Erkki Liikanen: On a sound and growth-enhancing financial sector in
Europe
Keynote speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the joint
Conference "The Comprehensive Assessment, the ECB's New Role and Limits of a
Common Supervision in the EU", organised by the Financial Risk and Stability Network,
Deutsches Institut für Wirtschaftsforschung (DIW Berlin), European School of Management
and Technology (ESMT), Jacques Delors Institut Berlin and Bruegel, Berlin, 30 October
2014.
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The social costs of the financial crisis - such as the losses in the GDP and the increases in
unemployment - have been very high. If policymakers - in central banks and in governments -
had not learned from the policy mistakes made during the Depression in the 1930s, the crisis
could have been even more destructive.
To avoid such crises in the future, or to at least limit their likelihood, we need a more stable
and resilient banking and financial system in Europe. To that end, we need better regulation
and supervision of banks and other financial institutions than before. Well-designed
regulation provide banks with the right incentives to choose their business model, scope, and
size efficiently to best serve the society.
It is a key responsibility of our generation to make the financial system much safer than it has
been. To be sure, we do not need to return to the repressive regulation of the post-war
period, and we need to ensure that the financial system does not prevent the recovery from
the global crisis. But we do need to find a better balance between rules and flexibility in
regulation than we have had.
The rest of this speech is organised as follows. First, I take a brief look at the European
financial sector and especially the banking sector before the crisis. Then I discuss the main
building blocks of reforms to European financial system. Finally, I provide views on the next
steps: future developments in the financial sector and necessary policy actions.
The European financial sector before the crisis
The banking sector has traditionally been and still is the dominant component in the European
financial sector, and developments in banking have also been of clear relevance to the
emergence of the financial crises in Europe. As the recent report by the Advisory Scientific
Committee of the European Systemic Risk Board tells us, over the past 20-25 years banking
systems in Europe had become too leveraged, too concentrated, and sometimes also too big.
As documented by the ESRB report, banks' domestic private lending as well as their total
balance sheets had ballooned. The total assets of the EU banking sector were over three
times the EU GDP in 2013. In several EU countries, the ratio is much bigger. As to the
concentration, the report points out that since 2000, the share of the three largest domestic
banks of the national banking system total assets had increased in all major EU countries
except Italy. The increase in leverage is illustrated by the decline in the median equity to
assets ratio of the largest listed EU banks to only just over 3% by 2008 from around 6% in
the late 1990's.
The increases in bank sizes and bank lending were not matched by an equivalent increase in
market-based financial intermediation. For example, the ratios of stock market capitalisation
to bank credit decreased considerably in the 2000s in the biggest EU countries. As a result,
the European financial structure became even more bank-based than before. The large
reliance of European firms - especially the SMEs - on bank finance has recently been a
drag on the recovery of the European economy as banks' ability to lend has been weak in
many EU countries in the aftermath of the crises.
It is now obvious that many of the developments in the European banking since the 1990's
sowed the seeds of the banking and sovereign debt crisis:
 Too-big-to-fail and too-big-to-save problems became more severe;
 Banks misallocated too much funds in asset markets fostering unsustainable
bubbles;
 Weakly capitalised banks' resilience to shocks became poorer;
 Increased concentration of the banking system made banks more interdependent
and vulnerable to contagion.
What has been done to develop the financial sector? - Lessons from the crisis
With this background in the banking sector, Europe faced the dramatic events of the financial
crisis. A wide-ranging discussion emerged and has continued on the reasons and lessons of
the crisis. One of the early, and one of the best accounts of the crisis was provided by Nobel
Laureate Jean Tirole.1 Professor Tirole accentuated the role of the inappropriate and poorly
implemented regulation as one of the critical factors explaining the emergence of the crisis.
In response to the crisis, a large number of international and EU wide regulatory reforms
have been launched. I will focus on three key areas of reform. These are new prudential
regulatory requirements for banks mainly following the standards set by the Basel Committee
of Banking Supervision; structural reforms planned for banks; and finally the introduction of
the Banking Union in Europe, especially the Single Supervisory Mechanism, or the SSM.
New prudential requirements
Prudential requirements set for the banking sector are undergoing a thorough reform. A lot
has already been achieved especially in the area of capital requirements developed by the
Basel Committee and implemented in Europe by EU legislation.
New capital requirements can go a long way to reduce incentives to take excessive risks
across different banking operations. Above all, they will improve banks' loss absorbing
capacity. These effects reduce the probability of bank failures. At the same time, sounder
capital requirements support banks' credibility and ability to intermediate funding also in
difficult market conditions.
Importantly, prudential regulatory requirements are increasingly set to address
macroprudential, system wide vulnerabilities and risks - in addition to targeting
institutionspecific risks. As also pointed out in the IMF's most recent Global Financial Stability Report,2
the introduction of macroprudential policy is a key step to promoting the soundness of the
financial sector especially in times of asynchronous economic and financial risks. Within the
euro area, country-specific macroprudential policy seems particularly useful as single
monetary policy is conducted for the entire euro area.
While EU Member States have designated macroprudential authorities, and the ECB also
has been assigned a new role in macroprudential policy in the SSM Regulation, it is
important to note that the financial system would benefit more if all actors in the financial
sector, supervisors, banks and their customers alike, paid more attention to systemic risks
emanating for example from excessive credit growth and leverage or misaligned incentives in
the financial system.
Closely linked and complementary to prudential requirements, the introduction of the new
recovery and resolution regime will help avoid bank bail-out or make it a rare exception.
When successfully implemented, it will provide for a set of tools to enable an orderly "failure"
of banks. The main tool will be the possibility to "bail-in" bank debt holders to absorb losses.
Moreover, the new recovery and resolution tools, provided that they are credible, will reduce
the implicit government guarantee and distortive risk-taking incentives created by bail-out
expectations and artificially low funding costs.
Structural reform
While the improved capital and liquidity requirements and the new resolution regime take us
a long way in addressing the too-big-to-fail problem, they do not take us all the way.
In October 2012 the High-level Expert Group on reforming the structure of the EU banking
sector proposed mandatory separation of a deposit bank and a trading entity within the
banking group to complement, not to substitute the ongoing regulatory reform.
The motivation for our decision to propose separation was the following:
 First, to limit the spill-over of benefits from the deposit guarantee system and any
implicit government guarantees to certain trading activities of banks.
 Second, to simplify the structure of large, complex banks. Reducing complexity by
means of separation facilitates management and implementation of incentives and it
facilitates supervision and monitoring by outside stakeholders such as shareholders,
bank creditors and other market participants, thus reinforcing market discipline.
 Third, to make it easier to impose recovery and resolution measures if a bank would
nevertheless get into severe problems. Simplifying the structure of the bank ex-ante
would also serve this purpose. It is crucial to make credible the resolution also of the
largest and most trading-intense banks.
 Fourth, to reduce the mixing of two very different management cultures in 1) the
customer-based retail and commercial banking and 2) the transaction-based trading
activities. The aim was to shift the focus from short-term to long-term, which is more
in line with the interests of the real economy and society at large.
The choice of where to draw the line between the deposit bank and the trading entity was
made so as to enable banks to service the real economy in the best way possible, while
separating the activity that should not enjoy the benefit of the implicit government guarantee.
Because the difference between proprietary trading and market making is hard to distinguish,
the Group proposed to keep them together in the separated trading entity. In this way,
market making would be provided on equal terms by trading units within banking groups and
entities outside the regular banking sector.
The High-level Expert Group also suggested that exposures to shadow banking entities such
as hedge funds ought to be separated from deposit-taking and lending activities.
Finally, we wanted to preserve the universal banking model and keep the trading activity
within the bank supervisory umbrella. This would also reduce the risk of migration of activities
to the shadow banking system. Having the deposit bank and trading entity under one roof
would also allow "one-stop banking" to continue where it is to the benefit of customers.
In January 2014 the European Commission presented its proposal for a Regulation on
structural measures improving the resilience of EU credit institutions.
The Commission proposal would cover the largest and most trading-intense banks in
Europe. The proposal obliges the competent authority to review trading activities and
empowers the competent authority to require separation of market-making, risky
securitisation and complex derivatives when specific conditions prevail.
The Commission proposal leaves an important role for the future judgment of the competent
authorities (which in most cases would be the ECB), the EBA and the Commission itself in
detailing the separation process and metrics to be used. Here transparency, predictability
and public accountability are crucial. Moreover, the elements of discretion need to be
implemented without compromising the level playing field in banking and the integrity of the
internal market.
In some respects, the proposed Regulation does also differ from the Group's
recommendations. The Commission's proposal includes an outright ban on organised
proprietary trading instead of requiring it to be assigned to a separate and separately
capitalised legal entity. Even though the definition of proprietary trading is rather narrow, the
Commission proposal resembles the structural reform implemented in the United States.
The Commission proposal is now in the hands of the Council and the European Parliament.
Banking Union
Today, our focus is on the Single Supervisory Mechanism, an important element in the
European Banking Union. The changeover to the Banking Union is definitely the biggest
change in the European financial regulatory framework since the adoption of the euro. With
the SSM taking its fully operative role in just a few days, this conference could not be better
scheduled to discuss the developments in supervision.
The decision on the creation of the common supervision was taken by the European Council
only two years ago in June 2012. The idea of common European supervision was not new,
but it had been debated in various forms and fora. One of the proponents of common
supervision was Professor Jean Tirole who proposed integration of supervision with the ECB
as an early lesson from the financial crisis.
On Sunday, the first core project of the SSM was finalised, when the results of the
comprehensive assessment were published. This exercise provides a very good starting
point for both the European banking sector and the ECB as a common supervisor. For
banks, the comprehensive assessment was intentionally designed to be very tough and
demanding. In comparison to previous supervisory actions, the comprehensive assessment
included not only the stress test, but an asset quality review to ensure that the basis for
stress testing is robust and the results comparable.
I believe that this strong exercise as a whole helps the European banking sector repair its
credibility by enhancing transparency and improving the resilience of the banking sector
through corrective measures. In this way, the comprehensive assessment supports banks'
ability to provide funding to non-financial economy, which is a necessary condition for
restoring growth in Europe.
However, prompt action is vital to further harmonise banking regulations in Europe. In
particular, making the quality of bank capital consistent across Member States should be a
priority, also for the SSM.
Also to make the SSM operational, the comprehensive assessment has been a very useful
exercise. During the past months, the national competent authorities and the ECB have got
the first flavour of acting closely together. The comprehensive assessment also provides the
ECB with a deep knowledge of the major banks to be under its direct supervision.
After thorough preparations since last year, the SSM will assume its supervisory tasks next
week. I am confident that due to the SSM, we will have a more effective and efficient
supervision, making the banking sector safer and helping it fulfil its tasks in the economy.
*****
For the ECB, taking over the responsibility on banking supervision is a big challenge. An
important question is how the ECB will reconcile its primary task of monetary policy and the
tasks assigned to it by the SSM regulation. It is crucial that the tasks of the ECB related to
micro-prudential banking supervision are clearly separated from the ECB's primary monetary
policy function. The separation of the policy functions is essential for safeguarding the
independence of monetary policy, and it also helps the supervisory function achieve its
objectives.
The separation of the supervisory function is required by the SSM legislation the provisions
of which require, for instance, strictly separated decision-making arrangements of the
Governing Council for different policy functions, but also separation of the supervisory staff
from the staff for monetary policy and other policy functions.
*****
The other main pillar of the banking union is the Single Resolution Mechanism, or SRM, that
better enables the resolution also of banks operating across the Banking Union Member
States.
The legislation on the SRM was approved earlier this year. Now it is of utmost importance
that the institutional framework is promptly implemented for the SRM to be fully operational
by January 2016.
The next steps for the financial sector in Europe?
How is the European financial sector developing now, and what are the new policy
challenges? Given the legacy of the crisis, the policymakers still face several challenges in
financial market policies.
In the short term, one challenge is that we must first find ways to boost bank lending
especially to SMEs to invigorate economic growth in Europe. There are issues on the
demand side but also on the supply side.
A special market segment has drawn attention during last months, it is the state of the
European securitisation markets. Public issuances in the European ABS markets remain low,
trading is thin in some market segments and the whole market carries a stigma in spite of the
fact that most European structured finance products performed well throughout the crisis.
In the short term, we have a clear need to stimulate ABS markets to stimulate credit creation.
In the longer-term the revitalisation of ABS markets would, among other things, (i) allow
better risk sharing among investors (ii) help banks to diversify their funding structure thus
increasing their resilience, and (iii) make firms less reliant on bank finance.
Concerning short term-challenges in the economy, the Governing Council of the ECB has
recently published decisions on targeted longer-term refinancing operations (TLTROs) as
well as ABS and covered bond purchase programmes. Together, the aim of these measures
is to further enhance the transmission of monetary policy. Their aim is to facilitate credit
provision to the euro area economy.
Turning to more longer-term developments, I am confident that if the planned regulatory
reforms are properly implemented, they will make the European financial sector sounder and
better able to fulfil its tasks in the economy, channelling funds from savers to borrowers in a
healthy manner.
Key financial sector reforms in the EU have focused on the banking sector. Banks' reputation
and the public confidence towards banks have suffered since the financial crisis. While
making banks more resilient, better structured and better supervised, the regulatory reforms
also advance the aim of rebuilding the confidence on banks.
At the same time, banking sector will very likely be complemented by financial markets and
other institutions in allocating funds to final customers. The new ECB report on banking
structures3 points out that the expansion of the traditional banking sector in the euro area has
slowed down since the beginning of the crisis whereas the growth has continued in the
nonbanking financial sector, especially in shadow banking.
The diversification of the financial system in Europe is a healthy development. However,
more attention needs to be drawn to the alternative funding channels to achieve two goals.
To remove any undesirable impediments to their efficient functioning. And to ensure that they
do not create new threats to financial stability.
Several new initiatives have been taken in the areas that go beyond banking.
These include the public consultation4 in early summer by the ECB and the Bank of England
to stimulate discussion on how to build a better functioning securitisation market in the
European Union. In particular, this consultation highlighted a suggestion to create standards
for the so-called qualifying securitisations to identify low-risk ABS products that are simple,
robust and transparent. The responses, published earlier this month,5 broadly supported this
initiative.
In January 2014, the Commission published a proposal for a regulation aimed at increasing
transparency of certain shadow banking transactions. The aim of this proposal is to improve
the reporting and increase the efficiency of supervision on securities financing transactions
so that the links to the banking sector are properly understood.
In his Political Guidelines for the next European Commission, President-Elect Jean-Claude
Juncker called for a Capital Markets Union to develop and integrate capital markets, also
with the aims of developing alternatives for bank funding, especially for SMEs, and making
Europe a more attractive place to invest.
These and other initiatives to develop functioning of shadow banking and financial markets
are very welcome. Work on this field still needs more systematic and serious reflection, but
we already have a good starting point.
Concluding remarks
Banks play a particularly important role in the financial sector in Europe, as the most
important source of finance for small and medium-sized enterprises. Banks also played a
critical role in the background for the financial crisis. The crisis initiated a comprehensive
reform of regulatory and supervisory framework of the banking sector, including new capital
requirements, structural changes, as well as the Banking Union with the Single Supervisory
and Resolution Mechanisms.
The regulatory and supervisory reforms are still partly ongoing, and they need to be carefully
completed and implemented. With the good progress achieved this far, the banking sector
seems to become more sound and resilient over time, thereby better able to provide loans
and other services without compromising financial stability.
At the same time, to complement bank finance in providing for adequate growth potential in
the real economy, alternative ways of funding need to be enhanced. But we also need to
improve our understanding of risks going beyond the traditional banking sector and to be
able address any threat they create to financial stability.
Both of these elements are important. Combining a better regulated and supervised banking
sector with a strengthened non-bank financial sector will contribute to financial stability and
improve the long-term growth prospects of the European economy and thus the welfare of
European citizens.