Jean-Claude Trichet: The current state of the EU banking sector
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Annual Congress
of German Savings Banks, Frankfurt, 5 May 2004.
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Ladies and Gentlemen,
It is both a pleasure and an honour to be invited to speak here today at the Annual Congress of
German Savings Banks. Being in front of such a distinguished audience of representatives of the
financial community, I would like to present some views on the current state of play in the European
banking sector. I will in particular analyse the factors that have contributed to its resilience over recent
years.
Since 2000, EU banks have been confronted by an extraordinary combination of adverse financial
market shocks against the backdrop of a slow-down in the economy. Some commentators have even
been surprised by the few banking problems in the euro area during this period, given that earlier
episodes of slow growth often went hand in hand with severe problems in the sector. For central banks
and banking supervisors, the resilience of the EU banking sector is, of course, very good news. At the
same time, it raises a number of questions. What is now so different compared with the stressful
periods that banks experienced in the past and what factors have contributed to this resilience?
A turbulent period for EU banks
But before addressing these issues, let me start by briefly recalling how challenging the environment
has actually been for EU banks over recent years. Without a doubt, the most momentous technical
and strategic challenge was the introduction of the single currency, now more than five years ago.
The very smooth transition that followed the adoption of the euro almost makes us forget the
uncertainties, and sometimes even concerns, expressed before 1999 about the structural implications
the euro might have on the euro area banking sector.
The second challenge faced by banks in recent years was that not long after the banking sector had
begun to adjust to operating with a new currency - including all of the efforts that this entailed - an
exceptional series of adverse events followed in quick succession. After an almost uninterrupted
stock market boom since 1995, a severe stock market correction set in in March 2000 and investors
faced three consecutive years of negative returns. Investor confidence was also badly shaken by
unprecedented episodes of serious corporate malfeasance. Although most of the main abuses took
place abroad, Europe also had its fair share.
Over time, we have observed that banks have increasingly diversified into securities trading,
investment banking and asset management. Although much was expected from this diversification
strategy, the market correction was a reminder that fee income generated by these businesses also
carries risks. Looking back, I think we can also say that some banks entered the businesses too late
and at too high a price. The corporate scandals that coincided with the market downturn raised further
questions about certain bank practices and Chinese walls did not always prove to be as impermeable
as might have been expected.
In my list of stressful events, I should also mention the re-emergence of country risk problems and
the fall-out from the terrorist attacks in the United States. Country risk re-emerged as Turkey and
Argentina were caught up in currency and banking crises. Although the crises had only limited
economic effects on the EU banking sector as a whole, some banks incurred substantial losses. As to
the tragic events in the United States, they had an immediate effect on the working of financial
infrastructures and markets, but this was tackled quickly and efficiently by the competent authorities,
including those here in Europe. In the medium term, however, the attacks shook investor and
consumer confidence further.
The third challenge, to conclude my brief overview, is that this extraordinary set of events took place at
the same time that the economy was starting to slow down from the second half of 2000 onwards.
As debt ratios in the corporate sector had risen significantly through the years of the stock market
boom, signs of financial distress quickly surfaced as firms found that profits were not matching earlier
expectations.
Overall resilience despite isolated weaknesses
But in spite of the circumstances that I describe here, the EU banking sector's financial health
remained overall robust. The return on equity of EU banks peaked at 12% in 2000. The sector's
profitability subsequently declined for two consecutive years, reaching 8.6% in 2002. Increased
loan-loss provisions for corporate loans, reduced commissions and trading income from capital
market-related business were mainly behind this fall. Although the decline was substantial, overall
profitability levels continued to be well above those recorded in the second half of the 1990s. In the
course of 2003 profitability picked up again.
Banks' solvency levels remained relatively unaffected by the adverse events. Thanks to these
adequate financial buffers, banks were able to withstand the shocks in their operating environment.
The aggregated total regulatory capital ratio continued to hover around 12% throughout the period
after 2000, which is well above the required minimum ratio of 8% for individual institutions.
Although the overall picture was rather comforting, I have to qualify this somewhat by saying that
some individual institutions indeed experienced serious difficulties. Often this was because of problem
loans in certain sectors, such as real estate, or because of the disappointing results in market-based
activities. In some instances, the intervention of public authorities or private banks was required to
prevent banks from failing.
Possible reasons for the EU banking sector's resilience
Ladies and gentlemen, I now come to the essence of my question, namely the factors that have
accounted for the EU banking sector's resilience over recent years. I am of the opinion that the benign
combination of cyclical and structural factors contributed to this resilience.
Let me start with the cyclical factors. Although the economy started to slow down in 2000, it was
preceded by a period of booming financial markets and strong growth. This expansive period helped
banks to build up financial buffers sufficient to withstand the subsequent downturn. Although the
economic conditions were weak for a long period of time, the slowdown itself was relatively mild.
Macro-economic instability, which so often coincides with a banking crisis, was absent in the EU in the
period from 2000 onwards. It is my conviction that the economic and monetary union contributed
significantly to this benign environment. First, by abolishing exchange rates between the former euro
area currencies, exchange rate turbulence was avoided. Second, the adoption of a common policy
framework based on price stability, fiscal discipline and the implementation of structural reforms
contributed favourably. The low inflation and interest rate environment, as well as sustained real estate
prices, supported some lines of banks' business. The retail business fared well and mortgage lending
was dynamic in the face of declining financing costs and increasing house values. This helped to
counteract weakened corporate lending and the market-related activities of banks.
I now come to the structural factors that contribute to the EU banking sector's resilience. There I see
that efforts made both by authorities and by banks, as well as developments in financial markets,
have paid off. As a central banker, I would like to start with the role played by the authorities. Over
recent years, the regulatory and supervisory framework for banks has been greatly reinforced.
Here we should duly recognise the progress made under the influence of the extensive guidance
developed by the Basel Committee on Banking Supervision. At the EU level there have also been
great achievements and crucial building blocks of a common sound regulatory regime have been
agreed upon. Here I am referring to the rules on access to the banking business, capital requirements,
large exposures and group-wide supervision.
Another positive development I see is the extensive international cooperation and information
exchange between authorities, who, as a result, are able to address the challenges of a banking
business that is increasingly performed across borders. In this context I have to stress the valuable
work that is being undertaken by the ESCB's Banking Supervision Committee. The committee, which
consists of EU national central banks and banking supervisors, performs extensive work in the area of
financial stability monitoring. It does this by looking both at cyclical and structural developments that
might affect the EU banking sector's resilience.
I equally want to stress the efforts made by banks. Risk management has been growing in
importance and is becoming more integrated in banks' overall decision-making. Thanks to innovation
in financial markets and advances in the quantification of risk, risk management practices have been
significantly improved. Although concerns have been voiced about the spectacular growth in credit
derivatives, they also allow banks to better shape their risk profile. Risk models which are increasingly
being used to gauge credit and operational risk allow for an empirical underpinning of risk
management. Through joint projects such as the one being undertaken by federations of savings
banks to develop risk know-how and management systems, advanced risk management tools have
also become available to smaller institutions. Outsourcing and centralisation in the field of individual
banks' payment and settlement systems is another example of such joint projects which are being
undertaken in a number of EU countries at the same time.
The profitability pressures I described earlier have not led banks into immobility; in fact they have been
quite responsive in taking corrective measures. Lending terms have been tightened and more
riskbased pricing strategies applied. In addition, non-core assets have been shed and the number of
branches and employees reduced. This is particularly evident in the national banking systems that
were in need of further substantial restructuring.
I want to conclude my overview by pointing to the developments in financial markets in Europe.
Again, the single currency has been a beneficial factor. This is most clearly illustrated by the
unsecured money market. A very well integrated money market supported by TARGET, the area-wide
wholesale payment system, now allows liquidity to be quickly channelled from areas of the European
banking sector that show surpluses to areas that suffer shortages. This has contributed to a more
robust banking system. The emergence of a number of highly liquid euro-denominated exchange
contracts has also facilitated banks' risk management.
Concluding remarks
Ladies and gentlemen, let me briefly conclude. I have discussed how, under the challenging
conditions of the past few years, the EU banking sector has remained robust thanks to a benign
combination of cyclical and structural factors.
Nevertheless, a number of challenges remain both for banks and authorities, in particular, in the
structural domain. Several EU countries are still faced with excess capacity in their banking systems
that will have to be further reduced over time. Likewise, cross-border consolidation might accelerate as
mergers and acquisitions pick up again following improved market conditions. Regarding regulation
and supervision there is the new committee structure that is currently being set up at the EU level to
improve rule-making and implementation; its agenda is demanding and challenging. Other important
challenges that lie ahead are the introduction of the New Capital Accord and the International
Accounting Standards, whose potential structural effects on the EU banking sector are still uncertain.
Finally, another significant change for the EU banking sector, as I mentioned, is the recent entry of the
new Member States into the EU. However, as these countries' banking systems are, to a large extent,
already integrated in the EU banking system, this should be favourable for a smooth transition.
Ladies and gentlemen, I thank you for your attention.