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SPEECH

Speech by Governor Stefan Ingves, ESRB hearing

Brussels, 16 May 2022

Madam Chair,

Honourable Members of the Committee on Economic and Monetary Affairs,

Ladies and gentlemen,

It is a pleasure to address you in my capacity as First Vice-Chair of the European Systemic Risk Board (ESRB). My term started in early 2020, but I have been part of the ESRB General Board since its inaugural meeting in 2011, including, for the first six years, as Chair of the Advisory Technical Committee. In other words, I have been along for the whole ESRB journey. In this time, macroprudential policy, very much thanks to the work done in your Committee and by your co-legislators, has evolved from an idea that existed mostly on paper into concrete instruments that have been widely implemented.

You invited me here today to explain how I plan to discharge my duties as the ESRB First Vice-Chair. These are difficult times for Europe. While the Russian invasion of Ukraine is first and foremost a human tragedy, it is also a severe economic shock. Therefore, I would like to start my remarks with an assessment of risks to the EU’s financial stability, touching on what we know so far about the impact of the war. And I would like to lay out what we learnt about the role of macroprudential policy when the economy is hit by a major external shock and what our priorities should be going forward.

Let me start with the first topic. Risks to financial stability have perceptibly increased since the beginning of this year as a tightening of financial conditions in the context of the ongoing normalisation of monetary policy, Russia’s invasion of Ukraine and renewed lockdowns in China is weighing on the recovery from the COVID-19 crisis. Prolonged high inflation and deteriorating growth prospects on the back of surging energy and commodity prices and supply chain disruptions are leading to an increase in the cost of financing and are reducing debt servicing capacity. The confluence of these developments and their possible mutual amplification have increased uncertainty and the probability of tail risk scenarios materialising. These developments also compound pre-existing vulnerabilities that were, in part, exacerbated by the COVID-19 crisis.

The war in Ukraine is affecting economic growth and inflation in the EU on account of weakening business and consumer confidence, rising energy and commodity prices, and further disruptions of global supply chains. This last element in particular is adding to the COVID-19-related disruptions from which the global economy has not yet fully recovered. The recent surge in coronavirus cases in China has led to an additional deterioration in this respect. These factors have compounded global inflationary pressures.

While the macroeconomic outlook for the EU is also affected, most forecasts still expect GDP growth in 2022 to be in the range of between 2% and 3%. Should such a robust growth performance indeed materialise, we might face a continued build-up of cyclical risks, most notably in the residential real estate sector in a number of European countries.

However, an assessment of financial stability risks needs to take into consideration tail risk scenarios, the probability of which has increased. Growth prospects are affected by the duration and scope of the war, the extent of the growth slowdown in China and the ripple effects that the tightening of financial conditions will have on the global economy. Moreover, second and third-round effects of surging energy and commodity prices could imply that the negative supply shock caused by the war can be larger than suggested by the share Russia and Ukraine have in global output and trade. Tail risk scenarios would imply a renewed rise in balance sheet stress for firms and households, particularly in sectors that are highly sensitive to energy and commodity prices or are still struggling with the legacy of the COVID-19 crisis on account of turnover losses and increased indebtedness. In addition, tighter financing conditions will particularly affect the debt servicing capacity of lower-rated firms.

Concerns about public debt sustainability over the longer term also persist. As a result of the pandemic shock, public debt-to-GDP ratios have increased across the EU. While this was necessary to overcome the pandemic shock, high levels of debt reduce the resilience to future adverse shocks. The impact of the war in Ukraine on growth in the EU has an additional negative effect on debt dynamics. Moreover, the war has brought about new public spending priorities, including (i) the support for refugees; (ii) expenditures to cushion the immediate effects of the commodity and food price shocks on households and corporations; and (iii) an increase in public investment to reduce the EU’s energy dependency on Russia and to strengthen its defence capacity.

The impact of the war in Ukraine on the EU banking sector has so far been contained well, reflecting generally low direct exposures to Russia, robust capital positions and the recovery in bank profitability to pre-pandemic levels. The main concern is not banks’ direct exposures to Russia or to companies directly affected by sanctions, but rather the broad-based impact of the war on economic growth.

The impact of the war in Ukraine could lead to a renewed deterioration in bank asset quality, at a time when some banks are still in the process of working out pandemic-related asset quality problems. Non-performing loans in the euro area continued to decline in the fourth quarter of 2021, but the share of IFRS 9 Stage 2 loans in total loans saw a renewed increase in the fourth quarter of 2021. In this context, it will be key to assess whether banks’ provisioning practices properly reflect the rise in credit risk on account of the direct and indirect impact of the war. Lastly, rising nominal interest rates should generally have a positive impact on bank profitability. However, this impact could – at least in part – be counterbalanced by a weakening of credit demand, potential new impairments and low interest income on portfolios of fixed-interest mortgages at low rates and with long maturities.

Let me turn to today’s second topic. What is the main objective of macroprudential policy in a time like this? The key word here is resilience. A resilient financial system does not amplify the shock but helps to absorb it. It supports the economy when it is needed most, contributing to recovery and reducing the long-term economic scarring. These are the benefits of resilience. But there are short-term costs, too, and it is our job to ensure the right degree of resilience. This is a task we are all facing: you, as co-legislators, when you draw up the rules, and we, as the EU macroprudential watchdog, when we move against a potential inaction bias. This is not an easy task, but past experience can guide us. I would now like to highlight three main points: the countercyclical dimension of the framework, the flexibility of the framework, and the importance of data quality as a public good.

The macroprudential framework needs to have a strong countercyclical dimension. We need to build capacity before systemic risks materialise. To this end, macroprudential authorities need to have the appropriate tools at hand and they need to use them proactively. Let me give you a few examples of such tools:

  • For banks – more releasable macroprudential capital buffers. This can, for example, be obtained by building up the countercyclical capital buffer earlier and in a more forward-looking manner. Authorities could also choose to set a non-zero neutral countercyclical capital buffer rate – one that is positive in a standard risk environment.
  • For insurers – more symmetric tools. They would shield capital ratios from both the negative impact of falling corporate bond prices in bad times and the positive impact of rising corporate bond prices in good times.
  • Finally, for financial markets, and in particular for derivatives markets – mechanisms ensuring that practices used to set the initial margin are not procyclical, as that would increase the magnitude of the swings in the margin, liquidity and leverage cycles.

The ESRB has put forward some proposals for these instruments and I hope that you will include them in the macroprudential toolkit. But let me stress that such a toolkit should not reduce risk-bearing capital in the financial sector.

Macroprudential policy needs to be flexible in order to respond to structural changes in the financial system and emerging risks. Risks tend to migrate to those parts of the financial system that are less regulated, or not regulated at all. A consistent approach to activities across the financial system is also key. Let me highlight an example from the real estate market: in most countries, the borrower-based measures are available for banks, but not for other institutions engaged in mortgage lending. This gap needs to be closed at the EU level: such instruments need to be available in all countries for all mortgage lenders.

Finally, we need to make substantial progress on the data quality front. Data quality is of fundamental importance – only reliable data enable us to promptly identify risks and select the best policy responses. You and your co-legislators recognised the importance of access to data: the ESRB has been given direct access to key datasets such as derivatives transactions, alternative investment fund data and securities financing transactions. Yet, fourteen years since the outbreak of the global financial crisis, we are still facing substantial and unacceptable data quality issues. I think we should be concerned for two reasons. First, financial institutions should be collecting and processing high-quality granular data for their risk management purposes. So poor data quality might be symptomatic of poor risk management. Second, poor data quality is undermining one of the key pillars of the post-crisis reforms: enhancing the transparency of the financial system to policymakers and regulators. One example can be found in the case of central counterparties and large banking groups: the low reliability of some of the data reported by these institutions is making the monitoring of a substantial part of the financial system more challenging, potentially making it impossible for authorities to identify certain risks. This has a negative impact on the stability of the financial system and thus on the reporting entities themselves. It is high time that data quality was regarded as a common good – not only by authorities but also by financial institutions. We, together with our member institutions, need to foster this approach.

Let me conclude. I think it is safe to say that our work is far from done. And frankly, it will never be done. It is just the nature of this business. The macroprudential framework is still incomplete and new challenges keep materialising, such as risks related to the non-bank sector, climate change and cyber threats, as I mentioned at the beginning. But I believe that the road that the ESRB has travelled these eleven years has made it into an institution that is able to rise to such challenges. I believe that the broad competence around the ESRB’s meeting table also makes it particularly well suited to tackle the multifaceted issues ahead, and I am proud to be contributing to this work.

I would also like to thank your Committee for the excellent cooperation with the ESRB over the years. You have brought many important topics to our attention. We also had the pleasure of welcoming a delegation from your Committee to one of our General Board meetings. Most recently, we interacted with you on two important dossiers: Solvency II and the Alternative Investment Fund Managers Directive. I am looking forward to our exchange of views today and further cooperation on macroprudential policy in the future.