“European banking supervision is well established, but we still need more harmonised regulation”

Interview with Sabine Lautenschläger, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, Supervision Newsletter, 13 February 2019

Sabine Lautenschläger, whose five-year mandate as Vice-Chair of the ECB Supervisory Board ends this month, talks about surprises during the creation of European banking supervision, ongoing challenges such as Brexit and governance, and the need for a more harmonised implementation of the supervisory rules.

As the first Vice-Chair of the ECB’s Supervisory Board, you helped build European banking supervision. Looking back on the past five years, did everything go as expected?

Well, if everything had gone as expected, that would have been the real surprise! Overall, however, it all went according to plan. Over the past five years we have built up European banking supervision from scratch, and we’ve put it on a steady course. All banks across the euro area are now supervised according to the same high standards.

But we had plenty of surprises along the way, of course, some of which were very welcome. Enjoying the excitement of being like a start-up was one of these surprises. And this excitement, this spirit, hasn’t gone away, even though we are now a well-established institution. Every day, the big innovation, “European banking supervision”, is followed by many smaller ones – new processes, new tools and new ways of working together. So both our newcomers and our seasoned experts get to learn and challenge themselves every day – me included! This is very enriching and one of the reasons why everyone continues to be committed, day in and day out.

Another surprise was less welcome. I never imagined there were so many different ways to supervise banks! The differences among countries were huge and often firmly embedded in national traditions. The road towards a harmonised approach is thus much longer and harder than I had expected. All of us have had to change our points of view, become much more open, listen to each other and question long-held beliefs. This is not an easy thing to do and we have to remind ourselves every day to keep an open mind.

Brexit was probably another surprise. How is the ECB preparing for this complex event, which will potentially bring more than another 20 large banks under its supervision?

Oh yes, Brexit was indeed a surprise, I can tell you. That said, we as supervisors always have to prepare for the worst: in this case, a hard Brexit. So we’re well prepared for an increase in the number of banks we are supervising. Five years ago, we took on about 120 large banks – so what we are facing now doesn’t look too daunting. And don’t forget that five years ago we had far fewer staff and less experience with integrated European supervision. Today, everything is in place to smoothly take on the supervision of a few more banks if that should become necessary.

But this doesn’t mean we should underestimate the potential impact of Brexit. If it does indeed happen, it will have a huge impact on the European banking market, an impact for which both banks and supervisors will have to brace themselves. Over the past two years, we have clearly set out what we expect from banks that relocate to the euro area. And we have urged and pushed banks to prepare for all potential outcomes of the political negotiations. So they should all be prepared, and they should all know what is OK and what is not OK in terms of organising their euro-area business. I am confident that we supervisors are prepared – to the highest degree possible.

Will Brexit be more of a burden or more of an opportunity for banks?

Brexit will require a lot of work from all of us, including supervisors. If you are a bank located in the United Kingdom and want to do business in the European Union (EU), or vice versa, you might have to set up a subsidiary or a branch and relocate some of your people or hire new staff. In this respect, Brexit will indeed be a burden, but clever banks will seize the opportunities it creates. They could, for instance, reorganise their structure in a way that allows them to be closer to their customers. Or they might acknowledge that it could be dangerous to put all their eggs in one basket by relying on just one central counterparty. Such a concentration might be more efficient, but it is also risky.

From my point of view, Brexit might also be an opportunity for the European banking market to become more integrated. A number of banks and other financial institutions are about to relocate to the EU, and we have to find ways to ensure that they are all treated equally – in terms of both regulation and supervision. So, one country leaving the EU might actually bring the remaining countries closer together.

Another major topic that you have had to deal with was regulatory reform. Have the Basel III reforms achieved all that they set out to do? What still needs to be done?

The finalisation of the Basel III reforms represents a big step forward; there is no doubt about that. The finalised reform package will help make banks safer and sounder. They stick to a risk-based approach while also introducing some new safeguards. The reforms constrain the use of certain internal model approaches and introduce input and output floors for banks’ internal models. This reduces excessive variability of risk-weighted assets and limits the scope for banks to reduce their capital requirements using internal models. In addition, the finalised Basel III framework includes a leverage ratio which also serves as a backstop to modelling risk. At the same time, it includes liquidity buffers which ensure that banks could survive longer should funding dry up.

These are all great achievements – particularly as they reflect a global agreement. However, there are still some open issues. In my view, we have not done enough to address sovereign risk, for instance. The same is true with regard to large exposures and concentration risks. We must also remember that the finalised Basel III framework is merely a set of standards whose implementation requires transposition into actual law. What counts is that it is faithfully implemented around the globe.

On the topic of implementing the Basel III reforms, in early December the EU agreed to a comprehensive legislative package to strengthen the resilience of EU banks. Are you satisfied with the outcome?

I welcome the agreement, and I hope that it can still be adopted before the European elections. The package will indeed transpose the Basel standards into European law and thus make the banking sector a safer place. That’s a big achievement.

But there is still room for concern. In some places, the package deviates from what was agreed in Basel. This affects, for instance, the leverage ratio, the fundamental review of the trading book and the net stable funding ratio. So the final rules on non-risk-weighted capital requirements, market risks and liquidity will be weaker than we would have liked them to be. At the same time, the global playing field will be less even. Another point is that the package could have more strongly supported the idea of a truly European banking market. Having cross-border capital and liquidity waivers for banking groups would have been an important signal in this regard.

Lastly, in some areas the package affects the scope of supervisors’ action. As it stands, it will become much harder for supervisors to ensure that banks meet their Pillar 2 requirements solely with CET1 capital. In other words, banks can revert to capital of a lower quality. Given how important capital is as a buffer against losses, this is a step in the wrong direction.

What risks do you see in allowing banks to use lower-quality capital to build up their Pillar 2 buffers?

I am seriously worried about this, and not only because it dilutes capital standards. At a deeper level, it leads to other problems. It gives banks an incentive to engage in financial engineering in the realm of Additional Tier 1 capital, which is something that I as a supervisor am not keen on. At the same time, smaller banks often have no access to the markets for Additional Tier 1 capital. Larger banks, by contrast, do have access to these markets and so can meet Pillar 2 requirements with lower-quality capital which is less costly. This is not a level playing field, in my view.

How much of a level playing field does exist for banks in Europe, and indeed globally?

It would be great if banks could compete on a global level playing field. Basel III provides a solid basis, but the proof of the pudding is in the eating – or rather in the implementation. And here, we still see differences, even within Europe. The Single European Rulebook is not as single as you might assume.

The actual rules still differ from one country to another. This creates at least three problems. First, it runs counter to the idea of having European banking supervision: supervising banks at the European level would be more effective and more efficient if the rules were more harmonised. Second, it opens the door to regulatory arbitrage. Thus, it not only increases the risk of crises, it also makes it more difficult to manage them if they arise. Lastly, it stands in the way of a truly European banking sector. So there is still a great deal to do in harmonising the rules and levelling the playing field.

Besides focusing on non-performing loans and business models, the ECB has drawn a lot of attention to governance, culture and ethics in banks. Why are these topics so important?

Well, banks are managed by people, and people occasionally make mistakes. They are often biased when taking decisions, and sometimes they do not behave in an ethical manner. Banks must reflect on this and find ways to put an end to bad decision-making and unethical behaviour.

The lynchpin of these efforts is a bank’s individual culture. It is this culture that determines how managers and staff behave. Does the board comprise managers with different types of experience? Do they reflect on their decisions? Do they listen to dissenting voices? Do the reporting lines fit the responsibilities or are there gaps and overlaps in reporting? Is there a strong control environment and do the insights from these controls feed into daily decision-making? Are managers thinking strategically, or just focusing on short-term profits? All of these are basic, yet crucial, questions which do not determine the fate of just one single bank: the answers to these questions are linked to the reputation of the entire industry.

It is first and foremost the responsibility of a bank to shape its culture. This is an important aspect that was neglected in the past. And we as supervisors can and should assess the checks and balances that are in place. We should review and influence the governance.

What else should European banks do to steel themselves against the next economic downturn?

For a start, they must acknowledge that the next downturn will come. So banks should not take on more risks than they could handle in a downturn. I know it’s difficult to earn money these days but the solution is not to take on excessive risks. Banks should remain careful and keep up their credit underwriting standards – particularly when it comes to leveraged loans and real estate.

So, banks should clean up their balance sheets – think of non-performing loans, for example –, review their business models and improve their business steering capabilities. In our analyses we see a group of banks that constantly outperform their peers. These banks come from different countries and have diverse business models. But one thing they all have in common is what we call strategic steering. They are able not only to make plans, but also to execute them. The management of these banks has a clear view and a firm grip on the entire institution, on the costs, risks and pricing of each product and activity. It seems, therefore, that strategic steering is what banks need.

What is your wish for European banking supervision?

All the best, of course! But seriously, I have a long wish list. First of all, I wish that European banking supervision will maintain the trust of the people, the banks and the markets. This depends on it doing a good job, of course. And if European banking supervisors are to go on doing a good job in the future, a few other wishes need to be fulfilled. First, we need to have more harmonised rules – as I’ve mentioned before. You cannot ensure a European level playing field in supervision when the rules are still national. Then there is the need to maintain supervisory discretion. Supervisors must be able to exert judgement and act upon that judgement. Only then can they cater for unexpected and individual circumstances.

But most of all, I wish for staff to remain as committed and passionate and European as they are now. To me, European banking supervision clearly shows that Europe does work and that it does improve our lives.

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