Yves Mersch: A regime change in supervision and resolution
Keynote speech by Mr Yves Mersch, Member of the Executive Board of the European
Central Bank, at the European Supervisor Education (ESE) Conference, Frankfurt am Main,
26 September 2013.
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Ladies and gentlemen,
Thank you for inviting me to speak today.
As you know, Europe has in recent years faced the worst economic and financial crisis since
the 1930s. Growth remains weak and unemployment is unacceptably high, with only the first
shoots of recovery showing through.
Yet out of these difficulties, some positives have begun to emerge. The euro area has
recognised that, for its collective stability, it has to deepen integration in certain areas - and it
is now beginning to do so. What we are seeing playing out today is not so much the
"audacity of hope", but rather the "audacity of necessity".
In my view, the most significant change taking place is the development of Banking Union.
Monetary Union needs Banking Union, not least because a stable banking sector is an
essential complement to a sound money. I therefore see the project of building Banking
Union as the most important integration step since the launch of the euro.
For those of us involved in supervision and other financial sector issues, it is an especially
fascinating time. We are at what political scientists call a "critical juncture" - that rare time
when a window of opportunity opens to fundamentally redesign institutions. It feels like being
back 25 years ago when we were preparing EMU.
But this also imposes on us a responsibility. This window may not open again for many
years, so we need to make sure that the decisions we take today are the right ones. Most
importantly, we need to ensure that Banking Union is not just a label - that it initiates a
genuine regime change in the way that banks are supervised and resolved.
How to achieve this regime change is what I would like to focus on in my remarks today.
The elements of a regime change
In my view, a genuine regime change has to involve two elements: first, building a single
system stricter
for banking supervision and resolution; and, once that is in place, building a
system as well.
Why do we need both elements?
We need a single system to ensure that we have a level playing field for the banking sector
across Europe - and hence to create a truly single financial market in Europe. 20 years after
the Single Market was supposed to be completed, the banking sector in Europe remains
fragmented along national lines. This has many drawbacks, not least that it disrupts
monetary policy transmission, makes banks more exposed to country-specific shocks, and
encourages home bias in government bond purchases that strengthen the bank-sovereign
loop.
To give an example of how far short we remain of a fully integrated financial market, a recent
study found that, between 2005 and 2012, the average number of bank mergers and
acquisitions per year in the United States was 343, whereas in Europe the yearly average
was just 58. One reason for this is that we have lacked a single system of supervision and
resolution across Europe, which has discouraged cross-border activity.
We need a stricter system to ensure that, when we have the new tools of Banking Union,
they are used proactively - namely, to create a stronger and more stable banking sector. We
still have an uphill struggle in Europe to restore investor confidence in the banking sector.
And this is partly because we do not have a consistently strict approach to banks - on
balance sheet transparency, on loss recognition and on resolution.
Evidence of this is the divergence in the price-to-book ratio for large and complex banks in
the euro area and outside. For banks outside it is currently around 1, while for euro area
banks it is only 0.7 - in other words, euro area banks are priced by the market at less than
their book value. An important reason for this is that countries outside the euro area have
made much faster progress in acknowledging losses and resolving banks that were not
viable.
Creating a genuine regime change, both in the system of supervision and resolution and in
its application, could therefore have a powerful effect for Europe. In the near term, it could
help accelerate the clean-up of banks' balance sheets and thus restart bank lending. In the
medium term, it could help encourage the development of genuinely European banks.
So how do we get to this regime change?
Building a single system
Let me start with the first element, building a single system. In my view, for any system to be
single, two conditions have to be fulfilled. First, there needs to be a single set of rules.
Second, if those rules contain any discretion, there needs to be a central authority that can
enforce them evenly.
A single system for supervision
For supervision, we are currently making progress on both these conditions.
In terms of rules, we now have a new rulebook for banks across Europe as part of the
Capital Requirements Directive IV. Within the single supervisory mechanism (SSM), we will
also have a single supervisory manual that will apply to all banks. This will cover issues like
the methodology for the Supervisory Review and Evaluation Process (SREP), off-site and
on-site reviews, risk assessments and model validations. We are thereby ensuring that the
same supervisory standards will be applied across Banking Union - and indeed, through
harmonisation with the European Banking Authority, across the EU as a whole.
In terms of decision-making, we are strengthening the centre by integrating the European
and national levels of supervision. A particular innovation here will be the Joint Supervisory
Teams, which will contain staff from both the ECB and the national competent authorities.
There will be one team for each significant banking group directly supervised by the SSM,
operating under the management of a coordinator working for the ECB. This guarantees a
collective approach and ensures that there will always be a European element in the
decision-making. Indeed, the final responsibility for decisions will rest with the ECB.
This process of creating an integrated SSM is of course a major organisational challenge.
We are bringing together 17 or more different national supervisors, with different operating
cultures and supervisory philosophies, into a single mechanism with a single culture and
philosophy. And the ECB will be directly hiring around 1,000 new staff, of which around
750 will be involved in supervision. So it will take time to reach our cruising speed.
With the SSM Regulation foreseen to enter into force at the beginning of November, we are
ready to publish the vacancy notice for the Chair of the Supervisory Board, followed by those
for the top management of the SSM - the four Directors General of the main departments
and the six Deputy Directors General. The vacancy notices for the middle management will
follow a few weeks later, and then - in accordance with the cascade principle - the broad
recruitment will begin. We need to be ready with the basic structure of the organisation for
the Asset Quality Review (AQR) towards the end of the first quarter of 2014.
Let me therefore briefly take this opportunity to describe how we foresee the SSM's
organisational structure.
The SSM will contain four Directorates General and a Secretariat Division. Two of the
Directorates General (DGs Micro-Prudential Supervision I and II) will conduct the direct and
day-to-day supervision over significant banks. The division of responsibility for supervision
between these two departments will be largely determined according to a risk-based
approach, allowing them to specialise by risk exposure, complexity and business model of
the credit institutions.
The third Directorate General (DG Micro-Prudential Supervision III) will host the conduct of
indirect supervision over less significant banking groups. Direct supervision of these banks
will still be carried out by the relevant national competent authorities (NCA) on a day-to-day
basis, but with regular reporting to the ECB.
The fourth Directorate General (DG Micro-Prudential Supervision IV) will perform horizontal
supervision and specialised expertise functions, such as supervisory quality assurance,
methodology and standards development, enforcement and sanctions, crisis management,
capital market risk analysis and model validation.
Within the organisational set-up, the middle management below the Directors General will
encompass Heads of Division and Section and Senior Advisors, from which the Joint
Supervisory Team (JST) coordinators will be chosen.
Let me also say a few words on how we foresee the practical work and the organisation of
the off- and on-site-supervision.
The Joint Supervisory Teams (JST) are responsible for the day-to-day supervision of
significant banks. They propose inspections, in which they participate without leading the
inspections. That task is allocated to the Head of Mission. The Head of Mission is nominated
by the horizontal Directorate General, Micro-Prudential Supervision IV - that is, by the ECB.
Generally, on-site inspection teams are led by NCA staff. This does not preclude, however,
the possibility of the ECB taking the lead.
The JSTs prepare the recommendations, lead the closing meeting of the inspection with the
credit institution, and provide the follow-up of the recommendations.
The horizontal DG is in charge of maintaining the on-site inspection methodology. Moreover,
it plans the on-site inspections to be conducted at significant banks on a yearly basis and
updates on a half yearly basis the global inspection planning.
On-site inspections are specific in-depth investigations of risks, risk controls and governance.
They are carried out on the basis of a predefined scope, timeline and resources, and use
investigating and inspecting techniques to test controls and substantive procedures, following
common standards.
They follow specific procedures and are conducted in an independent manner - vis-à-vis the
JST, the NCAs and the respective inspected credit institutions. The outcome of on-site
inspections will be a report containing findings and an executive summary.
A single system for resolution
A single system for resolution is just as important as a single system for supervision. Banks
need to know how they will be treated both in life and in death - as do the creditors that
invest in them. So here again, having a single set of rules and a central authority that can
enforce them is essential.
The single set of rules for resolution - the Bank Recovery and Resolution Directive - has
already been agreed by the Council of the European Union, and discussions are now under
way with the European Parliament.
In principle, I welcome this Directive as a vast improvement on the status quo. Before the
crisis very few countries had resolution frameworks in place, and this has led to ad hoc and
inconsistent approaches in different countries.
However, where I think this Directive falls short is in the discretion it still allows to national
resolution authorities to exempt certain classes of liabilities from bail-in. In my view, this is
not conducive to the building of a single system, as it leaves too much uncertainty about how
bail-in will be applied.
One can imagine a situation, for example, where a particular class of investors is excluded
from bail-in owing to national political economy concerns. Or a situation where larger
countries with larger resolution funds are in a position to exclude more creditors than smaller
countries. Investors will be forced to second-guess these issues.
In this context, having an authority that can take central decisions becomes even more
important. If there is going to be discretion in how resolution rules are applied, then we need
to ensure that this discretion is applied in the same way across different countries. This
underscores why a strong single resolution mechanism is so necessary - and, more
concretely, why that mechanism has to have independent decision-making powers and no
national vetoes.
A single resolution mechanism is also essential to ensure that we have a single approach to
the resolution of cross-border banks. Dividing resolution along national lines has not proven
an efficient way to solve cross-border coordination problems and achieve a least-cost
resolution strategy overall. Moreover, in a divided system we can anticipate protracted
wrangling over burden-sharing, which only delays the clean-up from a crisis.
To address this issue, I see it as essential that the mechanism comprises not only a single
resolution authority, but also a single resolution fund. The Commission's proposal for the
single resolution mechanism foresees such a fund, financed by levies on private banks.
According to Commission estimates, it will reach a size of about €55 billion by 2025.
I welcome this proposal in principle. But I think that, during the build-up phase, clarification is
needed on what will happen if there are exceptional circumstances which lead to the fund's
resources being exhausted. The proposal is unclear here. In my view a credible backstop is
essential to ensure that resolution costs can be separated from national budgets.
To sum up, what defines a single system is having a single set of rules that can be enforced
evenly from the centre. We are on the way to achieving this for supervision. I see it as
essential that we also achieve it for resolution. Banking Union is ultimately a way of
establishing a single financial market where banks are separated from their sovereigns. To
paraphrase Mervyn King, we therefore need to ensure that banks are both European in life
and European in death.
Building a stricter system
Let me turn to the second element of a genuine regime change, building a stricter system.
Putting in place new rules and institutions for supervising and resolving banks is essential.
But it is equally important to use them in a way that leads to a measurably stronger and more
stable banking sector.
How can we achieve this?
A new approach to supervision
The first building block is a willingness on the part of policy-makers to make bank balance
sheets more transparent according to the common standards of the SSM. The SSM
Regulation puts us in a position to do this by requiring a comprehensive assessment of the
banks the ECB will directly supervise. This requirement goes beyond a purely accounting
exercise. We have to ensure that the assessment is rigorous and managed from the centre.
There is no point in having a new pair of glasses if you are not willing to open your eyes.
Our current plan for the comprehensive assessment is to have three elements. First, a risk
assessment, which will identify broad risk factors, including funding and liquidity risks.
Second, a balance sheet assessment, which will review asset quality using calculation,
qualification and valuation checks of a broad risk-based nature, with central quality
assurance according to a common methodology. This will draw on the expertise of external
consultants. Third, a stress test, which will apply the results to an adverse scenario.
The linkages between the balance sheet assessment and the stress test still need to be
defined in detail. What is clear, however, is that both are communicating vessels. If the
former is a more thorough point-in-time stock-taking, then the later has to contain more
forward looking elements.
As a consequence of this three-pronged exercise, some banks might face capital gaps to
close. In our view, it is very important for the credibility of the exercise that the scope of the
process remains ambitious; this implies, for example, that a data integrity validation is
undertaken.
Of course, we need to be alert to the practical concerns of the stakeholders of the exercise,
including the banks. It is important that all requirements for the banks are clearly defined,
finalised, explained and delivered to them well ahead of the official starting date. Ideally, the
final templates, including the accompanying instructions on how to use them, should no
longer be altered once data is being compiled for the balance sheet assessment.
But we will not compromise on the scope and strictness of the exercise.
We would like to launch the exercise, starting with the determination of the risk portfolios, by
the end of this year already - although this depends to some extent on when the full
Supervisory Board is appointed. I am confident that, once the SSM Regulation has been
approved, the ECB and the European Parliament can work in a constructive spirit in
appointing the Supervisory Board - in particular in ensuring a fast-track procedure for the
appointment of the Chair.
When we have the results of the assessment, policy-makers also need to be willing to deal
with the consequences. Certainly, European banks are in a stronger position today than they
were a few years ago. For example, in Spain banks have provisioned €184 billion euro - that
is 10.5% of their loan books - and have raised €22 billion in new equity since 2008. But we
cannot rule out the possibility that the exercise will still reveal capital needs. It is essential
that there are backstops in place to address this.
If the backstops are not there, I fear that the exercise will create a lose-lose situation for the
banking sector. If the results reveal only small capital needs, markets will think they have
been fudged to save public money. If they reveal significant capital needs, markets will
question how they will be filled, creating uncertainty. Either way the confidence boost we
hope to gain from the assessment will be lost.
A new approach to resolution
The second building block of a stricter system involves changing the way in which we deal
with non-viable banks.
To begin with, we need to make sure that we use the new resolution powers to their full
extent. As most European countries do not have much experience with winding down banks,
there may be a tendency to avoid putting banks into resolution - by practising supervisory
forbearance and allowing banks ever more time to restore viability. The ECB as supervisor
has an important role to play here in ensuring that this does not happen.
To ensure that resolution powers are used in full, it would also help to have all the elements
of the new resolution framework in place at the same time. The supervisory powers of the
SSM will apply in principle from November 2014 onwards. The Bank Recovery and
Resolution Directive framework is foreseen to take effect in January 2015, and the start of
the single resolution mechanism is planned for the same date. But under the current
January
agreement, the new provisions on bail-in would only be applicable from 2018. This
means that there will be a period of three years where the resolution authority is unable to
use one of its key resolution tools.
For this reason, I favour bringing forward the entry into force of bail-in. The Directive still has
to be agreed with the European Parliament, and in my view we should push for a start date
of 2015 for bail-in so that we have the full resolution toolbox available from the outset
- instead of over-extending the State Aid rules as a proxy.
Conclusion
Let me conclude.
What I have tried to illustrate today is that a regime change involves two components. First,
the right rules and institutions to ensure a single system. Second, a willingness to use those
rules and institutions in a stricter manner. It is therefore a question not only of mechanisms,
but also of mindsets.
We have already made some encouraging progress, in particular on the SSM. But there is
still a long way to go, and success is only possible with a cooperative effort. Whether
Banking Union achieves a regime change will ultimately depend on the cooperation and
dedication of literally thousands of legislators, regulators and supervisors. It is the very
definition of a "team effort".
In the same vein, we need to strengthen our joint training efforts in supervision skills. The
European Supervisor Education initiative is an example of a common cross-border approach
which could be built upon.
Yet in my view Banking Union is the challenge of our times. The crisis has presented us with
a once-in-a-generation opportunity: to build a safer banking sector; to strengthen our
Monetary Union; and in the process to take forward the historical process of European
integration. We are privileged to have this opportunity - and we need to take it.
Thank you for your attention.