Enhancing the environment for banking competition

Keynote address by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the FIBI International Banking Conference 2017, Dublin, 22 June 2017

Today I want to speak to you about the state of competition in the European banking market.

My starting point is that, overall, competition in the banking sector benefits both consumers and society as a whole. This could be considered a controversial statement. There have been long and heated academic discussions on the perceived trade-off between banking competition and financial stability. The counterargument is that intense banking competition can lead to a race to the bottom in terms of banking stability.

However, I would argue that this problem can be avoided by providing a robust prudential environment. This can allow the well-known advantages of competition to be achieved in the banking sector, such as value-adding innovation, a wide range of competitively priced products, and resources shifting over time to the most efficient providers. The benefits of such competition will be greater if supervisors and regulators avoid micromanaging banks and give them leeway to compete in various respects, going beyond simple cost efficiency.

I will begin today by discussing the recent history of banking competition in Europe. I will then move on to outline what the necessary elements are for the “strong prudential environment” I refer to – which allows competition to thrive whilst also providing stability and safety.

Finally, having explained that both competition and stability can be achieved simultaneously, I will make some suggestions on how to improve banking competition further. I will emphasise the importance of good banking governance. In an environment where banks are well governed, bank supervisors can be confident that banks are managing their risks. This allows us to step back and give them more room to innovate.

Banking competition in Europe – recent history

So how has competition in the euro area banking sector developed over recent years?

Evidence from recent history is generally disappointing for those of us who see major benefits from vibrant banking competition. The trend has been towards market concentration at euro area level.

A traditional measure for market concentration is the Herfindahl index[1], which has increased in the euro area from below 650 in 2005 to 722 in 2015. In other words, a clear increase in concentration has occurred.

Other measures tell the same story. The combined market shares of the five largest banks have increased – both at euro area level and, in most cases, also at national level.[2]

Likewise, pricing data on interest rates also suggests that there has been no major recent improvement in the degree of contestability of national banking markets across the euro area. Interest rate dispersion increased drastically during the crisis and only began to decline in 2013. In a frictionless market, the interest rates on similar products across different countries should be the same. The observed dispersion therefore suggests that obstacles to competition still exist in the European banking sector.

Obstacles to competition

So let us take a moment to consider what the obstacles to competition could be.[3]

Before the crisis, diverging national rules and national supervisory practices made it difficult for competition to flourish across the euro area because it was costly for banks to compete across borders. On a positive note, the creation of the single rulebook and the progress made towards the banking union are significant steps forward. But further harmonisation is still possible, as I will explain later.

When the crisis hit, the nationally oriented system for regulating and supervising banks faced extreme challenges. As taxpayers ended up bailing out international banks, pressures understandably grew for banks to remain behind national borders. This diminished the contestability of markets. In addition, the crisis meant that some banks simply disappeared, either via liquidation or, more often, through forced mergers with their competitors.[4]

Since the crisis, banks have faced the difficult task of cleaning up their balance sheets. This process is still ongoing, and banks in some countries are finding it quite hard to cut their stocks of non-performing loans (NPLs). Such a situation reduces competition, as weak banks are not strong competitors in the market. In my view, banks should not and must not wait for the public sector to provide an overarching solution to this problem. The sooner they take bold and proactive steps to reduce their NPLs, the better it will be for everyone.

Overall, as a result of these factors we are seeing a post-crisis environment in which competition has, to some extent, decreased.

The implications of banking competition

Let us now briefly consider why some people worry about banking competition and why it may negatively affect stability.[5] When bank owners and managers have a cap on the losses they are exposed to, and when their balance sheets are opaque to outsiders, they have an incentive to take excessive risks. When competition in the banking market intensifies, this incentive may become stronger.

The “charter value hypothesis”[6] is particularly relevant in this context. Put simply, when competition is limited, the value of a bank to its shareholders will be high – as it can use its market power on an ongoing basis to make large profits. In such circumstances, bankers will act prudently in order to protect the bank from failure and its associated charter value from destruction. As competition increases and market power falls, the charter value of the bank also falls. This leaves bankers with less to lose from taking on more risk.

Banks in competitive markets may therefore be emboldened to operate in a risky manner. This could, for example, mean that they invest in too many risky projects, hold too little capital or operate with liquidity buffers that are too low.

Prerequisites for a strong banking market

These are legitimate issues to consider. However, I believe that the potential concerns about banking competition can be overcome by imposing an appropriate regulatory and supervisory environment. Three key elements are needed for this, in my view.

First, prudential rules on capital and liquidity should be easy to understand and internalise, and supervision of compliance with these rules should be robust.

Second, the regulatory and supervisory framework should be risk sensitive. This means that it should be to some extent dynamic, ensuring that banks which are pursuing riskier strategies face higher capital requirements and pay more for their deposit insurance. Notably, this is what European banking supervision now ensures – our Pillar 2 capital requirements impose varying requirements on banks, depending on their risks. Risk sensitivity also means that the banks that represent the biggest systemic risks to the economy should face tighter rules.

These two elements are crucial to ensure that banks do not have an incentive to compete with one another by simply taking higher risks on to their balance sheets.

Third, and maybe most crucially, there needs to be a credible resolution regime in place to ensure that all banks understand that they can be forced out of business if they fail, and that the losses associated with bad investments will remain in the private sector. Such a resolution regime is complemented by a strong state aid framework – which protects competition by providing deterrence against the temptation of bailing out failing banks.

A credible threat of failure is fundamental to achieving a healthy, “creatively destructive” market that works to improve outcomes for consumers and society. Other industries have similar market disciplines, and there are no good reasons why the banking sector should be different!

I think that, to a large extent, the crisis has taught us rather well what is needed for a healthy banking framework. We had to catch up, but in my opinion we can now credibly say that good progress has been made in achieving each of these elements.

Indeed, in thinking about that progress I am reminded of a recent conversation I had with the founder of a start-up in the European banking market. An engineer by background, he told me that he found it amazing how much bankers complain about the regulatory environment. Having founded a company that met the criteria to enter the banking market, he discovered that the system treated it in the same way as the incumbents – wherever they were across Europe. He said that in the engineering sector it was very difficult to gain the same status as competitors, so perhaps banking regulation is not too bad after all!

To sum up this section I would say that, given the steps that have been taken since the crisis, we can be fairly optimistic about the positive payoffs to society of strong banking competition. It is important to take signs of anaemic competition seriously, and to think about what can be done to foster competition in our banking sector.

How to foster the right type of banking competition?

What steps might be useful for promoting healthy competition in European banking? I will simply make three suggestions.

First, there needs to be a level playing field to allow well-functioning and well-managed firms to compete across borders and bring their services to a broader group of customers. This boost to competition will tend to increase the range of choices available to customers and will drive banks to improve quality and pricing.

Major strides have been made in harmonisation. In particular, the banking union entails a single supervisor with a single supervisory approach. Progress has also been made in harmonising the single rulebook for banking regulation across the EU. These elements have reduced the frictions that deterred banks from conducting cross-border business.

However, more could be done. There are still too many differences between national banking regulations, and more work is required to harmonise our European rulebook. The banking union should also be deepened, ideally with the addition of a European deposit guarantee scheme. This would be a logical step towards aligning the resolution financing elements of the banking union with the supervisory responsibilities, at European level. Misalignment between these elements is unsustainable in the long run and can create perverse incentives in the supervisory decision-making process.

Second, banks and supervisors should improve the quality of basic bank governance. This means that bank management boards must be well run – they should have access to good-quality information, they must be independent, and once board decisions have been taken they must be acted upon by senior managers. Boards must also set the right tone for the institution – building a strong ethical business culture, including by rewarding the right behaviours.

These things sound obvious, and perhaps they are. But obvious things are not always implemented! Moreover, when the governance of a bank is weak, strong prudential rules cannot necessarily protect us from the risk of a bank failing. For example, if a lack of control leads to irresponsible decisions on lending, and if data systems are too poor to effectively monitor risks, the problems a bank will face may already be too big to fix by the time that the issues are brought to the attention of supervisors. That is not because we supervisors are slow or out of touch, it is just the reality of the situation. Supervisors are always playing catch-up with the day-to-day decisions that are taken by a bank. This is one of the reasons why banks must be well managed – it is the boards who must take responsibility for overseeing the risks and shaping the business model of their institution.

Of course, the importance of good governance is not unique to banking – other industries must also be well run in order to be successful. However, given the potential negative spill-over effects to society from bank failures, the quality of governance in our sector is particularly critical.

For these reasons, since 2014 European banking supervision has been pushing for improvements in governance throughout the banking union. For example, we have strongly emphasised the scrutiny of governance frameworks within our Supervisory Review and Evaluation Process (SREP), which is our most important tool for supervising banks and forms the basis for bank-specific capital add-ons. Governance is one of the four key pillars of this process. Where deficiencies in governance are identified, the SREP process ensures that improvements are sought, and that higher requirements are imposed where needed. Indeed, as the SREP process repeats annually - it also provides a structure for verifying that governance improvements are achieved.

In addition to this, we have undertaken a rigorous thematic review of governance practices across the banking union. This feeds into the SREP process by building up a knowledge base on banking governance best practices. In turn, this provides a framework for judging bank performance in a harmonised way. With these tools we are making progress in improving banks’ capacity to take full responsibility for managing their risks.

I have already dwelt for quite some time on governance, but with good reason. The most important way to improve governance is to emphasise the responsibility and legal liability of the top management, in particular the management board.

And we should also recognise that the lessons of the past, so dearly learned, so evident and undeniable at the time, fade surprisingly quickly from the collective memory of senior bankers.

Once supervisors are convinced that the governance of a bank is competent and prudent, they can have confidence that the bank can be allowed more room to breathe. With such conditions in place, we can then step back from imposing constraints on the bank’s entrepreneurial creativity. Such a move could be positive for competition, which would also be positive for competition and positive for society.

My third and final suggestion for promoting competition is that the rules must be risk sensitive, meaning that banks are subject to requirements that are proportionate to the risks they pose to society. One area where progress could be made is reducing regulatory requirements in the case of banks that clearly represent a lower risk to the system.

As I said in Lisbon earlier this month, we need to carefully identify those banks that would fit into this category. And we need more than a simple size criterion. That would overlook the fact that small banks can also generate large risks for the economy. I therefore continue to favour an approach resembling that proposed by Thomas Hoenig, whereby multiple criteria are applied in order to capture risk in a more robust and sophisticated manner.[7]

It is entirely appropriate to “reward” genuinely low-risk banks with lower regulatory and supervisory burdens. This helps to set the right incentives – in a competitive market, the opportunity to work under reduced regulatory burdens will encourage banks to reduce their risk profiles. Similarly, such a regulatory design gives existing low-risk banks more scope to compete on fair terms with other, riskier banks in the market.


To conclude, I will leave you with three thoughts to contemplate.

First, it would be a positive step to increase the cross-border provision of banking services in Europe. It would increase competition in each local market, meaning more options for consumers, better quality services and more competitive pricing in the long term. I would therefore like to see, over time, an increase in the number of cross-border bank mergers in Europe.

Second, I want to reiterate the importance of good governance as a driver of banking competition. Banks that can demonstrate effective ownership and management their risks can be trusted by supervisors to take more of their own decisions on the shape of their business. They can then innovate and find new ways of providing attractive services to customers. We supervisors recognise that this is what a well-functioning market looks like – it is in the interests of all sides for governance standards to be high in order to allow this to become a reality.

Finally, I want to clarify my view on how best to split the roles of the public and private sectors in this industry. We as supervisors aim to make sure the market works in the interests of society. This means it must be safe, it must be fair, and it must ensure that failed banks exit the market. The rest of the work is then down to the private sector. With market discipline in place, banks must find for themselves the best and most cost-effective ways to give their customers what they want. I encourage banks to be bold and innovative when striving for higher productivity and better customer service. I wish them good luck in this endeavour, and I look forward to seeing the fruits of their creativity.

Thank you for listening.

[1] The Herfindahl-Hirschman Index (HHI) is the sum of the squared market share of each firm in a market. An index of 10,000 indicates that there is only one firm.

[2] See Section 2.1.3 of the Report on financial structures, ECB, October 2016.

[3] For information on this topic, see: Is Europe Overbanked?, ESRB, June 2014.

[4] The number of credit institutions and foreign branches in the euro area fell from over 6,000 in 2008 to 4,769 in 2015.

[5] For a more comprehensive look at the relevant academic issues, see: Bank Competition and Bank Supervision, speech by I. Angeloni, 4 July 2016; and X. Vives, Competition and Stability in Banking: The Role of Regulation and Competition Policy, Princeton University Press, 2016.

[7] For details on the full proposal, see his Term-Sheet of Regulatory Relief Recommendations for Traditional Banks, April 2015.

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