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)

Frankfurt am Main, 1 July 2021

Madam Chair,

Honourable Members of the Committee on Economic and Monetary Affairs,

Ladies and gentlemen,

It is a pleasure to address you for the first time this year in my capacity as Chair of the European Systemic Risk Board (ESRB). I would like to start by updating you on how our assessment of financial stability risks has evolved since we last met, focusing on the impact of the pandemic on non-financial corporates. I will then highlight two important reports which the ESRB is publishing today: one on money market funds and the other on climate risk monitoring.

Since the start of the pandemic we have been concerned that this devastating health emergency could be further aggravated by a financial crisis. If the financial system was impaired, precisely at a time when its role of supporting the real economy was most vital, this crisis would last longer and be more costly, both socially and economically.

Swift fiscal and monetary policy response has cushioned the real economy, particularly by easing liquidity strains, and has reduced the risk of spillover to the financial sector. Negative feedback loops between the real and financial sectors have [so far] been avoided, also thanks to a decisive supervisory response.

Governments have also been extending and adjusting their national support measures to avoid a cliff effect, i.e. the simultaneous phasing-out of measures before the recovery is fully entrenched. As you may recall, this was one of the ESRB’s major concerns at the beginning of the year. Our reporting framework shows that the national support measures that were announced, excluding moratoria, amounted to 18.7% of GDP[1] in March 2021. This support, most of which is in the form of public guarantees, is far from being exhausted, with uptake reaching 6.9% of GDP in March 2021 (up from 5.7% in December 2020). At the same time, moratoria schemes are expiring and their uptake has declined to 2.4% of GDP from 3.3% in December 2020.

The improved economic outlook on the back of rapid progress in vaccination campaigns has reduced the probability of severe scenarios. Against this background, the ESRB General Board last week noted that if economic and financial sector conditions do not deteriorate materially, our Recommendation on restriction of distributions during the COVID-19 pandemic could be allowed to lapse at the end of September 2021. The General Board will consider this matter at its next meeting on 23 September 2021.

Of course, the nascent recovery still faces uncertainty also due to the spread of virus mutations. In the current phase of the pandemic, our concerns about financial stability are shifting from liquidity risks in the non-financial corporate sector to balance-sheet vulnerabilities in that very same sector. Strong loan growth in the early phase of the pandemic, helped by generous liquidity support measures, has resulted in higher corporate indebtedness. This is especially true for small firms and vulnerable sectors. For example, in the sectors most affected by the pandemic, the share across euro area countries of corporate bank debt over firms’ total assets increased from around 26% to above 31% over a one-year period. This also enlarged banking sector exposure to those corporates, which is a natural consequence of the bank-based structure of the EU financial system and the design of the support measures.

It is important to prevent that the combination of high debt and weaker profits, especially in the sectors hardest hit by the crisis, leads to corporate insolvencies for corporates which are viable in the medium term. Otherwise, this could drive up the social and economic cost of this crisis and, as a second-round effect, also increase riskiness in banks’ loan portfolios. It is equally important to deal efficiently with the insolvencies of unviable firms, so that the resources can be reallocated more productively.

We are still ahead of the curve in respect of debt-related vulnerabilities of non-financial corporates, also since the national support measures are being extended. But these vulnerabilities need to be closely monitored by banks, by all supervisory authorities, both at micro and macro level, and most importantly, by governments.

For banks, the priority is to fully reflect credit risk in their loan classification and provisioning in a timely manner. I am aware that the supervisory authorities are devoting much attention to this issue. Moreover, to address asset quality issues, banks may need to further enhance their capacity to manage and resolve non-performing loans, including by seeking, on a case-by-case basis, solutions for restructuring the debt of viable but overindebted borrowers.

For governments, the priority is to manage a smooth transition from liquidity support towards more targeted solvency support for viable firms. They should also develop strategies for the successful restructuring of viable firms’ corporate debt, including incentives for private creditors. Importantly, banks’ expertise in assessing corporates’ business viability can contribute to this debt restructuring process.

In the case of firms that are found to be unviable in the post-pandemic economy, governments should ensure that efficient insolvency procedures are applied and new ones developed where necessary.

These findings are summarised in recent ESRB reports[2], which serve as our contribution to the ongoing discussions. It is worth mentioning that the most recent ESRB survey among the authorities shows a heightened awareness of the need to adjust fiscal support. In fact, in the first quarter of 2021 solvency-related support increased more vigorously than liquidity support in relative terms. However, when compared with the overall size of fiscal support, liquidity support measures still dominate. The ESRB continues to monitor the financial stability implications of national support measures and I will be glad to update you on our findings at our next meeting.

The pandemic also exposed some pre-existing vulnerabilities in the non-banking sector. We plan to address financial stability risks in the money market funds sector by issuing a recommendation by the end of the year. Let me briefly highlight our motivation and initial considerations for doing so.

Money market funds are important financial intermediaries which have a dual function: they provide short-term funding to borrowers, mainly EU banks, and they also offer on-demand liquidity to investors, who consider them to be a cash equivalent. Money market funds are, in fact, not a cash equivalent, because they cannot dispose of their assets easily in all market conditions. We saw an example of this in March 2020: investors were running for cash and money market funds had problems disposing of their assets to meet redemption requests.

Against this background, we are investigating three points. First, how money market funds are used by investors. In particular, certain money market funds might find it difficult to maintain a stable net asset value under stressed conditions, which can increase outflows as investors rush to redeem their shares before they depreciate, thereby aggravating the initial difficulties. Second, how the money markets operate. The fact that these markets are not reliably liquid should affect how funds manage their assets. Finally, how money market funds operate. They should be able to function without the need for central banks to step in during a crisis.

Today the ESRB is publishing an issues note, which describes in detail the systemic vulnerabilities we have identified as well as a broad range of policy options to reform money market funds. Building on this, we will identify the best policy mix to address vulnerabilities in money market funds. I am aware that several other institutions are looking into this matter – the European Securities and Markets Authority, the International Organization of Securities Commissions and the Financial Stability Board – and we want to contribute to this debate by bringing in the systemic perspective. Ultimately, this work will result in the aforementioned ESRB recommendation which will be addressed to the European Commission in view of the money market fund regulation review next year.

I am also pleased to announce that the ESRB and the ECB are today publishing a second joint report on climate risk monitoring. We need to acknowledge that much remains to be done to better measure climate risks and enhance understanding of their transmission to the financial system. Our report is bringing us a step closer in this direction, as we continue to work diligently to fill key knowledge gaps in this area.

Let me immediately jump to our two overarching findings. First, ESRB work has yielded an extremely granular mapping of climate change to the EU financial system, underscoring an important concentration of vulnerabilities in certain sectors, regions and firms. Second, acting early offers clear net benefits − also from a financial stability perspective. Whatever the short-term costs of orderly transition may be, they will pale in comparison to the costs of unfettered climate change in the medium to long term.

These findings underline the crucial and urgent need for climate policies and economic transitions, not only to ensure that the targets of the Paris Agreement are met, but also to limit the long-run disruption to our economies, businesses and livelihoods. For its part, the ESRB will further support the ongoing policy debate by continuing, together with our members, to work to better understand the transmission of climate risks to the financial system and its timing.

Finally, I would like to note that the ESRB is today publishing its annual report, which summarises our risk assessment and contributions to the macroprudential policy framework over the period from 1 April 2020 to 31 March 2021. 

Thank you. I am looking forward to our exchange of views.

[1]Combined 2019 GDP of ESRB member countries (EU27, Iceland, Lichtenstein and Norway).