The next step towards better banking supervision – new Europe-wide regulatory standards will enhance systemic stability

Opinion piece by Danièle Nouy, Chair of the Supervisory Board, and Sabine Lautenschläger, Vice-Chair of the Supervisory Board,
published in the Wall Street Journal on 4 November 2014

The world’s biggest banking supervisor becomes operational on Tuesday when the European Central Bank, in cooperation with 18 national authorities, takes on the supervision of the euro area’s banking industry. European banking supervision is the first of the three pillars of banking union, which is often characterised as the biggest undertaking of the European Union since the introduction of the euro. As a true European supervisor, our approach will be to implement best practices for independent, intrusive and forward-looking supervision that will ensure a level-playing field for banks’ operations.

The 2008 global financial crisis showed that many banks weren’t prepared and sufficiently robust to withstand such a serious event. This resulted in pressures on banks’ balance sheets, stalled transmission of funds from banks to the real economy and, in the worst cases, in failures that needed state bailouts. It became clear that the link between banks and governments, with the tacit guarantee that taxpayers would bail out failed credit institutions, was creating moral hazards that were unacceptable. So euro zone leaders created the banking union with the Single Supervisory Mechanism, to make the banking industry safer, and the Single Resolution Mechanism, to tackle the too-big-to-fail problem with systemically relevant banks.

One obstacle in assessing the banking system as a whole has been the difficulty in comparing banks across regions and business models. The comprehensive assessment of the euro area’s 130 largest banks, which the ECB in cooperation with the national supervisors completed last week, was a first important step in reviewing the banks’ assets across borders and institutions.

The associated asset quality review for the first time applied uniform standards for valuing bank assets and accounting for potential problems such as non-performing loans. The exercise was unprecedented in that it examined banks’ balance sheets vertically and horizontally, and was fully transparent. It gave us insights that will help strengthen supervision going forward, and also encouraged the banks to repair their balance sheets and assess their own positions in the banking sector. Consequently, many banks had taken action before or while the exercise was under way.

The assessment was a very good starting point for delivering tough and intrusive, yet fair and even-handed, supervision. To achieve this across the euro area and the European Union, a true level playing field needs to be created. This cannot be done by the new supervisor alone. Despite covering 18 countries—19 once Lithuania joins the euro on 1 January 2015—and directly supervising the 120 largest banks in the euro zone representing 82% of total banking assets, less significant banks will still have day-to-day contact with national bank supervisors. Those national supervisors will receive guidance from the ECB.

More broadly, it is important that regulators be on the same page with regard to standards. The international community has embraced this idea by agreeing to the regulatory framework for banks—commonly known as Basel III. Adoption and implementation has progressed, but there is still work to do to create equal rules for the banks.

The comprehensive assessment showed that consistent supervision requires fully harmonized regulation in the euro area. Many of the measures the banks took in preparation for the in-depth exercise were related to the issuance of top-quality, loss-absorbing capital (Common Equity Tier 1), but some measures were also taken under national transitional arrangements that will eventually lead to capital being fully defined as CET1. This confirms the need to improve the consistency of the definition of capital, the first step of which will be the harmonization of those national transitional arrangements.

Another consideration and one of our priorities will be the review of the models that banks use for calculating their risk-weighted assets. Past experience showed that based on their models, some banks’ calculations of the capital requirements were too low, and sometimes models were used when empirical data was not sufficient to do these complex calculations. That’s why we need to thoroughly examine the banks’ models.

Harmonized regulation and supervision won’t eliminate bank failures or bank crises altogether, but it can help prevent one failure from cascading into an avalanche that affects the entire system. It should be our common goal to establish a regulatory and supervisory framework that will make depositors feel safe, investors confident, banks stable and taxpayers calm.

As supervisor for all the euro area’s significant banks, we are set to go. But all stakeholders will need to contribute their share to achieve this. We rely on the European and national legislators, the European Commission and the European Banking Authority to continue their constructive role toward creating a single financial market in Europe. At the same time we will do our utmost to meet our mandate.