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I am delighted to be with you again this morning. I will start with our most pressing supervisory focus, which is to ensure that banks can effectively manage the fallout from the crisis. For this reason, credit risk continues to be a priority, as it has been since the start of the pandemic in early 2020. The latest economic data are encouraging and consistent with our expectation that economic activity will accelerate in the second half of the year. And banks have proven to be resilient so far. They have robust capital positions and their profitability recovered in the second half of 2020 and the first quarter of 2021. However, there is still some uncertainty about how the pandemic will evolve. Moreover, the recovery, and thus the economic impact of the pandemic, may be uneven across sectors and countries. This could have consequences for bank balance sheets.
Therefore, our main goal as supervisor is still to ensure that banks are able to identify and manage any credit risks on the horizon at an early stage. We want banks to remain vigilant and tackle credit risk proactively.
As a follow-up to the letter[1] we sent to banks last December on the identification and measurement of credit risk, we assessed banks’ compliance with our supervisory expectations. While most banks are fully or broadly in line with our expectations, certain banks, including some that now have fairly low levels of credit risk, need to address significant gaps in their risk control frameworks, which are the most important safeguard against a significant deterioration in asset quality in the future. The main areas of attention are the classification of loans, especially when there is a significant increase in credit risk (Stage 2 under IFRS), the proper flagging of forbearance measures and the timely and adequate assessment of borrowers’ unlikeliness to pay. The Joint Supervisory Teams have shared the findings with the banks and asked for remediation plans. The findings have also been fully integrated into this year’s Supervisory Review and Evaluation Process (SREP).
We note that some banks started to reduce provisions in the first quarter of this year, something which in past cycles happened close to the peak in bankruptcies, a point that we surely have not reached yet. We have also seen some banks taking on more risks by increasing their leveraged lending activities. While the leveraged loan market came to a standstill in March 2020, it quickly recovered to reach record levels. In fact, investors’ current search for yield has pushed spreads below the levels seen before the pandemic. The very low credit quality leaves the market vulnerable to further shocks, including sudden asset repricing. These are areas of potential concern and we are considering possible supervisory measures to ensure that banks take a prudent approach.
At the same time, we need to be prepared to return to normality, as our relief measures were designed to be temporary to mitigate the immediate impact of the pandemic. This also applies to the recommendation on dividends. We have been pleased to see that banks broadly adhered to the recommendation.
On the basis of the latest macroeconomic projections and our supervisory work on capital strength, we find banks’ capital projections to be more reliable, allowing us to assess their payment plans on an individual basis. Therefore, in the absence of materially adverse developments, we plan to repeal our recommendation as of the end of the third quarter of 2021 and return to reviewing dividends and share buybacks as part of our normal supervisory process, based on a careful forward-looking assessment of each bank’s individual capital planning. We expect distribution plans to remain prudent and commensurate with banks’ internal capital generation capacity and with the potential impact of a deterioration in the quality of exposures, also under adverse scenarios.
We allowed banks to make use of their capital and liquidity buffers to mitigate the impact of the pandemic. As already communicated last summer, we will allow banks to operate below Pillar 2 Guidance and the combined buffer requirement until at least the end of 2022. We are monitoring developments in banks’ asset quality very closely. If we identify a surge in distressed loans on bank balance sheets as a consequence of public support measures being phased out, we are ready to extend our timeline. The process of rebuilding bank buffers should not hamper efforts by the banking sector to respond quickly to the expected materialisation of credit risk from the pandemic.
While we are paying close attention to credit risk, we are also making progress on other topics. I would like to highlight three areas where we are continuing to harmonise the supervisory approach at the European level.
First, we have continued our work to harmonise the way in which options and discretions available in Union law are exercised by European supervisors. We published a first set of policies in 2016 and 2017. We now cover an additional set of options and discretions introduced primarily by the “CRR II‑CRD V package”[2] and launched another public consultation on 29 June.
Second, in mid-June we launched a public consultation on our draft revised Guide to fit and proper assessments and the new Fit and proper questionnaire. The revised guide aims to increase the consistency of fit and proper assessments across the banking union, recommends early engagement with supervisors also in cases where national legislation envisages ex post assessments and seeks to ensure more diversity within bank boards. At the same time, our assessments are still subject to national laws, and a true single rulebook with fully harmonised provisions is key to levelling the playing field and preventing loopholes in this area of supervision.
Third, we are currently benchmarking banks’ self-assessments against our supervisory expectations on climate-related and environmental risks. We have already started to work on incorporating these risks into our SREP methodology. Although this year’s findings will not be reflected in bank-specific capital requirements, we may need to impose qualitative or quantitative requirements in some specific cases. A full supervisory review (as well as a specific stress test focusing on climate risk) will then follow in 2022. Our most recent assessment shows that banks have started adapting their practices but still have a long way to go to be fully aligned with our supervisory expectations, and there is considerable heterogeneity across banks. All banks need to step up their efforts now, as climate risk is already here and will soon be an integral part of our regulatory and supervisory framework.
While we are continuing to improve and further harmonise European banking supervision, the completion of the banking union via a clear path towards the introduction of a fully fledged European deposit insurance scheme remains vital. There is agreement that further progress needs to be made to strengthen the crisis management framework. We have already contributed to the Commission’s recent public consultation on the review of the crisis management and deposit insurance framework and stand ready to actively participate in this important review.
Let me stress that completing the banking union is not an end in itself, but a necessary condition for reaping the maximum benefits of a fully integrated banking market. This is essential to ensure that European banks can play their role in an interconnected and digital European economy and can compete at the same level as their global peers. This is all the more important in the European context, as around two-thirds of credit intermediation from the financial sector to non-financial corporates is performed by the banking sector in the euro area.[3] This is a much higher percentage than in the United States. The remaining segmentation of our banking markets, which is to a large extent driven by legislative constraints reflecting the national nature of deposit insurance schemes, is an important inefficiency that ends up being paid for by bank customers and makes our economy less dynamic.
I would also like to point out that the new legislative cycle could provide an opportunity to review the treatment of European branches of third-country banking groups. These branches are currently subject to national supervision based on national requirements. Even if third-country groups must set up an intermediate parent undertaking in the EU, individual branches belonging to a third-country banking group will only be subject to national supervision. Specific booking models allow third-country groups to transfer assets and risks within the group, which means that it may be extremely difficult for ECB Banking Supervision to gain a comprehensive European overview of the risks these groups are taking in the EU and of the effectiveness of their risk management arrangements. While third-country banking groups should be free to choose to enter specific markets within the EU via branches or subsidiaries, greater harmonisation of the regulatory and supervisory framework is warranted, also to ensure a firm-wide view of risks and risk management and a level playing field within the banking union.
While we now seem to be on a path to normality, the ECB will maintain its strong focus on mitigating credit risk. At the same time, the ECB is making progress in other risk areas.
We hope that tangible progress on strengthening and completing the banking union can be made in the near future, to provide the same level of protection to the deposits of all European citizens and foster a genuine integration of markets within the banking union, to the benefit of European households, small and medium enterprises and corporates. I am pleased to be here today to discuss these issues with you. I now look forward to your questions.