ECB supervision at 5: challenges, opportunities and wishes

Speech by Ignazio Angeloni, Member of the Supervisory Board of the ECB, at the Official Monetary and Financial Institutions Forum, London 10 December 2018

I am glad to be here today and to participate in this discussion^[1]. Over the last few years, OMFIF has grown into a visible and lively discussion forum. Notably, it retains a keen interest in European Union affairs and a practice of inviting speakers from across the channel. I hope this interest will not be lost with Brexit.

The Single Supervisory Mechanism (SSM) is now marking its fifth anniversary. In November 2013, the SSM charter (or Regulation, as we call it) was adopted after lengthy negotiations with the Member States and the European Parliament. I tend to regard this as the starting date, although internal ECB preparations started much earlier (July 2012) and the effective exercise of supervision began a year later, in November 2014, the year in between being occupied by further preparatory work, asset quality reviews and stress tests.

The five-year mark is likely to coincide with some substantive changes in the life of the SSM. This is what I would like to talk about today.

In some respects, a cycle is closing. The SSM has laid out its strategy to deal with non-performing loans (NPLs), arguably the main problem facing European banks after the crisis. The clean-up of balance sheets will take several years, but the strategic direction is set. Solvency standards have greatly improved, as I shall detail in a minute. A new supervisory methodology (Supervisor Review and Evaluation Process, or SREP), more systematic, transparent and even-handed than the preceding national practices, was built and adopted. A few banks, faced with overwhelming problems, were declared failed by the ECB Supervisory Board and exited the market.

While all this was happening, the landscape changed. The economy is now in a new cyclical phase, and new risks are appearing. Volatility has returned to the financial markets. Brexit, with its profound impact on the structure of European banking on both sides of the channel, is looming. In the background, new political forces, less inclined to European cooperation, have gained ground in a number of countries; this may mean that the banking union, still incomplete and imperfect, will remain so for longer than initially thought.

I would like to offer some reflections on some of these challenges, which, as challenges often do, also entail opportunities.

The changing nature of bank risks

Let’s focus first on the prospective bank risks, and start by looking for a moment at the recent evolution of euro area banks. A few numbers illustrate the progress made.

The gross NPL ratio of significant banks supervised by the ECB dropped to 4.4% on a weighted average basis in the second quarter of 2018, from 7.6% at the end of 2014; a significant decline occurred in NPLs net of provisions. The decline accelerated in the last two years and was particularly rapid in countries with high NPL ratios. As we speak, 13 countries out of the 19 which participate in the SSM have gross NPL ratios below 5%, and 12 countries have net ratios below 2.5%.

The improvement in solvency standards was equally noteworthy. The CET1 capital ratio for the banks directly supervised by the ECB rose on average by around 3 percentage points (to 14.1%) in the period from end-2014 up to the second quarter of 2018. Comparable increases have also been seen in the other categories of capital. Importantly, this was not achieved by deleveraging, or by economising on risk weights, but largely by way of genuine capital increases.

The liquidity situation of the banks has also improved; the average liquidity coverage ratio increasing by some 14 percentage points to 141% from end-2014 to the second quarter of 2018.

These improvements are reflected in the recent stress tests. In the adverse scenario, the capital depletion of euro area banks was broadly the same as in the previous exercise, conducted in 2016, but thanks to the better starting position, the capital situation of the banks under stress was significantly better than it was two years ago. This means that banks are today better positioned to withstand adverse contingencies.

As impressive as they may be, these numbers are backward-looking; they say little about what risks banks will face in the future. I think an evolution is under way in the nature of these risks. First and foremost, the euro area is in a different cyclical position than it was five years ago. The recovery is more mature, and some indicators even suggest that activity may already be slowing. In an improved economy, the risks from traditional intermediation are reduced. Meanwhile, conditions in global financial markets have tightened; asset price volatility has increased and risk spreads have risen, notably in some emerging market economies. This affects, to a limited extent, euro area banks exposed to those economies.

The turn of the monetary policy cycle will progressively remove the extraordinary layer of liquidity that has compressed market returns and volatility over the recent past. Market risks are likely to become more prominent. The more volatile financial environment may facilitate contagion phenomena, which were virtually absent in recent years. This means that, relative to the past, the new risks are more likely to affect groups of banks with comparable exposures and similar vulnerabilities, rather than being limited and specific to individual banks.

Also important is the fact that sovereign risks have re-emerged in the euro area financial markets. A central objective of the banking union was, and remains, to mitigate such risks by neutralising the adverse nexus between banks and sovereigns. However, as yet no significant progress has been made in severing such link. Recent experience confirms that when sovereign spreads increase in a given country, all banks in that jurisdiction are affected, regardless of their individual characteristics: all see their capital buffers eroded, their funding costs increase and their stock market value decline. These risks are diffuse, though not necessarily area-wide systemic since so far the cross-country transmission of sovereign risks in the euro area has been limited.

The classic supervisory instruments (pillar 2 measures, large exposure limits and the like) are predominantly designed to address idiosyncratic risks, not diffuse ones. The legislation assigns the ECB a limited set of macroprudential instruments (specifically, structural and countercyclical buffers) and only allows the ECB to tighten the stance set by national authorities. The ECB has so far made little use of its macroprudential powers, essentially limiting itself to facilitating an orderly exchange of information among national authorities and promoting joint analyses and peer reviews. In the so-called “shadow banking” world of asset management and investment pools, European powers are even more limited. As a result, the macroprudential response of the euro area in the current economic upswing has been, so far, insufficient.

The point I am making is that bank risks may be evolving now in a direction that makes the existing framework less equipped to deal with them. This makes more urgent to strengthen the macroprudential framework and to enhance the scope for cross-border risk-sharing within the banking union.

Brexit and cross-channel cooperation

I now turn to cross-channel banking cooperation in the prospect of Brexit. Let me outline a number of issues that we regard as critical in this area^[2].

A large number of banks operating on this side of the Channel will be directly affected by Brexit through a likely loss of “passporting rights”. This means they will no longer being able to serve their EU clients without a meaningful local presence. Local presence requires relocating part of their business, applying for new banking licences or expanding existing ones.

To help preparations, we laid out a number of expectations on how to handle the post-Brexit scenario. Banks were made aware that the ECB would accept neither “empty shell” entities nor full back-to-back booking models. This means that sufficiently strong decision-making and risk management capability has to be in place locally. The underlying prudential logic is straightforward: without adequate local presence, the EU entity would be dependent on third-country entities to maintain operations. We also stressed that banks relocating to the euro area as a result of Brexit – which we call ‘incoming banks’- should possess adequate capital and liquidity buffers, in addition to managerial and risk-control capabilities. For the same reason we would not, as a rule, endorse the practice of staff performing functions in more than one entity – known as “dual-hatting”.

We are of course aware that relocations are costly, and that there might be operational difficulties related to the transfer of bank staff and infrastructure within a short period of time. This is why we remain open to the possibility of adjustment periods, to smoothen the process for incoming banks. I am glad to say that most banks have been receptive to our supervisory messages. The planning and implementation of banks’ relocation to the euro area is, in the main, moving in the right direction.

A further challenge is that banks are considering a menu of options to provide banking services to the EU, including through investment firms, third-country branches and direct cross-border access based on national laws. These different modalities are subject to diverging regulation, in some cases fully or partially beyond the ECB’s supervisory remit. This raises the possibility of regulatory arbitrage and financial fragmentation; there is a risk of regulatory race to the bottom. It is encouraging that the European legislator is working on legislation that would place large investment firms under the ECB’s supervisory remit. However, other loopholes will likely remain unaddressed.

We are also engaging banks which access the UK market from the EU, which we refer to as the ‘outgoing’ banks. For similar reasons, we have made clear to them that we would not endorse a practice on their side aimed at “back-branching”, i.e. using branches across the Channel to do business in the EU. We want any branches in the United Kingdom to be used primarily to conduct business in the United Kingdom.

A further area of engagement relates to the future clearing of derivatives in UK-based central counterparty clearing houses (CCPs), and whether such services could continue to be offered to EU members under a no-deal Brexit. This is an issue for both ‘incoming’ and ‘outgoing’ banks. We have been stressing that the financial sector needs to make appropriate preparations in this regard. The European Commission has stated that the existing system of equivalence would provide the necessary tools to ensure that central clearing remains unimpeded, even in the absence of a Brexit transition period, under strict conditionality and with limited duration.

Personally, I believe that Brexit, as undesirable as it is in so many respects, may bring opportunities for the EU financial sector. Its financial industry can grow more diversified and stronger as a result. Brexit will also require more interaction and cooperation between the ECB and the UK financial authorities. With the PRA we will work in the coming months on a comprehensive memorandum of understanding, covering aspects such as information exchange and the reciprocal treatment of cross-border banking groups.

Political headwinds

Let me now venture into less familiar terrain, that of geopolitical trends. Over the last five years, political forces supporting a return to national sovereignty have gathered strength; in several EU countries, they have either assumed a role in government or acquired sufficient force to be able to influence public policy in several areas, such as asylum and immigration.

The consequences for banking policies can be great. The banking union is an eminently cooperative project, involving a transfer of policy responsibility from Member States to the Union. Part of this transfer has already occurred, but several elements of the construct are not yet in place, and further political resolve is needed to complete it. If, as seems likely, the new forces are much less willing to engage in European cooperation, the completion of the project is in danger. A half-baked banking union may, over time, put financial and economic stability at risk.

Characterising the new political trends is not easy. A recent study defines sovereignism as a political movement that “advocates a return to an international order in which the nation-state, guided by the self-identified interests of the native ethno-cultural population, maintains or re-asserts sovereign control”.^[3] The overriding focus on national interest contrasts with the rationale of much of the European Union’s processes, which are based on the idea that Member States are interdependent and that their policies are a matter of common concern. Sovereignists tend to reject restrictions on the national will, whether they stem from market forces, supranational institutions or international relations more generally.

Sovereignism is often associated with another “ism”: populism. Here the emphasis is on “the people” as the sole source of legitimacy. Populists support direct expressions of popular will like referendums or, increasingly, social media; they are distrustful of mediated forms of government and the checks and balances provided by technocratic institutions. The appeal to the people, identified as a rule with the electoral majority, is etymologically reminiscent of democracy (which literally means “government by the people”), but the analogy is only apparent: modern democratic arrangements incorporate a much broader range of manifestations of popular will, such as constitutions, supermajorities, judiciary power, independent authorities (national and supranational), all ultimately stemming from the popular will but only in an indirect way^[4].

In banking, as in other areas, determining where the people’s interest really lies is not always easy. Who are “the people”, for example, when a failed bank has to be resolved? The depositors, who entrusted their savings to the bank without knowing how they would be used? The bondholders, who may have suffered losses because they relied on the bank itself for investment advice? Or the taxpayers (by far the most numerous group), who may end up losing money without having even realised that they were exposed to a bank risk? The interests of these groups typically conflict with one another in a resolution process.

The new political forces advocate state intervention, seeing the state as the best upholder of the interest of the people, in contrast with the free market orientation that has prevailed in recent decades. They tend to advocate the primacy of “politics” over “economics”, the latter seen as encompassing a combination of big business, financial markets and international organisations upholding orthodox policies, all of them supposedly conspiring to constrain the popular will.

Few indications are available as yet on how the new political forces will approach the challenges inherent in completing the banking union. I am personally convinced that there are no fundamental reasons why a strengthening of the banking union, which benefits financial stability and the quality of banking services offered to the people, should prove incompatible with their basic tenets and priorities; quite the contrary. But, as always, the devil will be in the detail.

It is important to always be aware of whose interests banking supervision is supposed to serve. To me they are those of the combined communities of those who use banking services (depositors and borrowers primarily) and of those who directly or indirectly bear the bank risks (including taxpayers). Those communities are very large and overlap to a large extent. The post-crisis banking reform agenda is predicated on the goal of making depositors more secure and taxpayers more protected. Taken together, taxpayers and depositors do not exhaust the generality of “the people”, but come close to it.

For all these reasons, the objectives of the banking union are deeply consistent with the promotion of the broadest collective interest which the new forces in the European political landscape purport to uphold. The supranational nature of the banking union is also helpful. Pursuing collective interest requires weighing up various types of special interests, which in banking are often vocal and well connected. A multinational supervisor is better placed than a national one in this regard, because decisions are made by a supranational body mandated to enforce a level playing field via peer review and peer pressure.

Conclusion

In three weeks’ time, the SSM will have a new Chair. Andrea Enria is a familiar figure in London, having led the European Banking Authority here for many years. It goes without saying that he possesses all the professional and personal qualities to be an outstanding successor to Danièle Nouy. To him and to the SSM go my very best wishes for the future, well beyond the end of my tenure as Supervisory Board member in March 2019.

The transition, in itself, should be unproblematic. Not only because of Andrea’s qualities and abilities, but because the supervisory function is firmly established within the ECB. The internal structures of ECB supervision are now fully functional, totalling around 1,200 people. Human resources are tight, but adequate. The staff is fully trained and highly motivated.

I have always believed in the benefits of a close association between central banking and banking supervision. Considering the new risks which banks are likely to face in the future and the other challenges I have mentioned, the integration between the two functions within the ECB will, if anything, need to be strengthened further.

Thank you for your attention.