Vítor Constâncio: Challenges for the European banking industry
Lecture (full text, delivered in abridged form) by Mr Vítor Constâncio, Vice-President of the
European Central Bank, at the Conference on "European Banking Industry: what's next?",
organised by the University of Navarra, Madrid, 7 July 2016.
* * *
The charts can be found at the European Central Bank's website.
The Footnotes can be found at the end of the speech.
1. Introduction
Ladies and gentlemen,
I warmly thank the organisers for inviting me again to this important event in Madrid, where I
last spoke two years ago, also in the context of the Master in Banking and Financial Regulation
of the University of Navarra.1
The future of banking is certainly a very topical subject, particularly after the global financial
crisis. The 2007-08 episode clearly demonstrated that financial crises, particularly when they
involve the banking sector, can be enormously expensive both in terms of direct fiscal costs
and associated costs for the real economy. Over the period 2008-14 accumulated gross
financial sector assistance by euro area governments amounted to 8% of euro area GDP, of
which, so far, around 3% has been recovered.2 Moreover, the crisis induced the Great
Recession and the costs of foregone output have been severe. At the aggregate level, the euro
area output is now 20% below the level it would have achieved had the trend growth in the
previous 15 years continued after 2007. Considering that the economy would grow from now
on at that same trend, the accumulated loss of output until 2030, properly discounted, would
represent more than three times the whole output of 2008. The crisis left a permanent
economic loss with broad scars in our societies.
In light of these consequences, regulators embarked on an ambitious international regulatory
reform programme after the crisis, which has mostly concentrated on making the banking
system safer and more resilient. In this respect, significant progress has been made: in the
euro area, banks have materially bolstered their capital positions, with the average common
equity Tier 1 ratio of significant institutions rising to 13% by end-2015 from around 9% in 2012
and 7% in 2008.
To a large extent, challenges and transformations in the banking sector are of a global
dimension, even if I will mostly illustrate it with European data.
The crisis was however not the sole product of banks' behaviour but also of the shadow
banking sector that expanded rapidly in the run-up to the crisis, forming a new market-based
credit system. There are unfortunately different concepts of shadow banking that add to
confusion. One version relates to all credit intermediation done by non-banks; another, more
relevant approach is not based on entities but encompasses all activities of the new
marketbased credit system. This comprises a vast array of financial services, in which banks are also
involved, resulting from the expansion of securitisation; of securities financing transactions
(SFTs), i.e. securities lending and repurchase agreements (repos); of collateral management
and intermediation; and finally, of risk transformation via transactions using derivative swaps ,
from credit default swaps to interest rate or forex swaps. Several of these activities can be
conducted by regulated banks or by less regulated institutions.
These activities became of extreme importance for two reasons.3 First, they contributed to the
creation of a market-based lending system backed by secured short-term market funding. This
is the proper concept of shadow banking or what is also called the new market-based credit
system. Second, these activities originated types of liquidity instruments which are forms of
money not usually counted in the regular monetary aggregates.
5
Several authors4, designate this type of activity as shadow banking. Those features,
especially the expansion of credit assets funded with short term securities (e.g. repos or ABCP)
led to a significant increase in the leverage of the entire finance activity and created chains of
inside liquidity, including by means of re-use of "repo-ed" securities, phenomena which were
at the centre of the financial crisis. The markets for these non-deposit short term financial
liabilities became very large and were crucial for the excessive leverage and the illusion of
abundant liquidity that led to the crisis.
The origins of this new credit system are related to the emergence of very sizeable cash pools
looking for safer places to keep that cash in the short-term than in the form of banks' uninsured
deposits.6 Secured collateral lending and repos as well as risk transformation via swap
derivatives (credit, interest rates and forex) were developed for that purpose. Securities lending
for shorting and generating collateralised levered transactions for asset managers were also
part of the new system. The activities of re-hypothecation and re-use of securities in the repo
market amplified the creation of chains of inside liquidity and high leverage with negative
consequences when haircuts increased and the repo market turned illiquid as the crisis
unfolded.
The international financial regulatory reform has primarily focused on the banking system. It
has not yet dealt with these new activities in an appropriate way.7 One could even say it has
aggravated what Charles Goodhart called the "boundary problem"8, referring to the gap
created between the more regulated part of the system, arguably the banks, and other less
regulated financial institutions. As he argues "If regulation is effective it will constrain the
regulated from achieving their preferred, unrestricted position, often by lowering their
profitability."
A crucial rationale for bank regulation relates to the fact that when they concede credit, banks
create money by creating a corresponding deposit. This activity that is at the centre or our
credit-money system, involves a significant liquidity transformation as deposits are much more
liquid than credits. In a recent book, Mervyn King called this property the "alchemy of banking"9
and many reforms have been proposed to overcome the fragilities created by banking as we
know it. I will examine some of them later.
While not taking in deposits, non-bank entities forming the new financial sector should also be
subject to some new regulations. There is a need to address vulnerabilities created by the
expansion of leveraged assets funded by short-term liabilities that play the same role as
money.
Chart 1 illustrates how banks have been decreasing their importance in the whole financial
system in benefit of other institutions forming the new market-based credit system. In 2008,
total assets of banks in the euro area stood at EUR 33 trillion and declined to EUR 28 trillion
at the end of last year. Meanwhile, assets of Money Market Funds and all other types of
Investment Funds have increased from EUR 5.6 trillion to 11.4 trillion in 2015, moving from
17% to 40% of total bank assets.
The expanded role of capital markets and the market-based credit system with the resulting
shrinkage of the banking sector are not per se negative developments. Diversification and
competition contribute to enhance efficiency and to lower transaction costs in the financing of
the economy. Banks too have welcomed the embryonic initiatives of the EU Commission to
develop a capital markets union in the future. As mentioned previously, banks also participate
in the new forms of financing and the bigger ones are crucially involved in all the activities
linked to capital markets, from the issuance to the distribution of securities and trading. On the
other hand, existing Investment Funds are often part of banking groups. However, despite
adjustments in business models, more traditional banks face accrued challenges.
Today, I will argue that banks are under siege but a successful adaptation to the challenges
they face is key to revive their prospects and their effective contribution to credit intermediation.
After all, one cannot ignore the importance of a stable, profitable and competitive banking
sector for sustainable economic growth, even if it is bound to shrink.
In this lecture, I will first dwell upon the main challenges that banking activity faces in the world
at large. I will then discuss some proposals that aim at a deep reform of the financial system,
in view of the future role of banking. Finally I will focus on the specific challenges confronting
the euro area banking sector, from low profitability to excessive NPLs, overbanking and new
regulations like TLAC and MREL.
2. Banks under siege: general challenges
Beyond increased competition from non-banks, the banking sector faces competition from
Financial Technology (FinTech) firms with other challenges relating to the low interest rate
environment as well as the regulatory measures still to come.
2.1. FinTech threat of unbundling banks
There is a lot of hype around the emergence of new specialised start-up financial firms that
take advantage of digitalisation and big data techniques aimed at unbundling the activities of
banks. This is not foreseeable despite the current excitement. This is because banks will also
adopt the new technologies and will defend their franchise. Furthermore, after crossing some
thresholds, the new forms of finance will eventually start to be regulated due to the same
market failures and externalities (i.e. asymmetry of information, moral hazard, adverse
selection and herd behaviour) that justify regulation in the banking sector.
Having said that, payment services could indeed become a domain where banks may lose
significant market share. Other activities at stake comprise: savings and investment
management over the internet, with robo-advisors that provide algorithm-based portfolio
management services online at a fraction of the costs associated with traditional portfolio
managers and investment advisors; crowdfunding or direct equity funding of projects by
investors gathered mostly over the internet; peer-to-peer lending (P2P) whereby online
services match lenders and borrowers which can be individuals or small businesses; or online
money management advice aggregating all bank and savings accounts of the clients.
Hundreds, if not thousands of start-ups can be found in all of these domains. The whole sector
is nevertheless still quite small. According to a recent study by McKinsey, USD 23 billion of
venture capital and growth equity has been deployed to FinTechs in the five years to 2014,
with around one-half of this total invested in 2014.10 A significant part of this investment was
concentrated in the area of payment services, where banks are facing the biggest challenge
from these new competitors. It is followed by P2P lending, which is the next most developed
activity, funded by hedge funds, institutional investors and sometimes even banks. The first
accidents with bad credits started to emerge recently as big data and smart algorithms can
also fail. As the sector expands, many more episodes will likely occur. Furthermore, if it starts
to cater for regular retail funding it will gradually become regulated as a banking activity.
Nevertheless, intensified competition from FinTech companies represents a potential threat for
banks. If they do not respond effectively to this challenge, this could lead to a loss of market
share and significant reduction in bank revenue. In five major retail banking-businesses
(consumer finance, mortgages, SME lending, retail payments and wealth management),
according with McKinsey, 10 to 40% of revenues and between 20 and 60% of profits will be at
risk by 2025, with consumer finance identified as the most vulnerable.11 In the end, new
competitors will likely capture only a small portion of these businesses, with banks' losses most
likely coming from margin compression.
The new technology of the distributed ledger or blockchain is of a different nature and
represents an opportunity, mostly for banks that have financial capacity to invest in it, and can
establish a wide network of secure, less expensive account transactions and settlements. Even
that will not dispense with some central official role to ensure final settlement and validate the
reputation and qualification of participant institutions in the network. Private money like Bitcoin,
behind the blockchain technology, cannot go far due to lack of confidence. Like many
commercial banks, central banks are also actively studying possible developments in this area
and attentive to their potential role in the future.
2.2. Uncertainty in the finalisation of the regulatory agenda
On the regulatory side, many of the measures deriving from the post-crisis agenda are already
in place: capital requirements were increased, (fully-loaded Basel III requirements are already
met by most banks), a leverage ratio was imposed, new liquidity rules were established.
The Liquidity Coverage Ratio (LCR) which was implemented in the EU in October 2015 aims
to ensure that banks have enough liquid assets to meet liquidity needs over the following
30 days. Moreover, the Net Stable Funding Ratio (NSFR) which will enter into force at a later
stage but is already complied with by most euro area banks will require banks to replace
shortterm with longer term funding, which is generally more costly (because of term premia). The
experience of the crisis has however demonstrated that some trade-off in profitability versus
resilience is well justified.
Importantly, a few remaining initiatives on the regulatory agenda for banks and the non-bank
sector still need to be finalised and implemented. After the revision of capital requirements for
the trading book and the final calibration of the Leverage Ratio, capital requirements will still
be fine-tuned with a full revision of the Standardised Approach as well as some restrictions on
the use of banks' internal models in the Internal Ratings Based (IRB) approach. The Basel
Committee on Banking Supervision (BCBS) and the Governors and Heads of Supervision
(GHOS) have nevertheless communicated that the overall bank capital requirements will not
be significantly increased. A Quantitative Impact Study (QIS) is being conducted for the banks
to report the consequences of the drafted measures and a final decision will be taken in
Autumn, only after these consequences are assessed. The commitment is that there will be
no Basel IV and that Basel III will be concluded by year-end thus providing regulatory certainty
for the future.
Another ongoing discussion that has added to regulatory uncertainty concerns the treatment
of sovereign exposures. This discussion is important and could indeed have a significant
impact on the financial sector. Three principles form the ECB's view on the matter: first, we
agree with the rationale to change the present system, where sovereign exposures are treated
as a risk-free asset; second, the revision should not create undue turbulence in markets, like
the repo market or short-term money markets at large, where sovereign debt is widely used;
third, the regulatory change should be at the level of the international standard, i.e., it should
come out of the BCBS' discussion. This latter principle is also in line with the Five Presidents'
Report and the BCBS is working on the issue.
Also at the international level, an agreement was reached at the end of last year on the Total
Loss Absorbing Capacity, or TLAC, for global systemically important banks (G-SIBs) with a
view to overcoming the "too-big-to-fail" issue and making resolution simpler and more
predictable. TLAC still needs to be implemented in Europe, where the Bank Recovery and
Resolution Directive (BRRD) provides for a similar concept designated as Minimum
Requirement of Eligible Liabilities (MREL) applicable to all banks.
The ongoing MREL regulatory preparations, in parallel with TLAC implementation, will be key
to ensure a consistent approach towards loss absorbing capacity. The way MREL will be
calibrated by the Single Resolution Mechanism will also have an important impact on banks.
The preliminary announcements to the industry and a possible interpretation of the Delegated
Regulation recently published by the EU Commission, has led to estimates of MREL eligible
liabilities by market analysts that would imply new subordinated debt issuance needs in the
order of EUR 560 bn.12 Such high required levels of issuance also stem from the assumption
that existing senior bank bonds that do not have a subordination clause would not be counted
to fulfil MREL. Such a requirement for subordination exists in the TLAC standard but the BRRD
omits the issue and the EU Commission or the Single Resolution Board have not yet clarified
what will be applied in the case of MREL. The whole set of issues related to MREL have to be
addressed with great care, as very high, new requirements of subordinated debt or capital
would not easily be absorbed in present market conditions and would therefore lead to financial
stability concerns. Ultimately, the level of MREL required for a bank should depend on how it
is planned to be resolved. On this matter, let me note that the BRRD sets no direct or automatic
link between determining the MREL level, and the 8% bail-in rule enables the use of the
resolution fund for absorbing losses or to recapitalise a bank. They are separate requirements,
which serve different purposes, and therefore also have different scopes.
2.3. Low interest rate environment
Beyond the structural trends and regulatory developments described earlier, the current low
interest rate environment, at global level, also poses important challenges for the banking
sector. To understand why interest rates are so low, it is useful to refer to the concept of an
equilibrium (or neutral) real interest rate. The importance of this concept is that it provides a
sort of anchor to a monetary economy, implying that monetary policy needs to shadow the real
equilibrium rate in order to meet its price stability mandate. When applying different
modelbased methods to estimate the real equilibrium rate for the euro area, it emerges that, in
comparison to pre-crisis years, estimates of the equilibrium real rate have sharply declined
during the crisis and have continued on a declining trend and are now in negative territory, as
is the case for the U.S. (see Chart 2). If the real equilibrium rate is decreasing then failure of
monetary policy to accompany the downward trend would leave the economy with too high
borrowing costs with respect to the return on investment. In turn, this would discourage
investment and consumption and generate recessionary and deflationary pressures.13
2.4. Regulation of shadow banking and the boundary problem
The regulatory reforms for the banking sector are contributing to a shift of activity and the
emergence of new players in the non-banking space, which in turn is leading to tougher
competition in areas traditionally dominated by banks.
To ensure a level playing field and to contain the emergence of new risks beyond banking, we
need to continue our efforts to establish a comprehensive regulatory framework for non-banks
and market-based activities. In my view, while we have improved our understanding of the
risks in this part of the financial system, there is still significant work ahead of us to overcome
the potential weaknesses in the regulation of entities and activities in this sector. Let me
mention two areas where important efforts are currently underway. First, at the global level,
the Financial Stability Board (FSB) has just published its consultation paper on addressing
structural vulnerabilities in the asset management sector. The paper lays out various
recommendations that aim at strengthening the resilience of asset management and
investment funds. Second, at the EU level, the work of the European Banking Authority (EBA)
on the new prudential regime for investment firms is well under way. This new regime will cover
a significant number of non-bank entities providing investment services. As recommended in
the EBA report of December 2015, the regime is expected to have three tiers, aiming at
introducing risk-sensitivity and proportionality. Systemic bank-like entities are expected to be
subject to the full CRR/CRD IV requirements, and less significant entities subject to less
onerous and more specific requirements.
Another important aspect in dealing with the risk stemming from shadow banking activities
relates to the introduction of macroprudential margins and haircuts in SFTs, including repos,
as well as in OTC Derivatives transactions.14
These tools would reach beyond the banking system and also address the build-up of leverage
and liquidity risks in parts of the financial system, where we have seen rapid growth in recent
years. Macroprudential authorities should have the power to set margins and haircuts. Margins
and haircuts are a determinant of the build-up of leverage via derivatives and SFTs, and are
strongly interlinked with the procyclicality of that leverage. For derivatives, the initial margin
determines the amount of exposure that can be created for a given amount of equity. In turn,
the size of the haircut on SFT collateral, particularly in repos, determines the amount of funding
market players can obtain for a given amount of collateral. In exuberant times, low volatility
and risk-aversion as well as competitive pressure lead to low margins and haircuts, supporting
the build-up of leverage. When the cycle turns, higher volatility and higher risk aversion feed
into higher margins and haircuts, amplifying de-leveraging pressures. As a result, a vicious
cycle can emerge, where higher margins and haircuts force de-leveraging and more sales,
generating a liquidity spiral. That is what Gary Gorton called "the run on repo" in the core of
the recent financial crisis15. The practices of re-use and re-hypothecation of securities also
deserves to be looked into and limited. These practices amplified the expansion of inside
liquidity, creating the liquidity illusion that all individual institutions were well funded which was
proven not true when "the run on repo" unfolded with significantly higher haircuts.
Another important measure to mitigate excessive leverage in the shadow banking sector would
be to introduce prudential leverage ratios. To monitor and impose a limit on both simple and
synthetic leverage ratios, built by the use of derivatives, would be essential. Appropriately, the
monitoring of the two concepts of leverage is included in the FSB proposed policy
recommendations to address structural vulnerabilities from asset management activities.
3. The alchemy of banks, the financial crisis and structural reform proposals
The discussion about the expansion of non-bank banking activities raises the issue whether a
more fundamental reform of the monetary and financial system is necessary to reduce the
probability of financial and banking crises. The essential fragility of banks, and now of the
market-based credit system, is the enormous maturity transformation inherent to their activity,
where the commitment to honour short-term liabilities - either in the form of deposits or
shortterm securities - has to be ensured at all moments.
In the past, the privilege of creating money by taking-in deposits, resulting from the extension
of credit, justified the more intense regulation of banking. However, as explained earlier, other
entities or activities are also now engaged in creating forms of money, increasing the maturity
transformation and leverage of the system while not being regulated as banks. Trying to
contain leverage in the financial system by just putting more demands on banks will not
address the system expanding outside the boundary.
Proposals to address the problem have emerged since the crisis and try to put an end to "the
alchemy of banking", thus eliminating panics and runs either on deposits or on repos and
similar short-term liquidity "promises".
Building on ideas dating back to the 1930s, the proposal of Narrow Banking, sustains that
banks would collect deposits remunerated at very low interest and would only invest in very
safe and short-term assets, such as government treasury bills. Extending credit to firms would
not be permitted, for not being sufficiently safe. Financing of investment would have to come
from capital markets or firms' self-financing.
There is a variety of versions of this proposal, the famous one being the so-called Chicago
Plan, proposed in 1930 by Chicago professor, Irving Fisher and also temporarily supported by
Milton Friedman, whereby a 100% liquid reserve requirement would be applied to all
deposits.16 The principles of Narrow Banking were subsequently adopted by the Positive
Money movement, an international social movement active in 12 countries.
Besides generating a financial system that would not create enough funding for investment
and growth, the approach brought to the present times has the major flaw of not addressing
the "boundary problem" as it addresses only the role of banks.
Another proposal - Limited Purpose Banking - put forward by Laurence Kotlikoff in 201017
would transform all financial institutions into entities fully funded with equity, like mutual or
investment funds. Entities could extend credit but a public institution should be in charge of
validating the respective ratings of those credits. Also in this case, the approach would lead to
insufficient finance for economic development.
An interesting and challenging vision is described in the book The end of banking18 written by
a macroeconomist and an investment banker under a pseudonym. The proposal is not only
the end of banks but also the end of banking activity, defined as the "creation of money out of
credit". It rests on two main elements: new digital technologies and new accounting rules that
would impede the "creation of money out of credit" by any type of firm. In this case, the
boundary problem is explicitly recognised and addressed.
The first element - digitalisation - will allow the unbundling of banks' functions by different
types of firms using digital techniques. The pooling that banks do by collecting small deposits
can be done over the internet; diversification of credits using hard big data to select, scoring,
rating and monitoring borrowers and loans' credit risk, are also made possible by digital
algorithms; maturity transformation and supply of liquidity services can be achieved by offering
market liquidity: custody accounts (not deposits) would offer immediate liquidity by rapidly
selling assets in the market. While not being cash-deposit liquidity, the speed and optimisation
software functions would get very close to it.
Unbundling of these functions is already taking place with FinTech and it will be completed
easily, according to the authors.
However, the new FinTech institutions could still try to do banking by matching liquidity
"promises" with securitised or unsecuritised credit. The second element of the proposal
impedes this by introducing a new legal and accounting concept of insolvency, that the authors
call a systemic solvency rule. A firm would be insolvent if its real assets would become less
than its total liabilities. Financial assets would thus not be counted as real assets. A different
way to enunciate the rule is that a firm would be insolvent whenever its financial assets exceed
its common equity. In this way, financial assets created by credit will have to be funded by
equity and so the alchemy of creating money out of credit could not hold.
The proposal is not much different from Limited Purpose Banking whereby financial firms are
a sort of mutual or investment fund. While financial technology would dispense with any
government intervention, the proposal is not more viable than the Limited Purpose Banking, in
my view.
In his recent book, Mervyn King proposes another approach to the problem of creation of
money or quasi-money through the granting of credit either in the form of loans or the purchase
of securities. In a nutshell, the proposal is as follows: all financial firms' assets when funded by
short-term liabilities would have mandatorily to be reported to the central bank and a haircut
would be negotiated to be applied for the provision of central bank liquidity should a situation
of liquidity stress emerge. The haircuts would be negotiated well in advance of any stressful
situation and the agreed liquidity provision would be extended without any other conditions.
The potential huge extension of central bank liquidity with monetary policy consequences and
the possibility of significant losses to the central bank in a crisis, with rapidly declining asset
valuations, renders the proposal controversial and fraught with difficult practical
implementation problems. It should also be stressed that the proposal, although aware of the
boundary problem, does not eliminate the possibility of creation of money and quasi-money
out of credit. What it does is to eliminate the liquidity crises that are normally the triggers of
financial crises. If and when inside liquidity would fail, outside (central bank) liquidity would be
readily available at a price.
A different approach to the central problem of the vulnerabilities created by the emergence of
a lightly regulated sector creating short-term liabilities is suggested by Morgan Ricks in his
recent book.19
It consists of establishing the legal obligation that all forms of short-term liabilities
created by financial institutions would have to be insured against a fee by an official institution,
similarly to what happens to deposits. This is certainly feasible but although reassuring users
of financial services, the scheme is not so encompassing as the one proposed by Mervyn King
and would not avoid liquidity strains in a crisis or the creation of money out of credit.
In conclusion, this analysis shows that it is difficult, if not impossible, for our economies - so
dependent on credit to invest and grow - to dispense with banking as an activity. Despite being
under siege with great needs of consolidation in the sector, banks are not going to disappear
in the near term.
4. European banking sector: facts and challenges
Let me turn to some of the more specific challenges that euro area banks are facing in the
post-crisis environment. First, I will focus on the low profitability environment banks operate in
and then address the structural challenges related to overcapacity in some banking markets
and the large stock of NPLs. Finally, I will discuss the prospects for bank consolidation and
some aspects of the resolution regime.
4.1. Low profitability
A key challenge for European banks is linked to the prolonged period of low profitability in the
sector. While bank profitability has recovered somewhat recently, it remains at very low levels.
Euro area significant banks' average Return on Equity (ROE) was 5.8% in 2015, remaining
below their cost of capital (estimated to be around 9%). In fact, the negative gap between
banks' ROE and cost of equity has persisted since the 2008 financial crisis despite some
narrowing in this gap recently (see Chart 3).
Furthermore, analysts remain unconvinced of the prospect of a significant recovery in bank
profitability in the near future. This is also reflected in continued low market valuations of euro
area banks. While market scepticism regarding banks' earnings outlook pushed down
priceto-book ratios around the globe (see Chart 4) during the episode of heightened financial market
volatility at the start of 2016, a continuing wedge between euro area and U.S. banks may partly
reflect the greater challenges euro area banks are facing in restoring profitability and adjusting
to a post-crisis intermediation model.
The continued weakness in bank profitability reflects a number of factors, including both
cyclical and structural challenges. A key cyclical challenge is linked to the difficulties in
increasing revenues in a low nominal growth and low interest rate environment and a flat yield
curve. The impact of the low interest environment on margins will vary across banks due to
differences in banks' ability to reprice deposits or in the interest rate sensitivity of their assets
(including, for instance, the relative share of floating vs fixed rate loans). That said, compressed
margins are only one side of the coin as the positive impacts of our monetary policy
accommodation helps offset the pressure on margins - through increased credit volumes,
lower impairment costs, higher capital gains on securities holdings as well as through funding
cost benefits from the TLT