5th Edition / November 2020

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BrieFin #5: 

Banking supervision amidst uncertainty

“It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity" 

Frank H. Knight, Risk, Uncertainty and Profit

The so-called ‘second wave’ of coronavirus is compelling us all, in our role as citizens, businessmen/woman, academics, public servants, to come to grips with uncertainty and acknowledge the fact that our understanding of the world and knowledge is only partial. If there is a technical area capable to withstand the winds of uncertainty and their impact on the financial sector and the society at large, this is banking supervision. In fact, prudential supervision embodies the coexistence of concrete and foreseeable rules with a generous dose of judgement, in order to cater for banks’ idiosyncrasies and deploy adaptive tools when circumstances require so.

In this sense, our fifth BrieFin explores different sources of uncertainty which impact upon the powers, tools, and methods used by banking supervisors. Far from threatening the integrity of the current framework, all five contributions portray and understand uncertainty as a positive force capable to renovate and enhance the supervisory architecture. In maintaining the dialogic and multi-stakeholder spirit that characterises the EBI and our regular publication, we are happy to offer different points of view in order to distill the challenges and opportunities of prudential supervisors and regulators alike.

The opening contribution from Edward Kane, Professor of Finance at Boston College, provides a critical reality check on the dubious use of loss concealment techniques allowed by bank accounting rules and standards. Such a system-wide distortion fed by ‘financial illusionists’ in his own parlance, perpetuates the so-called ‘zombie’ banks, which undermine the credibility of the financial system. Our second contribution from Concetta Brescia Morra, Professor at University Roma Tre, provides a comprehensive overview of how prudential authorities have and are still dealing with the crisis triggered by the Covid-19 pandemic. More concretely, the professors’ view provides a thorough analysis of the strengths and risks of having a detailed and not-so-easy-to-amend legal framework.

The third contribution is the regulators’ view, provided by Slavka Eley, Head of Banking Markets, Innovation and Products from the European Banking Authority. She explores the supervisory challenges stemming from environmental, social and governance (ESG) factors. Other than clearly describing what lies behind the concept of ‘sustainable finance’, the author operationalises what acting now means in order to mitigate ESG risks in the banking sector. Our fourth contribution from Gonzalo Gasós, Senior Director in Prudential Policy and Supervision at the European Banking Federation, offers a timely industry’s view on how to render our regulatory framework more robust and at the same time flexible. Interestingly, the academic and practice views coincide and share similar conclusions regarding the need to balance rules and more room for manoeuvre under critical circumstances. Finally, the young researchers’ view by M. Cecilia del Barrio offers an insight into the key supervisory challenges and opportunities enabled by new technologies which are currently transforming the payment and banking ecosystems alike.

We hope that these short but substantive pieces give our readers an overview of the intricacies but also the opportunities enabled by the need to cope with uncertainties. Our knowledge of the world will still be partial and limited; however, our understanding of how to manage existing and upcoming risks can be undoubtedly improved by dialogue and joint reflections.


1. A Critic's View 

Edward J. Kane

Professor of Finance at Boston College and Research Associate of the National Bureau of Economic Research[1]


Masters of illusion: Bank and regulatory accounting for losses in distressed banks 

Accountants portray themselves as truth-tellers, but especially when they work for a dangerously undercapitalized bank, their jobs are far more complicated than that. In a recent working paper, I compare skilled bank accountants to master illusionists such as Siegfried and Roy. Much as these famed magicians made audiences think that they could make large wild animals disappear, some bank accountants enhance their income by convincing client banks that they have the power to make losses disappear. But in both kinds of illusion, items we no longer see have not actually vanished. They have been moved surreptitiously to places for which outsiders have no sightline.

This relocation process occurs under the cover of one or another cloaking device. Bankers use a wide range of devices to cloak losses. The simplest of these involves under-reserving for known or anticipated loan losses by deliberately overestimating distressed borrowers' ability to repay. Other simple form entails moving the loss exposures off balance sheet, for example, by parking a troublesome position in a cross-border affiliate. Relocation of losses may take, of course, more sophisticated forms.

Evidence seems to support that what looks like an energetic effort by bank regulators and self-regulatory organizations to control loss concealment is at least partly a sham. In practice, details of banking reforms are worked out between bankers and regulators and confirmed by elected politicians. If successive banking reforms were not shaped to serve these parties' joint interests, the wave after wave of counterfeit reform we observe would not be allowed to work so poorly or would at least be designed to work better for a longer time.

The research develops circumstantial evidence that supports the narrower hypothesis that politicians and policymakers find it is in their joint interest to tolerate substantial loopholes in bank accounting rules and standards. Negotiating and enacting opportunities to hide bank losses serves the interests of politicians, bankers, and incumbent regulators alike, but does so in different and subtle ways. Accountants know that this system could not continue to function unless regulatory forbearance extended to their work as well. Figure 1 below shows that the Securities and Exchange Commission disciplined accounting firms in less than four and a half percent of the cases its investigators uncovered. The accounting industry’s self-regulatory arm – The Public Company Accounting Oversight Board – imposed penalties at roughly half that rate.

Figure 1

Big 4 accounting firms were punished for only a fraction of failed audits between 2009 - 2017

EBI BrieFin#5

Source: ATLAS Data Project on Government Oversight

Financial stability is an explicit goal of modern central banking and every bank and central bank regards secrecy as an important tool. Elected and appointed officials make informational evasions and falsehoods available to insolvent bankers because their evasions and falsehoods help officials to minimize their own exposure to blame and let them block and reshape the flow of adverse information at critical times. Although many forms of government secrecy are openly embraced, loss concealment is an unacknowledged instrument. Its purpose is to discourage disorderly bank runs in periods of financial stress. Especially in the short run, authorities find it politically and reputationally less dangerous to suppress adverse accounting information than it would be to hand the taxpaying public an immediate and accurate accounting of the bill that is coming their way.

In view of the severity of the Covid-19 crisis, regulators have decided to be less sneaky this time around. They have openly advised examiners and bank accountants to help troubled bankers to make loan losses disappear from their firms' balance sheets and income statements. Allowing too-big-to-fail banks to misrepresent the depth of their accumulating losses is one leg of a conscious strategy through which bankers and regulators hope to lessen the threat of destructive Covid-driven systemic runs on the world's banking systems.

The second leg of the strategy rests on another fiction. Prudential regulators around the world tell us that they can and do maintain financial stability by assuring the adequacy of what is called "bank capital". But the statistical measures of bank capital on which regulators focus their efforts are nothing more than repurposed variants of a bank's accounting net worth. With accountants able to conceal the impact of losses on accounting net worth, until and unless unsophisticated household depositors begin to fear that a bank may have let itself become deeply insolvent, the effectiveness of this control framework is being badly oversold.

In an industry crisis, this disposition toward supervisory informational deception and regulatory forbearance creates a risk-hungry herd of what economists now characterize as “zombie” banks. A zombie bank is a financial institution whose economic net worth is less than zero but can continue to operate because its ability to repay its debts is credibly backed up by a combination of implicit and explicit government credit support.

A zombie's managers can not only keep themselves in business, they can grow their assets massively. But they can only do this when and as long as creditors are confident that government officials somewhere are ready and able to force their country’s taxpayers to make good on any missed payments. Almost no matter what interest rate a central bank or deposit insurer charges a zombie for its emergency credit support, the funding is almost always being offered at what is de facto a subsidized rate. In providing this subsidy, taxpayers accept a poorly compensated equity stake in the survival of the zombie enterprise.

To treat taxpayers more fairly, it would be appropriate for authorities to presume that each and every bank threatened by a run is almost certainly undercapitalized. Because it is costly all around for depositors to close their accounts suddenly, it is reasonable to assume that at least the early wave of “runners” has seen something concrete to worry about. This line of thinking leads me to recommend that authorities should be required either to freeze the positions of uninsured creditors whenever a bank suffers a statutorily defined “abrupt and rapid shrinkage” in its liabilities or, in the event of a bank's sudden failure, to have the right to reverse transactions by uninsured creditors whose ability to exit would not have been possible in the absence of the emergency funding supplied by the central bank or other government agency.

This short piece seeks to explain that teams of financial illusionists stand ready to conceal developing losses and other forms of dishonest behavior. Bankers’ and regulators' capacities for deception make it self-defeating for taxpayers to accept a social contract that turns on accounting measures of capital and self-administered stress tests. I believe that the world’s system for penalizing accounting misrepresentation at government-insured financial institutions desperately needs to include the possibility of imposing criminal as well as civil penalties on violators. The processes through which bankers extract benefits from the safety net closely resemble those of embezzlement and the rewards bankers garner usually rise to the level of grand larceny. The difference between street crime and safety-net abuse lies mainly in the class and clout of the criminal and the subtlety of the crime.

[1] The research reported here has been supported by a grant from the Institute for New Economic Thinking. I am grateful for valuable instruction on the tools of illusion from Burton G. Malkiel and for helpful comments on this essay from Robert A. Eisenbeis, Richard Herring Larrry Wall, and Thomas Ferguson. I also want to credit Sandra Howe for the excellent assistance she regularly provides to my research.

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© BankUnderground

2. The Professor's View

Concetta Brescia Morra

Professor of EU Financial Law at University Roma Tre


Banking supervision in uncertain times

1. The response of the supervisory authorities to the COVID-19 pandemic 

At the dawn of the pandemic the Basel Committee on Banking Supervision (BCBS), the European Banking Authority (EBA) and the European Central Bank (ECB) issued a series of documents, guidelines, and approved amendments to the prudential legal framework for banks to facilitate the granting of credit to the real economy. A first set of resolutions aimed at enabling measures established by national governments to mitigate the negative impact of COVID-19 on their economies. Primarily, national measures included public guarantees on new loans and moratoriums on existing ones for firms in difficulty. A second set of resolutions established temporary capital, liquidity, and operational relief measures for banks to boost their capacity to finance the economy. In both cases, it comes down to temporary extraordinary measures.

In April 2020, the BCBS published a document titled: “Measures to reflect the impact of COVID-19”, which assesses the impact of the extraordinary measures geared towards the alleviation of the financial and economic impact of COVID-19 on the legal framework. The BCBS agreed that the risk-reducing effects of the various extraordinary support measures, namely government guarantees and different payment moratoriums taken in Member jurisdictions, should be fully recognised in risk-based capital requirements.

During March and April 2020, the EBA published several communications calling upon competent authorities to make full use of the flexibility embedded in the existing prudential regulation, and to draft guidelines containing interpretative aspects on the functioning of the prudential framework regarding the classification of loans in default, the identification of forborne exposures, and their accounting treatment.

The ECB played a crucial role in fostering banks’ ability to finance the economy. On 12 March 2020, the ECB announced a number of specific measures to ensure that banks can continue to fulfil their role in financing the real economy as the economic effects of the coronavirus became apparent. Some of these measures are complementary to those taken by governments to ensure that they are fully effective without encountering obstacles in the current constraints established by the prudential regulation of banks. To this end, the ECB has introduced supervisory flexibility regarding the treatment of non-performing loans (NPLs), the classification of debtors as “unlikely to pay” when banks call on public guarantees granted in the COVID-19 pandemic context, and loans under COVID-19 related public moratoriums. Moreover, the ECB adopted specific measures relaxing capital constraints, i.e., temporary capital, liquidity and operational relief measures to ensure that significant institutions are able to continue to support the real economy. According to ECB guidelines, banks will benefit from relief in terms of the composition of capital for Pillar 2 requirements. Furthermore, banks are temporarily allowed to operate below the level of capital defined by Pillar 2 guidance and the capital conservation buffer.

One last recommendation from the ECB to banks attempts to balance the need to favour their capacity to finance the real sector, on the one hand, with the need to preserve the robustness of the banks, capital, on the other. In this context, on 27 March 2020, the ECB updated its recommendation to banks on dividend distributions: to boost banks’ capacity to absorb losses and support lending to households, small businesses and corporations during the pandemic, it was recommended that banks should not pay dividends for the financial years 2019 and 2020 until at least 1 October 2020.

The European legislature has completed the framework of “extraordinary rules” with a package of reforms amending Level 1 regulations. On 28 April 2020, the EU Commission proposed a few targeted “quick fix” amendments to Regulation (EU) 575/2013 (Capital Requirement Regulation, CRR) in order to maximise banks’ ability to lend and absorb losses related to the COVID-19 pandemic. In this context, on 18 June 2020, the European Parliament approved the amendments to the CRR and Regulation 2019/876 (CRR2). The new rules establish exceptional temporary measures to alleviate the immediate impact of COVID-19-related developments by adapting the timeline of the application of international accounting standards on banks’ capital, by treating public guarantees granted during this crisis more favourably, by postponing the date of application of the leverage ratio buffer, and by modifying the way of excluding certain exposures from the calculation of the leverage ratio.

During the summer, when it was still uncertain how the macroeconomic shock would impact on the banking system, the authorities extended most of the temporary provisions granting flexibility in the application of supervisory rules. While the EBA phased out its guidelines on loan repayment moratoriums, the ECB extended the validity of many extraordinary measures. Indeed, it prolonged the recommendation to refrain from dividend distributions until the end of 2020, announced that banks would not be required to submit their plans for reducing NPLs until March 2021, and that compliance with Pillar 2 Guidance and the combined buffer requirement will not be required any earlier than by the end of 2022. On the latter point, the ECB declared that it would not attach any negative judgement to those banks which are making use of the buffers, in line with a recent recommendation of the BCBS of 17 June 2020. In particular, the ECB stated that “banks are encouraged to use their available buffers to absorb losses and continue lending to the real economy without concerns about potentially being stigmatised for using them or needing to quickly replenish them” (A. Enria The coronavirus crisis and ECB Banking Supervision: tacking stock and looking ahead, 28 July 2020).

All the measures described above are exceptional and temporary. Considering that the second wave of the pandemic is hitting many countries severely, including European Member States, it is difficult to forecast what the authorities’ exit strategy could be if the situation were to worsen from a health point of view and provoke a long-term economic recession. It is also too early to estimate the impact that this crisis might have on the stability of the banking system.

Once the immediate effects of the crisis would be overcome, will the extraordinary measures enable the development of new supervisory standards? The ECB commented that in the mid to long-term, banks should continue to apply sound underwriting standards, pursue adequate policies regarding the recognition and coverage of non-performing exposures, and conduct solid capital and liquidity planning and robust risk management. This means that a certain degree of flexibility is acceptable - indeed necessary - in extraordinary times, but it cannot become a standard practice in ordinary times.

2. The lesson we can draw from the pandemic

The model of prudential supervision laid down in the 1990s by the Basel Accords, focusing particularly on measures imposing risk-based capital requirements, was not abandoned after the Global Financial Crisis of 2007-2009.

The supervisory system established by Basel II in 2004 has not been radically changed by Basel III. Corrections have been made, such as those regarding how to weight asset-backed securities in calculating regulatory capital and capital requirements for market risks. Rules have been introduced for liquidity risks too.

On the other hand, in the years following the Global Financial Crisis, the supervisory authorities imposed higher capitalization levels, limits on the leverage of intermediaries (leverage ratio), constraints on the incentive remuneration of directors, and rules on NPLs which oblige banks to adopt strict policies. Those measures indicate the willingness of regulators to curb banks' loan growth to make the banking system less vulnerable in the event of new crises. In this perspective, a crucial role is played by authorities using their powers to set capital requirements above the minimum and to take the necessary early measures to address relevant problems in the management and coverage of risks.

The long-term evolution of supervisory rules shows that it is difficult for the general legal framework adopted in the context of the Basel Accords, as implemented in the European legal system, to change radically.

The lesson that we can draw from the previous months is that authorities need wide margins of discretion to react quickly and to adapt supervisory rules under macroeconomic uncertainty. To this end, the European regulatory framework contains one important weakness. In fact, the COVID-19 pandemic has exacerbated a problem embedded in EU banking regulation legal sources: the lack of flexibility of the rules due to the choice of the European legislator to fix, at the legislative level, a detailed framework for prudential supervision. This characteristic delays the prompt adaptation of prudential rules to crisis situations, in order to mitigate their pro-cyclical nature. Three examples are helpful to clarify the problem.

The first example concerns the measures set out by the BCBS in April 2020 to mitigate the impact of regulatory capital on unexpected events. In particular, the BCBS amended its transitional arrangement for the regulatory capital treatment of expected credit loss accounting. To implement it in Europe, an amendment to CRR was necessary. The second example is the new framework for the prudential treatment of NPLs. The European Council established a minimum loss coverage for non-performing exposures, detailing the different coverage requirements depending on the classifications of the NPLs as “unsecured” or “secured”, and whether the collateral is movable or immovable, amending Regulation (EU) 575/2013 in April 2019. The same standards were established by the ECB, who issued its guidance to banks in March 2018 (Addendum to the ECB guidance on non-performing loans). Should the COVID-19 pandemic require some degree of flexibility in the application of these standards, the ECB guidelines could be easily amended, while CRR requires a long process involving the EU Commission, the EU Council, and the European Parliament.

The third example concerns buffer requirements. As already mentioned, the ECB encouraged banks to use their buffers to absorb losses and continue lending to the real economy. To this end, the ECB declared that compliance with Pillar 2 Guidance and the combined buffer requirement will not be required any earlier than the end of 2022. Nevertheless, according to Level 1 prudential framework, if the Common Equity Tier 1 (CET1) ratio of banks falls below the level of combined requirements, automatic limits in the remuneration and distributions of dividends are triggered. This inflexible rule discourages banks to use buffers; indeed, banks are afraid of the potential negative reactions of market participants to the limits on dividends distribution. The strict rule contained in Level 1 Regulation seriously limits the ECB’s flexible approach to fully unfold the desired effects.

Against this backdrop, the “quick” reaction from the European Commission in its role as legislator, is very welcome despite highlighting how difficult it is to adapt the current regulatory framework to changes that can suddenly and unexpectedly occur in the real economy, as is currently the case with the ensuing COVID-19 pandemic. Having inflexible rules codified by law, meaning within the European legal framework Directives and Council Regulations, helps to achieve a level playing field among different legal and market systems. However, this regulatory choice also creates obstacles that are hard to overcome, especially when it is necessary to adapt the rules to new scenarios, as is the case now. The use of delegated legal acts to establish more detailed regulatory instruments, and the extensive use of interpretative powers by supervisors will result in a more flexible legal framework which will provide authorities with the possibility to promptly react to crises such as the one we are witnessing.

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© Getty Images/iStockphoto

3. The Regulators’ View 

Slavka Eley

Head of Banking Markets, Innovation and Products, European Banking Authority [1]

Environmental, social and governance factors as a new challenge for supervisors 

In recent years, the financial sector has been increasingly paying attention to the risks stemming from environmental, social and governance factors (ESG factors) under a broader concept of sustainable finance. Sustainable finance is understood as financing and other related institutional and market arrangements that contribute to the achievement of strong, sustainable, balanced, and inclusive growth, supporting directly and indirectly the Sustainable Development Goals. As included in the European Commission’s Action Plan: Financing Sustainable Growth, sustainable finance also refers to the process of taking due account of environmental and social considerations in investment decision-making, leading to increased investments in longer-term and sustainable activities.

Environmental considerations are those related to climate change mitigation and adaptation, and more broadly, environmental risks. Social considerations include inequality, inclusiveness, labour relations, and investment in human capital and communities. The governance of public and private institutions plays an important role in considering the environmental and social considerations in the management process and business mix.

ESG factors and the specific societal concerns on climate change have led the regulatory and supervisory community to consider these factors as a new source of financial risks to which the public and private sectors need to pay attention. As stated in the report ‘A call for action’ prepared by the Network for Greening Financial System, climate change has distinctive characteristics and hence needs to be considered and managed differently. These include (i) far-reaching impact in breadth and magnitude, (ii) foreseeable nature, (iii) irreversibility, and (iv) dependency on short-term actions.

What does to be considered and managed differently mean for the approach to mitigate the potential impact of climate change, and more generally for the management and supervision of risks stemming from the ESG factors (ESG risks)?

The current regulatory and supervisory frameworks for banks emphasise on institutions’ sound governance, oversight and risks management with specific requirements on adequate capital and liquidity to cover identified risks. The time horizon for the estimation of capital needs to cover unexpected losses under the internal capital adequacy process is 12 months. Banks’ business strategy and product mix are largely not covered by regulation as these are in the core of their entrepreneurship.

Supervisors examine banks’ business models as part of the supervisory review and evaluation process (SREP), by assessing the viability of the current business model for the upcoming 12 months and sustainability of the intended business model normally in a three-year time horizon. This time horizon is generally aligned with the financial planning of banks and remuneration rules (e.g., deferral of variable remuneration is as a minimum 3 to 5 years) and prudential stress testing.

On the other hand, ESG risks are expected to materialize, particularly considering possible climate scenarios translating into physical and transition risks (including social impact), far beyond the time horizon of three years and range in decades (e.g., based on scientific reports such as those published by the Intergovernmental Panel on Climate Change).

Therefore, the current risk management tools and methods, built around the short-term nature of financial risks, neither show the impact of ESG risks as material considering the time horizon nor adequately signal potential vulnerabilities in the longer-term, in particular in case of a quick shift in public policies. The same happens on the supervisory side: while the SREP covers a wide range of risks, ESG risks are likely not to be fully captured due to the longer time horizon.

At the same time, a successful transition to a more sustainable economy, depends on short-term action or acting now to reshape the business mix so as to make it less vulnerable to the potential future far-reaching and irreversible impact of climate change and related social implications.

How do we get the banking sector on the transition path considering the scientific evidence, societal expectations, public policies (e.g., Paris agreement and Sustainability Development Goals), while ensuring a risk-based prudential approach and respecting the freedom for banks to choose their business models considering their strategic objectives?

Generally, there are two main avenues for acting now on the ESG risks by the banking sector. The first is via risk management, incorporating ESG factors into existing frameworks and translating ESG risks into financial risks. This avenue involves incorporating a longer-term time horizon into risk management with easily understood, simple and comparable metrics. In particular, this approach involves scenario analysis as a key tool to understand the potential impact on financial performance and financial stability, allowing the management to adjust business models and internal processes accordingly.

The second approach is to acknowledge that scientific evidence and public policies included in specific long-term commitments of governments and other public bodies are capable of having a long-term impact on the economic environment, and if not properly considered in the adjustments of the business model and transition strategy, they might negatively affect banks financial stability and solvency in the long run. This avenue also considers societal expectations on public and private players as a way to contribute to the overall objectives of sustainable development.

The first approach is fully consistent with a risk-based prudential framework; however, it can be seen as reactive, as banks need to conduct a material scenario analysis first and then measure potential impact as evidence to adjust their business model.

The second approach is also compatible with a risk-based approach but is instead proactive. Under this approach, by analysing the impact of public policies and customers’ expectations, banks proactively implement changes on the business models and internal processes (e.g., sustainable business targets, green and social products, loan origination procedures, pricing considering ESG risks) to reflect them. At the same time, proactivity to incorporate sustainability considerations in business strategy and internal processes can be an important mitigation tool of the potential impact of ESG risks on banks in the long-term. The efforts of the European Commission to develop an EU Taxonomy for sustainable activities as a classification tool and to enhance sustainability-related disclosures support this approach by developing consistent rules and comparable information for financial market participants.

This proactive approach in strategies and business model changes could be one of the tools in order to be considered and managed differently. To that end, the following aspects could be considered by the banking sector as novelty components in their governance to address the ESG risks:

  • Setting clear objectives and targets for environmentally and/or socially sustainable exposures using simple metrics,
  • Advising corporate and retail clients on their transition path, and  
  • Implementing sustainability culture across the organisation.

By setting long-term objectives and targets to change the composition of the balance sheet into more sustainable exposures, and by disclosing the status of transition, banks can not only show their corporate and social responsibility, but actively build long-term sustainable business.

Institutions can meet their objectives and targets only if these match the demand for more sustainable products and investments by their customers. At the same time, customers will be affected by changes in sustainability-related public policies. The majority of businesses will need to adjust their operations to these new policies or will be generally affected by the impact of ESG factors, as well as individuals. Thus, banks have a new opportunity to play the role of business advisor to support the transition of their clients to more sustainable businesses and/or housing, and other retail financing needs.

The success of a proactive approach for sustainable strategy and business model requires the implementation of a sustainable culture across banking organisations, where the objectives and targets are translated into specific business and risk metrics, internal processes, business policies and procedures, as well as general institutional awareness and understanding of the sustainability objectives and ESG risks.

Supervisors may argue that their mandate does not include ‘promotion’ of certain business strategies or ‘directing’ institutions towards certain business models. Such arguments correctly point to the role of public policy but that is not argued here. A long-term sustainable strategy and targets are a key part of the risk mitigation toolbox, as physical and transition risks matter now and there is therefore no issue with supervisors entering into conversations with banks on their long-term sustainable business strategies and adjustments of business models. Such conversation should not pivot around the request to develop specific (‘green’) strategies, but rather to require them to define long-term sustainable strategies that take into account ESG factors, translated into the business mix and processes. This ESG challenge could be addressed in supervisory methodologies by introducing an additional element in the supervisory review – assessment of long-term resilience of banks – helping supervisors to get the longer-term view on the business model of banks considering ESG factors.  

The proactive approach by banks, the extension of supervisory time horizon, in combination with the incorporation of ESG factors into banks’ risk management, provides a way of being considered and managed differently and can deliver results leading to acting now. 

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4. The Industry’s View

Gonzalo Gasós

Senior Director of Prudential Policy and Supervision at the European Banking Federation (EBF); Member of the Advisory Board of the European Banking Institute (EBI)

Room for manoeuvre in the banking regulatory framework

The European banking sector is coping with the initial impact of the Covid-19. However, it is beset with uncertainties as the crisis unfolds. Banks and supervisors need two things going forward: firstly, some light in the middle of this long tunnel. Secondly, room for manoeuvre to cater for the needs of the economy.


Stress testing was conceived to shed light on how banks could absorb the impact of unexpected shocks and secure business continuity according to the severity of the situation. The results of the 3 EU-wide stress test exercises conducted by the European Banking Authority (EBA) in the last decade give an indication of the capital depletion under certain scenarios of the GDP decline:

  • in 2014, the central stress scenario of -2.1% GDP decline would result in 230 bps drop in the CET1 ratio after 3 years;
  • in 2016, the scenario of -1.8% GDP decline would result in 340 bps drop in the CET1 ratio;
  • in 2018, the scenario of -2.7% GDP decline would result in almost 400 bps drop in the CET1 ratio.

The current health crisis is a reality check for stress tests. The 2020 vulnerability analysis of the ECB adds more accurate and updated estimates. The central scenario of an 0.8% GDP decline by 2022 would dent the CET1 ratio in about 190 bps. However, a more severe situation of 6.3% GDP fall by 2022 would bring the CET1 ratio down by 570 bps. If the latter turns out to be true, a significant number of banks may fall below the regulatory minimum requirement.    

Against this background, the banking community will need ample room for manoeuvre to limit an impact that could otherwise be systemic. A point in case is the EBA Guidelines on legislative and non-legislative moratoria on loan repayments which has given breathing space to numerous households and businesses across Europe. Some banks might not be able to withstand the situation, but others could muddle through until the end of the crisis if the regulatory framework provides some degree of flexibility. The regulatory reform has significantly reinforced the resilience of the banking sector: the current framework is robust and comprehensive, including policy tools that were not contemplated in the past, like liquidity ratios, stress testing or recovery and resolution procedures. Nevertheless, if there is one drawback that deserves careful consideration, it is the lack of flexibility in some areas of the regulatory scope. The outbreak of the Covid-19 has laid bare the rigidity of the regulation, which allows very little room to move backwards when required.    

The first officer of the Titanic is said to have given the order to go astern in the face of an unexpected iceberg. The ship was equipped with the largest propellers to be built ever until then. It was conceived to move forward and fast. However, only the two side screws could be put into reverse, but allegedly, the central propeller did not have reverse thrust.

Supervisors have recommended banks to use their capital buffers in the face of an unexpected health crisis. The EU banking regulatory framework is more robust and sophisticated than ever. It was conceived as a series of additive layers of capital requirements, which can only be adjusted upwards by different authorities. However, with the exemption of the narrow Pillar 2 and countercyclical buffers, as well as the flexible approach to the 2020 Supervisory Review and Evaluation Process (SREP) announced by the EBA, the bulk of the framework does not have reverse thrust.


The current health crisis has revealed that bank lending is vital for economic recovery. There is a need to strike the right balance between capital requirements and lending capacity. Since the Basel III reform, there has been an open debate about the optimal level of capital, the point beyond which a marginal increase in the capital ratio would not justify, from an economic viewpoint, the corresponding reduction in lending to the economy. The original assessment of the long-term economic impact of stronger capital and liquidity requirements published by the BCBS with the Basel III reform in 2010, suggested an optimal level of around 13% with no offset of Modigliani-Miller effects. From a more heuristic approach, the recent request by public authorities to banks to use their capital buffers leads us to suppose that the optimal level should be somewhat lower than the 14.7% CET1 before the Covid-19 outbreak.  

Twenty years ago, the Basel ratio was just another metric on the dashboard of investors and bank management. The heightened minimum regulatory bar combined with the restrictions imposed by the mechanism of maximum distributable amounts have drastically raised the prominence of the regulatory ratio. Today, the minimum regulatory capital requirement has become the key market reference in the assessment of investors. The distance between the actual capital ratio and the minimum regulatory requirement (the voluntary buffer) is the yardstick to measure the creditworthiness of every bank.    

Therefore, it is no surprise that bank managers seem reluctant to narrow the size of the voluntary buffer; supervisors, on the contrary, argue that banks could shrink their voluntary buffers. Certainly, the Basel III framework envisaged a staged system of MDA constraints as banks used their buffers. However, the current crisis has proved that banks do not want to operate closer to the cliff of the minimum requirement because the regulatory penalties are way too harsh, so they prefer to keep a certain distance should bad things happened.

Consequently, if one admits that the optimal target level of capital in the banking sector to serve the economy best in times of distress is somewhat lower than the actual one - and evidence suggests that market dynamics do not reduce the voluntary buffer - then the only way to fuel more credit to the economy is to soften the penalties, at least as a temporary measure. A closer look at the composition of the capital requirement in the EU shows that the largest part of the regulatory requirement is fixed. The discretionary layers have been adjusted by supervisors, via Pillar 2 Guidance, and by Member States via countercyclical buffers and national systemic risk buffers. However, the relief is not enough. 


Supervisors should have greater room for manoeuvre to apply “reverse thrust” when it is justified and agreed. This could be done in various ways. For instance, the fix buffers could be releasable under certain conditions. This option could let banks keep up their lending when it is most needed by the economy without impairing their distance to the regulatory minimum level.

Coming back to the dim light shed by the stress tests and the vulnerability assessment, in a severe scenario, there would be three buckets of banks. First, those unable to endure a prolonged and severe economic plight. Second, those able to muddle through should a degree of regulatory flexibility be granted. Third, those able to bear the impact of the crisis without any temporary shortfall.

The first bucket may put the recovery and resolution framework to the test. It is uncertain how many banks would find themselves in every bucket, but it seems plausible that a severe scenario like the one depicted in the vulnerability analysis (570 bps of CET1 ratio depletion) would push a significant number of banks to the second bucket. Those banks will need some flexibility to keep on going. The regulatory framework was meant to prevent systemic risk originated in the banking sector from spilling over into the rest of the economy. Paradoxically, this time the systemic risk is originating outside of the banking sector and could potentially spill over into the banking system. The rigidness of the regulatory framework does not help. If a significant number of banks that could have thrived are pushed to the brink due to a temporary breach, the consequences to the economy could be serious.    

Finally, the few banks in the third bucket, the strongest ones, would be able to rescue part of the failing banks. In order to do so, they may need financing from the market. However, the general recommendation from supervisors to ban bank dividends does not help. Worldwide corporations from all industries combined keep on paying dividends with an average reduction of 23% in the first half of 2020. In Europe, the average reduction in dividend pay-outs, year-on-year, is 44% for all industries combined. This said, the majority of European banks have seen themselves compelled to let down their shareholders with an 86% overall reduction. As a result, all EU banks are at a considerable disadvantage in the funding market. If the ban is extended in 2021, there is little hope that strong banks can attract the capital needed for future sector restructuring and consolidation.


The regulatory framework is as solid as it is rigid. Capable of building up reserves, it is nonetheless unagile, in practice, when it comes to using them. Conceived to prevent and mitigate the effects of financial crises, it should be made more suitable to cope with the threats of non-financial crises. Nevertheless, some flexibility in certain parts of the system could improve its capacity to deal with external shocks while preserving its robustness.

A solution that would deserve careful examination is the possibility of turning the fixed part of the buffer stack into a flexible buffer component. In other words, the buffer component could be totally or partially releasable under certain conditions.

Instead of having supervisors calling upon banks to use their voluntary buffers in the middle of a crisis, the regulatory framework should envisage predefined rules and contingency plans for the release of prudential buffers, subject to supervisory consent, during phases of economic plight. This big and robust ship should be equipped with a system of reverse thrust.  

Such a solution could reduce the procyclicality inherent in the current framework, it could relieve market pressure by widening the distance to the regulatory penalty zone, and it could request the replenishment of buffers when the situation improves. In conclusion, it could offer the capacity to policymakers and supervisors to strike a better balance between banks’ resilience and economic growth.  

5. Young Researchers’ View

M. Cecilia del Barrio Arleo, EBI Young Researchers Group[1] 

Mirror, mirror on the wall, who has the most tech-adaptive supervisory tools of all? 

So far, this BrieFin number has explored different sources of uncertainty in the banking supervision arena: environmental, social and governance (ESG) factors, the Covid-19 crisis prudential responses and opportunities, and the less prominent but worth analysing loss concealment accounting techniques. This last contribution focuses on the legal and institutional uncertainties stemming from some of the most prominent transformations in the financial and banking systems enabled by new technologies. These financial technologies raise not only technical questions but also deep conceptual ones regarding the appropriate institutions, tools, and even the need for regulation. As accurately summarised by Saule Omarova, FinTech can be understood “as a systemic force disrupting the currently dominant technocratic paradigm of financial regulation”, which makes finance bigger, faster, less transparent, changes the nature of financial decision-making, and blurs jurisdictional and market boundaries. To manage increasing legal uncertainties, competent authorities can either introduce specific regulatory amendments in order to better cope with new actors and technologies or, on the contrary, leverage this moment to deeply rethink methodological, structural, and teleological aspects of financial regulation.

This contribution focuses on key supervisory governance challenges stemming from recent policy documents that portray the impact of technology on the banking ecosystem. On the one hand, the ECB response to the European Commission’s public consultation on the FinTech action plan, which offers a comprehensive and mid- to long-term view of the development of digital finance in the EU; on the other, the recent report that examines the issuance of a central bank digital currency (CBDC), the digital euro, and the ECB Crypto-Assets Task Force paper on stablecoins, in order to extract some of the challenges that these innovations entail for supervisory authorities[2]. This overview highlights a few but crucial aspects that will benefit from further analysis and collaboration between researchers and policy makers; the relevance and policy implications of these documents is enormous and by no means thoroughly examined here.

First, the ESCB/European Banking Supervision response to the Commission’s public consultation on a new digital finance strategy for Europe/FinTech action plan is a comprehensive and rich document that expresses the ECB views on (i) the adequacy of the regulatory framework for the digital age; (ii) consumers’ and firms’ opportunities offered by the Single Market for digital financial services; and (iii) the promotion of a well-regulated data-driven financial sector. A critical aspect raised throughout the response relates to the need to guarantee a technology-neutral approach to banking supervision. The success of this much-desired enterprise, however, depends on the capacity to implement the guiding principle of same activity, same risks, same supervision, which in turn depends upon the adaptive potential of the regulatory framework to the new digital reality (or “adjusting the regulatory perimeter”, as the document reads). A clear case is the entrance of the so-called ‘big tech’ into the financial services sector and their potential to quickly acquire large market shares, which can lead to concentration of risks that directly affect the operational resilience of the financial system (for further details on the EU response to limit the power of digital platforms see this FT article and related ones). Likewise, page 30 calls for the need to complement “the current entity-based regime with an activity-based approach”, with a view to ensuring supervisory consistency between incumbent institutions and market entrants. Further research can explore how to operationalise the move towards an activity-based framework, to guarantee a truly adaptive and organic supervision and not mere cosmetic amendments that refrain from challenging entity-based methods and tools.  

Moving to the second set of documents, although the idea of issuing a CBDC has been a hotly debated question over the past few years now, we have recently witnessed the quasi-simultaneous publication of two key pieces on the topic: the Report on a digital euro (ECB) and the one on CBDCs foundational principles and core features (Bank for International Settlements, which is not examined here). These reports have attracted considerable attention, and the dissemination of the former has been interpreted as a sign that the issuance of a digital euro is not a matter of if but rather when. Sandbu’s A digital euro is on its way states precisely this point, although his estimated time frame to complete the project is less optimistic than the title of the FT piece; meanwhile, CBDC promises have been realised in China just a few weeks ago. The digital euro report aims to lay the groundwork for a deeper technical, legal, and most importantly a broader policy debate thanks to ongoing public consultation. Some months before its publication in October 2020, ECB Executive Board member and Vice-Chair of the Supervisory Board Yves Mersch made the case for central banks involvement in the provision of some form of digital currency to the public, since “providing safe money and a reliable means of payment have been an integral part of the mandate and core business of central banks since their very inception”. His instructive speech distinguishes between a wholesale CBDC (business as usual, where a limited group of financial counterparties have access to central bank money) and a retail CBDC. As the digital euro report explains, the latter “could be implemented by opening accounts directly with the Eurosystem or through supervised intermediaries, while distribution of a bearer digital euro . . . would likely require the involvement of supervised intermediaries”. The use of intermediaries to facilitate CBDC circulation as contemplated by the retail design option triggers at least two broad and related supervisory questions. The first one concerns the involvement and scope of supervisory activities over these private intermediaries; the second one relates to the outsourcing of public law functions to private entities, and the need to distinguish between core and non-core services. The report explicitly states that “contrary to the elements of the design and issuance of a digital euro . . . practical arrangements with no impact on the central bank’s balance sheet . . . could, in principle, be outsourced, subject to strict Eurosystem supervision”. The outcome of the public consultation might shed light on this and many more fundamental design and policy questions.

Further supervisory concerns have been raised in the final document hereby addressed: the ECB paper on Stablecoins: Implications for monetary policy, financial stability, market infrastructure and payments, and banking supervision in the euro area. In fact, the digital euro report contains an Annex 2 entitled "The digital euro is not a crypto-asset or ‘stablecoin’". The difference between the former and the latter lies in their nature: while the report defines the digital euro as a “risk-free liability of the central bank”, stablecoins (an ambiguous and potentially misleading term) are characterised in the paper as “digital units of value that differ from existing forms of currencies” which depend on stabilisation tools to reduce price fluctuations. Insofar as supervised institutions play a role in stablecoins arrangements, and stablecoins thus become fully-fledged payment methods and even alternative store of value, supervisory powers need to be deployed in order to mitigate potential risks. The paper highlights that even if the activities performed by banks in this context “would not constitute regulated financial services pursuant to current EU law”, they can nevertheless be deemed to fall within ‘other business activities’ of credit institutions. Under these circumstances, outsourcing arrangements and their materialisation in contractual agreements will require an extra dose of supervisory scrutiny.

Central bankers and supervisors need to update and deploy their respective tools to guarantee financial stability in a context characterised by dynamically changing payment and banking ecosystems alike. These system-wide transformations enabled by new technologies represent a challenge and lead to (hopefully provisional) legal uncertainty. However, they are also an epochal chance to rethink and redraft the normative underpinnings of our regulatory framework, in order to properly embrace technology as a tool which serves a broader socially equitable financial system.


D. Ramos Muñoz (coordinator), E. Leone, T. Gstaedtner, E. Wymeersch, B. Joosen, B. Clarke, M. Lamandini, T. Tröger


M. Cecilia del Barrio Arleo and Carlos Bosque Argachal

Supervisory Board of the European Banking Institute:

Dr. Thomas Gstaedtner, President

Enrico Leone, Chancellor



The European Banking Institute based in Frankfurt is an international centre for banking studies resulting from the joint venture of Europe’s preeminent academic institutions which have decided to share and coordinate their commitments and structure their research activities in order to provide the highest quality legal, economic and accounting studies in the field of banking regulation, banking supervision and banking resolution in Europe. The European Banking Institute is structured to promote the dialogue between scholars, regulators, supervisors, industry representatives and advisors in relation to issues concerning the regulation and supervision of financial institutions and financial markets from a legal, economic and any other related viewpoint.

Academic Members: Universiteit van Amsterdam, University of Antwerp, University of Piraeus, Athens, Greece, Alma Mater Studiorum – Università di Bologna, Universität Bonn, Academia de Studii Economice din București (ASE), Universidad Complutense, Madrid, Spain, Trinity College, Goethe-Universität, Universiteit Gent, University of Helsinki, Universiteit Leiden, Leiden, KU Leuven Universtiy, Universidade Católica Portuguesa, Universidade de Lisboa, University of Ljubljana, Queen Mary University of London, Université du Luxembourg, Universidad Autónoma Madrid, Universidad Carlos III de Madrid, Johannes Gutenberg University Mainz, University of Malta, Università Cattolica del Sacro Cuore, University of Cyprus, Radboud Universiteit, BI Norwegian Business School, Université Panthéon - Sorbonne (Paris 1), Université Panthéon-Assas (Paris 2), University of Stockholm, University of Tartu, University of Vienna, University of Wrocław, Universität Zürich.

Supporting Members: European Banking Federation (EBF), European Savings and Retail Banking Group (ESBG), Bundesverband deutscher Banken / Association of German Banks, Ελληνική Ένωση Τραπεζών / Hellenic Bank Association, Associazione Bancaria Italiana / Italian Banking Association, Asociaţia Română a Băncilor / Romanian Banking Association, Asociación Española de Banca / Spanish Banking Association, Nederlandse Vereniging van Banken / Dutch Banking Association, Fédération Nationale des Caisses d’Epargne / French association of savings banks, Deutscher Sparkassen- und Giroverband / German association of savings banks, Confederación Española de Cajas de Ahorros / Spanish confederation of savings banks, Sparbankernas Riksförbund / Swedish association of savings banks, Cleary Gottlieb Steen & Hamilton LLP.