Christian Noyer: France's banking industry in 2006 - key trends
Speech by Mr Christian Noyer, Governor of the Bank of France and Chairman of the French Banking
Commission, at the presentation of the 2006 Annual Report of the French Banking Commission, Paris,
29 June 2007.
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Welcome to this press breakfast, organised for the release today of the 2006 Annual Report of the
Commission Bancaire. I would like to discuss the key trends that characterised France's banking
industry in 2006, not just in terms of structure and performance but also the regulatory environment in
which it operates.
It is clear that the framework for financial activity and banking risk management has changed in recent
months, confirming the ever more urgent need for new methods of risk assessment and for
appropriate supervision that can react swiftly to these changes.
In my view, several factors are important in this respect.
First, in a highly international context, banks' performances are increasingly being judged from the
outside, especially by shareholders. Those judgements are sometimes so harsh that they can have a
direct structural impact. Consequently, banks can no longer afford simply to post excellent results - as
again was the case in 2006 for most major international banks, especially French banks. They must
also make sure that the underlying quality of those results is sound. To do this, they must pay special
attention to the way they manage risks internally and plan their strategic expansion, and to their capital
adequacy policy.
Second, the economic and financial context in which French banks are operating is also a source of
risks. Indeed, lessons must be learned from the slowdown in the USA, amply illustrated by the housing
downturn, which resulted in higher risk in the sub-prime segments of the retail banking market. It
should also be acknowledged that financial markets could become more unsettled. If higher risk
aversion were to encourage greater use of risk transfer products, this could drain liquidity from some
markets and undermine the efficiency of banks' management. From a supervisory perspective, the
problem is all the more acute since the growing reliance on credit risk transfer instruments tends to
make it harder to assess the type and degree of risk that banks actually bear when, for example, they
arrange complex transactions.
Third, the regulatory environment for French banks is changing radically as a result of the Basel II
accords. Banks that have adopted the advanced approaches to risk management must put models in
place - usually as early as January 2008 - for the internal rating and assessment of credit risk, market
risk and operational risk. On-site inspection teams from the Commission Bancaire are currently
scrutinising these models. Their investigations show that, overall, large banking groups have taken the
measure of this project early on, so as to be ready for the deadline of the 1st January 2008, even if
some improvements need to be made in certain areas. Furthermore, most banks will have to meet the
next challenge of fine-tuning their risk management and calculating their economic capital in the
coming months, pursuant to Pillar 2.
In sum, these regulatory, economic and financial factors are prompting banks to change the way they
manage their risks, meaning that supervisors must be more flexible and more watchful. To clarify
these considerations, I would like briefly to address two issues:
1. The results posted by French banks in 2006 are good, but they are not without
vulnerabilities.
2. French banks are currently in the final straight as regards the implementation of the new
regulation. As the banking supervisor, our role is to support them during this transitional
period and to ensure together that the reforms are carried out properly.
French banks' 2006 results are good, but not without vulnerabilities
Like the majority of leading European banks, French credit institutions reported good results for 2006,
in line with the previous three years. For the three main banking groups under IFRS, the net banking
income grew nearly 19 per cent, more than in 2005. In all, the aggregate net income of the French
banking system, under French GAAPS, amounts to nearly €40 billion. This reflects a substantial
contribution from foreign subsidiaries and from non-banking business, especially insurance. Moreover,
most large French banks made major acquisitions outside their home market in 2006, particularly in
regions with strong growth potential.
Retail banking is still the main source of profit for French banks, accounting for nearly 60 per cent of
the largest groups' net banking income. That said, the domestic retail market began to decelerate in
the last quarter of 2006 and the first quarter of 2007. The net interest margins of several major groups
contracted, contributing to downward pressure on 2006 results. To an increasing extent, this margin
squeeze is not being offset by the rise in outstanding loans, while fees and commission income has
been growing less strongly than in recent years. The outlook for intermediation income in 2007 may be
less positive given the persistently intense competition in the credit market and the possibility that the
yield curve will remain either flat or shallow. Furthermore, we must learn a cautionary lesson from the
increase in borrower default risk observed in the sub-prime segment of the US retail market. The risk
may be less pronounced in continental Europe, but I would point out that margins on mortgage lending
are already thin and that there is a trend towards longer loan maturities. I am therefore calling on
French banks to make sure that they closely monitor their borrower risk exposure.
So far, the earnings slowdown in retail banking has been mitigated by good performances in corporate
and investment banking, private banking, and personal asset management, which provided new
growth opportunities. Through mergers and acquisitions, including leveraged buy-outs (LBOs), banks
were able to increase the proportion of income generated by non intermediation activities.
The recent competitive environment has actually fostered the gradual transformation of banking
activities, with a greater emphasis on the "originate and distribute" business model. With this model,
credit institutions arrange financings but quickly offload a substantial portion of their risks, for example
through securitisation, and take payment - much more so than in the past - in the form of fees and
commissions.
But although activity in new products such as LBOs is helping to boost French banks' revenues and
earnings, it is also a source of vulnerability. First, in terms of remuneration, fierce competition among
credit institutions is not only exerting downward pressure on margins; it is encouraging "covenant-lite"
deals - a worrying trend. These complex transactions are also beginning to generate new risks. On
this point, there is a tendency towards longer underwriting periods, during which banks bear the bulk
of the risk. Banks should also pay attention to the fact that counterparties such as hedge funds are
becoming increasingly involved in this type of deals.
Allow me two brief asides, if you will. First, with regard to LBOs, let me refer you to the study
appended to the Annual Report. On the topic of hedge funds, I would remind you that the Banque de
France devoted a special issue of its financial stability review to this subject and that the Commission
Bancaire pays close attention to banks' involvement with this type of counterparty. Let me also say
that we now comply fully with the recommendations set out in the Financial Stability Forum report
commissioned by the G8 and published on the 19th May 2007.
Getting back to the banking system, I believe that, in light of these developments, banks should adopt
an appropriate scale of charges and, more importantly, stricter oversight procedures, in line with the
rationale at the heart of Basel II approach.
French banks are currently in the final straight as regards the implementation of the new
regulation
Basel II is playing a key role in moves to buttress risk management at credit institutions. The European
Council and the Parliament adopted the Capital Requirements Directive on 14 June 2006, a crucial
milestone in implementing the Basel II mechanism, established by the Basel Committee for Banking
Supervision, within the European Union. The mechanism's three pillars - minimum capital
requirements, supervisory review, and market discipline - form a prudential framework that is both
more extensive and more sensitive to the risks actually incurred by credit institutions. Above all, Basel
II should encourage institutions to improve their internal management and carefully calibrate their
capital requirements.
At present, we are concentrating on assessing the implementation of internal ratings-based
approaches for credit risk and advanced measurement approaches for operational risk. The
Commission Bancaire therefore undertook a series of on-site inspection missions in 2006 and 2007 to
evaluate the systems and models developed by French institutions. The missions were initiated after
the Commission's General Secretariat had received the findings of the institutions' "internal
validations". The purpose was to make sure that institutions were in compliance with the minimum
regulatory requirements and, more generally, to check the quality of their information systems and the
conditions in which these mechanisms are used and controlled.
These inspections revealed that institutions had indeed already made extensive achievements, but
also showed that some of them needed to make further progress on Pillar 1 of Basel II, especially with
regard to:
- the collection and estimation of the Basel parameters, particularly probabilities of default
(PD) and loss given default (LGD): on this point, it is important that banks should steadily
upgrade again their historical data so as to cover full business cycles;
- permanent control and validation of information systems and/or models: implementing
thorough benchmarking and back-testing processes is crucial in this context.
With regard to Pillar 2, the Commission Bancaire urges banks to make certain that their Internal
Capital Adequacy Assessment Processes capture risks which are covered incompletely or not at all by
Pillar 1, especially concentration risk, liquidity risk and overall interest rate risk. In the months ahead,
priority must be given to developing stress tests that are more comprehensive, i.e. that encompass the
various risks (credit, market, etc.) and that aim for exhaustive coverage of risk exposure.
Banks must also meet their transparency requirements under Pillar 3 (market discipline), for both the
content and the frequency of their disclosures. This point is particularly important because the
Commission Bancaire's decision on whether to authorise the use of certain approaches may hinge on
meeting these requirements, which, moreover, tie in with those in the new IFRS.
It should be underlined that the Commission Bancaire carries out these activities in close cooperation
with other European oversight authorities as a member of the Committee of European Banking
Supervisors (CEBS) whose objective is to achieve closer convergence of supervisors' regulations and
practices. In this regard, CEBS has set up operational networks, known as supervisory colleges, for
major cross-border banks. Composed of the home-country and host-country supervisors of Europe's
largest banking groups, these networks make it possible to find pragmatic solutions to the main
problems encountered when implementing Basel II. Likewise, convergence of supervisory practices
must be also materialised by the filing of the first accounting and prudential reports in FINREP and
COREP formats, respectively, which form a common framework for Europe.
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Let me say in conclusion that over the past year the French banking system has demonstrated its
ability to develop new activities and thus find the fresh sources of growth needed to diversity its
revenues. But these positive results are not without certain vulnerabilities, given that margins are slim
and some complex financings are exposed to both operational risk and model risk.
It is therefore necessary to ensure that banks' balance sheets remain robust. To achieve this,
naturally, pricing structures must correspond to actual risk exposure, and risk management techniques
must be strengthened. But the level and quality of capital must also be appropriate.
Accordingly, confronted with the spread of banking strategies that earn high returns but engender new
risks, the Commission Bancaire is constantly on its guard in order to preserve the current levels of
resilience and performance of the French banking system as a whole. The Commission Bancaire
therefore intends to reinforce its action in order to improve the management and control of these risks,
while stepping up its efforts to promote a common culture of supervision in a coherent framework at
the European level.