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Ladies and Gentlemen, good morning.
This morning our topic is that of risks. As regulators of the banking sector, part of our remit is to assess and analyse risks, when drawing up resolution plans. Our overarching goal in the resolution field is to safeguard financial stability and at the same time protect the taxpayer from any future bail-outs of a bank that is deemed too big to fail.
It is important to underline that financial risks, including those of banks, can be reduced, mitigated or diversified through adequate prudential and risk management rules, but they cannot be annulled at all times. Therefore, regulators and the banking sector have to be aware, understand and put in place adequate measures to mitigate and reduce them to a tolerable extent, including in a forward looking way. In the following remarks, I will take a look at some of the well known vulnerabilities and risks. They concern banks’ profitability, interconnected exposures and exposures to property markets. I will then touch upon some of the issues stemming from the incompleteness of the regulatory and policy framework, in particular the missing pieces to complete the Banking Union.
2. Vulnerabilities and risks
Before I get into the risks, a little reflection on the improvements achieved by the industry with respect to some years ago. Since the financial crisis, efforts to make the European banking sector more resilient and sound have clearly brought results. European banks continue to strengthen their capital ratios. In the EU, the Common Equity Tier 1 ratio increased to 14.7% in Q2 2019, reaching a new peak since 2014. Significant progress has also been achieved in cleaning up banks’ balance sheets. Indeed, according to the EBA report released a few days ago, the stock of non-performing loans (NPLs) has been falling, with the average ratio of NPLs to total loans reaching its lowest level of about 3% in June 2019 with respect to 6% in June 2015. The average coverage ratio also slightly increased, by a little more than one percentage point (from 43.6% to 44.9%), over the same period. The work has however to be continued, as despite the significant improvement there is still wide dispersion of NPL ratios across countries.
Funding challenges abated amid lower funding costs and improved bond market access. Banks’ funding costs have declined year-to-date, driven by expectations of more accommodative monetary policy and receding risk aversion. Yet despite these progresses, the European banking sector remains exposed to old and new risks, with implications for resolution activities.
A vulnerability for the euro area financial stability is related to the subdued profitability outlook of the banking sector. In particular, overcapacity and cost inefficiencies weigh on many banks’ long term profitability prospects. In spite of the cyclical recovery observed after the crisis, in the past two years the Return on Equity of euro area banks was between 5 and 6%, a performance behind the returns observed in pre-crisis years and below that of some international peers, like US and Nordic banks; the ROE also falls short of the estimated cost of capital for many banks.
The slow progress in improving bank’s cost-efficiency, witnessed by the still high cost-to-income ratio, is one of the main factors behind the low profitability that we still observe. As the IMF and the ECB recently noted, profitability in the euro area is expected to remain low in the medium term also because operating costs for euro area tend to be around 65% of income on average, while Nordic peers continue to have costs close to 55% of income. In this context, the deteriorating growth outlook, the accommodative monetary policy and the associated “lower-for-longer” interest rate environment exercise further downward pressure on margins, further restraining profitability. On the other hand, this setting is expected to bring positive effects on the macroeconomic outlook, in turn helping banks to keep impairments low, dispose of and restructure NPLs and increase lending volumes. In any case, the SRB needs banks to be profitable in order for resolvability to work.
As a central component of an integrated financial system, EU banks are confronted with risks originated from their interconnection with other sectors of the economy. In particular, elevated levels of public and private sector indebtedness make banks vulnerable to a repricing in EU financial markets. In the event of shocks affecting the real economy (e.g. a recession) EU banks would be affected by higher impairments and losses. EU banks are also increasingly exposed to non-banking financial intermediaries. As an ESRB study found, the exposures of EU banks to shadow banking entities amount to over €1 trillion, 60% of which comes from entities domiciled outside the EU. For EU banks, this represents a channel for inward spill overs from third jurisdictions.
A further aspect to consider relates to exposures to property markets. The maturing cycle in this sector constitutes a financial stability vulnerability for some countries, with risks for banks. Real estate price dynamics have gathered traction for some years and there are growing signs of overvaluation emerging, although the phenomenon is still relatively heterogeneous across countries. The ESRB has recently published a set of country-specific warnings and recommendations on medium-term vulnerabilities in the residential real estate sector. While it has not identified significant direct near-term risks arising from residential real estate exposures of the banking systems of the concerned countries, second-round effects are not excluded in the medium term.
3. Completing the Banking Union and deepening the CMU
Moving now to the missing pieces to complete the Banking Union - several years have now passed since the financial crisis, yet there are a number of areas that have been addressed only partially.
Liquidity in resolution. This is an area where more work is clearly still needed in developing a robust framework. It is a key gap in the current resolution architecture. Yes, the Single Resolution Fund (SRF) could play a role in liquidity provisioning, but this role would of course be limited due to the SRF’s size both during the transition period and even after the target level is reached. While the Common Backstop will cover all uses of the SRF, including liquidity in resolution, this would still not address the liquidity needs of a large bank. Therefore other solutions should be explored.
The lack of a proper, harmonised EU liquidation regime is a major obstacle towards a fully-fledged Banking Union. The no-creditor-worse-off principle seeks to ensure that the treatment of creditors in resolution is not worse than the treatment they would have received under normal insolvency proceedings. Currently, with 19 different insolvency frameworks in the Banking Union, the analysis of the insolvency counterfactual for a cross-border bank in resolution is a challenge, and results in diverging outcomes depending on the home country of the institution. This is a risk we must try to overcome.
In addition, the ‘failing or likely to fail’ assessment is not always aligned to the criteria for liquidation at national level and may also lead to different conclusions. At present, there is a type of uncertainty and the situation of the failing bank may end up in a limbo, therefore this needs to be corrected. Indeed, if we could bridge this harmonisation gap, we might see the creation of a European bank liquidation regime. Given the differences across national insolvency regimes, an EU administrative bank liquidation regime endowed with a range of tools - for example, like those of the FDIC – and with a Deposit Guarantee Scheme able to provide financial support on a least cost basis as an alternative to the pay-out of depositors would be a much more efficient solution. Not only would this ensure centralised decision-making, but it would also allow for the application of a harmonised and effective toolbox, paving the way for a European deposit insurance scheme. Proposals for harmonisation have encountered resistance and will be faced with a long decision-making process, but hopefully this is more about “when” than “if”. We are encouraged by recent policy proposals to move forward on bank insolvency harmonization and to break the deadlock on a European deposit insurance system. Therefore, we strongly encourage the new Commission and the co-legislators to make this a priority.
As well as completing the Banking Union, we must also deepen the Capital Markets Union. A wide range of legislative measures has been finalised in recent years and substantial progress has been achieved under the remit of the CMU Action Plan. These measures are a significant step towards deeper European capital markets and to overcome market fragmentation and structural barriers. However, despite the measures taken so far, EU capital markets are not yet fully integrated. Indeed, they lag behind when compared to certain non-EU jurisdictions, leading to a heavy reliance on bank funding within the EU and a more limited choice for businesses, in particular SMEs, institutional investors and consumers as well as to limited private risk sharing. As a consequence, Member States and the Commission have shown a political desire to push for a further deepening of the CMU, resulting in more developed and integrated capital markets. Efforts should be concentrated in enhancing the access to finance for European companies, especially SMEs; reducing the barriers to the efficient functioning of an EU-wide capital market and to increased cross-border capital flows; providing incentives to enable retail savers to invest in capital markets, in particular in long-term investment products, while maintaining a high and proportionate level of investor and consumer protection; supporting the transition to sustainable economies; promoting the harmonization of insolvency legislation.
From the SRB’s perspective, it is evident that deep and integrated capital markets would complement the Banking Union contributing positively to a more efficient and resilient financial system, increasing the shock absorbing capacity of the Union due to private risk sharing and diversification of financing channels. By making available a greater pool of resources, this should facilitate the financing of bank capital and other eligible liabilities needed to maintain MREL, the requirement that ensures loss absorbing and recapitalization capacity to restore the banks’ capital position after resolution. In this regard, the new banking package introduces significant innovation to the MREL framework, concerning the quality and quantity of loss-absorbing resources. The framework is not cost-neutral for banks, therefore the compliance with the requirements may constitute an additional challenge, particularly for those banks which are not used to issuing debt in wholesale markets. They should therefore profit of the favourable market conditions to issue MREL compliant liabilities.
Conclusion
Ladies and gentlemen, in the past four years we have made progress and put many of the policies of our political masters into action. By working with the industry, with other public bodies at Member State, EU and international level, we have been successfully reducing the vulnerabilities in the financial sector – however there are still risks remaining on the horizon.
I am confident that by continuing to work together we can tackle the risks and challenges I have outlined, in order to maintain financial stability and protect the taxpayer from bank bail-outs.
I look forward to our conversation and to taking any questions you may have.
Thank you for your attention.
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