been negotiated with our international counterparts over a long period of time, and we have reached a satisfactory and balanced conclusion. It entails a long phasing-in of some elements, such as the output floor, which are more painful for European banks. Notwithstanding the challenging times we are living in, we need to maintain a longer-term view and continue to strengthen our regulatory framework.
To sum up, we are continuously adjusting our supervisory strategy in line with the challenges posed by the pandemic. Our primary focus today is on making sure that banks are adequately prepared for the immediate impact of the crisis. But as Churchill also observed, “kites rise highest against the wind, not with it”. We should therefore also look for ways to ensure that our banking sector emerges from the pandemic stronger.