The Single Supervisory Mechanism – the fast-changing landscape of traditional banking models
Remarks by Ignazio Angeloni, Member of the ECB’s Supervisory Board, FinanceMalta 9th Annual Conference 2016,
Malta, 26 May 2016
It is my pleasure to be here today and to address this annual conference organised by FinanceMalta.
Malta’s history epitomises, in the extreme, the opportunities and risks arising from a high degree of international exposure. Located strategically at the crossroads of three continents, Malta experienced many influences over the centuries, which make it extraordinarily attractive for visitors today: Phoenicia and Carthage, Rome and its Germanic conquerors, Byzantium and the Arabs. In more modern times, it was ruled by several European powers – Spain, France and Britain among others – while successfully resisting the Ottoman invasion. Malta became independent in 1964. When it joined the European Union in 2004 and the euro area in 2008 these influences then became part of the common heritage of the Union.
Recently, with the launch of the banking union and the establishment of the Single Supervisory Mechanism (SSM), a further dimension of commonality and cooperation with the European continent has been added. This is important for Malta because of the significant banking activities it hosts. The total assets of the Maltese banking system amount to 5.5 times of the country’s GDP, almost double the European average. Finance, including real estate, accounts for a significant share of national GDP. The main banks on the island are subsidiaries of foreign institutions, from both inside and outside the SSM area. Some of these banks provide the bulk of funding to the local economy, others operate mainly overseas. I would draw two conclusions from these data. First, part of Malta’s banking sector is, to use economics jargon, domestically systemic, meaning that its development and soundness are particularly important for the performance of the country’s economy. Second, there are important externalities, or spillovers, from Maltese banks to the rest of Europe, and vice versa. This is a powerful argument for establishing and maintaining a high degree of cooperation in banking supervision and regulation.
In my remarks today I will briefly review the fundamental arguments for the SSM, and the main criteria and actions that led to its establishment. I will then touch upon some of the activities and achievements of the SSM since it started operating in November 2014. Finally, I will conclude by mentioning the main priorities of the SSM over the medium term.
Banking union: rationale and components
At the height of the euro crisis, in 2011 and early 2012, the shortcomings of the institutional framework of Economic and Monetary Union, previously known to only a few, became more apparent and broadly recognised. In particular, it became clear that a monetary union cannot easily withstand shocks without being complemented by a well-functioning banking union. The strong interdependence of national economies, fiscal and banking sectors, with banks closely interconnected across borders due to the single currency, were not supported initially by a common regulatory and crisis management framework. The pre-crisis banking arrangements, built on voluntary agreements (called memoranda of understanding) between supervisory authorities and EU-level committees without binding powers, were unable to provide the cooperation needed to manage cross-border banking crises. The landmark cases of Fortis (a Belgian-Dutch entity) and Dexia (a Franco-Belgian entity), which failed in 2008 and 2011 respectively, painfully demonstrated this point.
The design of the banking union, first outlined in the Four Presidents’ Report presented in December 2012 (co-authored by the Presidents of the European Council, the Commission, the Eurogroup and the ECB), and subsequently complemented by other official statements, envisages a sequenced and gradual transfer to the European level of the functions performed by national authorities in the areas of banking supervision and regulation, including crisis management and the bank safety net. The strategy builds on three pillars.
The first is the establishment of a single supervisory authority within the ECB. The Single Supervisory Mechanism (SSM), which comprises both the ECB and the national supervisory authorities of the participating countries, is responsible for the safety and soundness of banks, as well as their systemic stability. The SSM Regulation assigns to the ECB specific and powerful supervisory instruments to attain these goals. The ECB directly supervises around 130 banking groups, covering a large part of the euro area’s banking activities. These groups are deemed “significant”, i.e. of special relevance because of their size or systemic characteristics. The smaller institutions (well over 3,000 of them) continue to be supervised by the national competent authorities, which in turn are subject to ECB oversight.
The second pillar is the Single Resolution Mechanism (SRM), which aims to ensure the orderly resolution of failing banks. The Single Resolution Board duly started operating in January 2016 in Brussels and is supported by a Single Resolution Fund, built up gradually by banking sector contributions to ensure that adequate funding is available during the restructuring of a bank.
The close connection between single supervision and single resolution is readily apparent. No supervision can be effective, especially while enforcing tougher requirements on weak banks, if there is no confidence that bank failures can be handled in an orderly way. In a multi-country setting such as ours, area-wide supervision is not compatible with national resolution powers, lest incentives be distorted. European supervision calls for European resolution. The two functions must carefully complement each other and carefully interact.
The third pillar of the banking union is deposit insurance. After the Great Depression of the 1930s, deposit insurance mechanisms were established in most advanced countries. The rationale for insuring bank deposits is also quite evident. Banks perform a unique role in the economy, as providers of payments instruments. To that end, deposits at every bank must be equally safe – a euro deposited at one bank must be equivalent to a euro deposited at another bank. A system-wide deposit guarantee scheme ensures this equivalence. The safety provided by the scheme reduces the risk of devastating bank runs, such as those which occurred repeatedly during the Great Depression and other crises. Equivalence and safety are public goods which justify an intervention, also in the form of a backstop, by the public sector. Again, and for similar reasons, area-wide supervision and resolution arrangements call for area-wide deposit insurance.
In November last year, the European Commission made a proposal for a European Deposit Insurance Scheme (EDIS). Its approach is to build on the existing national schemes and move gradually towards a European construction. The EDIS foresees three steps, starting from a re-insurance mechanism built on top of the national schemes, progressively evolving into a mutualised arrangement. The last step would happen in 2024, when the Single Resolution Fund and the requirements of the DGS Directive are fully phased in. As such, the Commission proposal combines clarity of purpose with gradual implementation.
While the rationale for a banking union comprising these elements is generally accepted, controversy has developed recently concerning the sequencing of the different elements. Critics of the Commission proposal argue that a mutualised scheme cannot be put in place until the risks inherent in the national banking sectors have been contained and have become more homogeneous. In particular, the exposure of national banking sectors to their own national sovereigns, a phenomenon referred to as “home bias”, is seen as a fundamental source of asymmetry in the degree of risk facing national banking sectors. In this way, the debate on the completion of the banking union intersects with another thorny issue faced by global regulators, that of the prudential treatment of sovereign exposures.
The concerns about banking risks and their possible uneven distribution should be taken seriously: sound and lasting supranational arrangements can only be based on trust and on a fair balance of commitment and responsibility. Yet, it must also be recognised that an incomplete banking union, if allowed to persist for long, creates additional uncertainly and risk, with destabilising effects that may extend to all participating countries. Policymakers can limit these risks by drawing up a coherent strategy, with clear goals and a reasonably fast implementation timeline. This, in essence, is the intent of the Commission proposal, which the ECB supports. Within the scope of its responsibilities, the ECB remains committed to reducing bank risks, especially where they are higher, and making them more transparent and manageable.
The SSM – recent activities and achievements
Let me now move on to the SSM and some of its recent activities.
As part of the preparatory work for the SSM, in 2014 the ECB conducted an in-depth review of the balance sheets of banks under its direct supervision – the “comprehensive assessment”. This exercise included an asset quality review, which analysed the main components of the asset side of the banks’ balance sheets, and a stress test. It provided an invaluable amount of information on the banks under direct supervision and was also an effective testing ground for ECB staff. Capital requirements for some banks were increased as a result. It is important to realise that the assessment focused on a limited number of drivers of bank risk, namely asset quality and sensitivity to stress. Therefore, it was really a starting point of our supervisory action; it was not intended to produce a final and definitive appraisal on the banks. Some observers have recently expressed surprise at the ECB imposing additional requirements on banks that had passed the assessment. This surprise is not justified, however, because the supervisory assessment needs to be all-encompassing and evolve over time. In 2014 the scope of the ECB’s supervisory review was broadened to include further sources of risk.
The comprehensive assessment was a powerful catalyst for banks strengthening their balance sheets far beyond the strict supervisory requirements. The average Common Equity Tier 1 ratio for banks classified as “significant” has increased from approximately 9% in early 2012 to above 13% now. While European regulation has evolved, with new instruments being phased in, more recently liquidity and funding structures have also come under closer supervisory scrutiny.
One central concern for ECB Banking Supervision is ensuring that business models are sustainable over time, taking into account the prevailing and foreseeable economic conditions. There are two main challenges to business models at present. The first is the low level of bank profitability. This is partly due to low interest rates, which compress intermediation spreads, especially for traditional retail banks. These low rates have persisted for some time, and not only in Europe, for a variety of contingent and structural reasons. They are unlikely to go away soon. Banks need to adapt to the new environment by containing costs and developing alternative sources of income. In 2015, the profitability of supervised banks improved slightly overall, albeit from a very low level: their return on equity increased from 2.8% in 2014 to 4.5% in 2015. This development is encouraging but its resilience remains to be seen.
The second factor is the large stock of non-performing loans (NPLs). NPLs also weigh on bank profitability and capital, thereby hampering banks’ ability to provide new lending to customers. Banks burdened by high levels of NPLs become risk-averse and less willing to lend. In 2015 the SSM banks made progress in tackling bad loans by improving their processes and increasing provisioning levels. The NPL ratio, based on harmonised definitions, decreased by 0.7% in 2015 to 7% of total assets, while the coverage ratio increased by 1.3%, to 45.3%. These numbers are averages, however, and performance varies widely across countries and individual banks.
The ECB conducts an annual assessment of bank risks to determine prudential requirements. This is the Supervisory Review and Evaluation Process, or SREP. In 2015, the SREP was introduced for the first time with a unified methodology developed by our staff. The methodology combines quantitative and qualitative elements and treats all banks consistently, while accounting for different business models. There are four components: business model assessment, internal governance and risk management, risks to capital, and risks to liquidity and funding. Each component is assessed both quantitatively and qualitatively, also with the help of numerical scores. The quantitative assessment is based on a broad range of data, including own funds, financial reporting, large exposures, and credit and operational risk. The qualitative component involves judgement on factors such as the quality of internal risk controls, risk culture and governance. It is important to develop a view on how these risks develop and the impact they may have within each specific bank. This analysis must combine expert knowledge with supervisory experience. Within the SSM, the Joint Supervisory Teams are responsible for providing the qualitative input.
As a result of the 2015 SREP, the Pillar 2 requirements for the institutions directly supervised by the ECB increased by an average of 30 basis points relative to the previous year. This moderate increase was deemed adequate, also from a macroprudential perspective, and it allowed for a gradual transition towards the “fully loaded” Basel III requirements. The new SREP for 2016 is now in progress, and will produce results around the end of the year.
I should also mention that the SSM has been quite active recently on the regulatory front as well. In principle, the SSM does not possess regulatory powers, which in Europe belong instead to the European Commission and the other co-legislators (European Council and Parliament), as well as, for lower-level legislation, the European Banking Authority (EBA). In practice, however, European banking law contains several elements of flexibility, called “options and discretions”, which allow the supervisory authority considerable room for manoeuvre. Since November 2014 the ECB has inherited from national supervisors the power and responsibility to administer this flexibility.
The need to strengthen the level playing in this area became clear during the comprehensive assessment, when we observed several significant differences in the quantity and quality of capital across banks that were not justified by the underlying risks. Accordingly, the ECB started its work on options and discretions from the very start – in November 2014. This work consisted of first identifying the provisions that needed to be harmonised, and then developing a consistent SSM policy for them. A comprehensive policy package was assembled by the ECB and discussed extensively with the national authorities, as well as with the European Commission and the EBA. It was eventually approved by the Supervisory Board and underwent a public consultation for input from the banking industry and other experts and stakeholders. The process, which included a public hearing, ended with the publication of the final legal text in March this year. All documentation is available on the ECB’s Banking Supervision website.
The harmonisation of options and discretions for significant banks is a major milestone on the road towards consistent supervisory practices. It means that banks will operate within the same framework and be treated consistently when submitting applications for waivers, exemptions or approvals. But it does not mark the end of the ECB’s efforts to creating a truly level playing field. Along with the national authorities, the ECB is also assessing a proportionate way to harmonise options and discretions for the less significant institutions. In addition, a second phase of the project, which includes options and discretions not prioritised in the first phase, is ongoing and will be concluded shortly.
There are other aspects of regulatory divergence that are beyond the responsibilities of the SSM, including the different ways in which the Capital Requirements Directive (CRD IV) has been transposed into national law, and the treatment of options and discretions granted to Member States. Progress on these fronts requires national legislators to contribute.
Before concluding, let me mention some of our priorities ahead. A more extensive description can be found in our second annual report, which was published in March.
A first priority that I already mentioned is the assessment of business models and their sustainability, especially in the context of low profitability. We plan in-depth reviews of the drivers of banks’ profitability at firm level and across business models. We intend to focus in particular on how banks are coping with the protracted low interest rate environment and the evolving regulatory environment.
Non-performing loans (NPLs) remain another focal area. A dedicated taskforce has been set up and will produce results this year. The goal is to move towards a more consistent approach to supervising banks with high levels of NPLs. In relation to this, we will also focus on internal governance and risk appetite, including, crucially, the assessment of the fitness and propriety of governing boards and managers. In this area we are developing new fit-and-proper testing approaches to help promote high professional and ethical standards and independence of judgement among bank administrators and managers. Currently, this is an area where divergent practices exist, partly linked to national legislation. The new framework that is being prepared will be phased in and, in order to create certainty for markets, it is desirable that it is adequately disclosed.
Our SREP methodology will continue to be refined this year, with the aim of making it more flexible, responsive and forward-looking. In this context, the internal capital adequacy assessment process (ICAAP and internal stress testing) will be strengthened. In preparation for the implementation of the new resolution framework and its requirements (total loss-absorbing capacity – TLAC; and minimum requirement for own funds and eligible liabilities – MREL), the banks’ preparations for “gone concern” scenarios will be scrutinised.
Let me conclude. If, with the benefit of hindsight, I look back at when the SSM was conceived and launched, I cannot fail to notice the huge amount of work involved and the remarkable achievements, on all fronts. Less than four years after the initial declaration of intent by the European leaders, the SSM is up and running and in good shape. But there is neither room nor time for complacency. Much work lies ahead. Difficult challenges will surely cross our path. The ECB is prepared to meet those challenges in partnership with the supervisory staff of all participating countries, large and small, in pursuit of the common goal of building a more competitive and resilient banking sector for all Europeans.
I am grateful to Cécile Meys for her excellent drafting support and to Sebastian Ahlfeld and Max Neumann for helpful comments.