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When I last appeared in front of your Committee in May, I presented the measures taken by ECB Banking Supervision in response to the COVID-19 pandemic. I stressed the importance of swift and unified action by policymakers within the banking union. I also announced that we were undertaking an analysis of the potential vulnerabilities of our banking sector under different scenarios. We published the results of this analysis in July. The conclusion was that under a central scenario envisaging a very harsh recession, with euro area GDP falling by 8,7% in 2020, followed by a fairly robust recovery in 2021-22, the banking sector would be able to withstand the effects of the shock on its asset quality and capital. In a less likely, but still plausible scenario, with a sharper recession followed by a more sluggish recovery, the deterioration of asset quality and the capital depletion could be significantly more material.
Today, seven months on from the first nationwide lockdowns in Europe, we are going through another difficult phase of this crisis, with both infections and related public interventions increasing. At this juncture, our main priority is to ensure that banks are well prepared to manage the impact of the crisis and, especially, that they become proactive in managing the upcoming deterioration in asset quality.
The crisis has so far not led to a noticeable increase in non-performing loans, or NPLs. In the second quarter of 2020, the NPL ratio for significant institutions stood at 2.94%, compared with 3.22% in the fourth quarter of 2019. However, we do expect a rise in non-performing exposures, particularly once public support measures, such as payment moratoria, expire. For most banks, we are already seeing the cost of risk increasing compared with 2019.
It is important that banks are ready to deal with the likely surge in NPLs. They should have adequate and clear policies for identifying and measuring credit risk at an early stage, in particular at a time when loans still benefit from public support measures. They also need to make sure they have the operational capacity to effectively manage the increase in distressed or defaulted exposures. Similarly, they should ensure adequate levels of provisioning for their loan books. By acting in a timely manner, banks can minimise any potential cliff effects when the moratoria and other government support measures begin to expire.
Authorities should also prepare to help deal with the expected rise in NPLs. I fully support the Commission’s work on a new action plan on NPLs, in particular to improve the functioning of secondary markets for NPLs. NPL securitisations could play a role. Asset management companies (AMCs) have also proven to be efficient tools for facilitating the management and recovery of NPLs. A European initiative, for instance connecting in a network national AMCs, via common funding mechanisms and harmonised pricing, could be a useful tool for addressing the expected rise in NPLs and ensuring a level playing field within the banking union.
Crucially, we should be faster, more integrated and effective in driving the necessary restructuring of the industry. After the last crisis, structural weaknesses in the European banking sector remained unaddressed, notwithstanding massive public support. Low profitability, poor cost efficiency, excess capacity, doubts on the long term viability of business models are at the basis of low market valuations. We should aim at exiting this crisis with a stronger banking sector, able to assist the necessary transformation towards a more sustainable and technologically advanced economy. Bank consolidation can be part of the solution, as it could focus efforts to improve cost efficiency and develop better focused, more sustainable business models. To clarify our prudential supervisory approach to consolidation, we recently published a draft guide and are now assessing the feedback from the public consultation. What we know from talking to banks and policymakers, though, is that there are multiple barriers to consolidation, particularly on a cross-border basis. I will come back to the impediments to deeper cross-border integration in a moment.
Unfortunately, the pandemic is not the only challenge we face. Environmental risks, like climate change, are a prime example of this. Brexit is another. We have continued work on both of these fronts, and expect banks to do the same.
We acknowledge that it is difficult to precisely measure climate-related risks. But we do know that banks will face considerable risks both directly related to climate change and from the structural shifts associated with the transition to a greener economy. These risks will in all likelihood also increase with time. The challenge will now be to review banks’ traditional risk management practices and ensure they can be adapted to manage exposure to climate risk.
From May to September this year, we conducted an important consultation on our draft Guide on climate-related and environmental risks. We expect to publish the final version of the Guide towards year-end. Starting next year, we will also start supervisory dialogues with banks to discuss how their practices compare with the expectations we have set out in the Guide. We are aware that methods for understanding and managing climate risks are evolving. But we expect banks to start working on their capacities now, and to enhance transparency in their climate-related and environmental disclosures.
As for Brexit, we have said for some time that banks need to be prepared for all possible outcomes at the end of the transition period. At the beginning of the pandemic, we extended some operational flexibility to banks. But during the summer we stepped up again our supervisory dialogue with banks about Brexit preparations. Many banks have made considerable progress, and some are well on track to achieve their post-Brexit operating models. However, some still need to intensify their efforts. This includes in particular the novation of contracts with those EU customers to whom banks had previously provided services directly from the UK. In addition, banks should not over-rely on back-to-back booking to the parent or other group entities in third countries. Risk management capabilities for products booked in the EU should also be located in the EU.
Thanks to the efforts made after the 2008 financial crisis and the subsequent sovereign debt crisis, euro area banks entered this crisis with more robust capital and liquidity positions than last time. To ensure the banking system recovers again, we should adopt the same spirit which has served us well in the past and ultimately led to the establishment of banking union: recognising that we will only come out of this crisis stronger if we act together as Europeans.
This means first and foremost strengthening and completing banking union. I would like to focus on two aspects here: the crisis management framework and the cross-border integration of banking groups.
The lessons of the last crisis have led to a significant strengthening of the crisis management framework. Banks, supervisors and resolution authorities are now required to prepare in advance for crisis situations. Significant amounts of liabilities that can absorb losses in a crisis are being built up. The resolution function has been appropriately moved at the European level in the banking union, thus ensuring a fully integrated response for those banks whose abrupt exit from the market would raise a public interest concern. Still, a large number of banks, also middle size ones, would be subject to liquidation according to national procedures that still differ in relevant respects. A more harmonised framework, also enabling the intervention of deposit guarantee schemes on a “least cost” basis, would be an important improvement.
From a supervisory perspective, it is also important to ensure that once we have declared a bank as failing or likely to fail and the Single Resolution Board has determined that there is no public interest in resolution, the bank exits the banking sector in a relatively short time frame so that it does not remain in “limbo”. To this end, in 2019 the Bank Recovery and Resolution Directive was amended to clarify that failing or likely to fail banks which do not enter resolution should be wound up in an orderly manner under national legislation. It is now up to Member States to ensure they transpose the relevant provisions into their national legislation to achieve this goal. But we also have to acknowledge that the lack of agreement on the establishment of a European Deposit Insurance Scheme (EDIS) is a stumbling block in promoting integration within the banking union.
Pending progress in this area, I have recently published some ideas on how to foster the cross-border integration of banking groups. This could in my view be done by introducing adequate incentives and safeguards for banking groups to enter into intra-group support agreements.
While these intra-group support agreements would have a contractual nature, they would be linked to the group’s recovery plans and further strengthened by empowering the supervisor to enforce the agreement. In this way, the liquidity needs of a group entity would be met in a timely manner, alleviating the concerns of host authorities while also enabling a more efficient allocation of liquidity at group level. This would be made possible by linking the granting of cross-border liquidity waivers to, among other things, the existence of adequate intragroup financial support agreements.
This crisis pushed us to adjust to new circumstances at a faster pace than ever before. We have done our best to react swiftly when required, and we will continue doing so whenever necessary.
We hope co-legislators can also work in the same spirit, acknowledging the benefits of banking union and agreeing on measures to make it stronger. The same applies to the post-crisis reforms agreed on under the Basel framework – the agreement reached was the result of in-depth and productive discussions. Here too, we should maintain a long-term view and faithfully implement these important reforms, as agreed on the international stage.