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

Opening remarks by Christine Lagarde, Chair of the ESRB, at the ECON committee of the European Parliament (by videoconference)

Brussels, 8 June 2020

Madam Chair,

Honourable Members of the Committee on Economic and Monetary Affairs,

Ladies and gentlemen,

It is a pleasure to appear before this Committee for the first time in my capacity as Chair of the European Systemic Risk Board (ESRB).

The ESRB has always had a strong relationship with this Committee. You played a crucial role in establishing the ESRB in 2010, and you have drawn its attention to many important issues (including the impact of climate change and the role of the International Financial Reporting Standards for financial stability). You have also greatly contributed to the strengthening of the institutional framework of the ESRB, which took effect at the end of last year. As part of this process, we are delighted to have implemented enhanced accountability and transparency measures. It is important that the ESRB clearly explains its actions to the European citizens, legislators and financial sector, particularly in these difficult times.

This brings me to the main topic of my opening remarks. I would like to explain how the ESRB has responded to the challenges posed by the coronavirus (COVID-19) pandemic.

There is no doubt that we have been confronted with a crisis the likes of which we have never seen in peacetime. All parts of Europe are affected and challenged. This time the shock does not come from the financial system; it is a devastating health emergency that threatens people’s lives, the businesses in which they work, the economy as a whole, and therefore also the financial system. Moreover, in a crisis of such scale, to prevent an even sharper loss of capacity and jobs in the economy we need to ensure that the financial sector continues providing its vital services to firms and households. In other words, while the financial sector is not immune to the shock, it needs to be able to help absorb it, rather than amplify it. Let me briefly discuss the risks to financial stability that we are concerned about.

First, this severe economic shock could trigger widespread defaults in the real economy, especially among firms and household which were already overindebted. While measures taken by governments and at the EU level can help to mitigate the negative effects of the COVID-19 pandemic on the real economy, the depth of the recession calls for developments in this area to be closely monitored. Second, despite a recent rebound in asset prices, there are still risks related to high volatility in financial markets given the substantial degree of uncertainty about the path the recovery will take. Third, as a result of the support measures taken by governments and the reduction in economic activity, concerns about government debt levels may re-emerge. And fourth, the difficult macroeconomic environment I just described poses significant challenges to financial institutions. Obviously, all the risks I just mentioned will be aggravated if we face a second wave of the pandemic.

The ESRB has responded to this emergency with a set of actions in five areas.

The first area is linked to the concerns about widespread defaults in the real economy. First and foremost, it is important that the real economy receives all the liquidity support it needs. At the same time, we need to take into account all the intended and unintended implications of the fiscal measures on the financial system. For example, measures implemented in one country may have positive or negative spillover effects on other countries. It is therefore important that macroprudential authorities monitor the implications of support measures at the national level, and that the ESRB in particular looks into any cross-sector and cross-border issues that may arise. I am glad to announce that the ESRB is today publishing a Recommendation that establishes minimum requirements for the national monitoring of such measures by macroprudential authorities and creates a framework for reporting to the ESRB.

The second area focuses on the concerns about market liquidity. The sharp drop in asset prices that occurred at the onset of the coronavirus pandemic was accompanied by significant redemptions from some investment funds and a deterioration in financial market liquidity. Investment funds with significant exposures to corporate debt and real estate assets were particularly affected. In that context, the ESRB adopted a Recommendation addressed to the European Securities and Markets Authority that it coordinate with the national competent authorities on focused supervisory engagement with the two corresponding sectors of investment funds. This will provide a better understanding of how well these funds are prepared for the conditions I just described, and help to determine steps that could be taken to enhance their preparedness. In the same vein, the ESRB asked the European Insurance and Occupational Pensions Authority (EIOPA) to promptly finalise the liquidity monitoring framework for insurers, which EIOPA and its members had already begun preparing as a response to the COVID-19 crisis.

The third area concerns the potential wave of credit rating downgrades in the corporate bonds sector and the fire sales this might cause. From a macroprudential perspective, it is important to ensure that the implications of these credit rating downgrades are well understood and do not impair the functioning of financial markets. To this end, the ESRB, together with its member institutions, continue to monitor the developments in this regard across the financial system.

The fourth area is linked to the concern that losses in the real economy will impair the functioning of the financial system precisely when its role of providing credit is most vital. There is therefore a need to boost financial institutions’ resilience. This can be achieved by restricting distributions (dividend payments, share buy-backs and variable remuneration) in vital sectors of the financial system. From a market perspective, restrictions of this nature can also help to remove the potential stigma attached to financial institutions that decide to preserve their capital resources in these times of crisis. The ESRB believes that a uniform approach is needed across the crucial segments of the financial sector and across the EU. This is why it is today issuing a Recommendation on the restriction of distributions during the COVID-19 pandemic. This Recommendation covers banks, certain investment firms, insurers, reinsurers and central counterparties and envisages distributions being restricted until January 2021. Furthermore, the Recommendation outlines guiding principles on payout restrictions within cross-border groups. As demonstrated in some instances during the previous crisis, flight to safety or a home bias might transform into a collective action problem: if all financial institutions withdraw their resources from host countries that are dominated by subsidiaries of cross-border financial institutions, local lending will be undermined. While the current crisis should not serve as a reason to suspend the rules of the Single Market principle of free movement of capital, there may be grounds for asking financial institutions and relevant authorities to carefully monitor developments in the financial sector and the real economy, in both home and host countries, and factor those developments into their decisions. The Recommendation therefore advocates that home and host authorities maintain a close dialogue. With this Recommendation the ESRB is supporting and complementing initiatives from the European Central Bank, the European Banking Authority, EIOPA and national authorities.

The fifth area focuses on the liquidity risks arising from margin calls. The COVID-19 pandemic has caused a sharp drop in asset prices and has increased volatility, resulting in large margin calls across both centrally cleared and non-centrally cleared markets. While the system was able to withstand these conditions, it is important to enhance its resilience for potential future periods of stress. Margin calls could increase further due to potential credit rating downgrades, which I have already discussed, and possible further market volatility. Such conditions could have negative implications for the liquidity management of market participants, such as clearing members and their clients, for their funding needs, and possibly even for their solvency if the liquidity stress leads to systematic fire sales of assets. Therefore, the ESRB is today publishing a Recommendation aimed at limiting cliff effects in relation to the demand for collateral in centrally and non-centrally cleared markets, enhancing central counterparty liquidity management, and reducing liquidity constraints related to margin collection. Moreover, with this Recommendation the ESRB intends to promote international standards related to the mitigation of procyclicality in the provision of client clearing services and in securities financing transactions.

While preparing our response to the COVID-19 pandemic, we have not lost sight of our medium-term priorities. I am very glad to announce that today the ESRB is also publishing a report on financial stability risks related to climate change. The pandemic has made us all aware of the need to ensure our financial systems are resilient when faced with large shocks that affect not only our economies, but also our wellbeing more generally. The costs associated with climate change appear inevitable, yet the financial markets are not fully pricing in this risk. One major impediment is linked to climate-related disclosures, which remain insufficient, incomplete and inconsistent. The European Commission’s ongoing consultation is very timely and welcome here. In the meantime, we have also been looking into the exposures of European financial institutions to climate-related risks based on the currently available information we have managed to collect. These exposures appear to be limited, on average, but concentrated exposures in a few sectors and firms could give rise to systemic risk. The ESRB and its member institutions are continuing their work in this area, notably on constructing forward-looking scenarios, and I am sure we will come back to this topic during our future meetings.

Thank you very much. I am now available for questions.