One of Europe's top bank supervisors is preaching vigilance for institutions on both sides of the Atlantic amid what she sees as a "fraught" economic environment.
Bank profits are high and capital levels are too, but Elizabeth McCaul, a member of the Frankfurt-based European Central Bank's supervisory board, said the fault lines are clear. Supply chain issues, rising costs and elevated leverage are weakening the quality of assets on bank balance sheets. Meanwhile, external risks to the banking sector, ranging from cryptocurrencies to climate change, are in need of tighter controls, she said.
"It's the type of environment I've seen a lot in my career, and it's the type of environment where you have the sense that there can be an accident," McCaul told American Banker last week. "You don't know where that accident will be. … So it means that you have to have your institutions very focused on strong risk management practices."
McCaul knows a thing or two about fraught economic conditions.
In 2001, as New York State's superintendent of banks, she helped avert a catastrophic bank run after the 9/11 terrorist attacks by coordinating with the National Guard to deliver cash to Manhattan banks.
After the U.S. financial system was pushed to the brink of collapse in 2008, she advised some of the world's biggest central banks, including the Federal Reserve and the ECB, as an executive at the influential consulting firm
Today, McCaul sits on the board of the ECB's Single Supervisory Mechanism, the governing body created after the global financial crisis to oversee the top 110 banks in the European Union. In 2019, she became the first — and thus far only — American to join the SSM board, where she sits alongside other representatives from the central bank and delegates from each of the Euro Zone's national supervisory authorities.
McCaul joined American Banker in our newsroom in Manhattan's Financial District last week to discuss the regulatory agenda in Europe, the state of global financial stability and the future of global bank supervision.
"The overall risk environment is very much top of mind and the potential effects on asset quality and the institutions is a real priority for us," she said. "We have asked banks to be very cautious in their capital trajectory analyses and we've asked them to look carefully at their capital planning processes."
Regulatory responses
The ECB and the European Parliament have responded to current economic uncertainties in several ways, McCaul said.
First, on the leverage front, the SSM has asked several institutions to increase their capital contributions to mitigate potential losses. McCaul pointed out that the European capital framework has some notable differences from the U.S. model.
"The U.S. has a very strong stress testing process to make the determinations about the capital levels. We have a supervisory process that builds up our view of what the capital levels should be, and it's aligned with the Basel requirements for Pillar 1 and Pillar 2," she said, referring to the international standards for minimum capital and supervisory review. "Then we have a stress testing component that we add into the development of the capital demand that we make from the institutions."
Managing climate risk is also a top priority for the ECB, McCaul said. In 2020 the central bank asked banks to assess their own climate exposures to all sorts of changes, then followed that up with a review of oversight gaps in the regulatory system. This past summer, it ran its first climate stress test. Like the six-bank
Still, McCaul said, the focus on climate risk has encouraged banks to think about the topic differently.
"We've moved the discussion in the banks and maybe the management of this issue in the banks from government affairs offices, regulatory affairs offices as something that's really a social policy, to bring about the understanding that it belongs in the Risk Management Office and the CFO office, because it's about balance sheets," she said. "This is a traditional risk."
Another change on the horizon is digital-asset regulation. While Congress grapples over
McCaul said there is much to learn about the risks related posed by the crypto industry as a whole as well as specific firms. Still, she said, the key principles of MiCA should address some of the glaring issues in high- profile failures in the business, like the
"There are components of MiCA that call for strong governance, strong internal controls, segregation of assets would be required," she said. "From what we can read about FTX now, we can understand that some of those basic governance, internal controls, segregation of assets, things are not in place."
A united front
One of the biggest strengths of MiCA, McCaul said, is that it provides a single regulator system for all of Europe. When dealing with activities that present a systemic risk — especially ones like crypto that can move seamlessly across borders — it is important for regulators to share common standards.
"Every time that I have seen a loss, some type of a loss in a marketplace, we've been able to identify a gap in oversight, and where you have gaps in oversight, that's where risk increases and that's where accidents can happen," she said. "One area that I also have regularly seen as contributing to higher levels of risk is the cross-border activity, where you don't have harmonization of rules. That can lead to gaps."
To close those gaps, McCaul said, the U.S. and other countries should enact standards to those that have been approved in Europe.
"It's extremely important that there be oversight and supervision of crypto assets that doesn't lead to regulatory arbitrage on both sides of the Atlantic," she said. "Where there isn't oversight, this is where risk develops and financial stability itself can be threatened."
Crypto is not the only cross-border risk that warrants a unified regulatory front, McCaul said. Operational resilience and information technology security are frequent topics of conversations among global bank supervisors, she said, adding that cybersecurity has been an acute focus since Russia's invasion of Ukraine in February. While cyberattacks have not ticked up as dramatically as expected, she said they remain elevated.
Another shared concern European regulators share with their American counterparts is the migration of lending activity — and, subsequently, risk — outside the traditional banking sector.
The so-called shadow banking sector is smaller and less developed in Europe than the U.S., where
McCaul said there are opportunities for the ECB to learn about nonbank management from American bank regulators, as well as instances where the groups can work together to identify risks and bring them
"We really need to make sure that we are cognizant of this risk, that we get a line of sight and data about the developments in that risk, and that we understand the interconnectedness back to the industry that we do have oversight of, the banking Industry," she said.
Overall, as financial markets around the world become more complicated and more connected, McCaul said, the first thing for regulators to partner on is improving transparency.
"Opacity is never our friend when we think about the potential for systemic risk or for losses to occur," she said. "Continuing to promote transparency about interconnectedness in the system, about the construct of products that are being developed, this is very important."
The tools for the job
McCaul's resume includes a decade at Goldman Sachs and six years as New York State superintendent of banks. Before joining the ECB, the New York native spent 16 years at Promontory, where she opened the firm's New York office and later went on to lead its European division.
Her interest in European finance dates back to her college days. As an economics and political science student at Boston University, she spent a year studying the European Common Market on scholarship from the German government, becoming interested in "the European project."
As Promontory's CEO of Europe, McCaul helped craft the framework for the SSM, which was adopted in 2013 and made effective the following year. She described joining the board in 2019 as the "greatest honor" of her life.
One of her top duties at the ECB is overseeing what is known as the "digital agenda," which includes monitoring cybersecurity, addressing novel challenges posed by financial technology firms and adopting technology to enhance supervision, both in Europe and globally.
All three responsibilities share a common objective, McCaul said, one that will be key to bank supervision the world over moving forward: harnessing data.
"Supervision is, by its nature, backward-looking. We rely on historical information. We ask for financial and statistical information from institutions that is dated, and the world is moving so much faster now," she said. "There's a lot of opportunity to increase our ability to harness that data, mine the data, understand the data and to do that we need to develop tools."
