26.10.2020
The banking sector and the challenges posed by the pandemic
III Foro Banca de El Economista: The present and future of the financial system
Pablo Hernández de Cos
Governor
*English translation of the original speech in Spanish
Ladies and gentlemen, good morning:
I should like to start by thanking the organisers of this event for inviting me to participate in
the III Foro Banca. Allow me also to mention in relation to the content of my address that,
as a member of the Governing Council of the European Central Bank (ECB), I am required
to observe the so-called "quiet period" preceding meetings at which monetary policy
decisions are to be taken. Accordingly, my reflections should not be interpreted as
indicating the monetary or economic outlook.
In the context of the COVID-19 pandemic and its already significant impact on the economy,
the specific challenges facing the banking sector, both in Spain and internationally, are
particularly relevant, given the role it plays in supplying financing to the productive sectors
of the economy and households.
It is evident that the crisis generated by the pandemic has intensified the credit, market and
operational risks faced by the banking sector. It is also evident that the improvements made
by the sector over the last decade, as regards the quality of its balance sheet and its
solvency levels, have placed it in a better position to absorb this crisis and to continue
supplying the financing that the economy requires.
Here the effect of the far-reaching international financial reform implemented over the last
decade should be emphasised. This reform, along with the various economic policy
measures adopted during the crisis, is helping to mitigate and manage these risks. In fact,
so far, the financial system has mitigated - rather than amplified - the impact of this crisis.
This should serve as a reminder of the importance of having a solid banking sector, backed
up by prudent global regulatory standards.
It should also serve to emphasise the importance of the response to the crisis being as
coordinated as possible at international level, something that the Basel Committee on Banking
Supervision (BCBS) has been working on since the start of the crisis. This is the only way of
ensuring an effective response and avoiding the collateral damage, in terms of financial
fragmentation, that would be generated by an uncoordinated isolated response.
However, this initially positive diagnosis must not lead to complacency. As we are all well
aware, the magnitude of the shock is huge. Also, its duration is uncertain, as the emergence
of fresh outbreaks of the virus in practically every country in the world has shown. And, of
course, we know that the ultimate impact on the banking sector will largely depend on the
scale and duration of the economic crisis generated by the pandemic, and on how effective
economic policies are in reducing its impact on households and businesses, as was
perfectly illustrated by the vulnerability exercise published by the ECB in July.
I would like to share with you some considerations on various aspects that I believe are
relevant in the current context. These considerations concern banks, on the one hand, and
supervisors and financial regulators, and economic policy-makers in general, on the other.
The use of capital buffers
The first consideration I would like to share relates to the accumulated capital buffers
and their use in this crisis. Solvency levels are now significantly higher than before the
global financial crisis. This is fundamental to ensure that the banking sector continues to be
in a position to perform its function of financing the economy during the present crisis.
Naturally, this also increases its capacity to absorb losses.
In fact, there is evidence that, in the countries that had the largest capital buffers, the
deterioration of "growth at risk", a concept developed by the International Monetary Fund
to capture expected GDP growth in stress situations, has been less severe than in other
jurisdictions. Likewise, the empirical evidence available shows that the greater the level of
banks' solvency, the greater their capacity to grant financing. In addition, our latest analysis
allows us to conclude that their use of the public guarantee programme has also been
determined by their solvency levels.
At the start of the crisis, prudential supervisors decided to release many of the
macroprudential (countercyclical capital and systemic risk) buffers, although these were not
very significant, because in many countries the systemic risk that had built up was not
sufficient to require their activation. In parallel, the microprudential authority (i.e. Banking
Supervision of the European Central Bank for significant institutions) has allowed banks to
operate temporarily below the levels set for some structural requirements such as the capital
conservation buffer, the Pillar 2 guidance (P2G) and the liquidity coverage ratio (LCR). Also,
the possibility of covering part of the Pillar 2 requirements (P2R) with non-CET1 capital was
envisaged.
The purpose of these decisions has been precisely to help banks continue to provide the
necessary financing to households and firms in such an adverse environment.
From a theoretical point of view, the easing of prudential bank capital requirements during
a crisis gives rise to a dilemma. On the one hand, this easing may, as I have said, boost the
provision of financing to the economy, but, on the other hand, it may, in certain
circumstances, reduce the loss absorption capacity.
According to our empirical analysis, the use of these buffers would allow banks to provide
more financing to the real economy, which in turn has a positive effect on economic growth,
boosting its recovery or moderating its downturn. And this positive impact on economic
growth is of such a magnitude that it leads, in turn, to higher demand for credit and higher
bank revenues, which ultimately translate into higher solvency levels too.
It should be recognised, however, that the use of buffers may be hindered if banks are afraid
that reaching certain capital ratios would be penalised by the financial markets, raising their
cost of financing and, thus, their solvency levels. This market stigma effect may lead banks
to avoid using capital buffers, which, according to the above-mentioned analysis, would
have a negative impact on the economy. One way of trying to alleviate this problem has
been through the forceful monetary and fiscal policy measures applied during the crisis,
which have enabled the financing costs of European banks to remain very low.
The use of these capital buffers by banks may also be hindered if there are doubts regarding
the process of capital buffer rebuilding after the crisis. The difficulty would be if banks were
required to rebuild their buffers at a time when the capacity to generate profit was modest
or the market was not receptive, as the fall of the banking sector on global stock markets
demonstrates. To ease this problem, the authorities have made it clear that banks will have
sufficient time to restore compliance with capital requirements and that the process will not
start before the main effects of the pandemic have been dispelled.
An additional issue that hinders banks' use of capital buffers is that, under current
regulations, if their capital levels fall below certain thresholds, preventive measures, such as
a ban on paying dividends and the suspension of interest payments on AT1 and T2
instruments, are activated. Once again, banks would suffer stigma in these securities
markets.
In short, the use of capital buffers continues to be an important aspect of the fight against
the economic effects of the pandemic. However, their actual use is hindered by the various
factors I have just mentioned. In this context, clear communication on the part of the
macroprudential and microprudential authorities regarding both the capacity to make use
of these buffers and the flexibility in their subsequent rebuilding is crucial. In any case, and
at the same time as we monitor the impact of the pandemic, over the next few months we
will have to continue to monitor the use of capital buffers and assess, where applicable, the
adoption of further measures in relation to them. On the basis of the experience gained
during this crisis and with a medium-term perspective, the balance between structural and
cyclical capital buffers may also be analysed as a way of avoiding, in future, the difficulties
observed in banks' actual use of capital buffers.
Dividend payment restrictions
A second question, closely related to the previous one, relates to the treatment of
dividends during the crisis. As you are all well aware, one of the recommendations of the
European prudential supervisors, which have been extended to a large number of other
countries, was that banks should not distribute dividends and should be very prudent when
determining the variable remuneration of their employees.
I think it is important to explain the reasons for this measure. Specifically, it seeks to ensure
that more funds are accumulated at banks to absorb losses, against a background of
heightened uncertainty. In general, all Spanish banks that could legally suspend or postpone
the dividends payable out of 2019 profits followed these recommendations. This will allow
them to add around 50 basis points in 2020 to the capital buffers that they had before the
outbreak of the pandemic.
The positive effect of this measure supplements and is boosted by other decisions adopted
by various economic authorities, which have reduced the capital requirements for banks
(specifically, by releasing a large part of the macroprudential buffers, as mentioned above)
and mitigated the impact of the pandemic on their income statements.
Moreover, the fact that the authorities' recommendation has been extended to all banks in
most jurisdictions, for the duration of the crisis (a measure that is, in any case, reversible
through future extraordinary dividends should more benign scenarios materialise than those
envisaged in the current circumstances), has limited the collateral effects of this measure
on banks' capacity to issue capital instruments at an appropriate cost.
In fact, although banks' cost of capital rose significantly after the emergence of the
pandemic, following the implementation of the broad raft of measures to mitigate its impact,
this increase has been fully corrected, without this recommendation having had an
apparently significant impact, at least on most European banking systems.
The ECB and the European Systemic Risk Board will review this recommendation before
the end of the year. The final decision will take into account the macrofinancial situation at
the time. That said, irrespective of the decision adopted, the recommendation for prudence
in this area must remain in force as long as the current uncertainty persists and until a solid
economic recovery takes hold.
Recognition of the increase in credit risk
Third, I would also like to refer to the increase in credit risk generated by the pandemic in
lending to households and firms and its recognition by banks.
In this connection, national and international organisations1 have issued various statements
to clarify the effects of COVID-19 on financial reporting by banks, in many cases providing
greater flexibility to the regulatory framework and the prudential impact of such reporting.
The measures focus on clarifying the existing accounting regulations for an appropriate
calculation of credit risk impairment of financial assets in 2020, distinguishing temporary
from permanent effects and recognising the role of public measures in sustaining lending.
The aim of these measures is to prevent provisions from behaving excessively procyclically
and mechanically as a result of automatic reclassification to non-performing of exposures
affected by temporary shocks. That is to say, they seek to avoid a downward adjustment to
the volume of credit in response to the COVID-19 crisis, and also to moderate the impact
on profitability. Likewise, consideration of the positive impact of public guarantees and
moratoria on the repayment capacity of private sector agents also seeks to mitigate the
deterioration in credit ratings.
These measures seek, as I say, to avoid a mechanistic application of the accounting rules
leading to a procyclical effect. However, poor use of the rules could facilitate inappropriate
accounting practices, delaying the recognition of actual deterioration in the credit quality of
certain exposures. For this reason, supervisory guidelines also consider that accounting
measures should not be detrimental to the appropriate identification of impairment or the
assignment of reasonable coverage for credit risk, providing banks with the necessary
incentives to maintain standards that meet supervisory expectations. These measures also
include the adaptation of banks' internal systems for the correct identification of
transactions affected by the measures put in place to adapt accounting to the COVID-19
crisis.
The crisis generated by the pandemic has already had a significant impact on the income
statements of non-financial corporations and on the incomes of households, and has
reduced the solvency of both. However, the increase in the rate of default has, to date, been
very limited. This is largely explained by the broad raft of measures adopted by the various
authorities, which have not only prevented a sudden sharp increase in the rate of default in
this period, but have also mitigated its future increase. In any event, the projections suggest
that the rate of default will increase significantly in the coming quarters even in the most
benign scenario.
In this connection, it should be noted that a large part of the adjustment in banks' earnings
in the first half of this year is due to the provisions made in advance for credit impairment
that has still not materialised, but will do so in the coming quarters. Specifically, Spanish
banks have set aside almost double the amount of provisions they recorded in the same
period of last year.
This has significantly reduced their profitability, but it has also raised their capacity to absorb
credit impairment, something that is particularly highly valued by investors in these
circumstances. The message I wish to convey is that banks should persist with this early
recognition policy, as it will subsequently facilitate their ability to continue to perform their
function of providing financing to the economy. In short, especially if the crisis proves to be
prolonged, banks must ensure proper and timely recognition of effective impairment of the
quality of their credit exposures through compliance with supervisory guidelines.
Global banking regulation
Fourth, I would like to reflect on global banking regulation. As I mentioned earlier, the
Basel reforms phased in over the last decade have attempted to incorporate into regulation
the lessons learned during the global financial crisis. The first phase of the Basel reforms
began in 2010 and was completed through a second wave of changes published in 2017.
The initial phase was aimed at raising the level and improving the quality of banks'
microprudential regulatory capital. The idea was to reduce their risk-taking by increasing
their "skin in the game" and providing them with greater loss-absorbing capacity. The
releasable macroprudential buffers I referred to earlier were also introduced.
The second stage of the Basel reforms focused on a matter brought to light during the first
phase: the calculation of risk-weighted assets (the denominator of the capital requirements
under the Basel standards) and the need to standardise their treatment among institutions.
Again, the aim here was to reinforce the credibility of banks' prudential ratios and
appropriate measurement of the risks assumed. A crucial aspect of this reform is the
socalled "output floor", which limits the benefits that banks can derive using internal models
to calculate minimum capital requirements.
The (pre-pandemic) impact analyses of the reform reveal that banks' capital requirements
would increase in some jurisdictions, although they would also be reduced by certain
elements. Some such elements, which were to be included in the European transposition of
Basel III, have already been implemented through the Capital Requirements Regulation
(CRR) quick fix, introduced in late June. In particular, the impact of the revised SME and
infrastructure supporting factors is reflected in the recent behaviour of solvency ratios.
Investments in intangible assets relating to software will cease to be deducted from capital
at a later date.
The objectives of the Basel III reform, which consist of balancing simplicity, comparability
and risk sensitivity, remain wholly in place. In this sense, after deciding to defer
implementation by one year so as to increase banks' operational capacity, all members of
the Basel Committee on Banking Supervision (BCBS) have committed to its full and
consistent implementation on the new date agreed. The economy and financial system will
thus have sufficient time to absorb the main effects of this crisis and to progressively rebuild
any buffers that may have been used.
Further, it should be noted that the BCBS is carefully assessing the impact of the reforms,
including the lessons learned from the COVID-19 crisis. This analysis will be based on
rigorous empirical evidence and will serve to determine whether any additional regulatory
aspects need addressing.
Low banking sector profitability
Fifth, I would like to reflect on what I consider to be one of the main challenges for the
banking sector in the short, medium and long term, namely the low profitability of the
banking business. It was already low in many European countries before the coronavirus
crisis, but the present crisis will put it under further pressure.
To address this challenge, banks need to continue to make efficiency gains, cutting costs
and making more use of new technologies.
Consolidation processes in the industry could be an appropriate way to achieve this aim.
Specifically, there appears to be room for consolidation both in Spain and in other European
jurisdictions where the indicators point to some surplus capacity. Naturally, such processes
are the responsibility of banks' owners, while our role, as banking supervisors, is to analyse
any merger plans submitted to us from the standpoint of business viability. This entails
assessing the solvency of the resulting institution, analysing the impact on overall financial
stability and overseeing the execution of the merger to ensure that the potential synergies
are indeed harnessed.
In this setting, transnational European mergers would be particularly positive. They would
facilitate further deepening of the banking union and provide greater potential for
diversification. They would also help establish broader customer bases, so that the cost of
the investment in technology could be more widely distributed, although the immediate
impact on cost-cutting would be lower.
In this respect, I wish to highlight the transparency exercise undertaken by the ECB in
submitting its Guide on the supervisory approach to consolidation in the banking sector to
public consultation prior to its approval. This Guide aims precisely to provide the market
with greater forward visibility on supervisory actions, to help banks design merger plans that
are sound from a prudential standpoint and ensure that the resulting institution has a
business plan that, when executed correctly, will add value.
However, institutions should also seek to enhance their efficiency by improving the use they
make of the information they hold. This requires significant investment in digitalisation and
also the incorporation of new data processing technologies that will allow them to change
their business model while controlling their risk profile. And this is why it is so important that
the "quick fix" has brought European prudential regulations on this kind of investment much
closer to the regulations already in place in the United States and Switzerland.
Investments of this kind will enable institutions to face up to any major potential competitors
- not necessarily financial institutions - that might venture into the credit market with more
guarantees of success. These firms - the big techs - possess an enormous amount of
customer data, and they make highly effective use of those data for their own needs. Recent
experience shows that these firms have caused disruption in the sectors they have entered,
taking over the most profitable business segments and driving out existing firms.
Naturally, the solution is not to curb technological progress that may benefit society in many
ways, but to ensure that existing banks use these technologies to process the information
they hold. In any event, the big techs will always have an information advantage, because
their relations with their customers go beyond the financial sphere. This allows them, as
large-scale purveyors of financial and non-financial products and services, to take
advantage of economies of scope and network economies. Accordingly, and to prevent
selection bias that can lead, for example, to the exclusion of certain social profiles, in the
medium term comprehensive personal data regulations are needed, similar to those already
in place in many countries' central credit registers.
The required deepening of the banking union
Allow me to end this address with a final reflection on the need to persevere with a European
response to this crisis in the financial sphere as well.
The response from the prudential authorities, accompanied by the monetary and fiscal
policy measures adopted, has so far enabled the initial impact of the shock to be absorbed
and prevented the materialisation of a systemic risk in the financial system that would have
further exacerbated the crisis and made it more persistent. However, in the current context
of uneven and uncertain recovery, we cannot rule out the possibility that the economic
impact of the pandemic and the persistence of these effects may be greater than expected.
In this sense, in the banking sphere, the response to the possible materialisation of these
risks can only be at the European level, given the commitment to the banking union.
In this response, the completion of the banking union with the approval of a fully mutualised
European deposit insurance scheme would make a decisive contribution to ensuring
financial stability in the euro area, both over the coming months and in the medium term.
Further deepening of the capital markets union project would also be essential.
Moreover, priority must be given to analysing how appropriate the European resolution and
winding-up regulations are for a hypothetical systemic crisis, and the possible role of asset
management companies in the event of severe impairment of European financial
institutions' balance sheets.
EU Member States should also make swift progress towards an agreement to create a
common European procedure for the administrative winding-up of credit institutions. This
procedure would benefit from the instruments developed for the resolution of credit
institutions, aiming to maximise the realisable value of the financial assets that make up the
bulk of banks' balance sheets. In Spain, recent experience has shown how inefficient the
existing insolvency proceedings for credit institutions are in terms both of timelines and
recovery in value. It would, therefore, be desirable for progress to be made in determining
an administrative mechanism for winding up credit institutions that maximises the
preservation of value and reduces both the timelines and the costs of the existing insolvency
proceedings.
Conclusion
To sum up, our duty, as economic and supervisory authorities, is to continue our close
monitoring of financial institutions and markets, to ensure that they continue to provide the
necessary flow of credit to the economy, and of financial stability risks stemming from this
crisis. We must continue to adopt measures to mitigate those risks and, naturally, stand
ready to provide an appropriate European response should such risks materialise.
Thank you for your attention.