Elizabeth McCaul: Beyond the spotlight - using peripheral vision for
better supervision
Speech by Ms Elizabeth McCaul, Member of the Supervisory Board of the European
Central Bank, at the S&P European Financial Institutions Conference, Frankfurt am
Main, 8 October 2024.
* * *
Introduction
Thank you very much for inviting me to today's conference, it is a pleasure to be here.
The former German Chancellor Helmut Schmidt used to say "People with visions
should go to the doctor". This sounds concerning to a supervisor. After all, the word
"supervision" is made up of the prefix "super", which means "over" or "above", and
"vision". But what exactly is vision? To find out, I followed Helmut Schmidt's advice and
went to the doctor.
What I learnt is that eye doctors distinguish between central vision, fringe vision and
peripheral vision.
Central vision is the very centre of the visual field. It delivers sharp, detailed pictures,
allowing us to focus on objects straight ahead. In the banking world, these are the
issues directly in front of us: capital, asset quality, profitability and key risk categories
including climate-and environmental risks or cyber risk etc.
Fringe vision refers to the area right outside the central vision, around 30 to 60 degrees
of the visual field, where visual clarity and detail recognition start to decrease. Fringe
vision helps us to absorb information faster when we read as our brains anticipate the
next words and letters, making the process faster and smoother. Translating this to
banking, this would be like noticing changes in the macroeconomic environment, rising
geopolitical tensions, and their impact on banks' business models and risk profiles.
Finally, peripheral vision is everything that occurs outside the very centre of our gaze,
beyond 60 degrees. It encompasses everything that can be seen to the sides, providing
spatial awareness which helps with navigation and balance. Improving peripheral vision
is crucial for athletes as it increases reaction speed, improves anticipation and reduces
the risk of injury. In banking, beyond the centre of our gaze are the structural
transformations of our societies and economies: the acceleration of technological
progress, including the rise of generative artificial intelligence or the impact of social
media on depositor behaviour; the reconfiguration of the financial value chain; new
entrants in the competitive landscape or the growing share of non-bank financial
institutions.
Good supervision and good risk management in banks require central, fringe and
peripheral vision. Good peripheral vision sets apart decent athletes from great ones,
allowing them to anticipate movements and respond swiftly to changes on the field. And
the same holds true for banking supervisors: while central vision and fringe vision are
crucial in focusing on immediate risks, it is the ability to maintain a broad, strategic view
- our "peripheral vision" - that ensures truly effective supervision. This broader
perspective enables us to detect emerging risks in the wider financial system, anticipate
potential disruptions and respond proactively.
In my remarks today, I will share our assessment of the current risk landscape,
describing what we see in our central, fringe and peripheral vision.
Central vision
Let me start with the central vision of the state of the European banking system.
In recent years, Europe's banking sector has shown resilience in the face of unforeseen
challenges: the pandemic, the energy supply shock following Russia's invasion of
Ukraine and a period of high inflation.
This resilience is reflected in the numbers: in 2015, the average ratio of non-performing
loans (NPLs) for significant banks in the banking union was 7.5%, at a time when some
banking systems had ratios close to 50%. At the end of the second quarter of this year,
this ratio had decreased to 2.3%, driven mainly by the reduction of NPLs in high-NPL
banks. Similarly, the Common Equity Tier 1 ratio for significant banks has risen from
12.7% in 2015 to 15.8% today. Bank profitability has considerably increased in recent
quarters, benefiting from higher interest rates, and return on equity now stands at
10.1%.
On the one hand, this resilience is a result of the strengthened supervisory and
regulatory framework put in place after the global financial crisis and the related
improvements in banks' risk management. On the other hand, looking particularly at
recent years, banks have also benefited from policy support which has helped shield
the real economy from adverse shocks. For example, during the pandemic,
comprehensive fiscal support measures contained corporate insolvencies and the
associated loan losses. While bank profitability and valuations have recently improved
due to higher interest rates, the effects of this supporting factor are gradually
diminishing.
Turning to liquidity, banks continue to show strong positions despite an ongoing
reduction in excess liquidity. Access to both retail and wholesale funding remains
robust, and the higher-than-expected stickiness of deposits has contributed to a stable
funding environment. Nevertheless, banks should remain cautious and ensure that their
liquidity and funding strategies are resilient to potential market disruptions. They need
to maintain robust asset and liability management frameworks to enhance their
resilience to both liquidity and funding risks as well as interest rate risk in the banking
book. I will return to this topic later again.
Finally, our supervisory priorities also include banks' capabilities to manage climate-
and environmental risks and cyber risk. Climate change can no longer be regarded only
as a long-term or emerging risk, which is why banks need to address the challenges
and grasp the opportunities of climate transition and adaptation. With regard to cyber
risk, we have recently concluded a cyber resilience stress test to assess how banks
would respond to and recover from a severe but plausible cybersecurity incident. While
cyber risk has become a key risk for the banking sector, geopolitical tensions have
further increased the threat of cyber-attacks.
So, we may ask: how much of this resilience is structural, how much is cyclical? To get
a more accurate picture of the current risk landscape, we need to slightly widen our
gaze.
Fringe vision
This brings me to the fringe vision, looking at the broader macroeconomic environment.
While the macro-financial environment has recently been improving as inflation
decreases, near-term growth remains weak and subject to high uncertainty. Recent
data indicate a gradual recovery in real GDP growth, primarily driven by the services
sector, while industrial activity continues to face headwinds.
Credit risk has only partially materialised so far, supported by strong fundamentals of
households and corporates. Still, NPLs are slowly increasing, particularly in the
commercial real estate (CRE) and small and medium-sized enterprise (SME) sectors.
While the macroeconomic outlook signals a lower immediate risk of recession, asset
quality in riskier segments is slowly deteriorating as the higher interest rate environment
experienced over the last two years after a decade of 'low for long' weighs and may
affect the debt servicing capacity of borrowers. In this context, we are conducting
targeted reviews on banks' portfolios that demonstrate more sensitivity to the current
macro-financial environment. This includes targeted reviews of SME portfolios and
following up on the findings from residential real estate and CRE portfolio reviews as
well as from deep dives on forbearance and unlikely-to-pay policies. Banks also need to
remediate persistent shortcomings in their IFRS 9 frameworks and maintain an
adequate level of provisions. In this context, we are continuing IFRS 9 targeted reviews
focusing on, among other things, the use of overlays and coverage of novel risks.
The current market risk environment is characterised by high risk appetite and benign
risk pricing, which has prevailed in financial markets over the past year. This
environment is susceptible to sudden shifts in market sentiment and episodes of high
volatility, as seen in the recent global financial market sell-off. Although markets
showed substantial resilience during the spike in volatility in August, banks should be
ready for and able to cope with further episodes of sharp repricing and high volatility.
The implementation of the recently postponed market risk part of the Basel III reform,
the Fundamental Review of the Trading Book, will strengthen capital requirements for
banks and help boost their resilience.
Rising geopolitical tensions
Also within the broader macro-environment, the evolving geopolitical risk landscape has
been on our radar for some time, considering the events of the past two and a half
years, namely Russia's war in Ukraine and the conflict in the Middle East.
While the direct impact of recent geopolitical events on the banking sector has been
contained so far and the immediate threats are limited, we need to remain attentive and
systematically assess the possible ramifications for banks. Geopolitical shocks are
cross-cutting and could have direct and indirect effects on banks' financial and
nonfinancial risks.
For example, geopolitical shocks can exacerbate governance, operational and business
model risks they lead to more sanctions or increased cyberattacks. We have seen a
clear increase in the number of significant cyber incidents in 2023 and 2024, driven by
attacks on service providers (typically ransomware) and by distributed denial-of-service
attacks on banks. There can also be material consequences for banks' credit, market,
liquidity, funding and profitability risks, especially in cases where banks have
largescale direct or indirect balance sheet exposures to the countries, sectors, supply chains
or firms and households that may be adversely affected by a geopolitical shock.
Moreover, geopolitical events can also have wider second-round effects that could have
negative knock-on consequences for the banking sector. For instance, downside risks
to growth from slower economic activity or worsened sentiment as well as upward
pressure on inflation related to supply or price shocks in energy or broader commodity
markets can disrupt banks' operating environment. Escalating geopolitical tensions
might also result in heightened financial market volatility, triggering further episodes of
asset price corrections.
The recent increase in geopolitical tensions calls for heightened scrutiny and robust risk
management frameworks in banks, so that supervisors and banks can properly assess
potential risks in the evolving geopolitical environment and proactively mitigate them. As
1
Supervisory Board Chair Claudia Buch said recently , strengthening resilience to
geopolitical shocks is a key priority for ECB Banking Supervision, and we will focus on a
range of risk factors, from governance and risk management to capital planning, credit
risk and operational resilience.
Peripheral vision
And now, let us exercise our athletic capabilities, and use our peripheral vision to look
at the wider risk landscape.
Structural trends, such as the reconfiguration of the financial value chain, the impact of
digitalisation and social media on liquidity, and the rise of non-bank financial institutions,
are reshaping the environment in which banks operate.
Reconfiguration of the financial value chain
The emergence of big tech companies and other non-banking firms offering financial
services is leading to a major restructuring in the market, changing the risk landscape,
blurring traditional industry lines and challenging conventional regulatory boundaries.
Companies whose primary business is technology are entering the financial sector
through e-commerce and payment platforms and subsequently expanding into retail
credit, mortgage lending or crypto services. These firms may explore alternative, less
regulated lending forms like crypto lending using peer-to-peer platforms, ultimately
mimicking the economic functions of banks without being subject to the same
comprehensive oversight.
We need to expand our tools and surveillance to prevent gaps in oversight and ensure
they are robust and versatile enough to oversee disintermediated, increasingly
interconnected and possibly distributed-ledger-based business models. We must adapt
the regulation and oversight of such firms, especially for entities that are mainly active
in non-financial services, to gain a thorough understanding of the financial activities of
large non-bank groups across jurisdictions and sectors. Let me underscore that we
should avoid a regulatory "race to the bottom" driven by a narrow mission of prioritising
innovation and attracting large firms, which may not contribute to the good of society.
Liquidity risk supervision post-March 2023
Earlier, I asked how much of banks' resilience is structural and how much is cyclical.
Let us look at the banking turmoil of March 2023 to better understand how banks
weathered this crisis and identify what lessons we have learnt with regard to liquidity
and funding.
First, the events were a reminder to banks of the changing and increasingly volatile
nature of depositor behaviour. Social media can play a pivotal role in encouraging large
numbers of customers to withdraw deposits. In the case of Silicon Valley Bank, this
behaviour was exacerbated by a highly networked and concentrated depositor base.
Moreover, the advent of online banking, digitalisation, and the influence of non-bank
competitors may also have a significant impact on depositor behaviour, affecting the
stability of liquidity and funding sources. Therefore, banks must adapt their approaches
so that they can monitor these risks more closely and understand the channels through
which deposits are collected.
We recently conducted a targeted review on the diversification of funding sources and
the adequacy of funding plans. Our findings indicate a concerning heterogeneity in the
adverse scenarios considered by significant banks. Often, these scenarios are only
described at a high level, are not conservative, or only "stress" individual balance sheet
items. The absence of comprehensive and credible underlying assumptions in these
adverse scenarios reduces the reliability of funding plans and increases execution risk.
The events of March 2023 also underscored the importance of banks' readiness to
swiftly implement contingency and recovery measures. Another recent targeted review
focused on collateral mobilisation. It found that banks have the operational capacity to
tap central bank liquidity facilities. However, banks' assumptions about the time needed
to monetise the assets appear rather optimistic in some cases, especially under
stressed conditions. This optimism could hinder banks' ability to cover any unexpected
outflows in a timely and sufficient manner.
Furthermore, banks need to adopt a more holistic and comprehensive cross-risk
analysis of potential vulnerabilities. The turmoil demonstrated how quickly deficiencies
in business models and shortcomings in the management of interest rate risk in the
banking book (IRRBB) can escalate into liquidity issues. It is essential to assess
spillover effects and understand how shortcomings in one area can amplify risks in
another.
From a regulatory perspective, the events of spring 2023, along with past crises, have
shown that compliance with the liquidity coverage ratio (LCR) and the net stable funding
ratio (NSFR) may not provide sufficient assurance about a bank's liquidity and funding
situation. For instance, an LCR above 100% might still hide significant cliff risks just
beyond the 30-day horizon. Two banks with identical LCRs might have vastly different
liquidity profiles owing to concentration risks not captured by the ratio.
However, it is important to remember that the LCR and the NSFR do not - and are not
intended to - prevent all liquidity crises. They are not designed to address every
residual risk, which should be managed on a case-by-case basis under Pillar 2. So
while we support a review of specific aspects of the current calibration of these metrics,
we are cautious about drastic changes.
Instead, I would focus on the supervisory follow-up. And I can draw four main lessons
with regard to the supervision of liquidity risk.
First, supervisors, like banks, need to carry out holistic cross-risk analysis. Instead of
looking at risks in isolation, we need to broaden our gaze and also focus on the
interplay between IRRBB, liquidity risk management and governance arrangements.
Second, we need increased supervisory scrutiny of banks' modelling of non-maturity
deposits, as these models are sometimes not based on proper economic evidence.
Third, it is essential that supervisors consider supplementary liquidity and funding risk
indicators, such as survival period or concentration metrics, to capture residual risks not
addressed by the LCR or the NSFR. In European banking supervision we have
successfully used maturity ladder reporting to calculate survival periods, which provides
a more comprehensive analysis beyond the fixed calibration of the LCR and the NSFR.
Finally, the March 2023 turmoil demonstrated the need for timely and up-to-date
information on liquidity and funding. We therefore introduced weekly data collections for
liquidity risks in September 2023. This has been instrumental in identifying changes and
detecting structural shifts across the banking system.
Growth of non-bank financial institutions
Another issue we detect in our peripheral vision is the staggering growth of the
nonbank financial institution (NBFI) sector. In the euro area, the sector has more than
doubled in size, from €15 trillion in 2008 to €32 trillion in 2024. Globally, the numbers
are even more worrying, with the sector growing from €87 trillion in 2008 to €200 trillion
in 2022.
The private credit market is of particular concern. It accounts for €1.6 trillion of the
global market and has also seen significant growth recently. The European private
credit market has grown by 29% in the last three years but is still much smaller than the
market in the United States, which is where investors and asset managers are often
based. The end investors are pension funds, sovereign wealth funds and insurance
firms, but banks play a significant role in leveraging and providing bridge loans at
various levels to credit funds. We have recently completed a deep dive on the topic and
found that banks are not able to properly identify the detailed nature and levels of their
full exposure to private credit funds. Therefore, concentration risk could be significant.
We know that risk from the NBFI sector can materialise through various channels. One
of them is through the correlation of exposures, especially given the growth in private
credit and equity markets. We supervisors do not have a full picture of the level of
exposure and correlations between NBFI balance sheets and bank lending
arrangements, lines of credit or derivatives to and from NBFIs.
To make the market less opaque and more visible within even our fringe and central
line of sight, we should further harmonise, enhance and expand reporting requirements.
We need to make information sharing between authorities easier at global level to
provide the visibility we need to play with more agility on the field.
Conclusion
Earlier, I asked how much of the banking system's resilience is cyclical and how much
is structural. I think it is safe to say that the European banking system is in better shape
today than it was ten years ago. This won't surprise anyone in this room. Stronger
capital and liquidity positions and healthier balance sheets are objective factors
contributing to the resilience of the system.
Still, I am a supervisor, so I am paid to worry. If my career has taught me anything, it's
that accidents are more likely to happen when people get complacent. This is why I am
calling on you to use your full vision - not only your central and fringe vision, but your
peripheral vision too. Crises often emerge from the shadows, and it's the overlooked
risks that pose the greatest danger.
Let me conclude with another lesson that I have learnt during my career. It's a quote
from Mark Twain: "There is no education in the second kick of a mule". We have seen
too many crises caused by hidden risks lurking beneath the surface - the ones we fail
to see until it's too late - which is precisely why we must get ahead of these risks this
time around.
Thank you very much for your attention.
1
Buch, C. (2024), "Global rifts and financial shifts: supervising banks in an era of
geopolitical instability", keynote speech at the eighth European Systemic Risk Board
(ESRB) annual conference on "New Frontiers in Macroprudential Policy", 26 September.