The Single Supervisory Mechanism: were expectations fulfilled?
Speech by Ignazio Angeloni, Member of the Supervisory Board of the ECB, at the 5th Conference on the Banking Union, Goethe University Frankfurt, 22 November 2018
It is a pleasure to be here today, and I thank the organisers for inviting me. As the first of a sequence of speakers, I will try to provide some thoughts for the subsequent discussion. I would like to look back at how the Single Supervisory Mechanism, or SSM – the first pillar of the banking union – has performed against the goals which we set for it at the outset. The underlying question is: were expectations fulfilled? Answering this question also helps us answer a related one: how should we plan the way forward?
Some critics say that, after five years, the European banking union is, at best, a half-empty glass. Being a supporter, I prefer to say that it is half full. But no matter how you see it, the verdict is the same: important things have been done and goals achieved, but some of the key objectives that the architects of the banking union had in mind are still ahead of us.
As we compare expectations and achievements, it may help to distinguish two categories of goals. The first includes the strategic objectives of the project, while the second covers the intermediate goalposts, things to be done in order to facilitate the achievement of the strategic objectives. These intermediate goalposts may, of course, have their own intrinsic value.
I would include among the strategic objectives the following:
- Restoring confidence in European banks, which had been shattered after the financial crisis.
- Breaking the adverse link between banks and sovereigns, thus promoting financial stability by diversifying risks area-wide.
- Enhancing banking integration through creating a level playing field for supervision.
Valuable intermediate objectives are:
- Combining the experience and knowledge of national supervisors with the European vision of the ECB.
- Building an independent, transparent and accountable supervisor in line with best international practices.
Let me follow this classification to try to characterise where we stand.
Restoring confidence in the banking sector
A key objective in the aftermath of the euro area financial crisis was to restore confidence in the banking system. Three important initiatives stand out in this regard – though many others played a complementary role.
First, bank capital was raised. This was done in steps, starting with the comprehensive assessment in 2014, with the CET1 ratio for the significant banks directly supervised by the ECB rising, on average, by around 3 percentage points (to 14.1%) in the period up to mid-2018. Importantly, this has been achieved mainly through genuine capital increases rather than adjustments in risk weights or deleveraging, assuaging the concerns of some critics who at the time were arguing that raising capital would lead to deleveraging and a credit crunch.
Second, we tackled credit risks, in particular the large volume of legacy non-performing loans (NPLs). ECB Banking Supervision issued a qualitative guidance on how banks should manage their NPLs and required banks to draft strategies to reduce them. This was followed by an addendum indicating supervisory expectations on provisioning levels for new NPLs and, more recently, by bank-specific supervisory expectations for the provisioning of the stock of NPLs. In this way, NPLs were put on a steady downward trend, with the gross NPL ratio of significant banks dropping to 4.4% on a weighted average basis in the second quarter of 2018, from 7.6% at the end of 2014.
And third, we are addressing the inconsistency and high variability in the capital requirements that banks with similar portfolios calculated using internal models. In order to enhance the adequacy and credibility of such models, we launched a targeted review of them, which is currently underway and is scheduled to be completed by 2020.
Let me return to the earlier question: was the key objective of restoring confidence in the banking sector achieved? To some extent surely yes, but a full answer is not straightforward. Financial stability, the statutory objective of the SSM, was ensured at all times, and prudential standards were strengthened. The right amount of supervisory guidance and pressure was exercised in this regard. The most difficult legacy problems were addressed, in some cases with banks exiting the market. Yet uncertainty around the state of certain parts of our euro area banking sector still persists. Price-to-book ratios recovered as of mid-2016 until the spring of 2018, but have subsequently lost part of the gains previously made. Market valuations still do not compare favourably with natural benchmarks, such as for example that provided by US banks. Profitability, while improved, still remains comparatively weak on average. One needs, of course, to consider that a safer banking sector may be expected to be somewhat less profitable than a riskier one, such as the one we had before the crisis. But the low returns of our banks are still too often the result of excessive costs, inefficient processes, weak business strategies and overbanking. More work is needed, therefore, by both the industry and the supervisor.
Recently, the EU-wide stress tests have provided new evidence on the resilience of major banks, but market reactions after the disclosure of the results suggest that uncertainties have not been completely dispelled. Here as well, more work needs to be undertaken to improve the informative value of stress tests, focused on scenario design, stress test methodology and the link between stress test results and subsequent prudential measures.
Breaking the adverse link between banks and sovereigns
The crisis exposed the well-known two-way fragility in the euro area financial sector: sovereigns were exposed to banking risk, and banks were exposed to sovereign risk. Whatever the direction of causality, stability (both banking and fiscal) risks being undermined once this mutually reinforcing feedback loop is in motion.
Eliminating the loop brings us to the very logic of the banking union, which is one of risk diversification alongside with risk reduction and centralised supervisory control. National banking risks can be diversified under an effective safety net covering the whole banking union. After five years, risk reduction has been achieved to a large extent. The building of an effective area-wide safety framework, however, including common resolution and deposit insurance frameworks, is lagging behind. This makes the whole construction unbalanced and puts a higher burden and risk on day-to-day supervision.
The banking union at present consists of perhaps one pillar and a half out of the three that were initially foreseen. The Single Resolution Board has been functioning since 2016, and the handful of bank failures have been addressed smoothly. The Bank Recovery and Resolution Directive provides a framework to deal with failing banks. However, key elements are missing or incomplete.
The Single Resolution Fund will only be fully funded by 2024, so that its current ability to provide liquidity at the point of resolution remains limited. Targets for capital in resolution (minimum requirements for own funds and eligible liabilities, or MREL) are being set by the Single Resolution Board, but will only gradually be phased in. Legislative gaps still exist in key areas, for example in the conditions for banks to be declared “failing or likely to fail” and the modalities of standard insolvency. The lack of harmonisation of national liquidation regimes complicates the task of making coherent resolution decisions, especially to avoid making some creditors worse off. Furthermore, as recent events have shown, major gaps exists in the anti-money laundering framework, which coordinated initiatives by the European Commission, the European Banking Authority and the ECB are now beginning to address. Finally, the so-called third pillar of the aforementioned safety net, European deposit insurance, is missing entirely.
The liquidity conditions prevailing in recent years have reduced the risks of the negative feedback loop between banks and sovereigns taking hold, as well as reducing the possibility of contagion both within and across countries. These conditions, however, were exceptional and will not last indefinitely.
Fostering a level playing field and banking integration
A level regulatory playing field is a cornerstone of SSM. A single authority must apply coherent rules to all its members. The existence of a single supervisor, based on a European regulation (the SSM Regulation), fulfils a necessary condition for creating this level playing field, but is not sufficient. I don’t need to explain to the many lawyers in this room that every supervisory decision must have a strong legal basis, lest it be easily challenged. Therefore, a level playing field requires there to be legal harmonisation as well.
The current legal basis of single supervision in Europe is a three-tiered system that includes European norms directly applicable to banks (such as the Capital Requirements Regulation, or CRR); provisions established by European directives (such as the Capital Requirements Directive) that are not directly applicable but are transposed into national law; and provisions that are purely national. This setup leaves ample room for national variations and rulings which create an uneven playing field across jurisdictions. Important areas where harmonisation is lacking include bank authorisation and licence withdrawals, fit and proper assessments and the imposition of a moratorium for banks in crisis.
Many of the legal provisions which ECB Banking Supervision currently applies were written before the banking union was conceived. National options and discretions are still available to Member States in various areas of prudential relevance, such as liquidity provisions for entities within banking groups. The current review of the CRR is not making much progress on this front.
An unlevelled regulatory playing field discourages the integration of the banking sector. A widely held expectation was that bringing supervision under a single roof would trigger a new wave of banking integration in the euro area, in the form of cross-border banking activities, subsidiaries and branches, and mergers and acquisitions, with benefits stemming from more competition in the provision of banking services. This has not happened. The legal fragmentation I have mentioned, the uncertainties surrounding the completion of the banking union, and especially the absence of area-wide deposit insurance, have been major discouraging factors. For banking groups, expanding across borders only makes sense if liquidity and capital resources can be allocated flexibly. In spite of the efforts done by ECB Banking Supervision to harmonise the options and discretions available in Union law, in the banking union this is only possible to a very limited extent.
Exploiting the synergies between the ECB and the national supervisors
Since the outset, it was clear to all of us planning the design of the single supervisor that a key opportunity resided in combining the expertise of national supervisory authorities with the European vision and values of the ECB, to eventually build a common supervisory culture based on common standards. This goal has, in my opinion, largely been met.
Our operational structure is well-known. The Joint Supervisory Teams, which form the operational core of the system in charge of day-to-day supervision, include ECB and national staff. Aside from that, collaboration between national competent authorities (NCAs) and the ECB is frequent and intense. At the decision-making level, the Supervisory Board has grown into an effective forum for debate and decision-making. A common supervisory culture among staff of different institutions is fostered, among other things, by the development of SSM training curricula and the constant effort to encourage the cross-border participation of NCA staff in missions and on-site inspections. The perennial problem of supervisory capture is addressed by rotating staff across units; mobility levels are higher in ECB Banking Supervision than they are in the rest of the ECB.
At all technical levels, the emphasis has been on promoting convergence to higher supervisory quality and global standards. A new risk assessment methodology has been established to determine banks’ capital requirements (the Supervisory Review and Evaluation Process), bringing together quantitative and qualitative information. We have also published several guides to foster supervisory harmonisation, such as those on leveraged transactions and on fit and proper assessment criteria.
Although the ECB does not directly supervise the less significant banks, we still make every effort to foster convergence in supervisory standards for them as well, so as to prevent the emergence of a two-tier supervisory regime.
Bringing independence, transparency and accountability up to the best global standards
The operational independence of the ECB’s supervisory function is protected both by the Statute of the European System of Central Banks and of the ECB, and by specific provisions included in the SSM Regulation, which apply specifically to the Supervisory Board. All of the Board’s members are independent in the exercise of their functions and are supposed to serve in the European interest. The national members do not represent their home institutions when they act within the Board.
Transparency is another area where we have made important advances. ECB Banking Supervision is required by statute to conduct public consultations for all new regulations it adopts, and to grant banks affected by its decisions a right to be heard. Such consultations (there have been 21 of them to date) are a transparent way for all stakeholders, including the banking industry, to express their views and make suggestions on supervisory policies before their adoption. Our website is a rich source of documents and other information (notably, the Annual Report and a supervision newsletter used to disseminate information in a non-technical manner, as well as supervisory statistics). Speeches and interviews with the Chair, the Vice-Chair and the ECB representatives on the Supervisory Board are regularly published, as is their weekly schedule of public speaking engagements. Dedicated public hearings on specific initiatives (recently, the NPL addendum) are also given extensive coverage on the website.
The interest in banking supervision issues is measured by the increasing number of public access requests at the ECB alone – up from five in 2015 to 91 in 2017. The frontier of transparency is constantly advancing; further progress is possible and should be expected in the coming years.
Ensuring a high level of democratic accountability has also been a strategic priority. ECB Banking Supervision officials have attended 14 hearings at the European Parliament since the SSM was launched, and had 13 confidential exchanges of views with Members of the European Parliament; in addition, there have been 8 exchanges of views with national parliaments. On a routine basis, we reply to written questions from MEPs (all exchanges are made public), and send to the European Parliament records of proceedings of all Supervisory Board meetings. The Chair and Vice-Chair of the Supervisory Board regularly report to the Eurogroup. Since 2014, ECB Banking Supervision has been the subject of two audits by the European Court of Auditors, one review by the European Commission, and one review by the IMF in the context of its Financial Sector Assessment Programme for the euro area. As recognised by the Commission, the ECB has demonstrated that it takes recommendations issued following such reviews seriously, often translating them into adaptations of our own rules or behaviour.
All these activities demonstrate that ECB Banking Supervision adheres to international best practices for transparency and accountability. The ECB welcomes legitimate public scrutiny of its policies and activities, and very much encourages it.
Let me conclude now.
I have focused my remarks on whether the SSM’s achievements so far have met our expectations. But just as achievements should never lead to complacency, a partial lack of them should not be a reason for discouragement. Retrospection should always translate into a drive for higher expectations and commitment.
We are, in many ways, reaching a milestone. Five years have passed since the SSM was launched. Euro area banks are different, and markedly better, than they were back then. Meanwhile, the economic environment has also changed; in fact it is changing as we speak. The risks banks will face in the future will not be the same as those they faced so far. Lastly, we are on the verge of a change in leadership at the top of ECB Banking Supervision.
As I look back, I am impressed by the thoroughness and speed with which certain goals that we set ourselves at the outset have been reached. In particular, we have been successful in combining national and ECB supervisory resources and expertise into an effective, independent, transparent and accountable banking supervisor, up to the best global standard.
The more distant and strategic objectives I mentioned are still largely ahead of us. Further energy and resolve, mainly in the political sphere, will be necessary to complete the banking union, adding the constituent parts that are still missing and building a stronger legislative basis.
I am convinced that we will get there. Hopefully, the road will not be too winding and treacherous.
Thank you for your attention.