The 2023 Regulatory Angle: EBA, ECB & SRB on their supervisory priorities
The European Banking Authority, European Central Bank and Single Resolution Board shared insights into their latest work and priorities in a Crédit Agricole CIB web conference ahead of the new year. Neil Day reports their views on the macro outlook, funding conditions, and capital framework.
Delphine Reymondon, head of liquidity, leverage, loss absorbency and capital unit at the European Banking Authority (EBA), kicked off the three presentations by saying that while European banks are generally robust in terms of profitability, capital, and liquidity, they face a macroeconomic outlook that is increasingly uncertain — with regard to energy supplies, geopolitics, inflation, monetary policy and a “high risk of recession”.
“The first downside risks are materialising,” she said, with banks reporting the first signs of a deterioration in asset quality, notably in relation to SMEs, consumer credit and energy-intensive sectors.
Along with Reymondon, Korbinian Ibel, director general, universal and diversified institutions, European Central Bank (ECB), flagged a first increase in Stage 2 loans.
“It’s not yet super-worrying,” he said, “but it’s something we are looking at very carefully. As we all know, when interest rates go up, the first thing that comes for most banks is that interest income increases, but the defaults that might follow the interest rate increases come much later, which is why we look at Stage 2 loans as a leading indicator.
“We believe there is a risk — let’s hope it’s not going to be realised — that a scenario will develop which leads to a much worse cost of risk in the future. This is why you see us giving so many warnings.”
While the regulators noted some parallels between the risks of the pandemic and those faced today, Ibel said there is a big difference between the Covid crisis and the Russia-Ukraine crisis.
“During the coronavirus (Covid-19) pandemic, basically everyone assumed a very, very dire scenario,” he said, “and then quarter by quarter you saw improvements in the forecasts because it didn’t turn out to be so bad — fiscal, monetary and supervisory measures were successful, and the economy stabilised much quicker than everybody had anticipated.
“Regarding the current crisis, in 2022 everybody assumed that it was going to be bad economically, but not so bad, and then quarter by quarter, with the energy crisis and the supply chain crisis coming in, the forecasts got worse and worse. This should be kept in mind.”
Banks should not expect a repeat of pandemic support measures, Ibel (pictured below) stressed.
“When we talk to bankers that we supervise, we sometimes have the feeling that they believe they navigated one of the deepest crises of the past decades without any scratches because everything is so great in banking,” he said. “Bankers did an excellent job, of course, and we fully appreciate and acknowledge that, but what should not be forgotten is that many of the positive developments were based on a lot of supervisory support.
“So bankers should not base their modelling on those times.”
In light of these considerations, the ECB has been looking anew at banks’ capital planning and Ibel said that supervisors will challenge management actions to ensure an appropriate level of conservatism.
He noted that dividend restrictions were a price paid for pandemic support measures, but that the ECB has not asked for an extension of its supervisory powers in this respect, judging its current powers to have proven sufficient. However, during a Q&A session, Ibel again advised prudence in respect of dividends.
“If you see an environment in which you will not only most probably observe a deterioration of the economy, but, on top of that, you know that the forecasts might not be 100% accurate, and they are going in a direction that is getting worse and worse, then what is the right reaction for a bank?
“In that situation, it must be to say, ‘I will keep my capital a bit higher. If I pay out now and later face a difficult situation… We saw after the great financial crisis how difficult it is to raise additional fresh capital. If the environment turns out to be very good, and much better than feared at this point in time, I can still pay out later.’
“That is why we like Common Equity Tier 1 (CET1) capital.”
Funding and interest rates: banks must tackle challenges
Reymondon at the EBA warned that the development of interest rates also means a worsening of funding market conditions, just as banks are replacing TLTRO funding. She also elaborated in detail on a specific area of scrutiny for the EBA being the management by banks of the interest rate in the banking book (for example in terms of modifications of assumptions underlying modelling of IRRBB risks, changes in hedging strategies, business model changes if any) and more generally the impact of the increase of interest rates on several prudential aspects.
“Servicing debt will be more costly,” she said, “and we are working on this, running some simulations, also to measure the impact on liquidity ratios in particular.
“There will be the need to substitute in particular this central bank funding with market funding,” added Reymondon, “and we have of course already seen a widening of spreads in wholesale markets, meaning that as some banks still need to reach final MREL targets arriving in 2024, there might be some more difficulties for banks especially of a smaller size and in certain jurisdictions.”
Sebastiano Laviola, director of resolution strategy and cooperation and board member at the Single Resolution Board (SRB), said such a scenario was foreseeable.
“For all the banks that essentially have resolution as a strategy, we always told them to exploit the period when the sun was shining to issue,” he said. “Some did. Others did less.
“We are closely monitoring the development of the markets and the funding plans of the banks,” added Laviola (pictured below). “In a period of extreme uncertainty, for lesser known names and those with weaker ratings, it is clearly more difficult to issue, even at higher prices. Notwithstanding that, some banks of this type have issued recently — albeit certainly at higher prices.”
In addition to the issue of funding, Ibel at the ECB said the development of deposits and in particular greater deposit outflows is a key question. He noted that deposits are typically invested on the basis of non-maturing deposit models, calibrated in a period in which interest rates were falling or stable.
“Many of these models do not even have the interest rate as an explanatory factor,” he said, “meaning that interest rates are not assumed to play a role, which is a very brave assumption for banks to make.
“My biggest concern — which is a scenario that banks should at least consider — would be if interest rates rise further and we suddenly see more and new market entrants with big platforms who see a chance to collect deposits for very low fees and invest them risk-free at a much higher rate. Banks which have invested deposits long term on the basis of their models have no way to counter this, because the assets they have invested in over recent years have relatively low yields.
“It’s not clear whether this will happen,” added Ibel. “The complexity of the regulatory framework, which is mostly seen as a burden by bankers, also gives the system strong protection. But there may be a trigger point where the benefits of entering the market for new players are very large and this is not included in the multi-year business plans of banks, so we have already had this in focus and will keep a close eye on any such developments in future.”
Capital framework: handle with care
While acknowledging that the capital framework for banks has become very complex, Reymondon at the EBA said it is not the time to be making changes to it.
“Some work is being done at the Basel table in terms of buffer usability, the role of AT1 and these types of aspects, and we are also doing some work there, but with a different perspective,” she said. “Our perspective is more to gain a better understanding of how all the different bricks in this framework are working together, and we are making some comparisons between different international frameworks to see what could be learned to maybe one day simplify the framework.
“But not today. When we replied to the Commission call for advice on reflections to amend the macro-prudential framework, our view was that we should not do it now. The current framework was not properly tested even during the Covid-19 pandemic, particularly in view of all the government support measures, and it is not even fully implemented yet.
“Simplifying the framework would also involve big hurdles,” added Reymondon (pictured below). “Since it’s so complex, if you wanted to simplify it, you would need to restart from… I wouldn’t say zero, but it’s really difficult to just touch some bits and pieces — it would be quite long term work. Stability in the regulatory framework is also key from an EBA perspective.”
Ibel echoed Reymondon’s sentiments, while highlighting that, in its response to the European Commission’s call for advice, the ECB had recommended other changes.
“The most important thing, and a lesson from the pandemic, is that it would be beneficial to have more macroprudential policy space via larger releasable capital buffers,” he said. “When we entered the pandemic, the buffer that was supposed to do that was the countercyclical buffer (CCyB), but there was not enough capital in the CCyB to be really impactful. This is why we had to use other measures, but that was a patch and not an optimal solution.
“There are different policy options to do this. You could have a fully or partially releasable capital conservation buffer. You could have a higher CCyB in normal times, so basically a positive neutral rate. Or you could have a core rate for the systemic risk buffer.”
Ibel then turned to the revised Capital Requirements Regulation (CRR3), reiterating the ECB’s opposition — shared by the EBA — to proposed deviations from Basel III.
“There is an international standard,” he said. “It was negotiated with the Europeans in the room — I’m the representative of European banking supervision at the Basel table — and this was already a compromise. Deviating from it now will most probably just lead to scepticism among international investors about the viability of European banks and whether or not they can trust the numbers — which is, of course, the worst thing we can do, because in the end it will increase funding costs and just make European banks less investible.
“So, from a bankers’ perspective, one might consider it a little bit short-sighted — all this lobbying to deviate here and there and get a little relief on different aspects. International investors are fully aware that Europe was and is materially non-compliant with the Basel framework. So please understand the importance of deviating as little as possible — it’s an issue that’s really dear to our hearts.”