Fernando Restoy: European banking sector - situation and challenges
Speech by Mr Fernando Restoy, Deputy Governor of the Bank of Spain, based on the
address delivered at the UIMP seminar "¿Qué hemos aprendido de la crisis?" ("What have
we learned from the crisis?"), organised by the APIE (Association of Economics Journalists),
Madrid, 17 June 2016.
* * *
Thank you, Miguel Ángel, for your introduction. As you know, it is a pleasure to be here once
again in Santander, participating in the closure of the seminar organised by the APIE
(Association of Economics Journalists) at the Menéndez Pelayo International University
(UIMP). As always, I greatly appreciate having been invited to what has become a traditional
event on the calendar.
Some days back in the course of a meeting, a renowned economics practitioner told me how
complex it can be for interested citizens to obtain a well-founded view of the situation of the
Spanish banking system. This struck me as a very appropriate remark. Despite the extensive
work by the Banco de España and other public and private agencies to compile and
disseminate information and analysis on banks, it is not always easy to gain proper insight
into the sector as a whole.
That is why I would like to take the opportunity today to offer an in-depth analysis of the
situation and outlook for Spanish and European financial institutions in the context of the
Single Supervisory Mechanism (SSM). In this connection, I shall first briefly review the
situation of the banking sector, focusing thereafter on the challenges banks will have to face
in the short and medium term. I shall conclude with some brief thoughts on the ECB's new
supervisory framework.
1. Recent developments in the banking sector
In recent years, and in response to the financial crisis, banks have substantially improved
their solvency levels, largely as a result of the new regulatory and supervisory requirements.
At SSM-supervised banks, in the last year alone their highest-quality (i.e. CET1) capital
increased on average by 70 bp, from 12.7% in 2014 to 13.4% in 20151. In the case of
Spanish banks, whose starting levels were somewhat lower, the increase exceeded 80 bp,
making for an average of 12.5% of CET1 at end-2015.
The profitability of the banking business, however, remains at low levels and, in any event,
far off the double-digit figures seen before the crisis. Among SSM banks as a whole, the
return on equity (ROE) in 2015 was slightly below 5%, whereas in Spain, in consolidated
terms, it was scarcely 5.6%.
Admittedly, it is unusual for the return on capital to stand in most euro area countries at
levels below the average cost of capital, on estimates made by the Banco de España. In the
case of Spanish banks, estimates of the cost of capital stood at 6.8% in December 2015,
drawing close to levels of 8% in early 2016, as a result of the period of instability observed in
financial markets.
We are thus in an environment in which the return demanded by investors is, in general,
lower than that obtained by banks at present. And this despite the fact that the risk that the
acquisition of bank shares entails should have lessened as a consequence of the reduction
in banks' leverage.
Naturally, the disappointing performance of bank profits is one of the factors behind the
decline in banks' share prices in recent months which, across the board, stand significantly
below their book value, as can be seen in Chart 1. This decline has been somewhat greater
in the case of Spanish banks, although these continue to evidence a higher ratio than that of
the main euro area banking systems.
Chart 1
PRICE TO BOOK VALUE RATIO OF THE BANKING SECTOR
1.2
1.0
0.8
0.6
0.4
0.2
0.0
June 2015 May 2016
SPAIN ITALY FRANCE
GERMANY EURO AREA EUROPE
SOURCE: Datastream.
2. Challenges for the banking sector
Several factors account for the low profitability of the banking business in Europe.
2.1 Low interest rates
One of the main factors is the maintenance of interest rates at low levels which, along with
the low level of economic activity, exerts downward pressure on banks' net interest income.
The pressure exerted by low interest rates does not only affect Spanish banks but is
common to most European entities, albeit with differing intensity depending on balance sheet
structure and the predominant type of banking business.
Hence, the adverse effect on profitability of interest rates holding at low levels is all the
greater the higher the percentage of loans extended at a floating interest rate, the lower the
percentage of assets recorded at fair value or the greater the proportion accounted for by
deposits in the bank's financing structure. That is to say, the current environment of low rates
particularly affects the traditional banking business of financial intermediation, namely that
which prevails in Spain.
Additionally, it should be borne in mind that the impact of changes in interest rates on bank
profitability is not linear. Any reduction in interest rates, in what is an environment with
already very low levels, affects bank margins with particular intensity. Indeed, the work
performed at the Banco de España shows (see Chart 2) that, for high levels of interest rates,
a moderate reduction in the Euribor exerts a positive impact on net interest income, since the
stimulus effect (quantity effect) exerted by lower rates on the demand for credit offsets the
reduction in the unit return on the loans (price effect). However, when interest rates are
already very low, a decline in the Euribor is associated with a reduction in the interest margin
(the price effect exceeds the quantity effect) as banks have less capacity to pass through the
reduction in interest rates to retail deposits owing to their proximity to the zero-rate level. It is
possible that these non-linearities may be exacerbated when interest rates move into
negative territory.
Chart 2
That said, there are also factors that mitigate the impact of low interest rates on results. In
particular, low interest rate levels contribute to reducing loan loss provisions, insofar as they
are conducive to a decline in non-performing loans. This mitigating effect is particularly
significant in Spain, owing to the prevalence of assets with floating rates on bank balance
sheets.
2.2 Non-performing loans
The second factor weighing down on bank profitability is the still-high level of non-productive
assets on the balance sheets of banks located in specific countries, despite the continuing
downtrend we have observed for some time. As can be seen in Chart 3, in some instances
the NPL ratio exceeded levels of 15% in mid-2015. With its ratio at approximately 7%2, Spain
stands only slightly above the euro area average, thanks to the reduction witnessed in the
past two years.
Nonetheless, the NPL ratio can be an imperfect indicator of the effect that non-productive or
problem assets may have on a bank's solvency, since it does not take into account the asset
collateral or the provisions set aside. The so-called Texas ratio, an approximation to which is
illustrated in Chart 4, offers a much broader view in that it also includes in its calculation the
provisions and capital available to the bank.
Chart 3 Chart 4
TEXAS RATIO PROXY (a)
NPL RATIO
% 1.6
30
1.4
25
1.2
1.0
20
0.8
15
0.6
10
0.4
5
0.2
0
0.0
UK DE FR EU SSM ES PT IT IE
UK DE FR EU ES SSM PT IT IE
Avrg. Avrg.
Avrg. Avrg.
(a)
DECEMBER 2014 JUNE 2015
DECEMBER 2014 JUNE 2015
SOURCE: European Banking Authority.
SOURCE: European Banking Authority.
Transparency Exercise 2015 (104 institutions).
Transparency Exercise 2015 (104 institutions).
a. The SSM average includes data on 15 of the 19 euro area countries. No
a. The ratio has been calculated dividing NPL by the sum of provisions
data for Greece, Slovakia, Estonia or Lithuania.
and capital (including equityinstruments eligibleas CET1 and reserves).
In any event, ensuring a suitable level of provisioning for problem assets is key to properly
identifying impairments and correctly measuring the bank's solvency. Moreover, a rigorous
provisioning review policy provides banks with the right incentives for the management of
their non-productive assets, since it reduces the book losses that the disposal of such assets
may generate. This is only achieved with stringent accounting regulations and strict
supervision of asset valuation on the bank's balance sheet which, as you are aware, has
been a key element in the Banco de España's supervisory strategy. Indeed, we have
recently amended the accounting Circular to which banks must conform in order, among
other purposes, to fine-tune the accounting criteria in respect of provisioning credit risk
losses. Further, for some time we have been actively contributing within the SSM to
developing a common methodology in this field encompassing best practices and ensuring
their uniform application across all countries.
2.3 Regulatory reform
The ongoing and still incomplete reform of the regulatory framework is another factor of
uncertainty that has affected banks' share prices.
With regard to the Basel Committee's agenda, major headway has been made in reforming
prudential standards and, in particular, in the treatment of credit, market and operational
risks. One of the most relevant areas of work under way seeks to correct the excessive
variability of risk-weighted assets (the denominator of the capital ratio) prompted by the use
of insufficiently homogeneous internal models. Such heterogeneity leads to inadequate risk
measurement and generates competitive distortions, harming those institutions subject to
more demanding regimes of model supervision.
The current challenge is to come up with a parameterisation of the new requirements that
enables risk measurement to be enhanced without significantly increasing capital
requirements for the system as a whole, as this is one of the commitments announced by
global supervisory authorities, in order to hold prudential requirements at levels compatible
with the pursuit of banking activity on a proper footing.
Banks must also meet the requirements stemming from the new resolution regulations, which
seek to minimise the need to use public funds to manage bank crises. In particular, under the
Bank Recovery and Resolution Directive (BRRD), significant institutions shall, in addition to
meeting the established capital requirements, have a minimum volume of liabilities enabling
losses to be absorbed should it be necessary. That is to say, they shall have debt
instruments at hand that may be converted into capital if they experience problems of
viability.
These requirements will likely prove a binding restriction for some financial institutions. The
issuance of these instruments may pose a challenge, especially for unlisted banks with little
experience in the issuance of convertible instruments or of subordinated debt. This concerns
a quite substantial segment of the European banking sector. Consider that almost 70% of
banks supervised by the SSM have not issued listed shares, 59% have not issued
convertible bonds and 18% do not have subordinated debt on their balance sheets (see
Chart 5).
Many of these banks will foreseeably have to make adjustments to their business model, to
align it to the change in size and composition of bank balance sheets required under the new
regulations.
Chart 5
SSM SIGNIFICANT INSTITUTIONS
BY OWNERSHIP STRUCTURE
100%
90%
LISTED
80%
• 59% have not
70%
issued any AT1
COOP. and
instrument (e.g.
60%
SAV.BANKS
convertible bonds)
50%
STATE
• 18% have not
40%
OWNED
issued any T2
instrument
30%
(e.g. subordinated
NON-SSM
20%
debt)
PARENT
10%
OTHER
0%
SOURCE: Banco de España
3. Possible responses by the banking sector
Macroeconomic and regulatory developments support the increasingly widespread
perception that there is excess capacity in the European banking industry that will heighten
competition and jeopardise the viability of those institutions least able to adapt to the new
environment.
3.1 Efficiency
Naturally, credit institutions' first line of defence is to gain in efficiency. In recent years, as
observed in Chart 6, cost-to-income ratios across the European industry have not
appreciably improved in the different banking systems and they remain significantly
heterogeneous. That suggests there is considerable room for improvement.
Spanish banks, for their part, are in a relatively good position compared with their European
counterparts, with a relatively high and growing degree of efficiency. In any event, it is also
true that office density, despite falling in recent years, remains high, especially when
compared with that of other European countries (see Chart 7).
In this area, new technological developments should allow further gains in efficiency by
providing for proximity to customers and for the marketing of products via means other than
face-to-face contact.
Chart 6 Chart 7
3.2 New products and services
The second foreseeable response by the industry to the narrowing of financial margins is the
search for income supplementing that from the traditional commercial banking business.
Net fee income relating to services (management or transactional), as a proportion of total
operating income, has been on a slightly rising trend in most countries. In the current setting,
it appears this trend is reflecting a lesser propensity of banks to subsidise certain
transactional services with a charge to net interest income.
That said, fee-generating business is subject to growing competition owing to the emergence
of new unlicensed bank competitors, which have demonstrated ample ability to harness the
new technologies (the so-called fintech companies). These new competitors specialise in
specific segments of the services value chain, services that in the past were exclusively
provided by banks, without being subject to banking regulation requirements.
Unquestionably, this scenario of new technologies and new emerging competitors poses a
challenge to the traditional banking business. However, technical progress is also an
opportunity for the more dynamic banks to generate efficiency and to extend the services
provided to their customers.
For instance, banks are proving very adept at developing instant payment services. And
some of them might be well-positioned to develop direct lending facilities (P2P) competing
with the new non-bank operators (e.g. crowdfunding). Banks retain advantages in terms of
experience, market roots and the ability to offer a full range of transactional and
intermediation services which should help them face competition which, nonetheless, will be
increasingly intense.
In our capacity as regulators and supervisors, we should seek to strike a balance between
facilitating technical progress, supporting the development of new products and services, and
properly safeguarding customers and financial stability.
3.3 Consolidation
Finally, orderly correction of the excess capacity in the banking industry will foreseeably
require greater consolidation in the sector. I spoke to you about this exactly a year ago in this
same forum and I believe that since then the view that such a process is becoming
increasingly likely has become widespread.
Ideally, consolidation should take place at the European level, in order to overcome the
strictly domestic vocation of the overwhelming majority of banks. The existence of more
banks with a pan-European outlook would amount to a private national risk pooling
mechanism that would help weaken the link between the macroeconomic risks existing in
each country and the stability of its banking system, adding robustness to the monetary and
banking union.
It is therefore important to identify and attempt to eliminate those obstacles that continue to
hinder such banking consolidation in Europe, in spite of the establishment of the banking
union. In particular, we must consider whether regulation and supervisory practices tend to
unduly penalise geographical diversification of a bank's business.
It would also be desirable to ascertain whether the current structure of the industry in various
countries, characterised by the existence of numerous banks that are not listed public
companies and that maintain strong links with national business sectors, hampers the
participation of foreign competitors, whether directly or through acquisitions.
All told, in the short or medium term it is likely that the need to continue reducing costs will
encourage bank mergers and acquisitions within each country in order to harness potential
economies of scale. In the largest European countries, there would seem to be room for
more consolidation. In fact, in many countries the level of concentration in the industry, as
measured by the Herfindahl-Hirschman index, is below that which might be considered to
pose a possible threat to competition (see Chart 8).
Chart 8
Accordingly, the European banking industry is facing important challenges arising from the
new macroeconomic environment, which is not conducive to income generation, and from
regulatory reform which, in order to protect financial stability, is introducing new rules and
safeguards that restrict the risk transformation business.
As a result, there is a need for banks to adapt their business models and corporate
strategies, and this will undoubtedly affect the structure of the sector.
The role of the supervisor is not, generally, to impose specific strategic action, which should
be determined by the banks themselves. Rather it is a matter of facilitating the process
maintaining the required supervisory standards and, thereby, offering incentives so that the
right decisions are made at the right time and in an orderly fashion, always for the benefit of
the shareholders, which almost always contributes to the sector's stability.
Allow me to conclude by briefly mentioning the banking union.
4. The Single Supervisory Mechanism
The supervisory framework in Europe has been significantly strengthened by the setting up
of the Single Supervisory Mechanism (SSM). Barely a year and a half after it started to
function, it has succeeded in putting into operation a supervisory model consistent with the
most demanding standards. As the result of the action taken following the analysis of the
banking sector conducted in 2014, the SSM has led to an appreciable increase in the
sector's capital and has prompted the most vulnerable banks to start cleaning up their
balance sheets.
The SSM has also shown itself capable of participating effectively in the resolution of crisis
episodes, like the one involving Greek banks.
Moreover, the SSM has managed to eliminate many of the national regulatory particularities,
has created a common methodology for the supervisory review of all banks and has made
significant progress in harmonising inspection practices by drafting and developing a manual
of common procedures.
At the operational level, in record time, joint supervisory teams have been put in place for
each significant institution and an ambitious programme of on-site inspections has been
developed. All these actions have been carried out within a framework of cooperation
between national authorities and the European Central Bank which is, generally, functioning
appropriately. Naturally, the fact that almost 100 employees of the Banco de España have
been recruited to the ECB's supervisory arm, making it the national authority that the ECB
has most relied on to cover its supervisory staff requirements, is something to be proud of,
although it is also an organisational challenge.
Given the complexity of the project, which includes coordinating the staff of 19 national
supervisors plus the ECB, and the short time that the SSM has existed, there is obviously still
room for improvement. That said, there is also palpable determination on the part of those
responsible for the SSM and its Supervisory Board (on which we participate) to continuously
review the arrangements and processes used in order to promote its improvement when
needed, counting on the conscientious contribution of all supervisory staff.
In sum, as a national supervisory authority, we can only congratulate ourselves on the
impetus the banking union is giving to the institutional strengthening of the euro area and on
its role in preserving financial stability. We also positively value our contribution (through our
staff and experience) to the effective operation of the SSM and ongoing improvement in its
procedures and supervisory arrangements.