Banking supervision in the ECB
Speech by Ignazio Angeloni, Member of the Supervisory Board of the ECB, at the ECB Central Banking Seminar, 10 July 2018
It is a pleasure to be here today and to address the participants to this central banking seminar. If my memory serves me well, I was among those who proposed, in 2005, to set-up this seminar series, with the purpose of providing central bankers from all over the world an opportunity to learn and to debate about the ECB experience. Many years have gone, and I have not been involved thereafter, but I am delighted to see that the initiative is alive and well.
While the seminar’s daytime program was almost entirely focused on monetary policy, my talk this evening is on banking supervision. Banking supervision is the most recent function acquired by the ECB: internal preparation started in late 2012, 14 years after the institution was founded. The operational start was in November 2014. Today, supervision is a major part of this institution, accounting for something between one third and one half of its budget. When, in 2012, the European leaders decided to create a single supervisor for the euro area, locating it here was, for many reasons, a natural choice. The ECB was a well-established institution, with a strong legal basis. It had experience in dealing with banks through its open market operations. Its staff had proven managerial skills and ability to deal with new challenges. Judging from the success in building the new supervisory function at record speed, one must conclude that choice to have been the right one.
In most countries of the world supervision is either located in, or closely connected to, the central bank. There are powerful informational and efficiency advantages in associating the two. Monetary policy involves conducting transactions with banks and taking risks that are, to a large extent, banking risks. Banks are a major channel of transmission of monetary policy, all the more so in Europe. Banking supervisors constantly monitor bank liquidity, part of which is provided by the central bank. When a bank enters a crisis, the central bank is its last-resort lender. The link between the two policies exists always, but tends to strengthen in times of crisis. The recent crisis is no exception; in fact, had there not been a crisis of that magnitude, in all likelihood there would no supervision in the ECB today.
I should mention, to be fair, that the reasoning I just offered is not uncontroversial. Some argue that a close association between the two functions involves risks, because potential confusion of roles or conflict of interests may lead one of them, or both, to deviate from their mandates. I do not intend to pursue this debate here; I will only say that, in my view, those risks can effectively be controlled by ensuring to both functions a high degree of autonomy, transparency and accountability.
In the rest of my remarks I will briefly discuss the main challenges that we have faced, how we dealt with them, and mention some open issues. I will focus mainly on banking supervision and the ECB, but also broaden the perspective to some extent, looking at the whole European banking union.
Challenges and achievements
The first challenge we had to overcome was logistical. ECB Banking Supervision was built from a greenfield. Only four years ago, it consisted of a few dozen people spread around half-empty offices. Today, the ECB counts over 1,000 professional supervisors, in a dedicated and fully equipped high rise in central Frankfurt; the so-called Eurotower, the same building that used to host the ECB before the new premises, where we now are, were built.
A second and more subtle challenge was organisational. The single supervision works, in many ways, as a network: at the centre is the ECB supervision, and around it are the national supervisory authorities, all composing the Single Supervisory Mechanism, or SSM. The collaboration between the two is continuous and intense. The groups supervising the individual banks (Joint Supervisory Teams) include both ECB and national staff. The Supervisory Board includes representatives of the ECB (such as the Chair, the Vice Chair and other members, including myself) as well as the heads of national supervisions. The challenge here consisted in building a cohesive system out of these different elements. In retrospect, we see that the Supervisory Board has rapidly grown into an effective forum for debate and decision-making. The JSTs, which are the operational core of the system, run smoothly overall, in spite of the complexities inherent in managing professionals from different institutions and countries.
The first supervisory priority of the newly established SSM was to rebuild confidence in the banks. After the crisis, European banks were undercapitalised and ridded with a mountain of dubious exposures. Starting with the comprehensive assessment in 2014, the capital level of the sector was progressively raised; the CET1 ratio for the banks directly supervised by the ECB (“significant”) rose, on average, by over 3 percentage points (to 14.6%) in the three years ending in 2017. Importantly, this was achieved mainly through genuine capital increases, rather than adjustments in risk weights or deleveraging. In parallel, supervisory efforts focused also on reducing credit risks. This was done in steps, by first issuing a qualitative guidance on how banks should manage non-performing loans (NPLs), addressing their governance and requiring banks to draft plans to reduce them; and then issuing an addendum to this guidance in 2018 indicating supervisory expectations with regard to prudent provisioning for new NPLs. These measures helped to put NPLs on a firm downward path. The gross NPL ratio of significant banks dropped to 4.9% on a weighted average basis by the end of 2017, against 7.6% at the end of 2014, as a result of a 25% reduction in the total outstanding NPL stock. Policies for further provisioning expectations on legacy NPLs are currently in progress.
Steps were taken also to level the playing field and to promote convergence to high supervisory standards. The determination of capital requirements was made more systematic through a new risk assessment methodology (the Supervisory Review and Evaluation Process, or SREP), bringing together quantitative and qualitative information. In 2016 we published a guide on options and discretions, aimed at harmonising the discretionary elements existing in the European banking legislation. In 2017 we published a guide on the criteria used in our “fit and proper” assessments of banks’ managers and administrators. In addition, the ECB took various measures to level the playing field and promote convergence of supervisory standards for the smaller (“less significant”) banks, which are supervised by national authorities under ECB oversight. Standards were developed in a number of areas, including options and discretions, SREP methodology, crisis management, fintech, recovery planning and on-site inspections.
A special mention should be made, here, to macro-prudential policy. As you know, this is a new approach to prudential regulation, which has acquired more relevance after the recent crisis. The macro-prudential approach requires the policymaker to pay attention not only to the stability of individual intermediaries or markets, but also to the interaction of each intermediary, or market, with the others, and the influences and feedbacks to and from the economy as a whole. Macro-prudential instruments – unlike traditional supervisory ones – require taking into account the effects that each bank can exert on others, and the stability of the broader economy. The ECB has acquired macro-prudential powers together with the supervisory ones. As a result, the ECB has adapted its internal structures, by enhancing the size and competence of its financial stability area.
The macro-prudential role of the ECB involves a close cooperation among the supervisory wing, the financial stability area, and the units that analyse and forecast the euro area and the global economies. Analyses and proposals are delivered to the Governing Council of the ECB (the ultimate ECB decision maker), to the Supervisory Board (which prepares all supervisory decisions) and to the Macro-prudential Forum, a body including the members of both the Governing Council and the Supervisory Board, which was created precisely to support the ECB’s macro-prudential function. The ECB also hosts the European Systemic Risk Board, an EU body including central banks and other prudential authorities, which monitors systemic risks in the Union and issues recommendations on macro-prudential policy.
Legal challenges in the conduct of European supervision
Let me now briefly elaborate on the legal framework used for supervisory decisions.
The importance of providing banking supervision with a strong legal basis can hardly be overemphasised. More than other policy functions (including monetary policy), banking supervision directly affects a host of private interests, institutional and personal; those of banks, their borrowers, investors and other stakeholders. Banking supervisors base decisions on legal provisions which are closely intermingled with the commercial and civil codes – in extreme cases, criminal law is involved as well. Supervisory decisions, even when made by paying painstaking attention to the letter and to the spirit of the law, always entail a legal risk. Adding to complexity, a supranational authority like the ECB makes decisions that affect subjects belonging to all 19 euro area countries, each of which has a different legal system. It is therefore of the utmost importance to ensure that the legal basis used by the ECB supervision is composed by a solid body of European norms, applying equally in all countries. At present, the legal basis of the single supervision is, roughly speaking, composed of three parts: a set of European norms applicable directly to banks (the so-called Capital Requirements Regulation, or CRR); another set of provisions established by European Directive (the Capital Requirements Directive, or CRD), which apply to banks only after having been translated into the national legal system by means of national law; and finally, other provisions that, though essential for supervision, are in neither CRR or CRD, hence are purely national. Finally, one should also consider that many of the legal provisions we apply were written before the launch of the banking union – indeed, before such a project was even conceived.
As a result of this, the legal framework underpinning banking activity in the euro area remains, still today, partly fragmented, and this prevents the banking union from developing its full potential. ECB Banking Supervision applies EU law when it exists, but is bound by national laws in important areas like bank licence withdrawals, the imposition of moratorium when needed to control a bank’s crisis, and fit and proper tests, as well as others. While the ECB has done all it could to harmonise the rules, the legislation remains partly uneven, leaving opportunities for national diversions and hampering the level playing field. Further work by the legislators will be needed in the coming years.
I should also mention, still under the legislative heading, the risks related to money laundering, which can be triggers of bank crises, as recent experiences show. Anti-money laundering frameworks are still national and are not harmonised at the European level. In this environment, close cooperation between the ECB and the national authorities is essential. In the medium term, establishing a European authority to combat money laundering – distinct from, but actively cooperating with the single supervisor – would be desirable.
Completing the banking union
Before concluding, let me move for a moment outside the walls of the ECB, to briefly refer to the other components of our banking union.
It is often said that our European banking union is supported by three pillars, a single supervision, a single resolution authority and a single deposit insurance. The three are meant to be complementary. The first acts ex-ante, for crisis prevention, and ensures that bank risks are kept under control. The second acts mainly ex-post, for crisis management, ensuring that failing banks can be resolved (that is, restructured or wound down) with minimum risks and costs for taxpayers and the broader economy. The resolution authority is also involved ex-ante, in preparing resolution plans. The third pillar, deposit insurance, intervenes ex-post to protect depositors; it is meant to provide assurance, to retail depositors in particular, that their money in the bank is safe. This is essential to safeguard the functioning of the payment system, and through that of the economy as a whole.
The Single Resolution Board was established in Brussels in 2015 and is operating, with all its legal powers, since 2016. Its crisis management activity has worked well overall; the handful of bank failures that have occurred have been addressed smoothly. Cooperation between the stakeholders involved (central banks and supervisors, including the ECB, plus national resolution and competition authorities) has worked well. Contagion and market disruptions have been avoided in all cases.
Nonetheless, the framework for bank resolution remains incomplete. The SRB is preparing bank resolution plans with the support of the ECB, but work is still ongoing. Targets for capital in resolution (minimum requirements for own funds and eligible liabilities, or MREL) will phase-in only gradually, over several years. The Single Resolution Fund, intended to provide capital and liquidity resources for banks in resolution, will be gradually phased in (until 2024), and a public backstop is still missing – although there is agreement in principle to establish it. Importantly, the third pillar, the European Deposit Insurance Scheme, or EDIS, is missing; the ultimate safety of euro area depositors still hinges on national deposit insurance systems, only partly harmonised in their functioning by a European Directive. National insurance schemes rely on national resources, and therefore may not be perceived by all bank stakeholders as providing the same degree of safety to all bank depositors in the banking union.
Let me conclude by saying that after almost four years of operation, we can say that the introduction of single supervision in in the ECB under the first pillar of the banking union was completed successfully. Our main responsibility at the outset, namely, of reducing bank risks and enhancing market and depositor confidence, has been achieved to a large extent and progress is still ongoing.
Of course, further improvements are possible and needed. Staff and Board of the single supervision are constantly striving for better standards. Importantly, as I have discussed in some detail, the legislative basis supporting the single supervision needs to be upgraded, especially in the direction of ensuring direct and homogeneous applicability of all norms to the banks under ECB supervision.
The other components of the banking union are less advanced. Area-wide deposit insurance does not exist yet. On the latter, agreement at the political level is blocked by a controversy between those who would like to see first a further risk reduction in the system, and those who consider that sufficient de-risking has taken place already and it is time now to introduce elements of risk sharing. While understandable in a political process, this controversy is essentially fruitless. Risk sharing and risk reduction are complementary and should thus progress together. As President Draghi put it in a recent speech:
“The dichotomy between risk-reduction and risk-sharing that characterises the debate today is, in many ways, artificial. With the right policy framework, these two goals are mutually reinforcing.”
Thank you for your attention.