Fernando Restoy: Capital requirements and banking union
Speech by Mr Fernando Restoy, Deputy Governor of the Bank of Spain, to the Analistas
Financieros Internacionales (AFI) conference on banking regulation, Madrid, 27 January
2014.
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Good morning.
Thank you, Emilio, for your kind introduction and for the invitation to take part in this AFI
(Analistas Financieros Internacionales) conference on banking regulation.
As we move into 2014, we face a year of major challenges for the banking industry. This is
so, above all, because of the historic importance of the start-up of the single supervisory
mechanism, which will effectively come on stream next November. At that point the ECB will
assume supervisory powers over the main euro area banks. And this institutional change,
marking the origin of the banking union, will come about against a background of
deepseated changes in the regulatory framework of banking activity.
Allow me to begin by reviewing some of the latest regulatory changes in the prudential field,
before sharing some thoughts with you on the ongoing construction of the banking union in
Europe.
Solvency regulations
One of the pillars of the financial reform, which arose in response to the shortcomings
evidenced during the crisis, has been the measures aimed at strengthening bank solvency.
As you know, the new solvency rules, known as Basel III, have been applied since the start
of this year in the European Union. They have been incorporated into legislation through a
Directive and a Regulation on capital requirements. The rules require banks to appreciably
increase the quality and quantity of regulatory capital. Further, they increase the instruments
at supervisors' disposal to restrict the risks of bank operations and to ensure financial
institutions have sufficient loss-absorbing capacity, and, more generally, to safeguard the
stability of the financial system as a whole.
Yet the mission to strengthen the regulatory framework in order to minimise the likelihood of
banking crises, together with their associated costs, is far from complete. You will be aware
that the Basel Committee on Banking Supervision is working on the definition and
appropriate parameterisation of new liquidity requirements to complement the solvency
requirements. At the same time, one task to be undertaken in the near future is the
enhancement of the current tools for measuring and provisioning risk on bank balance
sheets.
Specifically, the Basel Committee has advocated the advisability of working on improving the
methods for calculating risk-weighted assets and thus increasing their consistency and
homogeneity.
Indeed, an appreciable degree of heterogeneity has recently been evident in the internal
models banks use to calculate risk weightings under the advanced approach, whose use
must be approved by the supervisor. Supervisory practice indicates the technical difficulty
entailed in approving the models presented by banks and, in particular, in gauging their
ability to properly measure the sensitivity of the various portfolios to risk. It is thus not
unusual that the studies available should question the fact that banks with the same risk
profile are actually subject in practice to comparable capital requirements when they operate
in different jurisdictions.
The dissatisfaction arising from the difficulties in achieving an appropriate estimation of asset
risk weightings should not lead to conventional solvency ratios being discarded or to their
role as essential indicators of the financial strength of banks being questioned. Nor is it easy
to justify renouncing the use of the specific information at hand at banks - through the
advanced approach - to improve the measurement of the risk of exposures. Indeed, I believe
any effective regulatory reform should continue to aspire to have capital requirements
discriminate between different types of exposures on the basis of their risk and to avoid
excessively simplistic approaches that prevent capital requirements being adapted to each
bank's business model. What's more, the calculation of the solvency ratios and, in particular,
the use of advanced models should be subject to more demanding tests.
In this respect, various options - which are not mutually exclusive - have emerged in the
ongoing debate to refine the calculation of regulatory capital, and these merit in-depth study.
The first approach involves developing more accurate guidelines for the design and
parameterisation of acceptable models. A second course of action is the possibility of
imposing restrictions on the saving of own funds prompted by the use of the advanced as
opposed to the standardised approach which, at an extreme, could lead to the results of the
standardised approach being used as a floor for the required capital. A third proposal is the
use of a leverage ratio as a complement to the traditional solvency ratios.
As you know, the Basel Committee published, scarcely two weeks ago, a document detailing
the work performed to introduce, in the near future, a minimum leverage ratio in the
regulatory framework of banking activity.
As a concept, the leverage ratio can be defined very simply as the ratio of the bank's
highquality capital to its total exposure. However, transposing the concept to regulation requires,
in practice, adopting complex decisions on how to measure certain exposures (such as repos
and derivatives) and the extent to which these exposures should be netted or not for the
purposes of calculating the ratio denominator. And all this must be done bearing in mind the
existence of various approaches in the different jurisdictions linked largely to the
heterogeneity of the accounting frameworks in place.
The definition proposed by the Basel Committee is a pragmatic approach to the problem that
should provide for the application of a similar methodology for the calculation of the leverage
ratio worldwide.
In any event, the final calibration of the minimum ratio should be completed in 2017, with a
view to its definitive inclusion in the solvency rules in 2018. This calibration will define the
interrelatedness of the ratio to the other solvency measures and, specifically, the conditions
under which it will act as a binding constraint. We are still, therefore, at the analysis and
calibration phase. Next year, banks will be required to publish the ratio as a transparency
measure, which will be conducive to the final design of the new regulatory requirement
attaining a sufficient degree of consistency and homogeneity.
Evidently, the introduction of new prudential control measures entails an additional effort for
banks, at a time when the sluggishness of economic activity is exerting significant pressure
on their margins. Undoubtedly, however, adopting these measures while observing a prudent
implementation calendar will have an appreciably positive effect on the industry's soundness
and resilience and, consequently, on the economy as a whole.
Banking union
That said, as experience categorically shows, the harmonisation of solvency rules is not a
sufficient guarantee to ensure homogenous control of the financial position of banks located
in different jurisdictions. As important as having similar rules is the application of a common
supervisory approach. And the homogeneity of the prudential control exerted over financial
institutions is particularly important in economic areas that share an integrated banking
market and a common currency. Hence the importance for Europe of setting up a single
supervisory mechanism.
This mechanism, as the first piece of the banking union project, is essential for contributing to
doing away fully with the financial fragmentation that threatened the continuity of the euro
and to deactivating the vicious feedback loop between banking and sovereign risk, which
caused so much harm to economies such as Spain in terms of greater funding costs,
difficulty of access to credit and, in sum, lower employment and growth.
The single supervisory mechanism
As you are aware, the start-up of the single supervisory mechanism, the first pillar of the
banking union, is at a very advanced stage following the entry into force, just a few days
back, of the Community Regulation creating it. Currently, intense preparatory work is under
way, and I can assure you this poses a significant organisational challenge.
A key element is to establish an appropriate governance structure combining the leadership
of the ECB in the supervisory function with the involvement of the national authorities, all the
while ensuring that the assumption of prudential functions by the ECB does not clash with its
monetary policy responsibilities. Supervisory powers will mainly be channelled through the
Supervisory Board, whose chairperson and vice-chairperson, along with the representatives
of the national authorities, have already been appointed. The Board will convene for the first
time this very week. The four Directors-General of the ECB responsible for supervision have
already been designated, one of whom is the current Director-General of Banking
Supervision of the Banco de España, which is a cause of satisfaction for our institution. The
selection processes for the remaining management positions will continue over the coming
months.
Thanks to the work by several groups of experts, two essential pieces of the future
mechanism are at an advanced stage. These are, namely: the Framework Regulation that
will define the supervisory function, its internal organisation and the assignment of
responsibilities among the various authorities making up the mechanism; and the supervisory
manual, which will precisely set out the procedures to be followed by all the members of the
mechanism, including naturally the supervisory personnel of the national authorities.
The ECB and the national authorities are also working on developing the comprehensive
assessment of credit institutions in the participating countries, which began last November
and will be completed before the ECB assumes supervisory powers. This assessment will
include an asset quality review, performed with the help of auditors or external consultants,
and subsequent stress tests, which will be conducted in collaboration with the European
Banking Authority (EBA).
Shortly, the thrust of the design of these two exercises will be made public, although certain
features are already known, such as the minimum capital ratio that will be required in the
accounting review phase and which stands at 8% of common equity tier 1 capital (CET1),
according to the definition established in the Community Regulations, including the
envisaged timetable for the application of the various deductions.
Evidently, the exercise aims to strengthen confidence in the European financial system
through transparency and reinforcing the solvency of those banks that need it. Nonetheless,
the Spanish experience, in particular that from the exercises performed in 2012 under the
financial assistance programme, shows that the proper metric for measuring attainable
credibility is not based on the estimated capital needs resulting from the exercise, but on the
application of a sufficiently rigorous methodology enabling all potentially vulnerable segments
of the European banking system to be evaluated consistently, particularly those whose
reflection in the financial information published is of greater complexity. It is moreover
important that, as announced in the public communiqué released, the measurements of
capital made should be consistent with the regulatory framework in force which, in Europe,
essentially comprises the recently enacted Community Directive and Regulation on capital
requirements.
Thanks to the reform undertaken and the measures applied by banks, the Spanish banking
system is, generally, in a reasonable position to face these exercises. However, obtaining a
positive result in the exercise is only a favourable starting point for assuming the new
supervisory regime in a macroeconomic and financial framework which, despite the recent
improvement, remains beset by challenges to banks. Accordingly, irrespective of the results
of the exercise, banks should continue to focus on implementing measures geared to capital
preservation, improved efficiency and the pursuit of rigour in the recording and monitoring of
asset quality.
Single resolution mechanism and fund
The second essential element of banking union is a single resolution mechanism. It has been
said on numerous occasions that unified supervision will not suffice to eliminate market
fragmentation. Another prerequisite is that similar banking liabilities of banks based in
different jurisdictions must receive similar treatment in the event of solvency problems. In
order words, the resolution of vulnerable banks has to proceed according to common rules
applied on a centralised basis by a single authority.
Regarding regulations, the agreement reached to approve the future Bank Recovery and
Resolution Directive is a notable step forward because it offers a common framework for
orderly bank resolution at a minimum cost to taxpayers.
The Directive introduces burden-sharing or bail-in arrangements establishing a minimum
amount and clear order of cost assumption by shareholders and creditors. It thus makes for
accurate perception of the risk associated with each liability instrument and minimises the bill
to be footed by taxpayers for the disorderly winding-up of banks. Also envisaged is a
resolution fund fed by contributions from the industry to meet any needs for capital which
cannot be covered by burden-sharing exercises.
Furthermore, last December the Council of the European Union reached an important
consensus after several months of complex negotiations, which, taken together with the
aforementioned Directive, amounts in practice to the creation of a single resolution
mechanism.
Further to this consensus, a bank resolution board will be set up whose scope of action will
be the same as that of the single supervisory mechanism. It will have considerable freedom
to act urgently in cases of restructuring or winding-up. It was also decided to set up a single
resolution fund which will be progressively endowed with financial resources.
The bank resolution board will be entrusted with applying resolution rules uniformly,
approving restructuring and resolution plans for banks supervised directly by the ECB and
determining how the resolution fund is to be used.
The details of the single resolution fund are to be set forth in an intergovernmental
agreement of the participating countries before March. However, the consensus reached
stipulates that the fund will be financed through contributions from the European financial
services industry, although the resources contributed by the banks in each jurisdiction will not
be fully merged until ten years have passed. During these ten years the fund will have
separate compartments funded by contributions from the banks of each country, which will
be progressively mutualised year by year. Under this process, the system of burden-sharing
among the national and mutualised funds will be gradually adjusted until the national
compartments disappear completely around January 2025.
The complex agreement reached has yet to be accepted by the European Parliament, so
there is still uncertainty as to the final design of the mechanism. Moreover, the capabilities of
the mechanism will foreseeably be limited at first, since the single resolution fund is
constrained by its modest size and reduced mutualisation. Furthermore, for the time being,
the agreement does not include common public mechanisms for the resolution of vulnerable
banks after the available private funds have all been used up.
In this respect, although the new resolution rules reduce the foreseeable scope of the
required external funds, provision should be made for public financial support at EU level to
ensure the orderly resolution of systemic banks if necessary. For example, following the
example of the US, we could consider an arrangement in which the European Stability
Mechanism could provide the resources needed to the common resolution fund with a
charge to future contributions from the industry. Otherwise, the single resolution mechanism
would, at least in the short-to-medium term, foreseeably be insufficient to prevent banking
crises from continuing to be resolved with a charge to national funds, whether public or
private.
That said, the agreement reached should by no means be underrated. In particular, the
acceptance of the principle of transnational mutualisation of financial risk in Europe, although
implemented very gradually and limited to funds contributed by the industry, is essential to
ensure the homogeneous treatment of banking risk throughout the EU. Above all, from a
broader standpoint, the agreement means that a significant political obstacle to extending the
risk-sharing framework has been overcome. This will very likely pave the way for more
significant progress in European integration in the future.
Let me finish by noting that in recent economic history it is difficult to find bouts of regulatory
reform as intense as at present.
Globally, the unprecedented costs of the banking crisis for citizens as a whole have spurred
major regulatory changes designed, firstly, to tighten up prudential regulation so as to reduce
the likelihood of fresh crises in the future; and, secondly, to develop new resolution
regulations to lower and allocate more fairly the cost of maintaining financial stability. In
Europe the application of the regulatory reform coincides in time with a far-reaching
institutional change which has to lead to the creation of a banking union. And, in Spain, all
these important regulatory and institutional changes are taking place against a background of
deep reform of our financial sector which has involved the clean-up of balance sheets, the
recapitalisation of vulnerable banks, progress towards greater consolidation of the industry
and enhancement of regulations, particularly those governing savings banks.
All this understandably poses a huge challenge to the entire financial system which,
however, will emerge much stronger from a process of adaption that will, in all likelihood,
make it sounder and more efficient. This will contribute to the sustainable recovery of Spain's
economy in an increasingly integrated Europe.
Thank you.