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Regulation, proportionality and the sustainability of banking

Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the Retail Banking Conference "Creating sustainable financial structures by putting citizens first" of European Savings Bank Group, in Brussels

21 November 2019

When I read the teaser for this conference, I came across the term “regulatory rage”. And the question that appeared with it was this: At what point does regulatory reform trigger regulatory rage? In other words, when is enough, enough?

Well, I guess it depends who you ask. If you ask banks, they might tell you that regulatory reform gave way to regulatory rage a long time ago. If you ask me, you’ll get a different view. I believe the extensive regulatory repair that we have undertaken at the global level is a balanced response to the massive shortcomings identified during the crisis. And it is based on extensive consultations with the industry and on detailed impact assessments.

So let’s delve deeper into the topic. I will first discuss what the reforms mean for banks in general. Then I’ll take a closer look at smaller banks in particular, and make the case for a proportionate approach to regulating them. Finally, I will venture beyond the limits of regulation and discuss sustainable finance, a topic that features prominently in this conference and in the public debate.

Regulatory reform or regulatory rage? The case for Basel III

I concede that regulatory reform has taken quite some time. Work on Basel III began back in 2009, and the final part was agreed on only in December 2017. The full transition phase will then take us to 2027. That’s 18 years of regulatory reform. Or 18 years of regulatory uncertainty, as the banks would call it. In any case, it is time to bring the reforms to a close. Banks need certainty about the final requirements. And that is what we are pushing for.

This means implementing Basel III here in Europe – faithfully, consistently and in good time. I am aware that not everyone agrees on all parts of Basel III. But as it stands, Basel III is the best compromise that could be found, and so we should support it.

The final package mainly addresses issues regarding the determination of risk-weighted assets. Some parts of the new standards come from proposals arising from analyses conducted by the European Banking Authority, corroborated by findings from the ECB’s targeted review of internal models. The envisaged changes are needed to preserve the risk-sensitivity of the regulatory framework and to continue relying on internal models developed by banks.

But banks complain that this last enhancement to their safety and soundness comes at an excessively high price, especially in times of low interest rates and low profitability. Prior to the crisis and prior to Basel III, profits were indeed high. But were these the right profits? Or were they fed by excessive risk-taking, unrealistic expectations and irrational exuberance? Such profits can indeed be very high, but they are not made to last. These are the kind of profits we saw in the run-up to the recent crisis – and to most other crises in history. And these are not the kind of profits we want to see in the future. Basel III will ensure that profits are more sustainable by ensuring that banks are better capitalised and hold more liquidity.

This notion is underscored by research that suggests that banks with higher capital ratios face a better trade-off between risk and profits.[1] In other words, they generate the same level of profits with lower risk.

Transitioning from one regime to another may be difficult, of course. But it can be done. Just look at the United States: rules have already been strengthened there, the adjustment to the new standards has been faster and banks have restored a satisfactory profitability. In fact, they are more profitable than banks here in Europe, where we took a much more gradual approach when implementing the reforms.

The European Banking Authority has estimated the impact of Basel III. It expects that overall Tier 1 capital requirements for European banks will increase by around 24%.[2] This sounds very high, but the result rests on quite conservative assumptions. Thus, the true impact might be significantly lower.

So, to sum up: I do think that Basel III offers more stability at a fair price. Now, you might argue that even if the price is fair overall, banks are different – in terms of business model, size and complexity. And what is a fair price for one might not be for another. Smaller banks, in particular, tend to claim that new regulation places a disproportionate burden on them. Let’s take a closer look at this issue.

The same rules for everyone? The case for proportionality

It is true that the intended scope of Basel III only encompasses internationally active banks. In the European Union, however, it is applied to all banks, large or small, domestic or international. So, is there a case for applying the rules in a more proportionate manner?

This depends on the cost-benefit trade-off of regulation, which needs to be in balance. The benefits of regulation are determined by the riskiness of a bank. The riskier a bank is, the higher the benefits of strong regulation. Now, smaller banks often claim that they are less risky. They claim that their business models are more conservative and that they are thus less likely to get into trouble. And if they do, they won’t trigger a systemic crisis.

There is some truth in these claims. But smaller banks are not less likely to get into trouble, and if they have similar business models they may well get into trouble at the same time. “Too many to fail” may prove to be a real problem. Also, they sometimes belong to networks of interconnected institutions, which may well lead to a more systemic footprint.

What about the costs of regulation? Well, here we may have economies of scale. When we roll out very complex rules designed for large and complex banks, it will definitely be more costly for smaller banks to comply.

So evidently, we cannot have a “one size fits all” approach. For the sake of fairness and for a level playing field, rules must indeed be proportional.

This brings us back to the implementation of Basel III. While it will add to the overall capital requirements, smaller banks will be much less affected. As I have already mentioned, the EBA estimates that Tier 1 capital will increase by around 24% overall. But for smaller banks, the increase will be around just 5%. So, in a sense, the impact is proportionate.

More generally, proportionality is a key principle for European legislators, as enshrined in the Treaty. The latest revision of EU banking law follows this spirit. It foresees that smaller and non-complex banks will have to deal with less stringent requirements for reporting, disclosure and remuneration. And they will be able to apply simpler approaches for calculating some risks. The new provisions inserted in the Capital Requirements Regulation and Directive further emphasise these aspects. I don’t think it would be appropriate to revisit the fine balance that has been achieved only recently.

So, regulation is proportionate. Now, what about supervision? As provided for in the SSM Regulation, we take a proportionate approach also when supervising banks. Let’s look at a few examples.

First, there is reporting. As a general rule, smaller banks have to report fewer data points than larger banks. In numbers, that means 600 data points as opposed to almost 40,000. Still, I admit that the reporting burden remains too high for many smaller banks with simpler business models. And I think, in this area, we should listen carefully to their concerns and look for reasonable solutions to ease this burden. We are already working with other authorities to make data collection simpler and lighter. We are considering ways of streamlining our ad hoc requests for data, for instance. And we are trying to improve our advance communication to banks, so that our requests for information become more predictable and the feedback from our analyses more useful, also for internal risk management purposes.

Second, there are the supervisory fees we levy on banks. We decided to differentiate between the amounts banks have to pay based on their significance. Smaller banks – the less significant institutions – have to pay less.

Third, there is the day-to-day business. Here too, we take a proportionate approach. With regard to those banks we supervise directly, our approach is more intense for the largest and more complex banks, as well as for the more relevant subsidiaries. This is reflected in the amount of resources we deploy, and in the range, depth and frequency of our activities – both on-site and off-site.

We take a similar approach to banks that are supervised at the national level. The intensity of supervision depends not just on the riskiness of a bank, but also on its relevance for the domestic financial system. For instance, for the Supervisory Review and Evaluation Process, the common methodology being rolled out for the smaller banks in Europe is fully proportionate, in terms of both intensity and frequency.

To sum up: on the whole, all the tools for a proportionate regulation and supervision of European banks are in place, and we are committed to applying them while keeping a close eye on the compliance burden for supervised entities.

Beyond regulation? Sustainable finance

This brings me to my final point. Regulators and supervisors focus very much on making banks more sustainable. We try to put them in a place where they can withstand shocks and stay in business over the long term. And here, by making sure banks have enough capital and other liabilities that can be written down or converted into equity to absorb losses in a crisis, we have achieved a great deal.

But there is a broader notion of sustainability, of course, which now features prominently in the public debate. It’s about being sustainable on a larger scale, at the level of society. And climate change is one of the key issues.

There is a clear link to the economy and to banks. What is consumed, how it is produced and where it is produced does affect the environment. So, fighting climate change will require major changes in our economy. And as banks have a key role in allocating funds to the economy, they will play a part too.

Consequently, there are ideas to give banks an incentive to allocate more capital to green projects and assets. Some argue that regulation should feature a green supporting factor. In other words, capital requirements for exposures to green assets should be lower. From my point of view as a supervisor, it is not as easy as that. Our mandate is to make banks safer and sounder. Thus, the treatment of exposures to certain assets should be based on their risks.

These risks must be carefully analysed before we jump to policy conclusions. Any capital relief for green assets must be based on clear evidence that they are less risky than non-green assets.

That said, climate change certainly poses risks to banks. There are two broad categories of new risk drivers. First, there are the physical risks. With climate change we will see more heatwaves, droughts, storms and other natural disasters. We already do. These disasters will lead to economic and financial costs, which might very well have an impact on the balance sheets of banks. Second, there are transition risks. Given that the economy will go from “brown” to “green”, some sectors might suffer – those which are carbon-intensive, for instance. And to the degree that banks are exposed to these sectors, they might suffer as well.

Against this backdrop, the European Parliament has mandated the EBA to assess whether the regulatory and supervisory frameworks need to be revised. The ECB contributes to this work. At the same time, we work on how to define and measure climate risks. Clearly, this is a prerequisite to addressing them from a prudential point of view.

Of course, we do not work alone. The ECB is a member of the Network for Greening the Financial System. This network comprises 42 members – regulators, supervisors and central banks – from around the world. It is encouraging to see that so many institutions do see the challenge of climate change and have joined forces to deal with the associated risks. In line with this work, we might start voicing a few supervisory expectations for banks in the not too distant future.

But we are still in the early stages. We have to look deeper into these issues. And when we take action, naturally we will have to stay within the limits of our mandate.

Now, how do the banks themselves approach the topic? They are very much aware of climate change; a survey we recently conducted on a sample of banks indeed showed this. But so far, they have addressed climate change from the angle of corporate social responsibility. Now they should expand their focus and approach it also from the angle of risk management and disclosure.


Ladies and gentlemen,

Regulatory reform was necessary. And Basel III is the key piece of this reform, not least because it embodies a global effort. It embodies a global effort at a time when global cooperation seems to be going out of fashion. So it is also an important symbol. And it is in this spirit that the European Union needs to implement Basel III as it is. We have to prove that we are a reliable partner in the global regulatory community. And we have to ensure that a sector that is global in scope is covered by global standards and rules.

I understand that banks are different. They differ in size and in complexity. And yes, I am in favour of regulating and supervising banks in a proportionate manner. However, this must not be taken to the point where we overlook, neglect and thus reinforce risks. Regulation has to follow the risks.

And this is also true for sustainable finance. Climate change is one of the biggest challenges we face right now – if not the biggest. But the role of bank regulators and supervisors is limited; our job is to ensure safe and sound banks. So, if climate change leads to particular risks for banks, we have a duty to take this into account. And if there should be a risk differential between green and brown assets, we will take this into account too. All else is beyond our mandate.

That said, we should not forget that banks are free to pursue their business in a sustainable way. And by that I not only mean in a climate-friendly way. I also mean in a way that does not lead to another crisis but benefits the economy and society as a whole. Banks play a key role in society, and they should accept the responsibility that this entails.

Thank you for your attention.

  1. Mergaerts, F. and Vennet, R.V. (2016), “Business models and bank performance: A long-term perspective”, Journal of Financial Stability, Vol. 22, pp. 57-75.
  2. According to Table 1 of the EBA’s reply to the EU COM Call for Advice: https://eba.europa.eu/sites/default/documents/files/Basel%20III%20reforms%20-%20Impact%20study%20and%20key%20reccomendations.pdf

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