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2018: If not now, when?

Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB, European Banking Federation Boardroom Dialogue, Frankfurt, 24 January 2018

Almost one year ago to the day, I gave a speech here at the European Banking Federation. That speech was all about New Year’s resolutions. To be more precise: it was about all the New Year’s resolutions that banks should make from a supervisor’s point of view – my point of view.

Back then, the list included resolutions such as “adapt business models to remain profitable”; “improve risk management to remain stable”; and “deal with legacy assets to free balance sheets”. Looking ahead, you might now ask: “what should this year’s resolutions be?” And the answer is: by and large the same.

Does that mean nothing has been achieved during the past year? No, far from it. First, none of these resolutions could have been fulfilled within a single year. There’s no magic button to push; there’s just hard work. Second, good progress has indeed been made on many of them. So it’s no surprise that the list hasn’t changed, and it’s not necessarily a bad sign.

While the New Year’s resolutions stay the same, I would still like to add a new motto for 2018. And that motto is: “if not now, when?” Now is a very good time to deal with all the challenges – in fact, conditions are the best they’ve been since the crisis.

First, there is regulatory certainty: Basel III has been finalised. Second, there is supervisory certainty: European banking supervision has entered calmer waters – our methods and policies are now well known and predictable. Third, new technologies are unlocking new sources of income for banks. And fourth, the economy is doing well; it has been growing for almost five years. And that growth is not limited to just a few countries or sectors – it has become broad based.

All this provides an excellent backdrop to tackling the remaining challenges. And we should not forget a basic truth: good times never last. Banks should take this chance to make themselves shipshape before the choppy waters return. Otherwise, it might be too late.

So let’s revisit some of the issues that need to be addressed now, by both banks and supervisors.

Remaining profitable

In my view, the first thing to mention is profitability. Yes, I have discussed this issue before, and so have many others. Still, profitability remains a key concern for European banks.

It’s obvious that banks need to be profitable, just like any other business. They need to make enough money to pay off their creditors – if they don’t, they are dead in the water. They also need to make enough money to satisfy their shareholders – if their shareholders are unhappy, banks have a problem. And finally, they need to make enough money to build up buffers – if they don’t, they will get into difficulty when adverse conditions return.

So, are European banks making enough money? Well, it’s hard to say exactly how much is enough. After all, each bank has its own business model, its own risks and, thus, its own optimal level of profitability.

However, there are some things which indicate that European banks are not making enough money. First, banks in other parts of the world are doing better. Take US banks as an example. Compared with European banks they experienced a sharper fall in profits during the crisis, but they have adjusted faster and are now more profitable. Second, for listed European banks, price-to-book ratios are still below one. This is a clear sign that investors do see a problem. And third, a number of European banks are not earning their cost of capital. While their return on equity stood at 2.7%, on average, in 2016, their cost of capital is estimated at between 8% and 10%.

Take all this together, and it seems fair to say that European banks have a profitability problem.

From my viewpoint as a supervisor this entails two risks. First, banks may not be able to build up buffers to protect them from future downturns. As I already said, this might threaten stability. And second, when profits are low, banks might be inclined to embark on a search for yield. This in turn implies taking higher risks – another threat to stability.

So, there are a lot of good reasons for European banks to work on their business models. But where should they start? Well, an obvious starting point is the composition of their income. As it stands, net interest income accounts for more than half of European banks’ operating income. And given the prolonged period of low interest rates, it is easy to see that this might be causing problems.

I appreciate, however, that the problem is not that visible when you just look at the overall picture. Over the past three years, low interest rates have not only driven down interest income; they have also driven down funding costs. And these two effects have largely offset each other. As a result, net interest income has remained fairly stable in the European banking sector.

But this is just the broad picture. When you take a closer look, you see that for more than half of European banks, net interest income has actually fallen. And the rest have little room for manoeuvre in the future.

Against this backdrop, banks are seeking to expand their other sources of income. Many of them have predicted that their income from fees and commissions will rise sharply. But so far it has remained fairly stable. And of those banks for whom net interest income has fallen, only a few have managed to offset this decline with an increase in income from fees and commissions. Rebalancing their sources of income is a good idea; there’s no doubt about that. It remains to be seen, though, how quickly they can turn it into reality.

But income is just one side of the equation; the other side is costs. And here, the simplest piece of advice is this: if you cannot earn more, then spend less. However, in my view this statement is overly simplistic when talking about banks. After all, the money that banks spend serves a purpose. It helps to keep their business running and generate income. So the advice needs to be more nuanced: banks should spend less on things that do not help them generate income. One thing that comes to mind here is overly large branch networks.

Banks have room to cut costs, but they must not try to making savings in the wrong places. Spending less on IT systems is not a good idea, for instance – on the contrary, banks need to invest in this area. Likewise it is not a good idea to spend less on risk management by reducing the number of staff working in this important area. A bank that adapts its business model will inevitably enter new territory, and this requires even more careful risk management. So in the end, cost-cutting has to match the overall strategy that a bank chooses to pursue.

And this strategy will differ from bank to bank, of course. However, the common theme is that all banks need to rethink their strategies given the lack of profitability in the sector. Or to be more precise: almost all banks need to do so. There is a group of two dozen banks, of different types and sizes, which consistently outperform their peers. So, it is indeed possible for banks to make money these days. I find this encouraging.

Cleaning up balance sheets

In order to be profitable and resilient, banks need to do more than just adapt and seize new opportunities. They also need to do a bit of housekeeping: there are many balance sheets that still need to be cleaned up.

And here, we find a sizeable elephant in the room – or on the balance sheets, if you will. I am talking about non-performing loans, or NPLs, of course. It’s true that the amount of NPLs has fallen over the past year. But at almost €800 billion, they still pose a problem that is hard to overlook. And there are many reasons why it must not be overlooked.

First, NPLs are a drag on profits, which are too low anyway. Second, NPLs divert resources that could be used more effectively elsewhere. And third, NPLs weaken trust in banks, and trust is a core asset of every bank.

So, there are good reasons to bring NPLs down to more reasonable levels. I think everyone agrees on that – generally speaking. But as supervisors we have experienced intense discussions and a fair amount of resistance to tackling the issue. One of the arguments I have often heard is that it would hurt the economic recovery if NPLs were brought down too fast. This argument boils down to the claim that now is not the time.

And again I ask: if not now, when? The economy is doing very well now, but this will not continue forever. So banks that do not resolve their NPLs now will carry them forward into the next downturn, when they will grow and become even harder to handle – maybe even too hard. My first message to banks is this: doing too little to late is not a viable option. In fact, it is sure to lead to even bigger problems in the future.

And that’s why, as supervisors, we are putting so much effort into helping the banks resolve their NPLs. In early 2017, we published relevant guidance to banks. On that basis, we have assessed how they plan to reduce high levels of NPLs, and we have provided feedback to them. We will now monitor how they implement their plans.

But solving problems from the past is only part of the solution. We also have to avoid problems emerging in the future. To ensure this, we have published an addendum to our guidance that sets out how we expect banks to make provisions for new NPLs.

The addendum was subject to a public consultation, which closed in December last year. We have reviewed all the comments and legal opinions we received, and we will amend the addendum accordingly. Among other things, we may shift the date of application, and we will clarify the Pillar 2 context. At the same time, we are coordinating with the European Commission on its proposal for a prudential provisioning backstop under Pillar 1. The addendum will be finalised in the first quarter of this year. So my second message to banks is: get ready for the addendum.

It’s crucial that balance sheets are cleaned up when conditions are good. But sometimes, it’s only when conditions turn bad that we find out how clean they really are. Stress tests have therefore become an important tool to check how vulnerable balance sheets are.

This year, the European Banking Authority – the EBA – will conduct another big stress test. This test will cover some of the banks that are directly supervised by the ECB. To obtain the full picture, we will conduct our own stress test for many of the banks that are not covered by the EBA stress test, but are still directly supervised by us.

Just like the 2016 stress test, the upcoming one is not a pass-or-fail exercise. But there are three things banks should keep in mind: first, those banks with a capital shortfall in the baseline scenario will obviously need to cover this. Second, the results of the EBA stress test will be published. So, markets are likely to expect banks to address their capital shortfalls. And third, European banking supervision will, on a case-by-case basis, decide whether banks with a shortfall in the adverse scenario need to recapitalise. All in all, the stress test will be a moment of truth for the banks.

To sum up: cleaning up balance sheets is crucial. It will help banks to remain profitable and resilient, and, more generally, it will help to reduce risks in the banking sector. This, in turn, is a precondition for setting up the third and final pillar of the banking union: a European Deposit Insurance Scheme, or EDIS as we call it. And, as a side note, EDIS itself might come with another asset quality review. This would give banks another incentive to clean up their balance sheets.

Forging a European banking sector

More generally, EDIS will help to share risks more efficiently across the euro area. But as a first step it requires all countries to reduce risks. And in my view, we can move in parallel here. Risks have been reduced in recent years, so we can now take EDIS a step further. I am happy that the European Commission made a proposal in this vein at the end of last year, which has revived the debate.

From my point of view, the need for EDIS is clear. Among other things, it would restore the balance between liability and control when it comes to resolving banks. When a bank is resolved, deposit insurance might need to step in. And as resolution has now been taken to the European level, deposit insurance should follow suit.

Once the banking union is complete, it will provide a single frame for the European banking market. This will make it easier for banks to do business across borders, and thus help to forge a truly European banking market. This is the long-term vision of the banking union.

“Long-term” means it will not happen overnight. It seems that many banks are striving to get their own house in order before reaching across borders. Also, there are still some hurdles to be cleared – different tax and insolvency regimes, for instance. Still, I am convinced that sooner rather than later banks will see the euro area as a single jurisdiction and seize the benefits it offers. And then, the European banking market will turn from vision into reality.

So, the euro area is about to grow even closer together – at least in terms of the banking sector. And it seems that this holds some appeal for non-euro area countries as well. Some eastern European countries, for instance, have taken an interest in our supervisory tools and methods. And a Swedish bank has moved to Finland, leading the Scandinavian countries to consider the possible benefits offered by European banking supervision. I find all this quite encouraging. After all, it shows that it might be possible to further harmonise supervision across Europe – formally or informally.

However, not all countries see the benefits of a united Europe. The United Kingdom, for instance, is about to leave the EU. You all know that this will have an impact on banks in both the EU and the UK. It’s up to the banks to ensure that they retain their market access, even in the case of a hard Brexit. While transitional agreements might smooth out the change, they cannot be taken for granted. Banks therefore need to prepare for the worst-case scenario. And again, the question is: if not now, when? Time is running out.

Supervisors have to act as well. Over the past one-and-a-half years, we have developed policy stances and communicated our expectations. We welcome that the UK’s Prudential Regulation Authority (PRA) has also shed light on its approach to Brexit. Banks need to know where they stand. So far, we have cooperated very well with the PRA, and we expect this to continue in the future.

In fact, cooperation will become more important. Even Brexit will not untie the UK and European financial sectors; they will remain closely connected. This forces us to think about cross-border banking groups. How can we ensure that they are well supervised? How can we ensure that they are resolvable? In the wake of Brexit, we have come up with European answers to many of these questions.

As an example, we have defined how we expect entities from third-country groups to be set up and structured. Staffing, booking models and risk management are just a few of the relevant factors. Brexit has triggered policy discussions which will be relevant far beyond Brexit itself, and which will contribute to a more stable and more European banking sector. So it seems to hold true that in every sad event, there is wisdom to be gained.


Ladies and gentlemen,

In my speech today, I have highlighted a few of the challenges that lie ahead in 2018. These challenges need to be overcome. I know that this will require hard work, that it might be painful, and that there is never a good time to do it.

However, I would argue that the present is as good as it’s going to get. The future might seem far away, but it is not. And it might be less bright than the present. So again, my main question for 2018: if not now, when?

And, by the way, this question was coined in the first century before Christ by a scholar named Hillel the Elder. He also subscribed to the idea that, sometimes, the hardest thing in life is not doing what’s right, but knowing what’s right. From that perspective, one could argue that we have already done the hard part. We have a pretty good idea of what needs to be done.

So let’s fast-forward to 1988, when another well-known phrase was coined – this time by an advertising agency: Just do it!

Thank you for your attention.


Banco Central Europeo

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