Out of the past, into the future: Transatlantic views on the next stage for European banking supervision

Keynote speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB at the European Institute of Financial Regulation (EIFR) Webinar on “Banking Supervision in Europe: a US perspective”

Frankfurt am Main, 4 November 2020

It is a pleasure for me to be here today. I would like to thank the EIFR for inviting me. In sharing my views on the European system of banking supervision, it seems appropriate to spend a moment looking at our shared history and traditions.

Europe is home to the world’s oldest still operating bank. It was created in Italy in the Late Middle Ages, and not long after that, local banks began to flourish all across Italy and Europe, offering decisive support to local economies and their vibrant commercial endeavours.

Across the Atlantic, in the United States, the charter for the first state bank, the Bank of New York, was adopted in the late 1700s, thus initiating a long-standing tradition of state banks across the country. Roughly a century later, the New York State Banking Law, the first banking law in the history of the United States, was established. In essence, it launched the tradition of classifying activities performed by banks as “incidental to banking”, laying the foundations for the evolution of banking in the following centuries, first at the state level, and then at country level through the introduction of the federal National Banking Act.

So you see, similarities between the European and the US banking system have a long history. Both European and US banks started with the cultural tradition of serving the needs of their local communities. Each of them earned an important place in society by providing an essential service – supplying the life-blood of commerce to the local economy. Banking supervisory authorities on both sides of the Atlantic evolved very similarly, too, steeped in the customs of protecting their local communities and armed with local knowledge about risks and needs. Indeed, today’s banking sector in Europe and the United States is still characterised by serving the essential needs of local communities first and foremost, even if some of our banks also operate on a global scale. The great financial crisis then brought significant change to supervision in both jurisdictions, culminating in much more emphasis now being placed on delivering effective supervision through the adoption of a consistent and common approach.

The supervisory system and the banking sector of both jurisdictions now face significant challenges too, having to manage emerging risks while staying attuned to prevailing headwinds – currently determined to a great extent by digitalisation and the COVID-19 pandemic. These developments have effects on both the banking sector and the real economy and will likely affect the creditworthiness of many businesses.

I do not know which of the two jurisdictions, or which of the two systems of supervision, will ultimately prove to be better equipped to deal with the challenges ahead. Instead, with respect for the cultural traditions that are embedded in our DNA, I would posit that there is learning to be gleaned from both systems. And this is why today I will draw some parallels between the supervisory traditions and the developments of the banking sector in the EU and the US. As a member of the Supervisory Board of the ECB, my objective is to embrace any lessons that can lead to an even more effective European supervisory system and ultimately result in a stronger banking system in Europe.

Progress achieved since the establishment of ECB Banking Supervision

Before I focus on some of the similarities and differences in our supervisory traditions, it is worth acknowledging where Europe now stands. The progress achieved in harmonising regulation and banking supervision practices across Europe in the wake of the great financial crisis has been remarkable. European regulations have been strengthened through the implementation of global standards that are directly applicable to all banks operating in the European Union. The European Banking Authority has produced a unified body of over 250 draft guidelines and technical standards. Common definitions of capital and liquidity requirements are now applied consistently across all euro area banks.

Furthermore, following the establishment of a single supervisory body for the euro area, Pillar 2 requirements (P2R) started to be implemented uniformly across all euro area banks, applying to significant less significant supervised entities alike. ECB Banking Supervision has tightened its internal quality assurance and consistency checks to ensure a real level playing field exists for all banks. It also published the Pillar 2 requirements for individual banks for the first time this year, and it gave guidance and took supervisory decisions to address the large stocks of NPLs held by euro area banks, reducing them from 6.5% in 2016 to 3.2% at the end of last year. It seems unlikely that national policies alone would have yielded the same results in such a short time. What is more, this same ECB Guidance is now key for banks to weather the economic downturn as the consequences of the COVID-19 pandemic unfold.

Much like Europe, also the US supervisory regime started at state level, and then converged toward more centralized supervision. Disrupters to delivery of banking services emanating from both innovation and significant risks such as the pandemic mean that supervision cannot stand still on either side of the Atlantic. Centralized systems of supervision need to be dimensioned to deliver efficient and effective supervision.

Supervisory traditions in the EU and the US

A brief – though not exhaustive – analysis of the similarities and differences in our supervisory traditions may be of help in delivering this next, more efficient and more effective stage of supervision in Europe. Differences in our cultural traditions are evident, at once framing how supervision is delivered, and the direction it will take. They also translate into different views in terms of the risks we need to manage and the actions we might need to take. Let me give you a few examples.

Let us take the legal tradition underpinning supervisory practices in the United States and in Europe. In the United States, banking has been connected to the development and expansion of the activities that are considered to be “incidental to banking”. Interestingly, these days we may be seeing yet another shift in the definition of “incidental to banking” resulting from the push to embrace technology. In the US, fintech banking charters are emerging that may ultimately disconnect the definition of a bank from the deposit taking requirement. While this is currently under legal challenge, the question is whether it opens the way to technology companies being classified as banks without engaging in any deposit-taking activities.

In Europe, the Capital Requirements Requirement Regulation (CRR) defines credit institutions very much based on their balance sheets, as taking deposits or other repayable funds of the public and granting credits for their own account. However, also here we see some broadening of the definition and decoupling of the banking activities from deposit-taking, as it was decided to include systemically relevant investment firms in the definition of credit institutions.

If taking deposits is no longer a necessary condition to be a bank, does this mean that large technology companies will ultimately become banks too? Will payments transfers and virtual currencies become more important for supervisors to safeguard than the deposits themselves? These are questions that will underpin the very nature of supervision in the years ahead – in both jurisdictions. The answers have far-reaching consequences for the level playing field, and indeed for how the future of banking will be delivered and safely supervised in local communities. They also require that we continue to develop our supervisory models and ensure that they are fit for the future.

Let me now turn to the tradition of sanctions and enforcement in the United States. The most profound difference between Europe and the United States relates to the level of hefty monetary penalties US banks, including foreign ones operating in the US, have been subjected to in federal enforcement actions known as Consent Orders. While we may question the level and efficacy of these fines, Consent Orders also contain strong remediation requirements that in addition to the monetary sanctions require in improvements in governance, internal controls and technology systems to support enhanced risk management. Remediation activities are more costly than the monetary penalties, and arguably have greater effect on strengthening the banks. The validation of such remediation requirements is also embedded in the supervisory examination process.

Lastly, inspection traditions also differ across continents. In Europe, there is a tradition of separating off-site and on-site supervision; ad-hoc, independent on-site teams, separate from the dedicated joint supervisory teams, review bank practices and policies on-site and then benefit from a significant degree of freedom to deliver demanding outcomes and impose strict remediation actions to the banks, which are then followed up on by the joint supervisory teams operating in a different department. In the United States designated supervisory teams reside in the largest banks and conduct their supervision directly from there. In other words, onsite and off-site surveillance are more connected in the United States, and more separated in Europe.

An interesting difference in inspection traditions concerns the stress testing practices of both continents. Both regimes deploy forward looking stress scenarios to measure the resilience of banks and adjust their capital levels accordingly. In the United States, the Comprehensive Capital Analysis and Review (CCAR) stress test is a top-down exercise for the US largest banks only. Significantly, the exercise is strongly underpinned by a fiscal backstop that was initially manifested in the Troubled Asset Relief Program (TARP). In the US, the capital planning of banks is an intrinsic part of the stress test exercise: the CCAR, for example, incorporates the capital actions submitted by the banks at the beginning of the exercise into its own stressed projections, and banks revise their capital actions after the CCAR preliminary results are communicated back to them.

Europe conducts a bottom-up stress test on over a hundred significant institutions under the direct supervision of the ECB. The results of the stress test exercise help the supervisor set the Pillar 2 Guidance and inform the supervisory teams about the overall quality of the banks’ risk management practices. This is then factored into the Supervisory Review and Evaluation Process (SREP), but the timeline and the setting of P2R levels occur in a different moment in time. The link between stress test performance and supervisory decisions is thus addressed in a more holistic fashion through the SREP process, but this slight disconnection in timeline somewhat hampers a clear-cut understanding by the markets of the exact supervisory use of the stress test results in Europe.

Facing the pandemic: profitability challenges

In the immediate aftermath of the great financial crisis, the US banks that received public support were prevented from buying back shares, distributing dividends or pursuing growth strategies for a number of years. So, they turned inward, rebuilding balance sheets, restructuring and investing in technologies to reduce costs. We would do well to recognise that the now higher profitability of US banks comes only after almost a decade of depressed returns. Persistently low interest rates forced US banks to revise their business models, re-evaluate the size of their branch networks and seek out new sources of revenue that met the consumers’ preference for quick digital interactions. European banks have been struggling to restore profitability over the last decade too, owing to the effects of a sovereign debt crisis that produced long-lasting stagnation in many countries.

But thanks to the decisive steps taken in the wake of financial crisis on both sides of the Atlantic, both European and US banks entered the COVID-19 crisis with larger and more resilient capital and liquidity buffers. The COVID-19 pandemic has delivered the most severe blow to the economy since the Great Depression. The same is true for Europe. And the actions that the Federal Reserve has taken to address the crisis were similar – in immediacy, magnitude and goal – to those put in place by European Banking Supervision. In both jurisdictions, the immediate priority of the supervisors has been to support the efforts of banks to sustain the flow of credit to households and firms during the challenging times. Both European and US banks have benefited from extraordinary support since the beginning of this crisis, and in many ways now face similar challenges.

In the face of the COVID-19 crisis, the largest banks in both jurisdictions are provisioning for losses at record rates. US banks seem to be doing this at a slightly greater rate, but one must bear in mind that the portfolio composition of US banks is different than that of their European peers: in the United States, for example, consumer lending and credit card business weigh far more in the balance sheets of US banks than in Europe. But the point here is that in the face of this crisis, the importance of provisioning for likely losses is is paramount in both continents. This will put them in a position to absorb losses and lend to viable businesses through the most severe period of this crisis, and to be poised for growth from the very onset of the recovery.

Going forward, fortress building balance sheets will be as crucial for banks as fortress building their technology infrastructures and reduce costs. This will require them to scale up – both in IT budgets and in size. And here, consolidation is an avenue worth exploring – particularly in Europe, where much can be gained in terms of cost efficiencies.

Creating the conditions to mop up excess capacity in the European banking sector

In the United States, almost 500 banks were wound down during the financial crisis.[1] This came after a consolidation process that had already been underway for quite some time. In Europe, far fewer banks were wound down or actually failed in the same period. Weaker banks managed to stagger on, exerting pressure on margins for the rest of the sector. Since 2012, there has been an average of two transactions occurred year where the buyer acquired more than 20% of another bank. The picture is only slightly different for domestic markets: an average of 11 mergers and acquisitions took place annually between 2011 and 2019. The size of the European banking sector is much larger than that of other sectors of the economy, and banking assets are very large relative to GDP[2]. Although some of this can be explained by the relative importance of bank funding channels to Europe’s economy, overall excess capacity still produces an unwelcome hangover effect on the European banking sector.

I said earlier that consolidation is one avenue to the future. It would enable banks to diversify sources of income and foster private risk-sharing within the banking union, which would be strengthened as a result. This, in turn, would make the euro area on aggregate more resilient to idiosyncratic shocks.

The harmonisation achieved since the last financial crisis has definitely made it easier for banks to operate across borders, and it has also made the banking sector safer. But European banks do not yet fully enjoy the banking union as a truly domestic European market. The segmentation of euro area banking is one of the most worrying legacies of the financial crisis. It was – and to a certain degree, still is – widely believed in host countries that, in times of crisis, parent companies will protect their own interests, and home authorities will prioritise their own national objectives. This lack of trust is reflected in the low levels of cross-border banking within the euro area.

We have undoubtedly made progress in designing a stronger crisis management framework, with greater reliance on private investors being bailed in rather than on banks being bailed out by governments. The establishment of the Single Resolution Board and the Single Resolution Fund have been important steps forward in this regard. But the safety net is not yet fully in place at the European level. As long as deposit insurance remains national, Member States will have an incentive to ring-fence their banking sectors. This is why we need to finalise the banking union by establishing a European deposit insurance scheme, which would be a decisive step towards making it easier for both European and national legislators to eliminate the remaining regulatory provisions that trap capital and liquidity within national borders.

I am aware, though, that a fully-fledged European deposit insurance scheme that will take some time to materialise. Until then, there are steps that we as supervisors can – and will – take to try and dissolve ring-fencing to the extent we can. The crucial point here is how we can deal with cross-border banks that encounter difficulties. Resolution strategy, group recovery and resolution plans should play an essential role. If we want to strengthen confidence in crisis management at the European level, the best way forward is to reinforce cooperation with respect to the role of group recovery and resolution plans, as well as their practical implementation.

ECB Banking Supervision will continue to put a considerable amount of effort into strengthening the usability of these plans. But we are also taking one additional step in this direction, and are considering offering banking groups the option of having subsidiaries and parent companies enter into a formal agreement to provide each other with liquidity support, and to link this support to their group recovery plans. This should not only help to explicitly map out how group entities could support each other when difficulties arise, taking into account local needs and restrictions, but it should also make it possible to establish the appropriate triggers for providing the contractually agreed support at an early stage.

In the United States, both the resolution and insolvency of deposit-taking credit institutions are covered by a single bank insolvency framework that offers both resolution and liquidation tools. All insured credit institutions are resolved or liquidated under the Federal Deposit Insurance Act, which provides the Federal Deposit Insurance Corporation with resolution powers to arrange purchase and assumption transactions, and to set up bridge banks – and liquidation policies. There is no doubt that the single deposit and resolution scheme has helped interstate consolidation.


Let me conclude. To leave the past behind and move decisively into the future, banks will have to address the challenges of the present. Fortress building balance sheets now can pay significant dividends in the future, by enabling loss absorption and facilitating lending to viable businesses. But other challenges are structural. The digitalisation of the banking sector and the disintermediation of financial services are irreversible trends and require banks to gain scale if they are to tackle them effectively.

Regardless of their different traditions, US and European banking supervision will sooner or later have to address the same question: how will our supervisory framework continue to ensure the safety and soundness of banks, and through them, provide the life-blood of commerce to local economies? How will we continue to evolve? Maintaining an open conversation and a strong collaboration over the Atlantic will be crucial to finding an answer. And I am happy to have contributed to that important dialogue with my remarks today.

Thank you for listening.

[1]Between 2008 and 2012, a total of 465 banks failed. Federal Deposit Insurance Corporation, “Failures of all Institutions for the United States and Other Areas”, FRED, Federal Reserve Bank of St. Louis.
[2]Post-crisis repair and the profitability malady”, presentation by Andrea Enria, Chair of the Supervisory Board of the ECB, at the Forum Analysis, Milan, 17 September 2019

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