"The way back to normal banking supervision will be a balancing act" Interview with the magazine "bank und markt"

The interview was conducted by Philipp Otto.
Translation: Deutsche Bundesbank

Mr Wuermeling, we are back in the midst of a crisis, and while the financial system wasn’t the source this time, it is feeling the impact as well, of course. What’s your take on how banking supervisors have responded so far: just right, too soft, too much?

Banking supervisors certainly haven't been too soft in their response. Exceptional situations call for exceptional action, and we acted by rolling out numerous supervisory relief measures, making use of the flexibility within the existing framework. Admittedly, we didn’t find it easy to introduce many of these relief measures – the rules are there for a reason. That’s why we carefully weighed the pros and cons in each case to make sure we didn’t overshoot the target. Now it’s a matter of closely monitoring how the situation develops in case our measures need to be tweaked. At present, I don’t foresee either any major new non-standard measures or a rapid exit. That said, the availability of vaccines does now appear to be a bright spot on the horizon.

How important was the supporting monetary and fiscal policy action?

Swift and decisive action from economic policymakers has helped prevent the economy from plunging into a perilous downward spiral. Fiscal policy is delivering targeted support for households and enterprises, such as compensation for firms affected by government-ordered closures. In addition, the Federal Government’s economic stimulus programme is providing stimulus to help the economy make a quicker recovery. What’s clear in this crisis is that the onus is primarily on fiscal policy. But monetary policy in the Eurosystem is playing an important role as well by helping to ensure that the economic crisis does not lead to liquidity shortages in the financial system. Undesirable feedback loops would have made matters worse and perhaps even jeopardised price stability.

The current dislocations are affecting a great many sectors, so banks won’t emerge from this unscathed. How is financial stability faring under the shadows of coronavirus? Would you say the banking system can cope with the situation and cushion a huge wave of corporate insolvencies?

So far, banks in Germany have done a good job of navigating their way through a period overshadowed by COVID-19. The ratio of non-performing loans (NPLs) has barely increased since the pandemic began. But that shouldn’t lull us into a false sense of security. Loan losses generally only materialise with something of a lag behind developments in the real economy. And at present, the government support measures are shifting corporate insolvencies, and thus loan losses, even further into the future. This probably means that 2021 will see a deluge of credit defaults, and this will remain the case even with a broad-scale rollout of vaccinations. You see, the losses that accumulated in 2020 will only show up in the loan books for 2021. Those shortfalls won’t simply disappear even if things brighten up in 2021.

How important have the regulatory requirements imposed in recent years to preserve the stability of the banking system been during the current crisis? Those requirements weren’t always easy for the institutions concerned.

I appreciate that the reforms introduced in recent years have been a big ask for many institutions. But these efforts are now paying off: institutions are far more resilient and have a more comfortable capital base. At the end of 2019, banks in Germany had a Common Equity Tier 1 (CET1) capital ratio of more than 16% – that’s more than twice the level in 2006. Over and above the CET1 capital needed to meet the minimum requirements, they also hold just under €115 billion in capital buffers and €148 billion in unallocated capital. Institutions can now fall back on the latter in particular to absorb losses and continue supplying credit.

We are currently in an exceptional regulatory situation. How long is this going to last?

That is hard to say. Given the uncertainty surrounding future developments, we need to see how things evolve and adapt our response to the situation. Fiscal and monetary policymakers are operating in much the same manner. Whatever the future holds, my supervisory colleagues and myself will not jeopardise the process of stabilisation by making too hasty an exit. What matters to us is that banks remain fully able to perform their function in the economy – which is to supply credit – not just in normal times but also and especially during a period of economic recovery.

What’s the best way to get back to “normal” banking supervision? Surely, the second wave of COVID-19 will have changed one assessment or another, wouldn’t you agree?

The way back will be a balancing act. On the one hand, my supervisory colleagues and myself have always stressed that the exceptional measures we have taken are linked to the crisis, so they are clearly of a temporary nature. On the other, we need to remain cautious because the fallout from the pandemic still isn’t fully visible in the banking sector. All the more so since it is still unclear how severely the second COVID-19 wave will impact on the economy. So finding the right time to exit is a complex undertaking. But in any case, banks will be given sufficient time to replenish their buffers.

How risky would it be for the economy as a whole if the turmoil caused by COVID-19 were compounded by credit institutions becoming far more restrictive in their lending?

Banks had already tightened their credit standards in response to the elevated credit risk before the second wave of infections emerged. But we aren’t seeing any signs of far more restrictive lending or even a credit crunch. If banks severely curtailed the supply of credit to sound enterprises, that could well impact negatively on economic developments. Furthermore, monetary policy is supporting favourable funding conditions. Indeed, the Eurosystem is offering institutions exceptionally favourable funding options which banks can use to supply credit. One thing needs to be clear: rescuing insolvent enterprises is not the job of banks or central banks. That’s something that fiscal policymakers need to decide on and to fund as necessary.

Does that mean that the topic of NPLs threatens to flare up again across Europe as a risk to financial stability?

We are expecting to see an uptick in corporate insolvencies and thus more credit defaults over the next few quarters, though there’s no way of predicting quite what the scale will be. If NPLs pile up, credit institutions will need to classify them as such and scale them back again within a reasonable timeframe. Otherwise, there’s a risk that the banks will be paralysed for years on end, which could have a knock-on effect on their ability to supply credit to the economy. To prevent this scenario from materialising, European banking supervisors clearly formulated and communicated their expectations for dealing with NPLs. The toolkit for addressing NPLs is in place. Now it needs to show that it works in practice.

How do you think banking supervisors need to respond to this? Should banks be given greater leeway? Should requirements be reduced further?

What I said about the non-standard measures as a whole applies in equal measure to the topic of NPLs: it would be wrong for us to soften the requirements on a lasting basis. As a case in point, if supervisors accepted a laxer classification of NPLs on a substantial scale, this would only obscure the actual risk situation, meaning that the right response in the given circumstances might end up coming too late. The same applies to the rules designed to reduce NPLs.

How are discussions progressing with your European colleagues and at the BIS? Does everyone take a similar view of the situation, or are there significant differences in how people see the situation or the measures that need to be taken?

Since the outbreak of the COVID-19 pandemic, we have been liaising very closely on possible measures and risk assessments at both the European level with the EBA and the SSM and globally, too, through institutions such as the Basel Committee on Banking Supervision. The current consensus among the member states of the Basel Committee is that banking system resilience is satisfactory. It is unprecedented for an approach to be coordinated to such a degree at the global and European level. What I found remarkable was the speed with which it was possible to agree on what needed to be done. This also prevented global risks from affecting financial stability and put a stop to regulatory arbitrage.

Do you hope that Europe will now become more united and it will be easier to harmonise regimes such as the key insolvency legislation?

Insolvency procedures and legal frameworks differ widely across EU Member States, as does the associated company law. Not just that: insolvency law is closely linked to enforcement law, which is likewise a matter of national responsibility. Full harmonisation is an unlikely prospect. A more realistic goal would be to align certain aspects, such as banking insolvency law. Harmonised banking insolvency law would also be desirable from a German perspective in order to create a level playing field in this area.

And what does all this mean for the work that still needs to be done to create the banking union? What are the next key steps, and what’s holding things up?

The agreement to bring forward the introduction of the common backstop to the Single Resolution Fund was a major step forward. That said, further steps to reduce risk remain high on our agenda, even if significant progress has been made on this front. Needless to say, the current setting is putting new obstacles in our way. For one thing, the pandemic has left governments and banks even more closely interconnected than before. For another, we will see more non-performing loans showing up on banks’ balance sheets in the future. That said, it would be too easy to put the blame for all this on the COVID-19 pandemic; let’s not forget that problems existed before the onset of the virus, too. More work needs to be done to get to grips with these predominantly national risks.

What’s your take on the Risk Reduction Act, Germany’s implementation of parts of the banking package? It hasn’t exactly been welcomed with open arms in all quarters of the financial industry.

I see the Risk Reduction Act as a welcome piece of legislation. The European banking package and its national implementation in the form of the Risk Reduction Act put in place further key components of the Basel III framework in the EU and at the national level. This addresses regulatory gaps and weaknesses identified in the wake of the financial crisis and strengthens resilience in the banking sector as a whole. The current COVID-19 pandemic is a stark reminder of how important it is for banks to be resilient. At the same time, the Risk Reduction Act also takes account of the principle of proportionality.

Cross-border mergers are another topic that’s back on the table. We’re not asking you to comment on individual cases, but don’t they drive up the risk of institutions becoming too big to fail?

Our policy as supervisors is to take a neutral stance towards mergers. As part of our off-site supervision operations, we review mergers and consider to what extent the merged bank has a sound capital and liquidity base and appropriate governance structures in place, for example. Supervisors also ensure, in the context of resolution planning, that there is no hindrance to winding up an institution even if its corporate structure is more complex or international in scope. The too-big-to-fail issue you raise is a key topic: since the financial crisis, we have put a lot of effort into reducing risk in this area. Measures include drawing up recovery and resolution plans, early intervention measures, holding additional capital buffers and building up additional capital to absorb losses. This now means that a case can also be made for mergers that create more sizeable entities.

Looking ahead to the current year, what else will be important, besides coronavirus?

Needless to say, the COVID-19 pandemic will keep credit institutions and supervisors busy again next year. And it's not as if the “old” challenges have vanished into thin air. Quite the opposite, in fact. The pandemic is actually making some of them even trickier still, such as the low profitability in the German banking sector. That said, institutions should also look at the opportunities that 2021 offers them. Just take the sweeping transformation of the economy as a result of structural changes caused by the pandemic and decarbonisation, where there will be a huge need for funding – and thus demand for credit. The digital transformation of financial services will also remain on the agenda, both as a source of opportunity and of risk. The European Commission has marked out a very progressive path in this field with its digital finance strategy. Initiatives include bringing the supervisory framework into line with various developments such as cloud computing and crypto assets, which will also ease digital innovation.

Given the immediate risk presented by COVID-19 combined with the longer-term challenges posed by low interest rates, profitability, digital transformation and the like, would you say Germany’s banking supervisors have the firepower they need to face what the future might hold?

German banking supervisors have demonstrated their ability to act and their flexibility so far in the crisis, as the feedback we have received from institutions confirms. At the same time, we are readying ourselves to face the topics that will shape the future, like new digital risks. Together with BaFin, we have drafted a digital agenda for banking supervision. We are looking to embrace new technology as a way of improving our analyses, streamlining processes and equipping our supervisors with fresh tools. One of the Bank for International Settlements’ global innovation hubs will be embedded in the Bundesbank’s innovation network in Frankfurt am Main. We are very ambitious in this regard because innovative technologies can help banking supervisors take a huge step forward. 

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