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November 21, 2017

Sabine Lautenschläger, Member of the ECB Executive Board and Vice-Chair of the ECB Supervisory Board, spoke about the big challenges facing the banking sector in Europe. She mostly focused on the issues related to non-performing loans (NPLs), Brexit, and the calculation of capital buffers using internal models.

Ms. Lautenschläger highlighted that NPLs are risks that have already materialized. She made a case for resolving NPLs, as they are a drag on profits; they might weaken trust in banks and keep banks from lending to the economy. Although the NPL ratio in the euro area has decreased since 2015, the banks need to do more. They must devise ambitious, realistic, and credible plans to get rid of their NPLs. ECB published the qualitative guidance for banks, which sets out the ways in which banks are encouraged to deal with NPLs. On that basis, reduction plans devised by the banks have been scrutinized. She also mentioned: "But dealing with NPLs also requires us to look to the future. Once the balance sheets have been cleaned up, they should stay like that. That is why we have published a draft addendum to our guidance, which is currently the subject of a public consultation. This draft provides transparency for the banks as we lay out what we expect from them in general in terms of prudential provisioning for future NPLs."

Unlike NPL, Brexit is an example of the type of risk that emerges suddenly and unexpectedly. With respect to Brexit, the key issue for banks that operate in the UK will be to find a way to maintain market access. After Brexit, these banks might have to seek another route into the European market. The most obvious route is to relocate and become part of the European market. This is an important issue, as the deadline is just over 16 months away. Ms. Sabine advised all affected banks to be prepared for the issue. There are a lot of things that need to be considered. Settlement finality, for instance, might be affected by Brexit, because the protection of the EU Settlement Finality Directive regarding the unwinding of transfer orders will no longer apply across the Channel. Another issue is the continuity of contracts, that is, the ability of market participants to continue servicing existing contracts, in particular derivatives contracts, without appropriate permissions in place. Banks should, therefore, include this topic in their contingency plans. Finally, banks should assess what Brexit means for their recovery plans. In this area, ECB is working on a booking model assessment framework, which will set out what is expected from banks. These expectations will follow the principle of proportionality. 

Additionally, banks must hold adequate capital buffers to deal with risks, including potential losses. For the banks who set the risk-weights using their own internal models, the models must work properly and there must be a level playing field for the supervisory approval of these models. All major internal models used by ECB-supervised will now be assessed under the targeted review of internal models (TRIM), which is a huge project. She mentioned that ECB is working on updating its guide for TRIM, along with its four goals. First, goal is to ensure that bank models comply with regulatory standards. Second is to harmonize the treatment of internal models from the supervisory perspective by removing unwarranted or undue heterogeneity in capital requirements for banks with similar risk profiles, just because they are headquartered in different jurisdictions within the euro area. Third goal involves ensuring that the results of internal models are driven by risk only, instead of being materially driven by modeling choices. Fourth resulting goal is to confirm that capital requirements are adequate. She concludes that once TRIM is finalized and banks have addressed the potential findings, capital requirements will be calculated more consistently across institutions. 

 

Related Link: Speech (PDF)

Keywords: Europe, EU, Banking, NPL, Brexit, Capital Buffers, Internal Models, TRIM, ECB, BIS

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