Hearing before the Committee on Economic and Monetary Affairs of the European Parliament

Introductory statement by Mario Draghi, Chair of the ESRB Brussels, 9 October 2012

Dear Madam Chair,

Dear Honourable Members,

I am very pleased to appear before this Committee today to inform you about the activities of the European Systemic Risk Board (ESRB).

As you know, the ESRB complements the know-how of central banks, national supervisors and the three European Supervisory Authorities by delivering what has come to be called a macro-prudential perspective. What this means is the capacity to analyse risks across market segments, to address vulnerabilities – which currently lie mainly in the banking sector – and to examine medium-term risks in the financial system as a whole.

Based on such analysis, combined with proposals for remedial action by way of warnings or recommendations, the ESRB will help to protect Europe’s economy from fragility in the financial system.

An important step in the ESRB’s work was the publication of the first risk dashboard on 20 September 2012. The dashboard was requested by this Parliament in the legislative process establishing the ESRB. It consists of a set of quantitative and qualitative indicators aimed at identifying and measuring systemic risk.

The risk dashboard has been produced in cooperation with the European Central Bank (ECB) and the three European Supervisory Authorities (ESAs). It is one of the inputs considered by the ESRB’s General Board in its discussions of risks and vulnerabilities in the financial system.

The dashboard, which will be updated quarterly, looks at six different categories of risks, sectorally and across the financial landscape. It should be considered an information tool that orients further analysis on systemic risk, rather than a fully-fledged early warning system.

The General Board has decided to publish the dashboard and its underlying data on the ESRB’s website.

Risks in the banking sector

Let me turn to the current situation. The European economy and financial system continue to face challenging times – and it is vital always to be mindful of systemic risks. But there are also reasons to be confident, provided that policy-makers continue to implement agreed measures with determination.

These measures include macroeconomic and structural reforms to ensure competitiveness and sustainable public finances. They include continued financial reform to ensure a resilient and well-functioning financial system. And they include further development of Europe’s institutional framework.

From a macro-prudential perspective, there are three main possible risks. First, the risk of setbacks in the implementation of agreed measures. Second, the risk of downside macroeconomic news with implications for banks’ asset quality, profitability and funding. And third, the risk that feedback loops between these two factors may affect the supply of credit, which in turn will affect the real economy.

Revitalising the supply of credit is crucial for the recovery. Notwithstanding some reductions in market tensions, financial activity remains impaired in various parts of the system. At this time, the role of macro-prudential policy is primarily to restore trust in the financial sector.

To rebuild investors’ confidence in banks, it is necessary to reassure them about asset quality. There are a number of options that authorities can consider. One is enhanced disclosure, for example, on the level of provisioning. A second option is supervisory assessments of asset quality, possibly including peer reviews by supervisors and third party assessments and a third option, where necessary, is the setting up of separate entities to deal with low quality assets.

Important work is already being done by the European Banking Authority (EBA), assessing forbearance in the banking sector, promoting coordinated reviews of asset quality and harmonising definitions of key variables – such as non-performing loans.

The ESRB plans to make further proposals for macro-prudential policy, particularly on vulnerabilities linked to bank funding. In light of the impairment of some credit and interbank markets, the ESRB, together with the EBA, is reviewing asset encumbrance and complex funding instruments such as synthetic exchange-traded funds and liquidity swaps. The aim is to identify sources of systemic risk and policy actions to mitigate them. I intend to present the results of this process at the next hearing in the first half of 2013.

Risks in financial markets

The ESRB’s examination of the financial system extends well beyond the banking sector. Today, I would like to focus in particular on developments in the field of central counterparties (CCPs) and over-the-counter (OTC) markets. I will outline the analytical work done by the ESRB and the policy advice it has given.

The implementation of the G20 commitment to central clearing for all standardised OTC derivatives has important consequences for the EU financial system. The ESRB started to assess the systemic implications of the more prominent role for CCPs that they will become a crucial node within the financial system.

Macro-prudential examination of CCPs relates, in particular, to the pro-cyclicality of margining and haircutting practices. Such practices have an important bearing on financial conditions in the economy. While the more prominent role for CCPs reduces counterparty risk, it inevitably implies an increase in concentration risk. Therefore, the ESRB issued advice to the European Securities and Markets Authority (ESMA) on two aspects regarding the systemic resilience of CCPs.

On collateral, the ESRB advised the ESMA to increase the systemic resilience of CCPs by better defining the type of eligible collateral and the conditions under which commercial bank guarantees may be accepted as collateral by CCPs. The ESRB also advised that risks related to cross-collateralisation should be adequately taken into account.

On clearing among non-financial corporations operating in derivative markets, the ESRB advised the ESMA to restrict the possibilities for such corporations to settle outside CCPs, so as to reduce counterparty risk. Regrettably from a macro-prudential viewpoint, there is a risk that the systemic vulnerabilities identified by the ESRB will remain at least partly unaddressed. This is due to an interpretation of the EMIR legislation that has made it difficult to translate fully the ESRB’s advice into technical standards.

On OTC markets more broadly, the ESRB is examining potential risks stemming from market practices that have become very common in the so-called ‘shadow banking’ sector. For example, collateral pledged by a client may be re-used by a lender for own borrowing needs.

This pattern, which is called re-hypothecation, may be repeated several times for the same collateral. It can therefore create a contagion chain in case any party fails to deliver. In other cases, when collateral for securities lending transactions is represented by cash, that cash may re-invested by the lender. In case such re-investment takes place in a risky asset or for a longer maturity, there are risks of so-called reuse of cash collateral in securities financing transactions.

Macro-prudential policies in the EU

Banking union and the role of the ESRB

The ESRB has also reviewed the current plans on the banking union and welcomes the European Commission’s proposal. Board members consider that the macro-prudential benefits of the Single Supervisory Mechanism (SSM) would be enhanced if an adequate resolution regime for banks were implemented without substantial delay. The Commission’s initiatives for establishing a ‘single resolution mechanism to resolve banks and to coordinate the application of resolution tools to banks under the banking union’ are to be encouraged.

The ESRB is reflecting on the implications of the proposed SSM for its own work. The Commission’s proposal directly affects macro-prudential policy and its implementation – suggesting for the ECB exclusive competence within the euro area ‘to set counter-cyclical buffer rates and any other measures aimed at addressing systemic or macro-prudential risks in the cases specifically set out in Union acts’.

The ESRB has repeatedly stressed that macro-prudential policies should be sufficiently flexible to prevent the build-up of systemic risks. Policy-makers should be encouraged to mitigate emerging risks as soon as they are identified, rather than fostering a bias towards inaction. Flexibility can be balanced by members’ coordination to safeguard against potential negative externalities or unintended consequences.

The ESRB is working on a general framework for the coordination of macro-prudential policies in the EU. First results can be expected in the coming year.

Meanwhile, a review of the mission and organisation of the ESRB itself will take place in 2013. Three members of the ESRB Steering Committee – Stefan Ingves, Chair of the Advisory Technical Committee, André Sapir, Chair of the Advisory Scientific Committee, and Vítor Constâncio, Vice-President of the ECB – will examine the functioning of the ESRB, including in light of the forthcoming banking union.

Follow-up on ESRB recommendations

The ESRB is also working on first implementation of the ‘act or explain’ mechanism set out in the ESRB Regulation to ensure that addressees respond properly to ESRB recommendations. The first set of deadlines for replies to the ESRB recommendations issued in 2011 expired in June 2012.

The current review suggests that the ‘act or explain’ mechanism has functioned smoothly. At the same time, more work lies ahead to enhance our assessment framework. The ESRB Secretariat has contacted relevant European and international institutions – such as the Commission, the IMF, the OECD, the FSB and the Bank for International Settlements – to learn from their experience.

Conclusions

In concluding, I would like to emphasise that there is substantial progress in the understanding of systemic risks and the design of macro-prudential policies in the EU. This would not have been possible without the active involvement and dedication of all ESRB member institutions and committees.

On the occasion of the rotation of the Chair of the Advisory Scientific Committee, I would like to thank in particular its first Chair, Martin Hellwig, and to wish all the best to the new Chair, André Sapir. I understand that you will have the opportunity to exchange views with the Chair and Vice-Chairs of the Committee very soon.

Thank you very much for your attention. I am now at your disposal for questions.