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So, to my first point: Resolvability in times of Covid-19. The pandemic represents an unprecedented shock for the European economy and worldwide. According to the latest European Commission’s 2020 outlook, broadly in line with the ECB’s GDP forecasts, the euro area economy will contract by 7.8% in 2020 and will recover by 4.2% in 2021.
This scenario would amount to a far deeper downturn compared to the great financial crisis, when euro area GDP had fallen by 4.5%. Furthermore, an asymmetric recovery across different sectors of the economy and Member States is expected.
In contrast with the last crisis, this current crisis did not originate from the financial sector. Indeed, the euro area banking system entered the crisis on a much stronger footing than at the start of the great financial crisis. Thanks also to the regulatory reforms introduced, its resilience has in aggregate increased in terms of capital and liquidity.
According to the ECB banking supervision, over the five years between Q4-2014 and Q4-2019, for significant banks
As regards the Minimum Requirement for Own Funds and Eligible Liabilities - or MREL in resolution jargon - between 2017 and 2019 banks continued to build-up their capacity to reach the SRB requirements.
At the end of last year, the average MREL shortfall reduced to 1% of total risk weighted assets from 1.8% at end-2017, while the aggregate funding needs required for compliance decreased to approximately 4% of the total consolidated MREL requirement at end-2019, from 7,2% in 2018.
The build-up of the MREL capacity continued in the current year, although at a lower pace due to the impact of Covid-19; in the first two quarters of 2020 banks issued almost 180 billion of gross eligible funds, an amount 4,7% lower than in the first two quarters of 2019 (chart 1). In terms of volatility of funding costs, after the peak registered in March, the indexes of subordinated and senior bonds have been progressively recovering, however in October they have been characterised by fluctuations and negative reaction to the renewed concerns over the pandemic developments; at end-October the index on subordinated debt was 1.7 times the value registered before the virus outbreak (chart 2). By the same token, gross bond issuances of euro area banks have shown fluctuations in the recent period, while remaining in the lower issuance range of the 2015-19 average (chart 3).
While the banking sector was able to survive the immediate most severe hit of the crisis, there are no reasons for complacency. The new wave of restrictions implemented across Europe to curb the resurgence of the health crisis will again increase uncertainty for households and corporates; as a consequence, the impact on the banking sector itself is not yet clear and will largely depend on the effects of the measures taken to support the real economy and how industries fare during the crisis. On the positive side, the baseline scenario underlying the vulnerability analysis conducted in the summer by the ECB confirms that the banking sector is resilient overall. However, the results also show material consequences should tail risks materialise. Under the more adverse – much less probable - scenario, capital depletion could lead to an average decline of 5.7 percentage points in core capital - the Common Equity Tier 1 ratio - with a potential increase of non-performing loans (NPLs) to around €1.4 trillion, much higher than in the great financial crisis.
Against this background, the uncertain outlook poses significant challenges to financial stability. This is why a strong resolution framework that prepares for and can manage bank failures is a key element in mitigating the negative impact of the current crisis. When it comes to resolution planning, at the SRB we have been carefully monitoring the impact on banks and financial markets and have joined the other authorities in an effort to alleviate the immediate operational burden on banks. At the same time, we continued to ensure that banks make progress to strengthen their resolvability.
Let me mention some of the actions we took in connection to COVID-19. We had to balance the need to provide relief to banks to face the current economic (and operational) challenges, and the need to make progress on the requirements to become “resolvable”. On the operational side, we postponed less urgent information or data requests, in line with the EBA’s recommendations. Overall banks managed to respect the limited extension of the deadlines, therefore our 2020 resolution planning cycle remains well-on track.
In terms of MREL requirements, since the legislation envisages that the capital buffers are added on top of MREL, the SRB has implemented the capital relief measures taken by some national macroprudential authorities. In addition, as regards existing binding MREL targets, i.e. those set under the BRRD1 rules, the SRB announced that it would take a forward-looking approach to banks that may face difficulties in meeting these targets before new MREL decisions under the new BRRD 2 rules take effect; the new provisions envisage binding targets, an intermediate one in 2022 and a final one in 2024.
Finally, the SRB has assessed the need to adjust transition periods for the build-up of MREL. We have recalibrated intermediate targets with data referred at June 2020 when we found material balance sheets changes with respect to the information referred at December 2019. At least so far, the need for such adjustments was limited. 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 believe that this pragmatic 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.
As concerns the prospects of the banking system going forward, it is of utmost importance to monitor closely the evolution of the non-performing loans (NPLs). While so far the crisis has not led to a noticeable increase in deteriorated exposures, banking supervisors expect a rise of non-performing exposures, particularly once public support measures, such as payment moratoria, expire. Against this background, it is key that banks are ready to cope with the likely surge in NPLs. Banks are required first to implement adequate policies for the early identification and measurement of credit risk. Second, they should build the operational capacity to manage effectively the increase in distressed or defaulted exposures. Third, intermediaries should ensure adequate levels of provisioning for their loan books. These actions would make the disposal process of the NPLs smoother and faster and would allow banks to minimise any potential cliff effects when the moratoria and other government support measures begin to expire. On the contrary, any delay in the NPLs recognition jointly with a poor management of deteriorating asset quality could negatively affect banks’ balance sheets in the short-to-medium term. This would also hinder the capability of banks to support viable firms and households and ultimately the economic recovery.
In this context, the proposal for a directive on credit servicers, credit purchasers and the recovery of collateral, currently undergoing the final stages of negotiation between the European Parliament and the Council, aims at fostering the development of secondary markets for NPLs by tackling undue obstacles to credit servicing and to the transfer of bank loans to third parties across the EU. The proposal provides inter alia for a definition of the activities of credit servicers, establishes common standards for authorisation and supervision and imposes conduct rules across the EU. As a complement to this initiative, a central platform, eventually run at EU level with common standards for valuation and due diligence, including vendor data rooms, could well support the functioning of the NPL secondary markets.
The deterioration of banks’ asset quality is expected to further worsen banks’ profitability, which continues to be one of the structural weaknesses of the euro area banking sector. Indeed, euro area banks have registered an average return on equity close to zero in the second quarter of 2020, from 6% an year earlier, and market data show that EU banks’ share prices are currently priced 28% lower than in December 2019.
The pandemic has also triggered a decisive push in the demand for digital products. In order to cope with the increasing competition from non-bank players and newly established credit institutions with specialised business models, banks should exploit this situation to accelerate the digital agenda in their planning, as well as the reorganisation of business models to become more efficient. In this regard, consolidation of the banking system could be a way to deal with the challenges of low profitability and digitalisation, reducing at the same time the current excess capacity. Some ongoing initiatives signal that banking groups are seriously addressing these topics. Although there is no role for resolution authorities in the approval of consolidation transactions, the SRB supports any market initiative that enhances viability, and is in close dialogue with the supervisory authorities and the banks themselves. If well designed, such transactions bring benefits not only in going concern, but may present opportunities to strengthen banks’ resolvability.
2. Looking forward: SRB programme for the next few years
Now, ladies and gentlemen, I want to move to my second point: the SRB’s programme for the coming years. In these unprecedented times, work on resolvability and crisis readiness to ultimately supporting financial stability will be even more essential. The SRB has set realistic but ambitious objectives in its multiannual work programme, covering the period 2021-23. Let me mention some of them.
On resolvability, the focus will be on the implementation of the “Expectations for Banks”, the best practices document published by the SRB last April. It is a key reference document for banks to build, under the SRB steer, the capabilities to become resolvable gradually, by 2023. This is the deadline to implement such expectations, and the next resolution planning cycles will give us the vehicle to advance. In addition, the SRB will further operationalise resolution plans, making the resolution strategy actionable at short notice. In the 2021 cycle, the SRB expects to adopt 109 resolution plans and 233 MREL decisions. The SRB will also start some pilot on-site visits at the banks, to check certain aspects of the resolution framework; over time, leveraging on these first experiences, the SRB will develop the capacity to perform fully-fledged on-site inspections on resolution topics, which will be carried out in full cooperation with national resolution authorities.
As regards the policy framework, the SRB will refine and update the MREL policy to complete the implementation of the banking package, including guidance to respond to MREL breaches, implement the new provisions of the eligibility framework as well as the EBA RTS on various MREL-related aspects. The SRB will also develop a new methodology to conduct resolvability assessments, fully based on the Expectation for Banks, which will feed into a heatmap aimed at tracking individual banks’ progress and benchmarking across banks. This will also be used as a basis to take formal action to remove substantive impediments, if banks’ progress is found to be insufficient.
The SRB plans also to extend its approach on the Public Interest Assessment (PIA). In particular, the PIA of each bank is revised annually as part of the resolution planning, but also at the point of failure, which allows to take into account the prevailing circumstances at that point in time. The implementation of the PIA has been subject to academic and policy debate, focussing on possible refinements and enhancements. I will mention the following aspects: first, the possible consideration of system-wide events also at the time of resolution planning in the context of assessing the financial stability objective; second, the enhancement of the approach to the protection of covered deposits, by assessing the financial stability implications stemming from the funding of the DGS in case of large pay-outs; third, while resolution is the strategy chosen for most of banks under the SRB remit, the assessment of the impact of a failure on the disruption of critical functions of banks at regional level, in addition to the impact at national level, could still be worth exploring. I believe the current legislative framework provides the right level of flexibility for the resolution authorities to perform these enhancements in an effective way.
On crisis preparedness, a key focus will be on resolution tools other than bail-in. In 2021 work will concentrate in particular on the operational preparatory steps for the sale of business tool (from virtual data rooms to due diligence process, etc.). In addition, we continue to perform crisis simulations (dry-run) to test our preparedness: handbooks, ICT platforms, cooperation procedures, etc. The SRB performed two dry-runs in 2020; the objective for 2021-23 is to perform several other dry-runs, simulating the entire management process and decision making in resolution cases and drawing lessons on the basis of the results obtained.
3. The revision of the crisis management framework
I now move onto my third and final topic: the revision of the crisis management framework. As I mentioned earlier, the efforts made after the greater financial crisis – in particular the prudential and crisis management reforms and the creation of the Banking Union - allowed the European banking system to weather the challenges brought about by the Covid-19 crisis thus far. However, this does not imply that it will continue to be so in other stages of the crisis or in similar situations. The completion of the Banking Union would instead allow facing the evolution of this or other crisis in a much better way. In this context, the enhancement of the crisis management framework will be key in the next few years. Let me touch briefly on the most important shortcomings and the possible ways to address them from my personal point of view.
In the first place, in the current framework a limited number of banks, if deemed failing and with a negative PIA, would still be subject to different national insolvency frameworks. This may create some challenges. The no-creditor-worse-off principle (NCWO) – which seeks to ensure that the treatment of creditors in resolution is not worse than the treatment they would have received under normal insolvency proceedings - becomes very difficult to assess and to meet with different national procedures, and for cross-border banks may result in different outcomes depending on the home country of the institution. In addition, the criteria for liquidation are not aligned to those underlying the failing or likely to fail assessment, so there is the risk – and it materialised already - that banks do not exit the market in a relatively short time frame after they have been declared FOLTF and with a negative PIA, but they end up in a ‘limbo’.
A second topic which is also under discussion among policy makers concerns the challenges faced by some medium size deposit-funded banks which lack an easy access to wholesale funding markets and could be too small to be resolved but too big to be liquidated.
In my personal view, a possible solution to these gaps would be to establish a harmonised administrative liquidation regime backed by a common insurance scheme to finance the transfer of assets and liabilities (transfer strategy tools). Similarly to the FDIC, a common deposit guarantee system able to provide financial support on a least cost basis as an alternative to pay out of depositors would be a much more efficient solution. Not only would this ensure centralised decision-making, but it would also allow for the application of a harmonised and effective toolbox. In this context, such a common deposit guarantee system should not enjoy the super-priority ranking granted to national DGSs under the current framework, and the application of the least cost test should become a common feature for the access to common funding.
By contrast, the option of having only national deposit insurance systems to finance the sale of business would perpetuate an uneven playing field for banks and depositors across the Banking Union, lead to higher fragmentation of the banking sector across national lines and increase the sovereign-bank nexus. The creation of a fully mutualised deposit insurance scheme remains therefore an essential component of any solution in the medium to long term, and transitional solutions based on national guarantee systems should be geared towards it. It would also help to overcome ring fencing, and enable a better flow of capital and liquidity across the Banking Union, which would in itself increase private loss absorption. This is why we need political agreement to build gradually a common system.
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Conclusion
In conclusion, these are strange and challenging times. The European response by the monetary, supervisory and resolution authorities as well the fiscal response by governments to the outbreak of the Covis-19 crisis have been larger and more coordinated than ever before. We will come out of the crisis stronger if we continue to act together. Given the uncertainty of the economic outlook, work on resolvability becomes even more important to safeguard financial stability and protect taxpayers. The completion of the Banking Union and in particular the enhancement of the crisis management framework would greatly facilitate this task. Resolution is a field in evolution, where research, analytical and policy studies like those you are conducting at this Academy may provide a lot of value. Thank you for your attention.