Interview with Eurofi Newsletter

Interview by Danièle Nouy, Chair of the Supervisory Board of the ECB, published on 6 September 2016

How to explain the national bias developing in banking regulation in the euro area (i.e. national liquidity and capital buffers, TLACs, intra Eurozone exposures considered as cross border, …)? What are the consequences of such fragmentation for the financing of the economy, the single market and for financial stability (when considering the resolution of a cross-border bank)?

Financial markets in Europe must grow closer together, and they are doing so. The national bias is not developing, as the question suggests; it is actually getting smaller and smaller. The playing field is becoming more level – just think of the Single Rulebook, the Single Resolution Mechanism and European banking supervision.

However, we are in a transitory period and are moving quite fast, compared to previous benchmarks, towards a truly integrated financial market. European banking supervision as the first pillar of banking union is less than two years old; the Single Resolution Mechanism as the second pillar was set up at the beginning of the year, and the Single Resolution Fund is still work in progress. Finally, the third pillar of banking union, European deposit insurance, is still being discussed.

So, banking union has not been completed yet, particularly with regard to burden sharing. An additional burden on national safety nets may still be imposed, in the event of a crisis. We therefore aim to strike a balance between ensuring appropriate prudential safeguards and facilitating the free flow of funds across borders. This is, for instance, relevant with regard to the liquidity requirements of cross-border banks. When we harmonised the exercise of options and discretions in the European regulation, we ensured that banks have the option to fulfil liquidity requirements at the consolidated level rather than at the level of subsidiaries – this promotes the free flow of funds across borders. Given the incomplete burden sharing, however, we also ensured that systemically relevant subsidiaries still have to maintain a minimum amount of liquidity. This policy will be revised in future, bearing in mind the steps taken towards the completion of banking union.

In order to make national bias and ring-fencing things of the past, we must move towards finalising banking union and creating truly integrated financial markets. I think three things need to be done: first, we have to build the third pillar of banking union: European deposit insurance. Second, we have to further harmonise European banking regulation. I firmly believe we need more regulations and fewer directives – while regulations are directly applicable, directives need to be transposed into national law and are therefore a potential source of further fragmentation. Third, harmonised regulation has to be consistently implemented through the work of the European Banking Authority and European banking supervision.

Failing to achieve these objectives would result in a European banking system that is less strong, less efficient and, as a result, less able to properly finance the euro area economy.

How to explain the relatively low appeal of EU banks for investors? Is it due to their insufficient profitability or their perceived risk profile?

Well, the good news is that European banks are much more resilient today than just a few years ago. Since early 2012, their capital ratios have increased from 9% to more than 13%. But it’s also true that European banks face a number of challenges. One of these challenges is the prolonged period of very low interest rates, which is forcing banks to rethink their business models in order to remain profitable. For certain European banks, another challenge comes in the form of legacy assets, such as non-performing exposures, which clog up banks’ balance sheets. And finally, there’s the digitalisation of the banking business, which certainly offers huge opportunities but, again, to those who manage to adjust their business models. So, it’s not necessarily the banks’ risk profile, but rather their profitability that weighs on the minds of investors.

There is something else that may make investors more cautious and more reluctant to invest: the veil of uncertainty covering Europe these days – from the economic through to the political sphere, in particular due to the Brexit.. And it is often claimed that the reform of banking regulation is also adding to that uncertainty. It is therefore up to policymakers to ensure there is at least certainty around regulation: Basel III has to be finalised by the end of the year as planned and new rules, for example regarding bail-ins or Pillar 2 capital requirements, have to be communicated clearly and implemented as foreseen.

How can EU banks improve their profitability in the current environment of lasting low interest rates, high competition and with the further tightening of banking regulation? What are the priorities for supervisors, regulators and banks to improve the situation?

We, as banking supervisors, like banks that can generate profits in a sustainable manner. Only profitable banks can set aside enough capital for bad times, and only profitable banks can attract investors. So there’s a close link between the stability of a bank and its profitability. This link is reinforced by the tendency of banks to compensate for weak profits by taking excessive risks. Against that backdrop, we’ve made business model and profitability risk one of our top supervisory priorities in 2016.

At first glance, the profitability of European banks is improving. The average return on equity for the large European banks stood at 4.5% in 2015, compared with 2.8% in 2014. However, a closer look reveals some flaws in the picture. Profitability improved last year, but it did so from a very low level and the aggregate figures conceal divergent developments from one bank to another. Also, the increase in profits was partly driven by non-recurring revenues. Growing fee income also played a role, but it remains to be seen to what extent it can keep growing in the future. And finally, low interest rates may eventually take their toll: high-yielding assets will either mature or be prepaid, while at the same time any decrease in interest expenses is limited by the zero lower bound on deposits.

Now, what can banks in Europe do in order to remain profitable? They most certainly have to rethink their business models in view of the prolonged period of low interest rates, increasing competition and ongoing digitalisation. Moreover, a number of them also have to deal with their non-performing exposures more efficiently. And this is not only a task for the banks themselves. In many countries, it implies legislative reforms relating, for instance, to the repossession of collateral or the fiscal treatment of banks’ provisions.

How can the SSM and domestic EU supervisors help to reassure the markets about the reliability of the RWAs that they have validated?

Many large banks use their own models to determine the risk-weighted assets (RWAs), which are used to calculate capital requirements. Since the financial crisis, some observers have started to ask whether these internal models are appropriate for determining capital requirements. This perception was backed up by various studies which show differences in RWAs’ densities that cannot always be explained by banks’ specificities, as well as certain inconsistencies between banks’ capital requirements calculated by internal models.

The results of these studies and the broad range of models used by banks indicate that more harmonisation is needed, hence the work undertaken by the Basel Committee in this respect. This is also why, from the very beginning, the SSM decided to conduct a targeted review of internal risk models with two overarching objectives. The first objective is to reduce non-risk-based variability of capital requirements calculated by internal models. The second objective is to define supervisory expectations and issue recommendations regarding both the adequate maintenance of the models and the consistency of their results across institutions.

This will make the playing field more level and ensure the credibility of risk-weighted assets, and in turn the credibility of capital requirements.

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