12 June 2024

SSM's Buch: Evolving risks – evolving supervision

" All of this triggers structural changes in the real economy and the financial system – changes that will take time to fully materialise and whose final effects are highly uncertain. These evolving risks mean that supervision also has to evolve, and it is evolving. .."

The environment in which banks operate has changed significantly in recent years. Several major shocks, including the COVID-19 pandemic, the Russian invasion of Ukraine, the energy crisis, the increase in inflation and the turbulence on international banking markets in March 2023, have had profound economic and societal effects. Climate change and nature degradation require deep structural changes in the economy and affect the risks banks are facing. Digitalisation and the market entry of new financial institutions are changing the competitive nature of banking markets. In addition, heightened geopolitical risks are having an impact on the post-war global institutional order and international economic relations.^[1] All of this triggers structural changes in the real economy and the financial system – changes that will take time to fully materialise and whose final effects are highly uncertain.

These evolving risks mean that supervision also has to evolve, and it is evolving.

This year, we are celebrating the tenth anniversary of European banking supervision, which is the first pillar of the banking union. The banking union was a direct response to the global financial crisis and the European sovereign debt crisis. The increase in cross-border banking activity and the risk of contagion, both across borders and between banks and sovereigns, meant that supervision in Europe needed to be harmonised. In its first ten years the Single Supervisory Mechanism (SSM) has delivered effective supervision in the euro area through a common, consistent supervisory framework building on national best practices.

In the case of Germany, its 25 significant banks are now directly supervised by the ECB. But national supervision continues to play a significant role. The ECB and national supervisors work together in Joint Supervisory Teams (JSTs) led by the ECB. Less significant institutions (LSIs) remain under national supervision while the ECB has an oversight function. For Germany, this means that the Federal Financial Supervisory Authority/Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and the Deutsche Bundesbank supervise more than 1,000 banks, accounting for 40% of the domestic market in terms of assets – the highest share of LSIs in the euro area.^[2] The ECB’s Supervisory Board includes representatives from national supervisory authorities. Moreover, 90% of inspectors responsible for on-site inspections are employed by national authorities.

So European supervision only works well if national supervision works well. And national supervision has evolved. For example, in response to the Wirecard scandal that erupted in 2019, national supervision in Germany has been reformed significantly, with BaFin being granted new powers and tools.^[3]

Supervision in Europe and Germany has come a long way over the past decade. And it must continue to evolve if we are to respond to the new environment and become more efficient and effective.

In May this year the ECB’s Supervisory Board took important decisions to further develop supervision in Europe. But before I describe this reform in more detail, let me give you a quick overview of where we stand in terms of risks and banks’ resilience.

Risk and resilience in the European banking sector

The resilience of banks in Europe has increased over the past decade, driven by several factors.

First, legacy risks have been reduced. Non-performing loans (NPLs), once the bane of the European banking system, have fallen significantly. The NPL ratio of significant banks declined from over 7% in 2015 to less than 2% in 2023. This is the result of better macroeconomic conditions, better supervision, better regulatory frameworks and better loan workouts at banks. But financial crises cast long shadows. It takes a long time for the burden of NPLs to be fully removed from the balance sheets of households and firms, with negative implications for growth dynamics.^[4] So it is crucial to avoid a renewed build-up of NPLs as European economies go through phases of transformation and are exposed to new shocks.

Second, and in addition to improvements in asset quality, the resilience of banks has been strengthened through better capitalisation. Banks’ aggregate Common Equity Tier 1 ratio, which is based on their risk-weighted assets, increased from 12.7% in 2015 to 15.6% in 2023. By contrast, the leverage ratio, which is based on their total assets, increased less, from 5.3% in 2016 to 5.6% in 2023. One important driver of the increased capitalisation has been the post-crisis strengthening of the regulatory framework. But it is also important to note that the shocks that have hit European economies in recent years have largely been buffered by fiscal and monetary policy, thus shielding the banks from their full impact...

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