François-Louis Michaud's interview with Revue Banque: Banks must not underestimate the increasing role of new entrants

Banks must not underestimate the increasing role of new entrants

While the war in Ukraine poses a new risk, it must not overshadow the necessary transformation of the banking sector in the medium term. What is at stake is the necessity of addressing the challenges of digitalisation and the environmental crisis, as well as the needs of the European economy.

 

The sanctions imposed on Russia following the invasion of Ukraine are hard to apply in practice for banks. Maybe the EBA can clarify their implementation?

The imposition of sanctions is a delicate matter. We need to set up the systems to identify the individuals concerned, to process the transactions – the process is far from smooth. Moreover, there are differences between jurisdictions, and questions of interpretation. However, the whole process must be done rigourously. This was stressed by the EBA in its press release of 11 March, which also opened a communication channel for banks to send their queries to the European Commission. Our press release further recalled that it was essential, from the humanitarian point of view, not to cut off refugees’ access to basic payment services. We therefore pointed out that, in such emergencies, a simpler know-your-customer check could be followed, similar to the crisis in Syria in 2016.

 

In this context, should we fear a destabilisation of certain banking markets?

Europe has not experienced such an upheaval since the fall of the Berlin Wall or even the end of the Second World War. However, the direct exposures of European banks to Russia are very limited: only around EUR 76 billion. Our latest quarterly Risk Dashboard1, published at the beginning of April, shows that three banking systems are more exposed than the others, namely France, Austria and Italy. However, the level of exposure is low: less than 2% of their total direct exposures and via derivative exposures.

In the derivatives market, the share of the notional to underlying raw materials is even lower: less than 0.2%. On the other hand, indirect risks and the way the financing of some sectors could be affected are not negligible. Nevertheless, these events have occurred at the time of an economic recovery, which remains strong. Finally, European banks have a strong resilience, with a CET1 level higher than15% in the wake of the pandemic. In the worst scenario of our stress tests published in July, their CET1 also remained higher than 10% over the next 3 years.

 

Is it necessary to retain the risk of war for future tests?

We are currently preparing a methodology for the European stress test that will be conducted with EU banks and their supervisors in 2023. The identification of the risks to be taken into account at the end of 2022 in the scenarios of the European Systemic Risk Board will certainly include this aspect to enable banks to understand all their non-financial risks.

 

What are the environmental challenges?

The first challenge is to collect information, understand the climate risk to which banks are exposed and help them to provide this information. Obtaining this information is difficult and costly. In 2021, one of our studies showed that even for financing provided to large Europe-based companies, the information available was very limited and, where available, the transition risk for these stakeholders was high. The EBA has therefore implemented transparency and disclosure requirements to propose reporting methods, such as the green asset ratio, which will lead banks to communicate more clearly and consistently on their exposures by referring to the EU taxonomy. This will create a coherent framework that will allow comparisons and facilitate policy‑making in terms of transition.

The second challenge is finding ways of encouraging banks to improve their climate risk management. This is the aim of the work with supervisors performed in the framework of Pillar II. To support these activities, the EBA will propose methods to reflect the situation of banks in this pillar.

The third challenge concerns the work within Pillar I relating to the calculation of capital requirements, which currently does not specifically reflect the environmental impact. The issue at stake is to identify precisely how assets with the most adverse environmental impact can impair economic performance and how they can be taken into account. The EBA will soon publish a discussion paper on this subject.

It remains to be seen whether the Pillar I rules need to be changed or whether obtaining more information will allow banks to manage their activities in greater detail. A question of horizon arises as most of the climate risks are in the medium long term, while the calculation of capital is largely based on historical data and considers a rather close horizon.

 

The EBA proposes to extend sustainable financing to securitisations that led to sub-primes. Isn’t that risky?

Securitisation is potentially a very useful tool for redistributing risk and allocating it among investors seeking diversification.

Following the subprime crisis, the EBA and the European authorities created a simple, transparent and standardised securitisation vehicle2, which is easy to set up and fund. While there is currently demand for credit risk on the part of banks, long-term investors and funds, the STS market is growing slowly. It has taken market shares with more opaque and heterogeneous instruments, which is a good thing.

But we also want to extend the scope of securitisation through simple, transparent and standardised (STS) securitisations. We think, for example, that they may facilitate green securitisations. And to facilitate this initiation, the EBA supports the idea that securitisations should be considered green not only if they have a green underlying value, but also if their products are used to invest in green assets.

 

The finalisation of the Basel III agreement has been delayed. For how long?

The French Presidency communicated its objective to proceed as far as possible with this issue. With Basel III, the risk awareness is increasing. The model-based approach is better mastered, enabling better management, while the standard approach is refined. We can expect a gradual implementation between 2025 and 2028. The European Commission proposed an excellent compromise, from our point of view, which is loyal to the Basel agreement and takes European specificities into account.

 

Will the obstacles to sector consolidation be removed?

The Commission proposes a consolidated calculation of the output floor and then its intra-group allocation rather than an entity-by-entity calculation, which is a step in the right direction. Liquidity must also be able to circulate within groups.

With the EBA’s Single Rulebook, the Banking union’s single supervisory and resolution mechanism, banking institutions can deploy their activities in the European area, which is largely unified. It is also up to them now to establish an expansion strategy, which may include consolidation, in order to best serve the European economy.

 

Is the increase in interest rates good news for banks’ profitability?

First of all, it should be recalled that the low interest rate environment is not necessarily prejudicial for banks and that some of them have remained very profitable despite these low rates. An analysis of their rate sensitivity conducted by the European Central Bank in 2017 showed that the impact of the rates on their profitability depended to a large extent on their portfolio of activities, their business model and their asset/liability management strategy. Low rates also allowed the European economy to recover from the major financial crisis, improved the refinancing conditions of banks, and supported their activities. A sharp steepening of the rate curve is, however, a healthy phenomenon for the banking sector as long as it corresponds to an upturn in economic activity, which seems largely to be the case at present, despite the uncertainties linked to the war in Ukraine.

 

Could banks’ improved profitability delay the consolidation of the banking sector?

Short-term profitability should not be confused with long-term structural profitability of the sector. The question is what kind of banking sector does the European economy need? It needs an effective and efficient banking sector with low-cost financing. This requires stakeholders with critical size, good technology, good information systems and sufficient sophistication to meet the challenges of digitalisation and the environment. The deployment of systems enabling this transition is difficult to implement and costly. The European banking sector needs to be sufficiently efficient and responsive to address these new challenges. A certain degree of consolidation of the sector might help in this respect.

 

How are banks addressing this technological challenge?

We are witnessing a profound transformation of financial intermediation, which aims to resolve information asymmetries and provide liquidity. In doing so, the banking sector is developing its technology to understand risks and the situation of borrowers. However, banks are currently facing competition from technological companies with large databases that are developing knowledge of customer behaviour that is similar or even superior to that of theit own.

It is therefore essential for the banks to further pursue their technological revolution. This is what they are doing, inter alia, through partnerships or by creating their own technological entity.

Nonetheless, the ongoing changes must not be underestimated. The market is becoming ever more competitive with the apparition of these new entrants, who are niche or mass players.

 

Are you referring to the entry of blockchains, fin-techs and other providers on the market?

Absolutely. These new players have substantially transformed the value-added chain and the banks’ business model. Banks need to determine their approach to these developments, in the sense of deciding whether and how to cooperate with these new stakeholders or, on the contrary, whether to compete with them. The European Commission relied on the EBA’s work to prepare its proposal for the DORA3 Regulation on operational resilience, a whole digital strategy to ensure that these third-party service providers fall within the scope of the regulation and to prevent any inequality in the competition or risk treatment. The role of the EBA will be to develop a prudential regulation in this regard.

 

In March, the EBA published a warning on crypto-assets. What do you think about the MiCA4 Directive, which is currently in the trialogue phase?

A European regulation of crypto-assets is a very useful and desirable step, in view of the risks they may pose for investors, issuers and the environment – indeed, ‘mining’ is very expensive in terms of its carbon footprint.

These instruments are often presented as a simple, certainly new, class of financial assets, whereas, fundamentally, the logic of their initial promoters or even some technological enterprises is to circumvent banks and money issued by central banks.

In any case, the risks inherent to crypto-assets must be understood by their buyers, who are often attracted by the technological novelty and the prospect of high gains. This is the reason why the EBA has regularly strived to alert the general public to this issue since 2013.

 

In what phase is the consultation on the identification of shadow banking entities? What would be the impact for the money market funds?

The standards will be published in June. We received about 20 answers, which were generally very encouraging. The money market funds reiterated their position, but there is broad international consensus that they carry certain risks.

We follow the principles of clarification, transparency, identification and diversification of risks, with the aim of avoiding the risks of concentration around these stakeholders.

These funds are an important and very useful source of liquidity for banks and businesses, but they also represent a source of vulnerability and volatility, as the withdrawal of liquidity at the beginning of the COVID-19 crisis showed.

 

What are the dangers of de-risking?

That banks will decide to abandon certain activities if they find the associated compliance restrictions too costly. This could lead to financial exclusion of certain stakeholders, which is particularly relevant in the case of the fight against the risk of money laundering. We believe that it is possible – and desirable for the community! – to comply with reasonable and effective compliance obligations without having to abandon certain activities. To this end, artificial intelligence can facilitate the processing of the risk of money laundering and analyse the behaviour.

 

An overhaul of the anti-money laundering and countering the financing of terrorism (AML/CFT) system is under way. What will be the consequences for European banks?

It is a very positive development. Before 2018, five European directives had been adopted but transposed very differently at national level. That was a minimal harmonisation, which in itself hinders effectiveness. The current project aims for a uniform treatment. The regulation will take the form of an EU regulation, rather than a directive, in order to reduce the measure of discretion on the part of the Member States. Finally, at the beginning of 2024, a single authority, AMLA5, will assume the responsibility for the fight against money laundering and financing of terrorism and will cooperate closely with the national authorities.

 

The interview was conducted by Sylvie Guyony and Tân Le Quang.

Revue Banque, 12 April 2022.