Uncertain futures
Claudia Buch urges banks to be on their guard against emerging risks
The future is uncertain
Uncertainty is a key theme for Claudia Buch. Since taking over as ECB Supervisory Board Chair at the start of the year, Buch has repeatedly spoken of the heightened uncertainties facing the world today. (See for example her speeches of February and March.) Last month she warned that climate change, geopolitical tension and new technology could reshape the European and global economy in ways that are extremely hard to predict. Hence Buch’s emphasis on resilience and ensuring the banks under her supervision are strong enough to meet the challenges ahead.
At a more technical level, Buch has zeroed in on banks’ credit models. Current statistical models may not fully capture the ‘novel risks’ ahead. (In particular, Buch was very critical in a recent speech of banks’ use of ‘overlays’ to their expected credit loss models under the IFRS 9 accounting standard – a topic I’ll discuss more fully in a future post.)
Looking ahead
The SSM head has therefore urged banks to improve their models and supplement them with additional forward-looking risk assessment tools, such as scenario analysis. Below are some thoughts on how this logic could apply to each of the main areas of uncertainty that Buch has identified.
Climate change
Every month, it seems, now brings a new temperature record or extreme weather event. As SSM Vice-Chair Frank Elderson has articulated, both climate change and the policy response to it will affect the risks banks face (financial, operational, legal and reputational) via multiple channels. Hence the ECB continues to ramp up the pressure on banks to integrate climate and environmental risks into the broader risk management frameworks.
Transition planning will be an important part of this process. The latest EU banking law (CRD 6) requires banks to produce (and submit to supervisors) plans detailing how they will adapt to the transition to a zero-carbon economy. So banks will have to consider how they manage exposures to high-emission firms and sectors as well as provisioning for the physical impacts of a changing climate.
It is easy to imagine the ECB then requiring banks to use these plans as a baseline, and then model the impact of alternative scenarios involving a more or less rapid green transition.
Geopolitics
Like climate change, increased geopolitical tensions can impact on banks’ businesses via several channels. Trade disruptions could hurt particular borrowers (increasing their credit risk) as well as impacting broader economic growth. The outbreak of conflict could lead to sudden swings in commodity prices. Sanctions or other economic coercion measures could force a sudden exit from some business relationships or markets. So there is a case for requiring banks to consider how exposed they are to different potential geopolitical shocks.
The difficulty in predicting geopolitical shocks, however, is a major challenge to scenario analysis. To pick just one example, in 2022 several major western intelligence services famously doubted that Russia would attack Ukraine right up to the day of the invasion. So how should banks decide what scenarios to model? How could supervisors assess their choices? (It would be a brave supervisor indeed who prescribed a list of geopolitical shocks that banks must be able to withstand.)
A better approach may therefore be to use reverse scenario planning – have banks work backwards from their current exposures to identify what plausible geopolitical shocks could materially threaten their viability. That would give management a basis to think about how they would react if a scenario did materialise – or whether they should change their strategy to reduce their vulnerability ex ante.
Going digital
The technology uncertainty is different again. Here, Buch has highlighted the possibility that digitalisation could fundamentally alter the competitive dynamics of the banking market. The easy scalability of digital services could allow a few banks to rapidly grow their market share at the expense of more analogue rivals. Alternatively fintech or bigtech firms could attract customers away from banks. Either dynamic could seriously – even fatally – threaten the viability of ‘digital laggard’ banks.
The ECB is already pressing banks to articulate comprehensive digitalisation strategies. Buch’s comments suggest it will now also expect them to explicitly address the broader market impact of new technology as part of their business planning.
A second area of digital risk concerns liquidity. The role of social media and online banking in fueling and facilitating last year’s US bank runs has been widely noted by supervisors. The ECB has already announced it will review banks’ liquidity contingency plans this year. It may well expect them to use more conservative assumptions about the flightiness of deposits in a more digital world.
(Interestingly, one area of digital transformation that Buch has not spoken about is the possible advent of digital currencies – another topic for a future post.)
Across the board
The uncertainties that Buch has pointed to will thus affect banks in multiple ways – and across almost all the areas of supervisory activity. (E.g. Business Model, Risk Management, Credit Risk and Liquidity Risk – the four elements of the Supervisory Review and Evaluation Process (SREP).) Depending on how far the ECB chooses to go, Buch’s greater focus on forward-looking assessment could transform supervision, posing new challenges for banks to comply.
Prepare for the worst
European banks have successfully weathered several severe shocks in recent years. But Buch has warned against complacency. Her emphasis on uncertainty and contingency planning for future risks serves to show that the ECB is not just ‘fighting the last war’.
It may also help protect the ECB against future criticism. If – or when – a new risk materialises and a bank does fail, supervisors can at least say they told banks to be vigilant in advance.