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

Introductory statement of Mario Draghi, Chair of the ESRB, Brussels, 20 November 2017

I am very pleased to be back speaking to your committee in my capacity as Chair of the European Systemic Risk Board (ESRB), for the second hearing of this year.

Since we last met, the ESRB has published its sixth Annual Report, which covers the period between 1 April 2016 and 31 March 2017. This Report presents the ESRB’s risk outlook, examines the focus of its macroprudential analysis and discusses its contributions to the EU macroprudential policy framework. It also includes the follow-ups to the previous ESRB recommendations. During our last two meetings I updated you on the most important issues, which are covered by the Annual Report. Therefore, in my remarks today I would like to concentrate on four topics:

  • developments in the macroprudential policy framework, in particular as regards countercyclical capital buffer and real estate instruments;
  • the ESRB’s report on the financial stability implications of the new International Financial Reporting Standard 9 (IFRS 9);
  • the ESRB’s contributions to the policy framework beyond banking; and
  • the ESRB’s work to shed light on the derivatives markets.

Let me start with the countercyclical capital buffer, a time-varying component of banks’ capital. This buffer allows macroprudential authorities to adopt a dynamic approach to making banks more resilient. They can increase banks’ capital requirements in good times, to curb rising risks, and release additional buffers during a downturn. The countercyclical capital buffer is also designed to counter the potential amplification of shocks. By and large, the financial crisis has shown that steps taken by banks to strengthen their balance sheets in a downturn can constrain credit supply to the real economy. This, in turn, exacerbates the economic downturn and further weakens their balance sheets as credit risk materialises. Releasing the countercyclical capital buffer will alleviate pressures on banks’ balance sheets in an economic downturn and make it easier for them to provide credit to the real economy.

We have already seen several macroprudential authorities activating this macroprudential tool. Sweden did so in 2015, for example. This year the Czech Republic and Slovakia have further increased the buffer rate, while the United Kingdom has announced that it will activate the buffer in 2018. If we look at the European Economic Area as a whole, the number of countries using this macroprudential tool increases to six, with Norway and Iceland[1] tightening their macroprudential policy in this regard.

In 2014 the ESRB issued a recommendation[2] providing authorities with guidance on setting countercyclical buffer rates. This recommendation underlined how important it is for the authorities responsible for setting the buffer rate to have a good communication strategy. While the policy decisions regarding countercyclical capital buffer rates are still rather new, such communication does more than just increase the predictability of macroprudential policy decisions – it also enhances the ex ante policy signalling and helps manage expectations.

As regards the real estate sector, we discussed ESRB country-specific warnings on vulnerabilities in the EU residential real estate sector, as well as the ESRB Recommendation[3] on closing real estate data gaps, when we met last November. Since then Member States have further enhanced their policy framework (for example in Austria[4]) or taken additional measures for the residential real estate sector (for example in Finland[5]). A large majority of Member States now have some measures in place that target risks in residential real estate, and many of them use several instruments in their policy mix, for example using borrower-based macroprudential measures in addition to those that increase the resilience of lenders.

Currently, the ESRB is conducting a risk analysis of EU commercial real estate markets. The analysis confirms that significant data gaps exist for the sector, hampering macroprudential monitoring. Therefore, I would strongly encourage the relevant authorities to work towards implementing the ESRB recommendation.

The ESRB continues to monitor risks to the EU financial system and remains the main forum for European authorities to coordinate measures, share experiences and conduct peer reviews.

Financial stability implications of the International Financial Reporting Standard (IFRS) 9

Let me now turn to the main findings of the ESRB report on the financial stability implications of IFRS 9.[6] As you may recall, this report was triggered by questions put to us by this Committee.

The most important change introduced by IFRS 9 is the shift from an incurred loss approach to an expected credit loss approach for measuring impairment allowances. This means that banks will have to recognise impairments earlier, curtailing excessive forbearance towards non-performing loans (NPLs) and helping ensure that the banking sector can be repaired in a timelier and more comprehensive manner in future downturns. A prompt and forward-looking recognition of credit losses addresses the criticism of the “too little, too late” provisioning resulting from the incurred loss approach. If a downturn can be identified in good time, procyclicality may be reduced and the credit contraction may be less severe. Early loss recognition may also reduce market concerns about capital adequacy in a crisis, and is typically regarded as positive in terms of enhancing transparency and the effectiveness of market discipline. For these reasons the report concludes that IFRS 9 is a major improvement, particularly regarding accounting for NPLs.

However, the expected credit loss approach also means that banks will have to react to new and forward-looking information as it is received when accounting for impairment of assets. This means that impairment allowances may increase suddenly and significantly when economic conditions deteriorate, which could have certain procyclical effects. This would depend on several factors, including:

  • first, the extent to which the downturn can be anticipated by the expected credit loss models of banks (hence the relevance of developing good and sound models);
  • second, the sectoral and geographical diversification of the loans on banks’ books (in other words, their sensitivity to the cycle); and
  • third, the maturity of these loans.

The ESRB report considers a number of policies that could address such procyclical effects. For example, stress testing could be used as a means to gauge the variation in impairment allowances associated with adverse scenarios, in order to ensure that sufficient capital buffers are in place and to allow for remedial policy action if required. If banks can withstand a hypothetical adverse scenario, they would likely be able to cope with the early recognition of expected credit losses under a real downturn, as required by IFRS 9.

ESRB activities beyond banking

I would also briefly like to discuss our activities regarding the non-banking part of the financial sector. When we last met, I underlined the importance of a sound recovery and resolution regime for central counterparties (CCPs), which have become critical hubs in the financial system. Legislation in this area is progressing, and the ESRB contributes to this process by identifying areas that could be improved to better address macroprudential considerations. For example, the ESRB opinion on the draft Presidency proposal[7] underlines the need for cooperation and coordination between resolution authorities for banks and CCPs, as a CCP would typically get into difficulty as a result of one or more banks that are clearing members of this CCP becoming distressed.

Furthermore, creating a harmonised recovery and resolution framework for the insurance sector across the EU is also important. Ordinary insolvency procedures may not always be consistent with policyholder protection and financial stability objectives. This means that they may not be sufficient to manage the failure of a large insurer or the simultaneous failure of multiple insurers in an orderly fashion. The Netherlands and France are in the process of developing such frameworks after experiencing the near-failure of some financial conglomerates during the global financial crisis.[8] Furthermore, Romania has already developed a comprehensive recovery and resolution framework of this kind following difficulties faced by two large insurers in 2014 and 2015.

ESRB analysis and monitoring of the EU derivatives markets

Let me conclude by saying that the ESRB is also focusing on analysing and monitoring the EU derivatives markets. Thanks to the global regulatory reform, derivatives transactions must now be reported to trade repositories. The European Market Infrastructure Regulation (EMIR) has granted the ESRB access to the full EU-wide dataset of derivatives transactions compiled in trade repositories[9]. This collection of large-scale transaction-level data represents a milestone in the process of enhancing the transparency of derivatives markets for policymakers. Despite the technical and conceptual challenges that are naturally present because of the unique nature of this type of information, these data are already proving to be fundamental to our understanding of these markets from a systemic perspective. For this reason, the ESRB is specifically focusing on developing data infrastructures and analytical methods to move towards a timelier and more detailed monitoring of these markets. Our work in this regard is progressing and I hope to report back to you when we meet in the future.

Thank you. I am now available for questions.

[1] Please note that, under the European Economic Area Agreement, as amended in its Annex IX (Financial services) by Decision of the EEA Joint Committee No 198/2016 of 30 September 2016, the relevant authorities of Iceland, Lichtenstein and Norway became ESRB members, albeit with a special status.

[2] Recommendation of the European Systemic Risk Board of 18 June 2014 on guidance for setting countercyclical buffer rates (ESRB/2014/1). Available at: https://www.esrb.europa.eu/pub/pdf/recommendations/2014/140630_ESRB_Recommendation.en.pdf?83075f19bd8f21d8a3b8e6afe7bea49b

[3] Recommendation ESRB/2016/14 of 31 October 2016 on closing real estate data gaps.

[4] The Austrian Financial Market Authority will have the power to use certain borrower-based instruments, such as loan-to-value limits.

[5] The Finnish Financial Supervision Authority has introduced an average risk weight floor of 15% on residential mortgage loans.

[8] For more information, see “Recovery and resolution for the EU insurance sector: a macroprudential perspective”, available at: https://www.esrb.europa.eu/pub/pdf/reports/esrb.reports170817_recoveryandresolution.en.pdf

[9] Under EMIR, the reporting of derivatives transactions to trade repositories is mandatory for transactions in which at least one counterparty resides in the EU. This applies to non-financial counterparties and all financial counterparties, including CCPs. EMIR grants the ESRB and the European Securities and Markets Authority exclusive access to the full EU-wide dataset of the derivatives transactions.