A delicate moment for supervisors - challenges and priorities in a global pandemic
Speech by Mr Agustín Carstens, General Manager of the BIS, at the AMF-BCBS-FSI High-level virtual session on the post Covid-19 banking system, Basel, 9 December 2020.
It is a pleasure to address this distinguished audience although I would have preferred to meet you all in person in Abu Dhabi as originally planned. But, living as we are in trying times, we have to be patient and hope that the recent news about a vaccine soon brings tangible results.
At the outset, I would like to wish all of you and your families good health and express my deepest sympathy to those affected by this pandemic. I would also like to thank the Arab Monetary Fund for their long-standing cooperation with the BIS in organising events such as the one we have today. Global cooperation is always important, but even more so in times of crisis.
The Covid-19 pandemic is the biggest challenge that policymakers have faced in recent history. While no two crises are alike, this one has tested our health systems, our economies and our financial sectors. In the Arab region, home to over 400 million people, the pandemic is felt by all countries and communities, and its economic consequences, as in so many jurisdictions, are likely to be deep and long-lasting. Arab countries saw a sharp fall in revenues from tourism, remittances, trade and general economic activities. Oil-exporting countries were hit twice: by the pandemic and by a plunge in oil demand and prices.
This situation calls for unprecedented measures. In response to Covid-19, we have seen an unparalleled degree of fiscal and monetary support worldwide. Many jurisdictions have launched guarantee programmes to support bank lending to companies, especially small and medium-sized enterprises, and payment deferral programmes to help struggling borrowers.
The actions taken by supervisory authorities were also unprecedented. Responding quickly, they relaxed capital and liquidity constraints and encouraged banks to draw down their Basel III capital and liquidity buffers in a measured fashion. Meanwhile, several authorities have suspended or discouraged dividend distributions to preserve banks' lending capacity without jeopardising their solvency, a measure for which I argued in March this year.1
Authorities have also paid a great deal of attention to credit risk and how to assess it. These measures were guided by the Basel Committee (BCBS), which has issued useful guidance on how Covid-related support measures should be treated under accounting and prudential frameworks.2 Helpfully, banks entered this crisis with enhanced resilience. Thanks in part to the Basel III reforms, the global banking system was significantly better capitalised and had more liquidity than at the start of the 2007–09 Great Financial Crisis. As a result, it has held up better in the Covid-19 crisis than in the last one.3
But supervisors have plenty of challenges ahead in the post-pandemic world. After the outbreak of Covid-19, they implemented a range of emergency measures. This work is far from over. But equal attention is required to address longer-term, more structural challenges such as the sustainability of banks' business models, the intensified use of new technology in financial services and the impact of climate risk on financial stability. These are likely to regain the spotlight once the Covid-fuelled crisis is behind us.
Let me share with you some reflections on the challenges created by Covid-19 for banks and their supervisors, and on supervisory priority areas for action in the short and medium term.
Challenges created by Covid-19 for banks and their supervisors
Supervisors are responsible for evaluating and promoting the safety and soundness of the financial institutions they supervise, as well as for safeguarding the stability of the financial system. The Covid-19 shock has made their work particularly difficult, reinforcing the need to achieve the right balance between microprudential objectives and the macroprudential objective of system-wide resilience. Pursuing only the microprudential objective in the midst of a crisis would be self-defeating. Taken to excess, shoring up capital and liquidity to ensure the stability of an individual institution may cut the flow of credit to real-economy sectors when they most need it, thus raising solvency issues and hurting any bank with credit exposures to these sectors.
I will argue that three elements make supervisory risk assessments more complex than ever. First, the substantially riskier environment for banks amidst an uncertain outlook; second, the side effects of regulatory relief measures; and third, operational challenges related to the unique nature of this crisis.
Heightened risks amidst uncertain outlook
The pandemic has increased all material sources of risk for the banking sector – most prominently, credit risk. As the economic fallout has affected virtually every segment of banks' credit portfolios, the impact of the crisis on bank balance sheets could be considerable. This is particularly true if government support is withdrawn prematurely, putting additional strain on the repayment ability of households and businesses.4
Other risks, such as market and liquidity risk, have also increased. We have seen bouts of volatility in capital markets, margin hikes for cleared and uncleared derivatives, and widening spreads in some market segments. Early in the crisis, there was also pressure on wholesale funding for banks, although this pressure was alleviated by central bank action.
In addition, the pandemic has heightened the risks to banks' operational resilience. The threat of financial crime has increased as the pandemic leads to an even heavier reliance on technology and third-party service providers.5 Money launderers, for example, may have seen an opportunity to take advantage of the increased need for financial institutions to identify and onboard their customers online. Similarly, for cyber criminals, work-from-home arrangements with remote access to corporate networks have significantly expanded the attack surface.6
Uncertainty compounds these financial and non-financial risks. Despite some encouraging news, the pandemic's trajectory remains uncertain. Nobody yet knows when an effective vaccine will be ready at scale, or how many more waves of the pandemic we will face until then. What we do know is that the longer the pandemic lasts, the greater the potential impact on bank balance sheets. What we also know is that pandemic-related policy measures do not eliminate risks but shift them from the private to the public sector, with banks being exposed to both. Looking ahead, the pandemic is likely to exacerbate the more structural challenges in the financial sector, such as technological disruption, low for very long interest rates, and, in some jurisdictions, stubbornly low profitability.
Regulatory relief measures
In response to the pandemic, many jurisdictions – including in the Arab region – have introduced debt relief programmes in the form of credit guarantees and payment deferrals. Meanwhile, the BCBS and prudential authorities have unveiled extraordinary regulatory relief measures. Some of these prescribe how banks and their supervisors should consider debt relief programmes within the prudential framework to avoid unwarranted erosion of regulatory capital.
Regulatory relief measures were fully warranted to support bank lending to businesses and households. But while they provide banks with flexibility in support of the real economy, they come with side effects that become more pronounced the longer the relief measures remain in place. This is particularly so if credit risks continue to mount on bank balance sheets.
Most importantly, regulatory relief measures confront supervisors with significant challenges in assessing the risk profile of banks and their financial health. Indeed, most of the relief measures undertaken have direct implications for the computation of regulatory capital, risk-weighted assets (RWAs) and key indicators of asset quality.7
This latter issue may be of great relevance at present. Under BCBS guidelines, a loan is classified as non-performing if either one of two criteria is met: the loan is past due for more than 90 days or the borrower is unlikely to repay, regardless of the reasons leading to this situation. But this is different now – when counting the number of days past due, banks may exclude payment holiday periods. This means that a borrower will only become past due once the payment deferral period ends and if the borrower is subsequently unable to make the rescheduled payments in a timely manner. This underlines the importance of sound policies and procedures with regard to the assessment of a borrower's unlikeliness to pay. It also underlines the importance of banks' efforts to faithfully reflect credit risk in their financial statements and reported regulatory metrics, and to remain as transparent as possible. This facilitates supervisory risk assessments and helps to maintain the trust of capital markets.8
Operational challenges for authorities
The pandemic has affected the operations of both financial institutions and authorities. With large parts of their workforce working remotely, supervisors – like the staff of other institutions – have had to adjust their working patterns, putting to the test their IT systems and their institutional agility.
Supervisors have had to take a great many extraordinary measures in a relatively short space of time. When the BCBS issued guidance in response to the pandemic, supervisors had to act on it in the context of their own legal frameworks and local conditions. Under these circumstances, in March, the Committee decided to defer the implementation of the outstanding Basel III standards by one year, which has undoubtedly helped to free up operational capacity for supervisors.9
The new normal of travel restrictions, social distancing and shelter-in-place requirements also forced supervisors to modify their practices. Pre-pandemic, supervisors exercised scrutiny over banks through a combination of off-site monitoring and on-site inspections. With the pandemic, most of the latter became impracticable.
Instead, supervisors now increasingly rely on off-site supervision and reporting. Some supervisors have also moved to convert assessments that would normally be done on the ground into off-site exercises, such as internal model investigations.10
From supervisory challenges to priority areas for action
Short-term priorities
In the immediate future, supervisors will have to remain fully focused on tackling the many challenges Covid-19 has brought to the fore.
The current one is to achieve the right balance between the macro and micro objectives of prudential regulation and supervision. The difficulty here is that policy instruments are imperfectly aligned with specific policy objectives. Most relevant prudential policy instruments – whether classified as microprudential or macroprudential – work through the constraints they impose on the same variable: bank capital. Therefore, in principle, the available policy tools can have a mixed impact on a given banks' resilience in the current uncertain environment and its willingness to keep lending to the real economy.
The experience of the pandemic points to limitations in the existing macroprudential framework. Its most relevant instrument within the Basel III toolkit is the countercyclical capital buffer (CCyB). However, sizeable buffers were not built up before the Covid-19 outbreak in most jurisdictions and a number of authorities would have preferred to enter the crisis with a larger CCyB. As a result, the CCyB amounts that were available to macroprudential authorities to respond to the shock were limited.
As a consequence, authorities had to rely on other, essentially microprudential instruments, such as encouraging the use of supervisory buffers and of flexible criteria for asset classification and measurement, to meet the macro-stabilisation objective.
There is no doubt that this approach was fully warranted given the current macroprudential framework. In any case, there is a limit on how far microprudential tools can be used to achieve a macroprudential policy objective – that is to support the orderly flow of credit to the real economy – without jeopardising the policy objective of ensuring the safety and soundness of individual financial institutions.
One particular area for supervisors to watch is asset quality. Supervisors need to closely monitor bank practices in identifying non-performing loans and provisioning. Such assessments, which require banks to distinguish between borrowers facing short-term liquidity problems and those with longer-term solvency issues, may become particularly challenging the longer that the crisis persists.
Once the withdrawal from Covid-19 measures begins, authorities will face a dilemma. The challenge will be how and when to exit from regulatory relief measures. In terms of timing, authorities need to steer a course between Scylla and Charybdis. Acting too early may remove much needed credit to support economic growth. Waiting too long may delay necessary resource reallocation and put additional long-run pressure on the financial sector as the solvency phase of the crisis could expose any depletion of loss-absorbing resources, potentially undermining confidence in the post-crisis regulatory regime and its ability to preserve the financial system's stability. At the end of the day, authorities will have to balance the benefits of economic relief with financial stability considerations.11
Lastly, to cautiously prepare for the worst, it seems wise, as a number of authorities are already doing, to step up their contingency planning for resolution. That could include reviewing the feasibility of resolution strategies, raising internal awareness of decision-making procedures and seeking ways to rebuild operational capacity in case of need.
Medium-term priorities
When Covid hit, efforts to address the more structural challenges facing the banking sector were probably pushed to the backburner. While supervisors must continue to do their part in the fight against Covid-19, it is also important that they do not lose sight of medium-term priorities.
A key feature of today's banking sector seems to be its persistently low profitability in some parts of the world such as Europe and Japan. This often indicates excess capacity, which calls for a stringent sustainability analysis of banks' business models. If overcapacity poses a financial stability risk, supervisors may consider adopting, as some are already doing, a proactive strategy to facilitate the sector's orderly consolidation.
The sustainability of banks' business models may also be affected by technological disruption, including competition from new players. Alongside the benefits new technologies bring, innovation may also create or increase risks for consumer protection, market integrity, operational resilience and, eventually, financial stability. In addition, the proliferation of new technology-enabled business models will continue to raise questions about the regulatory perimeter, and whether existing regulatory frameworks need to be adjusted.12
On climate change, financial supervisors continue to study the related systemic risks. These are of two general types. First, there are physical risks related to climate-induced damage to economic production or infrastructure. These are risks external to the financial system, akin to the pandemic outbreak. The second are transition risks, related to potentially disorderly risk mitigation measures in anticipation of or in response to physical risks. But no international consensus yet exists on how to embed those risks into regulatory and supervisory requirements. As a first step, perhaps, there is a promising emerging practice of asking banks to conduct their own self-evaluations on the impact of specific physical and transition risk scenarios.
To enhance cooperation, central banks, supervisors and regulators have set up the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and, in the insurance sector, the Sustainable Insurance Forum (SIF). I'm very happy that we are joined by Frank Elderson today, who is the Chairman of the NGFS, and the BIS Deputy General Manager, Luiz Awazu Pereira da Silva, who leads our climate-related work.
Technology for supervision
The crisis only strengthens the case for supervisors to embrace technology in order to keep up with the digital transformation that the industry is experiencing. New technologies can also help us to improve supervisory processes, making them less dependent upon on-site reviews.
How can new technologies generate sufficient value in terms of supervisory efficiency and effectiveness? There are three conditions, and all of them need to be met.
First, making more intensive use of technology for regulatory, supervisory or oversight purposes (suptech) has implications for the skills supervisors will need. Hence the need to further strengthen supervisors' capabilities to analyse granular data and build supervisory capacity in technology-related fields such as data science and data analytics.
Second, supervisors need timely access to sufficiently granular and high-quality regulatory data. Current reporting procedures are often based on dated legacy systems and sometimes heavily manual processes, resulting in high complexity and costs. The good news is that the availability of innovative technologies such as APIs, cloud platforms and artificial intelligence provides plenty of scope for enhancing regulatory reporting. Innovations in regulatory reporting are already taking place in the shape of data standardisation, data transformation rules, granularity or the format of required data reporting and data transmission. Indeed, some supervisors have already made substantial progress in innovating their regulatory reporting process.13
Third, to seize these opportunities, supervisors may need to accept a certain degree of trial and error as an integral part of their digital transformation. By nature, supervisors have a strongly risk-aware culture that may not always sit comfortably with a mindset for experimentation.14 This could also have a bearing on the resources that supervisors are willing to devote to suptech.
At the BIS, we have already undertaken projects on the potential of suptech applications, with the aim of supporting capacity-building in financial authorities. Let me mention just one. In 2018, our FSI launched the so-called "Informal Suptech Network", which provides an information-sharing and exchange venue for suptech experts from different jurisdictions. The network now has over 100 members.
Lastly, I would be remiss not to mention the BIS Innovation Hub in this context. The Hub's mission is to spearhead its stakeholders' response to digital innovation and to foster international collaboration. To this end, it builds on the efforts of central banks that have already made significant advances in certain fields. With the recent decision to expand the Hub's global footprint, regtech and suptech will feature prominently in the Hub's portfolio of projects. The Singapore Hub Centre, for example, is creating a digital platform connecting regulators and supervisors with digital and technology solution providers. This will help central banks develop innovative solutions and policies for cost-effective supervision.
Conclusion
Let me conclude.
We are in the midst of a major transformation. An economist would say that Covid-19 has caused a structural break. Detecting that break was easy; much harder is the question how to deal with it, especially since the pandemic's trajectory remains uncertain.
Thus, supervisors will have to remain on high alert in the immediate future, as they face formidable supervisory challenges. Meanwhile, it will be important for them to keep an eye on issues beyond Covid, such as the sustainability of banks' business models and resilience more broadly.
What is clear from the Covid-19 crisis is that it will accelerate the financial sector's digital transformation. Also, that supervisors will need to match the financial sector's intensified use of technology by harnessing technology for their own purposes.
In these times, international cooperation and coordination are more important than ever. We at the BIS stand ready to play a supporting role and do our part.
References
Banerjee, R, G Cornelli and E Zakrajše (2020): "The outlook for business bankruptcies", BIS Bulletin, no 30, 9 October.
Basel Committee on Banking Supervision (2020a): "Governors and Heads of Supervision announce deferral of Basel III implementation to increase operational capacity of banks and supervisors to respond to Covid-19", March.
--- (2020b): "Measures to reflect the impact of Covid-19", April.
Borio, C and F Restoy (2020): "Reflections on regulatory responses to the Covid-19 pandemic", FSI Brief, no 1, April.
Crisanto, J C and J Prenio (2020): "Financial crime in times of Covid-19 – AML and cyber resilience measures", FSI Briefs, no 7, May.
Crisanto, J C, K Kienecker, J Prenio and E Tan (2020): "From data-reporting to data-sharing: how far can innovations challenge the status quo of regulatory reporting?", FSI Insights on policy implementation, forthcoming.
Carstens, A (2020): "Bold steps to pump coronavirus rescue funds down the last mile", Financial Times, 29 March.
Coelho, R and J Prenio (2020): "Covid-19 and operational resilience: addressing financial institutions' operational challenges in a pandemic", FSI Briefs, no 2, April.
Cœuré, B (2020): "Leveraging technology to support supervision: challenges and collaborative solutions", speech at the Peterson Institute for International Finance, 19 August.
Drehmann, M, M Farag, N Tarashev and K Tsatsaronis (2020): "Buffering Covid-19 losses – the role of prudential policy", BIS Bulletin, no 9, April.
Ehrentraud, J and R Zamil (2020): "Prudential response to debt under Covid-19: the supervisory challenges", FSI Briefs, no 10, August.
Ehrentraud, J, D Garcia Ocampo, L Garzoni and M Piccolo (2020a): "Policy responses to fintech: a cross-country overview", FSI Insights on policy implementation, no 23, January.
Ehrentraud, J, D Garcia Ocampo and C Quevedo Vega (2020b): "Regulating fintech financing: digital banks and fintech platforms", FSI Insights on policy implementation, no 27, August.
European Central Bank (2020): "What are the priorities for ECB Banking Supervision amid the pandemic?", October.
Hardy, B and E Takáts (2020): "International banking amidst Covid-19: resilience and drivers", BIS Quarterly Review, December.
1 Carstens (2020). See also Borio and Restoy (2020) and Drehmann et al (2020).
2 BCBS (2020b).
3 Hardy and Takáts (2020). The authors compare the year up to end-2008 (for the Great Financial Crisis) with the corresponding period up to mid-2020 (for the Covid-19 crisis).
4 Banerjee et al (2020).
5 Coelho and Prenio (2020).
6 Crisanto and Prenio (2020).
7 Ehrentraud and Zamil (2020).
8 Borio and Restoy (2020).
9 BCBS (2020a).
10 See eg ECB (2020).
11 Ehrentraud and Zamil (2020).
12 Ehrentraud et al (2020a, b).
13 Crisanto et al (forthcoming).
14 Cœuré (2020).
