The European banking sector in 2016: living in interesting times
Speech by Danièle Nouy, Chair of the Supervisory Board of the Single Supervisory Mechanism,
at the Eurofi Financial Forum,
Bratislava, 7 September 2016
Ladies and gentlemen,
“May you live in interesting times” is an allegedly Chinese proverb that is often quoted. Although it turns out that it is not Chinese at all, it still seems to apply to us. We are indeed living in interesting times.
Since the autumn of 2008 we have experienced a series of interesting events: a global financial crisis, a global recession, a debt crisis in the euro area, geopolitical tension in eastern Europe and Brexit, to name just a few. “Interesting” may be one word to describe the times we are living in – “uncertain” may be another.
And it seems that this uncertainty is ultimately reflected in the financial markets. Whenever something unexpected happens, people turn to the markets to see how they react to it. To a certain extent, that is understandable. After all, financial markets are the biggest and fastest forward-looking information processing machine that exists – even though that machine is sometimes driven more by human sentiment than by hard facts.
So, let’s see what the financial markets are telling us about the banking sector.
What are the markets telling us about the banks?
The good news first: banks have become much more resilient over the past few years. The core indicator for resilience is bank capital, and the relevant capital ratios have increased from 9% in 2012 to more than 13% today. The recent stress test conducted by the European Banking Authority and the ECB confirmed the resilience of the European banking sector – it would withstand even a period of severe stress.
However, this welcome increase in resilience seems to be at odds with what the markets think about the banking sector. So far this year European bank shares have lost more than 20% of their value. Given that banks are more resilient than ever before, what is it that investors are worried about?
Well, resilience is just one side of the coin – or the balance sheet in this case. What investors worry about is the profitability of banks. And we banking supervisors worry about it, too: only profitable banks can maintain and improve their capital buffers – and remain resilient.
So it is profitability rather than stability that markets worry about. Let’s take a brief look at what exactly is weighing down their profitability.
What is weighing down banks’ profitability?
Above all, markets seem to be concerned about two things: the prolonged period of low interest rates and the legacy assets on banks’ balance sheets. There are other factors too, including sluggish economic growth, tougher competition and structural changes such as digitalisation.
The low level of interest rates is particularly relevant for European banks. For large banks in the euro area, net interest income makes up, on average, more than half their total income.
Low interest rates, generally speaking, are part of a monetary policy package that should improve the macroeconomic environment in the euro area. As the state of the banks always reflects the state of the economy, they indirectly benefit from low interest rates.
Nevertheless, regarding the specific effects of low interest rates on banks, we have to make a distinction. In the short term, low interest rates might actually boost profits. They might increase the value of fixed-income securities that banks hold. They might also increase net interest income: funding costs go down quite quickly when interest rates fall, but yields on existing fixed-rate loans take more time to adjust.
Eventually, however, low interest rates will take their toll on banks: high-yielding fixed-rate loans will either mature or be repaid, and be replaced by lower-yielding assets, which will decrease net interest income. At the same time, the gradual decline in interest expenses borne by banks will come to a halt as they will be reluctant to charge negative rates on deposits. Funding costs will hit a lower limit, yields will decrease and net interest margins will decline – this is what markets anticipate.
What can banks do? The obvious solution would be to move away from interest income towards other sources of income, such as fees. In short, banks need to rethink their business models. Some banks could also explore the possibility of reducing costs as a way to improve their profitability, particularly as high cost-to-income ratios might indicate room for improvement.
Against that backdrop, digitalisation represents more of an opportunity than a challenge. Banks should seize the opportunity to streamline their processes and release new products, open up new distribution channels and attract new customers.
As well as low interest rates, there is another issue that worries the markets: non-performing loans, NPLs for short. Indeed, some parts of the European banking sector still have high levels of NPLs, which weigh down balance sheets, restrict loan growth and curb profitability.
It is the responsibility of the banks to clean up their balance sheets – it is for their benefit, and I think they understand this. Non-performing loans are a problem – a problem that must be addressed today but cannot be solved overnight. Bringing high levels of these loans down to reasonable levels takes time.
ECB Banking Supervision will shortly launch a consultation on guidance for banks on dealing with their non-performing loans. The guidance provides recommendations to banks and sets out a number of best practices we have identified. The guidance constitutes the ECB’s supervisory expectations and serves as a basis for supervisors to evaluate how banks handle NPLs.
Looking beyond banks, I believe that some countries could further improve their legal and judicial frameworks to facilitate the timely workout of non-performing loans.
While markets worry most about low interest rates and non-performing loans, they also seem to worry about a third issue, which is of a more structural nature: regulation. In particular, banks claim that higher capital requirements and uncertainty about further regulatory reforms hurt profits. I agree about the uncertainty but I have a different view on the capital requirements.
We should not forget where we have come from. Regulatory reform was necessary: what has been done had to be done.
Only well-capitalised banks can finance the economy throughout the entire business cycle. If banks are poorly capitalised, they tend to be exuberant in good times and cut back their lending in bad times, making crises more likely and more severe. Studies that compare the costs and benefits of higher capital requirements have shown that, in the end, the benefits outweigh the costs. But this does not necessarily mean that more regulatory capital is always better. There should be room for supervisors’ judgement and pillar 2 capital.
What banks and markets need, however, is regulatory certainty. And this is what we strive for. Basel III, the centrepiece of the regulatory reform, will be finalised by the end of the year, and regulators are focusing on not significantly increasing overall capital requirements. The regulatory reform is coming to an end. Granted, it has been a long journey, and not an easy one, but it has paved the way towards a more stable banking system.
Ladies and gentlemen, to judge by the reactions of the financial markets, Europe’s banking sector is going through a rather difficult phase. The question is: will the journey end well? I am quite sure it will, but it is still an uphill climb. The financial crisis has undermined confidence and it will take time and effort to fully restore it.
Banks were at the centre of a crisis that reshaped the world of finance. They have to accept that they are now operating in a different environment and that further structural changes are ahead. To preserve their profitability and take advantage of the change, they have to adjust today, not tomorrow.
And this brings me to another allegedly Chinese proverb which offers some advice for banks: “welcome what you cannot avoid”.
Thank you for your attention.