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2020: New Decade, Different Risks in Banking?

Key messages

2020 Key Risk Drivers

Supervisory Priorities

Customer Impact

The author of this articleWouter Spitaels - Project Consultant
Recently, the European Central Bank (ECB) released a new update of the Single Supervisory Mechanism (SSM) Risk Map. As different focus areas arise, banks will have to change their risk orientation in the decade ahead. Which key risk drivers have been identified? Which priorities have been set? Moreover, and most importantly, how will this impact customers? Let’s find out.

2020 Key Risk Drivers

The European Central Bank’s Single Supervisory Mechanism (SSM) Risk Map summarizes the key risk drivers affecting the euro area banking system over a two to three-year horizon. The SSM 2020 Risk Map, which is displayed below, plots the different risk drivers on the impact/probability axes. Four key risk drivers, which may trigger or reinforce each other, for 2020 are:
 

  • Over 50% of banks currently see their Cost of Equity exceeding their Return on Equity as a result of low interest rates, IT investments, risk management improvements, increasing salaries, digitalization costs, etc. Business Model Sustainability will be key in the years to come.
  • Economic, political and debt sustainability challenges in the euro area result in increased credit risk and deteriorating banking profitability. Given the fact that 45% of all rated market-based corporate debt is rated BBB, “fallen angels” (i.e. those at the low end of the investment-grade scale) raise multiple debt sustainability concerns.
  • Although banks are strengthening the management of their sourcing risks, they remain vulnerable to cybercrime & IT deficiencies. Deep interconnectedness will result in systemic impact when third or even fourth parties are being targeted by cybercriminals.
  • Due to relaxed lending standards for residential real estate loans, the amount of Non-Performing Loans (NPL) will continue to increase in the future. Consequently, euro area banks will have to face increased credit risks.

The following risk drivers have a similar impact/probability when compared to their previous (i.e. 2018) position on of the ECB’s Risk Map: repricing of financial markets, misconduct and climate change related risks. Overall, we notice the ECB having a more negative outlook on the global economic cycle fuelled by the risks mentioned above. Euro banks however, are adequately capitalized, with a 14.2% CET1 ratio.

Source: European Central Bank (2019). ECB Banking Supervision: Risk Assessment for 2020.

Supervisory Priorities

Given the changes on their Risk Map, which are described above, the ECB has set new supervisory priorities:
 

  • First, the ECB Banking Supervision will focus on the continuation of balance sheet repair by euro area banks. By performing the follow-up of Non-Performing Loans (NPL) guidance, detected shortcomings of Internal Ratings-based models and trading risks, they aim to further restore the health of bank balance sheets.
  • Secondly, supervisors intent to strengthen banks’ future resilience by assessing banks’ loan originating processes, exposure quality, internal capital (ICAAPs), liquidity adequacy (ILAAPs), IT & Cyber Risks, business models and profitability. Additionally, the European Banking Authority (EBA) and ECB will conduct stress-testing exercises during 2020.
  • Other supervisory priorities, such as Brexit or the ongoing IFRS 9 implementation, will be tackled in 2020.
"In the next decade during which financial ecosystems will further develop, risk management departments should stay on top of technological innovations, rapidly evolving customer expectations and other market evolutions."
Wouter Spitaels - Project Consultant Financial Institutions

Customer Impact

The above-mentioned risk drivers and supervisors’ responses will (indirectly) impact our lives in various ways. Below, we – TriFinance Financial Institutions – summarize our views on how customers will be affected.

Given the importance of business model stability, banks will look to offset lower interest income and costs related to reviving end-of-life IT systems, new IT investments, extensive customer journey analyses, digitalization, risk management improvements, etc. As a result, euro banks will have to re-engineer processes and implement leaner management structures as the costs of vital digitization projects still exceed benefits.

For reasons mentioned above, some European financial institutions are currently considering negative deposit interest rates (e.g. when the deposit exceeds certain thresholds) or a further increase of various fees. However, euro banks should not underestimate depositor reactions once they introduce negative interest rates. Currently, it’s unknown at which point depositors will demand cash instead of deposits. It goes without saying that reaching this point might endanger the stability of the financial system. Furthermore, EBA (2019) supervisory data shows that banks, which are more reliant on deposit funding, might put this funding source at risk once they start introducing negative deposit interest rates.

Because of the global drops in interest rates, the search for yield appears to be unstoppable. Apart from potential spikes in volatility and persistent trade protectionism, Belgian investors should consider potential bubbles in bond market, stock market and household debt. Additionally, the European Systemic Risk Board (ERSB) warns about Belgian house prices currently being overvalued by 15%. The ESRB recommends the Belgian government to activate legally binding ‘borrower-based measures’ (e.g. limits to Loan-To-Value (LTV) or Debt-To-Income (DTI) ratio), which will directly impact households.

Given recent breaches of Anti-Money Laundering (AML) and Combatting the Financing of Terrorism (CFT) rules, euro area banks will have to step up their game. Hence, financial institutions will have to improve controls, governance and continue educating their customers, which proved to be a challenging task.

Conclusion

Apart from economic, political, cybercrime, credit and debt sustainability challenges we, TriFinance Financial Institutions, consider business model sustainability as the main risk euro area banks will be facing during the next decade. Therefore, banks will have to intensify the integration of innovation, strategy and (agile) risk management within their organization. Consequently, in the next decade during which financial ecosystems will further develop, risk management departments should stay on top of technological innovations (e.g. PSD2, etc.), rapidly evolving customer expectations and other market evolutions (e.g. cashless society).
 

Sources

  • European Central Bank (2019). ECB Banking Supervision: SSM Supervisory Priorities 2020.
  • European Central Bank (2019). ECB Banking Supervision: Risk Assessment for 2020.
  • European Central Bank (2019). Financial Stability Review November 2019.
  • European Banking Authority (2019). Risk Assessment of the European Banking System.
  • Federal Reserve (2019). Financial Stability Report November 2019.

About the Author

After finishing his Master in Banking and Finance at UGent, Wouter started his professional career at TriFinance. As a member of TriFinance’s Young Hub Program, Wouter worked on several risk management projects at four major clients within the Belgian financial sector. Currently, Wouter is working as Commercial Risk Expert at one of Belgium’s largest retail banks.

About TriFinance’s Risk Management & Compliance Practice

The practice ‘Risk Management and Compliance’ practice focuses on supporting banks and insurance undertakings in anticipating and addressing the tighter regulatory standards relating to risk management, compliance and internal control by monitoring the different European and local regulatory and supervisory bodies.

For more information on the Risk & Compliance Practice, please check out the following page.

For more info, you can always contact Wouter Spitaels.
(wouter.spitaels@trifinance.be or +32 2 712 08 90).

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The author of this articleWouter Spitaels - Project Consultant

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