On 28 July 2020, ECB Banking Supervision published its first assessment of the potential vulnerabilities of the euro area banking sector in the wake of the coronavirus (COVID-19) outbreak. Also on the basis of the results of this assessment, we decided to extend the end of the period in which we recommend that banks should not pay dividends or buy back shares from October 2020 until the end of the year. We also provided new information on the likely path back to normality, ie a gradual exit from the extraordinary capital and liquidity relief measures, as well as the way forward with respect to the operational relief measures taken at the outset of the crisis.
In this blog post I will explain our assessment of the results of the vulnerability analysis and discuss the rationale behind the package of measures announced today.
The current macroeconomic shock is of unprecedented magnitude and it is still highly uncertain how it will develop in the future, including its eventual impact on the banking sector. We know that this year the fall in GDP will be the most severe in peacetime for the European economy. But the economic outlook remains contingent on too many uncertain variables, including a possible strong resurgence of infections accompanied by more stringent containment measures.
While the vulnerability analysis represents an important first insight into the aggregate resilience of the euro area banking sector under different scenarios, there is still material uncertainty about the extent to which asset quality will have deteriorated once the moratorium measures are lifted, particularly for the most affected economic sectors and bank portfolios. This uncertainty around the trajectory of asset quality is reflected in the different provisioning policies adopted by banks and is a matter of supervisory concern.
Let’s take a look at each of these elements in turn.
The results of the vulnerability analysis
The vulnerability analysis is our best estimate, at this specific point in time, of the impact that the COVID-19 outbreak may have on the euro area banking sector. As the planned EU-wide stress test exercise was cancelled this year due to the pandemic, we, like other competent authorities, decided to carry out a top-down analysis using data that were already available, without asking the banks for additional information. The exercise was based on data from the end of 2019 and it applied, with some adjustments, the methodology developed by the European Banking Authority (EBA), which includes the assumption of static balance sheets.
The analysis projects how the prudential position of banks will develop under two macroeconomic scenarios included in the June 2020 Eurosystem staff macroeconomic projections: the central macroeconomic projection (central scenario), which is still the most likely to materialise according to ECB staff, and the alternative severe scenario, which involves a strong resurgence of infections accompanied by more stringent containment measures.
The central scenario foresees euro area GDP falling by 8.7% this year, before growing by 5.2% in 2021 and 3.3% in 2022. Under this scenario, by the end of 2022 aggregate capital depletion for the euro area banking sector will be 1.9%, reducing average Common Equity Tier 1 (CET1) capital from 14.5% to 12.6%. Most banks would reach maximum capital depletion in 2022. Under this central scenario, our opinion is that the euro area banking sector will remain, in aggregate, well capitalised and can continue to fulfil its core function of lending to the real economy.
However, a more severe scenario is also plausible, whereby GDP would fall by 12.6% this year and grow by just 3.3% in 2021 and 3.8% in 2022. In short, a much deeper recession and a much slower recovery than in the central scenario. Under the severe scenario, the aggregate CET1 ratio of the euro area banking sector would decline, on average, by 5.7 percentage points, reaching 8.8% by the end of 2022. Such a pronounced reduction of the sector’s own funds would prove challenging, and several banks would need to take action to continue meeting minimum capital requirements. Still, the overall shortfall of the sector would be contained.
The scenarios and the analysis of their impact on the banking sector have also taken into account, as far as possible, the significant fiscal, monetary and supervisory measures that have already been taken to help cushion the economic impact of the crisis.
As I mentioned, the analysis has been conducted within a top-down framework and, also considering the current unusual working modalities, we have not discussed bank-specific results with individual banks. Our supervisors will use the findings in a non-mechanistic way to assess banks’ macroeconomic projections, provisioning policies and capital plans.
There is clearly no room for complacency, but we can take some comfort from the fact that the sweeping regulatory reforms of the past decade have actually brought the banking sector into a position where, overall, it is sufficiently resilient to tackle a shock of a magnitude never seen before in the European Union.
This being said, the outcome of the exercise also indicates that authorities must be ready to take additional action if the economic situation further deteriorates due to a strong resurgence of infections and more stringent containment measures.
Prudence in times of uncertainty
The macroeconomic outlook remains uncertain, and there are persistent difficulties in accurately estimating the capital trajectory after the existing moratoria come to an end. In our view, this justifies measures that mitigate the risk of simultaneous deleveraging and procyclical behaviour. These measures include extending the recommendation to refrain from distributions and buy-backs until the end of 2020 while giving banks enough time to replenish their buffers organically.
Regarding our decision on distributions, once again our guiding principle has been to safeguard the resilience of the system in the face of fundamental uncertainty by preserving loss-absorbing capacity at a time when any forecasts about short-term economic developments and their impact on the banking sector are highly volatile.
This decision has not been taken lightly. I am aware of the concerns raised by investors about the suspension of distributions and I would like to strongly emphasise the exceptional and temporary nature of this recommendation. We will review our decision in December and, if we can estimate with more certainty the impact of the macroeconomic outlook on asset quality and our supervisors are convinced that banks’ capital projections are sufficiently reliable, we will repeal the recommendation and move back to our ordinary assessment of planned distributions on a bank-by-bank basis. We prefer to be prudent today rather than having regrets tomorrow should overall economic conditions deteriorate further.
As I also noted in March when we issued the original recommendation, I believe that this prudent behaviour now will benefit shareholders in the long run and help to preserve banks’ franchise value. I am firmly convinced that, by following the recommendation, banks are also enhancing their reputation by signalling to stakeholders and the general public that they take their collective social responsibility seriously at a time of great suffering and extreme uncertainty for all European citizens. With more available capital, banks can book more provisions now for potential losses down the road, especially when the national measures on moratoria are lifted. Doing so will support the economic recovery when this challenging period is over. A healthy banking sector will be crucial in supporting sustainable economic growth.
We are also mindful of the recommendation of the European Systemic Risk Board of 27 May 2020. In this recommendation, competent authorities were explicitly invited to ask financial institutions to refrain - until 1 January 2021 - from distributing dividends, buying back shares or creating an obligation to pay variable remuneration that has the effect of reducing the quantity and quality of own funds of EU financial groups. To that effect, I have sent a letter today to all the banks under our direct supervision asking them to adopt extreme moderation in variable remuneration payments until the end of the year.
Return to normality
I will now address the third key aspect of our supervisory approach, which concerns how we communicate our exit strategy from the supervisory relief measures taken at the outset of the coronavirus crisis.
In March 2020 we adopted several supervisory relief measures aimed at enabling banks to absorb losses and keep lending to the real economy, preventing the risk of abrupt deleveraging processes as much as possible.
As part of this effort, we announced that we would allow banks to temporarily operate below the applicable capital and liquidity buffers. And here I would like to underscore once again that buffers are specifically designed to be used in situations like the current one in order to avoid the regulatory framework having a procyclical impact.
We already communicated that supervisors will not attach any negative judgement to banks which are making use of the buffers (see FAQs on ECB supervisory measures in reaction to the coronavirus).
The Basel Committee on Banking Supervision also recently recommended that banks use their buffers, confirming that 'a measured drawdown of banks’ Basel III buffers' was 'both anticipated and appropriate in the current period of stress' (see press release of 17 June 2020).
So banks are encouraged to use their available buffers to absorb losses and continue lending to the real economy without concerns about potentially being stigmatised for using them or needing to quickly replenish them.
ECB simulations show that if banks decided to use their capital buffers there would be clear benefits for the economy and for the banks themselves, without any noticeable negative effect on their capital position. Lending growth would be higher compared with a scenario where they aim to preserve their current regulatory capital levels. Using the buffers would support higher GDP growth and, as a result, credit losses would also be lower, leading to higher bank profits. The positive effect on credit quality and profits would almost completely compensate for the effect of balance sheet expansion, so that the overall capital position of the sector would be broadly similar both when buffers are used and when they are kept intact.
In this context, we are clarifying today that banks will not be required to start replenishing their capital buffers before the peak in capital depletion is reached. In any case, compliance with the Pillar 2 Guidance and the combined buffer requirement will not be required any earlier than the end of 2022.
We hope that, as the overall situation improves, it will be possible to carry out the EU-wide stress test next year under the aegis of the EBA. This will inform the 2021 supervisory cycle and the setting of the Pillar 2 Guidance. The specific timeline for reaching the capital levels set out in this Guidance will be decided on a case-by-case basis in accordance with the individual situation of each bank. In particular, ECB Banking Supervision will look at the profitability of banks and how much capital will be necessary to replenish the buffer. To be perfectly clear: if a longer time frame is necessary because the buffers have been used to keep lending to the real economy or to absorb losses caused by the crisis, our supervisors will work with the bank to decide on the most appropriate time frame, taking into account the criteria mentioned above.
Regarding the combined buffer requirement, I know that banks are even more reluctant to use this buffer, mainly because of automatic triggers limiting remunerations and distributions, including coupons on capital instruments other than common equity. As we have already said, we cannot influence the legislative limitations on payments but we can exercise flexibility in assessing the capital conservation plans that banks are required to submit for our approval. And we will do so while applying the same criteria and timelines indicated above for the Pillar 2 Guidance buffer.
This should provide banks with ample assurance that we will not require accelerated compliance with the buffers once the crisis situation is over.
A similar approach will be followed for replenishing the buffers of high-quality liquid assets, which are required to ensure compliance with the liquidity coverage ratio. Banks will not be required to restore compliance with the buffer requirement any earlier than the end of 2021. In any case, specific adjustment paths will be designed, taking into account the prevailing conditions in funding markets.
Finally, let’s take a look at our operational relief measures. We announced today that banks will not be required to submit their plans for reducing non-performing loans (NPLs) until March 2021. By then, we expect them to have a better overview of the impact of the COVID-19 crisis on their asset quality, which should enable more accurate NPL targets to be set. Banks with high levels of NPLs are nevertheless expected to pursue all available opportunities to bring their asset quality to sustainable levels. All banks are encouraged to put in place effective management practices and strengthen their operational capacity to deal with the expected increase in distressed exposures.
On the other hand, the six-month suspension of pending supervisory decisions has not been renewed. It is our assessment that the operational challenges that banks faced at the start of the pandemic have become more manageable, as remote working arrangements have proved resilient and efficient and staff begin returning to their offices. This means that, from October 2020 onwards, banks will be expected to resume remedial actions following the findings of Supervisory Review and Evaluation Process (SREP) assessments, on-site inspections and internal model investigations. Supervisory processes for adopting new decisions on the targeted review of internal models (TRIM), on-site follow up letters and internal models decisions will also start again from October 2020.
The ECB also expects national competent authorities to apply all the measures discussed above to less significant banks.
With today’s disclosure of the aggregate results of our vulnerability analysis, the extension of the dividend distribution recommendation and the indications on the contingent phasing-out of our supervisory relief measures, we have provided a comprehensive package to help banks better understand our supervisory strategy and plan ahead for the foreseeable future.
In the extraordinary circumstances created by the pandemic, all our supervisory measures and actions are and will continue to be aimed at ensuring that the banking sector can remain resilient and support the economic recovery with an adequate supply of credit.
Andrea Enria is Chair of the Supervisory Board of the European Central Bank.
This post was originally featured on the ECB's 'Supervision Blog', and can be accessed here.