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

Introductory statement by Mario Draghi, Chair of the ESRB,
Brussels, 28 November 2016

Mr Chair,

Honourable Members of the Economic and Monetary Affairs Committee,

Ladies and gentlemen,

It is a great pleasure to update this Committee on the work of the European Systemic Risk Board, in my capacity as Chair of that body.

Since we last met, the ESRB has published its Annual Report, which covers the period between 1 April 2015 and 31 March 2016. This Report not only presents the ESRB’s risk outlook and examines the focus of its macroprudential analysis, but also offers an institutional overview of the discretional policy measures taken under CRD IV/CRR, and includes the follow-up to the previous ESRB recommendations.

Today, however, I would like to discuss the most recent activities of the ESRB, putting them into the wider context of what the ESRB was set up to achieve.

The ESRB was designed as an independent body tasked with the macroprudential oversight of the EU financial system as a whole. Our broad, system-encompassing mandate is mirrored by our broad membership – the ESRB brings together central bankers, financial supervisors, the European Supervisory Authorities, the European Commission and the Economic and Financial Committee as well as the independent voice of academics, who are represented on the ESRB Advisory Scientific Committee. This set-up is crucial for the ESRB to be able to fulfil its mandate, since it has no binding powers but relies on soft powers and peer pressure.

I would now like to turn to our recent activities, which are good demonstrations of how the ESRB delivers on its priorities.

I am pleased to announce that, today, the ESRB is publishing a report on the macroprudential policy issues arising from low interest rates and structural changes in the EU financial system. The ESRB plays an important role as a forum for cooperation among institutions that contribute to preserving financial stability across the European Union. The report has been jointly produced by the Advisory Scientific Committee and the Advisory Technical Committee of the ESRB and the Financial Stability Committee of the ECB, and is an excellent example of successful cooperation among ESRB members.

When we last met I mentioned that the aim of our work in this regard was to assess the financial stability implications of low interest rates from a truly systemic viewpoint. Therefore, the report takes a holistic approach, covers all major sectors in the financial system and takes into account cross-sectoral spillovers and contagion channels when examining the risks and potential policy options.

The report groups the risks identified together into the following three areas: (first) the sustainability of business models; (second) broad-based risk taking; and (third) risks related to changes in the structure of the financial system. While there is some evidence that financial stability risks related to the sustainability of business models, and, to some extent, those related to broad-based risk taking may develop over time as growth and interest rates remain low, risks related to changes in the financial system’s structure are of a more conjectured nature.

Let me briefly outline the risks in the three areas I have just mentioned.

As regards the sustainability of business models, an environment of prolonged low interest rates puts pressure on the profitability and solvency of financial institutions which offer guaranteed returns (guaranteed return life insurers and defined benefit pension funds). A sustained low interest rate environment may also be weakening the resilience of the EU banking sector over time, as it is one of the factors negatively affecting banks’ profitability due to the downward rigidity in deposits rates and the reduced net interest income. At the same time, in an environment of prolonged low economic growth, stronger loan growth may not able to compensate for the declining net interest margins. Furthermore, there are also limits to the extent other sources of income can compensate for the decline in interest income, over a longer horizon.

Moreover, financial stability risks related to financial markets may increase in a prolonged low interest rate environment as a result of the search for yield. This may be the case if the search for yield results in (i) a build-up of leverage; (ii) crowded positions in risky assets; and (iii) uncertainty regarding fundamental asset price values. As a consequence, the risk of asset re-pricing may materialise and expose the balance sheets of market participants to revaluation risks.

Finally, the low interest rate environment is likely to accelerate the transition towards a more market-based structure. While the shift of activities towards the non-banking sector entails the benefit of a “spare-wheel function”, that is, an alternative source of finance for the real economy in the event of shocks to the banking sector, it also carries with it a risk of higher sensitivity to market shocks.

The ESRB report also presents a series of policy options to mitigate and prevent the materialisation of the financial stability risks described. It is important to consider policy options from a holistic and system-wide perspective, in particular given the interrelations between the risks and the need to mitigate regulatory arbitrage. In general, the ESRB policy options focus on (i) increasing the resilience of financial institutions, including to the risk of re-pricing; (ii) enhancing the framework for the resolution of financial institutions; and (iii) improving the monitoring of risk taking.

Nevertheless, the policy options discussed in the report should not be understood as ESRB recommendations, but rather as a set of proposals for further consideration by the relevant stakeholders. The policy options include measures that could be implemented in the short term, and which in some cases are already being included in existing ESRB work (such as, for example, work towards developing a recovery and resolution framework for insurers, which I have mentioned on earlier occasions), as well as in longer-term projects that aim to identify, assess and mitigate systemic risk.

The ESRB report also underlines the need to close the remaining data gaps. There is no doubt that regulatory reforms implemented in recent years have significantly improved the availability of data for the purposes of supervisory monitoring in a number of sectors of the EU financial system. However, some remaining data gaps need to be closed and macroprudential risk monitoring needs to be enhanced in cross-institutional cooperation, making full use of existing and future data sources (for example, under EMIR and AIFMD). In particular, disclosure requirements and the understanding of leverage (for example as regards investment funds) and funding positions need to be improved significantly, as does information about collateral re-use. This is essential in order to identify spillover channels and critical nodes in the interconnected financial system. Finally, the monitoring of financial and real asset valuations should be stepped up.

Bearing all that in mind, I am pleased to announce that the ESRB is already taking action aimed at closing real estate data gaps. Today, it is publishing a recommendation, which covers both the residential and commercial real estate sectors. With this recommendation the ESRB aims to establish a more harmonised framework for monitoring developments in real estate markets in the European Union. The recommendation provides a common set of indicators that national macroprudential authorities are recommended to monitor when assessing risks originating from the real estate sector along with working definitions of those indicators. The ESRB will monitor compliance with the recommendation by means of an “act or explain” procedure. The deadline for implementing this recommendation is end-2020.

Moreover, the ESRB is publishing eight country-specific warnings on medium-term vulnerabilities in the residential real estate sector. The warnings are addressed to the relevant ministers in eight Member States, namely Austria, Belgium, Denmark, Finland, Luxembourg, the Netherlands, Sweden and the United Kingdom.

The ESRB has a legal mandate to issue warnings when significant systemic risks are identified and to flag up such risks when necessary. The ESRB decided on 22 September 2016 to issue the eight warnings and to make them public following a Union-wide assessment of vulnerabilities relating to residential real estate. The ESRB analysis was forward-looking, with the aim of identifying vulnerabilities that are a source of systemic risk to financial stability in time for measures to be taken to mitigate the risks or their impact, should they materialise. The ESRB assessed all Member States, took account of the vulnerabilities and trends that have the potential to disrupt financial stability within a period of around five years, and concluded that significant vulnerabilities prevail in those eight Member States.

The key vulnerabilities highlighted by the ESRB assessment relate to household indebtedness and the ability of households to repay their mortgage debt as well as to valuation and price dynamics in residential real estate markets. Household indebtedness and the overvaluation of residential real estate develop over the course of years; it usually takes time before they build up to critical levels but, in the event of a shock, the related vulnerabilities can materialise quickly – for example, in the form of reduced household consumption, loan defaults and price falls.

As regards the banking system of the warned countries, the ESRB has not identified direct near-term risks arising from residential real estate exposures, although second-round effects are not excluded in the medium term. Moreover, Member States have taken steps to ensure the resilience of their banking sectors, for example through the increase in bank capital requirements in recent years.

The underlying sources of the residential real estate-related vulnerabilities differ among the eight countries in question and the ESRB warnings are designed to help Member States in tackling those issues, which are mostly country-specific. Even though the vulnerabilities identified are generally not expected to materialise in the short run, policy measures could still be taken soon, since macroprudential and other economic policy measures are more effective when introduced in good time.

Let me conclude by saying that, going forward, the ESRB will continue to exercise its mandate of macroprudential oversight of the financial system in the European Union, including identifying country-specific financial stability vulnerabilities. Its institutional set-up allows the ESRB to exercise peer pressure and work against inaction bias – this includes issuing warnings if a significant systemic risk to financial stability is identified and needs to be flagged up, and issuing recommendations for remedial action.

Thank you for your attention. I am now available for questions.