How have European banks been doing so far in the current situation?
There is a tendency to compare this crisis to the crisis of 2008. But while the outcome in both cases is a severe economic downturn, the role and the position of banks are different. First, banks entered the current crisis in much better shape than they were at the start of the previous one – not least thanks to the extensive regulatory reforms undertaken over the past decade. Second, this time around, banks are not the source of the problem, although they do still have a crucial role to play – their capacity to absorb losses and keep lending to the economy is essential for a fast recovery once the social distancing measures come to an end.
So far, banks have fulfilled their role. The results of the euro area bank lending survey published at the end of April show that banks managed to accommodate a significant increase in the demand for loans, especially short-term loans or drawing of committed credit lines to meet the financing needs for inventories and working capital at small businesses and corporates. So far, this has taken place without a significant tightening of credit standards compared with past crises. This reflects the enhanced resilience of banks. Still, looking ahead, some risks are bound to materialise. Most prominently, as the economy goes into a tailspin, asset quality will deteriorate. This will put downward pressure on interest income and upward pressure on credit impairments. It is also likely that banks will see losses related to market risk. Against this backdrop, we have taken a number of measures to help banks support the economy.
Indeed, you have announced a series of relief measures for banks in response to the coronavirus (COVID-19) pandemic. Is there evidence that the measures are benefiting the real economy?
The key objective of all our measures is to ensure that banks remain in a position to absorb losses and continue lending to the economy. In line with the design of the regulatory reforms put in place after the last financial crisis, we encouraged banks to draw on their capital and liquidity buffers – after all, that’s what buffers are there for. So those banks that actually make use of buffers would in fact be acting responsibly. At the same time, in keeping with our recommendations, banks are protecting their capital by withholding dividends and postponing share buy-backs. In addition, credit risk is being eased thanks to public support to the economy, which helps companies in trouble and cushions the impact of a demand-side shock. In particular, government guarantees on bank loans are expected to work well in combination with supervisory relief measures. Finally, monetary policy has effectively countered an increase in funding costs and market losses from bond holdings.
There are a number of estimates of the lending capacity created by these measures, especially when considering their mutually reinforcing effects. The estimates all point to a very significant potential impact. But it is still too early to say how much banks will actually be willing to expand their balance sheets. This will essentially depend on market participants – investors, rating agencies and market analysts – not taking a negative view of banks that do actually use their capital and liquidity buffers. According to the results of the lending survey, banks expect a surge in the demand for credit in the second quarter of 2020 and envisage that this will be met with an easing of credit standards.
I should also point out here that the measures we have announced – in particular with regard to the use of capital and liquidity buffers – will remain in place for as long as needed. In other words, once the situation improves, we will not suddenly flip the switch; we will allow a very gradual return to pre-crisis capital and liquidity levels.
Do you see elevated risks or risks that may still emerge in the banking sector?
Of course, in a crisis like this, there are many risks that suddenly become relevant. Liquidity risk is often first in line. But, thanks to the ECB’s monetary policy measures, the situation looks fairly stable at the moment.
There are, however, other risks that may materialise at a later stage, so we are not yet seeing the full impact of the crisis on banks. Take credit risk, which is one of the most prominent risks in an economic downturn. We assume that an increase in non-performing loans, for example, will only start to be visible at the end of the second or third quarter of this year – so in about one to four months. The overall scale of the deterioration in asset quality will largely depend on the depth and length of the recession, and at the moment there is still a wide range of possible scenarios that could materialize.
Looking ahead, how will you be assessing the impact of the current crisis and the vulnerability of banks?
We are continuously monitoring the state of the banks, of course, and are in close contact with all of them. At the same time, we are conducting an analysis of banks’ vulnerability, taking into account different scenarios and hypothetical shocks. This analysis will give us a good understanding of how the crisis could affect banks’ balance sheets, where the greatest risks lie and what can be done to mitigate them.
Some major US banks have seen a significant fall in their profits for the first quarter of 2020 owing to higher provisioning for loan losses. With European banks being generally less profitable and not as well capitalised as US banks, do you believe that European banks have built up sufficient buffers to weather the crisis?
Major US banks have indeed materially increased credit loss provisions in the first quarter of 2020. This also reflects required changes in accounting rules, which euro area banks started to implement in 2018.
That said, indeed, US banks have recently been significantly more profitable than their euro-area peers. And in a crisis, solid profitability is the first line of defence. While euro area banks may be lagging behind, they have still made profits during most of the years since the financial crisis. More importantly, they have ramped up their capital and liquidity buffers, and these are the fundamental line of defence against any crisis. Looking ahead, low profitability could mean that euro area banks need longer to replenish their buffers after the crisis. But, as I said, we will give them ample time to do so. At the same time, we will continue putting pressure on banks to accelerate the changes needed to restore more sustainable levels of profitability. This requires a refocusing of their business models, more effective measures to improve cost-efficiency and a greater focus on the use of new technologies.
In your opinion, why haven’t banks used their liquidity buffers to a greater extent?
It is too early to make an assessment. In the first few weeks of the lockdown measures, there was pressure on banks’ liquidity positions. This was driven in particular by the significant use of committed credit lines and by some pressure on money market funds and asset managers created by deteriorating conditions in the commercial paper market, which banks helped to address. Nevertheless, banks have benefited from the ECB’s accommodative monetary policy stance, which may have indirectly contributed to an increase in their liquidity buffers. More precisely, the public sector purchase programme has improved the value of bonds held as high-quality liquid assets, and the collateral easing measures have enabled banks to pledge additional instruments in order to obtain liquidity.
Still, some banks might be reluctant to use their liquidity buffers, especially close to the time their liquidity positions are disclosed. Their main fear seems to be that, if they are the first to dip into their buffers, the markets may see this as a sign of weakness compared with their peers. So let me repeat: the buffers are meant to be used in a crisis, and we will continue to assess banks’ willingness to use these buffers. Insofar as we are able to remove relevant obstacles, we will consider doing so.
You’ve recommended that banks should not pay out dividends or buy back shares and you’ve encouraged a prudent approach to variable remuneration. Are the banks and their leaders listening?
Yes, they are. Of the €35 billion in dividends that were planned to be paid, we expect that more than €27 billion are being retained as capital on banks’ balance sheets. Planned share buy-backs have also been cancelled. And we expect banks to take our call for extreme moderation on variable remuneration seriously. So banks have acted responsibly, and this will shape their reputation in the future. In a crisis such as this, banks should preserve every euro of capital that could be used to absorb losses and to continue lending to the economy. I am well aware that healthy banks need to be attractive to potential investors, and I am also aware that a regular flow of dividends at euro area banks has been an important factor for equity investors, as profitability remains persistently low. But I believe that preserving capital at this juncture is also in the interest of investors in the longer term. And I want to reiterate that this is an exceptional and temporary measure to deal with an exceptional and temporary situation.
There were some concerns that we might also consider other restrictions, including on additional Tier 1 instruments. Let me be clear: we are not planning to put any constraints on payments of such instruments. Restrictions on payments of these instruments will be automatically triggered only if banks hit certain capital levels set out in the legislation – but as of today, banks still have significant buffers to use before reaching that point.
The economic crisis is expected to drive up non-performing loan (NPL) levels again. Will European banks be back where they were five years ago? How will this be addressed?
Indeed, the euro area economy is projected to shrink even more than during the last financial crisis. So it’s likely that non-performing loans will increase substantially – despite all the support measures that have been taken. And this would not be the result of poor risk management practices in banks, but of asymmetric, exogenous shock. The impact might therefore be sizeable in all euro area countries, not just a few. But banks are certainly more resilient than they were in 2008. NPL volumes at the end of 2019 were virtually half what they were five years ago. The vast majority of banks with high NPL levels met their NPL reduction targets for 2019, and many banks exceeded them. Supervisors are also much better prepared. After all, we have spent a lot of time putting in place policies to deal with non-performing loans.
Since the start of the current crisis, we have also shown flexibility with regard to non-performing loans. But while it’s important to help banks weather the current downturn, it’s equally important to ensure that they continue to correctly identify and manage any deterioration in asset quality and report this back to us, in line with the existing rules and the ECB Guidance on non-performing loans. This is essential for us to maintain a clear and accurate picture of risks in the banking sector.
In any case, it is crucial that banks prepare well for the expected rise in the number of distressed debtors and non-performing loans. Failing to do so would not only hamper economic recovery, it would also weigh on banks’ profitability and asset quality. So I urge all banks to ensure that they are up to speed in key areas of NPL management, that they have adequate and clear policies to identify and measure credit risk, that their staff has the knowledge and the tools to effectively manage the increase in NPL workout cases, that strong governance is in place – with adequate and frequent monitoring of evolving risks – and that their IT systems are fit for purpose.
Will this crisis bring about the desired consolidation in the European banking sector?
First of all, there is still a need to consolidate – this has not changed. We still see excess capacity that weighs on banks’ profits and cost-efficiency. The extraordinary support measures that have been put in place by central banks, supervisors and fiscal authorities are meant to support households, small business and corporates, not to keep alive banks that went into the crisis with unsound business models and that were not viable in the first place. For these banks, the crisis might trigger an even greater need to act, and consolidation could indeed be part of the solution. But consolidation could also be a tool for sound banks that wish to improve their profitability in a low-interest rate environment.
As supervisors, we will continue encouraging banks to consider consolidation in order to improve sustainability. We will assess each consolidation project that is brought to our attention on its own merits and exclusively on technical, prudential grounds. We are also committed to clarifying our general approach to consolidation and will soon provide greater clarity to the banks and markets.
It is up to the banks to decide whether domestic consolidation is preferable to cross-border acquisitions. However, it is regrettable that there are still so many barriers that hinder cross-border consolidation. These include fragmented tax, company and insolvency laws. And then there is the legacy of ring-fencing measures adopted during the previous financial crisis, and the remaining obstacles posed by prudential rules that prevent group-wide management of capital and liquidity within the banking union. To overcome the resistance to removing these barriers, we need truly European safety nets, including European deposit insurance.
In your view, has this crisis strengthened or weakened the banking union?
Let me stress that the banking union has worked well in the current crisis. European banking supervision was able to react very fast and in a fully unified manner. Compared with 2008, this is a huge improvement! So, if anything, the current crisis is a wake-up call: it shows that we need European solutions for European problems. This is not a new idea, but it has once again proven to be true.
So, we need to complete the banking union, most notably by establishing European deposit insurance. This remains one of the top priorities. But we need to go further. We need to make it easier for banks to operate across borders as this would support private risk-sharing and improve citizens’ access to low-cost and high-quality banking services; we need to improve and harmonise the toolbox for dealing with crises in small and medium-sized banks; and we need to make the financial sector more resilient to country-specific shocks. Overall, our goal should be to complete the banking union within the current institutional cycle, by 2024.
- The interview with Andrea Enria, Chair of the Supervisory Board of the ECB, is published in the Supervision Newsletter
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