Challenges for banks in the near- to medium-term

Opening statement by Ignazio Angeloni, Member of the Supervisory Board of the ECB, to the Plenary Session Roundtable “The Future of Banking: Will European Banks survive?” at the Dolomites Winter Finance Conference, organised by The Free University of Bolzano and held in Brunico-Bruneck, 15 February 2019

I am glad to be here and to participate in this roundtable discussion dedicated to the future of banking[1]. In my remarks today, I will briefly elaborate on the challenges which banks are likely to encounter looking ahead. In so doing, I would like to distinguish between the challenges brought about by the prevailing macroeconomic environment and those that stem from the legal and regulatory framework underpinning banking activity as well as banking supervision.

Legacy challenges and prospective banking risks

Starting with the macroeconomic aspects, I would first like to highlight that, from a system-wide perspective, the overall resilience of the euro area banking sector has markedly improved in recent years. The Common Equity Tier 1 capital ratio for the banks directly supervised by the ECB rose on average by around 3 percentage points to 13.9% (on a fully-loaded basis) in the period from end-2014 to the third quarter of 2018. It is worth noting that this outcome was achieved not by deleveraging or by lowering risk weights, but rather through genuine capital increases in most cases. Credit risks in the system have also been reduced, with the gross non-performing loan (NPL) ratio of significant banks supervised by the ECB dropping to 4.2% on a weighted average basis in the third quarter of 2018, from 7.6% at the end of 2014. The rate of decline has gathered momentum over the last two years and has been particularly rapid in countries with high NPL ratios, such that 13 of the 19 euro area countries now have gross NPL ratios below 5%, and 12 of them have net NPL ratios below 2.5%.

The outcome of the 2018 stress test – the final results of which were recently published[2] – also suggests that banks are now in a better position to withstand adverse shocks than was previously the case. In the adverse scenario of the stress test, the capital depletion of euro area banks directly supervised by the ECB was similar to that in the previous exercise, conducted in 2016, but – owing to a better starting position – the capital situation of the banks under stress is now assessed to be significantly better than it was two years ago.

However, notwithstanding the progress made in recent years, there are a number of legacy challenges exposed by the crisis which still need to be fully addressed. While there are notable differences both across and within different euro area bank jurisdictions, these can be broadly grouped into four categories, with banks needing to: (i) continue to adapt and rethink business models in a bid to improve profitability; (ii) engage in further balance sheet repair and clean-up, also to support the process of business adaption that I just mentioned; (iii) strengthen governance frameworks, especially as regards the control of risks and the credit screening process; and (iv) ensure that they have both adequate plans and sufficient means to ensure their own resolvability should the need arise.

As banks continue their efforts to deal with legacy risks, new challenges might be emerging. The nature of banking risk seems to be evolving in line with the shifting cyclical position of the euro area economy. Although indicators suggest that euro area activity will slow in the period ahead, the risks from traditional banking intermediation can be expected to be lower than they were during the recent crisis period. In addition, the turn of the monetary policy cycle should lead to a gradual removal of the extraordinary liquidity provision measures that have helped to compress both market returns and asset price volatility over the recent past. This may cause problems for those banks which took greater risks in the period of abundant liquidity in a bid to shore up their bottom line. In fact, financial market conditions have already tightened, with asset price volatility rising and certain risk spreads – notably those of some emerging market economies – also increasing. Taken together, these developments suggest that market risks are likely to become more prominent.

Enduring challenges from an uneven and incomplete regulatory landscape

Let me now briefly turn to the challenges stemming from the legal and regulatory framework underpinning banking activity in the euro area. One of the key founding aims of the banking union was to overcome the financial fragmentation which had surfaced through mostly “national” responses to the euro area financial and sovereign debt crisis. This piecemeal approach threatened to destroy the single financial market and undermine the entire construct of European Monetary Union itself. Banking union’s three constituent pillars – a Single Supervisory Mechanism, a Single Resolution Mechanism and a common deposit insurance scheme – were designed to act in concert to restore overall confidence in the banking system. On the supervisory front, the creation of a level playing field underpinned by a single rulebook was a critical element of this strategy.

Almost seven years after plans to establish a banking union were first drawn up, many of the legal provisions which the ECB needs to apply when carrying out its supervisory duties still date back to a time before the banking union was even conceived. The legal basis underpinning the ECB’s actions is a three-tier system made up of European norms directly applicable to banks (such as the Capital Requirements Regulation); 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 exclusively national in nature. This legal constellation offers considerable scope for national variations and rulings which create an uneven playing field across euro area jurisdictions. ECB Banking Supervision has done a lot to redress this, for example by harmonising the options and discretions available under EU law, as well as by issuing a number of guidelines in important areas where harmonisation is still lacking and national law continues to apply (including bank authorisation, and fit and proper assessments). While these have been important milestones, there are practical limits to what can be achieved through such exercises. As a result, legal harmonisation remains incomplete, with Member States retaining options and discretions in various areas of prudential relevance, such as liquidity provisions for entities within banking groups. Unfortunately, the ongoing review of the key pieces of European legislation which govern banking activity (the so-called “banking package”, which is almost finalised) does not make much progress in this regard. Waivers on capital and liquidity requirements within cross-border banking groups will remain largely national in nature.

Legal fragmentation interacts with other elements of institutional incompleteness within the banking union, altering incentives for banks and domestic authorities alike. In particular, the fact that the third pillar of the union – a shared deposit insurance scheme – is missing entirely implies that authorities which host large banking groups from other euro area countries are more likely to cling on to ring-fencing measures to retain capital and liquidity within national borders. This is also true for the “capital in resolution” which banks need to maintain (minimum requirement for own funds and eligible liabilities, or MREL). This acts as a dissuading factor for banking groups looking to expand their operations beyond their home jurisdictions. Until this self-reinforcing vicious circle is broken, the increased cross-border integration which the banking union was meant to help bring about will remain elusive. Remaining legislative gaps in the second pillar of the banking union – resolution – which relate, for example, to the conditions for banks to be declared “failing or likely to fail”, and the lack of harmonisation of national liquidation regimes, are a further complicating factor. Discrepancies standing in the way of a harmonised process to govern bank exits across the euro area in a smooth manner reinforce the status quo, strengthening the notion that solutions for troubled banks should remain within national borders.

Concluding thoughts and open issues

I realise, in concluding, that I have said much more about the risks faced by banks at present or in the immediate future than about challenges that will materialise over the medium term. Taking a longer perspective, I see two main challenges facing European banks: the first stemming from global competition, the second from technological change.

Banking competition at the global level has increased recently. US banks have recovered more rapidly from the crisis than their European peers. They have sharply increased in terms of size as well as profitability; European banks have not. This poses a serious challenge for our banks, because the ability to generate returns internally is vital, in the medium term, for the solidity of the sector. The profitability of European banks has been persistently weak for two main reasons: the need to provision for credit losses accumulated during the crisis and the low or even negative level of interest rates. The provisioning effort is now gradually coming to an end. By contrast, interest rates will remain low for a while, because the economy requires it. While the returns of European banks have increased lately, they have not yet reached the levels enjoyed by their competitors or even those they historically enjoyed themselves. Banks should manage this transition by ensuring careful control of their costs and by developing, to the extent possible, other sources of income – such as the provision of client services.

The digital revolution presents both challenges and opportunities for banks. On the one hand, complex banking services are likely to become “unbundled”, meaning that they may be fragmented into components that can more easily be targeted by competitors or outsourced. At the same time, large non-financial firms, especially retailers with a strong IT focus, will step up their efforts to enter the banking business by exploiting economies of scope. On the other hand, digitalisation – if used well – can be a powerful tool to reduce bank costs, meaning that those banks that make more intensive use of IT should see lower cost ratios over time.

One thing is certain: the banking industry, globally and in Europe, will remain highly competitive. And this is a challenge for the banks themselves, as well as for the supervisors.

Thank you for your attention.

[1]I am grateful to Francisco Ramon-Ballester for preparing a first draft of this statement. I am solely responsible for the views expressed here and for any errors.
[2]See “ECB 2018 stress test analysis shows improved capital basis of significant euro area banks”, press release from 1 February, available on the ECB’s Banking Supervision website.

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