Exchange of views on the banking reform package with the Finance and Treasury Standing Committee of the Senate of the Republic of Italy

Introductory statement by Ignazio Angeloni, Member of the Supervisory Board of the ECB, Finance and Treasury Standing Committee of the Senate of the Republic of Italy, Rome, 28 June 2017

It is a pleasure to be back in the Senate and to contribute to the work of this Committee.

The ECB, as the single supervisory authority, has been invited to comment on the European Commission proposals for revising the banking reform package. Our view on these proposals will thus be the first topic of my remarks. I would also like to take the opportunity to reflect on the procedures for managing crises – procedures which have recently been put to the test for the first time.

Assessment of the banking reform package from the ECB’s perspective

The European institutions (the European Commission, the EU Council and the European Parliament) have been engaged in recent months in the first review of the new European banking legislation. This review is important for various reasons. Supervisory activity must be constantly and firmly based on the existing legislative framework. It follows that good quality legislation is a necessary condition for effective supervision. Since the European legislative framework is relatively new, having been issued or completely overhauled after the financial crisis, it is essential to review it in the light of recent experience. It should also be considered that the legislation was introduced before the start of banking union; this is therefore the first opportunity to adapt it, where needed, to this new reality.

The European Commission issued its proposals last November, and in recent months the ECB has had an opportunity to examine them at the technical level. A formal legal opinion of the ECB is being prepared and will be issued shortly. Moreover, Danièle Nouy, Chair of the ECB’s Supervisory Board, made comments on the banking reform package during a recent hearing at the European Parliament. My remarks will be based on the technical work and those comments. The forthcoming ECB legal opinion will provide more details.

Positive assessments

The Commission proposals contain many useful elements. I would like to highlight some of them in particular.

First, the amendments implement important international regulatory standards in European legislation. Among them are the net stable funding ratio (NSFR), the leverage ratio and the fundamental review of the trading book (FRTB). In the currently applicable CRR, the first two of these instruments (the NSFR and the leverage ratio) are expressed in general, non-binding terms. With regard to the FRTB, the Commission’s proposals modify both the standardised approach and the internal models-based approach for risk assessment, increasing their risk sensitivity. Such innovations thus move in the right direction towards a prudential approach more attentive to risk; it is therefore important to maintain consistency with international standards.

With reference to the Bank Recovery and Resolution Directive (BRRD), the Commission proposes to modify the banking resolution instrument. This entails first the transposition of international standards on total loss-absorbing capacity (TLAC) and the review of its European counterpart, the minimum requirement for own funds and eligible liabilities (MREL). The creation on banks’ balance sheets of these resources for the absorption of losses marks a further step, now being taken worldwide, towards minimising the use of public funds in managing banking crises. On another front, the proposed amendments also introduce for the single supervisory authority moratorium powers (temporary suspension of payments which might be necessary at certain stages of the crisis). Here too, the amendments aim to strengthen the supervisory instruments and make them more effective, thereby boosting the resilience of the banking system.

The Commission proposals further harmonise the insolvency ranking of creditors by creating a new category of non-preferred senior bank debt. This is a new way to comply with the TLAC standard and the MREL. This newly created asset class lies between the existing subordinated debt (Tier 2 and Additional Tier 1) and the more senior preferred liabilities, including deposits. The latter, having a higher position in the creditor ranking, would therefore become safer. Harmonising this matter serves to increase comparability and the equal treatment of investors and banks in different EU countries. It is important for this reform to get under way soon in order to give certainty to banks as they adapt themselves to the new MREL.

Allow me here to cover an important point. We believe that, in addition to the Commission’s proposals, preferential treatment for all depositors should be introduced in the creditor ranking. The current rules already offer a preferential position, in addition to the deposits protected by national guarantee schemes, also for the deposits of natural persons and small and medium-sized enterprises (SMEs) for the part exceeding the protection threshold. Bank deposits play a central role in the payment mechanism, and thus their contribution to a well-functioning economy justifies a higher degree of protection. A generalised preferential regime for all depositors would help to strengthen the effectiveness of the bail-in, allowing the application to other debt instruments before deposits. The risk of contagion linked to the bail-in of the latter is thus reduced.

The proposals also relate to the kind of presence in the euro area of banks established outside the EU. This is an issue of great importance, especially following Brexit, in preparation for which many banks which offer banking services from London using the European “passport” are taking steps to set up subsidiaries on the continent. The Commission duly proposes the mandatory establishment on EU territory of an intermediate parent undertaking (IPU), which, for large institutions, will ensure supervision of all their activities by the SSM. The IPUs should also include major subsidiaries to avoid easy circumvention of the regulations (the subsidiaries are in fact subject to national supervision).

Finally, we support the proposal to grant capital and liquidity waivers within banking groups operating on a cross-border basis within the EU. This promotes the efficient management of resources within the group, fostering banking integration. If enacted prudently, such waivers do not run counter to financial stability.

Critical areas and possible improvements

In our view, there are other areas where the Commission’s proposals could be improved. In some cases, in fact, they do not go far enough in promoting a level playing field in the euro area and do not equip the supervisor with the instruments it needs.

Referring to the Pillar 2 requirements of the legislation, the proposals restrict supervisory actions too rigidly in two key respects.

• The leeway to set such requirements is reduced. The Commission would like, in particular, Pillar 2 decisions to be governed by technical standards of the European Banking Authority (EBA). However, strict rules do not always allow the situations and risk types encountered in practice to be addressed. It is essential to keep such requirements flexible, especially in a banking sector with a wide variety of business models, practices and risk typologies as we have in Europe.
• The proposals also reduce the supervisor’s ability to collect information beyond regular reporting. Containing the statistical burden for banks is a commendable goal, but it should not limit the possibility of collecting essential information. For example, the ECB has recently conducted thematic reviews in the areas of bank governance and business models which would not have been possible with the constraints proposed.

Moreover, the proposals do not ensure an adequate harmonisation of the EU prudential framework, notably regarding national options and discretions. The single supervisor is faced with having to apply different legal frameworks in different countries when there are national discretions or differences regarding the transposition of the Capital Requirements Directive. Establishing a level playing field becomes impossible. If the legislator were to put such options and discretions in the hands of the supervisory authorities, the ECB could implement harmonisation at SSM level, as it partly did in 2016. (I referred to this aspect in an earlier hearing before this Committee).

The proposals do not clarify if and to what extent the supervisor has the power to make additional deductions from the regulatory capital in the event of risks not covered by the accounting rules. Prudential adjustments to capital are necessary to ensure that risks assumed by banks extending credit are appropriately reflected in the capital ratios. Greater regulatory clarity would give the supervisory authority more leeway to intervene to prevent a build-up of non-performing loans.

Finally, I would point out that the Council and the European Parliament have decided to fast-track the transitional measures to mitigate the impact of IFRS 9 on institutions’ regulatory CET1 capital. The new accounting rules will enter into force on 1 January 2018, however their impact on capital ratios would be reduced thanks to the ability of banks to apply the said transitional measures. As regards the latter, in our view their way of working should be simpler in nature and made mandatory to ensure comparability between banks, especially in the banking union.

The crisis management framework of the banking union

After the financial crisis, the assistance provided by European governments to the financial sector, especially banks, was very substantial. The European Commission estimates that the overall amount of financial aid granted to banks in the euro area over the 2008-16 period amounted to over €200 billion, or roughly 2% of the area’s GDP. The amounts have varied greatly between countries, with particularly high levels in Spain, Ireland and Germany.

As a result, concerns about the risks to taxpayers stemming from bank crises have increased. The reform of banking regulation implemented since then, at both the European and global levels, has aimed to shift the burden of bank rescues from taxpayers to the banks themselves and particularly, in varying degrees, to their shareholders, managers and creditors.

The European framework of reference is enshrined in the Bank Recovery and Resolution Directive (BRRD), which was approved in 2014 with the support of all Member States and which entered into force between 2015 and 2016. The Directive aims to ensure the orderly resolvability of banks without endangering financial stability or exposing taxpayers to excessive losses. It has been incorporated into Italian legislation through an Italian transposing act. Some key legislation is also contained in the Single Resolution Mechanism Regulation, which applies directly in the Member States.

Resolution is an alternative to normal insolvency proceedings (which are not suitable if banks provide essential services or “critical functions” that need to be preserved in the public interest) and state-financed bail-outs. In addition to the BRRD, the Commission issued guidelines, back in 2013, on providing State aid to banks; these remain in force and are applied in cases where the conditions do not exist for resolution to start.

The preparatory phase

The Directive governs the complete preparatory phase of the crisis management process. During their normal operations, banks are required to draw up recovery plans with actionable options, if difficulties arise, to restore their financial position. In addition, the resolution authorities must compile resolution plans which specify the actions to be taken in the event of failure. The ECB assesses the recovery plans of the significant banks after consulting the Single Resolution Board (SRB) and the latter prepares resolution plans after consulting the ECB.

If the financial position of a bank is deteriorating, the SSM Regulation grants the ECB instruments to provide a remedy, including, for instance, the possibility of asking banks to produce recapitalisation plans, to dismiss the management and appoint a temporary administrator, and to convene a meeting of shareholders and require the bank to draw up a debt restructuring plan with its creditors.

Crisis management and public intervention

Once the failure of a bank is deemed to be inevitable, the BRRD requires the competent authority to determine that the bank is “failing or likely to fail”. For the banks supervised by the ECB, this is a decision taken by the ECB’s Supervisory Board and confirmed by the Governing Council. Subsequently, the SRB assesses whether there are any measures aside from resolution which could prevent the failure within a reasonable timeframe and whether resolution is in the public interest in view of the bank’s critical functions and the risks to financial stability. If there are no alternative measures available and the intervention is in the public interest, the resolution authority will initiate resolution procedures using one of its tools: sale of the business to another bank, creation of a temporary bridge bank to operate critical functions, or separation of non-impaired assets from impaired assets and write-down of debt or its conversion into shares (bail-in).

Throughout this process, the European Commission (DG Competition) retains a critical role in all cases in which resolution action involves State aid. Resolution actions which entail State aid normally involve a bail-in of creditors, to the extent required. Even if resolution is avoided, recourse to State aid requires the prior sharing of burdens, limited to shareholders and junior creditors. The European Commission can also authorise, as happened in some recent cases, the reimbursement of selected categories of junior creditors for specific reasons, such as the improper sale of securities instruments.

The BRRD envisages the use of public funds in the event of resolution only after the creditors and shareholders of the bank have absorbed losses equating to 8% of its liabilities. In such cases, it is also possible to use the Single Resolution Fund to cover up to 5% of the bank’s liabilities. To ensure that banks’ balance sheets are drawn up in such a way as to absorb resolution costs, banks should hold a minimum amount of liabilities readily available for bail-in, i.e. the MREL as mentioned earlier. The SRB will establish the amount for each bank in the coming months.

The Directive also contains a number of safeguards to prevent financial instability or other undesirable or disproportionate effects of resolution.

The best known of these options is precautionary recapitalisation, which enables state funds to be injected to remedy serious disturbances in the economy and preserve financial stability. This arrangement, which is offered only to banks declared solvent by the ECB, avoids resolution and is subject to compliance with the European regulations governing State aid. The amount of public funds that can be used is limited to those needed to address a capital shortfall in an adverse stress test scenario; public funds cannot be used to cover actual or probable future losses. For the banks that it supervises directly, the ECB is tasked with confirming that a shortfall exists and determining its size. The principle of burden sharing is applied in all such cases.

The BRRD also offers the possibility of excluding or partially excluding certain liabilities from the bail-in. This power is at the discretion of the resolution authorities and must be justified by exceptional and specific conditions such as urgency, the need to ensure continuity of critical functions, or the risk of instability. However, as mentioned above, in order to be able to draw on public financial resources, 8% of the bank’s liabilities must be bailed in even if some instruments are excluded.

Lastly, the State can grant public aid as part of an orderly liquidation process. This option is limited to institutions that are not able to credibly return to long-term viability, and which should therefore be liquidated. In such cases the principle of burden sharing again applies.

Initial observations from recent experience

As you know, in recent weeks the crisis management framework of the banking union has been put to the test for the first time. The operations conducted are very recent, so I am not in a position to elaborate on any specific cases. However, I would like to make a few general comments.

1. My first observation relates to the timing of the crisis. The ECB is obliged to declare a bank to be “failing or likely to fail” if it is probable that it will be unable to meet its commitments within a short period of time. This may be the case for various reasons, for example because of a loss of solvency (capital ratios fall below the minimum regulatory requirements) or because of a liquidity shortage linked to deposit withdrawals. Both situations have occurred recently, but the timing was different: very quick in the case of outflows of deposits and often slower in the case of insolvency, particularly if liquidity support is provided in the form of public guarantees for bond issuance (a type of assistance that has to be authorised by the Commission). In the latter case, it is crucial that the moment of insolvency is defined correctly.
2. My second observation relates to the functioning of the procedures and the level of preparedness shown by the authorities. Various observers have in the past highlighted the risks associated with the fact that the procedures are new and complex as well as with the number of bodies involved at both national and European level. Their concerns related to the ability of the national and European authorities to coordinate effectively and to successfully conclude a resolution in a short period of time, as is always the case in a banking crisis (usually within a weekend, sometimes less). In this regard, the results have been satisfactory. The authorities involved (the ECB, the Single Resolution Board, the European Commission and national authorities at various levels) activated effective and rapid methods of communication and coordination. From an operational perspective, the procedures were conducted successfully.
3. A fundamental issue, raised many times by observers critical of the European system, relates to the fact that the new rules, by limiting the scope for state support, could themselves be a cause of instability, resulting in a crisis of confidence among depositors and in contagion from weaker banks to more solid ones. It is too early to express a definitive judgement on this risk, but if a conclusion can be drawn from our experience so far, it is that the danger of destabilising contagion has not materialised in the cases observed. What we have observed instead, in various instances, is that the loss of confidence by depositors and investors in the banks that were perceived as weak was accompanied by a strengthening, not a weakening, of the competitors that were perceived by the market as stronger, particularly in terms of liquidity flows. In the financial market, the impact on the value of listed shares and subordinated securities has been specific and not general. This information is important because it shows that the market mechanism in the banking sector is essentially working correctly. This mechanism leads to the strongest institutions being identified and indirectly contributes to the strengthening of the system as a whole.
4. The risks to stability feared by some with regard to the new European rules depend mainly on the impact of any bail-in, or its watered-down version (burden sharing), on less sophisticated investors who have subscribed to risky financial instruments. In previous years, these types of instrument were purchased at the retail level in various euro area countries. Data produced by the ECB show that the amounts, while reduced, remain considerable in some countries and, above all, in Italy. It is important for banks to be proactive in checking the actual figures and, if possible, to facilitate the reallocation of these instruments to professional investors. Since the presence of such securities in the portfolios of less sophisticated investors can objectively hinder the resolvability of certain intermediaries, the authorities are interested in this issue and can take useful coordination and stimulus action.
5. Lastly, many people are now asking themselves what consequences the approach chosen to liquidate the two banks in Veneto could have on the European rules and on the future development of banking union itself. It should be said straight away that the measures were taken in compliance with the European rules, as explained in the press release published by the Commission last Sunday. Nevertheless, in recent days many observers, including respected European and Italian ones, have expressed concerns that the liquidation at the national level, which was applied for the first time to significant banks directly supervised by the ECB, may constitute a precedent that could allow the rules to be circumvented in the future. This criticism, including in terms of public perception, needs to be taken seriously. Banking union is not yet complete and is therefore vulnerable. Its completion is in everyone’s interest, but everyone must also have confidence if it is to be accomplished in full. Confidence should be strengthened. It would definitely be useful for the Commission to conduct a systematic study on this experience, taking into account the legislative review currently under way.

Concluding remarks

I would like to conclude by thanking this Committee for its interest in issues relating to the regulatory framework of the European banking sector. The sound functioning of the sector profoundly affects the lives of everyone in Europe in ways and at times that are not always easy to understand. Both national parliaments and the European Parliament can play an important role in fostering this understanding and supporting the banking authorities – at both the national and the European level – in the performance of their duties.

The banking union, which has been in place for about three years, has already improved the quality of supervision by fostering standards that are more rigorous, transparent and consistent at the international level. The legislative review currently under way represents a significant opportunity for further progress, and it should not be missed. No matter how effective supervision may be, bank weaknesses and failures can never be ruled out altogether. This is why an effective and smooth crisis management framework is essential. Initial experience confirms that the system in place allows emergency situations to be handled in an effective and timely manner. There is room for further improvement.

Finally, I would like to mention that the European Commission is conducting a thorough review of the performance of European banking supervision so far. Its work is due to be published soon, and this will give parliaments and the general public another opportunity to gain an understanding of the ECB’s supervision function and assess how it has performed. This should also enhance transparency and democratic accountability.

Thank you for your attention. I am now at your disposal for questions.