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

Introductory statement by Mario Draghi, Chair of the ESRB
Brussels, 17 November 2014

Madam Chair,

Honourable Members of the Economic and Monetary Affairs Committee,

Ladies and Gentlemen,

It is a great pleasure for me to appear before this newly constituted Committee in my role as Chair of the European Systemic Risk Board (ESRB). For those of you who are newcomers, I trust that my comments will provide an informative introduction to the work of this important body.

The ESRB plays a key role in delivering a healthier financial system, which is a necessity for achieving a sustainable recovery in Europe. Today, I would like to update you on our activities.

Rebuilding confidence in the European banking system

European authorities have worked hard to rebuild confidence in the banking system. These efforts culminated in the EU-wide stress test coordinated by the European Banking Authority and the Comprehensive Assessment of significant banks conducted by the European Central Bank. The ESRB has made an important contribution here and plans further work in this area. It designed the adverse macroeconomic scenario for the stress test. And it will reflect on the results of the stress test and consider the possible implications of banks' responses for macro-financial developments.

The ESRB is also examining the systemic implications of so-called misconduct risk in the banking sector, i.e. the risk that banks are subject to fines and other sanctions due to violation of good conduct rules. The character of misconduct risk (typically a tail-event) and the increasing size of the fines create uncertainty about the business model, solvency and profitability of banks. The systemic nature of this risk derives from a number of factors. In many cases, misconduct issues arise across markets and also at systemically important banks. The costs typically rise in times of crisis and as such have a procyclical impact. Finally, misconduct can damage confidence in financial markets and institutions, which is vital for the proper functioning of the financial system.

For all these reasons, the ESRB plans to devise (together with EBA) a minimum methodology for banks to apply when calculating potential misconduct costs under stress. This will ensure a robust, rigorous and comparable assessment across banks and a consistent approach and appropriate contingency planning across jurisdictions. Misconduct risks should also be adequately captured in future EU-wide stress tests.

Operationalising macro-prudential policy in the banking sector

Since about one year new prudential rules for the EU banking system - the so-called Capital Requirements Directive and Capital Requirements Regulation (CRD IV – CRR) - have entered into force, establishing for the first time new macro-prudential instruments such as the countercyclical capital buffer. In June 2014, the ESRB issued a recommendation on how to set countercyclical capital buffer rates. Decisions should be guided by the objective of protecting the banking system against potential losses associated with a build-up of cyclical systemic risk. Thereby, they would support the sustainable provision of credit to the real economy throughout the financial cycle. The recommendation advises on how authorities should use the deviation of the ratio of credit-to-GDP from its long term trend as a common starting point in guiding decisions, in particular for the build-up phase. It also identifies cases when other indicators should be used, like measures of stress in bank funding markets, and indicators of general systemic stress (in particular for the release phase). Against this background, the first countries have notified the ESRB of the introduction of a countercyclical capital buffer rate – this stands at 1% in Sweden and at 0% in the Czech Republic, Slovakia and the United Kingdom.

The ESRB also reviewed a recommendation addressed to Member States aimed at creating a common framework for national macro-prudential authorities. This recommendation has helped establishing institutional competence at the national level and improving the effectiveness of the macro-prudential function. In general, the ESRB is satisfied with the degree of implementation. But I would encourage those Member States where the implementation process has been lagging behind ‒ i.e. Italy, Luxembourg, Poland, Romania and Spain ‒ to step up their efforts and put into place national legislation as soon as possible.

Across the EU, different institutional models have been used. In most cases macro-prudential powers have been attributed to the central bank (as recommended by the ESRB), in some cases to the supervisory authority, and in a few cases to committees chaired by the government or to the government directly.

Over the past year, Member States have actively made use of the new macro-prudential framework. The ESRB has taken a close look at around 30 national macro-prudential measures.

Broadly speaking, the measures implemented seem to be of two types: those aimed at addressing excessive credit growth and leverage, and those tackling the systemic risk arising from banking groups that are large and complex.

The countercyclical capital buffer that I mentioned earlier belongs to the first category. While this buffer is helpful regarding credit developments in general, it is less suited to address credit developments limited to specific sectors, such as real estate. Consequently, several Member States have implemented measures aimed specifically at the real estate market. For example, in Belgium and Sweden, banks are required to set aside more capital for mortgage lending. In contrast, other Member States, such as Hungary, Ireland and the United Kingdom, have introduced stricter criteria for borrowing, such as limits on loan-to-value, loan-to-income and debt service-to-income ratios.

The second category of measures focuses on solving the "too big to fail" problem, mainly by introducing higher capital requirements for banks likely to threaten the stability of the financial system in case of failure. Member States such as the Czech Republic, Denmark, Croatia and the Netherlands have followed this route.

Looking ahead

Mister Chair, Honourable Members, let me conclude with a brief look into the future. Now that the EU-wide stress test has been completed, I would like to focus in particular on risks outside the banking sector.

Market participants and authorities across the world are devoting increasing attention to the risk that normal cyclical volatility in financial markets might be artificially amplified by insufficient liquidity in some pockets of those markets. Liquidity services are typically supplied by specialised market-makers who for that purpose hold an inventory of the securities that are traded. A number of factors have led to a reduction in those inventory holdings. Technology permits market makers to roll-over lower inventory holdings at higher speed, for instance through high frequency trading. Higher competition may also have led to holding lower inventories, as market making is now considered as an autonomous business centre and is not always profitable in all market niches. Finally, the multiplication of trading venues (through technology and regulation) implies that the same inventory often serves multiple venues, each with its own features. In contrast, the demand for liquidity services has increased above all due to the increasing importance of asset managers. Both passively and actively managed assets require higher liquidity services: passively managed strategies (like Exchange Traded Funds – ETFs) because asset managers need to track market movements by buying or selling assets; actively managed assets because of a tendency to trade more frequently.

As a result, with less supply and more demand effective market liquidity may have become thinner in a number of markets. Interconnected asset markets can then easily propagate such liquidity shocks. In recent weeks, a number of sudden market movements – originating in the US and propagating in EU markets – had this nature. The ESRB will investigate this issue further, and I anticipate that I will be able to brief you on the results of our work at the next meeting.

Finally, I would like to note that we will publish a report early next year on the regulatory treatment of sovereign exposures. It is, to my knowledge, the only study conducted by an official institution on the systemic vulnerabilities arising from sovereign exposures. It will provide a good overview of the current and future regulatory framework, the specific risks, the scale of banks' and insurers' exposures to sovereigns (also benefiting from recent data published on the occasion of the last stress test) and the possible economic consequences thereof. The report will also identify possible policy responses that could be applied in the medium term.

Thank you very much for your attention.