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

Introductory statement by Christine Lagarde, Chair of the ESRB at the ECON Committee of the European Parliament (by videoconference)

Frankfurt am Main, 19 November 2020

Madam Chair,

Honourable Members of the Committee on Economic and Monetary Affairs,

Ladies and gentlemen,

I am glad to be back before the Committee for the second time this year in my capacity as Chair of the European Systemic Risk Board (ESRB). When we last met, on June 8, I explained that the initial impact of the coronavirus (COVID-19) pandemic exposed some pre-existing vulnerabilities in the non-banking sector. At that time, I highlighted the ESRB’s initial response to these challenges. In my opening remarks today, I would like to start with a brief overview of our actions since then.

In June I explained that one of the issues we were concerned about was the potential wave of credit rating downgrades in the corporate bonds sector and the implications for financial stability such downgrades would have. To this end the ESRB conducted a top-down sensitivity analysis[1] to assess the market impact of a large volume of sales of downgraded corporate bonds. We used an innovative set of models that combined quantitative measures of cross-sectoral portfolio overlaps with different behavioural assumptions. Our findings revealed that such sales could be a significant amplifier of stress but that in isolation they are not sufficient to generate financial instability.[2] At the same time, our system-wide analysis revealed interdependencies and vulnerabilities between sectors and countries. This highlights the importance of a cross-sectoral and cross-jurisdictional dialogue between policy makers, which is the main institutional mission of the ESRB.

Last time we met I also explained that the sharp drop in asset prices that occurred at the onset of the coronavirus pandemic was accompanied by large redemptions from some investment funds and a deterioration in financial market liquidity. In that context, the ESRB adopted a Recommendation inviting the European Securities and Markets Authority (ESMA) to coordinate a supervisory exercise by its members. We suggested that this joint exercise should focus on the two segments of investment funds which were particularly affected at the onset of the pandemic. These were investment funds with significant exposures to corporate debt and real estate assets. ESMA has already followed up on the ESRB Recommendation and identified important areas of weaknesses that need to be addressed. First, some funds presented potential liquidity risks and deficiencies in their liquidity risk management or valuation processes. Second, only a few funds have adjusted their liquidity processes in light of the liquidity issues encountered. ESMA has already determined steps to address these issues. These steps will make sure funds are better prepared for potential future adverse liquidity and valuation shocks, and I would like to thank ESMA for its prompt reaction.

More generally, investment funds have become an increasingly important part of the EU financial system and the ESRB published its annual monitoring report last month.[3] I am glad to note that many of the areas for further work that were identified by the ESRB in this report are also on the international agenda of the Financial Stability Board.[4] This includes risk in money market funds, where some market segments saw high outflows earlier this year.

The ESRB also drew some initial lessons from the stress episodes of March and April with regard to the insurance sector. I have highlighted these lessons in a letter to Vice-President Dombrovskis in order to inform the upcoming review of Solvency II. Let me highlight two points today.

The first point relates to liquidity risk. In contrast to banks, insurers’ business models are not built on taking liquidity risk. Certain activities of insurers, such as managing risks through derivative positions, can, however, be a source of liquidity tension. During the period of heightened market volatility earlier in the year, we observed large variation margin calls on insurers’ derivative positions, which strongly correlated with outflows from money market funds. Insurers may thus have contributed to spillovers across financial markets. This shows that there is a need to strengthen the liquidity requirements of Solvency II and grant supervisors the power to impose liquidity buffers on insurers with a vulnerable liquidity profile.

The second point I would like to mention is that in some jurisdictions, insurance supervisors resorted to ad-hoc solutions to smooth the impact of the sharp falls in asset prices during the market turmoil in March. They used measures available to them that were, however, not designed for this purpose. Once granted to insurers, these measures cannot be easily reversed and will continue to provide capital relief for the next ten years. We therefore see the case for improving the existing countercyclical mechanisms in Solvency II and for symmetric tools that build capital in good times which can be released against losses during crisis.

Let me now turn to the ESRB assessment of the main risks to financial stability in the EU, focusing on banking issues. The resurgence of COVID-19 infections has, obviously, further raised uncertainty and risks to EU financial stability. Swift and unprecedented policy measures during the crisis have provided crucial support to households and businesses, and have successfully helped contain the impact of the crisis. Nonetheless, many businesses are confronted with impaired cash flows, weak earnings and rising indebtedness. The longer the crisis lasts, and the weaker the recovery is, the higher the risk of a perceptible rise in bankruptcies will be. With the crisis becoming more protracted, it is important that liquidity risk does not turn into solvency risk.

These vulnerabilities will take time to manifest themselves on bank balance sheets—not least on account of the widespread use of debt service moratoria. But ultimately, the deteriorating quality of bank assets and the concomitant rise in provisions will take a toll on banks’ profitability and capital positions. By shifting risks to the public sector, government loan guarantees are mitigating the impact of deteriorating asset quality on bank balance sheets. But the share of government-guaranteed loans in total loans to non-financial corporations differs significantly from country to country. Moreover, while some governments have already extended the duration of loan guarantees or are considering doing so, potential cliff effects from their expiration are looming.

While banks in the EU have increased their resilience since the global financial crisis, the prospective deterioration in asset quality coincides with pressures on profitability and persistent structural problems, including high cost-to-income ratios, and in some cases, legacy issues related to non-performing loans. The return on equity of euro area banks declined from over 5% in the fourth quarter of 2019 to only slightly above 2% in the second quarter of 2020. While this was in part driven by higher loan loss provisions, these still remain below levels observed during previous crises.

To overcome the crisis as swiftly as possible, we need a sound banking system. This is why it is crucial for banks to recognise and provision for potential future credit losses. Moreover, it will be essential to prepare a strategy for resolving new non-performing loans, including through asset sales, loan restructuring, write-offs and asset management companies, where appropriate. The current crisis could also provide an opportunity to address some of the long-standing weaknesses of the EU banking sector by accelerating restructuring and consolidation. Finally, it may also be important to use retained earnings—which in part reflect the indirect effects of policy support measures—to strengthen banks’ resilience.

As you may recall, the ESRB Recommendation of June 2020[5] restricts distributions by banks, investment firms, insurance companies and central counterparties until 1 January 2021. We are currently carefully weighing up all the arguments for and against further action from a financial stability perspective, taking into account the consequences for all segments of financial markets. This assessment is being conducted in full coordination with all ESRB member institutions, which of course also includes microprudential authorities. The General Board of the ESRB will decide on this issue in December.

Before I conclude, I’d like to point out that the ESRB has not lost sight of its medium-term priorities. Clear identification of the individual entities and the connections between them is a key requirement for drawing a reliable map of the economic and financial landscape, which is necessary in order to reduce contagion. However, the EU lacks a uniform approach to the use of the legal entity identifier (LEI) across markets. Furthermore, the adoption of the LEI by non-financial sector entities is limited. This leads to a fragmented coverage, with important sectors being excluded. To address this issue the ESRB has recently adopted a Recommendation on identifying legal entities. With this Recommendation the ESRB calls for the introduction of an EU legal framework to uniquely identify legal entities engaged in financial transactions and to make the use of the LEI more systematic.

I would now like to conclude by stressing that the current situation requires continued and comprehensive policy support. The European response to the crisis has already demonstrated how important cooperation and communication between policymakers at all levels is. I believe that your contribution to tackling this crisis has been crucial and that we should continue our joint efforts in fighting the crisis as well as maintaining an open dialogue. I am convinced that together we will find all the necessary solutions. The ESRB is about to enter its tenth year of operations, and we recently published our ninth Annual Report. Going forward, the ESRB will continue to contribute to preserving financial stability in the EU in line with its mandate.

I now look forward to our discussion.

  1. A system-wide scenario analysis of large-scale corporate bond downgrades.
  2. Overall, our analysis showed that in a severe mass downgrade scenario with a corresponding yield shock, initial losses from repricing could amount to €150 billion-€200 billion across the entire financial system. Fire sale losses stemming from distressed market reactions could add another 20%-30% to these losses, depending on some further assumptions.
  3. EU Non-Bank Financial Intermediation Risk Monitor 2020.
  4. Holistic Review of the March Market Turmoil, November 2020.
  5. Recommendation of the European Systemic Risk Board of 27 May 2020 on restriction of distributions during the COVID-19 pandemic (ESRB/2020/7).

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