Mario Draghi: European banking supervision three years on
Welcome remarks by Mr Mario Draghi, President of the European Central Bank, at the second
ECB Forum on Banking Supervision, Frankfurt am Main, 7 November 2017.
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It is my pleasure to welcome you to this second ECB Forum on Banking Supervision.
When I spoke at the Forum in 2015, European banking supervision had only been in operation for
one year. Much had been achieved in that time - not least the comprehensive assessment of
bank balance sheets - but in many ways the single supervisor was still untested.
We saw European banking supervision as having two main objectives: to reduce bank-specific
risks through tough and forward-looking supervision; and to reduce country-specific risks in the
banking sector by applying those same high standards across the whole of the euro area.
Now, three years on, we can begin to take stock of what has been accomplished.
What is clear is that European supervision has been instrumental in building a stronger and more
resilient banking sector. The country in which a bank is located has also become a less
important factor in how its credit risk is perceived.
These two achievements have been a crucial complement for our monetary policy, too, since
banks are the main channel of financial intermediation in the euro area.
A well-integrated financial sector with sound banks has helped transmit our policy impulses more
evenly across the euro area. And it has allowed us to pursue an accommodative policy for as
long as necessary, without building up significant financial stability risks.
Progress with European banking supervision
There is no doubt that building European supervision has been a remarkable undertaking. Today
we have 900 supervisory staff working at the ECB who, together with 4,700 national supervisors,
directly oversee around €22 trillion in assets, representing around 200% of euro area GDP.
But more important than its scale have been the changes the single supervisor has prompted in
the conduct of supervision. It has broken with the past in a single, but fundamental way.
That is: it has brought about a more uniform approach in how banks are supervised, leading to a
more resilient banking sector overall. The key catalyst for this change - alongside the new EU
regulations - has been the harmonisation of the Supervisory Review and Evaluation Process
(SREP).
This harmonisation has allowed supervisors to converge towards common benchmarks in how
they assess risks; and it has helped them to be consistent in how their risk assessments are
then linked to supervisory capital add-ons and other measures.
To illustrate the difference this has made, in 2014 the correlation between SREP scores and
Pillar 2 capital requirements was 26% in the euro area. In 2016, it was 76%.
European supervision has therefore resulted in a substantial strengthening of shock-absorbing
capacity within the sector. The total capital ratio of banks supervised by the ECB has increased
by more than 170 basis points since early 2015. The quality of capital has gone up as well: the
high-loss absorbing component - CET1 - now makes up the largest share of total capital of euro
area banks.
Specific weaknesses are also now being addressed in their entirety across the euro area.
Currently the most important issue here is tackling non-performing loans (NPLs).
We all know the damage that persistently high levels of NPLs can do to banks' health and credit
growth. Internal ECB analysis shows that, over recent years, banks with high stocks of NPLs
have consistently lent less than banks with better credit quality, therefore providing less support
to firms and households.
And though NPL levels have been coming down for significant institutions - from around 7.5% in
early 2015 to 5.5% now - the problem is not yet solved. Many banks still lack the ability to absorb
large losses, as their ratio of bad loans to capital and provisions remains high.
We therefore need a joint effort by banks, supervisors, regulators and national authorities to
address this issue in an orderly manner, first and foremost by creating an environment where
NPLs can be effectively managed and efficiently disposed of.
Importantly, the development of European supervision has not only reduced the risk of individual
banks failing. It has also - as we hoped - had some success in reducing the importance of
location in perceptions of bank risk, because single, rigorous supervision is an essential
precondition for the other pillars of the banking union that more decisively sever the
banksovereign nexus.
Indeed, looking at the largest banks for which we have data available, the correlation between
bank credit default swaps and those of sovereigns is now considerably weaker than at the height
of the euro area crisis.
Still, there is no room for complacency, since these improvements are likely to have been driven,
in part, by the improved economic situation. It is therefore crucial that further reforms to de-link
banks from sovereigns do not lose steam, notably completing the other pillars of banking union.
The benefits of strong supervision for monetary policy
All these supervisory efforts have not only produced a more robust banking sector; they have
also provided crucial support for our monetary policy since we entered a new easing phase in
mid-2014. This support has come from two main sources.
First, stronger supervision has improved the transmission of our policy impulses through banks.
There is now plenty of evidence to suggest that the level of bank capital is a key variable in how
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banks lend during downturns, and hence also for monetary policy transmission.
See, for example: Buch, C. M. and Prieto, E. (2014), "Do Better Capitalized Banks Lend Less?
Long-Run Panel Evidence from Germany", International Finance, Vol. 17 (1), pp. 1-23; Kapan, T.
and Minoiu, C. (2013), "Balance sheet strength and bank lending during the global financial
crisis", Discussion Papers, No 33, Deutsche Bundesbank; and Osborne, M., Fuertes, A.M. and
Milne, A. (2017), "In good times and in bad: Bank capital ratios and lending rates", International
Review of Financial Analysis, Vol. 51, May, pp. 102-112.
It is therefore no surprise that the improved health of the banking sector, coupled with our credit
easing measures, has coincided with a marked improvement in the transmission process.
Previous asymmetries in bank lending rates across the euro area have now largely been
reversed, the cost of bank borrowing has stabilised at record lows everywhere in the euro area,
and so has its dispersion across countries. We can now say that the pass-through from our past
policy measures to lending rates is nearing completion.
The decline in lending rates has been particularly noticeable for small loans in vulnerable
countries, which are a proxy for the financing conditions faced by SMEs. SMEs are of course
highly dependent on well-functioning banks as their options are limited when it comes to
accessing market finance. For these small loans, the spread between vulnerable and more
resilient countries has now narrowed to a record low of 5 basis points.
This more even credit pricing across countries and firms has, in turn, been crucial to the
broadening of the economic and employment recovery, not least because SMEs represent 60%
of euro area value added and employ 70% of the labour force.
The second way in which stronger supervision has supported our monetary policy is by helping
contain any financial stability risks that may emerge during a long period of low rates.
One channel through which such risks can appear is search-for-yield effects: low rates can, in
principle, induce banks into making lower-quality loans, leading to higher loan losses. But with a
strong supervisor ensuring well-capitalised banks, the quality of lending tends to be higher.
This is confirmed by a major study looking at loan-level data in Spain, which finds that, when
overnight rates fall, highly capitalised banks grant fewer loan applications to risky firms than lowly
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capitalised banks, and have fewer loan defaults.
See Jiménez, G., Ongena, S., Peydró, J.-L. and Saurina, J. (2014), "Hazardous Times for
Monetary Policy: What Do Twenty-Three Million Bank Loans Say About the Effects of Monetary
Policy on Credit Risk-Taking?", Econometrica, Vol. 82(2), March, pp. 463-505.
With a more resilient banking sector in the euro area, we have seen this more positive picture
develop. Credit risk exposures in banks' loan books have declined as monetary policy has eased.
Default rates have fallen, and forward-looking measures also suggest a decline in credit risk.
This has of course been driven by improvements in credit quality as the macroeconomic
situation has improved. But it may also reflect the role of higher capital in resolving agency
problems: the more a bank is capitalised, the more its owners stand to lose if borrowers default
and cause losses. So the more equity a bank holds, the greater its incentive to make
higherquality loans.
Other financial stability issues associated with low rates have also not materialised, thanks in
part to the stronger supervisory framework.
At euro area level, we currently see no signs of credit-fuelled housing bubbles, which are at the
root of most serious financial crises. Since 2016, bank lending for house purchases has risen,
on average, by 2.9% per year - well below the growth rates of up to 12% recorded in the run-up
to the crisis. Some local pockets of risk have emerged, but both supervisors and
macroprudential authorities are actively taking steps to counter them.
We have also seen little evidence that negative interest rates are undermining bank profitability,
an issue which has caused a lot of concern. This would pose a financial stability risk to the extent
that it hinders banks from building up capital through retained earnings and makes raising market
equity too expensive. It would also affect monetary transmission for the same reasons.
In fact, net interest income has remained quite stable over the past two years, even as overnight
rates have drifted lower. And thanks to gains in other income components, banks' return on
equity has been rising and is converging towards their cost of equity. For the banks under ECB
supervision, return on equity has risen from 4.4% at the end of 2015 to 7.1% at the start of this
year.
This neutral impact of negative rates is largely due to the general equilibrium effects of monetary
policy that we have explained many times: when policy is accommodative, the main components
of profitability largely offset each other, since the positive impact of a stronger economy on
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loanloss provisions largely cancels out any negative effect on net interest income.
See Altavilla C., Boucinha, M. and Peydró, J.-L. (2017), "Monetary policy and bank profitability in a
low interest rate environment", Working Paper Series, No. 2105, ECB, October.
For some banks, however, these negative effects may be larger than for others. This is where
strong supervision is again crucial. As part of its SREP, ECB Banking Supervision carries out
detailed, comparative assessments of banks' business models, which feed into the ongoing
supervisory dialogue between the supervisory teams and banks.
This process is not prescriptive, but it helps bring to light important issues such as the
sustainability of banks' business models in a low rate environment, and their operating costs in
comparison with their peers, which in some countries are a contributing factor to low profitability.
Conclusion
Let me conclude.
We are now three years into the life of European banking supervision, and the track record so far
is encouraging. Though the single supervisor is still a young and developing institution, it has in
many ways lived up to the high expectations that accompanied its founding.
Rigorous and uniform supervision has led to higher levels of capital and a more resilient sector
overall. The credit risk of banks is now less determined by the credit risk of their country of
establishment.
Healthier banks have, in turn, helped transmit the ECB's accommodative monetary policy more
evenly across the euro area, leading to a stronger and broader recovery. And the new
supervisory framework has helped mitigate any financial stability risks that might have arisen as
a result.
In short, European supervision and European monetary policy have proven to complement each
other well. It is an approach which confirms the synergies that can be reaped when the right
policies are combined at euro area level.
1
See, for example: Buch, C. M. and Prieto, E. (2014), "Do Better Capitalized Banks Lend Less? Long-Run Panel
Evidence from Germany", International Finance, Vol. 17 (1), pp. 1-23; Kapan, T. and Minoiu, C. (2013), "Balance
sheet strength and bank lending during the global financial crisis", Discussion Papers, No 33, Deutsche
Bundesbank; and Osborne, M., Fuertes, A.M. and Milne, A. (2017), "In good times and in bad: Bank capital ratios
and lending rates", International Review of Financial Analysis, Vol. 51, May, pp. 102-112.
2
See Jiménez, G., Ongena, S., Peydró, J.-L. and Saurina, J. (2014), "Hazardous Times for Monetary Policy: What
Do Twenty-Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk-Taking?",
Econometrica, Vol. 82(2), March, pp. 463-505.
3
See Altavilla C., Boucinha, M. and Peydró, J.-L. (2017), "Monetary policy and bank profitability in a low interest
rate environment", Working Paper Series, No. 2105, ECB, October.