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Banks in shackles - myth or reality?

Speech by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, ALM Partners conference, Helsinki, 2 October 2018


After the crisis we saw a major re-regulation of the banking sector. These reforms were a necessary and inevitable response to the problems that arose.

Ten years on, we are now finally at a point where the package of new regulations has been finalised. It is now time to take stock, to assess what has been achieved – and to think what our future priorities should be. This is what I will try to do in my remarks today.

First I will look back and analyse the effects of regulatory reform. As is to be expected in such a major period of change, there are “winners” and “losers”. I will spend some time explaining how society has benefited, and how certain costs have been transferred to the industry.

Naturally, industry is not always delighted to shoulder new costs. Indeed, it is notable to hear at this time some complaints that regulation has gone too far and is now “shackling” banks’ decision-making too tightly. I will address this criticism, and will set out my opposing view – explaining how broad the scope for bank innovation remains within the new framework.

After looking back in this way on what we have done, I will then look ahead to analyse where the scope for constructive changes to our rulebook may lie. Within these remarks, I will emphasise the importance of incentivising good bank governance and will remind ourselves that achieving this goal requires supervisors to steer clear of micro-managerial tendencies.

What has our new regulatory environment achieved so far?

The post-crisis reforms have broadened the range of metrics that we now use to monitor banks’ health and in some cases constrain banks’ risk-taking. Basel II focused overwhelmingly on the risk-weighted capital ratio – i.e. one metric. We have now added: the Liquidity Coverage Ratio (LCR), the Net Stable Funding Ratio (NSFR), the leverage ratio, and stricter large exposures limits. A capital floor is also in the pipeline – which will constrain the extent that the results of internal ratings-based modelling can differ from standardised approaches to risk weighting. In simple terms, we have moved from a single metric to now using six key metrics to measure banks’ balance sheet strength.

Rigorous impact assessments were made prior to the introduction of these new tools. The calibrations were made very deliberately, based on the analysis of the best experts from around the world – also including input from the industry. Within the Basel community huge efforts were made to find a balance that works globally, and I believe that a fair and good set of reforms was agreed on that basis. None of the observed impacts come as a surprise to those who were involved in this process.

In this context, let’s take a preliminary look at what some of the impacts of the new rules have been so far.

The benefits – a more resilient banking system

In the first instance, it is clear that the public has benefited from the increased resilience of the banking sector that recent reforms have helped to deliver.[1]

Prior to the crisis, banks were not required to hold enough capital – and what capital they did hold was not required to be of sufficient quality. New rules now require banks to hold more of the highest quality capital. Euro area banks’ Tier 1 capital ratios have therefore increased on average by 3.4 percentage points since Q4 2014 – and are now above 15%.

It was also clear that prior to the crisis, many banks were simply over-leveraged in absolute terms. The risk based capital ratio was seen as potentially vulnerable to human error in setting risk weights, and so an unweighted capital requirement was introduced – the leverage ratio. On this unweighted basis, capital strengthening is also evident. Leverage has fallen by over a quarter in euro area banks since Q4 2014, with the weighted average fully-loaded leverage ratio increasing from 4% to 5.3% during this time.

One of the key reasons why many banks were particularly vulnerable in the run up to the crisis was their lack of resilience to liquidity shocks. In response to this, the Liquidity Coverage Ratio (LCR) has been introduced, which measures banks’ ability to withstand a 30 day liquidity stress. Euro area banks have strengthened their LCRs by more than a tenth since Q4 2014 – rising to 143% as of Q4 2017. Pleasingly, these improvements have been particularly concentrated among banks that were at the bottom of the distribution, with the 25th percentile across the euro area rising by 22 p.p. to 136%.

Linked to this, some banks’ exposure to liquidity shocks was too high as they relied excessively on volatile and short-term funding sources. To address this problem, the Net Stable Funding Ratio (NSFR) was introduced – which obliges banks to fund themselves in a stable manner. Partly as a result of this intervention, long-term funding positions as measured by the NSFR have increased by an average of 11% since Q4 2014. The average NSFR stands above the internationally agreed 100% requirement in all but one of the euro area Member States.

Beyond these reforms to increase bank resilience, much work has also been done to reduce the costs that arise when bank failures do occur. The Single Resolution Board (SRB) has worked diligently since its 2014 inception to enhance banks’ readiness for orderly resolution. 93% of banking groups within the SRB’s remit are now covered by a resolution plan, and complete resolution plans are scheduled to be achieved for all banks by 2020.

Orderly resolution requires bank balance sheets to be sufficiently loss absorbing, also following their point of failure. To help ensure this, EU Minimum Requirements for own funds and Eligible Liabilities (MREL) have been introduced. The SRB has now set targets for MREL at a consolidated level for the largest banks – thereby ensuring that these MREL targets cover 82.5% of banking assets in the EU.

These targets reach an average of 26% of risk-weighted assets and 10.9% of the total liabilities and own funds. This high degree of loss absorbing capacity will help to ensure that future resolution cases can be handled in an orderly fashion. In turn, this helps protect taxpayers from the excessive burdens they were forced to accept during the crisis.

All this evidence shows that the banking sector has strengthened quite dramatically since the crisis.

The key here is not just that banks have improved on any given scale. Rather, the critical achievement is that banks have made progress on each and every of these dimensions. Banks are more resilient to the direct risks they face, and also less likely to propagate those risks. Together, the benefits across the system are greater than the individual benefits because of financial stability synergies. This shows the benefit of thinking in a system-wide manner about microprudential and macroprudential questions.

This strengthened banking system we have been pushing for is a benefit to everyone. Citizens and taxpayers are more protected from bank failures, central bankers and supervisors now have more tools to maintain stability, and bank customers can be more certain of sustained service provision.

The costs – how have the new financial rules impacted bank profitability?

There are no free lunches in this world – so it stands to reason that all these benefits I have outlined must also have created some costs.

Naturally, and rightly, some additional costs have fallen on the industry. Before the crisis regulation and supervisory intensity were too light and did not take economic cycles sufficiently into account. This resulted in a period of excessive risk-taking which inflated banks’ short-term profits, but in the end resulted in long-term costs for citizens and taxpayers. The Basel Committee on Banking Supervision (BCBS) has estimated that at the end of 2015, real GDP levels for its member countries was 30% below its pre-crisis trend – a loss of over USD 76 trillion.[2] Even when one recognises that the pre-crisis trend was not sustainable, it is clear that society has paid a huge price for the failures of its financial sector in this case.

Correcting the bank regulatory framework has, by design, shifted costs that were being shouldered by taxpayers – back on to banks. Some of the implicit subsidy that was enjoyed by banks and their investors has now been withdrawn, and we therefore have a more disciplined banking sector in place.

When assessing the additional costs on banks, it should also be remembered that these firms have been strongly supported throughout the transition. For example, central bank liquidity has been plentifully provided to see solvent banks through difficult periods. Moreover, banks themselves will benefit in the long-term from the move towards a more stable market-oriented environment. As implicit subsidies have been withdrawn, distortions in the market have been reduced – thereby providing a fairer situation whereby the best firms are rewarded the most. Banks’ risk profiles are moving downwards, meaning that they expose their investors to less risk, which in turn implies that their funding costs should go downwards over time.

In response to the new environment, banks have changed their asset holdings, and revised their lending behaviour. Some people will argue this is a cost. I disagree – banks now pay a more appropriate price for the risks they create resulting in a safer financial system. Initial empirical studies are starting to show that the new rules are working in the way intended to discourage excessive bank risk-taking.[3]

Bank profitability

Adjusting to the new regulatory framework has also had implications for bank profit margins. Tighter regulation, combined with a period of relative macroeconomic stress has created an environment where profits are scarcer. Such periods of adjustment are a normal and healthy part of life in the private sector. Some banks will survive and eventually thrive, whereas others will continue to struggle and will end up exiting the market.

Over the past couple of years the macroeconomic cycle has begun to turn in a positive direction, and bank profitability has therefore begun to move back towards healthy levels. The average return on equity of euro area significant institutions stood at 6% in Q4 2017, compared with 3.2% a year earlier.[4]

Nonetheless, many euro area banks don’t expect their return on equity to match their cost of equity by 2020.[5] Further, many publicly listed banks still trade at price-to-book ratios below one – which indicates that banks need to improve further to meet investors’ expectations.

Beneath these averages, a broad range of performance is observed at the individual bank level. Some banks, across various countries and business models, somehow consistently manage to outperform their peers. These outperforming banks follow different strategies to bring down costs and to generate revenues. There is no single reason or common explanation why a bank cannot succeed.

What then explains the success of some banks? It is the way they are managed and governed. Those that more effectively steer the bank towards a well-specified set of long-term objectives end up doing better. This means keeping a close eye on the detailed drivers of income and costs – and to use sophisticated ways of pricing products in a sustainable but competitive way.

The job of banks is to compete. Markets should be allowed to function to facilitate this competition, and in turn this results in innovations that improve the experience of customers. It is not for us supervisors or regulators to take responsibility for banks’ profitability. We are here to contribute to the safety and soundness of banks, and of the financial system in general – so our analysis of banks’ business plans takes place in that context. If banks' business plans are a threat to either their individual soundness or to broader financial stability, then we intervene. Beyond this, we allow banks in the market their proper space to determine their own course.

Regulation and bank innovation – are the “shackles” too tight?

I note at this point that some bankers are currently advocating a roll back of financial rules, arguing that regulators overshot – resulting in excessive constraints on banks’ ability to innovate in the interests of their customers.

Allow me to take a military analogy to address these concerns. It has been said that the time to really worry about the health of soldiers is when they stop complaining. Similarly, perhaps the time to really worry about the health of banks is when their bosses stop complaining about regulation.

Needless to say, the comments from industry play a constructive role in the debate on the design of the rules. Our consultations allow us to take account of the industry’s comments and reflect them in the design of our rules. However, as the crisis showed – bankers’ interests do not automatically align with the interests of the public. This means that regulators need to take the lead in putting numbers to regulatory calibrations, ensuring that the externalities of banks’ activity are properly internalised.

Now, to the main question – does the multiple metrics approach we put in place following the crisis excessively constrain banks’ discretion to run their activities?

I firmly believe that there is no inconsistency between the new multiple-metrics framework and a banking sector that supports a diverse range of business models and strategies. The new quantitative rules we have put in place simply protect society against six flavours of balance-sheet risk. With the uniform enforcement provided by the banking union, these rules help to provide a fair and level playing field for banking competition. The rules protect safe banks from being undercut in the market by competitors taking excessive risks in the search for short-term profits.

Vast opportunities remain available to banks to vary their business strategies within the risk parameters that society has set for them. Banks can still adjust their lending rules as they see fit, they can innovate to find more effective ways of assessing borrowers, and there is still huge scope to devise better pricing models.

Decisions remain open to banks on how they invest and on what business model to pursue. In principle, we supervisors are satisfied when governance is good, and so long as regulatory obligations are fulfilled. This can entail a labour-intensive model focussing on a large branch network, or it could entail a digitally oriented operation with very few staff. We are fine with whatever works in offering customers what they want in a safe and sustainable way.

So, no – I do not believe the new rules excessively constrain banks’ ability to innovate in the interests of their customers.

A vision for the future – where do we go from here?

The body of regulation should rightly be seen as a dynamic living being. If it is static for too long, it is left behind by new market realities. There is always room for improvement, and after such an intense period of activity it is fair to assume that not every rule was designed perfectly.

It is good therefore that we take use of this relatively quiet period to reflect on where we go from here. I think it is still early in this period of reflection, so I will limit myself to speaking in relatively general terms about the most fundamental things that we need to prioritise.

In this respect, I see three key fundamentals to maintaining a sound regulatory structure.

First, bank balance sheets need to be sufficiently loss-absorbing to safeguard citizens and taxpayers from the potentially excessive costs associated with bank failures. We know from experience that banks will not choose a sufficiently loss-absorbing liability structure on their own – so regulation has to be there to push them in the right direction.

The question of the “optimal” level of capital remains a rich source of discussion amongst researchers. Policy-makers provided a rigorous quantitative assessment of the various impacts within the Long-Term Economic Impact (LEI) study published by the Basel Committee in 2010.[6] This showed societal benefits from bank capital peaking at a Tier 1 risk-weighted capital ratio between 16-19%. I do not see anything within recent research that leads me to think this estimate was too high.[7] As both our minimum standards and global banks’ current capital ratios remain somewhat short of this level – I see no room for relaxing capital requirements at this time.

Second, our regulatory structure must continually set the right incentives for banks to manage their risks in a manner that is consistent with societal costs and benefits. This requires us to monitor the performance of our “multiple metric” system to ensure that the calibrations and detailed designs are working as intended.

The metrics may interact with one another in ways that we have not yet foreseen. Some of the metrics may introduce pro-cyclical forces into the banking framework that need to be corrected. For example, concerns about the potential pro-cyclical nature of the risk-based capital framework continue to be raised.[8] It is hoped that the multiple metrics system we have now introduced will help to curtail any such pro-cyclical tendencies. Nonetheless, the interactions between the new interventions need to be closely monitored to ensure that unintended cyclical effects are avoided.

It should also be noted that the market reality in the banking sector may change compared with the situation at the time the regulatory calibrations were agreed. In this respect, it is also important to keep an eye to ensuring our actions are proportionate, and are limited to what is necessary to achieve the objectives set out in the EU Treaties.[9]

For all these reasons, we need to remain agile in the regulatory and supervisory community. When our assessments of the existing architecture show us that tweaks are needed to keep incentive frameworks in line with our objectives – we should remain alive to that, and dynamically respond as needed.

Third, and most importantly – banks need to govern themselves and their risks in an adequate way. Even very robust regulatory ratios cannot rescue a bank if the governance is weak.

Good governance sounds like a good idea to everyone. However, given that the key to good governance is for banks themselves to take responsibility for taking decisions in a controlled way – it is challenging for supervisors to have impact. To address this challenge, ECB banking supervision has invested a huge amount of effort since our inception in taking practical steps to make tangible progress. The ECB has engaged banks in a continuous dialogue on governance in the context of the Supervisory Review and Evaluation Process (SREP), as well as on-site inspections, fit and proper assessments, thematic reviews and deep dives.[10] Where problems are identified, ECB supervisors oblige banks to make improvements. EBA guidelines are also now in place thereby adding further structure to these ongoing dialogues.[11]

All that said, I think we can make further progress in improving bank governance simply by ensuring that we as supervisors and regulators have the right attitude and speak in the right tone. Clearly, it is up to banks to decide how they run their businesses – and it is for them to then take the consequences of those decisions, both positive and negative. We do not want to be in the business of micro-managing banks’ business strategies. Nor do we want to place so many regulatory constraints on banks’ balance sheets that we inadvertently straight-jacket banks into a single course of action.

Taking away banks’ discretion to such an extent would not be in anyone’s interest. That is why, in the first instance, we leave banks to choose their own path for governing themselves and appropriately controlling their risks. This helps to allow the positive elements of a vibrant private sector banking sector to be reaped – including the dynamic innovation that is needed to provide today’s customers with the services that they need.


To bring my remarks to a close, I would like to emphasise again that I generally endorse the re-regulation of banking that happened following the crisis.

It was a necessary step to increase the loss-absorbing capacity of bank balance sheets, and it is good that we have moved in the right direction to improve our tools for shutting down failing banks in a safe way.

My main message now during this period of reflection is that supervisors and regulators need to look forwards with the right attitude. We need to set the right framework within which banks can compete with one another – facilitating a safe but still vibrant and increasingly contested market place.

To achieve this paradigm whereby bank governance is invigorated by banks feeling truly responsible for the risks they take, and for their future success – we need to avoid straight-jacketing balance sheets excessively. We must continue to allow market participants to have the space to decide for themselves their business strategies, giving bankers the space to breathe and to innovate in the interests of customers.

Thank you for listening.

  1. The evidence on risk reduction reflects the content of the report “Overview of Progress in Achieving Risk Reduction Measures (RRMs) A Follow-up Note to the February 2018 discussions on EMU deepening”.
  2. Finalising post-crisis reforms: an update – A report to G20 Leaders.
  3. See, for example - Paul Kupiec, Yan Lee, Claire Rosenfeld, 2017, Does bank supervision impact bank loan growth? Journal of Financial Stability.
  4. “Supervision and business model analysis for Euro area banks”, Korbinian Ibel ECB, EUROFI Magazine September 2018.
  5. See footnote 4.
  6. An assessment of the long-term economic impact of stronger capital and liquidity requirements, BCBS, August 2010.
  7. A sound recent overview of recent research on the optimal capital is provided within “Rethinking Financial Stability”, Andy G Haldane, Bank of England Chief Economist, October 2017 (p8-16).
  8. For example, see – Sectoral risk-weights and macroprudential policy, A. Hodbod, S. Huber & K. Vasilev, Journal of Banking and Finance, 2018.
  9. For further detail on proportionality, see - Banking union in 2017 – How to supervise a €27tn banking sector? Speech by Pentti Hakkarainen, at the CIRSF Annual International Conference, Lisbon, 1 June 2017.
  10. For further detail on SSM activity on governance, see – (i) SSM thematic review on profitability and business.Models, ECB, September 2018, and (ii) Good governance for good decisions, Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB, Second banking supervision conference, “Governance expectations for banks in a changing financial environment”, Frankfurt, 22 March 2018.
  11. Guidelines on internal governance, EBA, March 2018.

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