Following the luncheon debate organized in June by the Official Spanish Chamber of Commerce in Belgium and Luxembourg with José Manuel Campa, the Chairperson of the European Banking Authority (EBA) shares with us his thoughts on the challenges, opportunities and trends affecting the European banking sector. Unpredictable events such as COVID-19 and the war in Ukraine, as well as new regulatory frameworks around sustainability and digitalization of the sector, are some of the factors that will determine the evolution of the European banks in the coming years.
We are living through a time of rapid and global change. Just when we thought that the crisis caused by Covid-19 was coming to its end, uncertainty has resurfaced due to the war in Ukraine. How successfully have European banks responded to the problems connected with COVID-19? European banks have responded well to the crisis conditions?
EU banks have so far overall coped well with the challenges posed by the COVID pandemic. One may well say that banks were part of the solution to address these economic challenges and not part of the problem.
Banks entered the pandemic well-capitalised and with sufficient liquidity to weather the upcoming storm.
Since the beginning of the pandemic, capital and liquidity ratios in EU banks have improved further. The average EU CET1 capital ratio [fully loaded] stood at 15.4% in Q4 2021, up around 40bps from pre-pandemic levels. Banks in Europe have maintained stable capital ratios in the past year which are comfortably above their regulatory minimum requirements. This positive outcome is not least due to the assertive fiscal and monetary policies undertaken by authorities as well as various regulatory and supervisory measures implemented.
The results of the EBA 2021 EU-wide stress test also confirmed that banks are well equipped to withstand a severe macroeconomic downturn. After an assumed 3.6% cumulative drop in EU GDP over the 2021-2023 three-year horizon (which is added to the 6% GDP drop registered in 2020), banks’ fully loaded CET1 ratio would fall by 485bps to 10.2% on average. Moreover, 90% of the banks in the stress test sample would remain well capitalised relative to minimum requirements.
In the past few months, uncertainty around the macroeconomic outlook has risen substantially just like the medium and longer-term risks for the banking sector. The Russian invasion of Ukraine is the main driver of this uncertainty.
What are the main consequences of the war in Ukraine for the European banking sector? Does this war pose a systemic risk for European banks?
The Russian war against Ukraine and ensuing uncertainties about gas & oil supply add to uncertainty. They provide an adverse backdrop to the current market sentiment and the outlook for the European banking sector. GDP growth forecasts are revised downwards further (latest example: EU COM spring 2022 forecast and World Bank and OECD forecasts beginning of June). Coupled with rising inflation, they weigh on consumer and business confidence. Expectations about monetary policy tightening are reflected in market volatility and asset valuations.
Our initial risk assessment shows that first-round effects are small and broadly manageable for EU banks as aggregate direct exposures towards Russian and Ukrainian counterparties are rather limited and they do not pose a fundamental threat to financial stability.
Second-round effects might be more material from a financial stability perspective. Supply chain bottlenecks as well as rising energy and commodity prices are pushing inflation further up and are raising concerns over its persistence. Stagflation related risks and implications for EU banks are also more and more moving into focus.
The current high level of uncertainty about the outcome of the war and the potentially large impact on the wider EU and global economy are a key driver of concerns. Implications might include the direct economic fallout of the war including the fiscal impact, the impact of sanctions from all actors involved, cyber risks and the longer-term impact on supply chains in the global economy.
EU banks have reported overall robust Q1 2022 results. Preliminary EBA data indicates slightly lower profitability on a y-o-y basis, with RoE at 6.6% (7.7% in Q1 21 and 7.3% in Q4 21). Yet this was mainly driven by various one-off effects and an increase in contributions to Deposit Guarantee Schemes and the Resolution Fund.
EU banks’ capital ratios were down Q-o-Q. CET1 (fully loaded) stood at 15.0% (15.5% in Q4 21). The decrease in capital ratios was a result of a rise in RWAs (around +3% Q-o-Q) and a slight decrease in capital.
Asset quality in Q1 22 continues on an improving trend, with an NPL ratio at 1.9% and a further decreasing NPL volume (2.0% NPL ratio in Q4 21) . But there are some early warning signs for deteriorating asset quality. Stage 2 allocation increased slightly to 9.1% (8.9% in Q4-21), yet with quite significant variation across countries.
Liquidity positions of EU banks slightly deteriorated. Liquidity nevertheless remains comfortably above minimum requirements in EU/EEA jurisdictions.
Operational risks of disruptions to financial infrastructure due to cyber-attacks, implementation of sanctions, etc, remain high. Although no system-wide cyber attacks were reported since the beginning of the Russian invasion, risk remain high, and competent authorities in the field of cyber security all recommend to remain highly alert.
The European financial sector is currently dealing with major challenges. Among other issues, Europe has led the way in developing a regulatory framework to incorporate ESG into risk management and business operations. How do you see this agenda evolving, and is it possible to achieve a globally coordinated approach?
The EU is indeed very active in terms of climate and ESG-related regulatory developments. The momentum is still there, as shown by the renewed Sustainable Finance Strategy of the European Commission published in July last year, and the proposed banking package (CRR3/CRD6) – currently under discussion by the EU co-legislators – which includes several provisions with regard to ESG risks and their management by institutions and supervision by competent authorities. At the EBA’s level, we are also progressively complementing the single rule book in the areas of disclosure, supervision, stress-testing and prudential treatment.
Regarding the incorporation of ESG into risk management and business operations more specifically, we have already started to update some EBA Guidelines to include ESG risks in the requirements which apply to institutions in terms of internal governance arrangements, remuneration policies and loan origination and monitoring processes. These aspects will also have to be taken into account in the supervisory review. More guidance will come from the EBA, especially on the assessment and management of ESG risks, including with potential requirements on institutions’ transition plans and stress testing. We also have an on-going public consultation on a discussion paper dealing with the integration of environmental risks in the prudential framework – the so-called ‘Pillar one’ i.e. prudential treatment of exposures.
While achieving a fully coordinated approach may sometimes be challenging, the impacts of climate change and other ESG risks are commonly recognised as a global challenge which has to be addressed globally through a coordinated regulatory response. The work of EU authorities including the EBA is closely intertwined with other developments at international level and we are contributing to international collaboration in this area. This includes the work conducted by the Network for Greening the Financial System (NGFS) and the Basel Committee on Banking Supervision (BCBS). In that regard, the ever-growing membership of the NGFS (now more than 110 members across the globe) and the recent BCBS publication of “Principles for the effective management and supervision of climate-related financial risks” are encouraging steps towards the development of a coordinated supervisory approach to climate risks globally.
“The COVID-19 pandemic and more recently, the Russian invasion of Ukraine, shows that events can develop very quickly – the main challenge for European banks is therefore likely to be stemming from something we cannot predict today. It is therefore important that the banking sector is robustly capitalized and can withstand external shocks.”
The sector is also undergoing a transformation linked to a disruptive element that is presenting itself as an alternative to the conventional financial system: crypto-assets. What are the implications of this paradigm shift for the banking industry and how can banks adapt to this new trend?
Crypto-asset products and services is a general term to refer to a new set of products and services that use a common technological innovation. This new technology, when regulated effectively, can complement existing financial products and services, for instance as an alternative means of capital-raising. And indeed, although EU banking sector exposures to crypto-assets remain very low, we see increasing experimentation and interest in DLT-based applications, for instance in the context of trade finance, inter-bank settlement, and securities settlement.
To facilitate responsible applications of crypto-assets it is absolutely essential that we have a robust and consistent regulatory framework across the EU and, insofar as possible, at the global level. The European Commission’s proposal for a regulation on Markets in Crypto-assets (MiCA), currently completing its way through the co-legislative process, will create a framework that mitigates the key risks identified previously in the EBA’s reports and advice to the European Commission whilst facilitating scaling up through establishing a common set of regulatory requirements for the issuance of crypto-assets and crypto-asset service provision. Crypto-asset service providers will also be in scope of the Digital Operational Resilience Act which will ensure the highest standards of resilience to guard against the significant threat of cyber-attack and operational disruptions. And the European Commission’s AML package, once agreed, will result in very important extensions to the definition of ‘obliged entity’ to ensure that all crypto-asset service providers have in place robust AML/CFT policies and procedures.
At a global level work along similar lines is underway and we at the EBA are participating in multiple international standard-setter work streams including:
- the Financial Stability Board’s monitoring of crypto-assets and DeFi applications;
- the BCBS work on the prudential treatment of banks’ exposures to crypto-assets on which we expect a further consultation imminently;
- and ongoing Financial Action Task Force (FATF) work to monitor the application of the standards and guidance to so-called virtual assets and virtual asset service providers.
The discussions at these tables are absolutely key to ensure effective mitigation of risks in the context of borderless technologies and global markets, in particular to address the risk of forum shopping and regulatory arbitrage.
In your opinion, what are the main challenges that European banks will face in the next 5 years?
The COVID-19 pandemic and more recently, the Russian invasion of Ukraine, shows that events can develop very quickly – the main challenge is therefore likely to be stemming from something we cannot predict today. It is therefore important that the banking sector is robustly capitalized and can withstand external shocks. That being said, if I were to venture a view, I would firstly look at the macroeconomic scenario, where the risk of a macroeconomic downturn or even recession would appear likely to occur within the next 5 years – banks need to be ready to handle this, something that we as regulators are very aware of.
If we look more broadly to the risk to bank business models, it is clear that sustainability and the increased digitalization of the economy are areas where banks have to adapt. The transition of the economy towards a more sustainable path is something that will affect all of us, but banks need to be ready to finance the economy and that will require investment into managing the risk stemming from such transition. At the same time, the increased use of technologies continues to transform our society – the use of artificial intelligence technologies also give rise to new challenges, but probably also expose us more to cyber-risks. For instance, banks will most likely be able to automate more processes, giving raise to cost reductions that can ultimately benefit customers, but we will also face a trade-off in how far we can go in the use of personal data. Banks will have to cope with all these significant challenges.