European banking supervision – a necessary innovation

Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB, at the WHU New Year’s Conference, Koblenz, 18 January 2017

The topic of this year’s conference is “Innovation in finance”. Admittedly, innovations in finance have a bad reputation. The former Chairman of the US Federal Reserve, Paul Volcker, once claimed that the only useful financial innovation he had seen in the previous 20 years was the ATM. And Warren Buffet once described innovative financial instruments as “financial weapons of mass destruction”!

Financial innovations did contribute to the crisis of 2008; that is true. But innovation also drives progress. A world without innovation would not have moved beyond the Stone Age – if at all. As a general rule, however, innovations must create value, not destroy it.

And following the financial crisis, there was one innovation that indeed created value. And it is this innovation I would like to discuss today: European banking supervision.

What is European banking supervision about?

In the summer of 2012, the euro area was a dangerous place – from a financial point of view. The markets had zoomed in on Italy and Spain, driving bond yields to new heights. The media was discussing a potential break-up of the euro area, as were some politicians.

Then, on 28 June, EU leaders met in Brussels and agreed on a package to stabilise the euro area. Among other things, this package included the plan to take banking supervision from the national to the European level.

Just two years later, in November 2014, the ECB took over banking supervision in the euro area. But what makes European banking supervision so important? Why do we need it?

Well, in very general terms, European banking supervision enhances the stability of the banking sector and makes future crises less likely. It is therefore an innovation that creates value for all citizens in the euro area.

In 2008, the world learnt that financial crises do not stop at national borders. The financial system is so closely knit that a crisis can start at eight in the morning in one country and spread around the globe before noon. This is particularly true in a monetary union such as the euro area. Here, it is almost impossible for countries to shield themselves from financial crises in other Member States.

Against that backdrop, it became clear that the scope of national supervisors was too narrow. European banking supervisors can now look beyond national borders. They survey the entire euro area; they can spot problems early on and prevent them from spreading.

This is related to another issue: national supervisors tend to be biased. They tend to be a little too soft on “their” domestic banks and sometimes a bit too protective. European banking supervision balances this bias. When necessary, supervising banks can mean prescribing tough medicine that is sometimes locally unpalatable. But that is our job. From a European supervisor’s perspective, it makes no difference whether a bank is German, French or Spanish. This ensures tough supervision that is also fair.

When supervising banks, we apply the same high standards across the entire euro area – each bank is treated equally. This makes the banking sector a safer place and contributes to a level playing field, with all banks having the same responsibilities and the same opportunities.

This, in turn, paves the way for a truly European banking sector, in which customers can choose from a wide range of banks that are supervised according to the same high standards. And banks can offer their services throughout the euro area and reap the benefits of a larger market. Such a European banking sector helps to allocate resources more efficiently and thereby supports economic growth.

How does it work?

So, with European banking supervision we took a major step towards a more stable and prosperous euro area. But how does it work in practice? Let’s take a quick look at the architecture.

The ECB is responsible for directly supervising the 127 largest banking groups in the euro area. Known as “significant institutions”, these hold around 82% of banking assets in the euro area, making the ECB the largest bank supervisor in the world.

For each of the significant institutions, we have set up a so-called “Joint Supervisory Team”, or JST for short. Headed by ECB staff and comprising supervisors from both the national authorities and the ECB, these Joint Supervisory Teams are the people who actually supervise the banks. In a sense, they are the cornerstone of European banking supervision.

Now what about the not-so-large banks? Most of them are relatively small in terms of assets, but – with around 3,500 so-termed “less significant institutions” operating in the euro area – they outnumber the large banks by far. The national supervisors directly supervise these banks; and the ECB only plays an indirect role. This means that we cooperate closely with national supervisors to ensure that the smaller banks, too, are supervised according to the same standards.

Altogether, the architecture of European banking supervision reflects two major principles that govern the exercise of powers by EU institutions. The first is subsidiarity, meaning that decisions are taken as close as possible to the local level. The second is proportionality, meaning that the exercise of power must be limited to what is necessary to achieve the objectives. The business models of smaller banks are mostly focused on the national market. At the same time, a smaller bank usually poses limited risks to the rest of the financial system. Therefore, it makes sense to supervise smaller banks at the national level and larger banks at the European level, and also to supervise smaller banks less intensively than larger banks.

Looking back: the first two years of European banking supervision

Looking back at the first two years of European banking supervision, what first springs to mind is harmonisation. We took the supervisory approaches of 19 different countries and merged them into one.

A case in point is the main tool of banking supervision, the supervisory review and evaluation process – often referred to as SREP. In the SREP, we analyse the risk profile of each bank from four angles. We look at the business model of the bank, its governance and risk management, potential risks to its capital position, and potential risks to its liquidity position.

Based on our analysis, we determine how much capital the bank should hold above the regulatory minimum. The higher the risk, the more capital the bank should hold as a buffer against potential losses. We can also apply other measures if needed – increased reporting obligations, for instance.

Thanks to the harmonised SREP, all large banks in the euro area are now measured against the same yardstick. This is a major improvement when we compare it to the fragmented world of national supervision. And we are about to take this one step further. Together with the national supervisors, we are currently working on a harmonised SREP for the smaller banks.

Another example for harmonisation concerns regulation. The European rules for banks contain a number of options and discretions. In essence, these options and discretions give supervisors some leeway in applying the relevant rules. We have agreed to exercise the options and discretions in a uniform way across the euro area. And again, we are working on extending this to the smaller banks.

But the regulatory landscape in the euro area remains somewhat fragmented. This is due to the fact that European rules come in two forms: regulations and directives. Regulations are directly applicable in all Member States; they provide full harmonisation. Directives, on the other hand, have to be transposed into national law – and the result can differ widely across countries.

Such differences in the rules run counter to the idea of European banking supervision. They require us to apply 19 different national rules instead of a single European one. That is bureaucratic, and it is expensive. If politicians are serious about banking union and a single banking market, then they must further harmonise the rules.

But European banking supervision is not just about harmonising rules and methods; it is also about growing together. ECB staff come from all over the euro area and beyond. The ECB is a melting pot of languages, cultures and traditions. At the same time, the ECB works together with supervisors from the 19 countries of the euro area.

It might take some more time, but we are on our way to becoming a truly European team of banking supervisors. And already today, European banking supervision shows us something very important and reassuring: Europe can work, and it can bring real benefits to all its citizens!

Looking ahead: the priorities for 2017

And that brings us to the actual content of banking supervision. How are the banks doing, and what are our supervisory priorities for 2017?

The good news is that banks have become more resilient. The universal buffer against potential losses is capital: the more capital a bank holds, the more losses it can bear before failing. And since 2012, capital ratios of banks in the euro area have increased from 9% to 13.5%. That is a very good development.

Still, many people seem to be concerned – investors, bankers themselves and we supervisors. What is it that worries us?

Well, resilience is just one side of the coin. The other side is profitability. A bank that does not make profits will eventually fail. And European banks do suffer from a lack of profits. Their return on equity lies well below their cost of capital. Over the long run, this is not sustainable.

In explaining the low profitability of European banks, the public debate focuses on two issues. The first one is low interest rates – as often heard in Germany. The second one is regulation – as often heard from bankers. But that is not the entire story: there are more things that weigh down profits.

It is true, of course, that interest income is important for banks. On average, it makes up more than half of the total income of large banks in the euro area.

So, low interest rates clearly affect banks. However, regarding the specific effects of low interest rates, we have to make a distinction.

Initially, low interest rates might actually boost profits. Funding costs go down quickly when interest rates fall, but yields on existing fixed-rate loans take more time to adjust. Consequently, net interest income increases. At the same time, low interest rates support the economy, which also benefits banks.

But at some point, low interest rates take their toll. High-yielding fixed-rate loans either mature or are repaid. Banks then have to replace them with lower-yielding assets. At the same time, the decline in funding costs comes to an end as banks are reluctant to charge negative rates on deposits. Taken together, this causes net interest income to fall.

The second issue that features high in public debate is regulation. In recent years, the rules for banks have been strengthened, and bankers now claim that regulation has gone too far.

Well, it is true that rules are a burden for those who have to comply. But we have to look beyond the banks. The financial crisis has put a huge burden on taxpayers – that is something the banks tend to overlook. Taking this into account, changes the conclusion. Stronger rules help to prevent future crises – taxpayers and the entire economy benefit.

It goes without saying that the rules must not be so tight as to squeeze the life out of banks. They should rather provide a strong framework that reins in excessive risk-taking, while allowing the market to function normally. And this is what has been achieved.

But let’s return to the other factors – besides low interest rates and regulation – that weigh on banks’ profits. Among these are legacy assets. In some parts of the European banking sector, banks still have high amounts of non-performing loans on their balance sheets.

Non-performing loans do not generate income and they require provisioning. Moreover, they limit the capacity of banks to provide loans to the economy and are hence an issue that reaches beyond the banks themselves. Disposing of non-performing loans would help the banks to remain profitable and to finance the economy.

And there is something else the banks can do to increase profits. Most European banks suffer from high costs. There is obviously room to become more efficient and, as a result, more profitable.

To sum up, banks in the euro area need to step up profitability. And in doing so, they face increasing competition, owing to overcapacities in the banking sector and innovation, such as digitalisation.

Admittedly, banks face many challenges these days. Naturally, our supervisory priorities for 2017 reflect these challenges.

First of all, we will further analyse banks’ business models and the drivers of their profitability. Banks obviously need to adjust their business models to a world that has changed. However, there are different ways of doing this, and not all of them are safe. When profits are low and liquidity is high, it is tempting for banks to embark on a dangerous search for yield. Against this backdrop, sound risk management is key – and that’s why we made it our second priority for 2017.

Next to business models and risk management, our third priority for 2017 is credit risk. I already talked about non-performing loans, and they are indeed the major issue in this regard. In 2016, we developed guidance to banks on dealing with non-performing loans. Our Joint Supervisory Teams will now monitor its adequate implementation.

Conclusion

Eight years have passed since the financial crisis. It was a devastating event, and it still casts a shadow on the banking sector. But it also provided an incentive for change and innovation. We overhauled the regulatory framework, and we established European banking supervision. These were decisive and important steps, which have brought us closer to a safe and sound banking sector.

However, regulators and supervisors cannot do the job alone. After all, the banks themselves are responsible for their own soundness and safety. They are a core element of the economy and that carries responsibilities.

Some of you, some of the students here at WHU, might join banks later in your career. If you do so, I hope that you will not forget the responsibilities that go with the job.

That said, I also hope, of course, that some of you will join the ECB and become European banking supervisors.

Thank you for your attention.