 It's our job to make sure banks are safe and sound. It's also our job to make sure that they can fend off any challenges. And right now, there are quite a few of them. Russia's unjustified invasion of Ukraine has pushed inflation up to levels we haven't seen in decades here in Europe. And this affects people in their everyday lives, businesses and, of course, also banks. We also don't know how long the war and its effects will last. Every year, we look at the challenges facing banks and determine what they need to do and how much capital they need to set aside to be able to cope during the year ahead. Today, we'll go through what we found in our latest review of this. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. I'm very pleased to be joined in the studio today by chair of the supervisory board, Andrea Enria. Andrea, thank you so much for joining us again here on the podcast. Thank you very much, Katie. Glad to be here. Now, Russia's invasion of Ukraine happened almost one year ago. It was a shock on so many levels, a shock that war is back in Europe and, of course, a shock in terms of how it affects our economy as well. Banks have been able to withstand the impact quite well, but I'm sure there are quite a few unknowns that they still need to keep a very close eye on. What are the results of your latest assessment? How are banks faring in these quite uncertain times? 2022 was a good year for European banks, I think. They closed the year with a strong capital position, strong liquidity position. Asset quality, surprisingly to some extent, kept improving throughout the year, while we were fearing an immediate impact of the Russian invasion of Ukraine on the macroeconomy and, therefore, on the ability of customers to pay back the banks. And the increase in interest rates that has accompanied, let's say, the raising inflation has also been a positive news for banks boosting their profitability to a large extent. So the situation has been improving, but our review of the banks concluded with basically stable scores and stable requirements in terms of capital. Why is that? Well, because we are still in a very uncertain environment and banks also do have some structural weaknesses in the way in which they manage risks in their internal controls and this is particularly important when you are in an uncertain environment. Okay, that all sounds fairly positive. You mentioned that capital requirements remained steady and the banks have, in general, shown a lot of resilience overall, but you already touched upon it. You are asking some banks for kind of stronger security nets in some areas, for example, their exposures to non-performing loans or what we call leveraged finance. This was the first time that you kind of looked at this idea of leveraged finance. Can you explain a bit what your findings were and maybe what this all means, why it's so important for banks? You're right, Katie. Since the pandemic, let's say, we started focusing a lot on our supervisory activities on specific areas of business in which particular risks may arise for banks. So for instance, we focus on exposures to sectors that were particularly hit by the pandemic, sectors that were exposed to the increase in prices for energy due to the energy shock following the Russian invasion of Ukraine. So things like food services. Exactly. Or even manufacturing using a lot of energy like ceramic or metal, chemicals and the like. So to see what are the potential risks stemming from there. But we also focus very much, for instance, on sectors which are fragile in case of significant interest-rating crisis. For instance, non-bank financial institutions, which have taken leveraged bets on certain sectors of the financial markets. For instance, finance leveraged buyouts and taking huge amount of debt. Now, if the amount of debt is huge, of course, when interest rates increase, these counterparts become very fragile. Leveraged finance has been in our radar screen for a while, but this is the first year actually in which we charge some capital add-ons for banks exposed to these particularly leveraged counterparts. So this is where you ask them to set aside more capital to cover that risk that comes from this leveraged finance. Exactly. And basically, we ask banks to strengthen their own internal risk management, their own what we call risk appetite. So sending limits and being able to manage risk. And when we found weaknesses, we asked banks to improve to reduce exposure to risks. And when we were not satisfied, of course, we asked banks to raise the capital to protect themselves against possible losses. Let's do it on one point that we've mentioned a few times now, the economic situation. It's still very hard to say exactly what 2023 will bring on that front. What exactly does this uncertain situation mean for banks? What are their biggest challenges in all of this? If we look at the central forecast, what we expect as a trajectory of our economy in the Euro area, this is still rather positive for banks. There would be probably further normalization interest rates, which is on average good news for the banks. And there will likely be a slow down or a shallow and short recession. So which is not good news, but let's say it's still probably more than compensated by the positive effect of interest rates increases. But as you say correctly, Cathy, I mean, we do have a lot of uncertainty here. So to some extent, banks will have to navigate a rather narrow path between, let's say, the shilla of a possible recession, stronger than we currently expect, or the Caribbean, let's say, of an interest rate increase, which is sharper and faster than we currently expect. And in both cases, there would be, of course, also a potential negative repercussions on their balance sheets. And this is why we are putting a lot of focus on banks' ability to actively manage this, to have strong internal controls, to be able to react fast to challenges in both directions. And also, I must say that banks sometimes seem a bit optimistic on the likelihood that once again, if things go wrong, there will be the discovery of the public support coming. But we are in a very difficult situation, a different situation right now. Monetary policy support will not be forecoming because inflation is particularly high, and those co-fiscal support will not be as broad-based and blanket support as it was during the pandemic. So these raises concerns, and I must add also that there are longer-term structural challenges. I mean, the digital transformation of our economies, the climate change, so managing these risks in an appropriate way becomes more and more crucial. Okay, so it's all about not resting on their laurels and making sure that they've got their risk controls in place, that they know what's going on in their business and not expect, as you said, the public support to come in and save them this time around. Now another of the economic challenges that we've touched upon a few times now in the conversation is the very high inflation that we've been seeing here in Europe. And of course, we at the ECB have been raising our key interest rates to get it under control. Now, last year when we talked on the podcast, we spoke about how banks are faring, and one of your concerns was low profitability at the time. And you mentioned earlier that, of course, higher rates will help there. But is that the end of the story? Is there more at play here in terms of how banks are doing or how banks will do in terms of their profitability? Higher interest rates are generally positive for banks. I mean, banks generally, you know, typically in their brick-and-mortar business, collect side deposits, and then they lend longer term, for instance, mortgages or corporate loans. So they benefit when there is higher interest rate environments. And in general, when the interest rates are moving, let's say the interest rates on the liabilities that they pay to the depositors move slower than the interest rates that they charge to customers, also because some of the contracts are variable rates. So the effect is generally positive, but there is a but. Of course, the higher the interest rate, the more certain categories of customers might find it difficult to pay back the loans. So there's a risk involved? Yeah, there is a risk involved that some customers can be unable to, let's say, respect their contracts, and they could become non-performing. So the point is that the higher the interest rates go, the more there will be distributional effects across banks, banks which are, for instance, very much focused on consumer lending or on commercial estate, residential estate, which are very sensitive to interest rates also on the side of customers, might face deterioration in asset quality. So it's positive, but of course there could be winners and losers, and that's where we as supervisors should focus. Now, this is your last year as chair of the supervisory board. A lot has happened since you started in 2019. You've mentioned in interviews a couple of times that being a supervisor isn't always easy. Andrea, what are you most proud of from your time as chair, and what would you like to achieve in this last year before the end of your mandate? The single supervisory mechanism, so the ECB together with the national authorities is not an easy organization. I mean, it's a bit of a tanker. So we are a heavy organization, very rules-based as all the authorities, the agencies in the European Union. So what I'm very proud of is that we managed to be very agile in responding to the sequence of shocks that we experienced in the last three years, so the pandemic, then the Russian invasion of Ukraine, and we deployed a number of policies that were communicated very fast that gave banks more flexibility on the one hand to take all the challenges, but also asking them to be super safe, to focus their risk management, to keep more capital in the banks, in their balance sheets. So I think this worked very well, and if the banks were, let's say, supporting the economy throughout these difficult times, I think it's also, to some extent, a merit of our good policies there. In terms of what I hope to lead to my successor at the end of the year, I think we started a cultural change in the organization, moving to a more mature organization. As I said, Europe is generally a very rules-based environment, so we tend to rely on codified rules, which makes our type of activities sometimes a bit bureaucratic and heavy-handed, tick the box. Supervision, I think, needs to be more risk-focused. We need to leave more room for judgment of the supervisors, and to have internal mechanisms that review and check their assessment. So we try to move in this direction. If you do more judgment, it means that you need also to be more transparent towards the banks and the public in general about how you make your judgments. So moving to an organization that is more risk-focused, more transparent, and better able to adjust the risks that are in the economy, I think is something that I would hope to leave to my successor. Well, I'm sure you will. I think we often forget that the single supervisory mechanism was only brought in in 2014, so it's not even 10 years old yet. So the fact that it's achieved so much and it's already at that stage of, shall we say, maturing is very impressive. Now, before we wrap up, we have a question that we ask all our guests on the podcast, and that's for a hot tip, linked to the topic, broadly linked to the topic we're discussing today. Andrea, have you thought of something to inspire our listeners? Yeah, I don't know whether it will fit your request, but let's see. One thing that I would like to mention is something that John Minor Keynes mentioned is treaties of probability, not one of his most renowned books written in 1921, and this is the so-called dilemma of the umbrella. Keynes was discussing about probabilities, and basically he was mentioning the point that there are situations in which you cannot really rank the probabilities. It makes it difficult to forecast what will happen in the future, so this is what is essential to his concept of uncertainty that we discussed so much today. Basically he said you can find yourself in a situation in which the barometer is high, but there are black clouds out there, so you have two measurement systems, and actually you cannot rank them. You cannot combine them in a deterministic estimate, and this is very much the situation we are in right now. We cannot really use our models and say this is what is likely to happen tomorrow. There are so many uncertainties out there that we have to rely a lot on judgment, and of course also on prudence, which is the call that we as supervisors always make. Okay, dilemma of the umbrella by Keynes. Very, very interesting. Thank you so much, Andrea. Well, that brings us to the end of this episode. I want to thank Andrea Andrea, chair of our supervisory board for joining the conversation today. Thank you, Katie. Check out the show notes for additional material on this topic. 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. Until next time, thanks for listening.