 The pandemic has triggered more fundamental changes to the environment in which we all operate, banks as well. We are entering a phase of strong economic recovery with banks exiting the crisis safe and sound. I am really convinced that the moment for the structural transformation of the European banking sector is now. And the two watch words that I would use would be resilience, but also complacency. It's key in making sure that the financial system actually greens together with the broader economy. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. You've just heard some of the speakers at the ECB forum on banking supervision. Every two years, policymakers, supervisors and bankers meet to exchange views on what's going on in banking and supervision. The recovery from the pandemic seems firmly underway, but that doesn't necessarily mean it's all plain sailing from here on in. Add to that climate risks that loom large on the horizon and there's a lot for banks and supervisors to be keeping their eye on in the coming years. It's no surprise then that the forum's topic this year was tomorrow's banking navigating change. It was all about checking whether banks are on the right course. Together with the forum's panellists, I'll be taking you on a journey through the highlights. We'll look at the impact of the pandemic on banks and whether they have the right tools to deal with what lies ahead. It was an extremely high level of uncertainty we were facing. We didn't know what would have happened in terms of the speed of the recovery, whether there would have been a recovery, how long the pandemic would have stayed with us. We didn't know that public support measures would have been effective as they have been. It was essentially that moment to preserve capital. That was supervisory board chair Andrea Enria talking about some of the support measures the ECB's banking supervision arm put in place to respond to the pandemic. Together with the measures by governments and central banks, these kept the economy afloat during the crisis. It was the banks that made sure money continued to reach people and firms keeping bankruptcies at bay. Measures like these meant the economy could come out the other side pretty much intact. I want to stress again the support measures were not for the financial sector. We're directed to people and businesses that were suffering from a war, a war against the virus. As Anna Boutin, group executive chairman of Bank of Santander underlined, we mustn't forget that this was first and foremost a health crisis. But today we're focusing on how the pandemic affected the economy and what the role of banks has been. And it goes without saying that the support measures were essential. But one downside is that they might make it harder to see what risks lurk below the surface. For example, a moratorium, or put simply a payment holiday, makes it hard for banks to judge whether a debtor is still solvent. The same is true for government guarantee schemes. They make the picture blurry for banks, but also for supervisors. And one risk that supervisors are looking closely at is something we call credit risk. It's basically how likely it is that people fail to pay back their bank loans. With support measures in place, it's harder for banks to judge whether a borrower will get into trouble. Supervisory board member Elizabeth McCall spoke about this at the forum. We have forbearance in place. We have fiscal supports. We have loan guarantees. And all of this is entirely appropriate, and it shouldn't be withdrawn in any abrupt manner. But we know that it will end at a certain point in time. And if we're masking what the overall credit picture is, what the asset quality on the balance sheets looks like, we will miss the overall picture. If banks can't assess the real credit risk, they also can't plan ahead and set aside money in case the borrower can't repay the loan. When it looks like a loan is very unlikely to be repaid, it becomes what we call a non-performing loan or an NPL. And that's probably a term you've heard us use before. Now, it's worth mentioning that credit risk isn't a new concern for supervisors. It had been high on their agenda for years, but the pandemic meant it needed closer attention. So how are things looking? NPL numbers right now are favorable. They still appear to be declining from the end of 2019. It was at 3.22% at the end of 2019. And now it's at 2.32% at the end of June 2021. The pandemic hasn't yet caused the wave of non-performing loans that we'd feared, leaving banks books in pretty good shape. But not all firms will survive the crisis. And not everybody will be able to repay their loans. We're starting to see some bankruptcies creeping up in certain sectors, especially. And the expectation is that as the supports are removed, you're going to see increasing bankruptcies and this type of thing. So this picture, this story is not ended. Now, to minimize an increase in non-performing loans, we as supervisors have repeatedly stressed that even in hard times, banks should only lend to customers who are able to pay back. We've reminded banks as well to keep a close eye on the risks and tackle non-performing loans early on. We've also warned them against releasing the money they've set aside too soon, just in case risks emerge later on. Banks need to be safe and strong to support the recovery. It's all about making sure they don't let their guard down too soon. There's good news here, quite a bit of good news. We've got a stability. We've got growth. We've got lending continuing. We have some protection that we see of households and businesses. But I want to really make sure that we don't succumb to any complacency as we take stock going into the end of the year. We really need to encourage institutions to have their houses in order to make sure they understand the credit picture. Now, if the pandemic wasn't enough of a challenge for banks, well, for all of us actually, another risk looming big on the horizon is the climate crisis. Maybe to just remind everyone who is looking of the urgency to start with. 1 and 1 half degrees means 70% more of the floods and the fires and the droughts that we're seeing today. Two degrees means 200% to 300% more of the floods, the fires and the droughts we see today. Today, we are not on a 1 and 1 half degree path. We are not on a two degree path. We are on a 2.7 degree path. Clear words there on just how serious the situation is from our supervisory board vice chair, Frank Elderson. Let's briefly unpack why the climate crisis is relevant for banks. There are two types of risk linked to climate change, physical and transition. Banks are affected by both. A physical risk could emerge from a bank lending to farmers affected by droughts. Making loans to a car manufacturer entails a transition risk in the sense that this car maker will be forced to eventually make greener models. And this will force them as well to restructure their business quite substantially. That's a good example of transition risk. But there's another element to it. Banks are going to play a huge role in our transition to a greener economy. In Europe, banks still provide most of the funding to firms, meaning they'll need to provide a lot of the money for that green changeover. So to make sure that they can do that, they need to take climate change seriously. As our supervisory board member, Kerstin Afjochnik, told me before the forum, We hope that banks will ultimately treat climate risk exactly the same as other risks in their balance sheets. This means that they need to identify the risks, measure them in a good way, and that they also need to follow up and report to supervisors as well as disclosure climate risk in a proper way. We've actually asked banks to assess to what extent they're addressing climate risks. Here's Frank Eldersen again, explaining what we found. Banks have been very, very open and very sincere. So I think this is very much to be applauded. That's the good news. The bad news is that actually, none of the banks under our supervision is even close to complying with all our expectations. So a lot of work still needs to be done. But we also saw that this work is achievable. We do see good practices and we will share those in this report that we will publish in some weeks time. And the good news there is that we see good practices in different banks, different business models and different geographies. So this tells us that this is possible, that it's not some kind of like an impossible ambition that we put there. It's possible, it can be done. In short, banks are aware that climate change can have a big impact on their business. But they still have a long way to go in preparing for it. Assessing climate risk is not an easy task. The data is still patchy and until that's solved, banks risk managers need to find other creative ways of measuring them. As supervisors, we're helping banks tackle this new challenge. After all, it's our job to make sure that they're safe and sound. We've already mentioned the self-assessment, but another big milestone next year will be the first stress test to see whether banks are prepared for climate risks. And climate is something that we're really gonna be putting a lot of importance on in the coming months. Looking ahead, there's no denying the challenge the climate crisis presents for banks. But there is progress, and we as supervisors will make sure that banks keep traveling in the right direction. There is actually no supervisor, no regulator around the world that still doubts whether they have a role to play. That I think that it is now so clear that we all understand that this is within our mandate that we need to help banks to make this change, to incorporating climate change and environmental change in their risk management, to grab the opportunities and to align their balance sheet with a Paris-compatible transition path. Now, the forum wasn't just about looking at what risks lie ahead of us. The participants also discussed the necessary steps to deepen integration of the European banking sector, basically what's going on with the banking union. The roadmap for the banking union was set up in 2012 in the wake of the financial crisis. The idea was to create a level playing field and an integrated banking market. Having all banks in the euro area adhere to the same rules would make them more resilient. That's overseen by our banking supervision arm. We have come a long way on the banking union. The roadmap the European Commission presented almost 10 years ago and visaged three pillars, a single banking supervisor, a single banking resolution, and the common European deposit insurance scheme. A supervisory board member hearsed enough Jochnik mentions. We've moved a fair way along that roadmap since 2012 and the pandemic was the first real crisis test for the banking union. The good news is that it passed. European supervision has ensured that unlike in the last crisis, banks acted as shock absorbers rather than shock amplifiers. That was President Christine Lagarde, but there are still a few things missing. Banking union is still not complete, stopping funds from being shared freely across borders. At the height of the pandemic, some countries tried to protect their local markets. This meant that banks were kept from transferring money to other banks in their group elsewhere in Europe, even though they could afford it. The shock has also affected countries unevenly, which might lead to lots of different approaches to tackling it. This is just one example that shows that a focus on national solutions only moves us further away from a more integrated banking union. But the one big building block that's missing from a complete banking union is the third pillar that Kirsten mentioned, the European Deposit Insurance Scheme, or EDIS. It would be a system to provide stronger protection for all bank deposits across Europe in case a bank becomes insolvent, as John Berrigan, Director General at the European Commission explained. There's a sort of principle reason that if you are presenting the banking union as a single jurisdiction, then all depositors should be equally protected across that jurisdiction. And the way you do that is through having a European Deposit Insurance Scheme. Without this missing part, the banking union is not complete. Not only is this not sustainable, it also means that banks aren't getting the most out of it. Some might argue now that there is no need for such a scheme. We have come out of the pandemic pretty well and banks are continuing their activities. But not going ahead with the insurance scheme is not an option. We need more action in this area, not just for us, but also for financial stability, for trust in banks, and for making sure that we can further integrate the European banking market. So there's certainly a lot for banks and supervisors to be keeping an eye on. If you'd like to dive deeper into any of these topics, check out the show notes for links to all of the panel discussions. This brings us to the end of this episode. 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 love to hear from you, so do share your feedback and ideas with us via social media. Until next time, thanks for listening.