Building on the achievements of post-crisis reforms

The conference coincides with the tenth anniversary of the start of the global financial crisis in the summer of 2007. The crisis shook the European Union to the core, and required substantial policy actions to stabilise the economy and the financial system. With a return to stability having been achieved, it is important that we take time to reflect on what we have learnt, what we have achieved over the past ten years, and where we need to do further work.

The crisis taught us that individual banks and the banking system as a whole needed to be more resilient than they were pre-crisis. As a result, many reforms have been put in place in recent years. Our banking regulation and supervision have become stricter. Moreover, the European regulatory framework now places greater emphasis on identifying and addressing system-wide risks. This includes the establishment of the ESRB and the creation of macroprudential instruments assigned to public authorities.
A more resilient post-crisis banking sector
In the banking sector, significant efforts have been made in recent years to increase resilience. In the euro area, for example, the average Common Equity Tier 1 ratio of significant institutions rose from 7% in 2008 to 13.5% by end-2016. And banks are required to set up solid governance structures and prudent risk management practices. Moreover, resilience is now tested more rigorously in a forward-looking manner. The EU-wide stress tests coordinated by the European Banking Authority (EBA) have become an important tool for quantifying banks’ capital needs, with a view to ensuring that they would be able to continue lending to creditworthy borrowers even during a severe recession.
Post-crisis prudential rules have also provided public authorities with macroprudential tools to address systemic risks in the banking sector. And the understanding of how to calibrate and implement these tools has advanced. For example, all Member States now have a countercyclical capital buffer framework that is fully operational. Four Member States have announced a non-zero buffer rate for domestic exposures.
Yet despite these steps forward, it is important to remain vigilant. One important aspect concerns the interaction between monetary policy and macroprudential policies. Financial and business cycles can potentially become de-synchronised, meaning that financial imbalances can grow in an environment characterised by relatively muted inflation. In such an environment, the use of monetary policy is not the right instrument to address financial imbalances, and may lead to substantial deviations of aggregate output and inflation from their desirable levels. This is particularly so in a currency union where monetary policy affects the entire region, but financial imbalances may be local in nature. Macroprudential policies, targeted at particular markets or countries, can play a key role in addressing such imbalances.
Medium-term vulnerabilities in some countries
Indeed, the ESRB last year identified medium-term vulnerabilities in some countries’ residential real estate sectors – precisely the type of situation that macroprudential policies are designed to address. It published country-specific warnings to eight Member States in November 2016, in accordance with its mandate to identify and flag significant systemic risks.
But beyond increasing the resilience of the banking sector, there is also a need to address the remaining legacies of the crisis. Two important aspects are the resolutionof already impaired assets, and better accounting for impaired assets for the future.
Despite recent progress, the level of non-performing loans (NPLs) on European banks’ balance sheets remains high. At the end of 2016, the stock of gross NPLs in the EU banking sector was around € 1 trillion. This number, however, does not take into account the fact that that collateralised lending plays an important role in Europe. For example, including collateral and provisioning, the coverage of NPLs is, on average, 82% in the euro area. Banks’ profitability, however, is affected by the lower returns provided by the NPLs, given the weight of gross exposures in total assets: gross NPLs represent 4% of the total assets of euro area banks, against only 0.8% for US banks.
Cyclical and structural factors
The outstanding stock of NPLs is a consequence of cyclical and structural factors. First, the severe recession resulting from the global financial crisis led to a deterioration of the quality of banks’ loan books. The current economic expansion should therefore help to improve the asset quality of European banks. At the same time, structural weaknesses still persist. These include inadequate internal governance structures in banks, ineffective and costly debt recovery procedures in some Member States and misaligned incentives that prevent a quick resolution of NPLs. To this end, the ESRB has proposed a series of measures to complement those already being taken at EU and euro area level.
In the short term, the ESRB’s proposals focus on strengthening banks’ NPL management, including their prudent measurement and the valuation of the associated collateral. Policymakers could aid this process by developing blueprints for asset management companies, accompanied by harmonised data templates across the EU.
Measures should also concentrate on insolvency regimes, debt recovery and servicing capacities with a view to improving recovery rates from NPLs. Over a longer horizon, secondary markets’ trading platforms should be further developed. And banks also need to be given adequate incentives, in particular in relation to accounting for impaired assets.
New accounting standard for the classification and measurement of financial instruments
From 1 January 2018 onwards, a new accounting standard for the classification and measurement of financial instruments, known as IFRS 9, becomes mandatory in EU. At the request of the European Parliament, the ESRB has recently published a report on the financial stability implications of IFRS 9 which concludes that it is a major improvement, particularly regarding accounting for NPLs. The most important change introduced by IFRS 9 is the shift from an incurred loss approach to an expected credit loss approach for measuring impairment allowances. This means that banks will have to recognise impairments earlier, curtailing excessive forbearance towards NPLs and helping ensure that banking sector repair takes place in a timelier and more comprehensive manner in future downturns. A recent impact assessment, based on a sample of 54 banks across 20 Member States published by the European Banking Authority, suggests that the introduction of IFRS 9 would lead to an increase of provisions of about 13% on average.
The expected credit loss approach also means that banks will have to react in their accounting to new and forward-looking information as it is received. This means that impairment allowances may increase suddenly and significantly when economic conditions deteriorate, which could have certain pro-cyclical effects. The ESRB report considers a number of policies that could address such effects.
For example, stress testing could be used as a means to gauge the variation in impairment allowances associated with adverse scenarios, in order to ensure that sufficient capital buffers are in place and to allow for remedial policy action if required. If banks can withstand a hypothetical adverse scenario, they would likely be able to cope with the early recognition of expected credit losses under a real downturn, as required by IFRS 9.
Part of the speech of Mario Draghi, President of the European Central Bank and Chair of the European Systemic Risk Board, at the second annual conference of the ESRB, Frankfurt am Main, 21 September 2017.
Source: http://www.bis.org