The shifting ground of banking – A supervisor’s perspective

Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB,
at the European Financial Round Table,
Frankfurt am Main, 19 October 2016

Ladies and gentlemen,

In 1912, the German scientist Alfred Wegener proposed the theory of continental drift – that our world originally consisted of one large land mass which slowly, over millions of years, gradually separated into the continents we know today. Several decades passed before his hypothesis was widely accepted and became the basis for plate tectonics – the theory that the earth’s shell comprises a series of plates which move and interact, literally changing the face of the earth.

Today, the banking world is facing a similar upheaval. It is being reshaped by some powerful forces. Eight years after the financial crisis, there are four “tectonic shifts” under way: one is supervisory reform, which has taken banking supervision to the European level; another is regulatory reform, which has strengthened the rules for banks; the third one is macroeconomic change, which is set to have lasting effects on banks’ business models; the fourth is technological change, which is opening the door to new competitors and might end up redefining the banking business.

Both supervisors and bankers are following all these changes very closely, but while supervisors focus on stability, bankers naturally focus on profitability. Nevertheless, we all know that profitability and stability should be two sides of the same coin.

From a supervisor’s perspective, profitability is important because only profitable banks can be stable. From a banker’s perspective, stability is important because only stable banks can be sustainably profitable.

Let us take a closer look at these four major changes and their impact on the stability and profitability of banks.

The new supervisory and regulatory landscape

A lot has been written and said about European banking supervision, so I will keep it short. Our mission is to provide tough and fair supervision based on harmonised standards. Compared with the fragmented system of national supervision we had before, the new system improves the stability of Europe’s banking sector.

It also aims to create a level supervisory playing field and contributes to a truly European banking sector where everyone has the same responsibilities and the same opportunities. That is what we strive for. We also took this approach in the recent stress test which we conducted together with the European Banking Authority. That test was not a pass/fail exercise, and it involved assessing 51 banks according to the same methodology, covering all main risk types.

And our vision for the future? Banks that offer their services throughout the euro area; banks that become more European and reap the benefits of a larger market. At the same time, customers who can choose from a wide range of banks that are supervised according to the same high standards. A banking sector of this kind would contribute to a more efficient allocation of resources, thereby supporting economic growth.

Over the past two years, we have made good progress in levelling the supervisory playing field. But there are still some obstacles to be overcome. For instance, we have a regulatory framework that, to some extent, remains fragmented along national lines. If policymakers are serious about creating a European banking union, they should eliminate the remaining regulatory differences.

Admittedly, the regulatory framework is more harmonised than ever before – at European level and at global level. Emerging from the depths of the financial crisis, we have harmonised the rules, and we have made them stronger. Higher capital requirements in particular contribute to a more stable banking sector.

We are aware that stronger rules impose a burden on banks and affect their business models. However, were those business models sustainable in the first place? In the past, they were often based on high leverage, relatively cheap wholesale funding, implicit public insurance, and, in some cases, elevated risk-taking.

Those characteristics – effectively distortions – served banks well for quite some time, until they led to a crisis that sent shock waves through society which are still reverberating today. Stronger regulation seeks to remove the distortions, thereby shifting the burden back to the banks. Tighter regulation might affect profitability in the short run but, in the long term, it increases stability, protects society from costly crises and ensures a steady flow of credit to the economy.

Regulatory reform was necessary – what has been done had to be done. Still, it represents a profound structural change for the banking sector. This change is now coming to an end: Basel III should be finalised by the end of the year, and overall capital requirements will not significantly increase.

Macroeconomic trends and business models

Over the past few years, the supervisory and regulatory landscape has been transformed and now provides a stable foundation for banks and the entire economy. After all, it is a core function of banks to serve the economy.

However, the link between banks and the economy runs in both directions. The economy is as important for banks as they are for the economy. Banks will always be affected by economic trends. When the economy weakens, non-performing loans become more of a burden; when interest rates fall, so does profitability.

Low interest rates in particular are currently a concern for banks across the euro area. That is not surprising as net interest income makes up, on average, more than half the total income of large euro area banks. Low interest rates therefore put pressure on the profitability of banks.

Against that backdrop, some bankers are pointing their fingers at the ECB. They implicitly – sometimes explicitly – say that raising policy rates would be the right thing to do given concerns about bank profitability.

Frankly, that surprises me a bit. After all, interest rates always reflect the state of the economy; central bankers do not set them in an arbitrary fashion.

In addition to that, low interest rates are only partly a cyclical phenomenon. For a few decades now real interest rates have been on a downward trend. This decline is driven by structural developments such as ageing societies and lower productivity growth.

So, banks need to rethink their business models and adapt them to the changed environment.

They certainly have scope to reduce costs; their objective is to become less dependent on interest income. In that regard, fee income is often considered as an alternative source of revenue.

But fees have become more difficult to levy. Consider capital market business. Some institutional investors seem to have developed an appetite for cheap passive investment strategies. The result is a trend towards simpler products that is further supported by consumer protection rules. And simpler products generate lower fees.

It seems therefore that business models are being challenged by more than just low interest rates.

Technological change – going digital

And there is something else going on. Banks not only face new regulations, a new supervisor and a tough economic environment; they also have to deal with technological change.

It is true: innovations in banking often spark a bit of unease among observers. Just think of Paul Volcker’s comment that “the only useful banking innovation was the invention of the ATM”.

Nevertheless, it could be argued that today’s technology just takes ATMs one step further. While ATMs offer customers access to cash 24/7, new digital solutions offer customers access to all sorts of banking services, anywhere, anytime.

Digitalisation has the potential to fundamentally transform the banking sector. Nevertheless, it is hard to see what the result will look like; that depends largely on how banks act and react.

For them, digitalisation offers opportunities and creates challenges. Among the opportunities are greater efficiency, new distribution channels and new sources of income. The main challenge is that banks are facing a new breed of lean and innovative competitors. Banks now need to decide how they will approach digitalisation, for they cannot ignore it.

From the perspective of a regulator and supervisor, two things matter. First, we have to ensure there’s a level playing field; second, we have to contain new risks that emerge.

In principle, European regulation is designed to promote a level playing field. It follows the “same business, same risk, same rules” principle, and is therefore technology-neutral and generally able to adapt to innovation. No regulatory overhaul should therefore be necessary.

As for potential new risks, from a microprudential perspective operational risks – to be precise, cyber risks – stand out. As more customers rely on online services, more data are exchanged and IT systems become more complex. That creates openings for cyber criminals and increases IT risks more generally. We supervisors regard cyber risks as one of the key risks for the European banking sector. Banks themselves should view them just as seriously.

Conclusion

Ladies and gentlemen, I realise that these are not easy times for bankers. But unpleasant times provide an incentive to adapt.

And adapting has become necessary. Tectonic shifts are under way in the banking sector, driven by supervisory and regulatory reform, macroeconomic trends and technological change.

Nevertheless, such changes are not unprecedented; they are part of business life, they have happened time and again in the past and they will happen again in the future.

Such disruption is not limited to trends that directly affect banks; it also applies to political events. On a sad day in June, a majority of people in the UK voted to leave the European Union. The banks in the euro area were well prepared and absorbed the initial shock fairly well – for European banking supervision, it was an undesired but successful exercise in crisis management.

With regard to the regulatory framework for banks, Brexit might facilitate the use of EU regulations instead of EU directives – from a supervisory point of view that is clearly desirable. Apart from that, the ultimate impact depends on the outcome of the negotiations.

In these uncertain, changing times, the usual truth applies: the banks that adapt will thrive, those that don’t will fail.

I believe in the ability of business men and women to find profitable ways to provide financial services to savers, to investors, to consumers, to the economy. As long as there is demand for such services, there will be supply.

For us supervisors it is important that change does not bring systemic instability and that financial services are offered in a sustainable way that does not endanger the financial system or the economy.

Thank you for your attention.