José Manuel Campa interview with Il Sole 24 Ore: Banks are well capitalised, but they need to get ready for the worst

Banks are well capitalised, but they need to get ready for the worst’

Economic conjuncture, a new wave of NPLs, climate risks with associated stress tests: the EBA Chairperson touches on issues across the entire sector

The war in Ukraine, the energy crisis, high inflation, economic slowdown and recession, rising interest rates, climate risks: banks are solid, well capitalised and with ample liquidity, but they need to be cautious, prudent in their analysis of credit risks and dividend payouts, in order to be ready for tough times ahead. The warning comes from José Manuel Campa, Chairperson of the European Banking Authority (EBA).

Here is the full text of Mr Campa’s exclusive interview with IlSole24Ore, a comprehensive dialogue on increasing risks, on loan-loss provisioning, dividends and buy-backs, on Stage2 loans, leveraged loans and mortgages, on debt moratoria and debt restructuring, on crypto-assets and non-bank entities, on TLTROs and liquidity, on Basel III, stress tests and climate risks.

The supervisory authority, EBA, is asking banks to assess risks more carefully when calculating the capital it distributes and prudential capital. Which risks are you most concerned about? Is it the most common risk of recession, or less common risks such as illiquidity, the energy crisis, disorderly market volatility, the unprecedented rise in rates in the eurozone?

There are many fronts to watch out for and a great deal of uncertainty in the air. The first concern is the recession which, as it seems, is not unlikely. The economy has been slowing down for some time now and each new forecast is worse than the previous one. This is partly due to the damage caused by the Covid-19 pandemic, even though it has been dealt with well by banks through tax warranties and moratoria. The economic slowdown is also partly caused by interest rates going back to normal after a long period of negative rates. Add to this the geopolitical crisis triggered by the war in Ukraine, the energy crisis and rising energy and raw material prices, and the future of globalisation or of de-globalisation. Despite all these issues, banks are in a good position; they are well capitalised and have a high level of liquidity. However, they need to be cautious when considering future scenarios and more conservative in their capital projections for the next two years. They must be ready for the worst.

Are banks following your advice? Has loan-loss provisioning increased?

So far we have only seen the figures for the second quarter, not the third. Profits were good. Overall, however, loan-loss provisioning has not increased. Only a few banks have increased it. Meanwhile, ‘Stage2’ loans, i.e. loans that are still performing but are at risk of becoming non-performing, are at high levels and have risen considerably, accounting for more than 9% of loans and advances at amortised costs. They have never been this high, so it is a pre-warning signal for us, a wake-up call. That’s why we recommend banks to be cautious and not to look at the past quarter but to the one that is coming. There is a great level of uncertainty.

Are you concerned about leveraged loans?

Our concern is that at the general level, with very low rates, leveraged loans have grown a lot. The rising interest rates will make this leverage even stronger. We are mostly worried about leveraged loans from the non-banking sector though. For us, leveraged exposures in banks’ balance sheets are a reason for increased attention but not for concern; banks’ leveraged loans equal 380 billion, which, compared to 2 trillion in mortgages, is not so high. NPLs, out of the total leveraged loans, represent 3.6%, exactly twice as much as the NPL/total assets ratio (1.8%). As for leveraged loans, non-bank financing is also growing significantly in the real estate sector: especially in Nordic countries like Denmark, and in the Netherlands, not in Southern Europe. The non-banking financial sector is not regulated in the same way as banks: we have been asking for more information from non-bank entities on the kind of operations they are involved in and, in particular, where they get the funds to finance mortgages. Another trend we have seen lately, and which we are monitoring closely, is the growth in non-bank consumer credit financing. This phenomenon is linked to digital lending and digital loans, of the ‘buy now and pay later’ kind. Here too, there is little transparency. Business activity grew significantly due to negative rates, but now the rates are rising, it will be difficult for these entities to stay afloat.

And what about the obscure crypto-asset market? Does it have systemic relevance?

Our assessment now is that crypto-assets do not pose a systemic risk to financial stability. This is also the result of our recommendations to the banks. For many years, EBA, ESMA and EIOPA have advised banks to avoid these instruments and not to recommend them to their clients as we considered them to be high risk. If a bank advises a client to invest in crypto-assets, it exposes itself to reputational risk when things go wrong. Banks have followed our advice, so there are not many links between banks and the crypto world. One must then distinguish between the two faces of crypto-assets: technology and products. Technology has entered the banking world, in trade finance, instant payments, such as blockchain. But there is no real business behind crypto products, and that is what worries us: they are called crypto-assets, but there is no real asset behind them. Those who invest in crypto-assets do so with one goal: to resell them at a higher price. This is the classic definition of a financial bubble. The MiCA Directive, which regulates certain types of products to protect consumers, has set out rules for crypto-assets in Europe. We are getting on the right path.

Banks complain about the competitive disadvantage vis-à-vis non-bank financial entities that are not regulated and supervised like banks. In the meantime, the FinTech sector is becoming a strong competitor...

Directives have been adopted at EU level to protect consumers in relation to mortgages and consumer credit, and this regulation affects the products. Banks are subject to supervision.

The latest ECB Financial Stability Review raises the alarm for non-bank financial operators exposed to extreme financial asset price volatility...

Banks’ traditional role is to collect savings through deposits and to provide financing for households and businesses, the economy, through the savings collected. Banks ‘transform the terms’. They use the assets they collect in the short term through deposits in the long term: they can do this because if they need liquidity fast, they can take it from the central bank. In the last decade, other non-bank financial operators started to employ this kind of short-term to long-term transformation, and this is the source of vulnerability. Mutual funds do not have access to central banks and when they need liquidity they must sell assets. What happened to the UK pension funds recently illustrates the issue. The Bank of England had to intervene. As non-bank intermediaries start doing the work of banks, that causes a potential source of instability; that is why one of the proposals for solving this problem is to allow funds access to central bank liquidity.

But the ECB’s liquidity for banks is not endless; the recent changes made to TLTRO loans prove that even the central bank’s taps can be turned off, right?

It is very simple. Monetary policy is now increasing the cost of money. This is a fact. The ECB is raising interest rates and reducing liquidity, thus making money more expensive. Banks are the monetary policy transmission mechanisms, so loans will become more expensive. The ECB’s actions cannot be expected to be compensated in any way by the banks, which continue to provide loans at the same rates as a year or two ago. This is not possible. Moreover, once TLTROs are redeemed in the short term using excess reserves, banks will need to fund themselves directly on the capital market due to the normalisation of monetary policy, their funding will be more expensive and this higher cost will be passed on in bank loans to companies and households. This is what the ECB expects to happen because monetary policy is transmitted through banks.

The ECB raised rates by 200 basis points to deal with high inflation, but the energy crisis may bring companies that were healthy a few months ago to their knees. Banks are still complaining about the EBA’s more restrictive criterion that came into force in January 2021: this is the case with the materiality threshold set at 1% and calculated as the ratio between the amount of a loan that is more than 90 days past due and is to be restructured by the bank and the borrower’s total exposure to the bank. Above this 1% threshold, default is triggered. The previous threshold was 5%. Do you plan to go back to 5%?

I am well aware that there are those who would like this percentage to be raised to 3%, 5% or even 10%. Should we change it? We are constantly monitoring the 1% closely and checking whether it works. When the rates were negative, 1% was very generous. When banks restructured their loans during the negative rate period, the present value of the loan before and after the restructuring was practically the same. Interest rates have now risen, however, and the exposure discounting shows different post-restructuring values. We aim to encourage banks to recall that they have granted an ‘amnesty’, which has resulted in a reduction in the loan value. After restructuring of the loan, banks must discount the exposure, identify the loss as soon as possible and put it on their balance sheet. Energy is much more expensive, and this is a shock that has major impact on bank customers who are in debt. When a bank restructures a loan applying a repayment schedule that prolongs the recovery of the loan over time, the present value of the loan drops because the borrower is unable to repay it in full on the agreed terms, thus causing a loss to the bank: a loan repaid after 10 years instead of 1 year has a lower value.

The pandemic came as a real shock and, during the peak of Covid-19, banks were given longer periods for moratoria and restructuring. Why don't banks take the same path to face the energy crisis?

It is important to make it clear that we, as banking supervisors, see a significant difference between the pandemic and the energy crisis. The pandemic created liquidity problems, while the energy crisis leads to insolvency. Covid was a strong external shock to the economy and it was considered temporary: once the pandemic was over, we would be more or less back where we were before the coronavirus. The banks had to manage the liquidity crisis of their customers. The analysis of the current situation is very different: first of all, we do not know if the energy crisis is temporary, but most likely we will not return to the pre-crisis prices and rates. The energy shock is permanent, and now rates have started going back to normal. This is why we ask banks to assess the credit risk of individual customers.

Banks are also returning to normal, in terms of dividends and buy-backs...

It is for the direct supervisors to make assessments on a case-by-case basis. At EBA, we provide general guidance for everyone and for now it is based on prudence. Profits and dividends have increased, buy-backs have resumed after a period of stagnation. And it is normal, after a ban like the one imposed during the pandemic, that the numbers are rising. The payout ratio (i.e. the percentage of profits distributed to shareholders in the form of dividends) has returned to just under 50%, which is the average level of the last five years. All these numbers are within the average figures of recent years. But we expect banks to assess the budgetary impact of what will come in the next two years, and for this assessment to be conservative.

Between the pandemic and the outbreak of war in Ukraine, banks enjoyed a brief boost, a bright spell. Profits had finally risen. But new rules are to be adopted that will lead to capital absorption: first Basel III and then climate change. What is on the EBA’s agenda in the coming months?

The reforms promoted by the Basel Committee on Banking Supervision must be implemented fully and on time. If any exemptions apply, they must be temporary, not permanent. Basel III is crucial in two aspects: for financial stability and because it is a global regulation that aims to maintain stability worldwide. The Basel III rules were devised in response to the Great Financial Crisis of 2007-2009 and will be finally adopted in 2030. It is a 23-year-long journey, so it cannot be said that these rules were rushed through. And the consequences of Basel III are a conscious choice of supervisors – take the output floor as an example. Basel III prevents certain banks from continuing to use internal models to reduce exposures to risks, thus limiting capital absorption. As regards EBA, we will publish the Risk Assessment Report in December, together with the results of the transparency exercise, which captures the viability of banks. In January 2023, the stress test starts, and it will finish in July. We will measure banks’ resilience to adverse scenarios over a three-year period, from 2023 to 2025. The impact of DORA (the Digital Operational Resilience Act approved by the European Parliament this year and to be implemented by banks within two years) must also be included in the banking regulation agenda. Finally, the qualitative stress test on climate change is scheduled for 2024 together with EIOPA and ESMA.

How will you proceed?

In fact, the first step on the sustainability journey is to find out where banks currently stand on ESG management and, above all, where individual banks plan to be in 5-10 years’ time when it comes to climate risk management. Let’s take it step by step. EBA is currently engaged in a qualitative assessment to determine whether banks measure climate-related risks adequately. We will publish a road map on climate risk before the end of the year. But one thing is certain: once the qualitative tests are done and we have a clear assessment of the additional risks arising for banks from climate change, the quantitative requirements will be set.

The interview was conducted by Isabella Bufacchi

Il Sole 24  Ore,  22 November 2022