Green fingers and financial stability at the ECB

Macroprudential regulation has certainly come on leaps and bounds over the past ten years across the major central banks. Where once abstract DSGE models ruled the roost, policymakers now take a more nuanced view of systemic risk, incorporating real economy elements that can propagate through to the financial sector. The latest hot topic is climate change, and its potential impact on output, labour markets and prices in the medium-term.

Disclosures and climate stress testing

Last week’s speech by Vice-President Luis de Guindos provided an interesting insight into how the ECB views its role in this area.

An enhanced stress testing framework is the ultimate aim, with a view to incorporating climate-related risks into the European Banking Authority’s biennial testing schedule. These sector-wide assessments are intended to capture the key systemic risks to the European banking sector and highlight areas of concern. A new framework is unlikely to be ready in time for the next round of tests in 2020, but don’t rule out 2022.

The first step in this process will be disclosure, building on the European Commission’s classification system for sustainable investments proposed last year. Acknowledging the progress made by private sector initiatives, de Guindos would like to see harmonised climate-risk scoring and a deeper understanding of potential exposures. Keeping tabs on business travel and energy usage is one thing, but more high-quality disclosure on the impact of climate change on banks’ financial assets will be key for policy.

Investors can certainly help, but policymakers may need to provide a nudge.

ECB financial stability review

The ECB also published its twice-yearly Financial Stability Review last Wednesday, giving us an overview of the main risks keeping policymakers awake at night.

Falling bank profitability and excessive risk-taking were key themes of the review, as was the re-emergence of property market risks. Low rates have created financial stability challenges in the ECB’s view as investors search for yield in riskier parts of the market. Non-bank financials, including pension funds and insurance companies are an area of concern in this regard. Hardly new news.

The ECB has suggested that further banking sector consolidation can help to reduce risk, particularly for those systems with many smaller weak performers, driving down cost-to-income ratios and improving profitability.

Interesting perhaps given the recent experience of Commerzbank and Deutsche Bank’s failed merger, with both citing consolidation risks and high costs as reasons to abandon talks.

For more information, please contact Richard Conway, Director at JCRA, at richard.conway@jcrauk.com.