Exchange of views before the Italian Parliament
Introductory statement by Ignazio Angeloni, Member of the Supervisory Board of the ECB, Rome, 20 December 2017
I thank the Committee for its interest in the views expressed by the European Central Bank (ECB) on subjects related to the banking and financial system, and for the invitation addressed to me. I have already had the opportunity to report this year to the Senate’s Standing Committee on Finance and Treasury. It is an honour to be able to contribute once again to Parliament’s work on these issues, as foreseen by European legislation.
First of all, I have to say that, as a result of legal provisions which govern my position on the Supervisory Board, I am not allowed here to report on confidential information relating to my function. This also applies, in particular, to confidential information concerning individual banks and measures taken in relation to them.
In my introduction I’d like to consider some issues closely linked to the work of this Committee, describing in particular:
- how the ECB performs its banking supervision tasks in the interests of savers and the public;
- recent developments in relation to banks, which pose problems but also entail significant improvements;
- the main actions taken between 2015 and 2017, and the priorities of ECB Banking Supervision, particularly including those involving non-performing loans (NPLs) and market risks;
- the European banking crisis management framework;
- European initiatives concerning the relationship between the banking supervisory authorities and the market supervisory authorities;
- finally, an element of Italian legislation in which a legislative amendment could support our supervisory work.
I will also be at your disposal for questions.
The crisis and the Single Supervisory Mechanism
The financial crisis dramatically revealed how rapidly and forcefully financial sector risks can spread and the repercussions that they have for people, businesses and savers.
During the sovereign debt crisis, a number of governments intervened to support banks, increasing the burden on public accounts. In other countries however the opposite occurred, i.e. weak public finances undermined trust in banks. These forms of mutual dependency between banks and state finances gave rise on several occasions to a vicious circle resulting in the fragmentation of the financial system, a prolongation of the recession and serious risks to the euro.
It is clear that the choice made under the Maastricht Treaty to keep banking policies – supervisory and crisis management –at national level threatened to undermine the whole construct of Monetary Union, with systemic risks on an incalculable scale. The solution was to transfer the objective – banking stability – to European level, creating a banking union. This decision was taken by European leaders in June 2012.
The first pillar of this union is the single supervisor at the ECB. It’s called the “Single Supervisory Mechanism”, or SSM, because its structure includes both the ECB and the national supervisory authorities of the participating countries, in a structured system of cooperation on different levels. (I have talked about this in previous Senate hearings, the records of which have been provided to this Committee.) After a preparatory phase, the SSM took up its duties on 4 November 2014.
Within this system, the ECB is directly responsible for supervising euro area banks deemed “significant”, i.e. those above a given size or exceeding certain operational criteria. These are the 119 largest banking groups in the euro area, or around 900 individual banks, either stand-alone businesses or parts of those groups. There are currently 11 Italian banking groups supervised by the ECB.
All other euro area banks (around 3,200) remain operationally subject to national supervision; the ECB limits itself to carrying out indirect supervision of the work of national authorities, focusing in particular on the harmonisation of supervisory practices and methodologies.
Within the ECB, supervision is functionally separated from the rest of the central bank, where monetary policy is conducted. The separation, enshrined in law, aims to avoid any mixing or conflicts of interest. The supervisory structures do not receive any information relating to the other “wing” of the central bank, and vice versa, except occasionally for specific reasons and by prior approval.
Before taking on its supervisory responsibilities, the ECB conducted an initial evaluation, the so-called “comprehensive assessment” (CA) of the “significant” banks in 2014. That analysis comprised two elements: a check of exposures at individual level, on a sample basis, to detect any risk characteristics (the Asset Quality Review or AQR) and a stress test to check the vulnerability of balance sheets to adverse economic conditions. The exercise was a response to a legal requirement set out in the SSM Regulation and made it possible to collect a large quantity of information upfront on the actual conditions of banks and take some first steps towards harmonised supervision at area level.
The results, published in October 2014, relating to balance sheets for 2013, revealed capital shortfalls in 25 euro area banks, including nine Italian ones. These shortfalls were partly mitigated by further capital raising in 2014.
The exercise took into account both the credit risks and market risks. The final result, measured by its estimated impact on banks’ capital base, amounted to around €260 billion, roughly balanced between the largest countries; for example, it was €49 billion for French banks, €46 billion for German banks and €47 billion for Italian banks. The capital shortfall of Italy’s banking system, which – once the recapitalisations carried out in 2014 have been taken into account – was €3.3 billion as compared with €9.4 billion for the euro area as a whole, can largely be explained by two factors: the economic recession, which was deeper in Italy than elsewhere in the euro area, and the capital shortfalls and management shortcomings of certain institutions.
The complex and in-depth analysis was limited to taking a “snapshot” of certain aspects of the balance sheet situation at that time. It did not cover all dimensions, including forward-looking ones, on which the supervisory action would focus. Nevertheless, the results already pointed to weaknesses in several banks, which were confirmed in the subsequent period.
From 2015 and with increasing intensity in the two following years ECB Banking Supervision was aimed in four strategic directions, namely:
- adopting a methodology for risk analysis which is transparent and systematic, and relevant to the economic and banking context of the euro area;
- strengthening the capitalisation and the robustness of the system in general;
- intervening gradually but decisively on principal risk factors, especially on non-performing loans (NPLs), and strengthening the supervision of internal models for risk assessment;
- contributing to a further harmonisation of the European banking rules (single rulebook), firstly by harmonising the discretion left to the supervisory authorities by the European legislator.
I have already reported on some of these issues in previous hearings, and so I will not dwell on them. However, I would like to briefly outline some of our most recent initiatives and give some insights into the situation of the banking system.
Strengthening banks to serve the economy and the public
The founding regulation of the SSM requires the ECB to apply high supervisory standards that are consistent for all banks in the 19 participating Member States. Equal treatment is a key characteristic of the SSM. Preserving it is a primary responsibility of the Supervisory Board.
The actions we have taken in these first three years go in this direction. I mention one of them here, perhaps the most important. With the cooperation of the national authorities, we have developed a uniform methodology to measure the risks of each individual supervised bank and establish prudential requirements to be applied to each of them. The methodology, which we call the Supervisory Review and Evaluation Process (SREP), aggregates in a systematic and consistent way the quantitative and qualitative information available on each bank. This is then summarised in parameters that measure riskiness, also taking into account the supervisors’ overall assessment. The results are discussed with the bank and ultimately lead to the setting of requirements for capital, liquidity or other factors that have to be met in the following year.
This process has played a key part in strengthening European and Italian banks in recent years.
In particular, the better quality capital of significant institutions has increased in the last three years by almost 2 percentage points, reaching 13.8% by mid-2017. The leverage ratio jumped by more than 1 percentage point, to 5.8%. During that period banks’ liquidity conditions and the stability of their funding also improved. Banks’ profitability has been hit in recent years, especially by the low interest rate environment, which compresses margins on traditional intermediation, and by the provisions on non-performing loans. Over the last year, profitability has started to improve again, but it remains at a historical low and varies greatly across banks.
The progress achieved in strengthening balance sheets is very important not only because it contributes to the security of people who entrust their savings to the banks, but also because more robust banks are better at supporting the economy by supplying credit in greater quantity and of better quality. Research confirms this conclusion almost unanimously. So it’s no surprise that the improvement in the health of the banking sector, together with the ECB’s monetary policy measures to support lending, has coincided with an improvement in the provision of lending to the economy, also highlighted by recent ECB surveys.
Credit risks and the problem of NPLs
Addressing the problem of non-performing loans was one of the key priorities of the SSM right from the start. The NPLs weigh on banks’ balance sheets, depressing profitability. They absorb resources of the bank and impede the search for new productive uses. All this harms investment and economic growth.
In addressing this problem we have adopted a gradual and proportionate approach to the situation of individual banks. After an analysis of the current state of affairs, we published our qualitative Guidance to banks [on NPLs] in March 2017. In it, we suggested, first and foremost, that banks set up internal information structures (to gather reliable data on the institution and the NPL characteristics) and operational structures (i.e. creating appropriate and autonomous units accountable to top management). Many banks did not have these structures and thus were not in a position to know the exact scale of the problem. On this basis we have then asked banks with larger exposures to define a strategy specifically for managing the NPLs, to be discussed with the supervisors. This dialogue is still ongoing. In it the ECB seeks to promote strategies that are ambitious but realistic.
In parallel we have adopted an approach to new NPLs. The draft Addendum published for consultation in October addresses the problem of new flows, indicating “supervisory expectations” with regard to prudential provisions for new NPLs. The consultation ended a few days ago and our staff are assessing the comments received, in order then to submit an updated text to the decision-making bodies (Supervisory Board and Governing Council of the ECB).
In this context, it should be borne in mind that the ECB’s supervision endeavours, in this as in other cases, to include its measures as general criteria, which are communicated to the market in the form of supervisory expectations. These expectations help to maintain consistency between the different banks and to ensure a high level of transparency.
The legal services of the European Parliament and the European Council have pointed out that the ECB, in formulating its supervisory expectations, should not overstep any boundaries in terms of regulatory and legislative powers, but should maintain its focus on the conditions and riskiness of individual banks. This observation is correct; when preparing the final version, the Supervisory Board will assess the wording to ensure that any misunderstanding is avoided. Pillar 2 measures, such as those related to risk provisioning, are always set for the individual bank. The expectations are a starting point for discussion; the ECB will never oblige a bank to respect the addendum criteria without first conducting a detailed analysis of the specific circumstances of the bank. In parallel, the ECOFIN Council in July called for legislative measures on NPLs, which the Commission is currently working on, and stated that these measures would complement supervisory measures.
Our initiatives, combined with the recent economic recovery, have started to produce significant results. The rate of gross non-performing loans, after exceeding 16% in Italy in 2016 (6.6% for the euro area), has fallen to around 12% (5.5% for the euro area), according to the latest data. Net of provisions, the figure for Italy has fallen from 8.5% to 6% (3.6% and 2.9% for the euro area). It’s clear that progress in Italy is above the euro area average. Another positive signal has come from the development, as of this year, of a more active market for non-performing loans in Italy, benefiting from the greater availability of information and an awareness of the problem which the ECB has helped to raise.
Considerable progress is being made, and it is particularly encouraging in the case of Italy. The economic recovery offers a window of opportunity, for an uncertain period of time, to complete the necessary adjustment more easily and to overcome the problem. Italy must not miss this opportunity. The Italian legislator can help here by making further legislative changes (in addition to those already adopted) in order to considerably reduce the time and costs involved in recovering loans.
Although the public debate has largely focused on NPLs, the ECB looks at all the relevant risk factors.
I have already talked about how market risks are incorporated into the stress tests. We also pay particular attention to instruments which are less liquid and harder to value, the so-called Level 2 and Level 3 assets. In the absence of liquid markets, these are valued with reference to other assets or on the basis of risk models. The aggregate includes many different types of exposure, mainly OTC derivatives, but also loans, unquoted shares, complex structured products, etc. Some banks, mainly in central Europe, have significant amounts of such exposures, but they are also found elsewhere, including in Italy.
We undertook an assessment to establish the nature and volume of these exposures. We found that, in aggregate terms, Level 3 assets, i.e. those that are most risky, are only held in small amounts: on average they make up 0.8% of the total assets held by the banks we supervise. For some banks, the volume is higher. Level 2 assets, however, are very significant, accounting for 16% of assets on average.
When assessing the risks inherent in these exposures, it must be borne in mind that they, by contrast with non-performing loans, do not in themselves result in default. For supervisors, the crucial issue is thus to ensure that these exposures, and the related risks, are valued correctly and prudently. To a large extent, and in line with European legislation and international standards, they are valued using banks’ internal risk models. Last year the ECB launched a targeted review of internal models, known as TRIM, which involves a systematic assessment of all the risk models used by the banks we supervise. This is an ambitious undertaking, involving several thousand different models, and it will not be completed until 2020.
In the meantime, we address the issue of market risk through our regular supervisory engagement: targeted assessments of financial instruments at fair value for selected banks, on-site inspections to ensure the correct classification of instruments from an accounting perspective, and checks on the proper functioning of internal risk management structures. This is reflected in the SREP methodology that I mentioned earlier. This topic of checking market risk, which may take on even greater significance as a result of Brexit, is included in our supervisory priorities for 2018.
Managing banking crises
The second pillar of the banking union is a resolution mechanism for managing banking crises.
During the financial crisis, governments provided the banking sector with a very substantial amount of assistance. The European Commission estimates that the total amount of state aid granted to recapitalise euro area banks between 2008 and 2016 was over €650 billion, or around 6% of GDP, of which around half was effectively used (including the guarantees, the amounts are much higher). In some countries, such as Spain, Ireland and Germany, the figure was higher than the average.
To varying degrees, concerns about the risks to taxpayers stemming from banking crises have increased in all countries affected by the crisis. The reforms implemented since then, at both European and global level, have responded to these concerns, shifting the burden of bank rescues from taxpayers to the banks themselves, in particular their shareholders and creditors.
The European framework of reference is provided by the Bank Recovery and Resolution Directive (BRRD), which has been incorporated into Italian legislation through a transposing act. Some of the legislation is also contained in the Single Resolution Mechanism Regulation, which is directly applicable in the Member States. In addition, the Commission issued guidelines back in 2013 on providing state aid to banks; these apply when the conditions for resolution do not exist.
This set of rules governs the entire crisis management process. I will just comment on a few points.
Once the failure of a bank is deemed to be inevitable, the BRRD requires the supervisory authority to determine that the bank is “failing or likely to fail” (FOLTF). That decision rests with the ECB in the case of the banks it supervises directly. This year, for the first time, the ECB took this decision in the case of three banks: Banco Popular in Spain and the two banks in the Veneto region of Italy. It is then the task of the Single Resolution Mechanism to decide whether to trigger resolution. If not, ordinary winding-up proceedings take effect.
The European Commission plays an active role in all cases involving state aid. Such cases normally involve a bail-in of creditors, as laid down by law. If resolution is avoided, state aid requires the prior sharing of burdens, limited to shareholders and junior creditors.
Both the Directive and the rules on state aid contain safeguards to prevent financial instability or other disproportionate effects. The main safeguard is precautionary recapitalisation, as applied this year in the case of Monte dei Paschi di Siena. The public funds that may be used are determined in a stress test; they cannot be used to cover losses already incurred or expected to be incurred.
I would like to share with you some reflections based on recent experience.
- The law requires supervisory authorities to declare that a bank is “failing or likely to fail” if the bank seems unlikely to meet its obligations. This can happen either because the bank’s capital has fallen below the regulatory minimum levels or because of liquidity strains linked, for example, to an outflow of deposits. Typically, in the event of a flight of deposits things move very quickly in the final stages. It is crucial – but also difficult – to determine the right time to intervene. This must not happen either too soon (because the bank must be given every reasonable opportunity to recover) or too late (to avoid favouring some creditors over others).
- From an operational perspective, the intervention procedures this year worked well and confounded the pessimistic expectations of some observers. The authorities involved (the ECB, Commission, resolution authority, national authorities) succeeded in coordinating their actions satisfactorily, over just a few hours and during the night.
- This year’s experiences have somewhat allayed the fears of possible systemic risks. In various instances we have observed that the loss of confidence by depositors and investors in banks perceived to be weak was accompanied by a strengthening, not a weakening, of competitor banks. This insight, although partial and limited to the cases in question, is important because it indicates that the market is able to distinguish between institutions of differing degrees of soundness and thus avoid panic.
- However, the same experiences also highlighted the fragility resulting from an incomplete regulatory framework. Over and above the absence of a European deposit protection scheme, which the ECB has called for on many occasions, the inadequacy of the European resolution fund, which still lacks a lender of last resort, and the fragmentary nature of the legal framework must also be emphasised. The presence of rules on state aid and resolution arrangements issued at different times and in an uncoordinated fashion has produced apparently contradictory results: for example, the fact that supervised banks in Europe are liquidated using national procedures and resources, or that winding-up proceedings may prove to be more favourable than resolution proceedings for the creditors involved.
- As regards the sharing of banking risks under the new rules, fears arising from the fact that risky financial instruments have in various euro area countries been subscribed to by retail investors lacking the appropriate information should not be underestimated. Although the outstanding amounts have been reduced they remain considerable in some countries and, above all, in Italy. It is important for the affected banks to be proactive in checking the actual figures involved and, if possible, to facilitate the reallocation of these instruments to professional investors. Since the presence of such securities in the portfolios of less informed investors can objectively hinder the resolvability of certain intermediaries, the authorities too are interested in this issue and may take appropriate coordination and stimulus action.
Cooperation between the ECB and the market supervisory authority
A point raised by this Committee concerns cooperation and the information flow between the banking supervisory authority and the market supervisory authority.
At European level, the legislation includes the Market Abuse Directive and the Market Abuse Regulation, both issued in 2014. The latter has force of law for the involved parties with national transposition being unnecessary.
The regulation defines the concept of “inside information”; this is information of a precise nature, relating to issuers of listed securities, which, if disclosed, could significantly affect the prices of financial products. The regulation establishes the principle that the responsibility to make such information public in order to prevent market abuse lies with the issuers.
After the establishment of the Single Supervisory Mechanism, the ECB and the European Securities and Markets Authority (ESMA), which coordinates the national market supervisory authorities, agreed on a harmonised model for a European memorandum of understanding (MoU) to be concluded between the ECB and the national authorities. Italy has already agreed to this MoU. This is a relatively new framework for collaboration, and it is still being adjusted and improved.
In the future, a more efficient flow of information and cooperation between banking supervisory authorities and market supervisors would be welcome under the auspices of ESMA.
Fit and proper assessment criteria of institutions
Before concluding, I would like to mention an obstacle we have encountered concerning the powers of the ECB relating to the fit and proper assessments of bank board members in Italy.
These powers are subject to strict limits resulting from Italian legislation. Although the Capital Requirements Directive (CRD IV) has been transposed into Italian law, the provisions on fit and proper assessments only enter into force with the adoption of an implementing decree of the Italian Ministry of Economy and Finance. Until this decree has been adopted, the fit and proper requirements applicable in Italy will be much reduced. Consequently, the current scope of the fit and proper assessments carried out by the ECB and the Banca d’Italia on Italian board members is limited.
Prompt and full implementation of the legal provisions would make for a more consistent approach between Italy and the rest of the banking union.
Thank you for your attention. I am now at your disposal for questions and comments.
 Articles 21(3) and 27 of Regulation (EU) No 1024/2013 of 15 October 2013 (“SSM Regulation”).
 Carige, MPS, Banco BPM, BPER, Banca Popolare di Sondrio, Credito Emiliano, ICCREA, Intesa Sanpaolo, Mediobanca, Unicredit and UBI.
 For example, in the AQR, the ECB used a harmonised definition of non-performing exposures prepared by the EBA. The analysis was carried out on the basis of existing legislation, but the ECB has made every effort to ensure the transparency and comparability of the financial year between banks and between different countries.
 See the ECB’s website, “Comprehensive Assessment 2014”.
 Overall, capital needs of €24.6 billion were identified at euro area level, of which €9.7 billion related to Italian banks. Taking into account the recapitalisation already carried out in 2014, additional measures to strengthen bank capital were required in 13 banks, for a total amount of €9.4 billion (of which €3.3 billion for four Italian banks). To cover the capital shortfall a period of six or nine months (the latter for the adverse scenario) was granted. All data and other details are available on the ECB’s website.
 A separate work stream was dedicated to positions on the financial markets, in particular by reviewing the credit valuation adjustments for derivatives. With the stress test, a detailed assessment of exposures to credit and market risk was also made which required banks to carry out a full reassessment of the trading books.
 See, for example, the assessments of Schivardi, F., Sette, E. and Tabellini, G. (2017), “Credit misallocation during the European Financial Crisis”, BIS Working Papers No 669; Osborne, M., Fuertes, A.M. and Milne, A. (2017), “In good times and in bad: Bank capital ratios and lending rates”, International Review of Financial Analysis, Vol. 51, May, pp. 102-112; Buch, C. M. and Prieto, E. (2014), “Do Better Capitalized Banks Lend Less? Long-Run Panel Evidence from Germany”, International Finance, Vol. 17 (1), pp. 1-23; and Kapan, T. and Minoiu, C. (2013), “Balance sheet strength and bank lending during the global financial crisis”, Discussion Papers, No 33, Deutsche Bundesbank.
 For a recent analysis, see Balgova, M., Nies, M. and Plekhanov, A. (2016), “The economic impact of reducing non-performing loans”, EBRD Working Paper No 193.
 The data are available at http://ec.europa.eu/competition/state_aid/scoreboard/index_en.html.
 In recent times, Consob and the ECB have communicated frequently. The ECB abides by the principle, enshrined in the above-mentioned law, that the information exchanged must be accurate and relevant; this does not apply, for example, to partial or incomplete analyses, which may be misleading.