Luis de Guindos: Building the financial system of the 21st century
Speech (via videoconference) by Mr Luis de Guindos, Vice-President of the European Central
Bank, at the 18th annual symposium on "Building the Financial System of the 21st Century: an
Agenda for Europe and the United States", organised by the Program on International Financial
Systems and Harvard Law School, Frankfurt am Main, 22 July 2020.
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In my remarks today, I will highlight the impact that the coronavirus (COVID-19) shock has had
on the banking sector and market-based sources of finance. In both the euro area and the United
States, the pandemic and the related lockdown measures have led to stark economic
contractions. These contractions have been shaped by key structural differences between the
two financial sectors, requiring differentiated policy responses. Irrespective of these differences,
a powerful trio of monetary, prudential and fiscal policy responses on both sides of the Atlantic
provided critical support that prevented the financial system from immediately seizing up, which
would have had severe consequences for financial stability in the near term. Looking ahead, the
pandemic shock may accelerate ongoing transformations in the financial sector landscape.
Moreover, the shock is highlighting the importance of macroprudential policy in both the bank and
non-bank financial sectors to safeguard a stable financial system.
The financial sector in the wake of the pandemic crisis and the policy response
Differences between the financial systems on each side of the Atlantic are well documented. The
financial system in the euro area is predominantly bank-based compared with the more
marketbased system in the United States. In fact, more than half of funding to non-financial firms in the
euro area is channelled through banks. By contrast, bank financing accounted for only 25% of
firms' total financing in the United States in 2016, although this share has increased slightly in
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recent years.
At the same time, the euro area financial sector has increasingly begun to resemble its US
counterpart over the past decade. The non-bank financial sector has seen exceptional growth:
total assets of the sector doubled from €24 trillion in 2009 to €48 trillion in 2019.
In considering how these secular changes affect real economy financing, composition matters.
Market-based financing is primarily accessed by large enterprises, while for small and
mediumsized enterprises - which are the backbone of the euro area economy - bank credit remains the
main source of financing.
Thanks to the Basel III regulatory framework, banks entered this crisis with stronger capital and
liquidity positions than they had before the global financial crisis. Their improved resilience has
been central in enabling banks to weather the initial strain of the pandemic shock and continue
funding the real economy.
The same cannot be said for the non-bank financial sector or the investment fund sector in
particular, which experienced a severe episode of liquidity stress and reportedly contributed to
market dislocations and price volatility. Euro area financial markets saw an unprecedented
selloff in late February and March 2020, with the EURO STOXX 50 index losing almost 40% of its
value. During this period, investment funds experienced exceptionally large outflows, similar in
magnitude to those seen during the global financial crisis. The combination of high redemptions
and low liquidity buffers prompted funds to sell both risky and less risky assets. This amplified
liquidity stress in an environment of rapidly increasing demand for cash and high market volatility.
Liquidity fell sharply - not only for riskier assets, but also briefly in high-quality markets such as
the US Treasury and money markets - as both financial and non-financial sectors sought cash.
Increased market volatility, in turn, forced non-banks to post higher margins on their derivatives
positions, thereby adding to the demand for cash and exacerbating liquidity stress.
The economic consequences of these developments could have been far worse had it not been
for the timely accommodative monetary and fiscal policies on both sides of the Atlantic.
Announced fiscal relief measures - which represent up to 20% of GDP in the United States and
in some euro area countries - are rightly acting as the first line of defence.
Actions taken by central banks were no less impressive and were essential to stabilise financial
markets and improve liquidity conditions across a broad range of assets. The Federal Reserve
System launched a range of measures addressing the main market segments and also
benefited from some form of credit protection from the US Treasury. Liquidity stress was
alleviated and margin calls declined, with renewed inflows being seen across all asset classes.
In the euro area, support provided by the ECB has reflected the importance of banks for
corporate financing - we have expanded and eased existing measures to support our price
stability objective. Our measures have provided a backstop against liquidity shortages, as well as
incentives for banks to keep credit flowing to the real economy. Sizeable increases in asset
purchases aimed to prevent a tightening of financing conditions which would have amplified the
downturn. Measures providing liquidity to banks at very favourable terms were complemented by
a collateral easing package and ensured the continued flow of credit.
These monetary policy initiatives were complemented by a range of actions by micro- and
macroprudential authorities to sustain lending during the downturn. A number of relief measures
were adopted to allow banks to temporarily operate below the level of supervisory capital defined
by the Pillar 2 Guidance. Supervisory flexibility was introduced on the treatment of
nonperforming loans and banks were encouraged to avoid excessive procyclical effects when
applying accounting standards. ECB Banking Supervision also asked banks to limit capital
distribution by refraining from paying dividends or buying back shares. Furthermore, the ECB
endorsed all macroprudential policy decisions proposed by national authorities in relation to
reductions in the countercyclical capital buffer and other macroprudential buffers. We also
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encouraged banks to make full use of all releasable buffers.
Timely monetary, prudential and fiscal policy supported near-term financial stability, but could not
prevent the pandemic crisis from exacerbating medium-term risks to financial stability, to which I
will turn next.
Looking ahead: challenges for the euro area banking sector
The banking sector has proven to be resilient in the initial phase of the pandemic stress. But this
is not to say that the sector will not face headwinds in the future. Market valuations were hit hard
at the height of the crisis and analyst forecasts of bank profitability for 2020 have recently
undergone large downward revisions amid concerns that banks will need to increase their
provisions for future credit losses.
Such a sharp deterioration in profitability adds to the structural challenges already facing the euro
area banking sector. As the ECB has repeatedly highlighted in its twice-yearly Financial Stability
Review, low bank profitability is being driven by both low cost-efficiency and weak
incomegeneration capacity. Overcapacity, legacy assets and a perhaps insufficiently diversified
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structure of revenues are some of the issues underlying these trends.
Bank consolidation (exploiting economies of scale and scope), further bank management actions
on resolving non-performing loans, and diversification of the revenue structure towards more fee
and commission income (depending on the specific business model) could be some of the ways
forward.
To enhance structural profitability over the long term, banks need to thoughtfully invest and
support digitalisation and the transition towards a low-carbon economy. The coronavirus
pandemic could in fact represent an opportunity for the financial sector to adapt to this new
environment more swiftly.
Looking ahead: challenges for the non-bank financial sector
Turning to the non-bank financial sector, the early stages of the pandemic shock have shown
how investment funds in particular can contribute to amplifying adverse market dynamics by
increasing market volatility and price dislocations. A number of funds facing severe liquidity
bottlenecks resorted to exceptional measures to cope with large outflows, such as applying
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swing pricing and redemption fees or even suspending redemptions.
In my view, the increasing importance of the non-bank financial sector in the financing of the euro
area economy calls for a stronger macroprudential framework for the sector. Such a framework
is still in its infancy. To date, the prudential policy framework for investment funds has primarily
relied on ex-post liquidity management tools under asset managers. These tools are, however, of
limited use in preventing liquidity stress at the system level. I would therefore argue in favour of
extending the current macroprudential toolkit by including ex ante liquidity management tools
(such as minimum liquidity buffers and redemption notice periods). Closer monitoring of
intermediaries' leverage and how it interacts with factors such as fund illiquidity is essential.
Leverage may also amplify procyclicality in the investment fund sector as it is an important factor
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in investors' redemption decisions.
We should thus reconsider existing leverage regulation on investment funds.
Conclusion
Let me conclude. The coronavirus pandemic and the associated lockdown measures have
caused an unparalleled shock to the global economy. Swift actions undertaken by monetary,
fiscal and prudential authorities in the United States and in Europe have been crucial in stabilising
investor sentiment and ensuring that the financial sector continues to support the recovery,
thereby mitigating the economic costs of the pandemic.
Although not at the epicentre of the crisis, the financial system has been under strain during the
coronavirus pandemic. Banks' market valuations were hit hard and a number of investment
funds faced severe liquidity difficulties. The pandemic crisis has increased the pressure on the
already low prospects for bank profitability in Europe, thereby underscoring the need for
consolidation and structural change in the sector. Digitalisation and the transition to a low-carbon
economy are particularly important elements of the ongoing structural transformation of the
financial system.
The pandemic crisis has also drawn further attention to the role of the new macroprudential
policy area in safeguarding the stability of the financial system.
Looking ahead, while the overall level of bank capital is broadly adequate, its composition may be
limiting the full potential of releasable buffers as a macro-financial stabilisation tool. Reviving the
debate about the appropriate balance between structural and cyclical releasable buffers is
welcome, facilitating a reallocation of capital requirements towards releasable buffers in a
capital-neutral manner.
Developments in credit intermediation outside the banking system, coupled with vulnerabilities
highlighted by the pandemic crisis, have shone a light on the need to strengthen the
macroprudential framework for non-banks. This is a truly global matter: action on one side of the
Atlantic has tangible effects on the other. A holistic framework and effective coordination at the
global level are therefore needed.
See "Trends in the external financing structure of euro area non-financial corporations", ECB Economic Bulletin,
Issue 5, ECB, 2016.
2
See "Macroeconomic impact of financial policy measures and synergies with other policy responses", Financial
Stability Review, ECB, May 2020.
3
See "Euro area bank profitability: where can consolidation help?", Financial Stability Review, ECB, November
2019.
4
See Financial Stability Review, ECB, May 2020, sections 4.2 and 5.3.
5
See "Is leverage driving procyclical investor flows? Assessing investor behaviour in UCITS bond funds",
Macroprudential Bulletin, ECB, October 2019.