Ignazio Visco: The exit from the euro crisis - opportunities and
challenges of the Banking Union
Speech by Mr Ignazio Visco, Governor of the Bank of Italy, at the conference "Europe and
the future of global governance", organized by the Italian Institute of International Affairs and
the US Council on Foreign Relations, Rome, 10 September 2013.
* * *
The euro area has suffered two recessions in the last five years. GDP contracted for five
consecutive quarters starting in the spring of 2008; the fall came to more than 4 percent in
2009. The subsequent recovery was short-lived: the outbreak of the sovereign debt crisis in
mid-2011 was followed by six quarterly declines. In 2012, GDP was still 1.3 percent less than
in 2007.
The signs now are that the contraction is drawing to a close. GDP resumed moderate growth
in the second quarter of this year, reflecting the expansion of exports and progress in
domestic demand, and the confidence indicators improved somewhat over the summer.
Actual and expected inflation remain subdued, well below 2 percent.
However, the timing and strength of the recovery are still highly uncertain. The resolve with
which European and national authorities continue to implement the reform strategy devised
to deal with the crisis will be decisive for financial conditions and for business and consumer
confidence. Externally, the slowdown in the emerging economies and the recent geopolitical
tensions in the Middle East threaten to undermine the prospects for world demand.
The crisis did not hit all the euro-area countries in the same way, and the recovery is
correspondingly asymmetrical. In Italy the recession has been longer and deeper than in
most other countries. Last year's output was almost 7 percent less than in 2007. In the first
half of 2013 GDP diminished again, but at a slower pace, with exports still providing the main
stimulus. The latest indicators are consistent with gradual improvement: the decline in output
should come to a halt in the coming months. The downside risks to this scenario are
compounded by investors' concerns about possible political instability.
The spark that ignited the sovereign debt crisis in the euro area at the end of 2009 was the
unveiling of the dramatic state of the public finances in Greece. But the tensions soon fed on
the economic weaknesses of other member states - macroeconomic imbalances, real-estate
bubbles, distressed financial systems, high public debt. The crisis became systemic in the
summer of 2011 with the announcement of the involvement of private investors in
restructuring the Greek debt, which made the markets suddenly aware of the implications of
the no bail-out clause in the EU Treaty. These events laid bare the incompleteness of the
European construction, the euro being a "money without a state". The spreads between the
government bond yields of the fiscally weak countries and the German Bund soared.
A serious crisis of confidence in the very survival of the single currency ensued, with adverse
consequences for the real economy. The situation deteriorated most severely in the banking
systems of the countries most directly affected by the tensions, whose perceived credit
standing soon aligned with that of their sovereigns; wholesale funding conditions deteriorated
sharply, cross-border interbank lending all but dried up. There emerged a perverse loop
between fragile public finances, weak economic performance, and deteriorating bank
conditions.
Given the risk of a severe credit tightening, the Governing Council of the ECB took resolute
action. With two special refinancing operations in December 2011 and February 2012 the
Eurosystem supplied banks with a trillion euros in three-year funds (over €500 billion net of
the volume of funds reimbursed in other refinancing operations). The liquidity injection was
effective: sovereign spreads dropped and the wholesale markets revived.
Europe's response to the sovereign debt crisis has been twofold. Domestically, to rein in the
risks from unsustainable public finances, individual countries have committed to prudent
fiscal policies and structural reform to enhance competitiveness. At European Union level, to
dispel the fears of euro break-up and "redenomination risk", a reform of economic
governance has been undertaken.
National action on the sovereign debt crisis has been heterogeneous. Fiscal adjustment was
indispensable in the more economically fragile countries, including Italy, to ward off the risk
of losing access to the market, which would have precipitated the crisis. Its negative
shortterm effect on economic activity was the price paid for averting more serious consequences.
With the benefit of hindsight it is clear that the reform of European governance was long
overdue. The long-dormant process was effectively set in motion by the sovereign debt
crisis. Despite hesitancy, overlaps and redundancies, within a very short span of time definite
progress has been achieved.
Together with the efforts at national level, the reform of European governance has begun to
rebuild trust among member states. The strengthening of the budgetary rules, which has
reinforced existing commitments and made them more credible without imposing more
demanding targets, and the extension of multilateral supervision to macroeconomic
imbalances have accompanied the institution of mechanisms for managing sovereign debt
crises and paved the way for discussion with a view to deepening European integration.
Until recently, Europe lacked the tools for managing a sovereign crisis. Between 2010 and
2012 EU countries disbursed some €280 billion in loans to their partners in difficulty, either
directly or through the newly established common financing instruments (the European
Financial Stability Facility, EFSF, and the European Stability Mechanism, ESM). Italy's
contribution amounted to €43 billion, which according to official estimates will rise to more
than €60 billion in 2014.
The European reforms are still in the making. Their full pay-off, as well as the reward for
national efforts, will come in the medium term. In the meantime, the distortions still affecting
the financial markets could undermine the transmission of monetary policy and jeopardize
the entire process. This risk materialized in the spring of 2012 when sovereign spreads
started widening again. By July the differential between 10-year Italian BTPs and the
equivalent German Bunds had once more exceeded 500 basis points, against the value of
about 200 points then estimated to be consistent with the two countries' economic
fundamentals.
The ECB Governing Council reacted by announcing Outright Monetary Transactions (OMTs),
a new method of intervention on the secondary market for government securities whose
purpose is to counter excessive increases in sovereign yields where they stem from
redenomination risk and distort monetary policy transmission; as such, they are fully within
the Eurosystem's mandate. The announcement of OMTs produced immediate benefits:
medium- and long-term yields in the countries under pressure decreased and the
fragmentation of markets along national lines was attenuated.
OMTs were made possible not only by the credibility of the Eurosystem but also by the very
process of reform they intend to protect. The fears of euro reversibility are linked in the first
place to concerns about the sustainability of the public debt and the competitiveness of some
member countries. For this reason the activation and continuation of OMTs are subject to
specific commitments regarding the public finances and structural reform, as part of
assistance programmes. The financing of the programmes with the ESM's resources is an
incentive to strengthen the governance of the Union further. Monetary policy can guarantee
stability only if the euro area's economic fundamentals and institutional architecture are
consistent with it.
Confidence in the irreversibility of the euro is the key. In the short term, the effective use of
ESM resources will preserve the progress made and safeguard the rights and the efforts of
those who have helped to develop the instruments of financial support. The OMT
announcement prevented a financial collapse with potentially ruinous consequences for the
European economy: all the member countries benefited, not just those at the centre of the
sovereign debt crisis.
Towards deeper European integration: the Banking Union
To ensure stability over the longer run, the effort to reform the European governance has
been stepped up. The subsequent stages are outlined in the report Towards a Genuine
Economic and Monetary Union (presented in June 2012 and updated in December by the
President of the European Council, working closely with the Presidents of the European
Commission, the Eurogroup and the ECB) and in the Blueprint for a Deep and Genuine
Economic and Monetary Union published by the Commission last November. Both
documents envisage a banking union, the introduction of autonomous fiscal capacity for the
whole euro area, and a common budget; they set the scene for the eventual political union.
A keystone of institutional reform, Banking Union is crucial to break the perverse feedback
loop between sovereigns and domestic banking systems. It has three key components: a
single supervisor, a single bank resolution mechanism, and a single deposit insurance
scheme.
In the summer of 2012 the European leaders decided to give priority to the construction of
the first component, the Single Supervisory Mechanism. The SSM comprises the ECB and
the national supervisory authorities. For the largest banks it will be based on strict integration
of European and national structures. For the others, it will involve the direct responsibility of
national authorities, under common guidelines; the ECB will retain the right to take over
direct supervision responsibilities where circumstances warrant. This far-reaching
institutional innovation will require an organizational adaptation as far-reaching and at least
as complex as that leading to the single monetary policy. The delicate launch phase will
require substantial investment in human resources and technical infrastructure. The national
supervisory authorities' workload will not diminish, as we strive to build a unitary new
mechanism from frameworks that differ in many respects. The preparatory work is
proceeding at the greatest speed compatible with the challenges of the task.
Building on the technical experience and reputation of national authorities, the SSM will have
to ensure a supranational vision. Supervisory practices within the euro area are quite
heterogeneous. It is vital to avoid any lowering of standards and instead to converge on the
best practices in supervisory methodology, modelling and assessment of banking risks. This
will ensure early warning of emerging instability at individual banks and at systemic level. We
attach special importance to aspects that are a fundamental part of the tradition of the Bank
of Italy, such as the central role of on-site inspections, methodologically robust quantitative
analysis, and close interaction with banks.
If successfully managed, the SSM will bring substantial benefits to the single market: it will
improve the effectiveness of monetary policy transmission, counter the ring-fencing trends
observed in the last years, thus fostering financial integration, facilitate comparison between
banks and banking systems in different countries, and in this way improve the monitoring,
control and mitigation of vulnerability factors.
Work is also continuing on the single resolution mechanism (SRM), the second component of
the banking union. This is indispensable to align the responsibilities for supervising banks
and handling crises. The Bank Recovery and Resolution Directive is intended to harmonize
the heterogeneous national practices, rules and tools for bank crisis management and keep
rescue operations from being financed with public funds. The Directive lays down a number
of preventive measures, together with rules for timely intervention and resolution, including
the bail-in of bank creditors. A fund to be financed by the banks themselves will be
earmarked for bank resolution. The European Commission recently issued a proposal for a
Regulation - which should be fully operational in 2015 - to institute an SRM under a single
resolution authority and with pooled resources. Concerning the third component of the
Banking Union, a draft directive has been prepared to implement a common network of
national deposit guarantee schemes by the end of this year.
The institution of the SRM must proceed expeditiously, with appropriate negotiations
between national and Community authorities. Once the mechanism is fully operational, the
availability of adequate resources will allow the cost of crises to be divided between the
bank's shareholders, creditors and the banking system as a whole.
During the transition to the SRM, the risk of a vicious circle between a fiscally weak
sovereign state and its fragile domestic banks persists. The ESM will only be able to directly
recapitalize banks - with the aim of restoring their viability and obtaining a remuneration of
the capital invested - after the effective entry into operation of the SSM. There remains the
possibility of using ESM funds indirectly, by means of loans to member states, but this would
bear on the public debt of the countries concerned, bringing the bank-sovereign loop back
into the picture.
The comprehensive assessment of the main European banks ...
With a view to the launch of the SSM, the ECB and the national supervisory authorities are
working to undertake a comprehensive assessment of the soundness of the significant
euroarea banks, those that will fall under the direct supervision of the SSM. This assessment
consists of thorough analysis of each bank's risk profile, comprising an overall balance-sheet
assessment (BSA), including an asset quality review, and a stress test. The exercise will also
cover other relevant aspects of banks' business, including leverage, corporate governance
and organization.
The comprehensive assessment is designed to make sure that the area's main banks are
managed in a sound and prudent manner, helping to dispel market concerns over their
soundness and risk profiles. Significantly, from the outset the assessment will also foster
confidence in the SSM itself, reinforcing mutual trust among participating countries. It will
therefore be a fundamental step in normalizing wholesale markets and restoring the banking
system to its principal, fundamental role of supporting economic activity and growth.
In order to attain these objectives, the comprehensive assessment must be completely
transparent, as regards not only results but also process and methodologies. The
appropriate involvement of external reviewers may enhance the credibility of the exercise.
Attention must obviously be paid to potential conflicts of interest and problems of
confidentiality. Also, level-playing-field issues among participating banks must be avoided.
The design of the balance-sheet assessment must recognize that national accounting and
supervisory practices differ radically, especially in the definition and measurement of non-
performing loans (NPLs). The European Banking Authority (EBA) is working to make
definitions uniform across systems and has recently issued a consultation paper on the
matter. This is a step in the right direction and should be finalized in time for its results to be
used for the BSA. In any case, the BSA requires a de facto harmonization of NPL definitions.
National practices also differ substantially in the measurement of risk-weighted assets, the
denominator of regulatory capital ratios. Differences in the models used by banks to compute
capital requirements - or in the approaches adopted by supervisors for validating them -
may undermine the comparability of banks' capital, so the BSA will have to pay close
attention to the way in which these models compute the risk weights of different categories of
assets, including off-balance-sheet items and "level 3" assets (non-traded assets whose fair
value is estimated through internal models). Again in this case, de facto harmonization is
necessary.
Furthermore, in order to be fully credible and to be perceived as a confidence-building
exercise the comprehensive assessment must be rigorously designed and carried out, with
clearly defined and well motivated thresholds for gauging any capital shortfalls. If, as
observed earlier, one of the objectives of the Banking Union is to break the perverse
feedback loop between banks and sovereigns, then an essential prerequisite is the presence
of adequate backstops against the capital shortfalls that may emerge from the BSA. Also, to
avoid pro-cyclical effects, clear and extensive communication of the process and its results is
necessary. The mistakes of the past in the sequence of the actions taken by different policy
makers should not be repeated.
... and a perspective on the Italian banking system
The Italian banking system offers a few illuminating examples of the problems and
challenges of the comprehensive assessment. In the international comparison Italian banks
appear to have a high NPL ratio and a low coverage ratio (i.e., the ratio of loan loss
provisions to gross non-performing loans). But it is clear by now that the comparison is
vitiated by disparities in accounting and supervisory practices, which must be taken into
account in order to obtain a fair assessment.
A case in point is the treatment of collateralized loans. Some major European banks do not
classify fully collateralized loans as NPLs, while in Italy loans are classified on the basis of
the borrower's creditworthiness, irrespective of collateral or guarantees. Both practices are
fully consistent with international accounting standards enforced in Europe, but the Italian
method makes the bank's balance sheet more transparent for investors. If Italian banks used
the same definition as some foreign banks, their stock of non-performing loans would fall by
about a third, decreasing their average NPL ratio significantly and raising their coverage
ratio; at the same time, the rise in the NPL ratio in the recent years would be less
accentuated, reflecting the sharp increase in collateral demanded by Italian banks in reaction
to the deteriorating economic outlook.
Let me be clear: I am not suggesting a relaxation of the Italian definition of NPLs - which, by
the way, is broadly in line with the one proposed in the EBA consultation paper. I am arguing
that the BSA needs to take this and other sources of heterogeneity into account.
Similar considerations apply to leverage. Italian banks have lower leverage than their
international competitors, partly because of their relatively small volume of business in
derivatives. Arguably, their operational risks are also comparatively low: Italian banks have
not been involved in any of the serious episodes of malpractice or the market-rigging
schemes that have damaged the reputation and of some foreign intermediaries and cost
them expensive legal settlements. These and other sources of heterogeneity, which tend to
bias international comparisons against Italian banks, have been documented by the Bank of
Italy in its Financial Stability Report as well as by market analysis. They will have to be duly
taken into account in the comprehensive assessment.
These arguments are intended simply to support a fair approach to the forthcoming BSA;
they are not meant to downplay the risks that the Italian banking system faces. While Italian
banks have demonstrated good resilience overall, thanks to their sound fundamentals at the
outset of the financial crisis, the sovereign crisis and two long and deep recessions have put
their balance sheets under severe stress. NPLs have been rising steadily since 2008,
depressing profitability and raising concerns over provisioning among analysts and market
operators. And even though I have set out the reasons why we need to quickly enhance
comparability among European banks, we take these concerns seriously. Indeed, we have
taken decisive action to address these risks, and we are confident that this will improve the
outlook for the Italian credit market.
Apart from episodes of malfeasance, which are relevant but circumscribed, serious
difficulties mainly concern a handful of medium-sized and small banking groups. This class of
banks has been particularly hard-hit by the recession, owing among other things to lesser
diversification of risks and revenues. Additional challenges have sometimes been raised by
weak ownership and corporate governance structures, which may complicate capital
strengthening and adaptation of business models. Intense supervisory actions have been
- and continue to be - taken on these banks. In some instances special administration has
been necessary to allow a clear recovery and return rapidly to ordinary management.
The Bank of Italy regularly reviews banks' asset quality as part of its standard supervisory
activity, assessing the risk exposure of each institution. The quality of banks' assets is
assessed continuously off-site, on the basis of detailed monthly supervisory reports. In
particular, the information contained in the Central Credit Register includes the exposure of
each bank to each individual firm: this enables us to assess the consistency of the different
banks' classifications of the same borrower, checking that non-performing debtors are not
classified as performing by some intermediaries. Moreover, the Bank of Italy monitors the
adequacy of loan classification criteria through extensive on-site inspections, among other
things in order to curb the forbearance risk typical of economic slowdowns.
In the second half of last year, against the backdrop of an exceptional and largely
unanticipated macroeconomic deterioration, the Bank of Italy launched an ad hoc
supervisory review of the adequacy of banks' NPL provisioning policies. This involved
simultaneous on-site inspections at 20 large and medium-sized banking groups whose
coverage ratios either were lower than average or had fallen significantly. The main findings
were published in a note posted on our website. Overall, the coverage ratio for the entire
NPL portfolio of the 20 groups rose from 41 to 43 per cent between June and December
2012, notwithstanding the sharp rise in NPLs themselves (the denominator of the ratio) in the
same period. In other words, the downward trend in coverage ratios since the beginning of
the crisis (2007-08) has come to a halt. The intelligence gathered in the course of the review
will also be used for the application of second-pillar capital add-ons.
Our supervisory action continues. We are closely monitoring the implementation of the
corrective measures that the banks were asked to adopt, while assessment of banks' asset
quality and provisioning levels is still ongoing and has been extended to other banking
groups in the course of regular on-site inspections. Any capital shortfalls that may emerge
will have to be met through proper actions within the banks' perimeter of decisions and with
recourse to the market.
At the same time, we are taking care to minimize the pro-cyclical impact of banks' actions on
the availability of credit to the economy. This is why we have called on banks to increase
their internally generated resources by curbing operating costs as well as dividends and
executive and directors' compensation.
Our current assessment is that notwithstanding specific difficulties, the challenge will be met
and market concerns will abate. But the state of the banking system is not independent of the
general economic environment. Action to revitalize the Italian economy and raise its growth
potential is thus as important as ever.
The move to the SSM must not blur our focus on the conditions of the banking system.
Supervisory standards and practices must be kept at the highest level of quality. This will
permit us to perform a homogenous and comprehensive assessment of euro-area banks,
with full disclosure of differences in business models but also with a common mandate to
build on existing strengths and to counter and shrink the areas of weakness.
The crisis has constituted a fierce challenge for the European construction. The threat of a
break-up of the euro, never taken seriously by the markets before, increasingly distorted
asset prices across the euro area. The economic and social costs have been severe.
Unemployment, especially youth unemployment, has soared. In the worst-hit countries
poverty levels have risen sharply, and social tensions have surfaced.
The responsible reaction of national and European authorities has averted the worst. The
recovery is now at hand, but downside risks remain significant. If we are to seize the
opportunity, we cannot relax our efforts. Ultimately, our economies must restructure to
become more competitive in order to rise to the challenges of technological, demographic
and geopolitical change. We must press on with structural reform. The key to success will be
a shared determination to advance towards a fully fledged European Union. In the current
stage, the test of our resolve is the building of an effective Banking Union.