Luis de Guindos: Euro area banking sector - current challenges
Keynote speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the
Annual General Meeting of the Foreign Bankers' Association, Amsterdam, 15 November 2018.
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Introduction
It is my pleasure to speak to you here in Amsterdam. Today, I will focus my remarks on the state
of the euro area banking sector and its current challenges.
I will first look back and take stock of the developments since the financial crisis. Much has been
done in the past ten years to enhance the resilience of the euro area banking sector. But as
welcome as these developments have been, under many metrics euro area banks are still
underperforming relative to their international peers. It is therefore reasonable to discuss the key
challenges that the sector is currently facing.
As I will explain, some of these challenges still relate to the legacy of the crisis. Equally
importantly, however, some are linked to the fragmentation of the euro area banking sector,
which acts as a drag on its operational efficiency and profitability.
While it is up to the banks themselves to address many of the issues surrounding these
challenges, I am convinced that policymakers also have an important role to play in reducing
fragmentation in Europe. So I will finish with some remarks on the policy action needed to
remove obstacles to the further integration of financial markets in Europe.
The euro area banking sector - developments since the financial crisis
Let me start with a brief recap on what has already been done to heal the fault lines that
appeared at the outbreak of the global financial crisis. The financial health of euro area banks has
improved markedly since the beginning of the crisis. The aggregate core capital (Common Equity
Tier 1) ratio of euro area banks stood at around 14% at the end of the second quarter of 2018,
the double of what is was in 2007. Regulatory liquidity ratios are at solid levels, with an aggregate
liquidity coverage ratio of 141%. European banks are also making progress in fulfilling the
minimum requirements for own funds and eligible liabilities (MREL).
One indicator of this is that the volume of Additional Tier 1 bonds and Tier 2 instruments issued
by euro area banks and held by investors in the euro area increased by two-thirds between 2013
and 2017. Finally, banks are also making progress in repairing their balance sheets - the
aggregate non-performing loan (NPL) ratio has nearly halved from its 2013 peak of around 8%, to
its current level of 4.4%.
The recently published results of the 2018 stress tests reflect exactly this. On average, core
capital of euro area banks after stress stood at 9.9%, up from 8.8% in the same exercise two
years ago. Underlying the results is the strong build-up of capital buffers in recent years resulting
in a better condition at the starting point of the exercise (end 2017).
I would however like to note that, while the adverse scenario was generally more adverse for
European economies than in the 2016 exercise, it did not capture events which have become
prominent through the course of the year, notably developments in emerging markets and
sovereign spreads. Taking these into account would add on to overall capital depletion.
While euro area banks are clearly better capitalised and more resilient, this exercise should not
hide the fact that areas of vulnerability remain. In particular, banks are still struggling to achieve
sustainable profitability. Admittedly, headline profitability figures show that the sector seems to be
improving rapidly - the average return on equity for euro area banks increased from 3.4% in 2016
to 6.9% in the second quarter of 2018. However, more careful analysis reveals that this
improvement is mainly due to a reduction in the cost of credit risk. This results, in part, from a
cyclical upswing that has stemmed the flow of new NPLs and led to provisioning costs falling to
post-crisis lows. At the same time, operating profits have remained modest overall and the
average cost-to-income ratio flat at 66% over the same period, reflecting some cyclical and
structural challenges.
Through the lens of the stock market, the outlook for bank profitability remains clouded,
confirming that these challenges are material. Euro area banks' average price-to-book ratios of
0.8, are still about half of those of their US peers, which stand around 1.6. But these
price-tobook ratios vary widely between countries and between individual banks in the euro area. This
variation is bound to arise from cyclical factors, but it also stems from differences in the progress
made by banks in tackling structural issues.
Challenges to bank profitability
Let us take a closer look at these cyclical and structural challenges to bank profitability.
On the cyclical front, banks are finding it hard to increase their revenue in the low interest rate
environment. Although credit growth has increased somewhat with the improving economic
conditions, it is not yet sufficient to compensate for the low interest rate margins. The continued
economic recovery should, however, reduce the negative impact of cyclical factors over time, as
banks' balance sheets adjust.
But most importantly, a number of structural challenges continue to dampen bank profitability.
These factors vary across countries and banks and include incomplete business model
adjustments, cost inefficiencies and excess capacity. The stock of NPLs also remains high at
some banks. Let me elaborate on each of these issues in turn.
Starting with the issue of business model adjustment, our analysis shows that, in the past,
diversified banks have been more successful in generating higher revenues from net fees and
commissions and trading when faced with pressure on interest income. This is perhaps no
surprise, as banks engaging in custodian, asset management or investment banking activities
are likely to be better able to gear themselves towards fee-generating activities, whereas
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commercial banks may not have access to such opportunities for diversification.
At the same time, one has to acknowledge that it is not only the low yield environment and lack of
income diversification that is challenging banks' business models. The rapid pace of
technological advances and the ensuing change in the competitive landscape are both a key
strategic opportunity and a challenge for banks. For example, a shift from branch networks
towards digital banking has enabled many banks, notably in the Nordic countries, to reduce costs
while maintaining sound customer bases and market shares. But clearly, a successful
transformation is likely to hinge on the support of beneficial structural factors such as labour
laws, how the market is structured and the digital readiness of the economy. Policy action may
thus have a role in supporting these conditions. Incumbent banks also need to be prepared for
the increasing competition from the non-bank financial sector and "Fintech", fuelled by the
increasing role of technology in financial services. Increased competition in lending, investments
and payments is bound to increase pressure on retail banking revenues. It will subject deposits
to more intense price competition, and may erode revenues related to overdrafts and payments.
Adjustments to business models are closely linked to the second challenge: the need to improve
cost efficiency. I already mentioned that digitalisation can enable substantial cost savings.
However, on aggregate, euro area banks have so far been unable to meaningfully reduce
operating costs in the aftermath of the financial crisis. In fact, euro area significant institutions'
operating expenses have increased by over 5%, on aggregate, since 2010, despite a 3% decline
in total assets over the period and the extensive restructuring efforts that have taken place in
many banks.
Third, regarding the legacy of NPLs we first need to acknowledge that significant progress has
been made. On average, NPL stocks are being reduced fairly quickly, particularly in countries
with the highest levels of NPLs.
Still, the burden remains heavy for a number of banks. Reduction plans for these banks look
ambitious for the coming years, but it is how they are implemented that will make the difference.
At the same time, the ongoing policy initiatives designed to address this issue and prevent a
similar build-up in the future are essential.
If these structural challenges are only resolved slowly, the outlook for the euro area banking
sector will hinge on cyclical developments and their impact on banks' operational environment. It
is thus interesting to look at the broader financial stability challenges for banks over the next
couple of years. Despite some positive recent trends, the risk environment has become more
challenging for the euro area financial system in many ways.
On the positive side, the growing economy and the ever more resilient banking sector are
supporting financial stability. This is partly why the financial system has recently proved resilient
to volatility, and why contagion across countries and markets has remained limited.
But these developments need to be put into the context of the continuing search for yield in the
markets, rising trade protectionism, and political and policy uncertainty, which increase risks to
financial stability.
Taking these factors together, the euro area financial sector is faced with risks, which can be
classified in three categories.
First, the factors that are related to the past, in other words, the legacy of the crisis, include a
still-significant private and public debt overhang. And as I just said, the banking sector is still
dealing with the challenges posed by the quality of its legacy assets.
Second, the current expansion of the US is now significantly longer than historical norms and the
second longest in US modern history. Looking ahead, a down-turn in the US macro-financial
cycle could trigger a correction in markets in particular for riskier asset classes. Furthermore,
tensions have grown in emerging market economies on the back of a stronger US dollar and
increased trade frictions. These developments may undermine global growth prospects and
ultimately lead to abrupt increases in risk premia. So far, however, we continue to observe high
risk-taking by market participants searching for yield in the low interest rate environment, a
symptom of which is increasing asset prices.
Third, in Europe, debt sustainability concerns have risen both in the public and private sector. As
regards public finances, Italy is the most prominent case at the moment in light of the overall debt
level and the political tensions around the Italian government's budget plans. Contagion to other
European sovereigns has however been limited.
Against this background, the risk of an abrupt rebound in risk premia remains high, and could be
further exacerbated by low market liquidity if market-making capacity evaporates. Developments
in the non-bank financial sector also require monitoring, as the sector continues to become
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larger, more interconnected and more exposed to risks.
Having said this, I would still like to stress that we currently see no indication of excessive credit
growth or broad-based asset price misalignments, in other words the types of developments that
have preceded previous financial crises. However, increasing asset prices in some sectors,
such as residential and commercial real estate in some euro area countries, do warrant close
monitoring, also following up on warnings issued by the European Systemic Risk Board (ESRB)
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and an ECB statement on this topic.
In sum, there is no reason to be complacent about financial stability risks in the banking sector,
which could materialise in a number of ways. At the current opportune moment with 22
consecutive quarters of economic growth behind us, minds should be concentrated on tackling
structural impediments to sustained profitability in the euro area banking sector.
Financial integration in the euro area banking sector
Let me now turn to financial integration. The economic benefits of an increase in cross-border
banking activities are unquestionable. These include higher diversification of risks, which can
improve resilience and lead to better risk-sharing across countries. To date, cross-border activity
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in the banking sector remains fairly limited in the euro area. Banking sector integration also
matters for the good functioning of the monetary union, as it fosters the smooth transmission of
monetary policy throughout the euro area economy.
Despite these benefits, progress in banking market integration in Europe has been slow,
particularly in retail banking. For example, in 2017 cross-border loans amounted to only 8.6% of
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total loans to firms and a negligible 0.9% of loans to households.
It is true that cultural, legal and language barriers may make it difficult to directly provide
crossborder banking services. Increased consolidation across countries may be the more realistic
way to make the single banking market more integrated. Banking union will also help address the
financial stability concerns surrounding resolvability, moral hazard and cross-border contagion
that are related to large cross-border banks.
But so far, banking union has not induced a wave of cross-border mergers. In fact, M&A activity
in the euro area banking sector, and especially across borders, has been declining since 2000,
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especially in the aftermath of the crisis. The overall value of M&A transactions declined from an
average of €51 billion in 2000-06 to less than €5 billion in 2017. Of this amount, cross-border
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euro area transactions accounted for 17% in 2017 compared with 21% in 2000-06.
Given the economic benefits of further consolidation in the euro area banking market, we should
pause for a moment to consider what is stopping us from reaping these benefits. There are
certain structural challenges that still need tackling. For example, some banks' high levels of
NPLs may reduce their attractiveness as potential targets, and therefore also deter consolidation.
This is another reason why resolving the NPL problem is of the utmost importance.
But financial integration may also be hampered by regulatory obstacles that hinder the free flow
of capital and the liquidity of banking groups. These obstacles often relate to regulatory
fragmentation and the ring-fencing of national markets. They could be addressed by further
harmonisation, combined with appropriate prudential safeguards to address possible financial
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stability concerns. Let me give you a few examples.
First, on the free flow of capital. Unfortunately, in the ongoing review of the Capital Requirements
Regulation, Member States have not agreed to introduce cross-border capital waivers within the
European Union. This is a missed opportunity, as such waivers would be consistent with the
establishment of the Single Supervisory Mechanism and the banking union. The potential
financial stability concerns raised by their proposed introduction could have been addressed by
making the waivers subject to additional prudential safeguards and transition arrangements that
would accommodate the planned future development of the banking union.
Second, on the free flow of liquidity. In theory, the existing legal framework already allows for
cross-border liquidity waivers within the EU. Unfortunately, the remaining national options and
discretions in the EU regulatory framework hamper the practical application of such waivers. For
example, the national large exposure limits on intragroup exposures that are currently in place in
several European countries prevent banks from transferring liquidity flexibly within the group. We
need further harmonisation to address such practical obstacles, also given that the regulation
already contains appropriate prudential safeguards for applying liquidity waivers.
Third, banking union as a single jurisdiction. In coherence with the current common supervision
and resolution mechanisms, the international regulatory framework should treat the banking
union as a single geographical area for the purpose of calculating capital surcharges of global
systemically important banks.
Banking union and the benefits of more integration
The banking union is key to reaping the benefits of cross-border banking activities in the
monetary union. But while we have made significant progress, the banking union is not yet
complete.
We still need a backstop for the Single Resolution Fund (SRF) to underpin its credibility, and a
common fully mutualised European deposit insurance scheme - EDIS. While discussions are
progressing on the SRF backstop, the negotiations on EDIS have stalled.
That is unfortunate, as both elements would improve financial stability in the euro area by
increasing confidence and reducing the likelihood and cost of a bank failure. With EDIS, this
would mainly happen via three channels. First, depositors would trust that their deposits are safe,
regardless of the location of the bank in question. This would help break the link between banks
and sovereigns. Second, pooling resources at the banking union level would enhance the
banking sector's resilience to shocks. Some argue that this would lead to unwarranted
systematic transfers between banking sectors. However, banks' contributions to the deposit
insurance fund can be designed to reflect their relative riskiness, in terms of NPLs or sovereign
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exposures, for example. Third, EDIS would remove the current misalignment whereby
supervision and resolution have been elevated to the European level, while depositor protection
remains a national task.
But it's not all about the banking union. We need to continue making progress with other
important initiatives to work towards a more complete financial union. The capital markets union
is another element that will foster cross-border financial integration. In the past, banks and capital
markets were sometimes seen as competing with each other for limited investment
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opportunities. Some even went further - seeing capital markets as a threat to traditional
banking models. However, banks and capital markets can complement each other in financing
the real economy. Seen in this way, the banking union and the capital markets union are not
mutually exclusive projects; they are, in fact, mutually reinforcing and can bring the Single Market
for financial services to the next level. This is particularly important in the light of the United
Kingdom's departure from the EU and the importance of London as a centre for capital market
services.
The synergies between the banking union and the capital markets union can be looked at from
two angles. On the one hand, the banking union supports the capital markets union by increasing
the resilience of banks, which in turn supports the development of capital markets. On the other
hand, the synergies also run in the opposite direction, as the capital markets union supports the
banking union. More integrated and jointly regulated capital markets would support cross-border
activities and the resilience of banks.
Let me be more specific.
In an integrated capital market, banks would no longer need to develop local expertise for each
national market. They could exploit economies of scale more easily by offering similar or even
the same products and services in several countries. By operating in a larger, more integrated
market, they would likely increase their cross-border holdings of assets and be able to build
larger and more diversified collateral pools for securitised products and covered bonds.
Cross-border assets would contribute to reducing the sovereign-bank nexus. And banks could
also benefit from a larger investor base for funding.
Conclusion
Let me conclude. Although we can see that the resilience of the euro area banking sector has
improved considerably since the financial crisis, the lingering structural challenges and the
financial stability outlook mean there is no room for complacency. It is important to tackle the
remaining structural issues that are preventing the financial union from reaching its full potential.
First, banks need to adjust their business models to further diversify their income and reduce
cost inefficiencies. They should also prepare for the challenges of digitalisation and competition
from technology companies. And it is of the utmost importance that the large stocks of NPLs that
still remain in some banks are reduced.
And second, policymakers need to maintain the momentum towards completing the financial
union. Undue regulatory obstacles to cross-border banking sector consolidation need to be
removed. Banking union needs to be completed with a backstop for the SRF and a credible
EDIS. Finally, we need to complete the capital markets union and take advantage of the
synergies between the two unions.
The work that banks and policymakers need to do will not be easy. But we should not be daunted
by the task ahead. We should take things one step at a time, making sure that we are always
making progress.
Thank you.
1
See European Central Bank (2016), "Adapting bank business models: financial stability implications of greater
reliance on fee and commission income", Financial Stability Review, November, pp. 147-157.
2
See de Guindos, L. (2018), "Coming to the forefront: the rising role of the investment fund sector for financial
stability in the euro area", Speech at Opening Conference, 21st Euro Finance Week, Frankfurt am Main, 12
November.
3
See the Governing Council statement on Macroprudential Policies, December 2016, and the ESRB warnings,
September 2016.
4
See ECB (2018), Financial integration in Europe, May. For more information on the benefits of cross-border
consolidation, see Hartmann, P. et al. (2017), "Cross-border bank consolidation in the euro area", Financial
Integration in Europe, May, pp. 41-64.
5
See ECB (2018), op. cit.
6
See ECB (2017), Report on financial structures, October.
7
See, for example, Chart 2.8 in ECB (2017), ibid., updated with ECB calculations based on Dealogic data.
8
See also Draghi, M. (2018), "The Benefits of European Supervision", speech at the ACPR Conference on
Financial Supervision, Paris, 18 September; and Praet, P. (2018), "Creating an enabling environment for
panEuropean banks in the Banking Union", remarks at the Eurofi Financial Forum 2018, Vienna, 5 September.
9
See Carmassi, J., Dobkowitz, S., Evrard, J., Parisi, L., Silva, A. and Wedow, M. (2018), "Completing the Banking
Union with a European Deposit Insurance Scheme: who is afraid of cross-subsidisation?", Occasional Paper
Series, No 208, ECB, April.
See Allen, F. and Gale, D. (1997), "Financial Markets, Intermediaries, and Intertemporal Smoothing", Journal of
Political Economy, Vol. 105, No 3, pp. 523-46; and Boot, A. and Thakor, A. V. (2000), "Can Relationship Banking
Survive Competition?", The Journal of Finance, Vol. 55, No 2, pp. 679-713 .