Supervisory priorities in the age of Covid and beyond

Speech by Mr Agustín Carstens, General Manager of the BIS, at the ASBA-BCBS-FSI high-level virtual session on the post Covid-19 banking system, Basel, 29 September 2020.

BIS speech  | 
29 September 2020


Ladies and gentlemen, good morning, good afternoon.

It is a pleasure to address this distinguished audience, although my preference, of course, would have been to meet you all in person in Panama as originally planned. Before I begin, let me wish all of you and your families good health.

A global sudden stop. That is how we at the BIS defined this crisis in our last Annual Economic Report. Shocks to both supply and demand caused by unprecedented lockdown and containment measures to tackle a health emergency led to devastating effects to output and employment.

In Latin America, the health crisis has been particularly acute and so has been its impact on activity, especially when the informal economy is also taken into account. Furthermore, for many jurisdictions in the region, additional pressure came in the form of massive capital outflows, drops in commodity exports and remittances, exchange rate volatility and downgrades or negative prospects for their sovereign ratings.

In response, public authorities across the globe took a range of measures to counter the effects of the crisis. Fiscal and monetary stimulus were deployed on an unparalleled scale to cushion the blow. Asset purchases, interest rate cuts, provision of public guarantees and payment deferral programmes stabilised the market and provided much needed liquidity to affected individuals and firms.

The outcome of such measures, at least in the short term, seems to be positive. Despite the colossal contraction of economic activity, second only to the Great Depression, credit continued to flow. This was largely thanks to the post-Great Financial Crisis reforms - notably Basel III - that meant that banks entered the current crisis significantly more capitalised and liquid than in the previous one. And it allowed them to continue to lend to households and businesses and to weather losses.

Prudential authorities also reacted swiftly. They eased capital and liquidity constraints, often suspended dividend distributions and issued clarifying statements on the measurement of expected credit losses with a view to sustaining the flow of credit to borrowers facing liquidity constraints.

On the other hand, the crisis has also revealed that macroprudential policies may not have fully worked as intended to address a truly exogenous shock. In particular, insufficient accumulation of easily releasable buffers ahead of the crisis in most jurisdictions, combined with banks' unwillingness to use existing buffers, prompted authorities to deploy microprudential tools to achieve macroprudential objectives.

Moreover, a number of relevant challenges lie ahead. Non-performing loans are on the rise and the magnitude of the impact of the crisis on banks' balance sheets could be considerable. Furthermore, several banking systems had been suffering from chronically low profitability in the run-up to the crisis. That means that supervisors need to carefully monitor banks' buffers and design contingency strategies in order to prepare for potential risks that, in an extreme case, could put pressure on banks' solvency, while helping to preserve the orderly flow of credit to the real economy.

Those challenges posed by Covid-19 must be addressed, while at the same time regulators must continue adapting their policy approach to the risks and opportunities posed by technological developments. The environment in which banks operate is fast changing, and Covid has accelerated trends that might otherwise have materialised in a few years. In this context, international collaboration to understand developments in innovative financial technology seems essential for authorities to continue to achieve their goals.

In the rest of my presentation, I would like to share with you some reflections on the lessons learned so far, the challenges ahead and the role of technology in the post-Covid era.

Macroprudential responses in the Covid crisis

Let me start with some comments on the experience with the macro-financial stability framework, and specifically the countercyclical buffer, in this crisis.

Prudential authorities' response to the current crisis sought to dampen excessive procyclicality by mitigating the risk of a system-wide deleveraging. By temporarily easing capital and liquidity constraints, authorities induced banks to sustain the flow of credit to affected borrowers. However, these measures also revealed limitations in the existing macroprudential elements of the framework.

First, sizeable buffers were not built up prior to the crisis in most jurisdictions. The countercyclical buffer was designed to generate resources, notably in the case of excessive credit growth, which was not the case in most jurisdictions, so buffers had not been accumulated. As a result, the firepower macroprudential authorities had with which to respond to the shock was considerably restricted. In contrast, in the few jurisdictions where the countercyclical buffer had been built up prior to the outbreak, its release probably helped to maintain the flow of credit to the real economy.

Second, given the exogenous nature of the shock and consequently the limited capital resources in the form of the countercyclical buffer, authorities used existing flexibility in their domestic macro-financial stability frameworks and deployed predominantly microprudential tools - such as supervisory buffers - to achieve a macroprudential policy objective. This is not ideal as the misalignment of tools, objectives and controls may create frictions and undermine the credibility of macroprudential policies in the longer run. This is because the microprudential authority may be reluctant to pursue a purely macroprudential objective, in particular if it conflicts with its own goals.

Third, banks have been reluctant to dip into the buffers despite the regulatory flexibility and statements of prudential authorities encouraging their use. This might be explained by different factors, including concerns about triggering automatic restrictions on capital distributions, reactions of market participants and rating agencies, and banks' ability to continue to lend without using the buffers. Therefore, a lack of "buffer usability" may have in theory affected banks' capital planning decisions and, their willingness to lend.

The Basel Committee has been monitoring ongoing developments with a view to pursuing further policy and supervisory initiatives if necessary.

Supervisory challenges ahead

While there might be a need to review and assess the effectiveness of macroprudential policies, other, perhaps more urgent, challenges lie ahead.

Despite the clear signs of recovery, the pandemic's impact on the global financial system may be substantial, even in the absence of a major second wave. The sharp contraction in economic activity and pandemic-induced structural shifts may render some business models obsolete. Moreover, if the crisis is deeper and more protracted than expected, and particularly if government support is withdrawn prematurely, the additional strain on households and businesses could severely undermine their ability to repay their loans.

The longer the crisis lasts, the higher the chances that corporate liquidity issues will become solvency problems. A decline in fiscal support and expiry of payment deferral programmes, especially if abrupt, would put additional pressure on asset quality. Indeed, loan loss provisioning has already taken a toll on banks' balance sheets. This trend could continue, and the current level of banks' equity prices indicates that market participants expect further deterioration of the loan portfolio and reduced profitability more generally in the future.

In emerging market economies, including those in Latin America, the situation may be even more trying. During the decade prior to the Covid outbreak, an increasing number of non-financial firms over-stretched their balance sheets, as in other parts of the world. However, a larger reliance on exports combined with increased borrowing in foreign currency may pose additional challenges for firms in these jurisdictions and cast doubt on their ability to service and roll over their debts.

Supervisors should try to act swiftly to assess the emerging vulnerabilities. A careful examination of the resilience of individual financial institutions, including through well designed stress tests, is key. Those exercises would certainly help tailor supervisory actions to the specific situation of each institution and facilitate the allocation of supervisory resources to the most vulnerable ones. In addition, keeping restrictions on dividend payouts by banks helps preserve capital and assures sufficient resilience and, in that way, also supports credit supply.

At the same time, crisis preparedness is essential. Authorities ought to make sure that their crisis management toolkits are in order. This means removing any relevant obstacles to their use and potentially testing them. Furthermore, critical services should be mapped and contingency plans put in place to ensure that the provision of financial services will continue even in the most adverse stress scenarios.

Priorities in the post-Covid era

While it is important that supervisors prepare for the challenges stemming from the Covid crisis, it is also imperative that they do not lose sight of longer-term priorities. Enhancing supervisory effectiveness should be a permanent goal, especially in this fast-changing environment. Failing to keep up to speed with market developments and new technologies is also a major risk to financial stability.

Innovation is key to achieving these objectives. By embracing technology, supervisors can enhance capacity, reduce manual work and improve the way data are used, hence contributing to several supervisory activities such as data management, market surveillance and micro- and macroprudential oversight.

Understanding how technology affects policy and its implementation and seeking ways to help authorities to embrace cutting-edge technology effectively is also a top priority for the BIS. The FSI has been contributing to this through its ongoing policy implementation work on fintech regulation and suptech.

Moreover, fostering international collaboration on innovative financial technology is at the heart of the newly created BIS Innovation Hub. The Hub achieves this objective by identifying and developing in-depth insights into critical trends in financial technology, exploring the development of public goods to enhance the functioning of the global financial system, and serving as a focal point for a network of central bank experts on innovation.

The experience in the short period since its launch in 2019 has been both encouraging and exciting. Today the Hub develops relevant projects across its three Innovation Hub Centres in Hong Kong SAR, Singapore and Switzerland. In addition, in the next two years the BIS will open other centres in Europe and North America in collaboration with central banks, which will allow us to expand our work across multiple fintech pillars.

Furthermore, last November the BIS Americas Office established the Consultative Group on Innovation and the Digital Economy with a view to fostering international cooperation in the area of financial innovation among several central banks from the Americas. The group has recently completed work on the use of application program interfaces (APIs) to enable digital identity verification as part of an open finance architecture that will allow non-bank financial institutions to provide financial services. Additional work is planned to develop further technological solutions, such as payment initiation APIs, with the objective of improving various aspects of the payment systems in the region.


Let me conclude with three messages.

First, while post-Great Financial Crisis reforms have come a long way in making the global financial system more resilient, the current crisis provides an opportunity to assess their effectiveness and to identify potential areas for improvement in the macro-financial stability framework.

Second, authorities should proactively address risks before they crystallise. The overall impact of Covid-19 on banks' balance sheets depends on many factors and will only become apparent over time. Despite the uncertainties, the timely identification and measurement of risks is critical for banks to provide confidence to supervisors and their stakeholders on their financial health. Furthermore, while this could result in the recognition of higher losses in the short term, delaying loss recognition is likely to leave banks and supervisors with fewer options, or no options at all, to address potentially critical issues.

In closing, let me say that a truly global shock requires a truly global response. Coordination failures and fragmented actions in times of heightened uncertainty will undeniably result in a protracted and more costly crisis. Effective information-sharing and coordinated measures are needed for a substantially superior outcome. Therefore, meetings like this one and the Basel Process more generally are of the essence if we are to deliver a successful response.

With that, let me wish you a fruitful meeting.

Thank you.

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