Claudia Buch: Evolving risks - evolving supervision
Speech by Prof Claudia Buch, Chair of the Supervisory Board of the European Central
Bank, at the Bundesbank Symposium "Bundesbank im Dialog" , Frankfurt am Main, 12
June 2024.
* * *
Thank you very much for the invitation to speak at this year's Symposium "Bundesbank
im Dialog". For more than 25 years, this symposium has been a key forum in Germany,
facilitating a dialogue between relevant stakeholders. This dialogue is particularly
important at the current juncture.
The environment in which banks operate has changed significantly in recent
years. Several major shocks, including the COVID-19 pandemic, the Russian invasion
of Ukraine, the energy crisis, the increase in inflation and the turbulence on international
banking markets in March 2023, have had profound economic and societal effects.
Climate change and nature degradation require deep structural changes in the
economy and affect the risks banks are facing. Digitalisation and the market entry of
new financial institutions are changing the competitive nature of banking markets. In
addition, heightened geopolitical risks are having an impact on the post-war global
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institutional order and international economic relations. All of this triggers structural
changes in the real economy and the financial system - changes that will take time to
fully materialise and whose final effects are highly uncertain.
These evolving risks mean that supervision also has to evolve, and it is evolving.
This year, we are celebrating the tenth anniversary of European banking
supervision, which is the first pillar of the banking union. The banking union was a
direct response to the global financial crisis and the European sovereign debt crisis.
The increase in cross-border banking activity and the risk of contagion, both across
borders and between banks and sovereigns, meant that supervision in Europe needed
to be harmonised. In its first ten years the Single Supervisory Mechanism (SSM) has
delivered effective supervision in the euro area through a common, consistent
supervisory framework building on national best practices.
In the case of Germany, its 25 significant banks are now directly supervised by
the ECB. But national supervision continues to play a significant role. The ECB and
national supervisors work together in Joint Supervisory Teams (JSTs) led by the ECB.
Less significant institutions (LSIs) remain under national supervision while the ECB has
an oversight function. For Germany, this means that the Federal Financial Supervisory
Authority/Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and the Deutsche
Bundesbank supervise more than 1,000 banks, accounting for 40% of the domestic
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market in terms of assets - the highest share of LSIs in the euro area. The ECB's
Supervisory Board includes representatives from national supervisory authorities.
Moreover, 90% of inspectors responsible for on-site inspections are employed by
national authorities.
And
So European supervision only works well if national supervision works well.
national supervision has evolved. For example, in response to the Wirecard scandal
that erupted in 2019, national supervision in Germany has been reformed significantly,
with BaFin being granted new powers and tools.3
Supervision in Europe and Germany has come a long way over the past decade.
And it must continue to evolve if we are to respond to the new environment and become
more efficient and effective.
In May this year the ECB's Supervisory Board took important decisions to further
develop supervision in Europe. But before I describe this reform in more detail, let
me give you a quick overview of where we stand in terms of risks and banks' resilience.
Risk and resilience in the European banking sector
The resilience of banks in Europe has increased over the past decade, driven by
several factors.
First, legacy risks have been reduced. Non-performing loans (NPLs), once the bane
of the European banking system, have fallen significantly. The NPL ratio of significant
banks declined from over 7% in 2015 to less than 2% in 2023. This is the result of
better macroeconomic conditions, better supervision, better regulatory frameworks and
better loan workouts at banks. But financial crises cast long shadows. It takes a long
time for the burden of NPLs to be fully removed from the balance sheets of households
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and firms, with negative implications for growth dynamics. So it is crucial to avoid a
renewed build-up of NPLs as European economies go through phases of
transformation and are exposed to new shocks.
Second, and in addition to improvements in asset quality, the resilience of banks
has been strengthened through better capitalisation. Banks' aggregate Common
Equity Tier 1 ratio, which is based on their risk-weighted assets, increased from 12.7%
in 2015 to 15.6% in 2023. By contrast, the leverage ratio, which is based on their total
assets, increased less, from 5.3% in 2016 to 5.6% in 2023. One important driver of the
increased capitalisation has been the post-crisis strengthening of the regulatory
framework. But it is also important to note that the shocks that have hit European
economies in recent years have largely been buffered by fiscal and monetary policy,
thus shielding the banks from their full impact.
The third factor at play is robust liquidity. Banks' liquidity coverage ratio increased
from 138% in 2015 to 158% in 2023. Effective liquidity risk management is becoming
even more important in the current environment. The monetary tightening that began in
July 2022 followed years of highly accommodative monetary policy and ample liquidity
provision. Moreover, heightened geopolitical risks are not fully priced in by markets,
which may lead to abrupt market reactions following negative news.
However, even if banks may meet capital and liquidity requirements, this will not shield
them from the impact of adverse shocks if risk management systems and governance
are ineffective. This is one of the key lessons from the turmoil on international banking
markets in March 2023.
The fourth factor is thus improving governance and risk management, which has
been a priority for European banking supervision in recent years. While progress
has been made here, more needs to be done. Strong internal governance and effective
strategic steering remains one of our top supervisory priorities. We will soon publish a
guide on governance and risk culture, including examples of good practice in this field.
Overall, there is no room for complacency. Risk management in banks needs to
continue focusing on forward-looking risk assessments and sustained resilience,
including capital, liquidity and operational resilience. European banking supervision
needs to foster this sound risk management in banks and ensure sufficient resilience.
The risk environment in which banks operate has evolved substantially in recent
years. IT and cyber risks, for example, are on the rise: the number of reported cyber
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incidents at European banks doubled from 2022 to 2023. And these attacks have
become more sophisticated. They can heavily disrupt the functioning of banks, with
potentially significant financial, reputational and legal implications. This is why
European banking supervision has flagged this topic as a key priority. The results of this
year's cyber resilience stress test will be published later this summer.
It is important to note that many changes are not merely cyclical; they are in fact
structural. Becoming climate neutral requires changes in relative prices for CO
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intensive activities and in the patterns of production and consumption. This will have
implications for the structure and location of energy-intensive corporate activity. In the
financial sector, the growing importance of non-bank financial intermediaries and
digitalisation require structural adjustments in the banking sector.
New risks are already materialising and impairing asset quality. But new NPLs
emerge slowly and often not in the countries or sectors affected by legacy NPLs. The
most visible increase is in commercial real estate, a sector that is particularly sensitive
to higher interest rates and weakening growth. More recently, the portfolio of loans to
small and medium-sized enterprises has also started to show heightened
vulnerabilities. Since the middle of 2023, banks have been reporting an increase in
Stage 2 loans and early arrears, highlighting fragilities that might turn into future NPLs.
Banks' provisioning flows have often not yet accounted for this emerging deterioration
in asset quality, and coverage ratios for NPLs are declining.
Other areas where NPLs could arise are less visible. It will take time for potential
loan losses to start materialising as pressure for structural change reaches the real
economy, affected firms use up their financial buffers and the effects of fiscal support
programmes fade away.
As risks evolve, banks' risk management needs to evolve, too. Many risks are quite
novel and have barely affected banks in recent years, meaning that past data and
existing risk models provide little guidance for the future. There is a high degree of
uncertainty. Banks thus have to work with scenarios analyses, placing additional
demands on governance and risk management.
This implies that supervision must also evolve. Supervisors need to understand the
changing risks and their impact on banks, they need to be forward-looking, and they
need to provide banks with guidance on scenario analysis. They also need to
communicate clearly with banks and ensure that identified deficiencies are remedied
promptly. All this takes time and resources, meaning existing tasks need to be
reprioritised.
Reforming ECB Banking Supervision's supervisory processes
This is why the ECB's Supervisory Board has embarked on a journey to make
supervision in Europe more efficient and effective. A new risk tolerance framework
has been in place since 2023, enabling supervisors to set bank-specific priorities in line
with the overall priorities of European banking supervision. A multi-year approach has
been put in place, allowing JSTs to spread the assessments of the Supervisory Review
and Evaluation Process (SREP) modules over a four-year cycle.
In addition, ECB Banking Supervision asked a panel of independent experts to
assess European supervision. Their report , published in April 2023, concluded that
ECB Banking Supervision has established itself as an effective and respected
supervisory authority. But it also noted that we could further improve our efficiency and
effectiveness by making existing supervisory processes more integrated and more risk
sensitive.
On this basis, in May 2024 the Supervisory Board decided on a reform of the
SREP, its annual check-up of banks' health. This reform will make supervision more
efficient and effective, while ensuring that the SREP remains fully compliant with the
relevant European Banking Authority (EBA) guidelines. Changes will be implemented
gradually, starting in the second half of 2024, and will be finalised for the 2026 SREP
cycle.
The Supervisory Board has six main goals for the new SREP.
1. Focusing risk assessments: to assess bank-specific risks, supervisors need
common tools, methodologies and procedures. But this does not mean that every
supervisory team has to address every risk with the same intensity every year. The new
SREP will build on and strengthen the multi-year approach. If assessments show no
material changes in a bank's risk profile, SREP decisions can be updated every two
years, under some conditions. This possibility - so far limited to a small number of
banks - will be extended, thereby making supervision more proportionate.
Smaller banks already report less complex and fewer data. Whether banks are
classified as small and non-complex institutions or as banks with a high impact
determines the intensity and nature of the supervisory approach. But we should be
clear that a smaller bank is not necessarily a less risky bank. Smaller banks also often
struggle with complex risk management and governance. The US banking market
turmoil in March 2023 was a stark reminder - it originated from relatively small banks,
not from larger banks.
2. Better integrating supervisory activities: ECB Banking Supervision carries out
various supervisory activities, including on-site inspections of risks, risk controls and
governance. Together with internal model assessments, these inspections complement
off-site supervision and targeted deep-dive analyses by JSTs on dedicated topics.
Horizontal thematic reviews, involving benchmarking across banks, enable a thorough
assessment of specific issues. Together, these activities provide an integrated
assessment of the risks that banks are facing and their ability to manage them. These
activities need to be well coordinated. In the new SREP, integrated planning of different
supervisory activities will be further improved to maximise synergies. This will also
provide banks with a clearer overview of supervisory plans, thereby making supervision
more predictable and more transparent.
3. Using the full supervisory toolkit: the European legal framework provides several
tools that can be used to ensure that risks are mitigated. These tools differ in their
intrusiveness. Moral suasion and operational letters are the softest, least intrusive tools.
Sanctions, higher capital requirements and periodic penalty payments are more
intrusive tools.
In the reformed SREP, supervision will become more effective and intrusive by using
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the full range of supervisory tools. If identified weaknesses are not sufficiently
remediated, ECB Banking Supervision will expeditiously increase the severity of
supervisory tools and swiftly move up the escalation ladder . In addition to issuing
binding quantitative requirements, this includes making wider use of legally binding
qualitative requirements and enforcement measures such as periodic penalty
payments. This is particularly relevant for areas in which banks have left supervisory
findings unaddressed for too long.
Let me give you an example. There is a large number of outstanding findings for
weaknesses in risk data aggregation and reporting - the lowest-scoring sub-category in
the area of internal governance in the 2022 and 2023 SREP cycles. This is not just a
technical issue, but one that can have severe implications for banks' decision-makers
when identifying and steering risks.
4. Enhancing communication: supervisory communication to banks needs to be clear
and concise. But SREP decisions can be long documents. In 2021, ECB Banking
Supervision introduced executive letters to facilitate better communication with banks
about key priorities. In the future, SREP decisions will be more focused, clearly outline
supervisory expectations and include strong measures when needed. Reducing the
length of SREP decisions will not, however, compromise their legal clarity or
enforceability. The length of decisions will continue to vary across banks, depending on
their specific situation and risks.
5. Making methodologies more stable: good supervision is based on consistent and
robust methodologies. Starting from very different practices across countries, European
banking supervision has made significant progress in developing common
methodological approaches, thus making supervision more predictable and more
transparent.
At the same time, our methodological framework is complex - reflecting the complexity
of modern banking. This complexity can be costly, for both supervisors and banks, as
analytical capabilities need to be built up and maintained. We therefore need to make
existing methodologies more stable and, where possible, simpler. ECB Banking
Supervision is currently working on a revised methodology for setting Pillar 2 capital
requirements, which will be published by the end of 2024 and fully applied in the 2026
SREP cycle. Making existing methodologies simpler and more stable also enables
supervisors to focus methodological work on novel risks.
reliable IT systems and good data
6. Making better use of IT systems and analytics:
analytics are crucial if banks are to serve their clients well. They are equally important
for supervisors. Evolving supervision thus requires continued investment in IT systems,
not least to reap efficiency gains from the use of artificial intelligence. We have
therefore prioritised our digital agenda. Our IT strategy for the years 2024-28 foresees
continued investment to improve efficiency, access to data, risk analysis and
collaboration. For instance, fit and proper assessments account for almost half of
supervisory decisions. They are used to assess whether members of a supervised
Heimdall
bank's management body are suitable for their roles. The tool supports
experts in processing the vast amounts of information they receive when carrying out
these assessments. This helps improve the quality of assessments, as the manual
workload is reduced and supervisors can focus on more complex cases. Another
example is Athena , a web-based platform helping supervisors find, extract and compare
information from a corpus of millions of articles, supervisory assessments and bank
documents.
Supervision will not become "light touch"
These changes will improve European banking supervision. They will make
supervisory processes more targeted, efficient, predictable and transparent. The SREP
will become shorter. From 2026 onwards, SREP decisions will be sent to most banks by
the end of September, rather than December as is currently the case. This will reduce
the time lag between the identification of deficiencies and the remedial action that
banks are expected to take. Supervision will become more intrusive by using the full
range of supervisory tools and moving up the escalation ladder more swiftly when
findings are not remediated.
The reformed SREP will not mean less supervision or a "light touch" approach.
The key purpose of supervision - to ensure that banks remain safe and sound - will not
change. But supervision will become more effective. This is more relevant than ever in
the fast-evolving environment that we live in. As the risk environment evolves,
supervision is evolving, too.
All of this will, ultimately, benefit growth and financial stability in Europe. The
evidence is clear: banks that are safe and sound are better equipped to lend to the real
economy. Banks that are well capitalised and resilient are better placed to compete in
international financial markets. And banks that have state-of-the-art governance
structures have better forward-looking risk assessments, can more easily shield
themselves against unforeseen events, and can continue to provide services to their
customers, including during periods of structural change and in times of crisis.
1
Yellen, J.L. (2024), " The Importance and Strength of the Transatlantic Alliance ",
remarks at Frankfurt School of Finance and Management, 21 May.
2
Véron, N. (2020), " Banking Regulation in the Euro Area: Germany Is Different ", 11
May.
3
BaFin (2021), " Reform as a long-distance race ", 8 December.
4
Research shows that unresolved NPLs are associated with lower output growth and
slower dynamic recovery. See Ari, A., Chen, S. and Ratnovski, L. (2019), "The
Dynamics of Non-Performing Loans During Banking Crises: A New Database ", IMF
Working Papers
, No 19/272, International Monetary Fund, December.
5
Interview with Il Sole 24 Ore
Tuominen, A. (2024), , 28 March.
6
Elderson, F. (2023), "Powers, ability and willingness to act - the mainstay of effective
banking supervision", speech at the House of the Euro, Brussels, 7 December.