What is, perhaps, most notable is that the supervisory focus was placed on banks’ interest rate risk and the sustainability of their funding plans, issues that are crucial in a context of rising interest rates and liquidity withdrawal by central banks. Also, the most exposed European banks were required to improve the way in which they monitor and manage this risk. In some cases, they were even asked to be more conservative in their interest rate assumptions and in their model calibration and validation. Similarly, when it became apparent that there were interconnections between the banking system and non-bank financial intermediaries, the decision was also made to place the supervisory focus on analysing the risks for European banks of this type of exposure. The EU banking sector is so far benefiting from the ongoing normalisation of interest rates, as the interest rate pass-through on the asset side still significantly exceeds the pass-through on the liability side. Consequently, aggregate banking sector profitability is at its highest level since 2014. However, several factors continue to cloud the outlook for banks. First, the deceleration in economic growth and higher interest rates may have an adverse impact on asset quality, leading to higher impairment costs, and on lending volumes, exerting contractionary pressures on income generation capacity. Second, banks’ funding costs are on the rise, bringing potential pressure on interest margins. The impact of these factors is expected to become more pronounced over time and more likely the longer the high-interest rate period continues.
This leads naturally to a related question which has been the object of recent press commentary, namely should the Bank’s holdings of gilts just be cancelled? The idea is that this would relieve the Government of having to levy the taxes to pay both the coupons on the gilts and the principal when it falls due. Government debt would fall at a stroke of the pen, apparently relieving the future burden on the taxpayer. Unfortunately this is not as good an idea as it sounds. Cancelling the gilts would deprive the Bank of the assets it needs to sell back to the market in order to suck the bank reserves out  BIS central bankers’ speeches  7  when the time comes to unwind the policy. It would also deprive the Bank of the wherewithal to pay the interest on the reserves in the meantime, so we would need either to keep Bank Rate perpetually at zero or else be willing to continue issuing additional reserves indefinitely in order to meet our obligations. One can easily see how this would eventually lead to inflation taking off. 4 In any case, it is not really clear why one would want to go down the route of cancelling the gilts. In undertaking quantitative easing, we are, for a period, replacing part of the government gilt stock with a monetary liability paying Bank Rate; cancelling the gilts is tantamount to making that period indefinite.