Interview with Euromoney

Interview with Ignazio Angeloni, Member of the Supervisory Board of the ECB, conducted by Dominic O'Neill on 8 August 2018

How much progress do you see recently in eurozone banks’ efforts to cut their non-performing loan portfolios, particularly in Italy?

We are encouraged by recent developments. There has been a clear improvement in the way banks respond to our stimulus. To start with, we were predominantly on the pushing side: we started with an action plan, we reviewed best practices, we undertook an extensive fact–finding exercise, and then we issued qualitative guidance and eventually an addendum.

Recently the response among our banking population and the authorities – not all of whom fully agreed with our approach at the beginning – has improved. Banks have become more proactive in tackling their NPL situation. They have built sounder decision-making and reporting structures and improved their internal policies. Now the banks themselves tend to come to us with proposals. They have a better understanding of the goals and the spirit of the project and have started to see the advantages it offers. The process is now moving ahead without the need for us to be very proactive.

The results are there to be seen, not only in the extent to which NPLs have been reduced but also in the way this has affected market perceptions. Confidence in the banks has strengthened, and with it the willingness of investors to provide capital. It is also encouraging that progress in the high-NPL countries has been relatively faster. You mentioned Italy: there, for example, the two largest banks have undertaken very sizeable NPL disposal operations, which have been quite successful. The mid-tier banks are also moving in the right direction.

How worried are you about the effect on this of the political situation in Italy?

The situation of banks everywhere depends not only on their own intrinsic features but also on the broader outlook for the economy and on what happens in the financial markets. All of this, in turn, is affected by the political situation.

In Italy, sovereign spreads started widening in May. Recently they have increased further, especially in the shorter segment. This is worrying because the spread, which is a direct expression of the confidence investors have in the sovereign issuer, is a burdensome tax weighing on everybody in the country, including the banks. Italian banks have suffered in the stock market, and the losses in sovereign portfolios have eroded their capital base. So far the negative shock has been absorbed without much effect on the cost and supply of credit, but this is unlikely to continue if the spread increases further. A credit contraction would endanger the recovery, which is already fragile for other reasons.

On the positive side, I can confirm that Italian banks are now in much better condition than they were two or three years ago: they are more resilient, better capitalised and stronger on the assets side. It would be disappointing and concerning if such progress were to be put in danger.

Is the real transfer of risk a question for you in NPL sales in which the bank provides financing and/or fees to the acquirer?

We assess each operation on its own characteristics, insofar as the operation affects the overall risk profile of the bank. Banks’ financing the acquirer of their own NPLs is something that does not happen systematically, but it can happen in some cases and to some extent. I wouldn’t say that the risk transfer is then automatically completely eliminated, especially if the bank does not finance the specific operation but, say, only parts of the acquiring company; it might then be exposed to a different type of risk. One has to assess the degree to which the risk transfer effectively takes place.

Your proposed quantitative coverage addendum to the NPL guidelines seems to have sparked an outsized amount of political debate over the past year. Now it has been reworded. Would it have been better to broach the idea differently, in hindsight?

The initial version of the addendum published for consultation may not have been sufficiently clear in explaining something that for us was rather obvious, namely that the provisioning parameters in the addendum are not “rules” to be applied strictly to every bank in an invariable way, but rather initial benchmarks to be assessed subsequently on a case-by-case basis. Supervisory expectations, in the NPL addendum as well as in other areas in which they are issued, are a starting point for the subsequent supervisory dialogue that our Joint Supervisory Teams conduct with each bank. For the sake of transparency, they are meant to indicate to the banks what we consider to be a normal outcome, unless other considerations or information come into play. The banks themselves are invited to put forward other considerations or information which in the end may lead to different outcomes in specific cases.

The lack of clarity on these concepts at the beginning may explain the feedback that we received, especially from the European Parliament. Perhaps for banks this notion was clearer, because they have a constant dialogue with us. At any rate, all this has been clarified in the revised addendum.

Many eurozone banks are still struggling to earn their cost of equity. What worries you most now: the slow death of banks from negative rates, or are asset bubbles and rising rates bigger dangers?

Before the crisis banks had on average higher profitability, measured by their return on equity, than they have today. This was partly because the denominator, equity, was very low. In fact, this was one of the reasons why the crisis happened. Now banks are better capitalised. Regulations and policies have been put in place to reduce their risk. This naturally leads to lower profitability on average. So, to some extent, a lower return on equity is a natural consequence of the new and safer prudential regime.

However, there are other factors as well. There is a cyclical component: the margins of intermediation are now compressed because of the historically low interest rate level. It is a cyclical situation, but a persistent one. When interest rates normalise, as is already happening to some extent, this will be corrected.

Another source of weak profitability is the high level of costs. In the euro area in particular, banks have very high cost levels. We monitor banks’ costs in our regular supervision and, when appropriate, ask the banks to make their business processes more efficient. However, we don’t have any instruments that we can use to intervene directly in banks’ cost structures; we can only use moral suasion as part of our dialogue with them.

Another element affecting bank returns is the business model. For example, traditional intermediation and fee income react to the economic cycle in different ways. Many banks have recently been trying to shift some of their activity from the former to the latter, hoping to escape the constraints of low intermediation margins. Diversified business models, encompassing traditional intermediation as well as the provision of payments, asset management and other services, may be more sustainable.

Isn’t it up to the banks themselves how high their costs are, and how much of their business comes from fees?

Absolutely. It’s up to them to conduct their business. This is part of the conundrum of supervising private companies which compete against each other in a free market. Some people think that supervisors have absolute control over banks in their remit, but in fact there are strict limits to what a supervisor can do. We can form a view as to whether a bank’s business model is sustainable over time and, if it is not, put forward arguments to this effect in the supervisory dialogue. This is pretty much it until the bank fulfils comfortably its prudential requirements. If the bank becomes riskier and compliance with its requirements is endangered, we can ask it to increase its capital or liquidity. But we cannot intervene in everything they do. Limits are provided by law.

What do you think about the role of mergers in improving the banks’ business models – is this happening as rapidly as it should?

We want the banking sector to be safe and efficient, to be capable of providing high-quality services to individuals and firms and ultimately to promote growth and collective welfare. Consolidation can be a means to achieve this under certain conditions. Much of the consolidation that we have seen recently, and continue to see today, is in the very small bank segment, particularly in countries that have many small cooperative banks. Small bank consolidation has been quite fast in Germany, for example, and in Italy. This is a process that usually favours efficiency and safety, because banks get closer to their efficiency frontier and strengthen their internal management and risk control structures.

Among medium-sized banks, there have been a few cases of consolidation, mainly nationally and not cross-border. When we receive a proposal, our main concern is that the resulting entity is strong from the beginning, right after the merger. The merger of two weak banks does not per se produce a strong bank; in fact, the opposite may be the case, because a merger is in itself a difficult operation. The resulting bank is bigger and more complex than the constituent entities. If we want the new bank to be strong from day one, we need to impose prudential requirements that are appropriate to the size and complexity of the new entity.

Were the mid-tier Italian banks therefore right to expect that your request for Banco Popolare to raise new capital (€1 billion) prior to its merger with Banco Popolare di Milano in 2016 was not a one-off? Is that why you haven’t seen similar deals?

We judge on a case-by-case basis. We need to consider the specifics of each operation. In the case you mention, I would venture to guess that the leadership of the bank today is probably not unhappy about having achieved a stronger level of capitalisation, since this puts them in a safer and stronger competitive position.

There may be other merger operations between mid-sized companies, and when proposals come, we will judge them on their specific merits. We do not have a preconceived consolidation map, and we neither can impose, nor want to impose, a business strategy on our banks.

What about large cross-border mergers in the eurozone: do you think the conditions for this are in place yet?

We are certainly not against the possibility of large mergers. Part of our mandate is to favour banking integration in the euro area, and cross-border mergers are one powerful way of helping to achieve that goal. But most important of all, the mergers have to be right. Mergers are particularly complex when large banks are involved. It should also be mentioned that the institutional environment of the banking union currently has a number of features which do not encourage cross-border merger operations. The most significant of these is the lack of a Europe-wide deposit insurance scheme.

Mergers have to be considered to be profitable. Today, when you merge, you cannot expect to be able to exploit all the potential benefits. For example, cross-border banks cannot efficiently allocate capital and liquidity among their subsidiaries in different countries. Ringfencing of capital and liquidity is seen particularly in host countries, which fear that support from the foreign parent company may be lacking in the event of a crisis, with the result that the domestic deposit insurance scheme would have to bear the full risk. With a single European deposit insurance scheme, host countries would not need to be so defensive.

The scope for granting capital and liquidity waivers to entities within a group is severely limited by today’s banking legislation. European banking supervision has increased that scope to some extent, by harmonising and regulating certain options and discretions under EU law. But many limits, controlled by Member States, remain in place.

American banks increasingly dominate the investment banking league tables in Europe. Does that matter, and would big cross-border mergers help?

It does matter. European banks may better understand the business environment and habits on this continent and be more able or willing to provide high-quality, tailored banking services to our firms. They may also know their European clients better, and have long-lasting business relationships with them. These advantages should not be overlooked. On the other hand, the US-based investment banking giants are, in many ways, masters of the business, and enjoy a superior scale and experience of business. I personally hope that Brexit, by forcing many of them to relocate from London to other European locations, will permit some transfer of expertise and will contribute, also by raising competition, to improving our business culture. There should be synergies between this development and the strategic plan to create a capital markets union in the EU.

Banks in Europe often seem to see themselves as the champion of their country, even of their local town or region. Is this still an important barrier to further consolidation?

The global systemically important banks have a global and European footprint, and are comparable in terms of mentality and business approach. The mid-sized banks, however, vary from country to country. For example, the French system is fairly concentrated on a few large and internationally active institutions. In the German system, regional traits (epitomised by the Landesbanken system) are very important. In the smaller countries, even mid-sized banks tend to be outward-looking. The Spanish system has completely changed its structure, following the post-crisis reform of the Cajas. It is difficult to generalise.

Today, within the banking union, banks are less able and less inclined to consider themselves as national champions. The single supervisory approach certainly does not encourage such thinking; our banks are continuously benchmarked against the performance of peers in other countries. Another factor discouraging national champions in the banking sector has been, in recent years, the firm state-aid control performed by the European Commission.

Would you say that provincial mentality survives more in the small institutions, which you don’t directly supervise?

The Single Supervisory Mechanism is not supposed to be a two-tier system. All banks are subject to the same supervision, but it is enacted in different ways: what we call significant banks (groups or solo entities with balance sheets over €30 billion, plus banks with major cross-border activities) are supervised directly by the ECB, while the others, the less significant banks, are supervised by the national authorities, under ECB oversight. The fact that EU banking legislation, in certain cases, provides for different regulatory treatment for banks of different sizes does not change the fact that all banks are subject to the same supervisory system.

Of course, the more intense involvement of national authorities with the smaller banks may mean that, in some cases, there are differences in the style in which supervision is conducted. To some extent this cannot be avoided, but we try to limit such differences by monitoring what national authorities do and by promoting joint supervisory standards. The SSM Regulation (our charter) assigns the ECB the responsibility for ensuring that there is a single system of supervision. All in all, I would say that there is very good cooperation between the ECB and the national authorities.

What is your attitude to the governance issues such a mentality might pose? Is it a problem that the savings banks in Germany tend to be chaired by local politicians, for example?

Governance is a very important area of banking supervision. Governance problems are at the root of, I would say, of the majority of bank risks we have encountered. One problem is that governance issues arise well before they have any observable impact on the balance sheet (in the form of capital or liquidity shortages). Supervisors can therefore be somewhat constrained in the way and the extent to which they can intervene.

We conduct routine fit and proper assessments of managers and administrators, upon appointment, for all the banks we supervise. We assess candidates on the basis of their competence, the time they can dedicate to the role, and the risk of conflicts of interest. Conflicts of interest generally fall into two categories: either politics is involved or there is proximity between the borrower and the lender (for example, a board member of a bank is an entrepreneur whose company borrows from the same bank). This type of conflict arises more frequently in small or medium-sized regional banks, where local business people often sit on bank boards.

We have issued guidelines for fit and proper provisions that deal with such issues. But what we can actually do in concrete cases depends on national legislation. EU law is rather generic in this respect, and takes the form of a Directive – the Capital Requirements Directive – which has to be transposed into national law to be enforceable. We can use moral suasion, which works to some extent. In several cases we have seen that the banks are internalising our guidelines, and they hesitate to make proposals that are in conflict with them. This is the only possible type of intervention if national laws do not allow us to go further.

Do you think it is a good thing for banks’ boards to be chaired by politicians?

Again, we need to go case by case and look at a number of things, beyond competence and experience: the type of engagement the person has with the bank, how much time that person has. For example, in certain Member States, legislation is fully compatible with politicians sitting on bank boards, and this is actually often considered to be good practice. However, if that person is very busy as a politician, he or she cannot devote sufficient time as a banker. There can also be specific reasons for there being a conflict between the two positions. Moreover, there can be a conflict of interest if the person borrows from the bank as an individual; our guidelines place specific limits on such borrowing. Finally, the board as a whole should ensure sufficient diversity, culturally, professionally, and in other respects. All these things have to be looked at, but as I said before, there is no European legislation that deals with these matters effectively. We would like EU law to be clearer, stricter and more detailed on how fit and proper assessments are conducted.

What is the SSM doing to make sure banks are fully prepared for Brexit?

We’ve been very busy on this. We have a lot of contact with the banks, both the outgoing and the incoming ones. Most of the banks involved in relocation or restructuring plans have now established an intense dialogue with the SSM (via the ECB or the national authorities or both) and are in the process of detailing their plans.

For the incoming banks, i.e. those relocating from the United Kingdom to the euro area, the key thing for us is to ensure that they put in place all the structures that are needed to conduct sound banking here. Establishing a legal entity on the continent cannot merely be a formality. They have to have a real structure here; have full control over and responsibility for the business they do; and have the necessary prudential safeguards, as well as high-quality staff, internal controls, risk management, and so on. That’s very important for us, and most of the incoming banks have now understood this need and incorporated it in their plans.

The story is different for the outgoing banks, i.e. euro area banks that access the UK market. Often, they work through branches, some of which are very large. Establishment or restructuring plans have to be authorised by the Prudential Regulation Authority. Our main concern here is “back-branching”, i.e. using a remote branch across the Channel as a springboard to do business in the EU, thus evading supervisory control. We want banks to use branches in the United Kingdom to conduct business in the United Kingdom.

All in all, preparations are moving ahead but are being slowed down by the remaining uncertainties in the political process, regarding timing (essentially, whether or not there will be a transition period until end-2020) and the nature of the arrangements that will be put in place. Banks are naturally hesitant to make costly decisions until they know exactly what is going to happen.

We are monitoring developments as closely as possible. We maintain close contact with the banks and are working with both the UK authorities and the European Commission. We hope, as everyone does, that the political decisions will be made as soon as possible so as to provide a firmer basis for preparations, by us as well as by market participants.