Euro area banks’ resilience
Euro area banks have emerged from the pandemic largely unscathed, mainly due to the unprecedented support from governments, central banks, regulators and supervisors. Bank capital in the form of Common Equity Tier 1 even increased throughout the pandemic and stood at 15.5% in the fourth quarter of 2021, with banks boasting ample liquidity and low and falling levels of impaired assets (the liquidity coverage ratio was 173.4% while the ratio of non-performing loans was 2.1%). Banks’ return on equity in the same quarter stood at 6.7%, and while this is slightly below the third-quarter figure, profits were still higher than before the pandemic. Still, it would be premature to give the all-clear just yet. We might not have seen the full story on asset quality, as stage 2 classifications remain above pre-pandemic levels, forbearance of performing exposures has increased, and defaults of non-financial corporates rose in the fourth quarter of 2021 and the first quarter of 2022.
But with Russia’s war of aggression on Ukraine, European banks face a new test of their resilience. Though direct exposures to Russia, Ukraine and Belarus are limited and concentrated in only a handful of banks, we do not yet know the impact of indirect effects. This is reflected in the results for the first quarter of 2022, which most listed significant institutions have already disclosed: whereas banks directly exposed to the conflict areas saw declining profits, the rest of the sample still posted results broadly in line with those at the end of 2021. But even if all euro area banks’ Russian exposures were to be written off, the consequences should, in all likelihood, be manageable for the banking system.
However, indirect effects could be more significant. The war has accelerated the increase in energy and commodity prices that started in 2021; it is contributing to uncertainty and prompting drastic changes within the energy sector, while also exacerbating the supply chain bottlenecks that arose during the pandemic. The resulting spike in inflation and slowdown in economic growth might impact more heavily on banks’ asset quality. While we have been focusing on credit risk since the outbreak of the pandemic, we are now concentrating particularly on the energy-intensive sectors, which are more affected by the war − rather than on the service sectors, which were most affected by the pandemic − as well as on sectors such as residential real estate, which may be influenced by the increase in interest rates that is now expected.
These challenges are clear and present, and they warrant close attention and monitoring. But they are not the only challenges that banks need to urgently address.
For their long-term resilience, banks now need to fully embed climate-related and environmental risks within their business strategies. The transition towards a low-carbon economy poses significant risks to banks via a set of transmission channels, for example through exposures to firms with high carbon emissions or through assets that might be impaired by climate-induced damage. That is why it is crucial for banks to develop a strategy to mitigate the long-term impacts of climate-related and environmental risks and adjust their processes and internal practices. The sharp rise in fossil energy prices may accelerate the green transition. And as Europe tries to wean itself off Russian oil and gas amid the war in Ukraine, this transition is no longer imperative from only an ecological and economic perspective, but also from a security standpoint. All these factors could precipitate transition risk for banks.
Banks must also have sound governance and risk management frameworks in place to cope with increased exposures to the counterparty credit risk stemming from capital market services. The low interest rate environment has incentivised some banks to increase capital market services to more risky and less transparent counterparties, often non-banks. ECB Banking Supervision will undertake targeted reviews and on-site inspections in the areas of counterparty credit risk governance and management to identify any deficiencies. Further disruptions in capital markets as a result of the war and related volatility cannot be ruled out, and so our supervisory focus remains unchanged in this area too.
Finally, the war has heightened the risk of cyberattacks in retaliation for sanctions. Banks have already been on high alert in the last two years as coronavirus-themed fraud attempts became more common, and they can certainly not afford to drop their guard now. European banking supervision seeks to buttress the banking system’s resilience to cyber and IT risks via several initiatives: strengthening the supervisory toolkit available to joint supervisory teams in this regard, implementing the cyber incident reporting framework, analysing IT risk under the Supervisory Review and Evaluation Process, and conducting on-site inspections to assess cyber and IT risk management.
Given the ubiquitous nature of these threats, ECB Banking Supervision seeks to actively promote cooperation at the European level, engaging with the European Commission and European Council, as well as at the international level, mainly within the Financial Stability Board. The potential disruption caused by cyberattacks conducted by state actors could even surpass the havoc wreaked by private perpetrators, and poses an unprecedented threat to societal infrastructures, including financial ones. Authorities and firms alike must undertake cross-border efforts to combat these risks.
Euro area banks have passed the test of the pandemic, but there is no room for complacency. Banks’ resilience is not only being tested again right now by the economic fallout and potential balance sheet consequences of Russia’s war of aggression, it needs to be strengthened to tackle the imminent challenges stemming from climate change, counterparty risk and cyberattacks. ECB Banking Supervision will maintain pressure on euro area banks so that they are well prepared for the challenges ahead, and our close cooperation with the Single Resolution Board (SRB) remains an integral part of our efforts. I look forward to continuing our discussion on the challenges for the euro area banking sector at our upcoming joint SRB/ECB conference entitled “The test of time: banking union a decade on”.
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About the author
- Anneli Tuominen was a speaker at the 2020 SRB Conference
Anneli Tuominen has been an ECB Representative on the Supervisory Board of the European Central Bank (ECB) – Banking Supervision since June 2022. Her responsibilities include the areas of crisis management, supervisory reporting and statistics, and fit and proper supervision.
She was Director General of Finland’s Financial Supervisory Authority (FIN-FSA)...