Benoît Coeuré: From challenges to opportunities - rebooting the
European financial sector
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the SZ (Süddeutsche Zeitung) Finance Day 2016, Frankfurt am Main, 2 March 2016.
* * *
Ladies and gentlemen,
For those of you here who work in the financial sector, your job depends on your ability to
assess and manage risk. What allows you to do this is the fact that many risks are tangible -
they can be identified through analysis, measured through models and hedged using
financial instruments. Risk is not per se an obstacle to decision-making; it simply frames the
parameters of those decisions.
The situation is different, however, when risk morphs into uncertainty1. Uncertainty, by
definition, cannot be predicted or quantified. It is therefore much more of an impediment to
decision-making. And that brings with it economic costs: firms postponing investment,
households postponing consumption and increasing savings.
In the European economy today we face several sources of uncertainty. We face uncertainty
about the outlook for the global economy. We face uncertainty about the direction of Europe
and its resilience to new shocks - the UK referendum, the next wave of migration. And
germane to this conference, we face uncertainty about the way forward for the European
financial sector.
A significant amount of this uncertainty stems from the fact that, eight years after the crisis,
we are still in a transition phase. Financial institutions are considerably stronger than in 2008
but they are still adjusting their business models to a post-crisis world. We have a new
regulatory regime, whose contours are not yet fully defined. And the new regime is being
overlaid on a financial sector that, in some cases, still has substantial legacy issues to
address. That creates unavoidable frictions.
But uncertainty can also be self-imposed, and policy decisions can play a role in that. In the
still fragile environment we face today, what is essential is that policy works to reduce
uncertainty - and does not become a source of uncertainty itself.
At the same time, policy cannot be an excuse for financial firms to put off revising their
business models and updating their technologies. To build confidence in the European
financial sector, all actors need to play their part. The post-crisis environment is a challenge,
but it is also an opportunity: for the financial sector to become more profitable, more efficient
and more stable.
What I would like to do in my remarks today is look more closely at the sources of uncertainty
we face today, and at what policymakers and private players can do to address them. There
are three areas in particular I would like to focus on: the business environment, the
regulatory environment, and the technological environment.
Business environment
The business environment confronting the European financial sector today is evidently
challenging.
Earnings among euro area banks continue to be weak, with their average return on equity -
although markedly improved since the crisis2 - remaining below their cost of equity. Cost
cutting and rationalisation has been ongoing since 2008, making further cost savings harder
to achieve. Low profitability constrains the capacity of banks to generate capital internally.
And new challenges have arisen in the face of an uncertain economic outlook, especially
given the weakness in emerging markets and in commodity-producing sectors.
So are there ways that policymakers can reduce this uncertainty?
One topical issue is, of course, whether monetary policy is contributing to weak profitability.
In particular, a concern has built up that, as central banks lower interest rates into negative
territory, the impact of monetary policy on banks is becoming increasingly adverse. That is
because bank lending rates fall linearly but their funding costs are non-linear - as interest
rates on retail deposits are sticky - which puts a squeeze on net interest margins.
Let me underline that we are well aware of this issue. We are monitoring it on a regular basis
and we are studying carefully the schemes used in other jurisdictions to mitigate possible
adverse consequences for the bank lending channel. But I also think we need to qualify the
narrative that banks' challenges flow largely from our monetary policy.
So far, many banks have been able to more than offset declining interest revenues with
higher lending volumes, lower interest expenses, lower risk provisioning and capital gains.
Last year, for example, euro area banks' aggregate net interest income increased, especially
as crisis-hit banks refinanced expiring high-yield liabilities. And negative interest rates are
complementary to our asset purchase programme, which has had clearly positive effects on
asset prices, credit risk and intermediation volumes. This has to be set against the direct
costs from our measures to net interest margins.
Moreover, in an environment of rising global uncertainty, what would be the costs for the
financial sector if monetary policy had not responded? We have seen from the recent sharp
fall in bank equity prices that the sector is highly sensitive to a weaker-than-expected
economic outlook. In that context, our commitment to our price stability mandate is vital to
anchor expectations of nominal growth. Those who call for a less accommodative monetary
policy have to ask themselves what would be the impact on banks' lending volumes and
loan-loss provisions if output were stagnant and prices falling.
More generally, market jitters have particularly focused on banks perceived to have residual
weaknesses - in particular those with high stocks of non-performing loans (NPL) and those
perceived to lack sustainable business models. These are challenges that have little to do
with the central bank. Reducing uncertainty from these sources requires other policymakers
and private players to act.
Two priorities stand out. The first is moving more decisively to deal with legacy assets.
Progress in NPL resolution is still slow when compared with the volume of problem loans. In
countries most affected by the crisis3, the ratio of non-performing exposures to tangible
equity and loan loss provisions - the so-called "Texas ratio" - currently stands at around
100% for many banks. That undermines confidence in their ability to absorb further losses,
creating volatility in the event of economic bad news, as well as hampering loan growth to
the real economy.
All the preconditions are now there to accelerate NPL resolution: NPL levels and provisioning
have been reviewed by the supervisory arm of the ECB as part of the Asset Quality Review.
The challenge now is to speed up the process of writing off and/or disposal. There are
various policy measures that can facilitate this process.
One is improving insolvency regimes, which help separate viable from non-viable borrowers
and enable the valuation of assets to be sold off. Another is increasing the efficiency of
judicial systems, which allows faster foreclosure of collateral underlying NPL portfolios. And
in my view there are also merits in facilitating the carve-out of substantial portions of bank
balance sheets. But this assumes, of course, that workable solutions exist for the transfer of
legacy assets at sensible prices to investors able and willing to manage them. It also
assumes decisive action to kick-start the market for loans in those jurisdictions where NPL
ratios are the highest - that is, in Cyprus and in Greece.
Second, banks with perceived business model risks need to do more to mitigate uncertainty
by reshaping their business mix and their operational models. Asset carve-outs could be
catalytic here as well: streamlining their balance sheets by disposing of assets can allow
banks to concentrate on developing new business, as opposed to managing legacy assets -
in other words, it can save them from "zombification". Beyond that, banks with weak
profitability need to find ways to increase non-interest income and, where possible, to reduce
further their operating costs. There appears to be scope for this too.4
On the earnings side, for example, we have already observed a trend among banks to
compensate for lower interest income by increasing fees and commissions. There is some
evidence that banks are offering fee-based products to clients as substitutes for
interestbased products. On the cost side savings are more challenging given the extensive
rationalisation efforts of recent years, but there is still one obvious "low hanging fruit" to be
picked: consolidation within the sector.
Indicators of market concentration suggest some over-capacity in the European banking
sector, especially in countries with more fragmented banking systems. For example, the
Herfindahl-Hirschman Index for the euro area, though rising in recent years, still stands
below 750. As a general rule, a figure below 1000 signals low concentration.5 Cost-income
ratios in some banking sectors also remain high. That implies there would be efficiency gains
from consolidation without exacerbating "too-big-to-fail" problems.
The fact that we now have a European supervisory and resolution regime presents the ideal
conditions for banks to capitalise on new cross-border M&A opportunities. What our
economy needs is European banks operating in a European market: large enough to operate
across borders and diversify risks, but small enough to be resolved with the resources of the
Single Resolution Fund. This would reap the full benefits of banking union and improve the
terms of the trade-off between financial stability and economic efficiency.6
For that to happen, however, we need to remove any remnants of the regulatory framework
that implicitly support home bias. For example, how much national discretion is allowed in
implementing rules; how fungible are liquidity and capital across borders; how regulations
affect the choice of subsidiaries versus branches - all these issues will crucially shape the
incentives of banks to become European. And if we do not get them right, the risk is that
consolidation ultimately happens through the more painful route of resolution.
Regulatory environment
This brings me to the second part of my remarks: the regulatory environment. Clearly, the
European financial sector is facing a profoundly changed regulatory environment after the
crisis. That applies to quantity and quality of capital, to leverage, to funding profiles, to
bail-inable debt, to risk management practices. Derivatives markets and market infrastructures
have also been subject to a comprehensive reform agenda.
Is this regulation a source of uncertainty? Taking a longer-term view, I find it difficult to
believe so. Thanks to regulatory initiatives, capital ratios for euro area banks have risen from
around 8% in 2008 to close to 14% today. Leverage ratios have improved in most countries.
And funding has become more stable: median loan-to-deposit ratios have fallen from more
than 140% in 2008 to around 110% now. Forcing over-the-counter (OTC) derivatives onto
central clearing has also netted out counterparty risk and reduced uncertainty over who owns
what in a crisis.
All this contributes to a more robust financial sector that is better able to absorb shocks. And
though there are always costs to regulation, most studies suggest that, in the steady state,
the macroeconomic benefits outweigh them. For example, Commission simulations find that
the new regulatory framework will deliver macroeconomic benefits of around 0.6-1.1% of EU
GDP per year, compared with long-term costs of about 0.3% of EU GDP per year.7
Where regulation can create uncertainty, however, is in two areas. The first is if there is a
lack of visibility on what the future regulatory regime will look like. And the second is if there
is uncertainty about how new regulation will be applied.
The volume of new regulation coming in has created uncertainty in the financial sector in
recent years. But I think the contours of the new regime are now clearer than before. The key
unfinished parts of the Basel III agenda, such as the leverage ratio, reductions in the
variability in risk-weighted assets, total loss absorbing capacity (TLAC) and the fundamental
review of the trading book, look set to be finalised in Europe by the end of this year. That
should help provide clarity on the post-crisis steady state. As confirmed by G20 Finance
Ministers and Governors at their meeting in Shanghai, the aim is now to focus on making
Basel III effective without further increasing regulatory capital requirements.8
But there are still some areas where, I think, more visibility would be beneficial. One is the
timeline for the Directive on Markets in Financial Instruments, which was recently postponed.
Regulators no doubt face a difficult trade-off between the urgency of reform and the need for
such a fundamental change in regulation to meet technical and logistical reality. But it is also
important that the process does not lose momentum, not least as this legislation will be the
backbone of a future Capital Markets Union.
Another area is the resilience, recovery and resolution of clearing houses, on which the
Commission will make a proposal later this year when the global framework has been
clarified. The CPMI, IOSCO and the FSB are making good progress in this area and will
deliver guidance ahead of the G20 Hangzhou summit.9
In terms of the application of regulation, we have also seen - perhaps inevitably - a degree
of uncertainty as the new regime beds in. For example, some of the recent volatility we saw
in bank shares seems to have coincided with uncertainty around how pillar 2 capital
requirements would be applied. But recent clarifications by the European Banking Authority
(EBA)10 and additional communication by the Single Supervisory Mechanism (SSM)11 have
now, I think, gone a long way towards allaying concerns. All things being equal, supervisory
requirements will also not be increased further.
What perhaps remains to be clarified is exactly how the new resolution framework will work.
The resolution cases in Portugal and Italy last year have sparked concerns about equal
treatment, but it is important to underline that this was not an application of the bail-in tool in
the Bank Recovery and Resolution Directive, but rather of the EU state aid rules. What is key
now is that creditors have certainty about where they stand in the new resolution hierarchy.
That would be enhanced, in my view, by ensuring that MREL (the minimum requirement for
own funds and eligible liabilities) is consistently implemented across the EU, including a
common EU framework on the degree of subordination of senior unsecured bank bonds12. It
would also benefit from clarifying the interaction between MREL and TLAC (total
lossabsorbing-capacity), in particular the differences in subordination and the treatment of
additional capital buffers. The ongoing MREL review, which will also implement TLAC, will
need to address any remaining inconsistencies and uncertainties, as banks need clarity to
start issuing the bail-in-able debt that will make the new resolution regime fully effective.
I trust many of these issues will be addressed and finalised in the course of 2016.
Technological environment
Finally, let me say a word about the third and in my view the most important area of potential
uncertainty in the financial sector: the evolving technological environment. What I am
referring to here is the emergence of disruptive new technologies - so-called "FinTech" -
which look set to profoundly reshape the structure of financial intermediation.
FinTech now spreads across financial market segments and along the value chain. It is
present, albeit still at an early stage, in payments, credit provision, investment and financial
advice, insurance. It runs from front office to back office. And FinTech innovations are
increasingly cascading into new areas. For example, the development of instant payments
infrastructures has helped develop new markets for mobile P2P, e-commerce or point-of-sale
payment solutions, which may become a new standard of payments in some areas.
On the face of it, I have no doubt that this is a positive development for the financial sector. It
leads to greater efficiency, better products and lower prices for consumers. It also has the
potential to support financial inclusion. In short, FinTech can be part of the answer to the
fundamental questions facing our economies: lack of productivity and rising inequalities.
That is why regulation is generally supporting opening up market access by introducing legal
certainty to previously unregulated services. For example, the revised Payment Services
Directive is expanding the list of activities that payment service providers can carry out to
include the initiation of payments and account information services. Where the uncertainty
comes in, however, is how this will affect incumbents.
FinTech presents an opportunity for new start-ups to compete with established financial
institutions in specific financial services, but without the costs of legacy IT systems and a
compliance-oriented business culture. FinTech also opens the market for "BigTech" firms
such as Apple, Google and Amazon, which have an in-built advantage in digital technology.
This threatens to take business away from banks which traditionally offered a package of
services, potentially weakening their business models.
What is more, over the longer-term technological innovations, such as distributed ledger
technologies (DLTs), could have profound impacts on financial intermediation. DLTs have
the potential to substantially reduce reconciliation costs for market participants, to
disintermediate incumbents in the financial value chain, and to allow for a more efficient use
of collateral. Through decentralised update and validation of records, they may even
challenge the basic business models of intermediaries or central market infrastructures.
So should policymakers be concerned about this?
Generally speaking, it is up to market incumbents to rise to this challenge. In particular,
banks facing questions about their business models should see the new wave of innovation
as an opportunity - to reach out to new customers, to increase efficiency, to revamp their
business models. After all, they still retain economies of scale unavailable to small start-ups
and intellectual capital unavailable to outsiders. FinTech may be exactly the shock the sector
needs to restructure after the crisis.
But policymakers also need to monitor developments closely. As more firms enter the market
it will be important to ensure a level playing field between entities providing similar financial
services. Moreover, market fragmentation might create challenges for a single European
market, as market innovators have a tendency to build closed-loop solutions or "silos", and
challenge the existing approaches towards containing systemic risk. For example, the
emergence of popular retail payment platforms in one country could undermine the market
integration already achieved in the context of SEPA.
We will have to see how the market evolves before assessing whether regulation should
provide a steer in one direction or another, whether the new approaches will provide full legal
certainty to market participants, and whether regulatory space can be provided to let
innovation develop without hindering financial stability. But we have started moving along a
steep learning curve. For example, the CPMI has launched work in partnership with IOSCO
and other standard-setting bodies on the impact of the distributed ledger technology and
related digital innovations on payments and market infrastructures.
Conclusion
Let me conclude.
The euro area is still recovering from a once-in-a-generation economic and financial crisis
that has left deep scars on the economy. It urgently needs higher growth to bring down high
unemployment, to deleverage the economy and to raise inflation back to our price stability
objective. Uncertainty in the financial sector only blocks that path.
To reduce uncertainty, both policymakers and financial institutions need to play their part.
They need to ensure that the financial system is fit for purpose and able to finance the
recovery. And they need to do so today, not tomorrow.
But we should keep in mind that the challenges facing the financial sector also present an
opportunity. A tough business environment can push banks to be more efficient. A new,
stable regulatory environment will make the financial system safer. And a disruptive
technological environment can lead to new business models and better financial services.
It is in all our interests to rise to this challenge.