Hearing before the Committee on Economic and Monetary Affairs of the European Parliament
Introductory statement by Mario Draghi, Chair of the ESRB
Brussels, 18 February 2013
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’s task is to identify and monitor systemic risk, and to issue policy recommendations to mitigate such risks. Today, I am pleased to present two new ESRB recommendations, one on ways to mitigate some risks encountered by banks in their funding activities and another to strengthen the regulatory framework disciplining money market funds in the European Union (EU). But before that, I would like to elaborate on the current situation. I will then turn to the new recommendations. And I will conclude on some medium-term ESRB work on interconnectedness and on a sound macro-prudential framework in the EU.
1. Current situation – the ESRB’s assessment of systemic risk
Let me start on a positive note with respect to the improvement in financial market conditions in recent months. Sovereign debt spreads vis-à-vis Germany have followed a downward path, some countries, such as Ireland and Portugal, have issued medium-term sovereign bonds for the first time since 2010, and general indicators of systemic risk have receded markedly. Furthermore, the geographical fragmentation of financial intermediation that has characterised much of the European debt crisis appears to be losing momentum, with deposit flows starting to stabilise and Target2 imbalances receding from their mid-2012 peaks. Finally, bank funding markets are also showing signs of improvement, as indicated by, among other things, the investors’ rising appetite for euro area bank debt.
However, a weak macroeconomic outlook in some EU member countries could affect banks’ profitability and capital levels.
Banks may delay necessary deleveraging and cleaning-up of their balance-sheets, exacerbating fragile macro-financial linkages and making more difficult to raise equity and provide credit to the real economy.
Where search for yield is driving investor choices, there is a vulnerability as a result of possible sudden risk re-pricing.
Finally, there are several reasons for remaining cautious about the improvement in bank funding markets. In addition to the risks noted earlier, EU banks have high refinancing needs over the coming years and continue to be dependent on central bank funding.
Addressing these challenges in a decisive and sustainable manner is a prerequisite for ensuring a more resilient financial system that is capable of supplying the financial services to support economic activity.
From a macro-prudential perspective, this includes: (i) supporting growth-enhancing reforms that help fuel virtuous macro-financial dynamics; (ii) continuing efforts to clean up banks’ balance sheets, based on a transparent and consistently applied prudent valuation of banks’ assets and reinforced by a coordinated asset quality review to ensure consistency across the EU, possibly under the lead of the European banking Authority (EBA); (iii) closely monitoring the potential build-up of fragilities in credit markets, with a view to strengthening the financial system’s resilience in the event of a downturn, including through adequate shock-absorbing buffers; and (iv) intensifying the monitoring of bank funding risks.
To elaborate on this last point, let me now turn to the two ESRB recommendations that are being published today, as one of them deals directly with the strengthening of bank funding.
2. ESRB recommendations on bank funding and money market funds, as are being published today
(a) ESRB recommendations on bank funding
At my last hearing before this Committee, I announced that, upon my return, I would present the results of the ESRB’s assessment of vulnerabilities related to bank funding and asset encumbrance. I am now in a position to present to you, first hand, an ESRB recommendation based on such assessments.
Let me mention the risks that we intend to address, and the responses we would like to provide.
First, the fragility of the “funding structure” of many of our credit institutions: the crisis showed that they were overly reliant on volatile and short-term funds, and excessively engaged in maturity transformation. For this reason, the ESRB recommends that credit institutions submit their individual funding plans to their national supervisors, as is already the case in a few EU Member States, and that the EBA co-ordinates assessment of those plans at Union level. The main goal is to ensure that supervisors have an aggregate view, at the national and EU level, of the banking sector’s capacity to indeed reach its funding targets.
Second, the growth in asset encumbrance: asset encumbrance is the use by credit institutions of their assets to guarantee financial transactions. The implications thereof are twofold. On the one hand, encumbering a large proportion of their assets may make it more difficult to obtain unsecured funding and may pose more challenges for the effective management and oversight of liquidity and funding risks. On the other hand, creditors can take recourse to a smaller set of unencumbered assets in the event of an institution’s default. To mitigate these risks, the ESRB recommends that credit institutions monitor and assess their encumbered assets internally, also through appropriate governance mechanisms, while supervisors review them on a regular basis. Finally, credit institutions should disclose information on their encumbered and unencumbered assets.
Third, the need to extend best practices for covered bond regimes throughout the EU: covered bonds have been used increasingly to finance credit institutions, and they should be preserved as a high-quality financial instrument. While harmonisation is made difficult by underlying national legal regimes, the ESRB recommends that authorities foster convergence to the highest standards.
(b) ESRB recommendations on money market funds
The ESRB is also publishing recommendations on money market funds (MMFs) today. MMFs are a key component of the shadow banking sector. In Europe, such funds manage around €1 trillion in assets, concentrated on a few countries (mainly France, Ireland and Luxembourg). Following the financial crisis, there was international agreement on the need for structural reforms in this sector.
The risk addressed by the ESRB is that a potentially destabilising run by investors on MMFs could lead to spillover effects for the wider financial system. The risk of an investor run may be higher for MMFs with a constant net asset value (so-called CNAV funds). The ESRB thus recommends that it be mandatory for CNAV funds to be transformed into funds with a variable net asset value (VNAV funds) over a sufficiently long transition period. Finally, the ESRB recommendations cover other areas that aim, in addition, to reduce the systemic risk related to MMFs, namely the introduction of explicit liquidity requirements, a better public disclosure and enhanced reporting and information sharing between authorities.
With its recommendations to the European Commission, the ESRB primarily provides input to the development of robust EU legislation in this area. At the same time, the recommendations intend to support global progress, as has recently also been advocated by the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO), also in major partner economies. The Financial Stability Oversight Council, the US counterpart of the ESRB, has recently published a consultative paper with the same objective.
3. Looking ahead: ESRB activities over the medium term
(a) Interconnectedness in the EU financial system
Looking ahead, one of the key areas of work for the ESRB is to gain a better understanding of the role of interconnectedness (or networks) play with respect to the resilience of the financial system. Interconnectedness is a core dimension of systemic risk. As the aftermath of the collapse of Lehman Brothers has revealed, linkages across institutions and markets – which contribute to diversification in a benign environment – can lead to sizeable contagion in adverse circumstances. This is of particular relevance for the ESRB as the process of financial integration has created a myriad of complex linkages within the EU financial system.
So far, the ESRB – together with the European Securities and Markets Association (ESMA) – has been examining this issue in relation to two specific market segments, namely interbank interconnectedness and contagion in the credit default swap (CDS) market. The ESRB and the ESMA are currently concluding their work in this important area. Final outcomes notwithstanding, one preliminary lesson learnt from this work is that a more holistic view of interlinkages in the financial system is needed to understand how shocks are transmitted across the system and how to mitigate them. Another lesson is likely to be that the assessment of systemic risk requires granular and timely data on bilateral exposures or “super-spreaders” (i.e. the hubs of the financial system or the most interconnected firms). Ultimately, this type of analysis could feed into the ESRB’s Risk Dashboard and provide a basis for a system-wide stress-testing exercise.
(b) Macro-prudential policies in the EU
Let me now say a few words on the progress being made in ensuring a sound macro-prudential framework across the EU. At the hearing before this Committee one year ago, I presented the ESRB recommendation on the macro-prudential mandate of national authorities. Since then, noticeable progress has been made. Several countries have already taken action and set up committees with explicit remits to monitor and mitigate systemic risks. Some (Germany, Greece, Malta, the Netherlands and the United Kingdom) have brought new macro-prudential legislation into force. Others (Czech Republic, Denmark, France, Poland, and Slovenia) have presented legislative proposals to their Parliaments. I am aware that many other countries are preparing to take similar steps. Finally, other countries (Bulgaria, Estonia, Ireland, Italy and Spain) deem themselves to be already compliant with the recommendation. The ESRB is monitoring developments and will report to the Parliament later on.
The next step in developing the macro-prudential framework is to provide these national authorities with a flexible toolkit of macro-prudential instruments to ensure that, once in place, they are able to prevent the local build-up of systemic risks. The ESRB has made important headway, at a technical level, in identifying both the primary and the intermediate objectives of macro-prudential policy, as well as an indicative list of instruments that should be available in order to attain all the goals. I am confident that I shall be able to report on this in greater detail at one of the forthcoming hearings.
As you are aware, some relevant pieces of EU legislation are being finalised. They include the CRD/CRR package, which requires direct ESRB involvement in the coordination of macro-prudential measures. Moreover, the draft SSM regulation also calls the SSM to cooperate closely with the ESRB. Finally, the two EU regulations underpinning the ESRB will be submitted for a review by the end of this year. With respect to all these new institutional developments, the ESRB will be at Parliament’s disposal as needed.
Thank you very much for your attention. I am now available for questions.