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

Speech by ESRB Chair Christine Lagarde, Hearing at the Committee on Economic and Monetary Affairs of the European Parliament

Brussels, 20 March 2023

It is a pleasure to address you in my capacity as Chair of the European Systemic Risk Board (ESRB). In my remarks today, I will set out macroprudential policy considerations for banks and non-bank financial intermediaries.

As you know, the ESRB issued a General Warning on the vulnerabilities in the Union’s financial system in September 2022. Since then, some economic developments have surprised to the upside, while some vulnerabilities identified in the Warning have come to the fore.

On the positive side, growth forecasts for 2023 have recently been revised upwards, while downside risks to the short-term economic growth have somewhat declined. Although growth is expected to slow down this year, the EU economy has proved to be more resilient than expected in the face of the large negative terms-of-trade shock from Russia’s war in Ukraine.

But developments in banking and financial markets over the past few weeks emphasise the need to remain vigilant about vulnerabilities in a challenging macro-financial environment. In this respect, I welcome the coordinated action by major central banks to enhance the provision of liquidity via the standing US dollar liquidity swap line arrangements.

The ESRB has identified in its September Warning the following key risks to EU financial stability and will continue to monitor such risks.

  • First, in an environment of still subdued growth prospects and elevated inflation, firms' and households’ balance sheets could come under stress.
  • Second, vulnerabilities in the non-bank financial sector could exacerbate volatility and asset price corrections.
  • Third, the challenging macroeconomic outlook coupled with elevated geopolitical tensions highlights the importance for banks of prudently managing their credit, market, and funding risks.
  • Fourth, the risk of system-wide cyber incidents remains severe amid heightened geopolitical tensions.

Turning to the EU banking sector, it remains strong in terms of its aggregate capital and liquidity position. Capital is much higher than it was fifteen years ago before the global financial crisis with a Common Equity Tier 1 ratio of 15.0% at the end of September. The liquidity position of the European banks is robust. If you look at the liquidity ratios on average, they are clearly above the minimum requirements and even the pre-pandemic levels. Even if you look at the composition of these liquidity buffers, their large part is cash and deposits with the central banks. The EU banking sector has benefited from the ongoing normalisation of interest rates, as the interest rate pass-through on the asset side still significantly exceeds the pass-through on the liability side. As a result, aggregate banking sector profitability has increased to its highest level since 2014.

As the September Warning stated several factors continue to weigh on the outlook for banks. First, the perceptible deceleration in economic growth and higher interest rates may lead to a deterioration in asset quality. Second, banks’ funding costs are rising, exerting pressure on interest margins. And third, banks are tightening lending standards over concerns about the worsening economic outlook and rising credit risk, which may weigh on lending volumes.

The impact of these factors is expected to become more pronounced over time. Individual financial institutions should carefully preserve their current levels of resilience, to ensure that they could weather a potentially less favourable environment.

Let me now turn to risks related to financial market corrections. This is important as all financial institutions, including banks and non-banks, interact in financial markets.

Such asset price corrections and heightened volatility could be exacerbated by vulnerabilities in the non-bank financial sector. In fact, there have been several episodes of market volatility in the last months that resulted in liquidity challenges for non-bank financial intermediaries. We are analysing such episodes with great care because vulnerabilities in non-bank financial intermediaries can result in procyclical selling behaviour that would amplify asset price falls.

The ESRB has repeatedly called for regulatory reforms in the non-bank financial sector. In particular, we flagged the need for a comprehensive set of tools to deal with systemic risks related to non-bank financial intermediaries. Both my predecessor and I have raised this point in your Committee many times. Overall, little progress has been made so far.

On the positive side, I very much welcome the position this Committee has taken on investment funds within the review of the Alternative Investment Fund Managers Directive and the Directive on Undertakings for Collective Investments in Transferable Securities. Your stance reflects most of the ESRB proposals and – if co-legislators agree – it would help reduce systemic risk. Certain policy enhancements would still be needed, for example to ensure better alignment of redemption terms and asset liquidity in open-ended funds. This is at the centre of the work undertaken at the international level – at the Financial Stability Board as well as the ESRB.

At the same time, I encourage you to help reduce systemic risk and increase resilience in other areas. First, in the investment fund universe, it is important for legislative reforms of money market funds to be implemented in the EU without delay. The ESRB issued a recommendation which aims to strengthen the resilience of this sector, without unduly restricting the economic functions that money market funds provide to other market participants and the real economy. We encourage the European Commission to act, and we hope that the European Parliament will contribute to the strengthening of this framework.

Second, in central clearing, it is important to enhance the European Market Infrastructure Regulation within the ongoing targeted review. We are sending you a letter with some macroprudential considerations to this end.

Last but not least, this Parliament should contribute to the strengthening of Solvency II for insurers, and not only in the area of liquidity risks. We have engaged with your Committee on this matter as well.

Let me conclude. Sound capital and liquidity positions and robust profitability are contributing to the resilience of the EU banking sector. But each and all financial institutions should carefully preserve their current levels of resilience, to ensure that they could weather a potentially less favourable environment. Moreover, thanks to the regulatory reforms implemented since the global financial crisis, authorities have the macroprudential instruments at hand to build up resilience further, if and when needed. At the same time, persistent vulnerabilities in the non-bank sector mean that the regulatory and policy responses for this part of the financial system need to be accelerated. We call on you as the co-legislator to contribute to a robust macroprudential framework for this sector.

Thank you. I will now take your questions.