François-Louis Michaud's interview with Revue Banque: If banks are to hold on to their role as financial intermediaries, they need to retain added value in their information management

‘If banks are to hold on to their role as financial intermediaries, they need to retain added value in their information management’

The financial ecosystem is undergoing many changes. The roles and positions of banks are in constant flux. As the new European legislature commences, François-Louis Michaud, the Executive Director of the European Banking Authority, explains how the regulator tries to work with them.

2024 is coming to an end. In terms of regulation, this year has been rather busy. What were the stand-out points, as you see them?

The European Banking Authority (EBA) is the banking and financial regulator, meaning that it clarifies the rules for the banks and those controlling them at the request of the European legislator, and it performs analyses of the soundness of the banking sector. The scope of the work in 2024 was huge, and it represents the end of a cycle. For the last ten years, prudential regulation has grown in strength, especially in the last five years. This last European legislature was a very significant one. It managed to finalise the regulatory reform following the major financial crisis that began in 2007. This is Basel 3 and the ‘banking package’ in Europe. The regulatory framework was extended to cover new areas, such as corporate social and environmental responsibility (ESG or CSR) in the broad sense, and the digital field. This involved extensive work on DORA, MiCA, and on climate risks. One last work stream of importance to the EBA, that will end in 2025, concerns anti-money laundering and countering the financing of terrorism (AML/CFT).

If we take the main files. Where do we stand today on the gradual entry into force of the Basel 3 rules?

The European legislator decided that the rules will come into force in January 2025. The additional work requested of the EBA to support the banks will be spread over four years. The first phase started in 2024 and should be completed by mid-2025. We are fully on course with the programme. Basically, the first phase was to work on credit risk and adjustments to the standard method of assessing this risk, and on some aspects of operational risk.

In broad terms, the banking package and the Basel rules have a twofold objective which is to strengthen the solidity of the sector and to establish balanced conditions of competition between jurisdictions. I think we have shown clearly that we were able to manage these two aspects.

Banking rules are important for the European banks. As a result of stronger regulation in the past ten years, our banks managed to jump all the hurdles coming their way, without any shocks. They included Covid, the invasion of Ukraine by Russia, conflicts in the Middle East, inflation hikes and rising rates... The US only applied these rules to their large international banks and the rising rates in 2023 threw up challenges for asset-liability management in their smaller banks.

In ten years, banks have reduced their risk taking. A massive amount of work has been done on re-designing their business models. As for international competition, the European Union (EU) has shown that it is able to deal with it. In relation to market risks, it has been decided to defer implementation of this part of the Basel package by one year.

At the Club Banque meeting in December 2024, the feeling was that banks were being systematically pushed towards standard rather than internal models...

Basel 3 brings a great advantage, in that it achieves a better point of equilibrium than Basel 2. Standard approaches have sometimes proved a little frustrating. They now take a more considered account of risk. In contrast, the internal model approaches had a kind of 'black box' feel to them. Being highly sophisticated, they could pose readability challenges for a supervisor and sometimes even for the governance of banks. Internal models are better framed nowadays.

Whether or not to use advanced models is entirely up to the banks. This depends on the level of sophistication of their activities. If it is high, an internal model can be more beneficial than a standard approach, and even better. The institutions choose the approach they consider least costly in terms of data acquisition, risk steering, etc. This is entirely their responsibility. Many have opted to use a standard approach.

Anyhow, whatever the choice, the supervisor and the regulator encourage adopting a considered approach to risk management.

Let’s take a moment to focus on an event in 2024, one that got little attention, as it is just a part of your everyday work! Every two years, you run stress tests. For the first time, in 2024, you ran a climate stress test on the financial system as a whole, and for a period of eight years. What lessons can we learn from this?

The use of stress tests is extremely important in our work. All other supervisory tools are based on historical statistical data, looking at the past. With the stress tests, we are projecting into the future, exploring scenarios and shocks, so as to identify areas of risk and fragility. The ‘Fit For 55’ exercise was also very interesting because it was cross-sectoral – typically the climate subject is cross-sectoral. It was therefore important to look at how the different components of the financial sector can react and to see the links between them.

The results are encouraging, but to be treated with caution. The losses linked to the transition are likely to be absorbed by the financial industry, but this stress test is based on the assumption of an orderly transition. Secondly, there is a lack of data in some parts of the analysis, significant simplification has been necessary and it was not possible to draw comparisons. The channels for transmitting the shock from one sector to another could not be fully explored either, as we still do not have sufficient data for a detailed analysis of the dynamics. A final precaution must be given about the rise in extremely severe climate events, for several months now. The transition may have to take place sooner than we had thought, if the physical risk continues to materialise in such a serious way.

On the subject of data, what steps would be needed to achieve a more qualitative collection of information?

EBA’s Climate Risk Work Programme is based on data capture, risk management by actors (with guidelines under preparation), and the possible capital burden of these risks. For the past five years, we have been trying to help banks produce these data by working with their customers to acquire granular information that they and we need to measure the impact of crisis scenarios and of the transition.

We have produced a reporting framework. We have proposed aggregate measures such as the Green Asset Ratio, to enable banks to work on this issue. We also prepare guidelines proposing a transition plan approach, from a prudential point of view, based on the CSRD requirements.

Data acquisition represents a long-term effort. In some sectors, we will be required to use sectoral data. Assessing risk, counterparty by counterparty, would certainly be too costly or too difficult for individual clients.

The CSRD Directive is one means of obtaining data by imposing constraints on businesses. Today, there is a sense of reticence, as for example in Mario Draghi’s report. Do you feel that the market is starting to hit the brakes?

We have had an intensive production and development phase for the last five years, in response to the legislator’s objective to make progress in this area. Work had to start. We worked with the stakeholders and we contributed what, in our view, was needed. This resulted certainly in a proliferation of texts.

We support efforts to harmonise, simplify, rationalise all this production, to iron out the bumps between the different corpus applying to businesses and banks.

Consolidating these requirements at this stage must ensure that they are consistent and compatible, so that the actors do not have to do the same thing twice or produce different types of data which in the end have more or less the same objective. Work on rationalisation still has to be done. I think this was the message of the President of the European Commission in her recent speech in Budapest, that the goal of an orderly transition remains paramount, but we must facilitate its implementation.

There has been some criticism of the relevance of the calculation elements of the Green Asset Ratio. Is it foreseen that these criteria might change?

We are very aware of the discrepancy between the numerator and denominator in this ratio. They do not cover the same realities and this was not our initial recommendation. In fact, we proposed another ratio: the Banking Book Taxonomy Alignment Ratio (BTAR), which banks can provide on a voluntary basis. Its aim is to represent the banks’ situation with a better aligned numerator and denominator. We are in favour of improving the Green Asset Ratio. It may be part of those proposed in the upcoming rationalisation work.

The fact that these ratios are low at the outset is not a problem in itself. The question is whether they increase over time or how they evolve from one bank to another. They already contain interesting information. For example, these ratios are quite different from one bank to another and from one jurisdiction to another. From the first submissions, we can already see that the situation is far from being uniform. This is information in itself, and our first objective is to ensure that the information is provided.

Some aspects will remain difficult to compare because the structure of the various European markets is not the same. But we can take inspiration from one market to another. Some banking sectors manage to produce this ratio under better conditions than others. Each party needs to ask themselves what they lack in order to achieve similar results.

This ratio can help investors, the market and the public to put the right questions to banks, and thereby foster a spirit of emulation.

A word on the capital burden of climate risks. Should they be treated just like other risks, or in a specific way?

We have been very clear about this. From our point of view, this risk manifests itself through risks we are familiar with, namely credit risk, market risk and operational risk. We simply need to refine the way in which these climate factors affect traditional risks, rather than separating them out or adding an additional risk. Environmental risks should be taken into account through existing categories. In this respect, we are also working on future pan-European stress tests, to ultimately avoid running too many parallel exercises.

Let’s talk about 2025 and a key topic, the money-laundering battle... You mentioned this earlier...

In the three financial sectors, the EBA was mandated to prepare the transition towards setting up a European anti-money laundering authority, the Anti-Money Laundering Authority (AMLA), due to start operations in 2025. The aim was to accelerate convergence between the Member States in this area. We reviewed the implementation of provisions in each of the 27 Member States.

We also enhanced the standards and set up a database so that the competent authorities in each country can exchange information on the prudential situation in their institutions, with a focus on combating money laundering. AMLA will be able to use this when it starts functioning.

Currently, we are working closely with the European Commission and AMLA preparatory teams on risk assessment methods and identifying the institutions that will come under its direct control to facilitate a quick start of the new authority.

How will the powers be transferred from one authority to another?

For four years, we have clarified the rules for refining how the fight against the risk of money laundering is taken into account by banking supervisors. AMLA will add an aspect of European supervision integrated into banks under the AML/CFT regime. This will be the biggest novelty. We will keep the responsibility for taking the money laundering risk into account in the prudential regulation. Money laundering losses must raise questions for the banking supervisor, as they may indicate a wider problem of governance or of internal control. An interface with the AMLA will have to be managed. We will be there also to facilitate the coordination between banking supervisors and money laundering supervisors. In this respect, we will have an observer role on the Supervisory Board of AMLA.

The European banking sector is considered resilient, nowadays. Where might there be pockets of vulnerability?

The good news is that the banking sector has never been in such good health, for such a long time. It has absorbed a series of shocks like never before. That deserves to be underlined!

Since 2021, we have tested diametrically opposed stress scenarios, on the impact of deflation and of stagflation. Each time, the banks came out with flying colours, and with CET1 capital ratios above 10%. Their liquidity levels are also good. Even despite the reduction of exceptional operations by the central banks, led by the European Central Bank, which ended their refinancing facilities. So, liquidity is high, capital is high, and the level of profit in banks over the past two years has never been so good. This has enabled them to distribute profits, buy back some capital and also put some in reserve.

However, there are still some areas of concern, namely, geopolitical developments and their macroeconomic impacts, the general debt in our economies, and concerns about certain sectors that would by definition be more fragile, such as commercial real estate. And then, the last important topic is the operational risk for banks.

The geopolitical risk is currently on everyone's mind…

Yes, the geopolitical risk is obviously a concern for all. Open conflicts in regions around the world can have direct or indirect impacts on our economies and our banking sectors. The exposure of our banks to these regions in open conflict is limited, at this time. Indirect effects, however, are more difficult to anticipate, as there can be impacts on value chains, supplies, etc. All this may be called into question and trigger price wars, restrict access to certain raw materials, and so on.

The transformation and evolution of international relations can also give rise to different commercial relationships, and to new barriers going up. Even in a situation of peace, this geopolitical dimension must not be forgotten.

The world becomes less about collaboration and increasingly about confrontation. Does this result in a regulatory confrontation?

I don't think we're in a regulatory confrontation. Discussions continue within the Financial Stability Board, the G20 and the Basel Committee, and they are going well. There is no regulatory battle. The world is fragmenting more because of political issues at a ‘higher level’, I would say, than a simple confrontation between regulators who pursue the same objectives of stability and efficiency.

So let’s go back to the areas of concern…

Migration crises and the risk of attacks can have macroeconomic consequences. From our side, we can try to assess the impact of these consequences, as we will do in the next stress test in 2025. The scenario will be published in January, but the methodology was published already in November.

What we will be looking at are the capital and liquidity reserves available to the actors. We don't know exactly what the transmission channels are or how they might materialise, but we must have plenty of reserves that can be mobilised and systems that can absorb shocks. Our task also involves understanding the infrastructural limitations, in particular of the information systems. The example of CrowdStrike is a good example in that cyber risk is not only a risk of attack, but sometimes about updating software. This case shone the focus on a wide-reaching collective fragility.

Operational resilience is very important, from our point of view. We would expect DORA to strengthen the collective security in this area.

There is another point which requires our attention, and that is debt risks, which are high.

Finally, there are pockets of risk, such as that of commercial real estate. For the time being, nothing dramatic. Bankruptcy and bad debt rates have been increasing for several quarters. That remains at very low levels -2% of bad debts on bank balance sheets. This is still very low, but it has started to rise again.

You talk about debt risks. Are European banks too exposed in relation to their national sovereign debts? Do you notice a kind of ‘Europeanisation’ of the portfolio?

The data we publish on their level of exposure to the sovereigns show a level of stability.

Over the last ten years, the strengthening of the regulation has neither resulted in restricted access to credit or an increase in the price of financing. The credit distribution remained abundant in the EU. It increased in nominal value by 40%, and by 90% for small businesses. There is therefore no question of credit restriction. Lending rates have also fallen relative to central bank rates over the period, there is therefore abundant credit in all sectors.

But a significant part of these loans is now cross-border, within the EU. The proportion of loans taken out with banks in other EU countries has increased. Almost 25% of loans to non-commercial businesses and 20% of loans to households are granted by banks in other Member States.

We therefore see a diversification happening inside the European Union. The majority of SMEs and households continue to be financed by their local banks. But there is an increase in cross-border loans, which should continue, facilitated by financial innovation and the new technologies.

In 2022, in your previous interview with Revue Banque, you referred to a risk to banks from ‘new entrants’ in the financial sector. How has this risk evolved?

There has been a double transformation in the financial sector. The first aspect is access to finance for non-financial enterprises. For ten years now, the banks’ share has been falling. The assumption is that financing in Europe relates to banks, but this is less and less the case. Today, almost half the financing is provided by non-bank actors, either by the market directly or private funds. Banks are involved in financing less than before, and they face more competition.

The second aspect of this transformation is the banking value chain. The role of service providers, particularly IT service providers, is increasingly important. The very purpose of DORA is to integrate them in the regulation and to ensure that banks are able to discuss with them and achieve sound operational conditions. MiCA in a way pursues the same purpose, by including some crypto-asset issuers and clarifying which ones are excluded. Incorporating these developments in the regulations makes the situation clearer for investors.

The priority for banks is to produce services with a value chain that they control. These services largely rely on the information transformation. The key therefore is to master the new technologies, so as to avoid competition or being dependent on third parties.

If they are to retain their role as financial intermediaries, banks need to retain added value in their information management, and in the production of services based on information that they collect and process. Non-financial actors are essential links in the value chain, and have to be part of the regulatory framework.

Some criticise Europe for lagging behind on innovation, particularly on crypto-assets. Its overly restrictive regulatory framework blocks innovation whereas the Americans are able to innovate, and to move very fast...

I do not think so. From the outset, the spirit of the European Commission's digital strategy has been to nurture innovation, and let it flourish while ensuring a protective framework for both investors and consumers. These two considerations feature prominently in all the texts, particularly in MiCA.

Are we losing out compared to the US? I do not think so. These products remain highly risky. They will remain accessible to savers or actors interested in this technology, but without taking undue risk, due to a fairly protective framework. So, I think the balance is good.

Banking sector competitiveness is the current focus of everyone. What steps is the EBA taking to support it?

Today, in the EU, access to finance is not problematic, from an economic point of view. It is in abundance, despite the tightening of the rules. Therefore, there is no contradiction between a more robust, more secure system and access to finance.

However, the question of strategic autonomy may arise. In other words, does the EU want certain sectors, that it wants to flourish, to be supported by European actors specifically or not?

If this is the case, are these sectors in sectors that European banks have lost some of the market share in over time? This question is not the same as the question about a possible restriction on access to credit.

Furthermore, the banks’ competitiveness can be improved through rationalisation and simplification. Three years ago, work streams were created to simplify reporting. We are working on a common glossary for the monetary statistics collected by the central banks and prudential authorities, so that the same data are provided only once and can be used for both. However, reporting requests tend to rise generally, at the behest of the legislator. The question now is: Can certain aspects of harmonised reporting be reduced or removed to restore a balance? Is it possible to dispense with certain harmonised reporting without this resulting in further increasing non-harmonised national reporting?

A constant balance must be maintained: harmonised reporting may seem to grow tentacles, but its aim is also to prevent multiple separate collections, which are a real problem for banks operating in several countries.

The regulatory framework created in the last ten years on microprudential, macroprudential and resolution requirements certainly requires a full overhaul. We noted the situation in a report last July on ‘capital stacks’ and there is certainly a need to adopt a more holistic vision.

In our monthly file, the European Banking Federation talks of regulatory inflation and a disconnect in European ambitions. Among the solutions mentioned are the Savings and Investments Union, securitisation, and completing the European Banking Union. Do you have any points of convergence with this position?

We are fully in favour of also relaunching or initiating a simplified, secure European securitisation system. The signs are there that this market is beginning to rumble, but it needs nurturing. This is one of our objectives for the coming year.

The STS title is a very good instrument in this respect, because it provides a good balance for both the buyer and the originator. It also allows supervisors to ensure that the risk transfer is done under the right conditions. The speed of risk transfer can only improve if banks use a simple, well-understood and well-known instrument. Everything that will be ‘made to measure’, on demand, will only slow things up.

In general terms, investors must have confidence and understand the products presented to them. Long-term investors, particularly insurers, being somewhat reticent on this subject, need to have a good understanding of the products being offered to them.

The virtuous circle involves standardisation and developing a mass market rather than a 'made-to-measure' market. Even if customisation might be more attractive for the originator because it generates higher margins.

If we want to industrialise this market, if we really want to turn securitisation into an EU-wide risk transfer tool, we need to use standardised instruments.

The interview was conducted by Fanny Avignon

Revue Banque