Although the banking sector is resilient, we still need to be vigilant
As was stated in the previous article, it has been 10 years now since the European Banking Authority (EBA) was established. Over that time, the EBA has contributed to the huge increase in the resilience of the European banking system. However, despite the fact that at first glance banks may seem strong and stable nowadays, as the EBA’s Director of Regulation, Isabelle Vaillant, points out, there is a need to be constantly vigilant and to complete the third pillar of the Banking Union – a common deposit guarantee scheme.
What does the EBA consider to be the biggest success of its 10-year existence? Why is the third pillar so important? And in what direction could the development of the European banking sector take? Isabelle Vaillant answers these questions and many others.
This year, the EBA is celebrating its 10th anniversary. What do you consider to be its biggest success during that period?
Without doubt, I think that the EBA’s greatest success in its first 10 years of existence is the creation of a single set of common rules applicable to all Member States of the European Union, known as the ‘Single Rulebook’. This is a key pillar of the Banking Union and of regulation of the financial sector in the EU. It has contributed to strengthening the European banking sector and promoting the single market while maintaining a level playing field for financial institutions as we know them today. It better prepares banks and their supervisory authorities to do their work and focus effectively on emerging problems.
For example, during a major financial crisis, the Single Rulebook helped banks and supervisory authorities to navigate a way forward. Its rules have proven sufficiently comprehensive and dynamic, even in the face of the pandemic. Thanks to this set of supplementary prudential rules, fast-track measures have been taken to enable banks to continue lending to citizens and firms in need. Last but not least, thanks to the higher level and quality of capital, and liquidity, the Single Rulebook has allowed a more robust growth in the EU banking system and freed up time that supervisory authorities would otherwise have to spend on setting standards for addressing risks.
Can you, therefore, distinguish between the earlier EBA approach – after the financial crisis – and now? How has it changed over the last year?
As I said, the EBA’s first 10 years focused mainly on creating rules and setting up a prudential framework covering more than 265 new technical standards that clarified primary legislation. Now, 10 years on, we are entering a new phase in our lives. It is time to learn from the past, to maintain a sense of purpose and to judge whether the regulation adopted is achieving the intended objective.
At the same time, I believe that the Single Rulebook should be flexible and adaptable. In this context, the EBA has indeed adapted many of its technical standards to take into account evolving business practices, new risks and changing conditions of financial stability. This concerns about 10% of the current rules. However, there is a view that the Single Rulebook is too large and too complex. To those who support that view, I say that the rules are maintained in proportion to the complexity of each bank’s business, and that the deeper the single market becomes rooted, the more the Single Rulebook can be simplified. In the future, it is also crucial that the internationally agreed Basel III framework is implemented fully, promptly and consistently in all jurisdictions so as to ensure a sound and properly functioning banking system capable of supporting economic recovery and growth in a sustainable manner. This is another of the objectives we are now focusing on.
The EBA has a number of plans for the following years, which are also mentioned in its annual report. But what is the top priority?
First of all, I would like to point out that the challenges that the banking sector faced before the pandemic have not disappeared. On the contrary, the health crisis has deepened these. In particular, the increased digitalisation of financial services and the risks associated with sustainability and ESG in general are two important areas where both challenges and opportunities will become increasingly significant. The EBA will continue to actively monitor these trends, risks and opportunities, and their impact on banks’ business models, and respond with changes in the rules when needed.
Another area that I have already explored is the Basel III framework and the need to complete it with a full, timely and consistent implementation of internationally agreed standards. If further crises or new challenges emerge, we must be ready to reap the benefits of that implementation. Finally, we will continue to play an important role in shaping new reforms, such as the implementation of the new regime for investment firms and the role of the EBA in addressing crises and recovery.
‘The EBA’s first 10 years focused mainly on creating rules and setting up a prudential framework covering more than 265 new technical standards that clarified primary legislation.’
You have already mentioned the pandemic. To what extent has it affected the stability of European banks? And what are the remaining risks?
Despite signs of improvement, as shown in the recently published EBA ‘Risk Dashboard’ document, covering the first quarter of 2021, profitability and asset quality are likely to be the two main challenges in the coming period. Until the pandemic is fully under control, banks will remain vulnerable to adverse credit risk shifts and the ratio of non-performing loans (NPL) is likely to increase, although this concern has not yet materialised.
Therefore, we must bear in mind that a high level of capital helps banks to withstand upcoming expected losses in connection with credit risks resulting from the crisis. There is still uncertainty about the short-term and long-term economic consequences. From this point of view, we have always argued that banks must first identify the extent of potential losses in a timely manner and build up a buffer accordingly. This is also linked to how the provision of new credit evolves. Through our benchmark, we also support supervisory authorities in identifying outliers. In September, we intend to publish a best practice report on some of the main aspects of IFRS9 modelling implementations.
Are the impacts of the pandemic different across the EU?
It should be noted that, before the outbreak of the pandemic, there were significant differences between countries, for example in terms of capital ratios and levels of non-performing loans. However, as regards the impact of the Covid-19 pandemic, I think I don’t need to talk about differences between jurisdictions, but rather about the differences between the impact of the crisis on different economic sectors, even within the same jurisdiction. For example, the pandemic has shown that the banking sector is strong and resilient overall, which could mitigate the effects of the health crisis and play an important role in its recovery by providing new loans. So far, no country has been identified for which, for example, capital requirements have not been met across the board or for which NPLs have increased excessively. There are examples of weaker banks in the EU, but these are idiosyncratic cases.
It is a fact that the impact of the crisis tends to be more sector-specific. For example, in particular accommodation and catering, as well as the arts, entertainment and recreation, have recently shown an increase in non-performing loans. Although the NPL ratio decreased from 2.6% to 2.5% in the first quarter, accommodation and catering services grew (from 8.4% to 9% quarter on quarter), as did the arts, entertainment and recreation industries (from 7.2% to 7.9%). Although some banks may have a higher proportion of exposures in relation to these sectors, it still doesn’t mean that their NPL ratios have increased extremely. Despite this, we are still monitoring the ability of banks to integrate forward-looking elements into their backstop functions and IFRS9.
You say that the banking sector is strong and resilient. On the other hand, the EBA draws banks’ attention to the fact that there is still some work ahead of them. Where do you see the largest reserves?
It is true that the system has remained stable even during the pandemic, and regulatory authorities have been able to free up capital and liquidity buffers. This is also due to the fact that banks’ starting point in terms of capital buffers, liquidity requirements and management and governance requirements was very different compared to 2007/2008, when we were hit by the major financial crisis. It has allowed us to react and face the current situation with greater strength.
On the other hand, despite all these improvements in the Banking Union, it is still not complete. In order for the scheme to achieve its objective, it is necessary to complete the third pillar, which is a common deposit guarantee scheme. In addition, it is necessary to pave the way for the free and effective movement of capital and liquidity across borders in order to reap the full benefits of the Single Market, while addressing the problems of failing banks through direct loss transfer mechanisms.
How far on is the common deposit guarantee project and in what way should it be specific compared to local deposit guarantee funds?
It is important to underline that national deposit guarantee schemes work the way they should both in the euro zone and in the rest of the EU Member States. Covered deposits are safe. However, these systems still need to be improved. In this regard, the EBA has issued several guidelines to harmonise the application of rules and enhance cross-border cooperation across the EU. In addition, we have already published four opinions, which will soon be five, on how to improve the current deposit guarantee framework, which we hope will be reflected in the revised DGSD (Deposit Guarantee Schemes Directive). The European Commission is due to publish it by the end of the year.
Regardless of whether a country is part of the eurozone or not, the EBA is continuing to work on improving the protection of depositors in all Member States. As regards the EDIS (European Deposit Insurance Scheme), let me say that this project is about further improving deposit insurance in the eurozone, i.e. in 19 of the 27 EU Member States, by creating consistency with the SSM (Single Supervisory Mechanism) and the SRM (Single Resolution Mechanism) and breaking the bond between the state and banks. The EDIS could offer a number of benefits, such as increasing risk absorption and the ability to handle large shocks. The EDIS would also facilitate cross-border cooperation, including with EU countries that are not part of it, thereby increasing depositor confidence. Last, but not least, the stabilisation and clarification of the remaining pillars of the Banking Union will continue to bring benefits in the post-crisis period.
However, the EBA is not directly involved in the discussions on the EDIS, although many of the technical details underlying the EDIS are currently included in the DGSD. Therefore, many of our recommendations on strengthening the DGSD are also relevant for the EDIS. Finally, let me reiterate that the EDIS proposal is a political choice and many issues can come into play in decision-making, such as the treatment of state ex-positions. Nevertheless, we are ready to provide support with our technical knowledge any work that can be done to make further progress in this regard.
Central bank balance sheets seem to suggest that we live in a world where all economic problems are addressed by quantitative deregulation and low rates. Do you see a way out of this circle?
It is not for me to comment on monetary policy, as this goes beyond my regulatory and supervisory role. From a banking perspective, it is true that an environment with low interest rates has helped stimulate economic growth and improve the provision of credit. The plan to boost Europe’s recovery, which seems to be increasingly focused on raising potential growth, improving long-term fiscal sustainability, in particular investing EU money in high-value and growing sectors, and fostering economic convergence across the EU, will be crucial in the years ahead.
This year, the EBA launched another of its Europe-wide stress tests. Is this year special, considering the developments in 2020 and this year?
We launched the Europe-wide stress test on 29 January, the results of which were published on 30 July. It’s an extremely important exercise and even more important now as we are still confronted with the major crisis caused by the pandemic. The objective of the stress test is traditionally to assess the resilience of EU banks to an unfavourable scenario, to ensure transparency through the publication of results in order to strengthen market discipline and to provide input for the regular supervisory review and evaluation process (SREP).
In addition, this year’s stress test will also allow us to assess whether banks’ capital buffers are sufficient to support the economy in times of stress. It can also be used as a basis for European supervisory authorities to discuss exit strategies linked to measures in the context of the Covid-19 pandemic or to introduce additional measures if real economic conditions deteriorate further.
Specifically, as regards the adverse stress test scenario, this reflects the principal risks for banks in the European Union that were identified by the EBA and the European Systemic Risk Board (ESRB). This time, however, the story describes an adverse scenario linked to persistent concerns about the possible development of the Covid-19 pandemic in an environment of long-term ‘lower-for-longer’ interest rates. Such a scenario would lead to a permanent decline in GDP and an increase in unemployment. And while the real GDP shock would be lower compared to last year’s scenario, the consequences could be very severe given the weaker macroeconomic exit point in 2020, which is still a credible scenario.
Sustainability and ESG for banks are a major issue that you have already studied. To what extent will this trend be a challenge for the banking sector? And how big a topic is it for the EBA?
As I have already mentioned when talking about our new challenges and priorities, ESG is one of them. It is precisely the decision of the EU legislators to fundamentally change the way European economies expand their production that should encourage institutions to treat ESG risks from a strategic point of view as well. In the area of financial regulation, a number of measures are being taken in the context of integrating sustainability considerations, redirecting capital flows towards sustainable investment and managing financial risks resulting from climate change, environmental degradation and social problems.
Therefore, the EBA is actively working to raise awareness of the integration of ESG risks into the prudential banking framework among EU financial market players. We are defining a framework for strategies and risk management, supported by our key indicators. In addition, we are implementing our stress tests and scenario analysis tools. We are assessing whether the prudential framework may require adjustments to reflect ESG risks. Last but not least, we will carefully consider the calibration of the existing prudential framework to ensure that its perspective adequately reflects the needs associated with this problem.
‘Until the pandemic is fully under control, banks will remain vulnerable to adverse credit risk shifts and the ratio of non-performing loans (NPL) is likely to increase, although this concern has not yet materialised.’
Another challenge facing banks today is ever-increasing IT and compliance costs. These costs are particularly significant for smaller banks. Among other reasons, this is why we may be witnessing various mergers and acquisitions. Is this the way to go? How do you view the consolidation of the European banking sector?
In an environment of very low rates, European banks are struggling to obtain sufficient credit margins. Nowadays, they operate at a level of profitability which is not sufficient to cover their capital costs. That is why I believe that, given the difficulties in achieving substantial increases in yields, banks should adopt ambitious cost-reduction strategies. The consolidation process taking place in many EU countries could be useful in this direction. Consolidation can indeed allow banks to avoid duplication of costs and exploit potential synergies and economies of scale. This is particularly important in the current process of digitisation which banks have begun. For example, the development of new software or new mobile applications does not change significantly with the size of the bank. Larger institutions are therefore usually better equipped to afford digital transformation.
In the EBA, however, we also pay attention to the side effects of consolidation. In banking markets where concentration is already high, further consolidation could have adverse effects on competition, in particular where consolidation remains primarily domestic. And even if the creation of FinTech companies limits the market power of banks, the role of competition authorities will be crucial in this respect. In addition, if the merger were to lead to a substantial reduction in branches, this could harm the financial integration of less tech-savvy customers. Recent innovative solutions, such as the use of post offices to provide basic financial services, could alleviate this problem.
Crypto-assets and distributed ledger technology (DLT) are also connected with technology. Some banks are more active in this area, others less. Do you see any potential?
The EBA continuously monitors the evolution of cryptocurrencies, and our monitoring has confirmed that European banks’ exposures to cryptocurrencies are not significant and do not pose a direct risk to their financial stability. However, as concerns so-called virtual currencies (e.g. bitcoin), in line with previous warnings published in the EBA report of January 2019, financial institutions are discouraged from engaging in activities involving trading such tokens on their own account. Any exposures to them should be subject to conservative prudential treatment.
In general, there is an increase in DLT experimentation and the tokenisation of assets across the financial sector in the EU (e.g. in the context of issuing green bonds, money transfers and commercial finance). This is also why the EBA welcomes the European Commission’s legislative proposals on a pilot scheme for DLT-based market infrastructures and a regulation on crypto-asset markets (MiCA) to facilitate cross-border scaling of these technologies, while ensuring risk mitigation for consumers and investors.
The EBA is actively working to raise awareness of the integration of ESG risks into the prudential banking framework among EU financial market players. We are defining a framework for strategies and risk management, supported by our key indicators.
As a result of the pandemic, Brexit has not been such a topic of conversation. But what does the literal move of the financial centre out of the EU mean for European banks?
Brexit is a regrettable decision which has, unfortunately, irreversibly fragmented financial markets. London, formerly the predominant part of the European financial markets, is now in a third country outside the jurisdiction of the EU. Unfortunately, this is not in the interests of the European Union. It is simply not sensible to rely on the provision of vital services in the EU fully and only depending on a third country.
Brexit put EU banks – clearing member banks and client banks – in a situation where they de facto rely on central clearing counterparties (CCPs) established in Great Britain to clear their derivatives transactions. This is a situation that increases significant risks to the financial stability of the EU, in particular if one of these CCPs faces difficulties in an adverse situation and is helped to recovery or led directly to a crisis solution. A situation of this kind would require a very strong cooperative relationship with the United Kingdom, which should be maintained in extremely turbulent times. At the same time, it should be ensured that EU clearing members are treated fairly, that the ECB or other EU central banks have access to all accurate and timely information, and that emergency liquidity can be provided to EU banks if necessary. Therefore, based on current, very significant exposures of European banks to UK CCPs, the deterioration of cooperation in stress situations poses a risk to long-term financial stability. This is also one of the reasons why the European Commission issued an interim equivalence decision in September 2020. It made clear that over-reliance of the EU financial system on services provided by UK-based CCPs requires a significant reduction in the EU’s engagement with these infrastructures. With this in mind, the decision gives European banks until 30 June 2022 to prepare for this. In line with this, the EBA has updated its SREP guidelines requiring EU supervisory authorities to assess how EU banks reduce these exposures. It is not possible to continue with the status quo. Alternatives to UK-based CCPs need to be developed in order to avoid any excessive risks to financial stability that might arise. This is a fundamental shift for European banks and European CCPs, which now need to build up the required capacity in EU market infrastructures.
Isabelle Vaillant has been involved in the financial world since the 1980s. She is a graduate of the Institut d’Études Politiques de Paris and has held many positions at the Bank of France since 1986. During her career, she has held many roles, ranging from economist and director of international regulation, to head of the International Credit Institutions Supervisory Department. Since 2011, she has served as Director of Regulation at the European Banking Authority.
The interview was conducted by Tomáš Houdek.
Časopis Bankovnictví, 18 August 2021