Progress and developments in European banking supervision
Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB, 18. Handelsblatt Jahrestagung on European Banking Regulation, Frankfurt, 24 November 2017
Earlier this month, European banking supervision turned three. And compared with its previous birthdays, this one did not receive very much attention. For a three-year-old child, that would have been a cause of unhappiness. But for a large European institution, it was a good sign, in my view.
It shows that the initial excitement has worn off. European banking supervision has become widely accepted – both as an idea and as an institution. Attention has now shifted away from its age, its organisation and its methods. Instead, the focus now lies on the essence of supervision: banks and their risks and challenges.
Still, I will take this opportunity to reflect on the past three years – not in detail, though, as we should look to the future, not dwell on the past. And I will look more closely at the content of supervision, not its methods.
European banking supervision – it never stands still
It is fair to say that European banking supervision has become a game changer. It has replaced 19 different national supervisory regimes with a single European one.
It aims to perform the same tough and fair supervision for banks right across the euro area. This approach, in turn, should make banks safer and sounder, contribute to a level playing field and help to create a truly European banking market.
Looking back over the past three years, we have come much closer to these goals. Most of all, we have achieved the desired European approach to banking supervision.
Take as an example the Supervisory Review and Evaluation Process, SREP for short. Thanks to it, banks across the euro area are now supervised consistently and according to the same high standards. And the effect is obvious. Since 2014, the correlation between SREP scores and supervisory capital requirements has almost tripled – from 26% to 76%.
In harmonising the methods, standards and tools of banking supervision, we went far beyond the SREP, of course. We also dealt with on-site inspections and internal models, fit and proper assessments and the recognition of institutional protection schemes, to give you just a few examples.
In short, we have designed and developed all the ways and means of attaining a specific goal: safer and sounder banks. This is what we have worked towards since day one – even before day one to be precise. In the months preceding the formal creation of European banking supervision we conducted a comprehensive assessment of the large euro area banks. This exercise allowed us to take a close look at the true state of the banks and it thus served as a starting point for our supervisory work on issues such as non-performing loans.
But our work was not just defined by what we discovered during the comprehensive assessment. It was and is also very much defined by what happens in and to the banking sector. And if there’s one thing we can be certain of, it’s that there’s always something happening. There will always be new risks and new challenges. In our second year, for instance, we were suddenly confronted with Brexit, which required a wide-ranging supervisory response. And this year, we were involved in handling the failure of three large banks – the first test of the new European resolution framework.
The fact that European banking supervision managed to deal with all this shows that it has become a mature institution. It can react to any new risk or challenge – quickly and effectively.
The same should go for the banks; they too have to react quickly. And this brings us to the second part of my speech: the European banks, their challenges, and how to deal with them.
But my story begins in another time and place.
European banks – they need to act sustainably …
On Easter Sunday 1722, a Dutch explorer set foot on an island in the Pacific, which he aptly named Easter Island. And he was fascinated by it. What he found on the island were almost 900 giant statues made of stone.
However, these statues also posed a riddle. To build them, the islanders would have needed tools. And to make these tools, they would have needed wood. Alas, there was not a single tree to be found on the island.
As you can imagine, the mystery of the statues sparked many theories. One of these was put forward by Jared Diamond. He assumed that the islanders had cut down all the trees and thereby destroyed the ecosystem. As a result, the islanders could no longer find or grow enough food; hunger turned into famine and, eventually, war, leading to the collapse of their culture and way of life.
Because of this theory, Easter Island has sometimes served as a metaphor. It should remind us of the importance of preserving and protecting the world around us. Or, as we say nowadays, it reminds us of the need to act sustainably.
And we can stretch this metaphor a bit further. Sustainability plays a role not only with regard to our environment. It also applies to the economy. And it applies to the banking sector. Banks, too, need to act sustainably.
This has never been more obvious than today, for two reasons. First, we have just been through a major financial crisis. And this crisis was a stark reminder of what happens when banks fail to act sustainably. Prior to the crisis, banks focused on creating value for shareholders who were often more interested in the next quarter’s results. Short-term profits trumped long-term sustainability.
Second, banks currently suffer from a lack of profitability – many of them do not even earn their cost of capital. This lack of profitability has many causes, and each bank suffers in its own way. Still, there are some things which have an impact on many banks at the same time.
First of all, the euro area economy is overbanked, which results in fierce competition and low margins. Second, many banks have high operating costs, which further erode revenues. Then there are factors such as the prolonged period of low interest rates and technological change. These last two factors have made conventional banking less viable, which also contributes to the lack of profitability.
Banks thus have to choose which path to take. Do they want to stick to the traditional business model, which often depends predominantly on interest income and is comparably low-tech? Or do they want to adapt more profoundly, rethinking their business models to lay a solid foundation for sustainable success?
As a supervisor, I would like to see them take the latter path, of course. It is not an easy path, though, as they have to adjust to a complex and fast-moving environment. Let us take a closer look.
… and adapt to a complex environment
The first thing to bear in mind is that Europe is overbanked. I already said that this is one of the reasons why European banks’ profits are meagre. In addition to that, it makes the banking sector as a whole less efficient, and each individual bank more prone to unsustainable behaviour.
Thus, the European banking sector needs to consolidate. And it has done so to some degree. Since 2008, the number of credit institutions in the euro area has fallen by 25%.
Still, the European banking sector is quite large by international standards. And this begs the question of how Europe became overbanked in the first place. Normally, market mechanisms should have prevented that. Well, it seems that in the past, natural “valves” were blocked. Like on a remote island, banks could not easily move out of the market to ease “population pressure”. The fact was, banks often were not allowed to fail. Instead, they were bailed out by governments fearful of bank failures triggering a systemic crisis. Thus, weak banks stumbled on.
This has changed, though. In Europe, we now have a Single Resolution Mechanism for banks, SRM for short. The SRM allows banks to fail in an orderly manner without unleashing a systemic crisis. This new mechanism passed its first test earlier this year, when three large banks failed. These cases were handled efficiently and effectively. So, the good news is that the market mechanism now functions as it should.
But allowing banks to go out of business is not the only way to ease the problem of overbanking. Mergers and acquisitions are another option, although here, we have not seen much activity over the past few years. Mergers and acquisitions in the euro area fell steadily between 2007 and 2016. It seems, though, that during the first half of this year they picked up a bit – at least in terms of value.
The lack of mergers and acquisitions can be explained by several factors. General uncertainty seems to be playing a major role, for instance. Moreover, the fragmentation of the market along national lines has not favoured cross-border mergers. But the banking union has brought us closer to a truly European banking market. And this, in turn, makes cross-border mergers more attractive.
So, it is fair to say that the door has been opened to consolidation. From a systemic point of view, that’s good. For individual banks, however, it raises the stakes. They are now much more exposed to market forces; if they can’t keep up with their competitors, they might be forced out of the market. So the pressure on banks to rethink their business models becomes even greater. This is the only way for them to ensure sustainable success.
And the environment is changing quickly. Take technological progress. Digitalisation of banking gets a lot of attention these days, even though it is not a particularly new concept. Online banking, for instance, goes back to the 1980s. And today, almost 60% of Europeans use it. But it is still true that we have gone far beyond online banking over the past few years.
To a large degree, this is driven by a new breed of financial companies: fintechs. They take new technology as their starting point and apply it to banking. Just think of products such as instant payments, digital wallets, peer-to-peer lending, crowdfunding and robo-advice.
Such innovations make it easier for customers to compare suppliers and quickly switch between them. At the same time, the value chain of banking is being sliced up. It is no longer owned by one firm, but shared by many. This enables fintechs to offer highly targeted services; they don’t have to set up fully fledged banking operations to compete with banks. The technical and financial hurdles to enter the market have become a bit lower.
All this makes the market more contestable. Incumbent banks face new competition to which they need to react. And it seems that banks are starting to move. They are venturing further into digital banking, often in cooperation with fintechs.
Digitalisation has the potential to offer many benefits to banks. It could help them unlock new sources of revenue and reduce costs. But there are also risks. Cybercrime has become a major issue, and generic IT failures pose a threat as well. Against that backdrop, many banks need to invest more in order to update and upgrade their IT systems and make them more efficient and more secure.
We supervisors also have to deal with digitalisation, of course. For us, it is important that business models based on new technologies are sustainable, and that risks are well managed. Here, we follow the principle of “same business, same risk, same rules”. With this in mind, we are now finalising a guide for granting licences to fintechs.
Given all the challenges they face, banks need to act flexibly, decisively and with a strong focus on sustainability. All this becomes easier if they start from a sound basis, and that includes a strong balance sheet.
In this context, equity plays a key role: high equity buffers have put banks on a strong footing. The good news is that equity buffers have increased in recent years. The average CET1 ratio of large euro area banks has risen from 9% in 2012 to almost 14% today.
And more equity does not just make banks more resilient. It also changes their incentives. All things being equal, banks with more equity have more skin in the game. They stand to lose more if things go wrong. This in turn should encourage them to be more careful when taking decisions, to be more aware of risks and to act in a sustainable manner.
The benefits of such behaviour reach beyond the banks. High equity buffers reduce the costs of financial crises, for instance. Recent research shows that the more equity banks hold during a crisis, the faster the economy recovers afterwards. This highlights how important equity is – not just for the banks, but for the entire economy.
But having enough high-quality equity is just one thing. The other thing is, of course, to have high-quality assets. And that is not always the case. Non-performing loans, or NPLs, are the big issue here.
In some parts of the banking sector, we still see high stocks of NPLs. And that is a problem for many reasons. NPLs do not just weigh on profits and keep banks from lending to the economy. They also undermine trust in the affected banks and require constant attention by staff and management. The latter two points are of particular concern where staff and management also need to focus on adapting business models. Moreover, banks overburdened with NPLs will most likely not be able to profit from good business opportunities.
Against that backdrop, it is important to resolve the NPL problem. And some progress has been made. Since 2015, the ratio of non-performing loans in the euro area has fallen from around 7.5% to around 5.5%. However, this is just an average, of course. In parts of the euro area, the ratio is much higher – much too high.
Some banks need to do more to address their NPL problem. And in the light of the improving economy, I would say: if not now, when? It starts with the banks setting their own ambitious, realistic and credible targets. But supervisors also have a key role to play. Earlier this year, ECB Banking Supervision published qualitative guidance to banks on how to deal with NPLs.
With reference to that guidance, we have now scrutinised the plans devised by the banks. And we have started to provide feedback. The situation is very diverse, so we need to assess it on a case-by-case basis and find the appropriate solution for each bank.
Still, a sustainable solution must go beyond solving the problem at hand. It must also ensure that the problem does not reappear. To that end, we have just published for consultation an addendum to our guidance. This addendum sets out what we expect from banks in terms of making provisions for future NPLs.
The goal is clear and straightforward: banks must have adequate provisions in place. We have firm expectations on this, which we have now spelled out. But to be clear: what I am talking about here are supervisory expectations. There are no automatic actions attached to them. Our guidance provides the basis for a structured dialogue with each individual bank.
This is what supervisors can do and should do. Still, the problem of NPLs needs to be addressed at other levels as well. Let me give you just one example: when it comes to resolving NPLs in court, there are huge differences between euro area countries. In some countries, such procedures take considerably longer than in others. This is something that national governments can address. They can streamline judicial systems and speed up court procedures.
In a banking union, there should be no significant differences in the time it takes to resolve NPLs in court. That said, there is also a place for out-of-court settlements – they too should become an instrument in resolving NPLs.
So in the end, it requires a joint effort by banks, supervisors, regulators and politicians to resolve the problem of non-performing loans.
To conclude, let us revisit Easter Island. As a matter of fact, there are other theories regarding its history. And these theories do not see the islanders as the ones who ruined the ecosystem. They see a more natural cause: rats. Rats arrived with the first Polynesian settlers, multiplied very quickly and destroyed the trees.
From that perspective, the history of the islanders could even be seen as a success story. They managed to survive in a damaged ecosystem. When the Dutch arrived in 1722, the islanders did not ask for food. This is taken as another sign that they were not a starving people at all. They were doing well, adapting and inventing new ways to make the most of the little they had.
However, this theory has also been contested, and we will probably never know what really happened. Still, the story harbours two lessons which also apply to banks.
First: change will always come. And if you want to survive and prosper, you need to adapt. That is very true for banks at the current juncture. But in their attempts to adapt, they should bear in mind the second lesson: act in a sustainable manner. Banks should not destroy the basis of their long-term prosperity by pursuing short-term gains.
Instead, they should bear in mind what Warren Buffett once wrote: “Someone’s sitting in the shade today because someone planted a tree a long time ago.” It is time for banks to plant this proverbial tree.
Thank you for your attention.
 Diamond, J. (2005), “Collapse: How Societies Choose to Fail or Succeed”, New York.
 ECB (2017), “Report on financial structures”, October.
 See Jordà, Ò., B. Richter, M. Schularick and A. M .Taylor (2017), “Bank Capital Redux: Solvency, Liquidity, and Crisis”, CEPR Discussion Paper 11934.
 See Hunt, T., C. Lipo (2011), “The Statues that Walked: Unraveling the Mystery of Easter Island. Free Press, New York.