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These are exceptional times. The ongoing recovery from the COVID-19 pandemic and disruptions caused by the Russian invasion of Ukraine make for an uncertain macroeconomic outlook. Against this background, the safety and stability of the European banking sector remain of paramount importance to us. That is why in my remarks today I will discuss the challenges we currently face and how we are tackling them through our supervisory work.
The gradual increase in interest rates is beneficial for banks on the whole. In the first quarter of 2022 increasing yields together with continued lending growth supported positive levels of net interest income. Moreover, net fee and commission income and trading results were solid, leading to positive trends in net operating income, which outpaced increasing expenses and led to improved cost efficiency.
As a result, most banks have been posting profits and even the few banks that have large direct exposures to Russia avoided making losses. In addition, continued progress in resolving legacy non-performing loans (NPLs) has helped improve banks’ resilience.
The current environment, however, is marked by increased volatility and lower equity valuations, as markets anticipate that the profitability and asset quality of banks may be affected by adverse macroeconomic developments. The June 2022 Eurosystem staff macroeconomic projections introduce for the first time a downside scenario entailing a possible recession in 2023 as a result of disruptions to euro area energy supplies. Similarly, we cannot rule out the possibility of more adverse growth and inflation scenarios, with the introduction of new or more severe sanctions in the energy and commodity sectors and possible retaliatory measures by Russia.
Higher credit risks originating from some banks’ exposures to Russia and to sectors hit hardest by the war, combined with weakening growth prospects, have already led to an upwards revision in loan loss provisions. Furthermore, the implications for asset quality of a disorderly exit from low interest rates would offset the benefits from rate increases, especially for residential mortgage lending, highly leveraged segments and sectors particularly sensitive to energy and commodity price inflation. According to preliminary data for the first quarter of 2022, the aggregate NPL ratio continued on the downward trend observed since 2014. However, this was driven by a reduction in NPLs by a few banks with high NPL ratios. In the meantime, there have been slight increases in the NPL ratios of several other banks. The share of stage 2 loans, i.e. loans with an increased credit risk, rose slightly both in the fourth quarter of 2021 and in the first quarter of 2022 and default rates also grew somewhat for corporates and households at the beginning of this year.
In the current situation, the supervisory priorities we laid out last year are more relevant than ever. One of our main priorities is to ensure banks emerge healthy from the pandemic, focusing on their credit risk controls. One year later, post-pandemic vulnerabilities as well as new challenges resulting from the current events I just described are having an impact on banks’ asset quality and require us to closely monitor the steps taken by banks to identify and manage distressed debtors at an early stage. This is especially relevant in sectors affected by the war through commodity and energy prices, such as manufacturing, as well as sectors particularly sensitive to increases in interest rates, such as residential real estate.
Another priority is to monitor emerging risks, such as banks’ growing exposure to leveraged lending, high yield segments and non-bank financial institutions (NBFIs). In the current environment, these can lead to disruptions with wider spillovers. We have therefore stepped up our efforts to ensure that banks manage the corresponding risks. In March of this year we issued a follow-up letter to our 2017 Guidance on leveraged transactions and asked banks to respond in detail on their risk practices. As regards NBFIs, during the COVID-19 crisis we conducted an initial review and in the spring of 2022 issued detailed supervisory expectations on prime brokerage to the relevant banks. We are also in the process of conducting a broader thematic review on counterparty credit risk and will perform on-site inspections at a later date focusing on this risk and covering prime brokerage and investment fund activities.
The fallout from the war also reinforces the need to speed up the green transition. There is a global consensus on the urgent need to supervise climate risks. On 15 June 2022 the Basel Committee on Banking Supervision (BCBS) published “Principles for the effective management and supervision of climate-related financial risks”, which are expected to be implemented in the near future. On our side, on 8 July we will publish the results of our supervisory climate stress test. Unlike the economy-wide stress test conducted by the ECB last year, this supervisory climate stress test is not a top-down exercise. Also, in contrast to our ordinary bottom-up supervisory stress tests, the goal is not to assess banks’ capital adequacy but rather their climate stress test capabilities. The results will focus on banks’ preparedness to measure and manage climate risk under different scenarios and the sustainability of their income sources under a green transition....
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