Supervising banks – Principles and priorities

Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the SSM & EBF Boardroom dialogue, Frankfurt am Main, 7 March 2019

Ten weeks have passed, or rather flown by, since I became Chair of the ECB’s Supervisory Board and I have now begun to appreciate the enormous tasks that lie ahead.

I am lucky enough to be able to build on the solid foundations established by Danièle Nouy and Sabine Lautenschläger in the first years of European banking supervision. The Single Supervisory Mechanism, or SSM, which they set up from scratch, is now well functioning and well regarded.

In these first weeks in the job, I have been very impressed by our staff’s high technical standard, their rigorous approach and their outstanding commitment. Thanks to this solid approach to European banking supervision, banks have become safer and sounder. The SSM was established to enhance the resilience of European banks; by this measure, the progress achieved in such a short span of time has been impressive.

Stability and integration – two sides of the same coin

Now that the SSM is moving to a more mature stage, we have to ask ourselves whether this is sufficient. After all, the banking union can only be successful if it delivers an integrated, truly domestic banking market for the euro area. This is essential in order to enhance private risk-sharing, so that a shock hitting a Member State or region can be better absorbed through a more diversified banking sector. The banking union was launched to address the adverse feedback loop between banks and their sovereigns and to ensure that banks more effectively meet the needs of corporates and households, also throughout a crisis. Market integration not only helps in enhancing efficiency to the benefit of bank customers; it is also intimately linked to the stability objective; in fact, it is the other side of the coin.

As yet, a highly integrated market remains a long-term goal, a vision. Despite the progress achieved, the European banking sector is still fragmented, as the restructuring process has taken place mainly along national lines. Also, not enough banks have exited the market. Too little consolidation has taken place, and where it did, it was almost exclusively domestic. Excess capacity has not been reabsorbed, which contributes to the low profitability of European banks. As supervisors, we cannot consider the post-crisis repairs to have been completed if market valuations and price-to-book ratios remain at the current depressed levels.

Establishing the SSM (and the Single Resolution Board, dealing with the second leg of the banking union) has undeniably been a big step forward. Supervisors from the ECB and national competent authorities work together intensively, on a daily basis, applying common methodologies and processes that lead to single decisions by the Supervisory Board, on which each authority is represented. This in itself goes a long way towards breaking down existing barriers.

Still, tangible progress on financial integration is eluding us. In my discussions with European bankers I sometimes sense a feeling of disillusion, a creeping resignation that our markets will remain segmented for a long time to come.

I am acutely aware that many of the decisions required to advance the integration of European banking markets lie outside the remit of supervisors. We have made progress in setting up a much more harmonised regulatory framework, a single rulebook directly applicable throughout the EU. However, there are important areas in which progress is falling short of what is needed. If we really aim to have a truly European banking sector, we should allow banking groups to freely allocate their regulatory capital and their liquidity within the euro area. But there is still reluctance to remove existing barriers.

I do understand the concerns of some national policymakers. They fear that banks are still “national in death” and that they might have to carry the burden when a bank gets into trouble. In the absence of clear safeguards to protect domestic interests in bad times, policymakers thus feel the need to require the local entities of banks to maintain relatively high amounts of capital and liquidity, also in good times.

In their view, if we are to grant more space for firm-wide regulatory approaches within the banking union, we would need to have a genuinely European safety net. And although some progress has been made with the agreement on the backstop for the Single Resolution Fund, the debate on the other element of the common safety net, the European deposit insurance scheme, remains stuck. Some people argue that before we share risks, we need to reduce them. Others say that risks have already been reduced enough to start mutualising them. This is misleading, in my view; it is not a question of “either/or” or of “first this and then that”. Legislators should move in lockstep on both objectives, with a clear vision on the final objective and a well-defined roadmap to get there.

While this difficult debate is taking place, I believe that as European supervisors we have a duty to seek pragmatic solutions that promote greater integration – within the current institutional and legal set-up. At the same time, banks might wish to consider branch structures, rather than subsidiaries, as a way to fully exploit the opportunities offered by the banking union.

Supervising banks – the priorities

Other important priorities for the SSM have been well defined and call for continued focus and effort on the part of both supervisors and firms. The cleaning-up of balance sheets has to be completed. Some banks are still burdened by high levels of non-performing loans (NPLs), which affect their soundness and their profitability. And the high levels of NPLs might also affect the terms on which they grant loans and to whom they grant them.[1] On both accounts, the outcome is likely to be bad for the economy.

European supervisors have therefore developed a framework that sets out their expectations on how banks should deal with NPLs. It has been designed to promote the clean-up of legacy NPLs and prevent the build-up of future NPLs. This framework is a huge step which should help banks to make faster progress. It is demanding, but flexible: it can be adjusted to reflect the specific features of each bank’s portfolios and financial position and it entails a continuous dialogue between supervisors and supervised entities. Indeed, partly as a result of applying this framework, we see that levels of NPLs are steadily going down across the euro area. The work we have just started on credit underwriting criteria should help to strengthen industry practices and prevent excessive build-ups of NPLs in future.

But it is not just about getting back to full health; it is also about staying healthy. And this requires a good dose of long-term thinking. It is as easy as it is dangerous to take the status quo for granted. Things usually change, and in financial markets, change can be very sudden.

Take market and funding risks, for example. Liquidity has indeed been abundant and cheap for quite some time now. But this will change at some point: liquidity might become more costly and markets more volatile, while banks need to issue debt instruments that could be bailed-in in the event of a crisis, as required by the Bank Recovery and Resolution Directive (BRRD). Also, the new framework for market risk developed by the Basel Committee on Banking Supervision might have to be implemented in a period of heightened volatility, while we still see sharp differences in valuation practices for financial instruments.

The robustness of internal risk measurement and management has to remain a central focus of our supervisory work. The review of internal models – the TRIM project – will be completed this year, but the follow-up to its findings, coupled with the implementation of the standards and guidelines developed by the European Banking Authority, will keep supervisors and banks busy for quite some time. It will be worth the effort, though: we need greater consistency and reliability of risk-weighted asset calculations in order to foster good risk management practices and fully restore the credibility of the regulatory and supervisory framework.

And then there is Brexit. The deadline is a mere three weeks away, and things are still very unclear. But no matter whether there will be a deal or no deal, or an extension of the timeline, we are prepared. Over the past two-and-a-half years, we have thought through all of the potential issues, and we have developed a number of appropriate policy stances.

At the same time, we have urged the banks to prepare as well. And they have made good progress. For those banks that want to relocate to the euro area, the relevant authorisation procedures have either been completed or will be completed in the coming weeks. For euro area banks operating in the United Kingdom, we are currently focusing on risk management, trading capabilities and their future UK operations. We expect all banks to have dealt with any remaining concerns by the end of March.

Taking a broader view, Brexit will change the shape of the banking sector, raising a host of questions. How should we regulate and supervise third-country branches or investment firms? And more generally, how can we deal with the continuing close interconnection between the UK and the European banking sectors? To me, one thing is clear: post-Brexit, withholding cooperation is no solution. UK and EU supervisors must find ways to work together towards a safe and sound banking sector. And I can reassure you that constructive solutions are being found.

Supervisory approach: rules and judgement

Let me now turn to the ECB’s approach to supervision. I believe that the fusion of different cultures has created a very robust supervisory model – a model that is rigorous, firmly based on on-site inspections, with a strong quantitative backbone, attentive to the consistency of outcomes and proportionate. There have been criticisms, though. In particular, it has been argued that the ECB has trespassed into rule-making – that it has ventured beyond its supervisory mandate.

This criticism is not well founded in my view. There are areas in which the rules are not specific enough, and we need to develop common supervisory criteria to address concrete issues. And there are many matters that the legislator has left to the choice of supervisory authorities: the work done by the SSM on options and discretions, generally well received and praised, is a case in point here. But there is a broader theme that interests me more. Are we supervisors too focused on applying rules rather than exerting judgement? Do we pay too much attention to the general case and not enough to the individual one? Are we constraining our supervisory judgement within an excessively tight set of criteria, which may prevent us from achieving the best results in every specific case?

First of all, we do not and should not design rules; this is up to the legislators and the technical authorities delegated by legislators. The ECB has a supervisory task, not a rule-making one. That said, there should be a feedback loop. Supervisors and regulators must talk to each other, and the experience of supervisors must inform the work of regulators. For instance, some rules may be less effective in practice than expected when they were designed. And some rules may interact in a way that makes them difficult to apply. For instance, the ECB has flagged the difficulty of applying early intervention measures due to the overlap of tools defined in the BRRD and the Capital Requirements Directive. The experience of supervisors should be taken into account when shaping and reviewing the rules.

But at the end of the day, rules are rules, and we have to apply them; there is no getting around that. This brings us to the other questions I just raised. And yes, good supervision reaches beyond the rules and general cases. Good supervision is based as much on judgement as on rules. Supervisory judgement is crucial in order to accommodate the individual situation of each bank; it should not be confined by overly detailed rules. In particular, this is crucial in a rapidly changing financial landscape in which rules and regulations simply cannot keep up. Here, we need to thoroughly understand evolving risks within and across banks, and we need to address them by taking a dynamic and forward-looking supervisory approach. Often this entails identifying emerging best practices and promoting them across the industry.

European banking supervision faces a special challenge in this respect. When it was set up, it brought together 19 Member States, each with its own supervisory culture. But the task was to create a common European culture. To reach this goal, to channel the different cultures towards a single one, a more rigid frame was needed to ensure consistency. But the closer we get to a common supervisory approach and culture, the more flexible the frame can be, and the more room can be given to judgement, possibly coupled with ex post quality and consistency checks.

We usually start from a common methodology that provides a level playing field. On this basis, we assess each bank, and we tailor our supervisory expectations to its specific situation. This requires us to have a constant dialogue with banks, of course, to be able to take into account its particular circumstances. It is important that we listen to your views, but form our own opinions based on our common standards and the range of industry practices around them.

Transparency, predictability and accountability

But communication is not a one-way street, and it goes beyond the confidential dialogue between supervisors and banks. We supervisors, too, must communicate and engage with a broader set of stakeholders – investors, bank customers and the public at large. For me, transparency has become a key issue, and here’s why.

First, our actions have an impact on a broad group of interested parties, in any of 19 European countries and beyond the euro area. This has become even more relevant since we introduced the concept of “bail-in” in our legislative framework. The moment we declare a bank failing or likely to fail and resolution or national wind-down proceedings are initiated, investors and creditors stand to lose money. So they must be able to understand how the new world works and what we are up to. And thus, transparency becomes more important.

Second, as I just said, our decisions are based on both rules and judgement. If we were to simply apply rules in a mechanical way, each of our decisions could be traced back to a specific rule. There would be full transparency and no uncertainty. The more we rely on judgement, though, the more we need to explain our decisions. Again, transparency and predictability become more important.

Third, in pursuing a public goal – safe and sound banks – we operate as an independent institution. Given the impact our decisions might have and the judgement we apply, we need to be both transparent and accountable. Lawmakers have therefore put a strong accountability framework in place, which I fully support.

To sum up: as European banking supervisors we must be accountable, and we must be transparent. We must carefully explain what we do and why we do it. Banks, investors and the public must be able to understand our principles and policies. Only then will they be able to anticipate our actions and expectations. And only then will they grant us the trust and independence we need to do a good job.

That’s why I see transparency as a key issue. And I think there is room to be even more transparent than we already are.

I am aware that there are some limits and risks we need to take into account. Supervisory work is bound by confidentiality: we often obtain highly sensitive insights through our work and disclosing them might put banks at a disadvantage vis-à-vis their competitors. There are legal limits to this kind of transparency, and they are fully justified.

But we can still put some more information out there so as to help markets form a view on the way we operate and on what we require from banks. Take the supervisory review and evaluation process (SREP), for example. The SREP is the ECB’s core tool for assessing the risks of each bank and determining its Pillar 2 requirements. I believe the ECB has made a commendable effort to become more transparent on its SREP methodology. However, I have heard some calls for more clarity and predictability with regard to our assessments. I think we should listen to such requests and check whether some things could be improved. Why not specify which risk drivers guide our overall decision, for instance?

Also, I notice that practices on the disclosure of Pillar 2 requirements vary widely. In some cases, no information is disclosed, even though it is essential for determining the triggers that may lead to suspending coupons or to converting Additional Tier 1 instruments into equity. Breaching Pillar 2 requirements can also trigger a “failing or likely to fail” assessment, with direct consequences for all categories of investors and possibly even for uninsured depositors. Greater transparency would thus be warranted, I believe.

Conclusion

Ladies and gentlemen,

The banking sector has been at the epicentre of the crisis. Irrespective of how successful we have been in designing and enforcing reforms and repairing bank balance sheets, the effects of the crisis propagated well beyond the boundaries of our narrow business interest. We are confronted with requests for radical change, often fuelled by discontent. People have been losing faith in the idea that the European project can make their lives better. I believe that it does make our lives better – from fundamental values such as lasting peace to small conveniences such as the ban on roaming charges; from exciting adventures such as the EU Space Programme to more sober endeavours such as European banking supervision.

But explaining ourselves better is not enough. We also need to listen more carefully. Only then will we understand the true nature of problems and the sources of discontent. And only then will we find the right policies to address them. As one of the founding fathers of the EU, Altiero Spinelli, once said, the quality of an idea is measured by its ability to rise again after failures. This is the overarching challenge we all face.

Thank you for your attention.

[1]See: Holton, S., McCann, F. (2017), “Sources of the small firm financing premium: evidence from euro area banks”, Working Paper Series, No 2092, ECB, Frankfurt am Main, August, and, Andrews, D., Petroulakis, F. (2019), “Breaking the shackles: Zombie firms, weak banks and depressed restructuring in Europe”, Working Paper Series, No 2240, ECB, Frankfurt am Main, February.

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