Frank Elderson: Maintaining prudence when navigating unexpected
tides and firming currents
Dinner speech by Mr Frank Elderson, Member of the Executive Board of the European
Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at
the 25th Frankfurt Euro Finance Week, Frankfurt am Main, 15 November 2022.
* * *
Vielen Dank für die Einladung, die Rede beim Bundesbank Euro Finance Week
Dinner 2022 zu halten.
I have been eagerly looking forward to speaking here for a long time now indeed ever
since the summer of 2021, when I first received the kind invitation to speak at the Euro
Finance Week Bundesbank dinner planned for last year.
The pandemic got in the way of that, but as a testament of how long-standing my
readiness to speak to you is, I still have my preparatory notes for the 2021 event. A
year ago, I intended to remind you that the rebound in the economic recovery was
increasingly advanced and would firm over the medium term as pandemic-related
constraints on spending are removed. I might have said that while higher inflation would
last longer than we at the ECB anticipated before, it would fall below our 2% target and
only gradually revert back to target in the medium term. Indeed, these were some of the
main considerations when assessing the macroeconomic outlook in the euro area
exactly one year ago. How that picture has changed, especially since Russia's
unprovoked invasion of Ukraine on 24 February.
Current economic and monetary policy outlook
Today, a mild recession in the euro area around the turn of the year is quite plausible,
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as ECB President Christine Lagarde recently highlighted. Today, we face euro area
inflation that continues to be far too high, having reached double digits in October.
Today, long-term interest rates in the euro area are around 2.5 percentage points
higher than when I was first due to speak to you last year. Today, as Bundesbank
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President Joachim Nagel said just last week, - " muss die Geldpolitik auf der Hut sein ".
Monetary policy must be on its guard.
And monetary policy is not just on its guard but is taking action. The increase in interest
rates reflects several steps in the monetary policy normalisation which the ECB started
in December 2021. These were the phasing-out of our pandemic support measures, the
subsequent full phasing-out of our net asset purchases, and three consecutive policy
rate hikes across our July, September and October monetary policy meetings totalling
an unprecedented 200 basis points.
Today, it is not evident that the observed turn in macroeconomic sentiment will
substantially alter the inflation outlook, even if a mild recession were indeed to
materialise. Against this backdrop, we have communicated that we will continue to
promptly withdraw monetary policy support and move policy rates further to a level that
is consistent with inflation reverting back to our 2% target in the medium term. While
policy rates remain our main instrument for steering monetary policy, we have made
clear that we are ready to adjust all our instruments to maintain the consistency we
need in our monetary policy to achieve our primary objective of price stability.
Datadependent, going meeting-by-meeting.
Heute wie auch morgen und übermorgen bleibt die Geldpolitik auf der Hut und
handlungsbereit.
Banking supervision when macroeconomic tides are shifting-
As both an ECB Executive Board member and the Vice-Chair of the ECB's Supervisory
Board, I am particularly interested in how banks adjust to the shifting macroeconomic
tides. Higher interest rates as such are generally good news for banks because - after
a decade of exceptionally low interest rates - they improve profitability. Indeed, euro
area banks performed well in the first half of the year as their net interest income
increased steadily, a trend that most analysts expect to continue in the near term as
further monetary policy normalisation takes hold. Yet, even if the expectation of
improved profitability for the median bank comes true in the near term, not all banks are
expected to benefit equally from the increase in interest rates.
More importantly, banks and we as supervisors need to be mindful that the increase in
interest rates does not occur in isolation. It is part of the increasingly daunting and
uncertain macroeconomic environment that I have just outlined - an environment that
differs from previous downturns in the last two decades in that it is largely characterised
by an economy running into constraints. In such an environment, it would not be
appropriate to expect fiscal and monetary policy to support the economy by sustaining
demand.
This combination of factors is one of the many good reasons why the Chair of the
ECB's Supervisory Board, Andrea Enria, has recently insisted that, even if balance
sheets are sound and profitability is favourable, it is still better to be safe than to be
sorry in banking supervision, especially in the current uncertain macroeconomic
circumstances.3
-and underlying currents are firming
Moreover - while the macroeconomic tides may have changed, many of the structural
challenges facing banks have not. Indeed, the underlying currents which banks were
already affected by last year, are still very much present. In fact, important currents
have even firmed with the change in tides.
This becomes very clear if we look at the consequences of the ongoing climate and
environmental crises. Another year has passed, and we have further confirmation - not
that any was needed - that heatwaves, floods, droughts and environmental degradation
are on the rise. The low water levels in the Rhine this summer - for decades a moniker
for a successful social economic model that has inspired the very objectives of the
European Union - show how traditional sources of economic welfare are being
upended by the climate crisis.
At the same time, Russia's terrible war against Ukraine has hardened the EU's
determination to make progress with the energy transition. It's true that, in the very near
term, the energy crisis will lead to an increase in the use of non-gas fossil fuels.
Nevertheless, the likelihood of a transition towards a low-carbon economy consistent
with the EU's commitment to reaching net-zero by 2050 has increased.
The main message from this should be clear. And it's identical to what I had in my notes
for last year, though I will express it even more forcefully today. Climate-related and
environmental risks are a source of financial risk. Even if the exact outcome is
uncertain, a combination of physical and transition risks from the ongoing crises will
materialise. And with global temperature increases drawing ever closer to 1.5 degrees
above pre-industrial levels, and the world being on track for a 2.8-degree increase by
the end of the century, these risks are increasingly likely to materialise in a disruptive
fashion. We need banks to manage these risks, in line with the expectations for sound
risk management practices that we have published in a supervisory guide in 2020.4
Two weeks ago, we published the results of a thematic review of how banks manage
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climate-related and environmental risks. This is the first time that our core banking
supervision teams - the Joint Supervisory Teams - have thoroughly assessed banks'
risk management practices in this area. Their findings show that, even though banks
are starting to manage these risks by putting the basic infrastructure in place, they still
have a long way to go to be truly resilient to the climate and environmental crises. For
example, they lack granular information on these risks, and their methodologies for
assessing their risk exposures remain relatively unsophisticated. And as supervisors we
are concerned about banks' ability to successfully execute their plans, as most of their
implementation practices are not sufficiently effective.
Against this backdrop, we will continue to scale up our supervisory activities on
climaterelated and environmental risks. We expect banks not just to be able to manage these
doing
risks in full by the end of 2024 at the latest, but to actually be so. This means that
by then they will need to be in full compliance with all the supervisory expectations we
set out in 2020. We have also set intermediate deadlines for them to reach specific
milestones, and we have shared the good practices among banks derived from our
thematic review. At the same time, we have made banks aware of the supervisory
consequences they will face if they fail to meet their climate and environmental risk
management responsibilities. Deadlines will be closely monitored and, if necessary,
enforcement action will be taken.
The case for maintaining prudence
While the prevailing macroeconomic tides and the inescapable currents of the climate
and environment crises may have different causes, they nevertheless have something
important in common. Even if we broadly understand their main characteristics and
transmission channels from a qualitative perspective, the models that are being used to
inform decision-making may be subject to pitfalls when quantitatively identifying and
assessing the associated risks of the current environment. This is especially true when
assessing the configuration of tides and currents in conjunction, in other words, when
assessing how the macroeconomic environment and the climate and environmental
crises interact.
Importantly, this applies both to the projection models that official institutions use to
inform policymaking - as the ECB does in its monetary policy - and to the internal
models that banks use to assess risk exposures. And while we can certainly draw
lessons from historical episodes of low growth, high inflation, increasing interest rates
and structural transformation, very few policymakers, supervisors or bank executives
have hands-on experience of navigating this set of circumstances. Experiences during
the pandemic with historically low defaults will also not be representative for the present
downturn because of the unprecedented role that monetary and fiscal policy support
played during the pandemic.
Indeed, the health and resilience of banks has increased significantly as they have built
on the regulatory reforms and supervisory efforts that followed the great financial crisis.
This has enabled them to support households and firms through the economic
hardships stemming from the pandemic. We need banks to be able to do the same in
the context of the current macroeconomic and climate challenges. We want banks to
thrive. And we need them to play their role in the economy, now and in the future. This
is why we continue to push them to assess whether their risk management tools and
practices are still fit for purpose, and to improve them where necessary. And it's why we
insist that banks should remain prudent and not take favourable developments in net
interest income for granted.
Let me conclude.
As banking supervisors, much of what we have to do echoes the mindset of monetary
policymakers. We have to remain on our guard. We are committed to delivering on our
mandate of keeping the banking system safe and sound. We will make sure that the
banks under our supervision remain mindful of and resilient to the risks that may
emerge. And we will use all the instruments at our disposal.
This goes beyond our formal supervisory measures. It means that, in our ongoing
supervisory interactions with banks, we will be perceptive with our eyes, receptive with
our ears and - whenever necessary and appropriate - insistent with our mouths and
intrusive with our presence and through our actions. Attentive to risks. Always
promoting prudence. To make sure that my future speaking notes can continue to refer
to healthy and resilient banks in the euro area, irrespective of the tides and currents that
come to our shores.
Vielen Dank für Ihre Aufmerksamkeit.
1
Lagarde, C. (2022), "Monetary policy in a high inflation environment: commitment and
clarity", lecture organised by Eesti Pank and dedicated to Professor Ragnar Nurkse,
Tallinn, 4 November.
2
Nagel, J. (2022), " Die Pandemie und ihre ökonomischen Auswirkungen ", speech at
the Wirtschaftsclub Karlsruhe, 10 November.
Enria, A. (2002), "Better safe than sorry: banking supervision in the wake of
exogenous shocks", speech at the Austrian Financial Authority Supervisory Conference
2022, Vienna, 4 October.
4
ECB Banking Supervision (2020), " Guide on climate-related and environmental risks ",
November.
5
ECB Banking Supervision (2022), "Thematic Review on Climate and Environmental
Risks 2022 - Final Results", 2 November.