Are European bank supervisors dangerously tempting fate?
They have started down the path of moral hazard, but the way back may not be easy
26 May 2020 | Keith Mullin
Keith Mullin
Keith Mullin

The seven US global systemically important banks (G-SIBs) increased their aggregate provisions against potential loan losses more than five-fold in the first quarter of 2020. Europe’s 13 G-SIBs, by contrast, upped their aggregate provisions by two-and-a-quarter times. Leaving aside the difference in sample sizes, that’s pretty representative of the regional divide. It’s different by a factor of almost 2.5x.

To many observers, this looks mightily odd, given that the European economy (which was already struggling prior to the Covid-19 crisis) is expected to perform worse than the US through Covid-19 and beyond. Does this suggest complacency? Is it a signal that European bank managements and supervisors have not learned lessons from the global financial crisis? Or is there something else afoot?

In the wake of the 2008 crisis, US authorities and banks adopted a conservative, pragmatic and resolute stance, and US banks took the pain a lot more quickly than their dithering European counterparts. Which dragged their feet over reducing high fixed costs bases – a process still far from complete – and had to be forced into expediting plans to deal with legacy bad debt exposures; another process that’s incomplete in some outlier jurisdictions.

It looks like US banks are once again more prepared to front-load future charge-offs. Because of bold actions taken in the wake of the global financial crisis – not just dealing with bad debt but upgrading business models, profiles and footprints too – US banks as a group are more profitable today than their European counterparts. (Helped, of course, by the better fortunes of the US economy.) One reason European banks are dithering over taking adequate provisions now could be the simple fact that they are not profitable enough to take the pain head-on.

But complicity by European bank supervisors is playing a much bigger role. Supervisors are in effect forcing banks to under-provision, the opposite of what they have been pushing them to do in recent years. They’re doing it in the name of avoiding volatility in regulatory capital and financial statements, and making sure banks keep to their new-found ‘saviours-of-the-economy’ status and keep their lending taps open. While the rationale for this latter point is clear, the fact that the powers-that-be want to force banks to lend into a sharp recession is extraordinary as there can surely be just one realistic eventual outcome: a sharp increase in non-performing loans, despite rock-bottom interest rates.

Andrea Enria’s open letter to significant banks in the eurozone in early April was crystal clear. The chair of the European Central Bank’s supervisory board stated right up front his desire for banks to avoid capital and financial disclosure volatility stemming from IFRS 9 (the accounting rule banks are now required to use to model expected credit losses).

What Enria ‘recommended’ was that banks avoid making excessively procyclical assumptions in their IFRS 9 modelling to calculate credit-loss estimates. For the avoidance of any residual doubt, he said he ‘expected’ large banks to consider his ‘guidance’. “Reducing inappropriate volatility in regulatory capital and financial statements at this juncture is crucial for avoiding procyclical tightening effects on bank lending and for ensuring that, in spite of the uncertainty, institutions’ disclosures remain reliable, consistent and comparable,” he wrote.

It’s worth pondering what appropriate volatility is as opposed to inappropriate volatility; it’s a pretty open-ended question. But just as Newton’s Third Law of Motion states that every action has an equal and opposite reaction, it’s also worth pondering what the unintended consequences of this supervisory approach might be. Smoothing out spikes might have some nominal benefits, but it can just as easily create misleading and potentially dangerous outcomes.

Determining accurate inputs for probability of default (PD) calculations is tricky at this point. Fair enough. And because PD outputs act as triggers for banks to move credit exposures through the various stages of performing to non-performing status under IFRS 9, a top-down approach that has a mechanical and immediate flow-through to provisioning, profits and capital might not reflect actual experience.

But then again it might. Sam Theodore, managing director of Scope Insights, wrote in a recent comment that the likelihood of a large European bank ending up in resolution is more remote now than at any time since before the global financial crisis. On the basis that supervisors are hardly going to force banks to endanger their solvency with one hand and push them into resolution with the other. I’m not sure what that says about the robust new post-GFC (global financial crisis) banking paradigm.

For a whole host of nominally good reasons to do with having banks continue supporting clients through the crisis, supervisors have offered regulatory forbearance on capital and the use of buffers. It’s too early to have any sense of how the multiple government measures across Europe providing support for companies and individuals (including payment holidays, grants and loan guarantees) will play out in terms of loss experience for the banks.

But predictions for the European economy are dire. A prudent approach for the banks would be to exercise extreme caution. Q2 and Q3 will offer a better picture of Covid-19 distress and things may well change as that picture emerges. But European supervisors have already started down the path of moral hazard. The way back may not be that easy.

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