 You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. The key word for the past two years has been uncertainty. During that time, the pandemic has changed the way we live and work. It's affected our economy and also our banks. And although the economy is recovering and banks have played a crucial role in limiting the economic fallout of the pandemic, new variants and supply chain bottlenecks pose challenges. In this episode, we're looking at how banks are faring in this challenging environment. I'm joined today by two guests, Supervisory Board Chair Andrea Enria and Vice Chair Frank Elderson. Welcome to the ECB podcast. Great to have you here today. Thank you, Katie. Now Andrea, I'll turn to you first. Every year, we assess the risks that banks face and we check how equipped they are to manage them. And this is all done in what we call the supervisory review and evaluation process, or SHREP for short. Some of the questions we ask in that are, does the bank have enough funds to support losses? Does it have a sustainable business strategy? And more recently, we've been asking things like, are banks taking the steps needed to deal with current challenges, such as the pandemic shock? Now Andrea, you and Frank just presented our findings from last year's assessment in a press conference. Could you summarize those findings for our listeners and explain a bit how satisfied you are about how European banks are doing? Yes, the picture which is emerging from our review is a positive one, surely more positive than we feared only one year ago. Banks maintain the strong capital, which means high funds to absorb losses. And this is important because this is what determines the ability of the banks to lend to the real economy, to households, to small businesses, to corporates. And indeed, loans kept flowing to the economy throughout the year, also thanks to the strength that banks demonstrated. Banks also came out to be more profitable than the year before, which is good because also profits are a defense from losses, from risks, and they have continued improving the quality of their assets. So that's all positive. Every year we give scores to banks. They run a report, let's say, and we maintain the scores broadly unchanged, which with respect to the expectations and the fears we had one year ago is a good news. Still, we have addressed banks a number of qualitative recommendations because we also identify shortcomings that we want them to fix, especially in the way in which they manage risks in their internal governance. And we expect remediation of these findings in the coming months, actually. We should not be complacent. We need a strong and efficient banking sector to support the recovery from the pandemic and to also help the digital and green transformation of our economies. OK, so overall it's good news for our banks. And well, if banks are doing well, then it's also good news for their customers. Now, I've already mentioned that we run this supervisory process every year. And if we go back a bit to 2021, our assessment then was very much shaped by the pandemic and how it was impacting our economy. And as part of our response to the crisis, we focused our assessment then very specifically on ensuring that banks could face that pandemic shock. If we fast forward to today, our latest assessments are the one that you just presented the findings of. This marks a kind of return to normality. Now, Frank, what exactly does that mean, a return to normality? And to what extent is this return to normality a positive sign that the crisis phase is over? Well, thank you, Katie. I think you actually explained it very well. This is a positive sign. But at the same time, I would say it is not a sign for us to relax. Actually, supervisors should never relax. I think that our task is to always be on the lookout for risks, even if the sky is becoming bluer and if the sun is becoming shiny, maybe especially then. So indeed, looking back what we did last year, the first year of the pandemic, we felt that what we needed to do is to really focus on the pandemic-related risks. Also to give banks operational relief, if you like, so that we really would just focus on those things that were top of their minds and top of our minds. And indeed, during 2021, we were able to return to what we then call a fully-fledged assessment. And that is, I think, indeed, an overall good sign. Now, as you mentioned already in your introduction, the economic outlook has improved. But, and here comes the supervisor, there are still uncertainties. It could be that the economy is going to be performing more strongly than we expect. That could, for example, be if the pandemic continues to evade and if households become even more confident, start spending more. But at the same time, as we all know, reading the newspapers, there are geopolitical tensions. And it could also be that the still-ongoing supply bottlenecks might continue to be in place longer than we are currently anticipating. So faced with all these uncertainties, what we are doing is carefully look at the quality of the assets of banks' books. And, you know, after all, it could be that the full impact of the crisis on companies, on people, on bankruptcy, on jobs, that that full impact might manifest itself with some delay. So yes, all in all, I think that, you know, when the pandemic hit us, had we known at that time that we would have been in the situation where we are today, we would have immediately signed off to that. But being where we stand today, we should not be complacent. Okay, so banks are doing well overall, even though the economy hasn't fully recovered yet, but they're not completely out of the woods. Now, I want to shift focus a little bit and look to the future, because indeed part of our job as a supervisor is to look ahead and to identify the risks that are emerging for banks. And what we do is then we take those risks that we've identified and we base the priorities for our supervision on them. And this is all what guides our work for the next two years, each cycle. I want to look first at one very important one of those risks, and that's credit risk. And this has been a big topic in our work with banks already during the pandemic. And credit risk is all about measuring how likely it is that people fail to pay back the money that they owe to banks, and also about seeing how prepared banks are to manage those losses. Now it goes without saying that the support measures put in place during the pandemic by governments, by central banks such as ourselves were essential to keep the economy afloat. But they have made it harder to see what risks look below the surface, both for the banks and for us as a supervisor. So Andrea, how are banks doing on the credit risk front? Well, your spot on, Katie, the strong support measures have clouded our visibility on the real credit risk that banks are facing. In several member states there were moratorium payments introduced so banks cannot use the regularity of payments as an indicator of the great quality of their borrowers. And that's essentially a payment holiday, isn't it? Yeah, it's a payment holiday basically, a suspension of payments for a certain period of time. So it's clear that we immediately throughout the year, throughout 2021 we pushed the banks to start developing new indicators and to start looking through the measures to look at the real ability of their customers to repay when the measures, the support measures would have been withdrawn. So that has been the greatest focus of our effort on credit risk. So that's really a new thing that banks have had to do. It's a completely new scenario for them. Yeah, absolutely. Well, actually it's partially a new scenario. They don't have the indicators they usually rely on but they should have the credit risk controls in place to identify early and manage early customers that are unable to pay. So we made a review process which was explicitly targeted on the ability of the banks to control the quality of their customers. And there is where let's say the outcome was not as satisfactory as we would have liked. We had I think in 70% of the cases the banks were addressed specific measures because we identified shortcomings. We addressed the letters to banks setting out our expectations. We asked them to self-assess themselves against these expectations and then we gave them some homework to fix the problems that we had identified. And there's a whole lot of work that we have done and we expect the bank to do to remediate these shortcomings. So that's I would say the most important focus of our effort in this year. This also means that for instance when I mentioned to you that we kept the overall scores unchanged but there are some areas in which the scores deteriorated and one of these areas is great risk indeed exactly because of these qualitative findings. So we will follow up with the banks on the individual recommendations that we made and we will make sure that they improve their processes. Okay, let's stay with these challenges that banks are facing. Frank, there's another very big risk on the horizon, the climate crisis, and some would even say that well it's not on the horizon it's already very much with us in the here and now. But what's important for our conversation today is that we've actually identified risks stemming from climate change as one of our priorities for the next two years for our supervision in the next two years. How exactly will this translate into the everyday work of our supervisors? I suppose what I'm saying is how will they concretely incorporate climate risks into their supervision of banks? Well, 2022 is indeed a very important year in our supervision of climate related and environmental risk and I add that environmental risk because it is broader than just climate. It's also about by the firstly laws for example. Now the first thing that I would maybe like to explain a little bit is that we are going to be conducting a climate stress test and there we are going to be seeing how well-prepared banks are to really deal with the shocks that climate risk might and will most probably cause. Now that is easily said a climate related stress test but we have actually never done that. It's a first for us but also for the banks it's also a learning exercise for the banks but also for ourselves. But what I always add is that we and they better learn fast because as you know risks have the nasty habit of not waiting to manifest themselves until we are perfectly prepared. They are out there and climate related risks as you said very clearly they are not waiting, they are there. The droughts, the floods, the fires, the wildfires, they are there. So that is one thing, the climate stress test. Second there will be also this year a what we call a thematic review meaning that our supervisors will be looking deeper into how banks are incorporating climate risks into their corporate governance, into their risk management, into their strategy. So really going into what you might maybe call the DNA of the bank. It's also going to be done not just by a central team but by the joint supervisory teams or the teams that really do the supervision. On a daily basis. On a daily basis. There is even going to be onsite on this as well so people going into the banks and really challenging them. Because really as I said we see climate related risk, environmental risk as one of the main challenges for banks and therefore also for us as supervisors for the years to come. Banks have been making progress. So we challenged them last year on the basis of expectations. We sent them letters. We asked for action plans. So there has been progress. But the pace is still way too slow. So all of us have to step out our game and then maybe to end here. Both this climate related stress test and the thematic review as well as these onsites. All that will feed in the findings will feed in this annual SHRAP process. So climate risks and the broader environmental risks that you've mentioned. This year is really going to be a big year for them in terms of supervision and I'm sure it will continue in the years to come as well. The way I put it is we have been preparing. Awareness has been created. We have issued our expectations more than a year ago. This is the year where the rubber hits the road. Now another challenge that banks are facing although it must be said that they've been trying to tackle this one for some years is the sustainability of their business models. There are a few gaps that are key to making the way banks work sustainable for the future. One in particular is low profitability and one way that you can tackle this or banks can tackle this is through the digital transformation. Frank, can you explain a bit how this all fits together? Talking about banks' business models maybe the first thing to say is it's not for us to define their business models. We are not at the steering wheel. We are the supervisor. But we do need to push banks to make sure that the business that they do today is sustainable and prepares them for the future. Why is that a challenge? One of the challenges is that as I think you and Andrea have already mentioned is the low profitability of banks. This has been around since long before we had the pandemic. One area where we are focusing on is the digitalization of banks. In today's world this is of course a key aspect. It's important that banks speed up that process dealing with the challenges both by the pandemic but also because customer preferences are changing. This is challenging because not all customers when we speak to banks they also meet all their customers that are afraid of this but by and large people are expecting to be able to in a modern way communicate with their banks. And of course there are competitors. Fintechs, the big techs entering the space as well. So more needs to be done by the banks digitizing their operations and also in that way and this will enhance profitability reducing costs. By being digital the marginal cost of an extra client of course is very low. So this is a way that banks can work to further recover from the pandemic. So I would say it is a good time to further invest in digital but it is also high time to do so. It's really interesting. So the digital push that we've kind of seen gain ground during the pandemic is not just a way for banks to kind of be more attuned to their customers needs and wants but it's also a way for them to be more efficient and also more profitable. Now the last priority I want to touch on today is actually also linked to how banks are run and that's their internal governance. Now in our assessment we also look at a bank's organizational structure, the people who run it and all the checks and balances that they have in place to ensure sound governance. Our latest findings have shown that internal governance is still a weak spot for banks and it's actually the area in which we made the highest number of recommendations. A lot of these had to do with banks' management bodies and indeed one topic that we've actually discussed here on the podcast with yourself Frank in relation to banks' management bodies is diversity. Now Andrea, I'm curious to know what role diversity can play in terms of internal governance, banks' internal governance. In my experience as a supervisor I've always seen banks failing or risking to fail when there were shortcomings in their internal governance. Either a dominant CEO that nobody there to challenge or a group think in a group of people very homogeneous in their thinking and pushing the bank in the same direction and eventually in these cases it's very easy to see that the banks can maybe do a lot of profit for some times and then crash against the wall because there is no internal checks and balances. This is very important. Having checks and balances internally at all levels, at the board level but also throughout the ladder. Of course the commercial people will push this or that business will try to find more customers to make more profit but you need to have a good balance with what we call the second line of defense. So the risk managers, the compliance officers don't check that they are not taking excessive risks or that they are not following improper conducts in managing their customers. So this is very important and having diversity at all levels is indeed essential. We are thinking of diversity in different dimensions. Gender diversity is a very important one of course and we have stressed this more and more in our processes, in our rep processes we've already seen some years but it's also differences in terms of age, provenance, in terms of professional background skills. For instance, we have been saying and Frank very strongly emphasized that climate change is very important having experts in this area in your board could be important. Digitalization, I mean it's important also there to help people that understand. So we showed last year I think in one of our survey that the banks that had IT experts in their boards were also the banks that had the lowest level of cyberattacks. So they had strongest defense because they had people understanding the issue up there in the board. So diversity is an important issue across all these dimensions. Banks need to devote more attention to that some areas, gender for instance they are in several member states also required to set targets and where they are not required by regulations they should set targets themselves and try to achieve them and we have seen that the progress has been pretty disappointing honestly even both when there were external targets and when the banks set the targets themselves. So we will continue using our supervisor review process to put pressure on banks that are a very important topic. You mentioned that this is the area where we have the highest number of recommendations these years actually it's not the first year that this is the case. It's pretty disappointing to see that you raise many recommendations and sometimes the recommendations of this year are the same that were there last year and they have not been remediated. So I think that we need also to find ways to raise the temperature that are not following up to our recommendations. Now, before we wrap up we always ask our guests if they have what we call a hot tip linked to the topic we are discussing today. What would you like to share with our listeners? Well, thank you Kitty. I am reading a book right now from Robert Schiller no Nobel laureate it's called Narrative Economics and I found it interesting because it focuses on those narratives that become viral that everybody believes them and even if there are facts there are plain truths that disprove them they keep running. Now all we told you today on our rep process tells us that the fact that banks are well capitalized has enabled banks to support the economy and avoid the pandemic that became mixed with the financial crisis that would have been a disaster for us all but still there is this narrative going on that if you are asking banks to maintain more capital they will not lend into the economy. This will damage growth. This will damage job opportunities. We are going now into a new legislative cycle in which international standards are to be implemented there is a lot of law being saying that if we tighten capital requirements this will be bad for the economy bad for growth. Well it's indeed according to this narrative it's a viral message that unfortunately still has success but it's not really well grounded so that was my tip today. Well thank you to both of you so much for joining the conversation today and sharing your and also your book recommendations. Thank you very much. Thank you Katie. If you're interested in the topic of banks do check out the show notes for other podcasts and further reading. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard please subscribe and leave us a review. We'd also love to hear from you so do share your feedback and ideas with us via social media. Until next time, thanks for listening.