Watchful and Wary

The ECB's latest Supervisory Newsletter sets the tone for the start of autumn

Hello and welcome back to ECB Supervision Watch. I came back from my summer break to read the ECB’s latest Supervision Newsletter - the ECB’s quarterly snapshot into its thinking on supervisory themes.

Here are some thoughts on the various topics it covers.

Basel and Buffers: Kerstin af Jochnick

Supervisory Board member Kerstin af Jochnick headlined the latest newsletter with an interview on the current state of the banking system and supervision. Af Jochnick – whose term will end in October – covered a fair amount of familiar ground. She highlighted the latest SREP reforms, announced by SSM Chair Claudia Buch in May. She called for the completion of the European Banking Union through the establishment of a common European deposit insurance scheme. And she supported full adherence to the global Basel capital standards.

What stood out for me, though, were af Jochnick’s comments on macroprudential policy and counter-cyclical capital buffers. Af Jocknick said she shared the ECB Governing Council’s assessment (set out in June, following on from the ECB’s May Financial Stability Review) that despite the current economic slowdown, ‘conditions are not ripe enough for macroprudential buffers to be released.’

It would not usually be remarkable that a senior ECB official should endorse the public position of the central bank’s leadership. Yet earlier this year there did seem to be signs of some tension between af Jochnick and others at the top of the ECB on the question of buffers. In February and March, af Jochnick argued for buffers to be releasable in the event of a downturn. In both cases her comments came a day after Buch had called on banks to build up their capital buffers in the name of greater resilience. While af Jochnick did not explicitly contradict her Chair, the difference in emphasis was unmistakeable.

So I couldn’t help wondering if af Jochnick had deliberately set out (or had been asked?) to use this interview (one of her last before she steps down) to set the record straight and clarify her agreement with the ECB leadership.

Collateral damage

The Newsletter’s main feature was on commercial real estate (CRE). The ECB has long identified CRE as a ‘vulnerable’ portfolio facing both cyclical and structural headwinds. Since 2018 supervisors have been conducting a campaign of on-site inspections (OSIs) into banks’ CRE exposures. These OSIs have identified multiple deficiencies, requiring a great deal of remedial work by banks.

This article focused on CRE valuations. Its central finding was that many banks systematically over-value CRE assets pledged as collateral for loans. This overvaluation is the result of faulty valuation methods, unrealistic assumptions and inadequate data. New regulations and guidelines in recent years have required more rigorous approaches, but many banks are not yet fully compliant. Overvaluation of collateral value, the ECB argues, leads to an underestimation of the risks and insufficient provisioning for CRE loans.

The feature adds up to a pretty damning assessment of banks’ CRE loan management. Add that to the uptick in non-performing loans – long anticipated by supervisors and now starting to show up in the data – and I wouldn’t expect any let-up in ECB attention to this area.

Leveraged loans

Next in the newsletter was an update on the ECB’s review of leveraged finance. The risks from leveraged transactions has been another long-standing area of concern for the ECB, which launched an Asset Quality Review of 12 banks leveraged loan portfolios in 2023.

The latest article summarises the review process but gives away little on its results. It discloses only that preliminary results have been shared with individual banks and that these and the ECB’s findings will be discussed in the coming months before the review concludes later this year. The article gives no indication of how far (or when) the review’s results will be made public.

This comes after Bloomberg reported in July that the ECB was considering requiring banks to add around €7 billion in provisions for their leveraged loans (down from €13 billion, according to Bloomberg, but still a very substantial cost for the banks concerned). My contacts tell me that the ECB was very much annoyed by this report, which was apparently based on a leak from inside the ECB. Hence perhaps the supervisory newsletter’s extreme caginess about the leveraged finance review’s eventual results.

New New Guide

A final point of interest in the Newsletter was the announcement of an upcoming update to the ECB’s Guide to Internal Models, which sets out supervisors’ expectations for how banks should meet regulatory requirements concerning credit and other risk models. The update will incorporate the requirements of the new EU Capital Requirements Regulation (CRR 3), which was passed into law this summer and will (mostly) take effect from January 2025.

The timing of the latest update is a little odd, coming so soon after the ECB issued the latest version of the Guide in February. By that point CRR 3 had been all but agreed (it had gone through ‘trilogue’ negotiations and was only awaiting final sign-off from the European Parliament and EU governments). But the ECB evidently felt it could not include it as it was not yet formally on the statute book. Why the ECB did not delay the new Guide until CRR 3 could be incorporated is not entirely clear.

The end result is a quick-fire second update to the Guide. To be able to move fast the ECB will not hold a public consultation but will instead host virtual round tables on selected topics. The new new version of the Guide will then likely be published around the end of this year.

Steady as She Goes

The August newsletter is always a useful window into ECB thinking before the start of the ‘new term’ after the summer. Overall, I see no dramatic change of direction or policy – which is no surprise. Instead the main theme to me is continued caution (if not paranoia) about the risks ahead – very much in line with Claudia Buch’s focus on maintaining resilience in the face of growing uncertainty.

As the night gathers, the ECB’s watch goes on.