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

Brussels, 20 June 2022

[Updated on 22 June 2022 at 15:15 CET.]

It is a pleasure to address you in my capacity as Chair of the European Systemic Risk Board (ESRB). Since we last met – less than a year ago – the economic landscape has shifted significantly. Therefore, I would like to start by assessing current risks to financial stability in the EU. This requires broadening the focus well beyond baseline scenarios to reflect the increased probability and severity of tail-risks. In the second part I would then like to set out the ESRB’s priorities for the macroprudential framework.

In our assessment, risks to financial stability have perceptibly increased since the beginning of this year. Changing financial conditions in the context of the ongoing normalisation of monetary policy and Russia’s invasion of Ukraine are affecting the recovery from the COVID-19 crisis. Prolonged high inflation and deteriorating growth prospects on the back of the strong increase in energy, food and commodity prices and supply chain disruptions are leading to a rise in the cost of financing and are impacting debt servicing capacity. The confluence of these developments and their possible mutual amplification have increased uncertainty and the probability of a materialisation of tail risk scenarios. These developments also compound pre-existing vulnerabilities that were, in part, exacerbated by the COVID-19 crisis.

The materialisation of tail-risk scenarios may significantly increase the risk of renewed balance sheet stress for firms and households. This particularly applies to 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, changing financing conditions will particularly affect the debt servicing capacity of lower-rated firms and firms availing themselves of loans with variable interest rates.

I am now turning to the outlook for asset quality and profitability in the EU banking sector. The impact of the war in Ukraine on the European banking sector has so far been well contained, reflecting generally low direct exposures to Russia, robust capital positions and the recovery in bank profitability to pre-pandemic levels. Our 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 and, concomitantly, credit and market risks. A renewed deterioration in bank asset quality could occur when some banks are still in the process of working out pandemic-related asset quality problems. In this context, I would like to note that, while non-performing loans in the euro area continued to decline in the fourth quarter of 2021, the share of IFRS 9 Stage 2 loans in total loans continued to increase. 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 in Ukraine. I would also like to emphasise that the profitability outlook for the banking sector is uncertain. In general, rising nominal interest rates should have a positive impact on bank profitability. However, this impact could 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 now briefly touch upon the risk of a further abrupt and broad-based correction in asset prices. Rising interest rates in combination with deteriorating growth prospects have exerted downward pressure on asset prices. These pressures were compounded by the Russian invasion of Ukraine. While the correction in asset prices has so far been orderly, the risk of a further and possibly abrupt fall in asset prices remains severe. In particular, current equity valuations seem to reflect two assumptions: (i) despite the negative growth impact of the war in Ukraine, growth rates in the major advanced economies will remain in positive territory; and (ii) central banks will be able to gradually reduce inflation rates to their targets as currently expected by markets. However, a materialisation of tail-risk scenarios – for instance due to sustained further increase in energy prices – could imply that these assumptions do not hold.

Please allow me to share with you our assessment of the risks related to residential real estate markets. In several EU Member States strong house price growth coincided with a rapid expansion of mortgage lending, suggesting the possible emergence of a price-lending spiral. At the same time, the normalisation of monetary policy is resulting in a pick-up in bank lending rates, which may slow down the demand for credit and house purchases. Especially in countries with a high proportion of variable rate mortgages, increasing interest rates may become a significant burden for highly indebted households. Moreover, the erosion of real household income on account of persistently high inflation may affect households’ debt servicing capacity. Together these factors are increasing the risk of a correction of real estate prices. At the same time, demand for residential real estate may be supported by buyers considering housing investments as a hedge against high inflation. Overall, risks to the residential real estate sector are highly scenario-dependent. Should the slowdown in growth in the EU turn out to be moderate, vulnerabilities in this sector could further increase, strengthening the case for implementing further macroprudential measures to foster prudent lending and borrowing and to build up resilience. In contrast, the materialisation of tail-risk scenarios could bring us closer to the end of the residential real estate price cycle.

I would now like to turn to the ESRB’s efforts when it comes to building a strong macroprudential framework. Two broad themes underlie our strategic priorities, and I will outline them for you now.  

First, we need to ensure that the macroprudential framework for banks is fit for the next decade. Above all, this [macroeconomic macroprudential] framework should provide more room to respond – through larger and more actively built up releasable capital buffers – and a set of tools to effectively deal with vulnerabilities in the residential real estate sector. This framework also needs to address new risks stemming from cyber threats and climate change. We recently published a Concept Note covering all these elements, which I hope your Committee will use as a guideline.

Let me give you today an example of one tool we can use to address the real estate vulnerabilities. The ESRB this year published its third set of country-specific warnings and recommendations on residential real estate vulnerabilities. Our analysis shows that macroprudential measures focused on borrowers would be crucial to contain a build-up of real estate risks. Yet such borrower-based measures are still not available in all EU countries. This gap needs to be closed – we need a general framework for borrower-based measures at the EU level. At the same time, we need to recognise existing differences across the EU in terms of real estate markets and legal constraints. The inclusion of these measures in EU legislation should follow the principle of “guided discretion”. This means that while a general framework would be set at the European level, implementation would be left to national authorities.

As I am speaking to co-legislators – let me provide you with some practical suggestions on how to include those measures in the EU legal framework. Including borrower-based measures in the [Credit Capital] Requirements Directive would complement existing capital-based tools in the banking sector. But more importantly, we should also include borrower-based measures in the Mortgage Credit Directive. This would be a first step towards implementing more activity-based regulation in the EU. Borrower-based measures would then be available regardless of the type of mortgage lender. This would help ensure the resilience of the whole financial system, reduce regulatory arbitrage and ensure a level playing field.

Second, we need to build a strong macroprudential framework for non-banks. With your Committee currently reviewing Solvency II and the Alternative Investment Fund Managers Directive, you are perfectly placed to strengthen the framework. Let me stress that the macroprudential elements introduced in the European Commission’s proposals to amend the two frameworks cover many - albeit not all – of the ESRB proposals and should not be watered down in the course of the ongoing legislative review. To this end, we have described all our priorities in the recent letters we have sent to you. Let me highlight a few examples today.

Regarding insurance, we see the case for improving the existing countercyclical mechanisms in Solvency II, and for more symmetric tools. You may recall that amid the market turmoil at the outset of the pandemic, certain supervisors agreed to ad hoc solutions to smooth the impact of the sharp falls in asset prices. To this end, the insurers used transitional measures available to them that were, however, not designed for this purpose. Once granted, these measures cannot be easily reversed and will continue to provide insurers with capital relief for the next decade. Now, having more symmetric tools in the framework would protect capital ratios from both the negative impact of falling asset prices in bad times and the positive impact of rising prices in good times.

We also see the case for supervisory market-wide powers to restrict distributions – such as dividends and share buy-backs – in exceptional circumstances. By protecting the capital levels of insurers, these powers would prevent de-risking. And de-risking is a concern because it has the potential to amplify any initial shock. Finally, having such market-wide powers in place would alleviate pressure from shareholders on the more prudent insurers that would have actually suspended distributions.

I have just discussed the borrower-based measures and the need to implement them – as activity-based tools – for the whole financial sector. These tools are of course also important for insurers, who in certain countries are becoming increasingly engaged in mortgage lending.

Let me turn to the review of the Alternative Investment Fund Managers Directive. It is extremely important address liquidity mismatches in the alternative investment funds which invest in inherently less-liquid assets. These include real estate, loans or certain corporate bonds. We need to ensure that funds’ redemption policies are structurally aligned with the liquidity profile of assets to avoid fire sales. To this end, managers of such open-ended alternative investment funds should demonstrate to supervisors that they can follow their investment strategy in all foreseeable market conditions. And to facilitate a consistent approach, the European Securities and Markets Authority should be given the power to draw up a list of assets that are inherently less liquid.

Risks related to leverage in alternative investment funds must also be addressed: we need a consistent application of leverage limits across jurisdictions, as well as increased transparency of these limits. This would help mitigate regulatory arbitrage by fund managers and inaction by national supervisors.

Let me conclude by saying that we need to keep scanning the horizon for emerging risks and structural trends affecting the EU financial system. To this end, the General Board will this week discuss the financial stability issues related to crypto-assets, the new joint ECB-ESRB analysis of climate-related risks, and our annual non-bank financial intermediation risk monitor. Finally, please read the ESRB’s Annual Report, which we are publishing today and which provides an excellent summary of our contributions to the macroprudential policy framework over the past year. Thank you for your attention, and I look forward to hearing your views.