Banking union in 2017 – How to supervise a €27tn banking sector?
Speech by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the CIRSF Annual International Conference, Lisbon, 1 June 2017
It is a pleasure to be here in Lisbon for this conference. I was happy to receive the invitation to speak on these important topics, especially when I learned of the location.
It’s particularly apt that we will be discussing the principles of subsidiarity and proportionality today – the 19th anniversary of the founding of the ECB. In my experience, the ECB has always striven to respect the EU Treaties’ emphasis on these principles in its decision-making and operations.
So I would like to take this opportunity to discuss how we, ECB Banking Supervision, have taken the same respectful approach to our tasks and offer some behind-the-scenes insights into how one of the world’s biggest banking sectors is supervised. I hope these remarks will serve as a useful starting point for exploring some of the important issues that are on today’s agenda.
Subsidiarity as a principle underpinning European banking supervision
Households across the euro area need a strong and vibrant banking sector to be able to handle their personal finances and of course firms need the same in order to pursue their business activities efficiently. Recognition of this, along with the competitive benefits of a single approach to banking supervision, famously led European leaders in 2012 to aim for the creation of a banking union.
Since this decision was taken, casual observers have often assumed that decision-making in the euro area banking system has all been centralised within the ECB. Today I will explain why things aren’t as simple as that. In doing so, I hope to provide some insights into how our structure and decision-making processes embody the principle of subsidiarity.
As I suspect you all know, the EU Treaties enshrine the principle of subsidiarity – meaning that they apply across all EU activities, including banking supervision. In essence the idea is that European bodies are only empowered to act where the European perspective provides the best platform for making decisions in the interests of the people of Europe.
This principle protects the system from the tendency of European policymakers to centralise power and decision-making. It helps us ensure that decisions are taken as close as possible to the scene of the action. However, it also requires us to make decisions at a level that is sufficiently high to allow proper consideration of all the implications of those decisions.
Before I get into the detail, let me make three quick points. First, our supervisory work is done hand-in-hand with colleagues at the national competent authorities. Second, while the ECB is the ultimate decision-maker as regards banking supervision, each national authority fully participates in Supervisory Board discussions and votes on each decision. Third, let us note last month’s European Court of Justice decision on the L-Bank case, which strongly endorsed the legality of our structures and their consistency with our legal obligation to respect the principle of subsidiarity. This bank had alleged that we had misused our powers in designating L-bank as a “significant institution” – to be directly supervised by the ECB. The ECJ rejected this interpretation and made it clear that the ECB is right to take the lead in supervising all euro area banks with €30bn in assets or more.
These points reflect our commitment to honouring the subsidiarity principle within our work at ECB Banking Supervision.
Indeed, looking back at the decision to elevate responsibility for banking supervision to the European level, subsidiarity has always been part of our raison d'être. There are three reasons for this.
First, the scope of purely national banking supervision was too narrow. Dirk Schoenmaker’s frequently cited “financial trilemma” helps us to conceptualise this simple reality. This trilemma states that financial stability, financial integration and national financial policies are incompatible – it is only ever possible to maintain two of these at any one time.
In Europe we have a system of single passports for banks to operate in all EU countries. And we have some cross-border banks that are of systemic importance to multiple Member States. It therefore makes sense for supervisory decision-making to take place at supranational level.
It means that the interests of all affected countries can be taken into consideration when supervisory decisions are made. Likewise, this European perspective gives the supervisor a broad view of the risks that can span the continent. This allows European banking supervision to take swift action to proactively manage cross-border risks and effectively maintain financial stability.
Second, I would argue that the national structure of banking supervision that existed in Europe had a tendency to be biased towards creating “national champions” and supporting local banking models.
I am not saying that this bias was the result of individual national supervisors having bad intentions. The reality is that the national supervisory model has a structural bias towards laxity that is beyond the control of individuals. In particular, the narrow focus of national supervisors fails to take into account the cross-border transmission of risk. This failure, in turn, tends to lead to a systematic underestimation of the scale of risks, and thereby to excessively light supervision.
By elevating supervisory responsibilities to the supranational level, this cross-border transmission of risk can be kept in check. Further, as we are held accountable at the European level, and have obligations to everybody across the euro area, we are insulated against the influence of national bias. This allows us to take a tough, harmonised European approach to banking supervision and create a level playing field for all banks.
Third and finally, I believe this tough, harmonised supervisory approach provides the right basis for establishing a truly integrated banking sector across the euro area. Banks know they will receive the same treatment wherever they are based. Further, they also benefit from having a single supervisor with the same processes in each country. It is also important to note that ECB Banking Supervision in Frankfurt is well resourced in comparison to the previous system of national authorities.
These factors should help encourage efficient and competitive banks to establish cross-border operations across Europe and thereby underpin a financially integrated market. Let me add that we regard healthy, efficient banks extending their business across Europe as a positive development. In the current environment, we would welcome more cross-border mergers.
The financial integration and competition that the banking union will help to generate is clearly a good thing for Europe, and in particular for the functioning of the currency. The banking union will offer all banks, wherever they are, a level playing field, thereby enhancing competition in the banking industry.
The competition will give consumers greater choice and better-quality service. The best firms will, over time, expand their operations in scale and geographical scope, and can then offer loans to individuals and firms in the real economy in an efficient and cost-effective way. When this happens in a context of a safe and sound banking sector everyone benefits, irrespective of location.
Likewise, a broad and integrated banking market helps to ensure that resources are allocated efficiently – thereby supporting growth. A single banking market also helps to smooth monetary transmission by avoiding unjustified differences in the cost of finance emerging across countries.
The important role of national competent authorities (NCAs) in European banking supervision
Having said that elevating banking supervision responsibilities to the European level is consistent with subsidiarity, I will now explain how we distribute responsibilities within the system. I hope to demonstrate that the allocation of duties between the central authority and national authorities is appropriate. Depending on the situation, the ECB is either the lead decision-maker or it delegates decisions – and at all times national authorities and the ECB must collaborate in order to reach the best outcome.
As explained in the previous section, the ECB is at the heart of European banking supervision. The European Court of Justice’s L-Bank decision last month confirmed the ECB’s status in this regard – making it clear that the ECB has exclusive competence for banking supervision issues across the banking union. In practice, on a day-to-day basis this means that the ECB takes direct supervisory responsibility for the biggest, most systemic and most international banks. These significant institutions are those with the greatest cross-border implications. They are the institutions which most strongly justify taking a supranational approach.
The ECB deploys Joint Supervisory Teams, or JSTs, to supervise the significant institutions. These teams consist of local experts from the national authority and ECB staff working in Frankfurt. They are headed by an ECB staff member who coordinates and oversees the work. This allows the ECB to fulfil its responsibility by taking the lead in supervising these banks, while also ensuring that critical local knowledge and expertise is maintained and utilised.
On top of these direct supervisory functions, the ECB also takes the lead in setting the horizontal policy framework for implementing European banking supervision. It makes sense for this work to be led centrally, given the aim of creating a single level playing field across the system. However, the expertise of national authority employees is extremely valuable for the ECB in making horizontal policy design decisions. Their contributions are facilitated by various ECB-chaired networks that have been set up for each important policy area.
Day-to-day supervision for banks with assets of below €30 billion are generally delegated to the NCAs. This reflects the fact that these banks have less of an impact across sectors, as their potential to have a major effect on the real economy is limited. In such circumstances, national supervisors remain well placed to continue taking the lead on these issues.
The ECB provides a strong lead by setting the horizontal supervisory framework, with a view to harmonising supervisory approaches, and establishing a competitive level playing field for these smaller banks. Further, when there are concerns that national supervisors are not adequately controlling risks within their local banks, the ECB has the right to step in and take over. This option is a disciplinary device that plays a helpful role in ensuring that the right incentives remain in place at the local level.
As I have already mentioned, NCAs are also active participants in the decision-making at the centre of European banking supervision. Each NCA is represented on the Supervisory Board and has a vote on all major decisions it takes. This role for NCAs strengthens ECB Banking Supervision’s decision-making capacity. It does this by ensuring the buy-in of national authorities on difficult supervisory decisions, and thereby adds legitimacy to the system.
Let me be clear here – the idea of the Supervisory Board is certainly not for each member to focus on defending and promoting their own national interests. Rather, we participate in our personal capacity, not as representatives of our home authority.
This follows the strong example that former Bundesbank President Hans Tietmeyer set during the early meetings of the ECB’s Governing Council. I spoke to Hans on this topic when we had the honour of hosting him at Suomen Pankki – Finlands Bank during a conference he was attending. He explained to me that at the first Governing Council meeting he actually refused to enter the meeting room until “Bundesbank” was deleted from his name badge. Clearly he felt strongly about this issue!
He was right to feel this way, and he made his point: Governors and Supervisory Board members should come to the Governing Council and Supervisory Board meetings to discuss decisions in an impartial way, and to make the best decisions possible for the euro area as a whole. We should all aspire to Hans Tietmeyer’s approach in our supervisory discussions – and this is certainly the direction of travel within European banking supervision.
Aiming to cooperate seamlessly across all levels of European banking supervision
To wrap up this section on subsidiarity – let me say that I hope my words help shed some light on the reality of our day-to-day work in European banking supervision. In particular, I hope I have shown that things aren’t as simple as “decisions a/b/c” are taken centrally, and “decisions x/y/z” are taken locally. In practice, there is a more cooperative spirit than this – and each set of decisions gains from the contribution of both sides.
As ECB Banking Supervision matures, we aim for our decision-making to benefit increasingly from a spirit of seamless cooperation across the local and central levels. This is the only way to maximise the collective wisdom we can bring to bear on individual decisions – and thereby attain the kind of subsidiarity best suited to the banking supervision context.
The second major theme I would like to touch upon is the principle of proportionality. This principle seeks to control the exercise of powers by EU institutions. The actions they take must be limited to what is necessary to achieve the objectives set out in the EU Treaties.
For European banking supervision, our main objective is to contribute to the safety and soundness of the banking system and the stability of the financial system in the euro area. Taking a proportionate approach to this objective means paying special attention to the banks that pose the biggest risks to the banking and financial system.
I will explain how the current rules and operation of European banking supervision work to support the principle of proportionality. Then I will talk about how we could take additional steps to incorporate proportionality even more in our work.
Current rules and approaches recognise the importance of proportionality
Regarding the current rulebook – I think we can clearly say that major efforts have already been made to integrate proportionality into the work of European banking supervision. The text of the Capital Requirements Regulation (CRR) makes it clear, for example within Recital 46, that the requirements are to be applied in a manner proportionate to each institution’s nature, business model and activities.
In specific terms, the CRR states that the Supervisory Review and Evaluation Process, SREP for short, which is used by supervisors to set tailored requirements on banks – should be carried out in a proportionate way. This means that the frequency and intensity of SREP processes should vary from bank to bank depending on a bank’s size, complexity and risk profile. Likewise, decisions on imposing supervisory measures must be taken in a proportionate way. In other words, a legitimate aim must be pursued, and this must be done in a reasonable manner – utilising only those measures needed to achieve the intended aim.
Our obligations to be proportionate in our work are also set out explicitly within the SSM Regulation. Article 1 makes it clear that European banking supervision is obliged to carry out its functions paying full regard to the different types, business models and sizes of credit institutions within its scope. This additional layer of proportionality obligations reinforces the fact that legislators clearly wanted to ensure that European banking supervision operates in a proportionate way.
Implementation of proportional approaches
So how do we translate these laudable principles into the reality of our day-to-day work? Let me give you some examples that show we take these duties seriously.
In this area, we have a balancing act to perform, as we are duty-bound to implement both harmonised and proportionate supervision. As you know, harmonisation of the supervisory methodology is important to create a level playing field across the banking union.
To reconcile these two objectives, we begin by setting a minimum level of supervisory activity that is applicable to all banks. This allows us to ensure that all banks are held to the same standards, and that supervisory intensity is, in all cases, sufficient to demonstrate that these standards are met. Our “minimum level of engagement” is a key building block of our harmonised supervisory approach.
This concept of a minimum level of engagement itself includes an element of proportionality – as it is not the same for every bank. Riskier and bigger banks automatically start with a higher minimum level of engagement, while smaller or less risky banks have a less demanding supervisory starting point.
The addition of extra layers of supervisory requirements for banks then ensures further proportionality in supervisory intensity. These layers vary depending on the size, systemic importance and risk profile of the bank in question. Logically – when a bank is large, systemically important, or otherwise risky – we of course invest more of our time and energy into trying to manage those risks.
This is just common sense, but it is also formalised within our systems via our strategic and operational planning process. Ultimately, our decisions on supervisory intensity are reflected within the annual Supervisory Examination Plan. That sets out, for each significant institution, what activities the JST will undertake each year – including risk-based decisions on what on-site inspections and internal model investigations to pursue.
Our proportionate approach to supervisory intensity covers everything we do. It defines our reporting requirements and determines the fees we charge and, ultimately, the supervisory measures we take to maintain a high level of compliance with the rules.
Aiming to improve the principle of proportionality
Given all that I have said, you might get the impression that European banking supervision is already working perfectly, and that the proportionality of our regulatory and supervisory system cannot be improved. Not so – there is always room to improve, and we try to think about this every day.
I recognise that there is an ongoing debate about the reforms that followed the financial crisis – namely, that they may have had a disproportionate impact on smaller banks. In this debate, I agree with the analysis of Governor Stournaras at a recent Bank of Greece conference on this issue. He thinks there is heightened focus on these issues at the European level for three understandable reasons:
- First, the maximum harmonised approach within the EU’s Capital Requirements Regulation has resulted in a much higher degree of convergence in regulatory norms. This closer harmonisation is necessary for the development of the banking union, but it also eliminates national discretions, which allow an opting-out from certain elements of the rules.
- Second, the post-crisis reforms have been expanded to cover new aspects of banks’ organisation and business activities. A denser set of regulatory requirements now applies to all credit institutions – including on issues such as liquidity and leverage.
- Third, the inception of the banking union has elevated supervisory responsibilities to the European level. This has taken decision-making responsibility concerning the level of supervisory intensity away from the national level.
Following these developments, European rules and bodies have become more important in determining proportional supervisory approaches. It is therefore natural that there is a more noticeable discussion at the European level on how to strike the right balance between proportionality and harmonisation.
Specific proposals for further proportionality
Let me now say a few words on some of the specific ideas that are currently circulating regarding additional measures to extend proportionality into European banking supervision legislation.
On this matter, let me say that the scope for potential regulatory relief should be mostly limited to reporting requirements. I firmly believe that we cannot compromise on safety, and thus that there is generally no case for reducing or eliminating requirements for certain segments of the banking market.
My view here is that any measures to reduce reporting requirements for the sake of proportionality must be very strictly limited to those banks that are definitively and demonstrably of lower risk. Providing some kind of relief in such strictly limited circumstances provides a justified competitive reward for those banks which pose less risk to the financial system, and hence to society.
Now for the critical question – how to separate “safe” banks from the rest when it comes to regulatory rules? My short answer here is that we should do this very carefully. We need to make sure that eligibility for any relief from reporting requirements is limited to those banks that are genuinely low risk. Otherwise, we will distort competition in an unjustified way and, in the process, make the system less safe and sustainable.
Regarding the detailed criteria for determining “low risk” status, I would endorse the type of approach that Thomas Hoenig of the Federal Deposit Insurance Corporation has proposed, namely strict and clear criteria that capture a fairly sophisticated picture of banks’ risk profiles. For example, the criteria could include a leverage ratio above 10%, low derivative exposures that are limited to simple products, and no trading assets and liabilities.
Of course, one can discuss the precise details of such criteria. However, it is clear to me that an approach that limits relief from reporting requirements in a strict manner by capturing multiple dimensions of risk is the right way to go. Banking risk is a complex phenomenon, and we therefore require more than a simple size criterion to understand it.
In my view, an approach to proportionality that relies solely on a size criterion would not be a risk-based approach. Such an approach would fail to learn the lessons from history. The past has shown us many times that it is quite possible for small banks to cause severe disruption to the economy, for example during the US savings and loans crisis, and also the Nordic experience.
So I advise against the proposal that I understand is currently under discussion, which would reduce reporting requirements for smaller banks in rather a crude way. Instead, we should take a more nuanced approach which ensures that lower reporting requirements are limited to only the least risky banks. This is something for us to contemplate further – both within the design of our existing processes, and also within the ongoing legislative debate.
To conclude, I have offered you today some of my views on proportionality, a principle which has been underpinning European banking supervision for some time. Existing legislation and practices already differentiate between banks in order to focus on the biggest risks to society. Regarding reporting requirements, perhaps there is scope to differentiate further in future. If so, this needs to be done in a sophisticated way – ensuring that only the least risky banks have reduced reporting requirements.
Regarding decision-making processes, our goal in designing European banking supervision has been to prevent the ECB from becoming a centralised “dictator” within the decision-making process. We have instead sought to honour the subsidiarity principle throughout our system. We are gradually incorporating an approach of seamless collaboration between the ECB and national authorities that applies across all our activities. This, I believe, is the right approach to supervising a €27tn banking sector.