Gabriel Makhlouf: The publication of the Financial Stability Review
2020:2
Remarks by Mr Gabriel Makhlouf, Governor of the Central Bank of Ireland, on the publication of
the Financial Stability Review 2020:2, 26 November 2020.
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Today we publish our latest Financial Stability Review (FSR) . The FSR sets out our judgements
on the main risks facing the economy and financial system, the capacity of the financial system
to withstand those risks, and the macroprudential policy actions we are taking to safeguard
financial stability. For the first time, today's publication contains a forward-looking assessment of
the resilience of the domestic retail banking system. Alongside this we also have the results of
the latest reviews of our macroprudential policy tools, including the annual mortgage measures
review.
The extraordinary circumstances we find ourselves in as a result of COVID-19 continues to be
the main backdrop for our assessments in this FSR. The global and domestic economies have
begun to recover from the initial phase, and the acute liquidity challenges have been managed
through fiscal, monetary and prudential policy support. However, the full transmission of this now
extended shock to the economy and financial system will take time, as the balance between the
impact of near-term policy supports and the depth of the implications of this shock for
households, businesses and the financial system plays out. We remain in a position where
liquidity challenges have not, as yet, resulted in widespread solvency challenges.
The economic shock triggered by measures taken to protect public health, both domestically and
across Europe, has been extended with the upsurge in cases since the autumn. With the Level
5 restrictions in Ireland these past weeks we have seen COVID-related unemployment rise again
in sectors most affected. The outcome for the domestic economy through the fourth quarter of
2020 will probably be somewhat weaker than expected when we published our latest forecasts in
the Quarterly Bulletin on 6 October. The macroeconomic impact of the most recent public health
restrictions is likely to be less severe than those in the spring, as the nature and extent of the
latest restrictions is different, enabling more activity in a number of sectors, such as
construction. In addition businesses and consumers have adapted and innovated (as we have
all seen from the click-and-collect options that have become available, for example).
However the macro-financial outlook beyond the current quarter is characterised by huge
uncertainty, tied to the progress of the pandemic, the successful roll-out of a vaccine, the
economic implications of the related public health response and the more medium-term
implications of this shock. While the domestic outcomes are most pertinent, the fragility at a
global level of rising sovereign and corporate debt and the potential for tighter financing conditions
could have implications for economic activity and asset prices in Ireland. Alongside this we have
the very near-term reality of moving to a new phase in EU-UK relations. Irrespective of the
outcome of the current negotiations, the UK's new status as a third country is a negative event,
especially for Ireland. The delay in clarifying the ultimate trading relationship between the EU and
the UK compounds the near-term challenges, adding to uncertainty, and limiting time available to
reduce inevitable frictions. Let me be clear, having a comprehensive trade deal for goods would
be better than not having one, but it remains only the better of two unfortunate outcomes, and
implementation presents significant challenges.
In this FSR, our analysis includes a more forward-looking assessment of the resilience of the
domestic banking system to two possible scenarios, consistent with differing paths for what is an
uncertain macro-financial risk environment out to 2022. While the more adverse of these
scenarios in particular would be expected to result in significant losses, the system in aggregate
has sufficient capital to absorb such losses and continue to support firms and households.
Relative to the previous domestic and global financial crisis of the late 2000s, both the nature of
the current shock, and the improved starting resilience of the banking system and the economy
more generally, means that the system as a whole is better able to serve the needs of
businesses and households through this period of uncertainty. Government supports for
households and businesses are supporting their resilience, and in turn that of the banking
system. However, while analysis such as this is vital to understand the risks posed to the
banking sector, I would also highlight the following points:
First, the degree of uncertainty with these projections is high, not just in terms of the
macrofinancial outlook, but also the impact of the various extraordinary policy supports, and how both of
these ultimately interact with banks' balance sheets.
Second, the system-wide position does not discount the potential for different impacts on
individual banks. Given the heightened levels of uncertainty, all regulated firms need to prepare
and plan for a variety of eventual outcomes.
Third, the response of the banking system itself will shape eventual outcomes. Our analysis
shows that tighter credit conditions imposed on a widespread and persistent basis by the
banking system would lead to worse macro-financial outcomes than would otherwise be the
case. Banks should use the extraordinary policy support being provided to maintain a
sustainable supply of credit to businesses and households through the recovery.
So, uncertainty remains high, but the benefits of resilience built up in recent years is most evident
now.
Among the factors that led to the better starting position as we entered the COVID-shock is the
enhanced policy framework that has been put in place in recent years, covering prudential
supervision, recovery and resolution, and macroprudential policy. Today we are announcing the
outcomes of our latest regular reviews of our macroprudential tools.
Before turning to the mortgage measures, I would note that the countercyclical capital buffer
(CCyB) rate remains at zero per cent. Given the current outlook, we do not expect to announce
a change in the CCyB rate through 2021. We are giving explicit guidance on this because we
want to provide as much clarity as possible to banks and facilitate the usability of those buffers.
Just to emphasise, again: buffers that have been appropriately built up in recent years are now
there to be used to absorb losses and support the economy through this period of uncertainty.
I will focus my policy remarks on the outcome of the annual mortgage measures review. The
mortgage measures have the twin objectives of strengthening borrower and lender resilience and
reducing the likelihood of an adverse credit-house price spiral emerging. This year the review
focused on understanding the impact of the COVID-19 shock on the housing and mortgage
markets. It drew on extensive analysis and stakeholder engagement on the effectiveness of the
measures. At our most recent meeting, the Commission of the Central Bank agreed that the
measures - as currently designed and calibrated - continue to meet their objectives and decided
that they will remain unchanged for 2021.
The implications of the COVID-19 shock continue to feed into housing demand, supply, market
activity and prices. Housing supply is likely to remain below pre-pandemic levels, and indeed
below estimates of medium-term demand, for an extended period. House price developments
have been relatively stable and market expectations are tilted toward minimal change over the
next year. Housing transactions and mortgage activity have recovered since the summer, but still
have some way to go to reach pre-pandemic levels. That being said, we have not found much
evidence pointing to credit supply or the operation of the measures themselves as being a key
driver of broader mortgage and housing market activity through 2020. While there was tightening
in credit criteria earlier in the year, consistent with a more conservative risk appetite on behalf of
lenders, the impact of the health restrictions on activity in the market appears to have been more
of a key driver in overall mortgage credit developments.
Taking a longer perspective, it is clear the mortgage measures have meant we were in a better
position going into the COVID-19 shock than the previous financial crisis. The benefits of the
measures are most evident in times of stress. We can see from our analysis of the initial
payment break data that borrowers with mortgages issued at lower loan-to-income values were
less likely to be in financial distress.
We examined whether a temporary loosening of the mortgage measures might be appropriate to
guard against any potential tightening in credit supply by lenders. However, the effectiveness of
any such action hinges on the drivers of tighter credit supply. As the measures only provide a
floor to underwriting standards any loosening would be unlikely to be effective in offsetting
tightening decisions by lenders which predominantly reflect changes in their own risk appetite.
More broadly, given the underlying demand-supply imbalance in the current housing market,
additional debt would likely lead to greater pressure on house prices and potentially exacerbate
affordability issues in areas of high housing demand, with associated adverse implications for
bank and borrower resilience.
As a community, we continue to grapple with fundamental challenges of sustainability,
affordability and delivery of appropriate housing supply to meet the needs of home-owners and
renters across the private and social domains. The mortgage measures help by ensuring
unsustainable lending practices do not exacerbate these challenges. We want the measures to
continue to enable sustainable mortgage lending in the Irish housing market. As both Irish and
international experience has shown, a fully functioning and sustainable housing market is not
achieved by excessive leverage in the household sector and imprudent lending standards by
banks.
At this event last year, I outlined a three-pillar approach for developing our macroprudential
framework to bolster resilience covering banks, borrowers and the area of markets-based
finance. Our response to COVID-19 has necessarily focused attention in 2020 on ensuring the
financial system uses the resilience built-up in recent years to support the real economy. We
believe the experience of the COVID-19 shock re-emphasises the need to have a robust,
comprehensive and effective macroprudential framework. It also presents some lessons for
how the framework could operate. Through 2021 and beyond, we will return to that multi-year
work programme in light of our experience of the COVID-19 shock and the evolution of the
European legislative framework:
In the area of bank capital, to deepen our holistic view on the interaction between the
macroprudential buffers themselves and with other policies during periods of growth and
periods of stress.This will inform the appropriate mix, level and build-up speed when the
recovery is fully-fledged.
For the mortgage measures, building on the benefits of having them as a permanent feature
in the market, we will consider the overarching framework informing our regular calibration
and further embed new data, to enhance our work in assessing their effectiveness. The
initial phase of this work will focus on expanding our public engagement on the operation of
the measures.
In the area of market-based finance, the significant market turmoil that we saw in March has
illustrated vulnerabilities in parts of the sector and there is growing international focus on the
resilience of market-based finance. As I have mentioned before, we will continue to work
with our European and international partners on the development of a comprehensive and
proactive macroprudential framework in this area.
Work across all these pillars will continue alongside our regular analysis, assessment and
calibration reviews of our existing tools. As a result, we will of course continue to take our annual
decision on the calibration of the mortgage measures, the Other-Systemically Important
Institutions (O-SII) buffer and the quarterly decisions on the CCyB consistent with our approach.
Over time, and as the insights from the framework reviews are fully developed, they will become
embedded in our regular calibration decisions.
To sum up, our main messages coming from today's FSR are three-fold:
First, the overall risk environment remains very challenging and continues to be
characterised by heightened uncertainty, closely linked to the path of - and response to - the
virus and the structural implications of this crisis.
Second, the banking system as a whole has loss-absorbing capacity for shocks that are
materially worse than current baseline projections. That loss-absorbing capacity is not,
however, unlimited.
Third, the macroprudential framework has helped ensure that the financial system is better
able to absorb the shocks being faced currently.The experience of the current shock also
offers lessons for the evolution of the framework over time.
On our part, we are committed to developing that framework, domestically and at European and
international levels, so it can most effectively safeguard financial stability and ensure the financial
system works in the best interests of consumers and the wider economy.