A penny for your thoughts – what’s on the mind of a supervisor?

Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB, at the Handelsblatt conference “Banken im Umbruch”, 6 September 2017

It has almost become commonplace to say that these are bad times for bankers. Still, it remains true. Particularly in Europe, banks face a whole series of challenges. They have to deal with legacy assets; they have to comply with tighter rules and tougher supervision; they have to adapt to new technologies; they have to fight off new competitors; they have to make the most of low interest rates; and they need to regain the trust of the people.

So how might this scenario play out? The easy answer is this: some banks will take action; they will adapt to the challenges, they will survive and prosper. Other banks won’t. In a nutshell, that’s how things usually work out in a market economy. It favours those enterprises that offer the best services to customers in the most efficient way.

But is it really that easy with regard to banks? And why should a supervisor care? Well, in fact, competition among banks is a bit more complex than I just implied. It is riddled with distortions, and it is closely linked to stability. That’s why supervisors should care. They must, together with regulators, ensure that the banking sector is both competitive and stable.

So let us take a closer look at these issues. How does competition in the banking sector work? How does it affect stability? And what is the role of regulators and supervisors?

Competition in the banking market – how it works

In 1935, the British economist John Hicks said: “The best of all monopoly profits is a quiet life”. What did he mean? Well, a company that has monopoly power does not need to offer excellent services at the lowest costs. Instead, it can settle for something less and enjoy a quiet life. The drawback is, of course, that it inevitably becomes inefficient.

Turning the story around, it could thus be argued that competition preserves efficiency. A company that has to compete with others cannot enjoy a quiet life. It must try to maintain or improve the quality of its products or services and, at the same time, control its costs. It must remain efficient. That also applies to banks, of course. And empirical evidence indeed shows that competitive banking markets are more efficient.^[1]

This is closely linked to another factor. To gain a competitive edge, companies must also be innovative. This is what Joseph Schumpeter meant when he coined the term “creative destruction”. New products and processes continually displace old ones; competition becomes a key driver of progress.

For banks, that can cut two ways, though. Some innovations have made life better, that’s for sure. Just think of ATMs or online banking. But then there have been innovations with more questionable outcomes. Just think of all the fancy financial instruments that played a big role in the crisis.

And this begs the broader question: how does competition in the banking sector affect stability? And to disappoint you right from the start: there is no clear answer.

Some people argue that competitive banking markets are less stable. This view goes back to the 1980s, when countries all over the world were starting to liberalise financial markets. And since then, it’s true, we have seen quite a few crises – from the US savings and loan crisis in the 1980s to the global financial crisis that started in 2007.

But why should competitive markets be less stable? Well, ill-considered innovations are just one of the issues in this regard. More generally, banks in a competitive market have smaller profits. They are thus less able to build up buffers, and that makes them less resilient.

At the same time, lower profits might induce banks to behave less prudently. This is made easier by asymmetric information. Depositors, for instance, often don’t know how banks invest their money. This leads to moral hazard. Banks invest other people’s money and might thus be tempted to take on too much risk. This is more likely in highly competitive markets where profits are low and the search for yield is a seemingly easy way out.

And then there is the issue of knock-on effects. In highly competitive markets, some banks will fail; that’s inevitable. However, if these banks are big enough, they can bring down the entire system.

These and other arguments suggest that competition must be bad for stability. But is that really true? Here, it’s worth recalling a famous remark by former US President Harry Truman. He said, in a moment of frustration: “Give me a one-handed economist…All my economists say, ‘on the one hand… on the other’”.

Indeed, it can also be argued that competition is good for stability. In less competitive markets, for instance, banks can charge higher interest rates. This in turn might encourage borrowers to take on greater risks.

So we can argue both ways when it comes to competition and stability. And not even empirical evidence can help us find an answer. Some studies show that competition leads to instability.^[2] Other studies say the opposite.^[3] So all in all, it is a complex question with no clear-cut answer.

One thing is evident, though: regulators and supervisors play a key role in this regard. They have the power to facilitate competition and preserve stability at the same time. It is up to them to rein in the distortions that are inherent in banking, and that make for the complex interplay between competition and stability. Let us take a closer look.

Competition in the banking market – setting the right conditions

The first thing to consider is market access. The easier it is for a new company to enter a market, the more contestable that market becomes. Incumbents are kept on their toes by the threat of new companies encroaching on their turf, serving customers better and more efficiently.

But in banking, market access is far from costless. New banks must clear many hurdles before they can begin to operate. Some of these hurdles are technical, others are financial. And some of them are regulatory.

These regulatory hurdles are necessary, but they require regulators and supervisors to strike a balance. On the one hand, they must ensure that only sound banks enter the market; the hurdles have to be high enough. On the other hand, they must ensure that the market remains contestable; the hurdles must not be too high. And on top of that, they must be the same for all in order to ensure equal opportunities.

But the conditions for market access are not set in stone. In fact, they have been changing for some time now. The main driver of this change is technological progress: digitalisation is taking apart the value chain of banking. This enables new companies to emerge which offer very specific services. They no longer have to set up fully fledged banking operations. The technical and financial hurdles have become a bit lower; the market has become more contestable.

Regulators and supervisors have to react to these changes, of course. And that’s what we do. At the ECB, we are, for instance, devising a guide on licensing that also covers fintechs. This guide will be published shortly for the purpose of a public consultation.

Once a bank has entered the market other things become important, such as the need for a level playing field. Competition can’t be fair if the playing field is uneven. And here, we have made some progress in Europe.

First, we have the single rulebook. Banks across Europe have to comply with the same rules. Second, we have European banking supervision. Banks across Europe are supervised according to the same standards. All this helps to level the playing field and support fair competition. And most importantly, it ensures fair competition on a market that spans the euro area.

Still, we are not quite there yet; the playing field is still uneven in parts. Neither regulation nor supervision has been fully harmonised. This is an issue policymakers must address if they are serious about creating a European banking union.

And one could even go further. Tax systems and insolvency laws, for instance, differ widely between countries. This, too, stands in the way of a competitive, efficient and truly European banking market.

But it is not just about a level playing field. We must also weaken the link between competition and stability. And here, too, we have come a long way. Take capital rules as an example. Banks must now hold higher capital buffers than ever before. Thus, even when competition gets fierce, capital buffers cannot be driven down without causing supervisors to react. The European market is a case in point. It is highly competitive, yet capital buffers have increased quite a lot over the past few years.

At the same time, we follow a risk-oriented approach when supervising banks. We can detect at an early stage excessive risk-taking that might be the result of fierce competition and rein it in.

What supervisors and regulators are striving for is a well-functioning market – a market that is efficient and stable at the same time. But there is one thing we still need to discuss: failure.

And just to be clear about one thing: supervisors help to make banks more resilient. But it is not their job to prevent each and every bank from failing. For a market to work, companies must be allowed to fail. As the economist Allan Meltzer said: “Capitalism without failure is like religion without sin. It doesn’t work well.”

However, in the banking market, the issue of failure is a bit tricky. If things go wrong, a failing bank might cause the collapse of the entire financial system and hurt the economy. Against this backdrop, failure might be seen only as a second-best solution.

During the crisis governments around the world opened their coffers to prop up stumbling banks. They did not do that out of love for the banks, that’s for sure. They did it to protect the financial system and the economy.

The long-term consequences are profound, though. First, bank rescues blew large holes in government budgets – money that could have been used to build schools, roads or hospitals. Second, bank rescues set all the wrong incentives.

They provided banks with an implicit and costless public insurance. The banks knew that they would not be allowed to fail. This in turn allowed them to gamble and take on high risks. They would earn the returns; taxpayers would foot the bill if things went wrong. In that regard, the market was dysfunctional.

So there is only one solution. To ensure a competitive and stable banking market, banks must be allowed to fail without disrupting the financial system. This is probably one of the most important lessons of the crisis.

And policymakers have learnt that lesson. In Europe, they have set up a legal and institutional framework: the Single Resolution Mechanism, SRM for short. The SRM ensures that banks can be resolved in an orderly fashion.

At the heart of the new framework is the “bail-in”, which contrasts with the “bailout” we saw during the crisis, when banks were saved with taxpayers’ money. From now on it will be shareholders and creditors who bear the costs when a bank fails. It’s they who make the gains in good times; it’s they who have to accept the losses in bad times.

This protects taxpayers and improves market discipline. Banks must realise that they will no longer be rescued. That should make them act more responsibly and manage their risks more effectively.

Likewise, investors must know that under the new regime, they might lose their money. That should make them invest more cautiously and keep a closer eye on what the banks are doing.

Most of all, this is relevant for retail investors. They should refrain from investing in bank bonds or other instruments that could cause them to suffer large losses. This is as much a question of sound selling practices on the side of banks as of financial education on the side of investors.

Now, the SRM was designed some time ago. However, it only recently underwent its first test when three euro area banks failed. And I’m glad to say that the mechanism passed the test.

The process of dealing with failed banks worked smoothly. And that is a major success given that each bank failure is a complex event which has to be handled by many parties. It seems that, for once, many cooks did not spoil the broth. On the contrary, the ECB, the Single Resolution Board, the European Commission and the relevant national authorities cooperated closely and effectively.

And, equally important, there were no knock-on effects. The failures did not harm the financial system.

Still, there are lessons to be learnt from the recent bank failures, of course. And we will make good use of the current review of the legal framework to improve what needs to be improved.

But most of all, we need to set up the third pillar of banking union: a European deposit insurance scheme. As a general idea, deposit insurance is widely accepted. It protects depositors from losses in the wake of bank failures. And it protects against bank runs, which threaten not only weak banks but sound ones as well. Thus, deposit insurance is a core element of regulatory frameworks around the world.

But deposit insurance at European level has still not been set up. In my view, it is overdue. Banks are now supervised and resolved at European level, so it makes sense to have deposit insurance at that level as well. That would be another step towards an efficient, stable and truly European banking market.

Conclusion

Ladies and gentlemen,

There is no doubt that we need a competitive banking market. It keeps prices low and the quality of products and services high. It expands choice for customers and it spurs innovation. And we all know that an efficient banking sector is a critical prerequisite of a healthy economy.

Still, when we talk about competition, we also have to talk about stability; they are closely linked. And it is the task of regulators and supervisors to ensure that the banking market is both efficient and stable. To achieve that goal, they have to set up a carefully balanced framework.

In my speech I have touched upon a few of the things that need to be covered by such a framework. To judge by the recent crisis, the most important factor is that banks must be allowed to fail without disrupting the market. And here, we have made good progress. The new European resolution framework has passed the test.

Of course, we are not quite there yet. There are still things that have to be improved – just think of the need for a European deposit insurance scheme. Still, we are making progress towards an efficient, stable and truly European banking market that can reliably serve the economy.

Thank you for your attention.