Sabine Lautenschläger: Banking supervision - a challenge
Speech Ms Sabine Lautenschläger, Member of the Executive Board of the European Central
Bank, at the Deutsches Institut für Wirtschaftsforschung, Hamburg, 8 September 2014.
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Summary
The effectiveness of monetary policy will be bolstered when the European Central Bank
(ECB) assumes its banking supervision responsibilities under the Single Supervisory
Mechanism (SSM), believes Sabine Lautenschläger, member of the ECB's Executive Board.
Bringing together the supervision of individual banks, the macro-prudential supervision of the
financial system and monetary policy under one roof will help to ensure that monetary policy
can focus entirely on safeguarding price stability, Lautenschläger said in a speech at the
Annual Conference of the Verein für Socialpolitik in Hamburg. The interaction between the
three policy areas of the central bank will reduce the risk of financial dominance, strengthen
the transmission of monetary policy and improve the management of the financial system.
"Both areas have a very strong interest in sound banks with viable business models that can
provide credit to the real economy", said Lautenschläger. Given that banks have already
been preparing over recent months for the requirements that will apply following the
imminent launch of the SSM and have strengthened their capital bases, their capacity to
provide credit to the economy has increased even before the official start of the SSM. This
strengthens the transmission of monetary policy.
For the central bank, which provides financing for commercial banks, it is very important -
particularly in times of crisis - to make a clear distinction between sound banks that are
solvent but suffering from liquidity shortages and insolvent banks that will not be able to
survive in the long run. A strong European supervisor would be able to dispel some of the
uncertainty attached to solvency assessments. This will help the ECB to fulfil its tasks,
because it will be able to provide liquidity support without fear of exceeding its mandate, said
Lautenschläger. However, reliable solvency information would only be able to help reduce
financial dominance if there is a credible regime for resolving banks. This requires a common
regulatory framework and a resolution fund with ample resources. In addition, stricter rules
regarding the granting of emergency liquidity assistance to commercial banks by Eurosystem
national central banks could reduce potential conflicts of interest.
Particularly in times of economic growth, the ECB's new tasks could permit an appropriate
reaction to potential excesses in asset markets, for example. Using interest rates to counter
such developments is not appropriate, warned Lautenschläger, because it could jeopardise
the primary objective of price stability. It is thus all the more important that the ECB's
Governing Council should have more tools at its disposal to counter imbalances.
* * *
My speech today is devoted to a relationship - to be precise, a triangular relationship. It's
about what makes a complex, yet successful relationship which does justice to the common
and different goals and interests of the three parties.
Starting this year, a triangular relationship, and in particular the workflows and
decisionmaking processes within it, is playing a specific role for the ECB, because in less than two
months the Single Supervisory Mechanism (SSM) officially begins its operations - and then
three policy areas will come under the umbrella of the ECB. Monetary policy will remain, of
course, our main task. The ECB will additionally take on responsibility for banking
supervision in the euro area. And we will play an important role in calibrating and
implementing macro-prudential supervision, even though national authorities will continue to
be primarily responsible.
Each of these policy areas has its mandate, goal and instruments. The task of monetary
policy is to ensure price stability. In this respect, interest rate policy is the standard
instrument (although there are now quite a number of measures that are non-standard). The
supervisory objectives are to ensure the safety and stability of the banking system as a
whole. The supervisory authorities have had, since the crisis, a veritable arsenal of
instruments which mainly concern the risk-bearing capacity of individual banks. The objective
of macro-prudential policy is the stability of the financial system as a whole. Even though the
ECB has of course exerted influence on financial stability via its monetary policy, starting in
November it will additionally use capital-based and liquidity-based instruments - in respect of
the institutions it directly or indirectly supervises.
Despite their differences, the three policy areas of monetary policy, banking supervision and
financial stability plus macro-prudential supervision are closely linked. One could even argue
they are in a triangular relationship: they influence comparable variables (such as
consumption and investment) and operate via the same transmission channels (such as
bank lending). Instruments which are used in one of the three policy areas inevitably affect
the other two; that makes it essential to clearly specify the objectives of each activity and to
clearly adjudicate on conflicting goals.
As is often the case in complex relationships, we could spend the whole day studying each
side of this relationship. Today I would like to specifically address the question of how the
new framework, how the two new banking supervision and macro-prudential supervision
tasks, will help the ECB to abide by its price stability mandate, as a kind of side effect. To
come straight to the point, I'll be talking about financial dominance, monetary policy
transmission and the financial cycle.
Reducing financial dominance
The classic function of a central bank is to provide liquidity to solvent banks. And the ECB
has unquestionably fulfilled this role even during the crisis. Our lending to banks rose by
more than €800 billion from 2008 to the height of the crisis in 2012. If the ECB had not
provided liquidity, there would have been bailouts, abrupt debt reduction and thus a
deepening of the recession - and this would have made our mandate of ensuring price
stability much more difficult.
However, there is no doubt that this lending entails risks for the central bank. It could fall into
the trap of financial dominance: the central bank could finance banks which are not suffering
merely from a temporary liquidity crunch, but which are permanently incapable of surviving,
which are insolvent. Financial dominance is accompanied by the risks of moral hazard and
market distortion and - worst of all - by the risk of monetary financing.
But how can a central bank become exposed to these risks? No doubt, it is a consequence
of the information asymmetry between a non-supervisory central bank on the one hand and
the banks and national supervisors on the other. Assessing the solvency of a bank often
takes more than the equity ratio. Having comprehensive knowledge of the capital situation
and the risk profile of the bank is a real benefit for such an assessment. This is particularly
true in financial crises, in the course of which an assessment of the solvency and
riskbearing capacity of a bank depends on many quantitative and qualitative parameters; we
should recall the often difficult valuation of assets that came under pressure in the crisis or
those that were not marketable.
For the ECB this aspect is more important than for many other central banks. Our monetary
policy works via the bank transmission channel, so it is bank-based. Thus, for our open
market operations almost 1,800 business partners are currently registered. By way of
comparison, the Federal Reserve has only 21 primary dealers. 72% of our business is
conducted via direct (and, of course, secured) loans to banks, a type of lending unknown to
the Fed. For this kind of monetary policy, information on the financial soundness of our
monetary policy counterparties is vital.
The creation of the SSM represents an important complement to monetary policy. A
wellestablished European supervisory body that is capable of acting can recognise emerging
internal risks in banks and strengthen their resilience and risk-bearing capacity. In addition, in
the event of a crisis the ECB will be able to resort to the sound judgement of the SSM. This is
especially true for the emergency liquidity assistance, which the national central banks are
responsible for granting. In this respect, the Governing Council, for its decision, will be able
to rely, among other things, on the SSM's expertise to judge whether it wants to raise
objections to the national emergency liquidity assistance.1
Now I don't want to sing the praises of synergy effects without pointing to some problems.
First, financial dominance may arise not only if the ECB, due to lack of sufficient information,
provides liquidity to non-viable banks. Financial dominance may also arise if the public gains
the impression that our interest rate decisions are influenced by concerns about their effects
on the institutions, in other words if we fall prey to a conflict of interests. Our credibility would
then be at stake. That's why, in the workflows and decision-making processes, we attach
great importance to the separation of monetary policy decisions and supervisory decisions.
That's why the functional separation below the Governing Council level will be strictly
observed and monetary policy decision documents will be submitted to the Governing
Council without any inflow of supervisory analysis, and vice versa.
Only at Governing Council level will the draft decisions meet one and the same
decisionmaking body. For example, if supervisory measures are taken in respect of certain banks the
Supervisory Board will forward the draft of the final decision to the Governing Council under
an implicit approval process - the process ensures that the members of the Governing
Council do not change the decision, but can only turn it down. This principle of a clear
separation between our different roles will also be carefully monitored by the European
Parliament.
To effectively counter any possible impression of fiscal dominance, systemically important
banks must be resolved without any risks to financial stability.
Currently, a Europe-wide framework for bank resolution is being set up, a Single Resolution
Mechanism with a resolution fund. We have thus taken a big step towards solving the
toobig-to-fail problem. The resolution mechanism will also serve to protect the central bank,
because it makes possible a Europe-wide, orderly winding-up of a systemically important
institution, without the Governing Council having to worry about the side effects on financial
stability of a short-term withdrawal of liquidity.
Effective supervision and the orderly resolution of banks thus also support the ECB's
monetary policy mandate. It helps the central bank to carry out its task, that is, to provide
liquidity assistance, without it having to worry about overstepping its mandate.
Improving the monetary policy transmission
The Eurosystem offers liquidity to banks to maintain financial intermediation in the money
market and to improve the transmission of monetary policy. For this transmission to work
optimally, a stable financial sector is needed. For banks are the most important channel via
which our monetary stimulus is passed on to businesses and households. And only healthy
banks can perform their role as lenders. So monetary policy-makers and banking supervisors
are very interested in having sound banks with viable business models that can lend money
to the real economy.
But how does the Single Supervisory Mechanism support the monetary policy transmission?
First, the comprehensive assessment, i.e. the health check of the banks, plays an essential
role. The assessment of bank balance sheets aims to uncover bad debts and to place all
banks with a solid capital base under the supervision of the SSM. And this assessment can
have a catalytic effect.
Prior to the health check, most banks accelerated their deleveraging or built up their equity.
The sum of bank balance sheets declined in 2013 alone by around 20 percentage points of
GDP. Since July 2013, the nearly 130 banks have built up capital amounting to
approximately €140 billion.2 As a result of the health check, one or the other institution will
make further provisions or raise capital. A lengthy period of balance sheet restructuring will
thus be significantly shortened.
In lending, we are already seeing the first positive signals. The decline in lending to
companies and households has stabilised. And our latest Bank Lending Survey suggests
that in the second quarter of 2014 lending standards eased for all categories of loans on a
net basis.
The Single Supervisory Mechanism can make a further significant contribution in support of
monetary policy; set up properly, it could, at best, enhance the effectiveness of monetary
policy during the next credit cycle. At this point, the interaction of micro-prudential and
macro-prudential policy, the second side of the triangular relationship, comes into play.
As I said earlier, many banks in the euro area had to deleverage significantly during the
crisis; they were not resilient enough. Some banks found it difficult to refinance because their
equity ratios were too low. So they had to increase their capital ratio during the downturn,
and this curbed new lending.
This cyclical behaviour cannot perhaps be eliminated with instruments from micro- and
macro-prudential supervision, but it certainly can be attenuated. Supervision in Europe will
take a preventive, risk-based approach. We will be pushing for more than compliance with
the minimum capital and liquidity ratios under the supervisory regulation. We will above all
check whether the business models of banks we directly supervise are sustainable, whether
bank-internal control structures and governance are set up in an appropriate way and
whether the institutions could survive crises. If during an upturn a bank's resilience is
increased, then there's less need to raise capital during a downturn to boost market
confidence. Under such circumstances, it should then be possible to use macro-prudential
instruments that support lending, such as the releasing of countercyclical capital buffers. This
would help monetary policy to achieve more predictable effects throughout the economic
cycle.
But the interests of the banking supervisors and of those responsible for macro-prudential
supervision do not always have to be aligned. I can easily imagine situations in which the
supervisor feels there is more capital and liquidity than necessary or that the increase in
margin requirements is more than necessary, while from a systemic perspective cyclical
behaviour is perceived to be crisis-intensifying.
The link between the two areas of responsibility at the ECB may also prove to be helpful
here, by internally resolving potential conflicts. The advantage of having the Governing
Council as a decision-making body for all three policy areas is that it can get a
comprehensive picture of the systemic risks and thus weigh up the micro and macro
considerations and can find a balance that should be beneficial to monetary policy.
But this is not the only advantage for monetary policy. By combining the functions within the
ECB synergies may arise, at best, in the choice of instruments to curb threats to financial
stability. For some monetary policy instruments, such as adjustments to haircuts or to the
minimum requirements for collateral, overlap with macro-prudential measures aimed at
liquidity and margin requirements.
The interplay between micro- and macro-prudence can therefore support monetary policy not
only during the cycle. It can also ensure that monetary policy does not have to deal with
problems that may lie on the periphery of its mandate.
At the same time, the combination of functions within the central bank also brings great
advantages for micro-prudential supervision. For monetary policy decisions, extensive
economic analyses are made to which the supervisors may resort in order to obtain
additional information about the environment and the conditions under which the banks
conduct their business. The ECB has extensive knowledge of the market and provides,
among other things, real-time insights into the general refinancing situation of the banks. In
short, the exchange of know-how and information creates synergies and leads to better
informed supervisory decisions and outcomes.
Steering the financial cycle
So far I have talked about the interaction between the areas of responsibility in the downturn
phase of the cycle. But what about the upturn?
In recent years there has been much discussion about the extent to which central banks
should play a role in steering the financial cycle - whether they should "lean against the
wind". Before the crisis, many opinion leaders believed that, given the difficulty of identifying
latent bubbles, it was the task of the central bank to make good the damage once the bubble
had burst.
As a result of the crisis, however, when a long financial boom had a major impact on price
stability, many economists have changed their minds and are demanding that central banks
should take into account risks to financial stability in their decisions.
The ECB has always included financial stability considerations in its monetary policy
decisions. In our two-pillar strategy financial imbalances are an important element in deciding
what measures are necessary, even when it is a matter of inflation that is too low. In
particular, the monetary pillar captures the relationship between excessive credit and liquidity
creation, and potential risks to future price developments, including that of a destabilising
asset price boom. Our actions have a deliberate medium-term orientation. This gives us a
sufficiently long horizon to take account of financial imbalances in our strategy. Elements of a
"leaning-against-the-wind" approach are therefore implicitly included.
However, should there be signs of financial imbalances emerging, we need to carefully
consider whether the use of standard monetary policy instruments is appropriate as a
response. There are two reasons for this.
First, it could conflict with our mandate to preserve price stability. The BIS estimates that the
financial cycle typically lasts around 16 years, compared with eight years for the business
cycle. This asynchrony can lead to periods in which inflation makes a rate cut necessary,
while the financial data favour the opposite. If we take only the financial cycle into account,
we may be forced, even with our medium-term orientation, to make compromises in terms of
our price stability objective. According to our hierarchy of goals, which gives priority to
monetary policy, this would not be permissible.
In addition, there is also the question of which interest rate path should be followed to
counter excessive credit growth. Some studies conclude that in a highly leveraged boom
even small changes in interest rates can have a strong impact.3 Other studies suggest,
however, that rather large interest rate movements would be required to counteract the
financial cycle, but these in turn would cause collateral damage to the economy and price
stability.4
Using monetary policy instruments to strengthen financial stability seems to be too crude an
approach in view of the heterogeneity in the euro area. So, for example, lending in the period
before 2008 was ten percentage points higher in some subsequent crisis countries than in
the non-crisis countries. A rate hike by the ECB, which always applies to the entire euro
area, would have had too great an impact on those regions that were not affected by
excessive lending.
But if monetary policy instruments cannot always simultaneously satisfy financial stability
aspects, then there is only one conclusion: we must consistently apply the Tinbergen Rule;
we need at least as many instruments as we have goals to achieve. A different goal requires
an additional tool that is appropriate and proportionate.
This is where the SSM comes into play - more specifically, the relationship between
macroprudential policy and monetary policy, the third side of the triangle. In principle, it should be
easier, by expanding the toolkit which is available to the ECB, with the SSM to establish a
clear separation of functions between the two policy areas. Monetary policy should
concentrate on price stability, which is an important variable throughout the euro area. The
focus of macro-prudential policy should be on financial stability. Particular emphasis could be
put on specific regional or sectoral imbalances.
However, there may be circumstances under which a clear separation is not so simple. This
is the case when the financial cycle extends across sectors and countries and represents a
threat to future price stability. A combination of monetary and macro-prudential measures
could then be the right answer.
Particularly for the macro-prudential measures, there are many different questions and
uncertainties about unintended spillover effects of regionally limited measures on other
countries or the entire euro area. Under such conditions, the fact that the ECB is also
responsible for banking supervision will benefit monetary policy. Because for all of these
issues, the decision-making is concentrated in the Governing Council. The Council's role is
to ensure an optimal policy mix.
As for macro-prudential policy, the national authorities, as I have already said, still play an
important shaping role. They have extensive knowledge of the national economic and
financial systems. The governors of most of the national central banks are involved in
national macro-prudential tasks. This will make the exchange of views and voting in the
Governing Council in respect of national and European macro-prudential policies
considerably easier.
Should opinions diverge - for example, in relation to the systemic consequences of a specific
measure - the ECB is authorised under EU legislation to improve existing macro-prudential
measures which have been implemented by national authorities or to make
recommendations for new measures.
Summary
Ladies and gentlemen, allow me to summarise.
My intention today has been to give you an understanding of the future tasks of the ECB, the
future triangular relationship. The Single Supervisory Mechanism and the new role in
macroprudential supervision will not, when properly set up, dilute the objective of the central bank,
but instead may contribute, as a side effect, to a strengthening of our monetary policy
mandate. And monetary policy can focus on its task of maintaining price stability. Banking
supervision will ensure that banks become more resilient; macro-prudential instruments
should have a dampening effect on asset price bubbles and cyclical behaviours. The
completion of the banking union will also contribute significantly to safeguarding financial
stability in the future.
Nevertheless, we must not succumb to hubris - we must not succumb to the notion that all
problems are solved thanks to the SSM. The health of individual banks depends not only on
supervision, but also on the overall economy and the structure of the banking system; and
the ECB's influence on that is limited. And we should not forget that irrational exuberance, as
can be found ex post in many a "bubble", is simply part of human nature. That's another
lesson the crisis should teach us.