Challenges facing the Single Supervisory Mechanism
Speech by Ignazio Angeloni, Member of the Supervisory Board of the ECB,
at De Nederlandsche Bank’s ‘Netherlands Day’,
Amsterdam, 6 October 2016
It is a pleasure to be here today, and I am grateful for the invitation. In fact it is more than a pleasure: it is an honour to be invited to speak in an institution with such a long and distinguished tradition, in both central banking and supervision, as De Nederlandsche Bank.
As some of you may know, I have been involved in the creation of the new supervisory function at the ECB since the beginning, which means since mid-2012. I say this because this event reminds me of one basic idea we had in those early days. In discussions with colleagues, also from this central bank, we thought at that time that the Single Supervisory Mechanism (SSM) should operate as a system or a network (I was never too fond of the word “mechanism”). It was to be a collection of individuals, with different expertise and viewpoints, combining the specialised knowledge and experience of national supervisors with the broader vision of the ECB. The different elements were to be pooled in a constant exchange of views and understanding, guided by the goals of high-quality supervision and level playing field. The Joint Supervisory Teams (JSTs) would be the heart of this interactive structure. Today’s meeting embodies the essence of that idea. I am therefore pleased to see that DNB organises initiatives like this, and one can only regret that this practice is not more widespread.
Next year will mark the 60th anniversary of the Treaty of Rome. In 1957, six countries, including this one, signed a treaty that would shape the future of the continent, laying “the foundations of an ever closer union among the peoples of Europe”. As we all know, these are not easy times for that vision. Whether we follow the Union’s political process, or look at the opinion polls, or simply read the newspapers and talk to people, everywhere we see signs of wariness and disillusion about the notion of an “ever closer union”. My reaction to this is threefold. First, the founding fathers 60 years ago knew well that the road to a united Europe would not be an easy one, that there would be setbacks and reversals. But they were able to look through towards the ultimate desire, common to all of us, to live and participate peacefully in a single yet diversified community. Second, the younger generations feel about those ideals even more strongly than we do; we can see this in the enduring success of the European student exchange program that bears the name of a great Dutchman who lived 500 years ago. Third – and here I go back to our more familiar ground – the ever-closer union has become very real recently for banking supervisors. Since November 2014, when the SSM started operating, we banking supervisors have been at the forefront of European integration. I think we should see our responsibility also in this broader frame. I also believe that we can look at what has been done in these two years with some satisfaction. But the job is not finished and lasting success not yet ensured. It will take more time and effort to make European banking supervision as effective and resilient as it should be, and a solid pillar of the European construct.
Today I would like to review some current and future challenges facing the SSM. Some of them are internal, i.e. they depend essentially on us, on how we work and organise ourselves. Others are external, belonging to the environment in which we operate – though to some extent they depend on us as well. Some of the outside challenges are institutional: I think in particular of the fact that the banking union is still incomplete. Others are market-related, having to do with how the banking sector will develop.
European Banking supervision – Improving what is already good
Among the internal challenges, I want to focus on two that involve heavily the JSTs, the Supervisory Review and Evaluation Process, or SREP, and the SSM action plan on non-performing loans (NPLs).
As you know, our supervisory model was built in steps. In 2014 the ECB conducted an asset quality review and a stress test on our future “significant banks”. The “comprehensive assessment” was a crucial testing ground for us and produced a large amount of valuable information. It also uncovered some capital deficiencies that were subsequently filled. In retrospect, however, our progress on this latter front was only partial. The exercise had inherent limits because it looked only at the asset side of banks and their sensitivity to stress. It did not examine other aspects, such as internal governance, risk controls or business model sustainability. As we would subsequently experience first-hand, these elements play a critical role in determining the soundness of many of our banks.
In 2015 we launched the SSM SREP, our proprietary methodology for risk assessment and quantification of prudential requirements. For the first time, European banks were assessed using a single methodology. The SREP is a complete heuristic process which covers four elements: business model, internal governance and risk management, risks to capital, and risks to liquidity and funding, which together encompass all proximate and remote determinants of bank risk. The SREP combines quantitative and qualitative elements and treats all banks consistently, while accounting for different business orientations and operational styles.
I think we all agree that the SREP plays a key role in the SSM, but perhaps it is worth reflecting on why it is so. I think there are three reasons.
First, the SREP links the “vertical” dimension of supervision (examination of individual banks) with the “horizontal” one (quality assurance and level playing field). Bank-specific assessments by the JSTs feed into a single framework that ensures their consistency. Again, this notion – the nexus between the horizontal and vertical dimensions in a matrix structure – was one we developed shortly after we started designing the SSM; the SREP implements this idea. Second, the formalised structure of the SREP, based on data and scores, ensures discipline in the supervisory process and in the setting of prudential requirements, making them clearer and more systematic. The judgemental component of the SREP allows for some degree of discretion, administered by the JSTs; but it is a constrained discretion, as we often say, not an arbitrary one.
This brings me to the third reason why I think it is important, which has to do with external communication. Communication is an essential ingredient of a successful policy. We face an increasingly complex communication world: our decisions are often challenged and never taken at face value. Clarity and coherence are essential, and there can be no clear communication without clarity in the internal thinking and decision-making process. The SREP can help make our decisions understood and accepted. This requires, however – and here I enter a somewhat controversial subject – that we gradually move towards a greater degree of transparency on the SREP method and its results than supervisors have traditionally been accustomed to. The SSM has already taken significant steps in this direction, and I believe others will follow.
As one would expect given its holistic nature, last year the SREP resulted in an increase in the overall Pillar 2 requirements for our banks, relative to the 2014 assessment. This increase was moderate in the aggregate (around 30 basis points as a ratio to risk-weighted assets) and quite diversified across banks. Including the phasing-in of macroprudential buffers, our banks strengthened their capital ratios even further. Looking at the whole post-crisis period, the strengthening of euro area bank solvency ratios has been impressive, close to five percentage points. This is the most powerful argument we have today when we claim that European banks are safer and sounder than they were at the time of the crisis. This improvement owes also to the SSM.
In 2016, we are introducing some adjustments to the SREP to enhance its risk sensitivity and flexibility. We distinguish between two components in the Pillar 2 capital. One is the Pillar 2 requirement or P2R, which banks have to fulfil immediately and maintain at all times. The other is the Pillar 2 guidance or P2G, which indicates to banks the adequate level of capital to be maintained over a longer horizon. A breach of P2G will not trigger automatic supervisory action, nor prevent the distribution of internal resources for dividends and bonuses. But it will trigger closer supervisory scrutiny and surveillance. The quantification of P2G depends on the outcome of the stress tests, in the adverse scenario. We expect the aggregate CET1 capital need, including the requirement and the guidance, to remain broadly stable relative to last year. Of course, there will be movements up or down for individual banks.
The flexibility provided by P2G is positive in itself, but in the end its impact will depend on how it is administered and on how banks will react. The Supervisory Board believes that an overall softening of capital requirements is not warranted for the aggregate of our significant banks at this time. This means that we expect, in general, that banks will satisfy their capital guidance in full.
Let me now move to the second challenge I mentioned, our NPL action plan. I don’t need to explain to this audience why NPLs are important: high NPLs weigh on balance sheets, by increasing expected losses and risks (unless adequately provisioned) and also, even when they are provisioned, because they hamper profitability and restrict loan supply. Against an average gross NPL ratio of around 7% for the euro area as a whole, the extreme values are 47% and 1%. To some extent, the high average level and the large differences are due to factors that supervisors can only indirectly influence, such as economic developments and the efficiency and speed of the national judicial systems. But in other respects, supervision can and should play a direct role.
We approached this problem in steps. In 2014, with the support of the European Banking Authority we introduced a harmonised definition of NPLs for the first time in the comprehensive assessment, thus allowing better comparisons and a more balanced assessment of provisions. Subsequently, we set up a high-level task force which conducted an in-depth stocktaking of best practices and developed general guidelines. The related documents are now undergoing public consultation. The draft ECB guidance addresses the main aspects of the strategy, governance and operations relating to an efficient disposal of NPLs. JSTs will use it as a basis for evaluating how banks handle NPLs. The banks find in the guidance recommendations and best practices which they are expected to adopt.
The next step is to go into individual situations, focusing on the banks more affected by the problem. This phase will see close involvement by the JSTs. The bank-specific plans, their design and monitoring, will become part of the regular supervisory process. Banks will need to establish, if they don’t exist already, specific units responsible and accountable for the formulation and implementation of work-out plans. We are aware that reabsorption of the stock of NPLs will take time. But this should not be a reason for delay: a long journey should start as soon as possible. It is the responsibility of the banks to clean up their balance sheets; we as supervisors can, and we will, as a matter of priority, help and encourage them to do so as quickly and efficiently as possible.
European banking union – completing the building
I turn now to the external environment in which the SSM operates, starting with the institutional side. As we have learnt from historical and international experience, effective supervision needs to be complemented by a resolution authority and a deposit insurance scheme. In Europe, the first has been established; the second is still being discussed.
Supervision cannot function if banks cannot, in extreme cases, be allowed to fail in an orderly fashion. The lack of an effective resolution mechanism makes supervision weaker and banks more susceptible to moral hazard behaviour. In the end, the result is more risk for the banks and for the taxpayer.
The Single Resolution Mechanism (SRM) started operating at the beginning of this year. At present its main focus is twofold: preparing resolution plans for the most important banks and setting the minimum requirements for own funds and eligible liabilities, or MREL. These requirements ensure that each bank has enough loss-absorbing capacity in case it needs to be resolved.
The challenge for us supervisors is to provide support to the new authority and ensure that effective modalities of cooperation are in place. Part of the work of the SRM will use bank-specific information that becomes available in the supervisory process; we should avoid unnecessary duplications in the collection of information. Importantly, it is in our joint interest that smooth procedures are in place when specific cases arise. The SSM and SRM have signed a memorandum of understanding that includes regular and ad hoc information exchanges. Regular consultations take place at staff and board levels, which naturally become more frequent when dealing with fragile banks.
The other pillar of the banking union is deposit insurance. The rationale for insuring bank deposits is uncontested. Deposit insurance reduces depositor uncertainty and the risk of devastating bank runs. Equally important, it helps preserve the singleness of money in the payment system – a euro remains a euro regardless of where it is deposited.
In November last year, the European Commission issued a proposal for a European deposit insurance scheme. While it is broadly accepted that the banking union should eventually include such a scheme, there is controversy regarding the timing. Critics argue that, since it involves elements of risk-sharing, it cannot be put in place until the risks in national banking sectors have been contained and balanced.
This objection should be taken seriously, but one must also consider that an incomplete banking union is a source of risk in itself. The last thing we need is to exacerbate bank risks by having an incomplete institutional framework. Hence it is important to proceed swiftly to complete the safety net and at the same time reduce the risks in the banking sector. A clear implementation timeline for deposit insurance, as we had for the SSM and the SRM, would help reassure markets on the soundness of the overall banking framework. In the meantime, the SSM should continue to focus on further reducing the risks in the banking sector. At global level, the Basel Committee on Bank Supervision is working to complete the Basel III reform agenda and improving the prudential treatment of sovereign risks.
I should also mention in this context the key role played by the regulatory and legislative framework. In spite of the great steps made in recent years, with the introduction of CRD IV, CRR and the SSM regulation, important asymmetries in the rulebook remain.
One major source of differences stems from the transposition of the directive in national laws. The transposition is supposed to cater for national differences in market structures and supervisory styles. Under the SSM, the latter have lost meaning; yet, the ECB supervision is obliged to apply national transposition laws. We have asked the Commission to exercise surveillance so that the directive is transposed everywhere in a harmonious way. In some other cases, the SSM regulation itself leaves room for interpretation on whether certain decisions fall within the competence of the ECB or the national authorities. Here again, the Commission can provide useful guidance.
Within our competence, we were active on the regulatory front last year, reviewing a large number of optional provisions in European legislation, the so-called “options and discretions”. We have agreed in the Supervisory Board on harmonised modalities of application. The legal texts were published months ago, and the full package regarding significant banks entered into force last week, on 1 October. We are now working on an extension to less significant institutions.
The European banking sector – coping with change
I move now to the last part of my remarks, which concerns the challenges facing the banking sector. I realise that perhaps this should have been the first part, not the last one. There may be some inward bias on my side, as I have focused for so long on helping make the SSM work. I also feel that most of you, as line supervisors and members of JSTs, already have first-hand knowledge of the banks, at least of some of them.
The times we live in are, in many respects, not favourable to the banking business in general, regardless of specific conditions, location or business model. Europe’s economy has long been, and will remain for a while, in a phase of low growth, at best. In this context, profitable investment and lending opportunities are unlikely to be plentiful. Sluggish growth is accompanied by historically unprecedented low interest rates, at short and long maturities, and low interest margins. Revenue from net interest margins accounts for more than half of the total gross income of euro area banks. Indirectly, the returns from non-interest income sources are affected as well. How long will this situation last? Economists are debating whether they are cyclical, hence short-lived, or structural (some even say “secular”), meaning that they are expected to be permanent or nearly so. What is certain is that they have been and remain very persistent.
The conditions I have described present a twin challenge for banks and supervisors. Banks need to rethink their business models, assessing their sustainability in the current and prospective environment. Survival in a hostile environment requires adaptability, as my Bundesbank colleague Andreas Dombret has recently remarked using a colourful comparison with dinosaurs. Banks also need to develop alternative sources of income and contain costs. Advances in information and automation technologies are opening up fascinating scenarios; it is plausible that the bank of the future – say, 25 years from now – will be very different from what it is now. We must begin now to understand that future and prepare for it. We supervisors must monitor the adaptation of business models, gauging their sustainability, together with the banks. In the SSM we have made business models one of our supervisory priorities, and we plan to encourage discussion of this subject.
A number of banks under our supervision still suffer from legacy problems. This aspect, unlike the previous one, differs greatly across banks and jurisdictions. One dimension of this is overbanking. A recent report by the European Systemic Risk Board showed that the size of the banking sector, already large in Europe, has expanded further in recent years in relation to the broader financial sector. The number of banks is slowly declining, but remains very large by international standards, especially in some countries. Amid challenging macroeconomic conditions, a recovery of profit margins will require a consolidation process. The other facet of the legacy problem consists of the NPLs, as I have mentioned. It seems reasonable to expect that bank consolidation and NPL disposal will be in many cases complementary processes, reinforcing each other.
Let me conclude by expressing the hope that my emphasis on the “challenges” facing all of us will not discourage you. With challenges always come opportunities, and the best opportunity is that of being able to improve ourselves. Ultimately, our common challenge and opportunity is to make our banking industry better and stronger, in the interest of all European people.
The SSM benefits from great traditions – those of the national supervisors such as De Nederlandsche Bank and others. I am sure that we can and that we will improve upon that tradition. To do that, we should always remain open to change and willing to learn from each other.
I can already see in this meeting the promise that this will happen.
Thank you for your attention.
I am grateful to Sebastian Ahlfeld, Francisco Ramon-Ballester and Andrea Zizola for their contributions. The views expressed here are personal and should not be attributed to the ECB.