10 July 2024

FT interview with SSM's McCaul by Arnold and Mourselas

We don't have a fully clear line of sight from the banking supervisory standpoint about the level of exposures that may be correlated to risk on NBFI balance sheets from banking industry lending arrangements, including repurchase agreements, lines of credit or derivatives to and from NBFIs

What is the state of the Eurozone banking system right now?

I'm pleased with the state of the European banking sector. My view comes from the hard evidence earned in the school of hard knocks, where the banks have proven quite resilient in the face of some very significant challenges in the last few years. Looking back to the birth of the Single Supervisory Mechanism (SSM) ten years ago – when the banking system faced collapse or collapsed in different countries – it is simply remarkable how far the landscape has progressed since that period of time. It's very impressive what has happened here in Europe with the success of the SSM. We owe much to the visionaries who conceived it and to my predecessors who built the strong banking system we now have.

In 2015 the core capital ratio stood at 12.7% and now it has increased to stand at 15.7% in the first quarter of 2024. Non-performing loans (NPLs) were 8% in 2014, or €1 trillion; now, NPLs are 2.3%, or €355 billion. The banking system has continued to demonstrate resilience and garner confidence against a number of challenges, including in the face of Russia's aggression in Ukraine, and during the pandemic when the economy stalled, ways of working were transformed, supply chains were disrupted, and inflation and record-fast rising interest rates changed the market dynamics dramatically after such a long period of low-for-long interest rates. European banks also fared extremely well during the fateful events of March 2023 when other countries you wouldn't have expected had failing banks and very threatened institutions.

So, the first ten years of the SSM delivering on a strong euro area banking system is an extraordinary story. Having said all that, no supervisor is ever complacent, and I continue to have a cautious stance given the significant uncertainties that still exist.

What are the main risks and concerns you can see? If you had warning lights on your desk, which ones would be flashing amber or red?

We are always looking for the warning lights on the dashboard for disturbances which may be lurking just beneath the surface of deceptively calm waters. I wouldn't characterise our posture as sanguine at the moment. There are certainly caution lights in front of us. For me the most prevalent one is the area into which we likely have the least visibility and where things can move faster than, for example, the normal credit dynamics. That is the non-bank financial intermediaries (NBFI) market, which has doubled in recent times: in the euro area in 2008 it was €15 trillion, growing to €32 trillion in 2024. Globally, the NBFI growth number is even more worrying, increasing from €87 trillion in 2008 to €200 trillion in 2022.

We are placing particular focus on the private equity and private credit markets. The growth there is especially noteworthy. In 2012 it was globally €3 trillion in the private equity markets. And in 2024 it's €8 trillion. The European private credit market has grown 29% in the last three years. At the end of 2023 the euro area private credit market accounted for about €100 billion, or 6% of the global market. Globally, it is now above €1.6 trillion.

This growth is remarkable and something that always worries us. And it is outside of the banking supervisory and regulatory perimeter. I have been involved in supervision in one way or another for a long period of time. You learn your lessons on the job. I was at the table when Long-Term Capital Management (LTCM) collapsed, when we learned the perils of correlation risk generated by same direction trading strategies on the books of a hedge fund to positions taken by banks we supervised. When LTCM’s trading strategy went south, it had an exponential impact on the banks, requiring a private bailout to avoid the implications of what was then considered an enormous systemic factor in the overall market. I suspect correlation risk is occurring again. We've had blips. Maybe even more than blips. Archegos was certainly a warning light. The gilt market dislocation caused by liability-driven investments in pension funds in the United Kingdom was another warning light, and we had hedge funds going down during the COVID crisis.

We know risk from the NBFI market can crystallise in several ways. It can be via the correlation of exposures where, especially given the growth in the private credit and private equity markets, maybe we have the same exposures as ones on bank balance sheets and where risk can spill over in various ways. It may also be the case that there are hedging strategies to the same exposures in both the regulated banking market and the NBFI market. And finally some of these funds, especially certain hedge funds, are becoming so big that they can partially move the market by themselves and are not likely to act as shock absorbers in the same way banks have sometimes acted. This matters also for liquidity dynamics in the system.

We don't have a fully clear line of sight from the banking supervisory standpoint about the level of exposures that may be correlated to risk on NBFI balance sheets from banking industry lending arrangements, including repurchase agreements, lines of credit or derivatives to and from NBFIs....

 more at SSM

© ECB - European Central Bank