 Our world has faced challenge after challenge over the past few years. During the pandemic, banks fared well and kept supporting people and firms. But now they find themselves in a new world. One of high uncertainty, war, rising prices and interest rate hikes. And this is challenging their resilience. Every year we review our supervisory priorities. So basically the risks and challenges that we look at when we're supervising banks over the next three years. We do this because as the world changes, so do our priorities as supervisors. And today we'll be talking about what our focus will be for the next three years. 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 joined today by two guests, Supervisory Board Member Sherstin Afyokhnik and head of supervisory strategy and risk, Mario Cualiarello. Welcome to the podcast, both of you. It's really nice to have you here in the studio. Thank you for having us here, Katie. Now, setting supervisory priorities is all about making sure that banks stay safe and sound in the current environment and that they're fit to withstand challenges that the future brings. If we have a think about where we are right now, central banks are raising interest rates to tackle high inflation. Now, these higher rates are actually good for banks. I mean, it means more profits for them. But at the same time, the economic outlook is worsening and this can have negative consequences for banks. For example, if their customers are not able to repay their loans. Sherstin, let's dive right into the first priority, which is all about ensuring banks are strong in the face of the current economic and geopolitical shocks that we're facing. What kind of areas of banks operations are you going to be looking at in this particular priority? Yeah, thank you for that important question. The first thing I would like to underline is that so far the banking sector as a whole has remained resilient to the large and negative external shocks it has faced in the recent years. It was first the adverse effects with the pandemic had on the economic activity and more recently they fall out from the Russian invasion of Ukraine. So while we don't have data for the full year yet, it's probable that 2022 will turn to be a good year for the banking sector overall. I would encourage those listeners who are interested in the final details of banking performance to take a look at the joint blog post which Mario and I have published about our supervisory priorities. We'll certainly be sure to link to that in the show notes. As you mentioned, the economic outlook has deteriorated significantly in recent months. The Russian war in Ukraine is ongoing. Inflation has been on the rise and central banks have raised their key policy interest rates to fight that. The combination of these factors presents a number of risks to banks and they need to be ready for their potential materialization in the future. So in the near term, we are looking in particular at how banks manage their credit risk. High inflation, rising interest rates and slowing growth are putting pressure on many actors in the economy, especially people and companies. Banks lend to these actors and one big part of this supervisory priority looks at the risk of loans not being able to be paid back. That's what we call credit risk. Okay, that's what credit risk is all about. So it's the possibility that loans might not be able to be paid back. Exactly. So credit risk isn't a newcomer to our supervisory priorities. We were already focusing on credit risk last year in particular because of the pandemic. The support measures that many countries put in place were of course essential for the economy. But they also made it harder for banks to see which loans could turn bad. So that's because the measures kind of artificially supported everyone and it's more difficult. It's a bit of a blurry picture, right, to see which loans are good and which ones maybe the people actually would have struggled if they hadn't had those support measures. Exactly. You are explaining it very well. But now they have to deal with this new world where they are faced with fresh challenges despite having not yet fully recovered from the pandemic. Many companies have been exposed to these economic and geopolitical shocks. For example, for higher energy prices or having to pay more for supplies and labor. They may have to allocate a larger share of their income to these things leaving them with less to pay back loans. This is particularly true for energy intensive sectors most affected by the war such as agriculture and transport and those facing higher costs for materials like construction. So what does it mean for banks? I mean, if they have this increase in credit risk, what does it actually mean for them in practice? Yeah, the increase in credit risk has an impact on banks as a quality of the loans or assets on their books because it will go down. This may mean that they have to hold more capital to cover potential losses. And we have already seen a rise in the number of loans showing an increasing amount of credit risk also known as non performing loans. Mario, I'll turn to you now. Now when it comes to credit risk, what exactly do supervisors look at concretely here? So we know that they're going to be checking that the banks can manage this credit risk. But what does that mean in practice? Okay. Thanks. This is a good question. I mean, first of all, we need to acknowledge there have been some progress in the banking sector over the past years in terms of credit risk management. Still, our supervisors during this year have found that there are still gaps and some shortcomings to be addressed. And I think our concern is that especially in light of the deterioration of the macroeconomic conditions, banks should be ready to put forward the right practices to detect, measure and then mitigate the credit risk so that they can avoid that loans become a problem for the banks for the banks themselves. So how exactly do the supervisors do this? Like what things exactly are they going to be looking at? There are several ways. I would say that the toolkit of the supervisors is quite broad and they can use it for understanding and assessing what banks are doing for flagging deficiencies when this is needed. And of course, require and enforcing corrective actions. Some issues are systemic, so they involve many banks at the same time in a similar way. So in this case, the typical tool is the thematic reviews in which you can look and compare banks across the board. And I think this is one of the benefits of being a European supervisor. You can look horizontally at the sector, you can compare and contrast the banks and also identify good practices and best practices to disseminate. Because you have more of a bird's-eye view over it. Exactly. You can look horizontally and then deep dive when this is needed. We have also the on-site inspections, which is a very powerful tool because the supervisors can go directly in the premises of the banks and look at what banks are doing and the assessment is more direct. Then there are also issues which are idiosyncratic in nature. They involve mostly a few banks and in this case the supervisory teams are following up directly with these specific banks. Perhaps if you want, I can give you a couple of examples for the next round of priorities. One is on the process that banks are following for granting a loan, is what we call loan origination. This is a general issue but we will focus mostly on the housing market but also the commercial real estate, the office space. And here there are clear guidelines at the European level and we want to be sure that banks are following these guidelines. And basically the main principle we are following is that banks should be able to assess since the start of the process how credit-worthy the counterparty is in order to be sure that the customer is getting the right product with the right price and especially that the borrower will be able to repay their loans, is what Kerstin was mentioning earlier. So even before the customer is on their books, making sure as soon as they submit that application for the loan. That's exactly the point. And this is not only a tool for his management, so for the benefit of the banks but it's also a safeguard for the customers of the banks because eventually there is no benefit for them to get a loan they cannot repay at some point. Perhaps another example is more linked to what Kerstin was saying on the impact of the geopolitical risk at large. We will look at the vulnerable sectors. This is something which we have done already in the past and also shows how flexible our toolkit is because we were looking already easier at accommodation, transportation, tourism, so all the sectors hit by the pandemic and now we are shifting the attention to the sectors which are more heavily affected by the war in Ukraine and some issues on the supply chain. So for the following cycle we look more at the companies using a lot of energy, oil, gas and so on, especially manufacturing but also the energy traders. And in this case what we do and our supervisors are doing is to look at the exposures, the assess whether banks are able to monitor the evolution of trade risk and also if they are putting aside enough provisions for dealing with trade risk in case things go wrong. Let's turn now to addressing some more, shall we say, structural weaknesses within the banks themselves. And this is actually another important part of our supervisory priorities, especially as we look beyond the immediate challenges that the economic environment is presenting at the moment. First of all, digitalization. She asked, what are the challenges for banks when it comes to adapting to this ever digital world? So thank you for this important question again. So I mean in our supervisory priorities we highlight that banks need to look beyond the challenges which lie immediately ahead and they have to keep a medium term horizon in their radar screen and certainly the efforts to digitalize should be part and parcel of any strategy for banks in that regard. Digitalization presents a real opportunity for banks to better serve their customers, changing needs and use new technology to be more efficient but it doesn't come without also risk. So banks have to put in place digital transformation strategies. It's not just about being digital for the sake of being more digital. We expect those strategies to ensure that banks' business models are sustainable also for the future and we are seeing some gaps there and we'll be looking closely at those in our supervision. We also want banks to tackle the risks that come with using more innovative technologies. As part of their digital transformation, banks rely more and more on technologies and third party providers for delivering banking services. So more outsourcing also means that banks are reliant on external providers for some of their critical IT services. So this creates more complexity and means banks are much more interconnected with other players all over the world. And this is of course a risk of operational resilience. So we will be publishing details on our expectations in this area and we will continue the discussions on the strategies that banks are now providing. Okay. Now Mario, we talked a bit about the risks that come with moving to more digital operations and Sherstin's mentioned this higher degree of interconnectedness that we have. One thing that comes to mind there for me at least is cyber attacks. What's the situation like on that front for banks? First, as you mentioned, the cyber attacks have become a major challenge for the banks and for the operational resilience of the banks. And they are more and more difficult to handle first because they are getting more complex and second because they are changing over time. So it's difficult to track what is going on in the market and also they are cross-border by construction. So far what we have seen during the pandemic, notwithstanding the acceleration of the digitalization, banks were able to remain resilient and this is a good sign. And overall the operational losses remained limited. But of course the war in Ukraine is bringing new challenges. I think one concern which Kerstin already mentioned is the outsourcing of some of the critical services. Here what we have seen is that there are an increasing number of activities that banks are outsourcing outside. And while this is to some extent a natural evolution given the complexity of the banking business is also an element requiring that there are in place enough risk controls. At the end of the day now producing banking products or services is becoming part of our supply chain and we should have told the links of this chain are equally strong. And while we are direct supervision on some of the links we don't have on all of them. So it is important also that banks have in place internal controls. And some of these external providers, some of the infrastructures are also outside the European Union. This of course makes them more vulnerable. Especially in this kind of geopolitical situation because they can become in a way the victims of some retaliation especially in response to some of the sanctions in this case against Russia. Perhaps if you allow me the last element I would mention which is more related to the governance of the banks and the board composition. All these business is becoming more complicated. So it is important that the right expertise is at the right place. So of course you need the technical experts at the working level but it is equally important that in the management bodies there is sufficient expertise for steering the bank in the right direction. That brings me actually nicely on to the next challenge, the next structural challenge that I want to talk about. We have discussed climate change several times on the podcast already as well as how banks are actually doing in tackling climate risks and we'll be sure to link to those episodes in the show notes. One of our priorities in the more medium term is to continue on our path and to keep on stepping up our efforts in addressing climate change. It's not the first time we included climate change in our supervisory priorities but we are expecting progress at, shall we say, a much faster pace than normal because it's just so urgent. Can I ask you a blunt question? Have you seen any progress from banks since including climate risk in your supervisory priorities? How are things looking there? As you say we have been talking about climate risk for several years now and we are talking about I think first long term risk and now we are talking about medium term risk. But climate change is very real for all of us so the extreme weather that we have seen in Europe is increasing the likelihood of severe damage to infrastructure, houses and livelihoods which of course impact the banks that lend to and do business with those affected. So the climate transition is also gaining momentum triggered in part by Russia's war in Ukraine and the disruption that this has to energy markets. The transition will affect banks' exposures to heavy emitting sectors and those whose business models will not be sustainable in the net zero world. So that's like people with very energy intensive operations but those that emit a lot of fossil fuels and those that really need to change their operations so that we can transition to a net zero world. Exactly, exactly. So in the last year in particular we have come a long way on climate in our supervision. We have carried out the climate risk stress test in the summer and we have done a thematic review of how banks are doing in incorporating climate and environmental risks in their operations and strategies. We saw that banks are making progress in incorporating these risks into their business operations and risk management but there is still a long way to go before they are in line with what we expect as supervisors. Mario, what we just said, there's still a long way to go until banks will be where we want them to be in terms of our supervisory expectations. What exactly will your supervisors be looking at when they go to the banks and look specifically at climate change? Well I mean as Kerstin said we have done a lot of work in 2022 so in our priorities we are planning to follow up on what we have done in 2022 and work and build on it. So first of all we will look at the findings of the stress test and the thematic review and of course we will ask banks to fill the gaps we found in this work. Especially when it comes to weak processes for assessing the impact of the climate and environmental risks but also banks ability to run proper stress test against climate risk. In our assessment some banks do have a good vision on how to support their customers in reaping the benefits of a smooth transition but still struggle to incorporate this vision into the concrete actions. And we will also try to collect and disseminate the good practices because this is part of our job and effort in this field. We are very determined in this activity and expect that by the end of 2024 the banks will be aligned with our expectations on these risks. Well thank you both of you for explaining what our supervisors will be looking at over the next three years. It's really interesting. Now before you go I do have one last question. We always ask our guests on the podcast for a hot tip linked to the topic we're discussing today so broadly speaking keeping banks safe and sound. Have you thought of something to inspire our listeners? Perhaps I could give it a try. I always like the movie The Big Short. There's also the book but the book I think is not as good as the movie for once. And I think for me what is interesting is that there is a group of investors there who understood before anyone else the bubble in the US housing market. And I think this shows that some risks might be obvious and still go undetected by most. And I think this is why we are making an effort in avoiding blind spots in our assessments. But it's not easy. So this is for me the lesson from the movie. That's a great hot tip. One of my favourite films so I'm very happy with that. Thank you so much. Well that brings us to the end of this episode. I want to thank Shestin Afyoknik and Mario Qualiarello for joining the conversation. Make sure you 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.