Yves Mersch: Three challenges for the banking sector
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
at the European Financial Forum dinner, 2015 Cumberland Lodge Financial Services
Summit, Cumberland Lodge, Windsor, 12 November 2015.
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Thank you very much for inviting me to speak to you this evening.
I have been asked to give a "central bankers' view" on the various issues being discussed at
this conference, so let me lay out upfront the perspective I will be coming from. While I am
indifferent to how structural changes affect individual financial institutions, I have a strong
interest in how they affect the financial sector - and in particular, in a bank-based economy
like the euro area, how they affect the ability of banks to finance the real economy. We need
to make sure that in an environment of structural change we still have strong and sound
banks.
At present, euro area banks continue to struggle with low profitability driven by both cyclical
and structural factors. On the cyclical side, the low nominal growth and low interest rate
environment makes traditional banking activities such as retail lending using maturity
transformation less lucrative. On the structural side, banks' return on equity remains below
their cost of equity, which points to a need for further balance sheet adjustment.
Nonperforming loans (NPLs) in particular remain an important obstacle for banks to provide new
credit to the real economy.
These challenges need to be addressed both by raising growth potential and by a concerted
effort to complete the clean-up of bank balance sheets. Yet as important as these issues are,
they are largely legacies of the recent crisis. What I would like to concentrate on - as you are
discussing at this conference - are the forward-looking challenges to the banking sector, and
how they will affect banks given the already difficult operating environment.
I would like to focus on three that I see as particularly relevant: the payments challenge, the
markets challenge, and the regulatory challenge.
1. The payments challenge
One of the key challenges facing banks is the impact of disruptive new technologies on their
retail payments business - the so-called "rise of the FinTech".
Such competition from non-banks in retail payments services is of course not new. Western
Union and Moneygram, for example, are well-established non-bank providers. But what is
different now is that various factors are coinciding which look set to fundamentally change
the landscape of the retail payments market, and in ways that threaten banks' dominant
market position.
First, regulation is opening up market access. With the revised Payment Services Directive
(PSD2), the list of activities that payment institutions can carry out is being expanded to
include the initiation of payments. They can also provide account information for accounts
held at other payment service providers. This will inevitably - and deliberately - weaken
banks' market power.
Second, consumer preferences are changing rapidly. Retail customers now expect to be able
to integrate e-commerce, social media and retail payments. They also expect to be able to
switch seamlessly across digital platforms. These are not areas of strength for many banks:
given their heavier compliance obligations, banks have traditionally invested more in the
security and resilience of their systems rather than optimising the user experience.
Third, payments technology is evolving at an unprecedented speed. Contactless cards,
online payments, mobile payments, are all becoming more prevalent. Keeping pace with
those technologies will require major investment from banks, and they have to contend with
the fact that their new competitors - for example PayPal and Apple - already have an edge
in digital technology.
The initial effect of this disruption in the payments may well be to reduce the role of cash
payments, which will not fundamentally affect banks. But in my view banks should not take
this challenge lightly. According to estimates by Deloitte, retail payments will generate
around €128 billion in revenues for banks in 2015, or around a quarter of total European
retail banking revenues.1 With profits already depressed on lending activities, banks can
scarcely afford to start seeing margins being squeezed and market share lost in other areas.
So banks would be well-advised, to my mind, to face this challenge head on. Whether via
joint ventures or higher investment, they need to keep up with technological change if they
are to have a long-term business model. Banks accounted, however, for around 20% of the
€10 billion euro total investment in FinTech in 2014, and collaborations between banks and
non-banks a further 20%. Non-banks accounted for the remaining 60% - a clear gap to
close.2
But should policymakers also take an interest in how this disruptive process unfolds? Or
should they just stand back and let the market work? I would offer a somewhat nuanced
view.
In principle, I would always prefer as little interference as possible in the creative destruction
process. History shows us that new entrants have brought many benefits to the retail
payments market. For example, merchants were the initial drivers of the introduction of
payment cards in the US in the 1930s and, just a couple of years ago, it was a mobile
network operator in Kenya that succeeded in making mobile payments widespread in that
country. PSD2 was introduced precisely because there is no good reason for the regulatory
framework to protect the rents of banks.
But policymakers also need to monitor carefully the system-wide impact of these
technologies. Innovation should not come at a cost to consumer protection. We do not want
a situation where unregulated non-banks create pressure for a race-to-the-bottom among
more regulated banks, which might be detrimental consumer security. Nor do we want banks
that must comply with higher consumer protection standards to be disadvantaged. So going
forward, policymakers must ensure that the regulatory landscape is fair: neither stifling new
operators, nor harming establishing ones.
I say this as a central banker not only because one of the ECB's statutory tasks is to ensure
the smooth operation of payment systems. I say it because, ultimately, trust in payments
means trust in money as a reliable medium of exchange. For a sound currency, consumers
must have 100% confidence that their money can be exchanged safely.
2. The markets challenge
Non-banks are not only increasingly entering the retail payments market in the euro area,
however; they are also entering the lending business. This brings me to the second
challenge for euro area banks: the markets challenge.
For some years now, we have been witnessing a trend towards more capital market-based
financing in the euro area, driven by both deleveraging among banks and the very low cost of
market finance. Looking forward, the Capital Markets Union (CMU) project promises to
further deepen market finance in Europe by, among other things, making it easier for young
firms to access risk capital and smaller firms to issue bonds, as well as deepening markets
for high quality securitisation.
So what will this mean for European banks?
In the long run, deeper capital markets may lead to more competition in the provision of
financial services and hence weaken banks' market power. For example, research looking at
the pre-crisis period suggests that where banks face limited competition in their domestic
markets, they tend to charge higher margins for lending to SMEs, and that effect increases in
3
financial systems which are more bank-based That would change if small firms had more
options to diversify, for instance through efficient private placement markets or further growth
in crowdfunding.
There are nevertheless good reasons why banks are the primary lender to SMEs in most
national markets - they have the client relationships, information database and domestic
networks which are necessary for that type of lending - so banks are unlikely to be displaced
by non-banks for quite some time. The challenge posed by CMU is therefore not, at least in
the medium-term, about surviving. It is rather about thriving. CMU presents banks with an
opportunity to recover profitability and to find a niche within the emerging market for new
financial products in Europe.
Because in the euro area we have a universal banking model, more disintermediated finance
will have to involve banks as the primary market makers. With CMU on the horizon, there is
now a window for banks to specialise in specific products, become market leaders and
bolster their sources on non-interest income. In particular, the development of securitisation
markets offers significant possibilities for banks. There is clear demand for a conduit between
non-bank investors looking for SME exposure and small firms looking for new sources of
financing.
From my viewpoint as a central banker, I hope that banks indeed seize on this opportunity,
because I think it would ultimately lead to a more robust banking sector as a whole. For
example, European securitisation markets would improve risk-sharing among banks: one can
imagine a world where small, local banks originate loans while larger, global banks securitise
and market them. And a true CMU would also mean convergence of some parts of
insolvency law and deepening of markets for distressed debt, which would help banks work
through NPLs more quickly in future and hence increase the resilience of the banking sector
to shocks.
Moreover, if bank finance declines in importance over the longer-term, that might also
encourage some much needed consolidation in the banking sector, which would in my view
be beneficial for the real economy. We see at the moment that overcapacity hinders the
recovery of bank profitability, as weaker banks distort competition and make it difficult for
other banks to re-price loans.4
Whether all this materialises, however, hinges crucially on how far-reaching the CMU project
really is. The Commission's Action Plan for CMU has put forward many areas for further
work, but each will take years to implement. What type of CMU will ultimately emerge
therefore remains to be seen. I am sure Commissioner Hill will give us more guidance on this
tomorrow.
3. The regulatory challenge
As I said, however, CMU is for the longer-term. For the medium-term, SME financing in the
euro area will still mainly come from banks. So we need to make sure that there are no
unnecessary obstacles to that process. And this brings me to the third challenge facing
banks - the regulatory challenge.
The regulatory agenda since the crisis has no doubt been essential. Banks had too little
capital, too much short-term funding, too high leverage, and created too great a cost for
society when they failed. The reforms that have been introduced so far have increased
resilience and, in extremis, made banks less costly to resolve. And there is no reason why
this should, in principle, diminish the ability of banks to serve the real economy - research
suggests, for example, that higher bank capital has no negative impact on lending.5
But as new regulation accumulates, we know that it can also come with costs as well. In the
economics jargon, policymakers always have to be watchful that, in attempting to internalise
externalities, they do not inadvertently create new externalities. The possible risks can be
summarised under the headings of complexity, clarity and consistency.
As regulations have built up since 2009, they have tended to introduce more complexity, and
with that comes an inevitable cost in terms of compliance. For example, a study from a few
years ago estimated that to comply with Basel III for a midsize European bank would require
up to 200 full-time jobs.6
That is not per se a problem, but one has to look at it in the context of the current
environment facing banks. If banks are simultaneously aiming to cut costs to restore
profitability, while raising the resources they dedicate to compliance, there could be a
consequence elsewhere: for instance, IT resources may be diverted away from innovation.
That would hinder the process of technological adaptation that is key for their long-term
viability. So I would argue that regulators should be mindful of the burden they are placing on
banks and the potential unintended consequences.
If banks are to adapt effectively to the new regulatory environment, they also need clarity on
what it will look like. The risk of a prolonged period of regulatory reform - and remember the
current phase has been ongoing since 2009 - is that it creates a moving target, which in turn
prevents the industry from settling into sustainable new business models.
To give just one example, some banks responded to the crisis by switching to a vision of
retail deposit-funded subsidiaries, which was also supported by the initial wave of regulation,
for example the Net Stable Funding Ratio. Now, with the introduction of the Total Loss
Absorbing Capital rules, they may be forced to reconsider those business models as they will
need to issue more unsecured long-term debt. Let me be clear: I am not making a value
judgement about these regulations. What I am saying is that, if we want banks to adapt
successfully to the post-crisis world, we need to give them sufficient visibility about the future.
Finally, regulation needs to be mutually consistent. In particular, if we want banks to be
bigger players in a more market-based financing mix, we need to ensure that regulation
supports that transition and does not unduly impact banks' ability to transact in capital
markets. We know that one side effect of the reform agenda so far has been banks retreating
from, or scaling down, certain market making activities.
This is a particular issue for less liquid markets, such as ABS, which depend on market
makers that can absorb temporary supply-demand imbalances. It is also one reason why
part of the CMU Action Plan is a call for evidence on the cumulative impact of financial
services reforms. Going forward, we should be careful to ensure that new regulations, for
instance aimed at separating the banking and trading arms of universal banks, do not have
negative consequences for market-making activities that are not justified by significant risks.
Likewise, we should be mindful about the fallouts of an ill-designed financial transaction law.
Conclusion
Let me draw to a close.
The euro area banking sector is facing challenges on all sides: from new technologies, from
new market players, from new rules of the game. Those challenges, insofar as they lead to
competition and innovation, are healthy. They are how a well-functioning market economy
works.
But we must also recognise that, in the euro area, we need sound banks. A weak banking
sector means a weak economy. So I entreat banks to respond to the challenges of the new
environment and reinvigorate their business models. And I entreat policymakers to create a
fair, clear and consistent level playing field where that can happen.
Thank you for your attention.