Recent developments and open questions
in the European banking industry
Speech by Governor of the Bank of Italy
Ignazio Visco
Ladies and Gentlemen,
It is an honour and a privilege to address this assembly. I would like to express my
gratitude to Governor Linde and President Prados del Amo for the kind invitation to be here
today. I will take this opportunity to share with you some reflections on the state of the
European banking industry, of which Spanish banks are a fundamental part.
I will start with some considerations on the evolving structure of the sector; I will then
move on to the issue of profitability; and I will conclude with my take on the main open
questions we need to address over the coming months.
The long journey: evolving structure of the European banking industry since the
financial crisis
Since the global financial crisis, the European banking industry has undergone a
considerable structural transformation, along three closely intertwined dimensions.
The first one concerns the profound changes in both regulation and institutional
set-ups. Capital requirements have been raised, leverage has been limited, and stringent
liquidity requirements have been established. The institutional set-up has also been
completely modified. In a very short time frame, the Banking Union has been launched,
with the introduction of the Single Supervisory and Single Resolution Mechanisms (SSM,
SRM). A new framework for managing banking crises has been adopted. Although the
third pillar of the Banking Union - the European Deposit Insurance Scheme - is still
lacking and in other dimensions advancement is slow, the overall progress has been
remarkable. It would perhaps have been unimaginable only a few years ago and testifies to
the strong determination to continue along the path to European integration.
The second dimension of structural change relates to the contracting size of the
European banking sector, which not only reflects the tightening of regulation but also other
factors, such as the need for banks to clean up their balance sheets, the impact of
technology, as well as the increased role of non-bank financing. In the aftermath of the
crisis, the total assets of the euro area banking sector declined significantly both in absolute
terms, by 15 per cent between 2008 and 2016, and relative to GDP; leverage has been
reduced across the board, and especially in countries where it was higher.
The downsizing of the European banking sector is also the result of important changes
in its industrial organisation, which represent the third dimension of structural
transformation. Between 2008 and 2016 the number of euro area banks declined by around
25 per cent, with Spain being one of the countries where the reduction was greatest. The
number of branches is also decreasing and the use of resources is generally becoming more
efficient.
Overall, this set of structural changes is delivering positive results. The European
banking system is enhancing its resilience and all actors involved are contributing:
regulators, banks, and supervisors. There is, however, no room for complacency. As I will
discuss next, legacies from the crisis still linger and remaining vulnerabilities call for
continued vigilance and unwavering determination on all sides.
Out of the woods? Not yet: some crisis legacies are still with us
The issue that epitomises the problems left on the table is low profitability. On the
aggregate, the return on equity of euro area banks has not yet recovered since the financial
and sovereign crises, and remains low by historical and international standards. There are,
however, important heterogeneities: small and medium-sized banks are still suffering, while
larger intermediaries are recovering. In 2017, net interest income improved for some
intermediaries, while fee income, supported by the asset management business, increased
more broadly.
Profitability is also well below estimates of the cost of equity for most banks. Despite
the differences across banks and jurisdictions - in Spain, for example, the gap is relatively
smaller than elsewhere - the problem extends across Europe. The causes of the phenomenon
can be traced back to both transitory factors - such as the legacy assets from the adverse
cyclical developments - and structural elements, including the need to adjust the business
model to technological change and to the new regulatory environment.
The ongoing recovery of the global and the euro area economies contributes to
addressing the transitory impediments. However, analyses and simulations from various
sources seem to suggest that for a non-negligible part of the European banking sector this
may not suffice to recover adequate levels of profitability.
Going forward, the target for banks' profitability may actually prove to be lower than
the one deemed appropriate by some international institutions, such as the IMF. Indeed,
once the transition to the new regulatory regime is completed, and a safer banking system
has emerged from the reforms, investors might reduce the returns that they expect to receive
from banks. In other words, in future months the "reform dividend" may translate into a
lower cost of equity. Indeed, estimates of the cost of capital for European banks show that it
has declined significantly since the beginning of the year, although it remains higher than
the average in countries, like Italy and Spain, that have been hit particularly hard by the
financial crisis. This is a key issue that deserves further analysis and that we have to keep
monitoring closely.
A contribution to closing the gap must also come from banks' efforts to increase
profitability in a structural way. This is something that concerns most banks, those facing
difficulties as well as those that currently show healthy conditions. Against this backdrop,
while there is no single winning business model, the experience of the most profitable banks
provides useful guidance for both costs and revenues. On the revenue side, a greater
diversification of the sources of income in favour of high quality financial services can help
compensate for the prolonged compression of interest margins. A progress in this direction
is already visible, but international comparisons suggest that there is ample room for
improvement.
The expansion of non-bank financing and technology-based intermediation, despite
increasing competition, also offers banks opportunities for broadening their revenues by
focusing on the provision of related and complementary services, for example in the areas
of corporate finance and asset management. Benefits for income generation can also come
from mergers and acquisitions geared towards exploiting economies of scope and scale, and
facilitating investment and access to capital markets. Those of a cross-border nature can also
foster financial integration.
On the cost side, there is a broad consensus that operational efficiency needs to be
improved resolutely. Since the beginning of the crisis, the banks' cost-to-income ratio has
deteriorated in the majority of countries. In many cases this has reflected the reduction in
revenues per unit of assets, while the cost-to-asset ratio has often improved. In Spain there
has been a major effort in streamlining branch networks; the number of branches has
dropped by almost 40 per cent since 2008. In Italy the figure is less impressive, 15 per cent,
but progress has been made nonetheless.
As in other countries, there is room for further streamlining - not only as regards
branch networks but also operational costs, including, where appropriate, labour costs and
managers' remunerations. Cost savings coming from further rationalisation can be used to
redirect spending towards investment in technology and innovation, which can go a long
way to enhancing productivity.
Needless to say, further progress in the clean-up of balance sheets is also necessary to
increase profitability. Encouraging signals are emerging: as the economic recovery
consolidates, credit quality is improving. In Italy, which is one of the countries where the
problem of non-performing loans (NPL) is most acute, the flow of new NPLs relative to
total outstanding loans has fallen to the levels prevailing before the crisis. The stock of
NPLs is also falling quite significantly, and disposals currently under way will lead to a
further drop over the coming months. It is important that such disposals are implemented in
an orderly fashion, in order to avoid fire sales and keep the market price of NPLs at levels
consistent with their recovery rates. Indeed, sales at very low market prices, which reflect
high returns required by the buyers, would put undue pressure on banks' balance sheets and,
ultimately, lead to a contraction in the supply of credit to the real economy.
This clean-up of banks' balance sheets must continue, both in Italy and elsewhere.
For this to happen, European banks must strengthen their strategies for NPL management.
In this respect, the guidelines published last March by the SSM are an important point of
reference and indicate several possible options, from the creation of separate and
specialised management units, to the recourse to external managers, and to the sale of
portfolios on the market. The stock of NPLs in banks' balance sheets depends crucially on
the length of the recovery procedures which in turn depends on the protection granted to
the creditors by the law in the event of insolvency of the debtors and on the time that
courts take to enforce the law.
In Italy the stock of NPLs is high also because the outflows are small, due to the very
lengthy judicial recovery procedures. Reforms recently introduced to significantly speed up
the credit recovery process are already positively affecting the market price of NPLs; such
effect will continue in the coming years. In Spain, as a legacy of the crisis, banks have taken
large stocks of foreclosed assets onto their balance sheets. In other countries, other
vulnerabilities, such as for instance the large concentration on banks' balance sheets of
complex and illiquid activities - those classified as Level 2 and Level 3 assets, need to be
closely monitored.
A public consultation has recently been launched on a draft addendum to the ECB
guidelines considering the introduction of mechanisms that set compulsory minimum
write-downs, increasing over time, on loans that will be classified as non-performing. It is
important to recall that, in the current context, any policy action needs to strike a delicate
balance between the goal of speeding up the resolution of the NPL problem and the goal
of preserving financial stability.
In particular, supervisors should refrain from imposing measures that de facto imply
blanket sales of NPLs on banks, which in the current circumstances would lead to a fall in the
market price of NPLs and thus to a transfer of resources from the banks to a handful of
specialised investors operating in an oligopolistic environment. This type of policy would
erode banks' own funds at a time when raising capital can still be difficult, thereby putting the
ongoing recovery at risk. While there is no question that, especially because of the positive
effects of the recovery, banks should make clear progress in the management of NPLs, I
would dare to evoke the great nineteenth century Italian writer Alessandro Manzoni, who in
his masterpiece "I promessi sposi" had the Spanish Gran Canciller de Milán Antonio Ferrer
say to his coachman during a famous riot in 1629: "Pedro, adelante con juicio".
Looking forward: expectations for a safer and sounder industry, and open questions
The financial crisis has spurred a global regulatory response influencing almost every
aspect of the banking industry: lending, securities and derivatives trading, funding, bank
supervision and resolvability. Such reforms have led to more demanding capital and
liquidity requirements, less room for banks to exploit leverage, stronger constraints on their
organisational structure to ensure resolvability. Further adjustments will come as single
pieces of the reform package, such as the requirements regarding loss-absorbing liabilities
(TLAC and MREL), are implemented. Moreover, the adoption of the new accounting
standard IFRS9 in 2018 will change loan valuations: banks will have to make provisions for
expected losses and no longer only in the event of a default. The new standard will force
banks to improve the allocation and assessment of loans and to adopt new criteria to
measure credit risk and calculate loan loss provisions.
A key priority now is to rapidly reach - after a too long negotiation period - an
agreement on the finalisation of the Basel 3 reform package aimed at reducing the ample
variability of risk-weighted assets as calculated by internal models. Following that, a period
of regulatory stability - free from further rule-changing - would be opportune, not only to
allow banks to fully adapt to the new system, but also to avoid the incessant production of
rules becoming in itself a source of uncertainty, and thus a hindrance to banking activity.
Looking ahead, there is reason to be confident. Expectations are for a sounder and
gradually more profitable European banking industry. This is also borne out by the market's
assessment of the outlook for banks. The completion of the regulatory reforms will dispel
the uncertainty that is still preventing the market from fully perceiving the benefits of the
reduction of excessive risks in banks' balance sheets. But we know that the stakes are high.
For those banks that will not be able to withstand the increased pressure, it is important to
prepare measures in advance that will make it possible for them to exit the market in an
orderly fashion.
Should new crisis situations emerge, preserving financial stability will hinge critically
upon the availability of an effective crisis management framework, one characterised by
prompt and decisive action, close cooperation among all the parties involved, and a clear
definition of responsibilities and priorities. This is how in the past even severe strains were
overcome without damage to savers or the overall economy.
The experience gathered thus far within the new European framework for bank
recovery and resolution can teach us important lessons on whether the new set-up also
meets such criteria. In particular, besides the resolution of Banco Popular in Spain, earlier
this summer three crisis situations were tackled in Italy, leading to the precautionary
recapitalisation of Banca Monte dei Paschi di Siena, and to the orderly liquidations of
Veneto Banca and Banca Popolare di Vicenza.
All these decisions complied fully, albeit in different ways, with European legislation
and procedures. To the extent permitted by these rules, efforts were made to find the
solution that best protected the interests of all parties involved; the recourse to public funds
represented only a small fraction compared to the taxpayer money employed just a few
years ago by other countries in overhauling their own banking systems. The measures
adopted have been successful in eliminating the tail risks weighing on both individual banks
and the sector as a whole. In fact, over the last six months, stock prices of major Italian
banks rose by 25 per cent, against the 11 per cent on average for major European banks.
However, these initial experiences have also highlighted some inadequacies and
pitfalls in the new resolution framework. In the Italian cases, the final decisions were
adopted only following a lengthy and complex process due to the fact that in some instances
(e.g. the precautionary recapitalization foreseen by the BRRD) the new framework entrusts
the management of banking crises to numerous mutually independent authorities and
institutions, both national and supranational. Such a framework is hardly compatible with
rapid intervention and lacks an effective coordination mechanism for setting priorities and
establishing guidelines on the margins of discretion afforded by the law. Moreover, no
specific procedures are in place to account for the decisions taken.
A further lesson that can be drawn from the recent cases is that it is important to
preserve margins of flexibility in the framework, as even relatively small banks' failures, if
not properly managed, may have extensive and, at times, systemic consequences. Even the
resolution of a middle-sized bank could have been problematic, had the overall economic
and financial conditions made it difficult to identify possible buyers and the bail-in of senior
bond and relatively large deposit holders become inevitable.
Overall, these experiences can be taken to support the view - which I have voiced in
several occasions in the past - that the new resolution framework does not fully take into
consideration the risks associated with its own implementation and thus needs further fine
tuning. The new rules were rightly designed with the goal of contrasting opportunistic
behaviour by banks, but their application must also take into account the broader objective
of safeguarding financial stability. I believe that the transitional period foreseen in the
implementation of the new framework has been too short for all parties involved to
adequately adjust to the new regime. This has been especially important in light of the fact
that some of the crucial elements for the overall balance of the framework - such as the
availability of adequate loss absorbing liabilities in banks' balance sheets, just to mention
one among several others - were not yet in place.
Furthermore, in my opinion the interpretation of the new rules on the management of
banking crises and on state aid in some cases has been overly restrictive, denying recourse
to some tools used in the past to effectively manage crisis situations without causing
undue disruption. For example, recourse to the preventive intervention by domestic
deposit protection funds is now treated as equivalent to state aid, and thus not permitted,
even though these funds are entirely private and their utilisation is guided by
entrepreneurial considerations, and not by the authorities' decisions. In addition, the use of
public funds to address banking problems, even in specific circumstances where it may be
economically and financially advantageous, is now subject to very stringent limits even
after shareholders and subordinated creditors have been bailed-in and the old management
completely replaced.
The interpretation of state aid rules as put forward in the EU legislation in 2013 has
severely limited the possibility to establish a publicly supported asset management company
(AMC) to deal with banks' NPLs. I strongly believe that protecting taxpayers' money must
be a priority in managing banking crises. But I also think that the seriousness of
macroeconomic shocks, the negative externalities that come from the dismal performance of
the real economy, the market failures that result from the lack of a robust secondary market
for NPLs are important conditions that may justify the recourse to public funds. This
recourse might have been excessive in Europe in the years following the global financial
crisis, but the reaction to such an excess may have also been somewhat extreme.
It is important to carefully evaluate the costs directly and immediately borne by the
State in each single intervention. However, those that may arise from a mismanagement of
the crisis should also be carefully considered. To some extent this consideration may
explain why the AMC hypothesis has recently returned to the spotlight. Under some
proposals, an AMC should be established at the national level but in accordance with a
common European framework. This implies that the conditions under which it would
comply with the EU regulatory set-up, including the BRRD and the rules on state aid,
should be properly spelled out.
In order to address the NPL problem successfully, such a company would need to
attract a relatively large number of banks. Banks' participation in the scheme should be
voluntary, and subject to standard restructuring plans defined ex ante. Most importantly,
NPL transfer prices should be determined so to make the AMC profitable, but without
making them excessively detached from their real economic values (i.e., the values that
could be reasonably recovered over time).
All this leads me to suggest that the opportunity to improve upon the new regime of
bank crisis resolution should not be missed. This can be accomplished through the review of
the BRRD scheduled for 2018, as well as via the ongoing negotiations on issues related to
the implementation of the MREL requirement and the completion of the Banking Union. In
particular, the framework should envisage adequate tools to address banking crises of a
systemic nature. Ways to limit contagion externalities should be considered, possibly
allowing for the recourse to state aid in situations of serious market turbulence, and devising
mechanisms to properly address liquidity crises.
Some shortfalls can be addressed along the road towards the completion of the
Banking Union. Indeed, the Banking Union is still missing two very important pieces: the
availability of common public funds to support resolution procedures in the case of ailing
banks - the Single Resolution Fund's fiscal backstop - and a common bank deposit
insurance scheme, again supported by a common public backstop. These are key
ingredients for the overall balance of the new system: in their absence, it would not be
easy to counter the views of those who claim that the fiscal backstop should remain a
national prerogative and that, therefore, the national authorities should have the final say
in all interventions aimed at minimising the overall costs of the distress. Furthermore, we
should also reflect on how to deal with possible crises of banks for which the existence of
public interest, necessary for the initiation of a resolution procedure, is denied. This is the
case for the smaller banks, but it may also apply, as it has been recently the case, to banks
considered significant within the SSM. Indeed, it would be difficult to object to the
observation that the current framework calls on these banks to pay into a crisis
management system from which they cannot benefit.
* * *
To conclude, progress on all these fronts - and, more generally, toward a deeper
European integration - can be achieved only if we overcome the mutual distrust and
prejudice among member countries that have developed in recent years. In doing this, we
should strive to give sound and fair application to the principles underpinning the new
European rules, preserving the value of banking activity, to the benefit of savers and
borrower households and firms.
Thank you for your attention.
Designed and printed
by the Printing and Publishing Division of the Bank of Italy