The case for more transparency in prudential supervision
Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the EBI Global Annual Conference on Banking Regulation
Frankfurt am Main, 20 February 2020
I am honoured to be here today to speak about the role of transparency and information in banking regulation and supervision. Many thanks to Professors Lamandini and Troger for organising what has become one of the most anticipated academic events for discussions among experts in legal disciplines, banking regulation and banking supervision, with a specific focus on the Single Supervisory Mechanism.
I am particularly grateful for their invitation to discuss the importance of transparency in banking supervision, as transparency is one of my foremost priorities as Chair of the ECB’s Supervisory Board.
Let’s think back to the beginning of the last century and to one of the greatest American legal minds, who would soon become one of the most noteworthy judges of the Supreme Court: Louis Brandeis. In his seminal essay, “What Publicity Can Do”, he neatly described the role of transparency and information disclosure in financial markets: “Publicity is justly commended as a remedy for social and industrial disease. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”
However, it took the Great Crash and the Great Depression before this warning and recommendation was heeded with the establishment of the Securities and Exchange Commission and many other institutional reforms. Like many great minds, Brandeis was right but ahead of his time.
And while publicity was relevant at the beginning of last century, it is even more relevant now. More than at any other point in history, our world thrives on information, especially so in financial markets where knowledge is not only power but also money. In fact, knowledge, or information, is what makes markets tick. If there were perfect information, prices would send the right signals and resources would be efficiently allocated. So there is no doubt that transparency and information play a key role in ensuring that markets are efficient.
But what does that mean for banking supervisors? What should our policies be on information sharing, on transparency? To use Brandeis’s metaphor, how much sunlight is needed, or appropriate, in banking supervision? These are delicate questions, especially if we consider the long-standing tradition of confidentiality in the conduct of banking supervision, a tradition that is also enshrined in legal obligations under European directives and regulations.
When performing our core tasks we access and process large amounts of bank-specific information, which we use to assess banks’ riskiness and viability. The first question I will address is: to what degree should the bank-specific outcomes of our work become public?
Our daily work also builds on extensive policies and methodologies, which we always combine and complement with supervisory judgement. So the second question is: how transparent should we be about our approaches?
We think about these questions quite intensively. And, as it turns out, they are fairly complex to answer. So today I can only offer you a few preliminary thoughts. I will argue, though, that more transparency is warranted both for supervisory outcomes and supervisory approaches.
Transparency of supervisory outcomes
Let us begin with the first question. Supervisors have a deep knowledge of the banks they supervise; how much of this knowledge should they share?
Well, banks are, in general, a special case when it comes to transparency. Information – or rather asymmetric information – is at the heart of financial intermediation. The business of banking is by nature more opaque than other types of business. A bank’s management has much broader access to information than the bank’s owners, creditors and depositors. Stakeholders also differ substantively in terms of economic knowledge. This gives rise to principal-agent problems, limits the exercise of effective market discipline on bank managers and brings trust to the forefront. In banking, trust and stability go hand in hand. If trust is damaged, banks are left in a precarious position: one piece of information – whether right or wrong – can trigger runs, fire sales or other equally damaging herd behaviours, which can potentially take a bank down.
The financial crisis was a case in point: new financial instruments enabled banks to bundle and sell risks. But the way these instruments worked was opaque. At the height of the crisis, no one seemed able to see which banks held which risks. No one was able to put a price on assets. This lack of information created a vacuum – a vacuum that was quickly filled with rumours, irrational fears and best guesses. Trust in the banking sector vanished, the interbank funding markets froze, and the whole financial system plunged into an unprecedented crisis.
So it seems clear that more transparency not only helps to make the market more efficient but also to make it more stable. Transparency in and of itself does not reduce risks, of course. It does, however, make it easier to spot and address problems before it is too late. It increases market discipline on bank managers and provides a solid underpinning of trust, and trust is the key to stability.
That is why banks have to follow strict disclosure rules – much stricter rules, in fact, than other companies. With the introduction of the Pillar 3 requirements, the Basel Committee on Banking Supervision has gone a long way in enhancing banks’ disclosure of their positions and compliance with prudential standards. Still, there is ample room for improvement in the clarity and comparability of Pillar 3 disclosures. The European Banking Authority (EBA) is trying to address this through draft implementing technical standards submitted for public consultation towards the end of 2019. Additionally, the requirements to disclose price-sensitive information under the European rules to prevent market abuse seem to be applied in different ways across the banking union. The ECB has now started a dialogue on this topic with the European Securities and Markets Authority, the ESMA.
But let us focus on bank supervision, on the specifics of our role as supervisors. Can and should we publish information on supervisory outcomes? Should we help markets form a clearer picture of where banks stand?
My general answer is “yes”. But I acknowledge that there are limits, including legal limits, which are fully justified. Bank-specific information can be very sensitive and disclosure requirements should not go so far as to damage a bank’s competitive position. Furthermore, given the key role of information and trust in banking, we should always ensure that what we publish is properly explained and duly understood.
But within these limits, I think that we can and should do more.
This has already started. In January this year we published, for the first time ever, bank-specific Pillar 2 capital requirements, P2R, for all the banks that we directly supervise. Individual P2Rs offer a concrete and comprehensive insight into our view of a bank in terms of overall riskiness and where we, as supervisors, set the bar. In my view, the supervisory stance on capital requirements will help investors to take more informed decisions, and it will help banks to better assess where they stand vis-à-vis their peers. The feedback we received on our initiative was indeed fairly positive. And what was a voluntary exercise this year will become a requirement from next year onwards: having seen the merit of enhanced disclosure, the legislator has introduced a P2R disclosure requirement for large institutions within the revised capital requirements regulation.
Our supervisory assessment is not limited to P2R, though. Every year we communicate to banks what capital buffer we expect them to maintain, on top of all existing minimum and buffer requirements, so as to be able to withstand stressed situations. I am referring to the Pillar 2 Guidance, or P2G. So, what about publishing P2G outcomes as well? Personally, I would argue in favour of doing so. But I am aware that this remains very controversial. Some are concerned, for instance, that markets might think of the capital guidance as a hard minimum requirement, which it is not. It is just another capital buffer that banks can use if needed, for example when market stress materialises or the bank takes a temporary capital hit to restructure its business. As I said, ensuring that whatever we publish is properly explained and understood is part of our mission. Against this backdrop, I think we need an open debate on whether we can be more transparent in future, even with P2G.
And this brings us to stress testing, which is the basis for setting P2G. Stress tests are another important supervisory assessment, and thus another source of very valuable information. We have seen this since 2011, when the first EBA stress test introduced the practice of disclosing a large set of data on individual banks. In the current setup, granular stress test results are only published for those euro area banks that are part of the EBA stress test sample. The ECB also conducts stress tests for the significant institutions that are not part of the EBA sample. And it was only in 2018 that we began publishing the aggregate outcomes of the exercise, without any information on individual banks. You can probably see where I am heading: should the ECB be more transparent on stress test results for those banks that are not included in the EBA sample? Again, my personal view is that yes, we should, in a proportionate way. This year we will classify banks into four groups according to the impact of the stress test on their capital position and will then publish the list of banks in each group.
So to sum up: based on their insights, supervisors can provide market participants with very valuable information on how they think banks are doing. My view is that they should provide this information. But I must make one thing very clear: the idea is to help markets form independent and unbiased views. We don’t want to steer markets in one direction or the other. Nor do we want to upset markets.
Transparency of supervisory approaches
So far I have discussed transparency of supervisory outcomes: this is about information on the performance of banks. Let me now turn the spotlight on the supervisor. Our announcements and actions have consequences – very specific consequences. As I have already said on other occasions, we now live in a bail-in world. When we decide to declare a bank failing or likely to fail, investors stand to lose money. Likewise, our decisions and actions in ongoing supervision may trigger restrictions on dividend distributions and payments on other capital instruments. Our Pillar 2 decisions have an impact as they set the threshold for “failing or likely to fail” assessments. They may affect consolidation strategies.
We also pursue a public goal – safe and sound banks; and we do so as an independent institution. Given the impact our decisions may have and the discretion and judgement we apply, we depend on the trust of the public and must be accountable in the performance of our tasks.
Put all this together, and it becomes clear that we must aim for transparency. We must not spring any supervisory surprises. Our policies and decisions must be sufficiently clear, predictable and comparable in the eyes of the entities they address. More broadly, the markets and the wider public must be able to understand what we do, and why and how we do it.
Don’t get me wrong: supervision is not and should not be a mechanical exercise that is purely rules-based. We must exert judgement and supervisory discretion. We cannot afford to have banks perceive our activity as a mere reaction function. However, we must ensure that our actions and decisions do not unduly surprise market participants; we must publicly elaborate on what drives our decisions and give more visibility to the consistency embedded in our approaches.
At the start of the banking union, this was a challenge, of course. In 2014, the ECB took over banking supervision in the euro area, and this was a new concept. By design, European supervision was shaking up long-established national practices, replacing them with something new and still in the making. It was unavoidable that this change would create some uncertainty.
But it is equally fair to say that the ECB has done a great deal to explain this new supervisory world. In recent years, it has provided a raft of insights into its inner workings. We have published our supervisory manual and – in particular – provided quite a lot of detail around the Supervisory Review and Evaluation Process, the core tool of ongoing supervision. Likewise, much work has been done to clarify, simplify and enhance transparency in the area of supervisory options and discretions. And finally, the ECB’s approach to tackling non-performing loans garnered plenty of publicity.
In my discussions with stakeholders I also perceived a lingering concern about the consistency of the capital requirements and buffers across banks under our direct supervision. I have looked carefully at our internal processes, and I know how much attention is devoted to this issue, also in the discussions within the Supervisory Board. Still, I intend to tighten our internal quality assurance and consistency checks to ensure a level playing field across banks within the banking union. And I expect the overall transparency and predictability of supervisory outcomes to improve as a result of this work. Take for example our policies on mergers and acquisitions, M&A for short. Many seem to think that we are actually standing in the way of a more integrated and consolidated banking market. Well, we are not, but we apparently need to communicate our policies towards M&As more clearly. And we will be: we plan to clarify, among other aspects, the M&A assessment process as well as concrete policy aspects, such as the treatment of badwill and the determination of capital requirements for the resulting entity.
Ladies and gentlemen,
In my speech today, I have made the case for transparency, for letting more sunlight into financial markets, including banking supervision. But there is one thing we have to keep in mind – it is not just the amount of available information that determines market outcomes. It is also how this information is processed; and here, humans are limited – especially when it comes to risk and uncertainty. As we all know, irrational behaviour and exuberance sometimes prevail.
At the same time, transparency doesn’t mean much if people don’t know what they are looking at. This is a call for both banks and supervisors to publish clear information in a prudent manner. And it is a call to improve financial literacy so that all stakeholders, including retail investors, better understand the risks they are taking.
So even though transparency is a necessary ingredient for efficient and stable markets, it is not sufficient on its own. That said, we are seeking to make transparency the hallmark of European banking supervision. But I acknowledge that it is a complex topic which requires more scrutiny. We will continue working on the issue, and, in the spirit of transparency, we will keep you posted on our progress.
Thank you for your attention.