The (long?) shadow of the pandemic – what lies ahead for banks and supervisors Speech given at the Bavarian Banking and Corporate Evening at the Deutsche Bundesbank’s Regional Office in Bavaria

1 Welcome

Mr Benedikt,

Ladies and gentlemen,

Over the last 15 months since the outbreak of the coronavirus pandemic, you have all played a major role in keeping our economy functioning; you have continued to provide on-site banking services and have maintained lending operations. During this crisis, banks have not been part of the problem but have instead been part of the solution.

In my speech today, I will try to take an all-round view: the shadow of the pandemic – what lies ahead for banks and supervisors. But let me start by saying: where there is shadow, there must also be light. The post-pandemic period does indeed present opportunities – including for Bavaria’s banks and savings banks.

2 Challenges and opportunities in lending business

Challenges: negative interest rates, interest rate risk, non-performing loans

Of course, the challenges faced by lending business stem directly from the economic environment: first, negative interest rates, second, interest rate risk, and third, non-performing loans.

First and foremost, from a monetary policy perspective, negative interest rates are needed to ensure that the inflation outlook in the euro area clearly converges to a level below, but close to, 2%. In pursuing this aim, monetary policy makers are acting independently – and independently of banks’ profitability.

A glance at the actual figures – taken from the Bundesbank’s latest Annual Report – shows that, in 2020, German banks paid around €2.7 billion in interest for negatively remunerated excess liquidity held with the Eurosystem. The fact that this is only around €0.3 billion more than in the year before, despite the rise in excess liquidity during 2020, is mainly thanks to the two-tier system. Since the end of 2019, part of institutions’ holdings of excess liquidity has been exempt from the negative deposit facility rate under this system, thus easing the burden on banks.

But that’s not all. Something the public debate often fails to note is that banks are, in fact, granted additional relief when they borrow money from the central bank through the third series of longer-term refinancing operations, or TLTRO-III, which has more favourable conditions. The more credit that commercial banks supply to the economy, the more favourable the conditions on these operations become for these banks, with rates ranging from -0.5% to -1%. Although the interest from the TLTRO-III operations will only be paid to the banks when the refinancing operations mature – so at the end of 2024 at the latest – the Bundesbank is expecting interest income for German banks and savings banks of up to around €1.7 billion in 2020 as a result of their participation in TLTRO-III. Again, these figures are all taken from the Bundesbank’s most recent Annual Report.

So, as is often the case, it is the overall outcome that counts. Even though the TLTRO-III operations were not designed with this aim in mind, they are, in effect, partially offsetting the negative interest rates on excess liquidity. Together with the two-tier system, then, the burden is being eased in two ways. In 2020, the remaining net interest expenditure for German banks stemming from the negative interest rate on excess liquidity thus amounts to roughly €1 billion – and that’s leaving aside the fact that some banks are themselves charging their customers negative deposit rates. By way of comparison, in 2019, German banks’ net interest income was approximately €82 billion.

All the same, the low interest rates are naturally putting banking business under pressure. But the main burden is the declining interest margin in lending business rather than the negative interest due. Analyses conducted by the Bundesbank indicate that, from the beginning of the negative interest rate policy period to the end of 2019, declining interest margins cost banks in Germany around four times as much as the negative interest rate on the deposit facility. I should add that, as a banking supervisor, I am talking about the banking system as a whole here – and what applies in general doesn’t necessarily apply to each individual bank.

All in all, German banks are still struggling with regard to profitability. However, initial analyses of our data suggest that, in 2020, banks were at least able to compensate for the burdens from the negative interest rates on the deposit facility that they still had to bear after the TLTRO. This is being done by amending the terms and conditions for deposit business, taking into account not only the pass-through of negative interest rates, but also other interest rate adjustments. The impact on institutions’ balance sheets remains to be seen, and we will be looking very closely at this in our analyses of banks’ profitability. But just as low interest rates are not the sole cause of low profitability, interest business is not the only lever that can be adjusted in order to boost it. This is up to the credit institutions.

It can’t be denied that negative interest rates pose a challenge to lending business. But the path upward, which involves rising interest rates, is not particularly easy either, which brings us to the second challenge – a potential rise in interest rates and, with it, a potentially steeper yield curve.

Banks usually obtain funding via demand deposits, but, at the same time, issue medium to long-term loans. This maturity transformation means that the maturities on the assets and liabilities sides of their balance sheets are different, thus leading to interest rate risk. Housing loans with long interest rate lock-in periods granted to households, in particular, can increase this risk.

So what will happen when interest rates pick up again? For long interest rate lock-in periods, the answer is probably not very much at first. In fact, net interest income could even rise over the next few years if the yield curve becomes persistently steeper and banks continue to issue loans with long maturities and correspondingly higher interest rates.

However, this earnings outlook is subject to interest rate risk. The Basel interest rate risk coefficient – a regulatory metric used to measure interest rate risk – provides supervisors with a reliable indicator. Assuming a parallel shift in the yield curve of 200 basis points on the reporting date of 31 December 2020, the present value loss would amount to 10.7% of regulatory own funds. If the curve were to steepen, the loss would be slightly smaller, but still significant. These are average values. The interest rate risk coefficient is higher for savings banks and cooperative banks, at 12.3% and 15.1% respectively. So interest rate risk is likely to play a larger role here. 

But looking at the special factors that are responsible for the current rise in inflation, interest rate risk does not immediately set alarm bells ringing. All the same, banks should bear it in mind as part of their risk management.

The third challenge is how to deal with non-performing loans, or NPLs. This is becoming a key issue again during the crisis. In Europe, of course, this mainly affects institutions and countries that already have large stocks of NLPs. It remains essential to ensure that NPLs are quickly identified and swiftly reduced. It is especially important that banks keep a close eye on their exposures to sectors that have been hit hard by the pandemic. The same goes for exposures affected by moratoria, because – unsurprisingly – we are already seeing higher loss rates here than for loans that are serviced normally.

Institutions’ credit risk assessments are already being reflected in increased loan loss provisioning. Calculations based on supervisory reporting show that German banks’ net transfers to credit reserves roughly tripled in 2020 compared to the previous year, reaching approximately €12 billion. However, we need to view this figure in perspective, since transfers in 2019 were very low. So although the increase is very large in comparison with 2019, all in all, it has a fairly moderate impact on banks’ balance sheets.

Opportunities: financing the transformation

After all of these challenges, let’s finally turn to the opportunities. Our entire economy is about to undergo a transformation, and this will need to be financed – an important and meaningful task for the banking industry.

I see three key factors driving this transformation.

The first are the changes to our economy following the pandemic – by which I mean the potential structural changes in areas such as work and housing, mobility and shopping habits, right through to the restructuring of global supply chains. Not only will this affect travel and hospitality, it will also have an impact on the real estate market and on trade and industry as a whole. The pandemic has set some things in motion, and we still need to analyse which changes will be permanent.

The second driver is the trend towards digitalisation. I don’t just mean the aspects of this that we have experienced as a result of the pandemic. It is not only about stepping up the use of existing technology such as online banking or video conferences. Digitalisation goes much further than this. It is about harnessing efficiency, expediting and improving communication channels, and creating new customer experiences. And it must also involve containing risks as well as ensuring that we are well defended against cybercrime. Cloud technology and artificial intelligence offer exciting solutions. At the Bundesbank, we have launched our “Journey to Cloud” initiative, which aims to make our own applications in the cloud more robust and flexible. We should now take the digital momentum from the pandemic and use it to take a leap forward – a leap into a real culture of digital innovation.

The third driver of the transformation is the need to make our economy sustainable. This year alone has seen the development of two political strategies relating to sustainable finance – one from the German Federal Government and one soon to come from the European Commission.

The role of the banks in the transition to a greener economy is indisputable. But delighted though I am about this necessary step towards sustainability, one thing is important to me as a banking supervisor: we must not lose sight of the risks. In our supervisory meetings this year, we will discuss how credit institutions can incorporate climate risk into their risk management. Of course, a discerning eye is required here. Just because an investment is “green”, that doesn’t mean it is low risk or even risk-free. As is so often the case, we will need to examine this in detail; the financial agents involved will still have to make the decision themselves. So banking supervisors certainly won’t be saying that, from now on, loans can now only be granted for eco-friendly economic activity. And because not every sector of the economy can become equally “green”, funding sources for other investment shouldn’t be allowed to dry up either. Take traditional craft firms and small-scale industry, for instance.

The transformation of our economy offers major opportunities for lending business. Ladies and gentlemen, sound out these opportunities, analyse new trends in the economy and don’t ignore new market segments. Who are the business and private customers of tomorrow? What funding and services do they need, and how will these services be provided? The volumes and structures of funding requirements could change. It is possible that new and more flexible financing instruments will be needed, which will change the face of lending business and call for different expertise.

So, ladies and gentlemen, as you can see, there is light and shadow, neither of which are static. Against this backdrop, in my role as a supervisor, I have one fundamental requirement – appropriate risk management. Taking part in the transformation and tapping into new market segments naturally entails risks, perhaps even major risks. Each bank must determine its own appetite in this regard. That said, in any event, its risk management needs to cover and manage all existing and new risks.

This also applies with regard to the pandemic. Vigilance remains key. It is essential to analyse which enterprises will remain stable despite the current burdens and where credit losses could indeed occur. Banks should not get swept up in the general euphoria as the pandemic subsides. Because their moment of truth might still be to come.

3 Regulatory and supervisory decisions

Regulatory and supervisory decisions are on the horizon.

Proportionality

You will remember that, with the CRR II, we made a start in simplifying things for smaller institutions. We have taken a major step forward in implementing this over the last few weeks. We have now classified these institutions for Germany – in EU terminology they are referred to as “small and non-complex institutions” (SNCIs).

The results are in: Bavaria is a leader on this front, where there are just over 300 classified institutions, while there are around 1,150 (corrected) across Germany as a whole – this means that one-quarter of the German SNCIs are domiciled in Bavaria. The list of institutions in Germany classified as small and non-complex (SNCI) was drawn up by the Bundesbank on the basis of European regulation; BaFin will inform the institutions concerned from the middle of June. This means that around 80% of institutions in Germany are classified as SNCIs, yet these banks account for only around 18% of total assets. 

This list serves as a starting point for granting regulatory relief to SNCIs. It was Germany that kept bringing up the idea of proportionality in European negotiations. Now it is actually being implemented.

First, disclosure requirements will soon increasingly be tiered according to the banks’ size and capital market orientation. In this case, SNCIs will have to meet fewer requirements in future. There will also be a simplified Net Stable Funding Ratio (NSFR) for SNCIs, with the smaller number of data points being the main difference compared with the full NSFR.

SNCI classification is a very important step in my view, because, for the first time, there will be a definition at the European level stating that small banks do not in fact pose the same risk to the financial system as large banks with international operations. So why should they be regulated as extensively? And once such a definition exists and is implemented, it can then also serve as a basis for further regulations based on the principle of proportionality.

But one thing should be made absolutely clear: all of the relief granted will be entirely operational. We won’t tinker with the capital or liquidity requirements of small banks.

The European Banking Authority (EBA) also recently published a report on the cost of compliance. This report is a cost-benefit analysis of European supervisory reporting, and it, too, focuses on small and non-complex institutions. It is for precisely these banks that it aims to reduce the costs of reporting. On balance, various substantive and technological measures are set to lower these costs by 15-24%, or between €188 million and €288 million.

The EBA has developed a total of 25 recommendations for reducing the cost of the European reporting system. The recommendations – many of which were German proposals – include changing the formulation of the reporting requirements as well as the nature of the reports themselves. The EBA is already holding consultations on simplifications when reporting additional parameters on liquidity monitoring. Amongst other things, these would allow SNCIs to be exempted from submitting three of the reporting templates and thus up to 60% of the relevant data points overall. On top of this, a consultative paper on the reporting of asset encumbrance is in the pipeline. The proposed exemptions it includes for SNCIs could mean that they would require up to 72% fewer data points in this regard.

Moreover, the recommendations focus on areas of improvement in the development of reporting requirements and designing the reporting process to be more efficient. For example, in future, only one additional modification to the reporting requirements is to be made per year – although this assumes that the underlying legal texts do not change.

Proportionality has multiple levers that we will need to adjust, and I can assure you that I will always be ready to make those adjustments.

Implementation of Basel III

The same holds true for the upcoming CCR III and CRD IV, the European-level implementation of the final Basel III package. After the deadline for implementing Basel III was pushed back due to the coronavirus crisis, we are now expecting a draft bill from the European Commission in the autumn.

It will come as no surprise when I say that the Bundesbank considers it vital for Basel III to be implemented fully and consistently. That said, the Basel standards do indeed allow some scope for discretion. We should use this discretionary scope in a reasonable and prudent manner – to examine, for instance, precisely whether we can implement the concept of proportionality more extensively.

From Germany’s perspective, we have already submitted proposals to the European Commission together with the German Banking Industry Committee, the Federal Ministry of Finance and BaFin in order to further simplify the regulation of SNCIs as a way of boosting proportionality. For example, we propose completely exempting SNCIs from disclosure and the regulation pertaining to remuneration.

The costs of Basel III are frequently the subject of heated debate. What lies ahead for banks?

As I already mentioned, the EU does not yet have a draft bill for Basel III, but there are implementation scenarios for which we can estimate the consequences.

The EBA is looking at sample institutions to see how minimum capital requirements would change. In the EU scenario, which includes, amongst other things, the SME supporting factor – the capital relief for lending to small and medium-sized enterprises – the EBA expects minimum capital requirements for the German sample institutions to rise by 26% by 2028. That said, the EBA uses extremely conservative assumptions in its calculations. The Bundesbank and BaFin estimate that minimum capital requirements will go up by 22% for the German sample.

What will this look like beyond the EBA sample? We carried out a projection and estimate that the capital requirements for the entire German banking market will rise by around 12% in this EU scenario. This significantly lower figure reflects the fact that the large increase is primarily due to new rules for internal models. Most of the German banking market currently consists of smaller and medium-sized institutions that do not use internal models at all. By contrast, the EBA sample mainly included larger banks that work with internal models.

But even this 12% is not set in stone. If you look at other factors currently being discussed in Brussels for implementation, we estimate that capital requirements for the German banking market will probably only go up by around 8% in the end. This represents an absolute increase in the requirements by approximately €28 billion by 2028. By way of comparison, the current surplus capital in Germany’s banking system amounts to around €150 billion.

These are, of course, the figures for the entire banking sector. Capital requirements can differ widely depending on the institution and business model. And rightly so, as Basel III is intended to regulate riskier business more strictly.

For the majority of German banks, particularly savings banks and cooperative banks, the Bundesbank anticipates a relatively manageable impact: institutions that exclusively use the standardised approach to calculate their minimum capital requirements will see their capital requirements rise by only around 3% on average. For some of these banks, their capital requirements will even decrease. Institutions that employ internal models, however, could see them increase. Ultimately, large banks will therefore feel the effects more than small banks.

In a nutshell, Basel III offers us scope for discretion. Let’s work together constructively towards a proportional implementation.

4 Conclusion

Ladies and gentlemen,

Allow me to summarise what I have said once more:

  1. Challenges and opportunities facing banks: negative interest rates, interest rate risk and non-performing loans are challenging – but, at the same time, there are major opportunities for lending business when it comes to funding the transformation of our economy. The catchwords here are “digital” and “green”.
  2. Decisions in banking supervision and regulation: the classification of small and non-complex institutions is a milestone in terms of proportionality. In this case, we should pull on the right levers in the reporting system and when implementing Basel III across the EU.

Ladies and gentlemen, when I decided on the title of today’s speech back in March, the shadow of the pandemic was much longer, the incidence of infection much higher, and vaccination rates much lower. Since then, these figures have undergone very positive developments. The shadow of the pandemic remains, however, especially for banks that may still be experiencing delays in recording credit losses in their books. We need to stay alert, but we can allow ourselves to enjoy a glimmer of optimism as well.

I now look forward to our discussion and your views on this topic.