“Capital requirements for banks are levelling off”
Interview with Andrea Enria, Chair of the Supervisory Board of the ECB, Supervision Newsletter
13 November 2019
Andrea Enria, Chair of the ECB’s Supervisory Board, says that banks have become more resilient and supervisory expectations are stabilising, but the next storm may be looming. He also outlines what makes a successful merger and why we need more transparency in supervision.
European banking supervision turns five this month. The ECB and the whole system of supervisors in general have been quite tough on banks with regard to capital buffers and levels of non-performing loans. Are banks sufficiently resilient?
When European banking supervision took off five years ago banks were still struggling to deal with the legacy of the crisis and repair their balance sheets. They had to strengthen their capital positions; they were weighed down by non‑performing loans; they faced scepticism over the reliability of their internal models, and therefore the calculation of their risk-weighted assets; and they had to address weaknesses in their governance and internal control procedures. We have come a long way since then – the post-crisis repair process is now coming to an end and the level of supervisory requirements for banks has stabilised accordingly.
Europe’s largest banks now hold more and better capital, with an average CET1 ratio of 14.4%. So, overall, we can see that capital requirements and buffers are levelling off, while supervisors are increasing their focus on specific risk areas in individual banks. At the same time, the level of non-performing loans is going down at a fast pace, from around €1 trillion in 2014 to less than €600 billion today. However, asset quality indicators have not yet returned to pre-crisis levels and we are still lagging behind in international comparisons. But we are heading in the right direction and banks are meeting, and often exceeding, the targets they agreed with the supervisors.
So, to answer the original question, I would say yes, banks have become more resilient. But the euro area banking sector is still plagued by weak profitability, which is driving low market valuations. This also reflects the excess capacity in the system and the concerns about the long-term sustainability of business models. Within the euro area, banking business is still largely segmented along national lines, which is an additional drag on bank efficiency. Finally, improvements are still needed in terms of internal governance and risk culture.
What can be done to improve banks’ profitability?
For one, banks need to focus on areas where they can improve, namely increasing cost efficiency, investing in technologies and designing and implementing better strategies. This will help increase their profitability. For our part, we need to keep up the pressure through our business model analysis, for example. But we also have to acknowledge that there are structural impediments in the markets that we should try to help address. Healthy and profitable banks will be better able to withstand the next storm – the clouds of which we can already see on the horizon.
What will supervisors look at more closely when examining banks in the coming years?
Well, we will certainly continue with our efforts to repair banks’ balance sheets. We will follow up on our guidance on non-performing loans to help banks further reduce the stock of non-performing loans and better provision for future ones. We will also continue our work to ensure the adequacy of internal models, which are widely used by European banks. As these models play a big role in determining capital requirements, banks will have to remedy all the shortcomings that we found in our targeted review. Finally, we will take a closer look at trading risk and asset valuation, with a particular focus on complex instruments that are booked at fair value.
Going forward, we will work on limiting the flow of risks right at the source. Over the past few months we have collected data on banks’ credit underwriting standards. We will use this data to understand more about how banks grant loans and to identify risks across different business segments of banks’ loan portfolios, so that we can take action where needed. Other issues that are high on our agenda are IT and cyber risks, governance and internal control issues and the general sustainability of banks’ business models.
As the memory of the crisis fades, we will face increasing pressure to water down regulatory requirements and relax supervisory pressure on banks. We should fight tooth and nail to preserve our supervisory model, which has proven extremely effective. But I do believe we also have to bring forward a simplification agenda. Line supervisors and banks alike complain that our model is rather burdensome and not always capable of allocating resources in a risk-based manner. We should make a genuine effort to reduce the burden of administrative compliance and adopt a more agile modus operandi, provided that this can be done without harming our objectives.
Overbanking in parts of Europe and the need for mergers has been widely discussed. Will you automatically require merged entities to increase capital, as some believe? What are the decisive factors for successful mergers from a supervisory point of view?
It is true that there is excess capacity in the European banking sector, and this has been the case for quite some time now. Instead of exiting the market, many weak banks drag on and put pressure on margins for all other banks. As a result, European banks are less profitable than they could be.
The sector needs to consolidate. This would help restore efficiency and mop up excess capacity. Both national mergers and cross-border mergers would be useful, and it is futile to debate in abstract terms what is more desirable. National mergers are likely to generate greater efficiency gains, thanks to the existence of overlapping distribution networks. Cross-border mergers would help to bring about a more integrated European banking market in which risks can be better diversified and shocks better absorbed. The most important thing is that rules and policies do not obstruct banks’ choices.
While I am strongly in favour of consolidation, as a supervisor it is not my job to actively promote – or discourage – any form of bank consolidation. Instead, we supervisors assess the viability and sustainability of the merger from a prudential point of view. A successful merger would result in a bank with a business model that provides strong governance, sufficient capital and liquidity, and the means to enhance profitability. I would like to dispel the perception that the ECB requires higher levels of capital from merged entities. Capital requirements and buffers reflect the supervisory assessment of the business plan in each proposed deal and have a medium‑term perspective. Our objective is to support, rather than discourage, the effective restructuring of the merged entities and ensure that the resulting business model is sustainable.
Since the creation of ECB Banking Supervision banks have voiced concerns about excessive data requests by the supervisor. What are the benefits of these data collections and what can you do to ease the reporting burden for banks?
We are aware of the burden that banks have to carry when it comes to reporting requirements. This is an issue that banks often raise; we hear them and we are taking it seriously.
I think the ECB has made serious efforts to ensure a proportionate approach. The scope and frequency of our reporting requirements vary according to the size and riskiness of the bank, as reflected in our supervisory judgement. And, as a general rule, smaller banks report far fewer data points to supervisors than larger banks – an average of 600 data points, compared with up to 40,000 for the largest banks. We have endorsed further simplification of reporting requirements for smaller banks and further efforts are underway at the European Banking Authority to reduce the reporting costs for small, non-complex institutions, in line with the recent revision of the Capital Requirements Regulation.
However, there are two important issues we have yet to address. First, no matter how proportionate our approach may be, it may still generate excessively burdensome requirements when combined with the reporting requests from other authorities – including the national competent authorities, macroprudential authorities and central banks. More coordination is needed. Second, ad hoc data collections come on top of regular reporting. These exercises are necessary to capture new risks or to delve deeper into the assessment of existing risks. They could also be beneficial to banks’ risk management, as they would allow benchmarking against peers. Still, we need to improve our planning and the way we communicate these initiatives, and exercise some discipline. This is exactly what we are doing right now.
You have spoken about making supervisory assessments more transparent. Why is this important and how far can you go without breaching supervisory confidentiality?
There are at least two reasons why we should be as transparent as possible. First, our actions could affect a wide range of stakeholders financially. This has become even more of an issue since we moved from a bail-out to a bail-in world. If a bank fails, investors and creditors stand to lose money. This means they need to understand the risks they are taking and they need to have sufficient and appropriate information to assess those risks.
Second, we pursue a public goal – a safe and sound banking sector – and we do so as an independent institution. This means we attach a lot of importance to being accountable to the public. This also requires us to be transparent: we must carefully explain what we do, why we do it and how we do it. Banks, investors, creditors and the public must be able to understand our principles, our policies and our actions.
When it comes to individual banks, however, we are limited by the need for confidentiality. But I believe that the system as a whole can become more transparent. From 2021 onwards, banks will be required by law to disclose their Pillar 2 requirements, or P2R for short. At present, around 70% of the banks we supervise already disclose this information. So we are not that far away, but there are still differences which cannot be justified in a single jurisdiction. I hope that we can convince more banks to disclose their P2R at the end of the current supervisory cycle in early 2020. To provide more context, we could even think about indicating which risk assessments shaped the P2R.
Looking further ahead, we should also think about being more transparent about the Pillar 2 guidance we give to banks. This is something we must seriously consider.
You have called for a rethinking of stress tests. What should be changed and why?
Since the crisis, stress tests have been an important tool for both supervisors and banks, but they need to be adapted to the post-crisis world. During the crisis, the purpose of stress tests was to measure the size of capital holes in banks’ balance sheets. Today, as supervisors we primarily use the stress tests to identify vulnerabilities that might lead to problems further down the road. But they can also provide useful input for banks’ internal risk management activities and a very granular disclosure of information to market participants. These distinct and potentially conflicting purposes have led to what is now a fairly complex, resource-intensive exercise. There is also a “beauty contest” dimension to stress testing, as banks try to look as attractive as possible to markets – often at the expense of realism. It is time to go back to the drawing board and see how we can improve.
When redesigning stress tests, we must strive to make them as relevant and realistic as possible. At the same time, we should ideally reduce the burden for both banks and supervisors in terms of resources. These should be the guiding principles for redesigning European stress tests.
Against this backdrop, one option would be to split the stress tests into two components: a bank view and a supervisory view. The bank view would be a largely unconstrained bottom-up approach, with each bank accounting for its individual circumstances. If done properly, this would make the results more realistic and more relevant for the banks’ risk management. The supervisory view would be a constrained bottom-up approach, challenged via top-down models. This should lead to greater consistency across banks, which is important as the results provide the basis for determining capital buffers – the Pillar 2 guidance. The two views could then be published alongside each other so that markets could form their own view.
This is just one idea of how we could move forward, and there might be other ideas around. One thing is certain, however: we should start discussing these ideas sooner rather than later.
Brexit has now been delayed until 31 January 2020. Will you also give the banks more time to meet supervisory expectations in preparation for Brexit?
Since the United Kingdom decided to leave the European Union, we have pushed banks to make all the necessary preparations for Brexit: they need to have all the necessary licences in place to continue serving their customers in the EU and they need to adapt their business models to the post-Brexit situation. Overall, we found that banks, both those relocating to the euro area and those based here with operations in the United Kingdom, had prepared reasonably well for the 31 October Brexit date.
Despite the extension until the end of January, our supervisory expectations and the previously agreed timelines for banks to implement their Brexit plans remain the same. We continue to urge banks to implement their target operating models, including transferring assets and staff and strengthening their risk management capabilities in the EU. Our message is still the same: the overall timelines have not changed.