Luis de Guindos: Opportunities and challenges for the euro area
financial sector
Opening speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the
22nd Euro Finance Week, Frankfurt am Main, 18 November 2019.
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I am honoured to open the 22nd Euro Finance Week. We gather here every year to discuss the
recent financial and economic developments in the euro area and beyond. As we are going to
publish our Financial Stability Review in two days' time, today I will focus on the health of euro
area financial institutions and the opportunities and challenges they face in the current
environment. I will also offer some policy considerations.
Opportunities and challenges for euro area banks
Let me start with euro area banks, which have been reporting persistently low profitability in
recent years. The aggregate return on equity of the sector slightly declined to less than 6% in the
12 months to June 2019. This weak performance is broad-based, with around 75% of significant
banks generating returns below the 8% benchmark return demanded by investors for holding
bank equity.
Poor profitability of course reflects both cyclical and structural factors.
The current macro-financial environment in the euro area is challenging for euro area banks. The
recent softening of the macroeconomic growth outlook and the associated low-for-longer interest
rate environment are likely to weigh further on their profitability prospects. Many market analysts
are concerned about the drag on bank profitability that could result from the negative impact of
monetary policy accommodation on net interest margins. And net interest margins are indeed
under pressure.
Just focusing on this one aspect is misleading, however. Importantly, it neglects the first-order
effect of monetary policy in supporting economic activity. Without this, bank lending volumes
would have been significantly lower and provisioning costs substantially higher. These factors,
together with the increase in asset values, have broadly offset the negative impact of low rates
on net interest margins. In addition, the introduction of the two-tier system for reserve
remuneration will help mitigate the cost of negative interest rates for banks.
Structural factors are at the heart of weak bank profitability, however. In particular, euro area
banks face challenges linked to the sector's overcapacity. There are too many banks. Many of
them have low market shares and so are under high competitive pressures, also from outside
the sector, for example from fintech companies. Another important dimension of overcapacity in
the euro area is persistent cost inefficiencies. Banks are not fully benefiting from economies of
scale and are relying on overlapping physical distribution networks. As a result, their
cost-toincome ratios - currently at 66% - are high when compared with those of their peers in the
United States and the Nordic countries.
So, how can euro area banks return to sustainable profitability? And how can they make more
decisive progress in tackling structural challenges and cost inefficiencies? Let me mention two
avenues which would support an increase in bank profitability.
First, there is room for banks to adjust their business models. In fact, ECB analysis has found
that the best performing banks have diversified their income sources, improved their cost
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efficiency and invested in digital technologies to a greater extent than their peers.
Second, consolidation via mergers and acquisitions may allow banks to exploit economies of
scale and scope, which should bring about improved performance. Cross-border mergers, while
less likely to produce cost savings or economies of scale, would have an additional benefit of
improved risk diversification and would thus result in more resilient profitability. To this end,
policy-makers may need to remove obstacles to cross-border mergers and acquisitions,
promote further integration and pursue the banking union agenda.
It is also worth recalling the good news. Banks have noticeably improved their resilience over the
past few years. This largely reflects the new regulatory framework. They now need to hold more
and higher-quality regulatory capital and they must maintain liquidity buffers. They also need to
finance themselves through stable funding sources. And they have to plan for their potential
resolution and issue debt instruments that can be bailed in. While these adjustments can be
challenging in the short term, in the long term they increase the banking sector's resilience to
adverse shocks, reducing the likelihood of costly financial crises.
In fact, the euro area banking system already complies with the new requirements for high-quality
capital and liquidity buffers. But even though banks have improved their capital positions in recent
years, only a small fraction of bank capital requirements are in the form of the countercyclical
capital buffer (CCyB), which authorities can release in the event of systemic stress to help avoid
costly economic deleveraging. This suggests that the current composition of capital
requirements may need to be rebalanced to give the CCyB a more prominent role.
Opportunities and challenges for euro area non-bank financial institutions
I will now turn to the euro area non-bank financial sector, which has grown rapidly since the
global financial crisis. Its total assets have almost doubled over the last ten years, growing from
€23 trillion in 2008 to almost €46 trillion in June 2019.
Euro area non-banks are playing an increasingly important role in financing the euro area
economy, especially through their sizeable investments in bonds issued by euro area
nonfinancial corporations. Euro area investment funds, insurers and pension funds jointly hold half of
these bonds, as opposed to 7% held by euro area banks. The greater role of non-banks can be
positive from a financial stability perspective as it helps diversify the sources of financing
provided to the real economy. Moreover, life insurers and pension funds typically provide one of
the most stable sources of long-term financing.
But, similar to banks, non-banks also face several challenges in the current environment, with
profitability being one of the major concerns. As bond yields have fallen, non-bank financial
intermediaries are holding a growing share of low-yielding bonds, which decreases their
investment income in the medium term.
Many non-banks tend to compensate this by searching for yield in riskier, more illiquid and higher
duration assets. This can be a welcome and intended outcome of monetary policy
accommodation as it may help to ease financing conditions for non-financial corporations. But
this trend also has a flip side, it contributes to rising risks and vulnerabilities in non-banks'
balance sheets.
Liquidity risk is a particular source of concern, as illiquid funds can face severe difficulties in
dealing with large-scale outflows. Over the past one and a half years there have been several
cases of UCITS funds under such stress. All these funds had large liquidity mismatches on their
balance sheets as they invested in illiquid assets but offered daily redemptions.
Another source of concern is the elevated exposure of non-banks to highly indebted segments of
the corporate sector. Excessive risk-taking may adversely affect the ability of non-banks to
absorb shocks, especially if economic conditions deteriorate. Moreover, downgrades of
corporates to sub-investment grade ratings may force non-banks to sell assets to fulfil their
investment mandates. This could amplify price movements in credit markets in times of low
market liquidity. It could also generate spill-overs to the wider financial system and the real
economy, as funding flows might recede and the cost of corporate financing might increase.
Against this background, we need to think about potential gaps in the current regulatory
framework. In particular, we should embark on developing a macroprudential framework for the
non-bank financial sector, which is still in its infancy. Additional policy instruments should ensure
that non-banks can sustain their financing of the real economy under different economic
conditions. They should aim to mitigate risks related to procyclical risk taking and excessive
leverage, liquidity and maturity transformation. One could consider macroprudential restrictions
on fund leverage and additional liquidity management tools that align redemption terms more
closely with the liquidity of funds' assets, for example. The policy tools should also provide
incentives for non-banks to internalise the impact that their actions have on the rest of the
financial system and the real economy. In particular, such policy tools could mitigate non-banks'
potential to amplify exuberance in upturns and adversely affect financial and economic conditions
in downturns.
Of course we cannot have a one size fits all approach for non-banks and we need to account for
differences in balance sheet structures and business models when designing any
macroprudential policy framework. But the growing size of non-bank financial institutions, their
greater importance to the financing of the real economy and their interconnectedness with the
rest of the system highlight the importance of developing a sound macroprudential framework for
this sector.
Conclusion
Let me conclude.
Currently, one of the most significant vulnerabilities of euro area banks relates to their weak
profitability prospects. The lacklustre outlook reflects both structural and cyclical factors. The
banking system is operating with significant overcapacity resulting in persistent cost
inefficiencies and competitive pressures. At the same time, the weaker cyclical momentum and
associated low interest rates are weighing on bank profitability, although monetary policy
accommodation has supported lending volumes. However, we need to acknowledge that banks
have made significant progress in repairing balance sheets since the outbreak of the financial
crisis. Nevertheless, a rebalancing of the current composition of capital requirements towards a
more prominent role for the CCyB could help mitigate costly economic deleveraging in
downturns.
Non-bank financial intermediaries have grown rapidly over recent years in the euro area, which is
a welcome development. But similar to banks, they are also facing profitability headwinds in the
current environment. As a consequence, they are searching for yield in riskier assets. Given their
increasing importance in financing the real economy, their increased risks and vulnerabilities
highlight the need for the development of a macroprudential framework for this sector.
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See Andersson, M., Kok, C., Mirza, H., Móré, C. and Mosthaf, J., "How can euro area banks reach sustainable
profitability in the future?", Financial Stability Review, ECB, November 2018.