José Manuel González-Páramo: The challenges of the European financial
sector
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at a conference organized by the Spanish National Council of the
Urban Land Institute (ULI), Barcelona, 26 May 2011.
* * *
Ladies and gentlemen:
I. Introduction
It is a privilege for me to participate in this conference organised by the Spanish Council of
the Urban Land Institute, dedicated to the very important topic of the challenges currently
faced by the European banking sector. Many of these challenges are associated with the
ongoing restructuring process of the banking sector and the completion and implementation
of the new European and international regulatory and supervisory framework.
The protracted financial crisis that we have experienced since 2007 has unveiled important
sources of vulnerability in the financial system. These include weaknesses of the regulatory
and supervisory framework of the banking sector, which failed to ensure the safety and
soundness of financial institutions both individually and as a system. This has prompted the
relevant authorities to pursue a number of reforms of the microprudential supervisory and
regulatory framework, while also assigning central banks all over the world macroprudential
tasks in recognition of the importance of the systemic component of financial stability.
In addition, the crisis has shown that the relationship between financial development and
economic growth is not really linear and that, when financial sectors become "too large"
relative to their home economies, risks to financial stability and macroeconomic stability may
arise. Moreover, the crisis has undermined the sustainability of some business models that
were rather widespread among large international banks, while also exposing the
shortcomings of corporate governance and of the evaluation and management of the
different sources of risk within financial institutions.
Given the location of this conference, I should recall that one of the factors that make the
current crisis so challenging and costly is the interaction among its various housing-related
components (housing prices, housing finance and the construction sector). Indeed, we know
that a housing market bust was typically a feature of the costliest systemic crises
experienced over the past century, including the Nordic banking crisis of the early 1990s and
the Japanese financial crisis started in the 1990s. In my intervention, I will try to highlight the
aspects of the current policy and regulatory debate that are most relevant for the housing
sector.
II. Towards a new economic and financial paradigm: The "new normal"
The crisis has affected the macroeconomic and financial environment in which banks
operate. In the aftermath of the crisis, it is very likely that many fundamental elements of our
economies and financial systems will work differently in a number of aspects, reflecting
processes of adjustment in the behaviour of agents and policy-related reforms that are
currently under way. More generally, empirical evidence shows that systemic banking crises
typically affect the structure and dynamics of economic systems over very protracted
periods.1
Before venturing into the future, let me recall the main elements of the pre-crisis economic
and financial paradigm, i.e. the "old normal".

Reduced macroeconomic volatility. Prior to the deterioration of the crisis in October
2008, our economies experienced two decades of significantly reduced
macroeconomic volatility. A number of empirical studies documented a significant
decline in the variability of both economic growth and inflation in almost all major
industrialised economies. Most of the debate among monetary economists focused
at the time on the predominant source of "the Great Moderation" among three main
candidates: (1) better macroeconomic policies, (2) structural changes in the
economies, and (3) less disruptive distributions of shocks ("good luck"). While the
alternative explanations could in theory have different implications for the
sustainability of the decline in macroeconomic volatility, in general few doubts were
expressed about the steadiness of this new state of the world: the "Great
Moderation" was here to stay.

Sustained economic growth. The decline in macroeconomic volatility was also
accompanied by a significant improvement in economic performance as agents
were able to extract the dividends of sustained price stability and reduced
uncertainty about macroeconomic activity. Potential growth in most developed
economies rose, enabling their citizens to benefit from protracted periods of
economic expansion, only infrequently interrupted by relatively moderate
recessions.
 Strong dynamics of house
prices. Sustained economic growth, supported by low
and stable interest rates, contributed to improving expectations about asset prices,
particularly about house prices. Optimistic expectations about housing markets at a
time of: (a) increasing deregulation and liberalisation of the banking and financial
sectors, (b) fast financial innovation, and (c) progressive globalisation of financial
markets, led to rapid appreciation of house prices, which was supported by
excessive indebtedness of households in some countries. The rise in household
indebtedness and house price inflation was particularly significant in those countries
in which the decline in nominal interest rates as a result of the shift to price stability
had been more pronounced and in those that received large immigration flows.

Increased profitability of the financial sector at a time of historically low risk premia.
In the years preceding the crisis, the profitability of banks and other financial
institutions significantly improved as a result of generally favourable economic and
financial conditions. At the same time, it was pointed out that the improvement in
profitability had taken place against a background of: (1) unusually subdued volatility
in financial markets, (2) credit risk premia at historically low levels, (3) very high
valuations of asset prices, and (4) relatively light regulation and supervision in some
countries. Moreover, the improvement in the financial positions of banks had taken
place in an environment characterised by ample market liquidity across a number of
global financial markets, which led to almost no liquidity risk premia being priced in.
As the crisis is still unfolding, we cannot tell with certainly how our economic and financial
systems will function in the future. However, we can safely predict that many of the elements
of the old paradigm will no longer be valid. This will give rise to an
economic and financial
"new normal" in the post-crisis period. Some of the its main elements, that can be sketched
out based on previous experiences of systemic banking crises, are as follows:

Somewhat higher macroeconomic volatility and lower potential growth

Protracted periods of adjustment in housing markets and in the construction sector

More rigorous scrutiny of valuation of property as collateral for credit, also using
making use of independent valuation sources

An upward shift in the pricing of credit and liquidity risk

Stricter regulation in order to strengthen the resilience of the financial sector, though
probably at the cost of making financial intermediation somewhat more expensive
 Evolving role of central banks (stronger inclination towards "leaning against the
wind" policies and the assignment of macroprudential objectives)
Changes in the macroeconomic environment, regulatory and supervisory framework as well
as industry structure may have very significant implications in the way the financial sector
operates in the future. Let me briefly elaborate on some of those implications.
III. The banking sector after the crisis
An important consequence of the financial crisis is the significant transformation which is
taking place in the EU banking sector. The global overhaul of banking regulation and
supervision resulting from the crisis, the demanding macroeconomic environment and the
ongoing deleveraging and banking restructuring in some European countries are key factors
which are shaping the future of the banking industry both in the short- and medium-term.
In the context of the lessons learnt from the crisis and of the regulatory reform, the rest of my
speech will focus on the main aspects of this reform and the developments in the size of
banking sectors, banking business models and corporate governance. I will conclude by
discussing the role of central banks in the new macro-prudential supervisory framework.
III.1 Regulatory and supervisory micro-prudential framework
The crisis has revealed serious gaps in the regulatory and supervisory framework for
financial institutions, both with regard to the prudential rules on capital and those on liquidity.
Several systemically important institutions that seemed to have a solid financial position
before the crisis proved not to be sufficiently resilient to withstand the shocks that have hit
the financial system in the past three years and a half. Consequently, governments and
central banks had to provide an unprecedented amount of support, and in parallel with this
process, several initiatives have also been launched that resulted in a major overhaul of the
regulatory and supervisory framework.
A core element of the regulatory reform was the complete revision of the Basel II framework
(now commonly referred to as Basel III) that has been recently agreed by the members of the
Basel Committee and endorsed by the Group of Central Bank Governors and Heads of
Supervision. The key elements of the new framework include:
(i) a new definition of regulatory capital that will improve both the quality and
consistency of the capital base,
(ii) the introduction of capital conservation buffer requirements that would constitute an
additional layer of protection for banks, especially in periods of excessive credit
growth,
(iii) the strengthening of the risk coverage of the capital framework that would represent
a revision of the prudential rules on securitisation and trading book activities as well
as the counterparty credit risk framework,
(iv) the planned introduction of a non-risk based leverage ratio that would serve as a
supplementary measure to the risk-based requirements to contain the build-up of
excessive leverage and address model risks associated with the risk-based capital
framework, and
liquidity risk framework
(v) the development of a that would aim at improving the
resilience to liquidity shocks of the banks.
The new measures will be introduced over a transition period of 8 years, and have been
calibrated with the aim of avoiding severe implications for the national banking system, while
supporting economic recovery2.
III.2 "Too large" and non-transparent financial sectors?
Turning to the developments in the banking sector, let me recall that the size of the financial
systems dramatically increased during the past few decades both in Europe and in the US.3
To judge whether the financial sector has grown "too large", it is crucial to answer the
question of whether or not the expansion of finance before the crisis was driven by
fundamentals.
On the one hand, it is clear that this process was fuelled by fast economic growth and a rapid
accumulation of savings in emerging markets. On the other hand, developed countries
engaged in rapid innovation in the field of financial products, which allowed the more efficient
channelling of domestic and global savings towards productive investments. The most
striking developments in this respect occurred with credit default swaps (CDSs) and
securitised products. This increase in financial innovation may, in turn, have led to an
inefficient allocation of resources, excessive risk-taking and over-leveraging of the system.
Examples of such resource misallocation include the expansion of the US subprime
mortgage market and of the shadow banking system.
Similarly, while we have always known that financial innovation can contribute to enhancing
risk diversification, it is clear that innovative financial instruments also have the potential to
undermine financial stability. For example, the complexity of new instruments might lead to a
misallocation of capital and risk among market participants. In this respect, the crisis has
exposed the fragilities of the securitisation process, including the misalignment of incentives
among agents participating in the origination and in the distribution, lack of transparency with
regard to the risks underlying securitised products and the inadequate management of the
risks associated with the securitisation business. It is by now evident to everybody that
weaknesses in the business model based on "originate-to-distribute" contributed to the
worsening of loan quality.4
The experience of the crisis also suggests that most investors hugely underestimated the
risks of the most complex financial instruments. This is precisely why there is an increasing
demand for transparency about both the degree of risk of individual instruments and the
2
The impact assessments carried out by the Basel Committee and the Financial Stability Board with relation to
the transitory and long-term effects of the Basel reform package revealed that the costs of financial
intermediation may temporarily rise during the implementation phase (e.g. in terms of increasing spreads,
lower credit volumes and a more moderate GDP growth). However, in the long run, the net positive benefits
are expected to dominate as a result of lower probability of crises to occur.
3
In the euro area, the expansion of banks' balance sheets has been around 400% between 1992 and 2007
(just before the crisis) whereas nominal GDP has increased only 130%. As a result, the ratio of banking sector
total assets to GDP, a measure of the depth of bank intermediation, increased from 145% in 1992 to 331% in
2007. It should be also noted that the reported assets understate the growth of bank activity in that period, as
a lot of it took place off-balance sheet.
4
See, among others, G. Dell'Ariccia, D. Igan and L. Laevan, "Credit Booms and Lending Standards: Evidence
from the Subprime Mortgage Market", IMF Working Paper, No 08/106, IMF, 2008; and A. Maddaloni and
J.-L. Peydro, "Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from Lending
Standards", ECB Working Paper No. 1248, October 2010.
exposures of institutions to different instruments, markets and counterparties. The EU-wide
stress test exercise proved to be an important step toward a more transparent assessment of
the exposures of individual institutions to different instruments and countries. The
forthcoming EU-wide stress test will be more comprehensive and detailed than the previous
exercise, thereby playing an even more important role in supporting banks' access to
medium- and long-term funding.
Going back to the ongoing regulatory reforms, while the overall impact in terms of the size of
the banking sector is expected to be moderate on average, some business lines or
institutions may be relatively more severely affected. Overall, credit institutions that are
smaller and focused on the traditional retail banking business are not expected to be
severely affected by the new prudential rules. However, some large universal banks
(especially those with significant investments in other financial institutions and in insurance
companies, often across borders) will face new challenges, mainly resulting from the new
definition of capital and from the introduction of the leverage ratio.
These large institutions are typically more leveraged than their smaller counterparts and, as
a result of the introduction of certain adjustments in the calculation of the regulatory capital,
their capital bases may need in some cases to be strengthened further in order to include
only high quality resources with true loss absorbing capacity. Given that the structure of the
financial system is rather heterogeneous across EU countries, the national banking sectors
will have to face different challenges in the years ahead.
It is important to emphasise in this context that several policy initiatives have been launched
recently to address the specific risks associated with systemically important financial
institutions (SIFIs). In particular, the Group of Governors and Heads of Supervision agreed in
September 2010 that SIFIs should comply with additional capital requirements over and
above the Basel III minimum requirements.
Extensive work is currently being carried out under the aegis of the Financial Stability Board
to develop a framework for the identification of the SIFIs and the calculation of the additional
capital requirements. Its recommendations will be delivered to the G20 summit in November.
This is an important step forwards towards an international regulatory framework of SIFIs
that ensures consistency and a level playing field across jurisdictions.
In addition, important initiatives are underway - both in Europe and globally - to enhance the
banks resolution regimes so as to be able to handle systemic crises in an effective and
orderly way, while also minimising the burden for taxpayers. In particular, such regimes must
consider the case of institutions that are active across borders.
The FSB is identifying the key elements of effective resolution regimes. At the same time, the
reform of national (or in the case of the EU, supra-national) resolution frameworks is already
underway in the main economies. In Europe, the European Commission has published a
public consultation document on the planned EU framework, for which legislative proposals
are expected in June.
Furthermore, work on how to strengthen the regulation and oversight of the shadow banking
system must continue. The FSB is developing recommendations on this issue in
collaboration with other international standard-setting bodies. It is also vital to identify entities
or activities within the shadow banking system that may be sources of systemic risk.
At the same time, in the short- to medium-term it will be inevitable to improve the cost
efficiency of banks as well as to make changes in the ownership structure and in the
business activities of certain institutional models, while also restructuring some segments of
the national banking sectors. To live under the "new normal", banks must first get there. This
may require consolidation as well as changes in corporate governance, transparency and
business models.
III.3. Business strategies and corporate governance
Business models
The crisis has shown the vulnerabilities of some business models. In particular, it has
exposed the fragilities of those models based, on the one hand, on "originate-to-distribute"
activities and securitisation techniques, and, on the other hand, on excessive dependence on
wholesale and capital markets for funding. Although no business model outperformed the
others during the crisis, there is evidence that banking models based on higher diversification
of activities and funding proved to be the most resilient. This explains why such models are
becoming increasingly attractive within the European banking landscape.
Indeed, diversified business models act as better shock absorbers in times of stress, and
their ability to perform well under stressed conditions represents an additional incentive to
adopting them. In the aftermath of the financial crisis, rating agencies, investors and
counterparties have significantly reduced their tolerance to leverage and now discriminate
more between firms with different risk profiles.
In this regard, the main priority of EU banks in terms of their business strategies in the
postcrisis period is currently to focus on their balance sheet structure (e.g. the composition of
lending and of their funding sources), with a view to making it more robust and transparent.
Furthermore, some banks still remain too dependent on central bank facilities for their
funding, which is not sustainable in the long run. This requires efforts to adjust business
strategies towards more sustainable models. There is some evidence that point to an
increasing recourse to retail deposits among large EU banks. After experiencing a reduction
during the years prior to the crisis, retail deposits started on an upward trend in late 2008,
and such trend has continued into 2009 and 2010. A remaining challenge is though the fact
that at present banks are often competing for the same deposits, which makes it difficult to
achieve substantial increases in their deposit bases and may also erode their margins.
At the same time banks have reviewed the geographical location of their assets. The
increasing internationalisation of important European groups reveals the preference among
large EU banks for regional diversification.
Reforms of the regulatory framework that aim to render bank business models more resilient
are a key factor that will contribute to moving funding structures away from volatile short-term
sources towards more stable long-term ones, such as capital and deposits. As a
consequence of the substantial strengthening of the regulatory requirements on trading book
exposures and on securitisation, the relative attractiveness of traditional investment banking
activities is expected to decline. Similarly, with the envisaged introduction of the non-risk
based leverage ratio, certain institutions specialised in business lines that are traditionally
considered as relatively low-risk (e.g. mortgage lending) may need to reconsider their
activities and look for alternative sources of revenue.
Risk management
Apart from the regulatory initiatives, the banks' internal risk management represents a first
line of defence against increasing risks. The need for improved risk measurement and
management practices with regard to the main risks institutions are exposed to (e.g. credit,
liquidity and market risks) has also been recognised in a number of industry studies that
have identified areas in need of improvement5.
Supervisory authorities have issued guidelines on required improvements in corporate
governance and risk management (in areas such as liquidity and stress testing) and have
also issued supplemental guidance under Pillar 2 (the supervisory review process) of Basel II
that addresses the flaws in risk management practices revealed by the crisis. Although
progress has been made in improving internal risk management systems, considerable work
must yet be done.6
Looking forward, the re-shaped banking strategies need to reflect a better balance between
risk and returns. An important challenge for the EU banking sectors in the next few years will
be to find the optimal level of return that preserves long-run profitability, without incurring in
unknown risks.
There are also several initiatives aiming to improve corporate governance in key segments of
the financial industry. Let me recall in particular the European Commission's proposal of a
directive on credit agreements relating to residential property. The objective of the proposal
is twofold: (1) to create an efficient and competitive single market for consumers, creditors
and credit intermediaries, and (2) to promote financial stability by ensuring that mortgage
credit markets operate in a responsible manner. In addition, the FSB has issued a report
entitled "Thematic Review on Mortgage Underwriting and Origination Practices" aiming to
improved oversight of the residential mortgage market and underwriting practices.
III.4 Central banks and the new macro-prudential supervisory framework
I would like now to provide a brief reference to the new macro-prudential supervisory
framework in Europe.
The financial crisis has provided a vivid illustration of the importance of having in place an
effective framework of macro-prudential surveillance that can complement micro-prudential
supervision both at the national level and in a cross-border context. Thus, in order to
enhance their abilities to assess and address potential systemic risks, over the past few
years significant work has been undertaken by authorities at country, regional and global
levels with the aim of setting up a macro-prudential policy framework. In this respect, a major
achievement at the European level has been the establishment of the European Systemic
Risk Board (ESRB), entrusted with the responsibility of macro-prudential oversight at the
EU-level. The ECB plays a key role by providing the ESRB with a Secretariat, and thereby
logistical, administrative and analytical support.
A key objective of the ESRB is to link systemic risk analysis with appropriate policy
responses. The analytical work will focus on identifying, measuring and assessing the
potential sources of systemic risks on the basis of broad and deep information, and on
applying a wide range of analytical tools to process the relevant data. The work will entail the
assessment of the potential impact of the risks identified and of the ability of the financial
system to withstand the related shocks. On the basis of the outcome of its risk analysis and
assessment, the ESRB may issue concrete and well targeted risk warnings or policy
recommendations.
There is no doubt that the establishment of the ESRB introduces a new function at the EU
level that will enhance the ability of European and national authorities to promote the stability
of the EU financial system as a whole. At the same time, much work needs to be done to
advance in the design and implementation of the macroprudential frameworks. Indeed, unlike
for monetary policy, the framework for macroprudential policy is not yet well developed. In
particular, most of the policy tools that are considered for macro-prudential purposes at this
stage fall under other policy area domains, such as micro-prudential supervision (e.g. capital
and liquidity requirements), monetary policy implementation (e.g. minimum reserve
requirements) and fiscal policy (e.g. tax incentives on mortgage interest rate payments).
The first genuinely macro-prudential tool to have been introduced is the counter-cyclical
capital buffer that will be gradually implemented as part of Basel III. This buffer will be
activated in periods of excessive credit growth, such as the credit booms frequently
originating from or associated with housing price bubbles.
Further prudential tools include the caps on loan-to-value ratios, loan-to-income ratios or
debt servicing-to-income ratios, which are typically applied to mortgage loans. Unlike the
capital or liquidity requirements, these measure act through the demand for loans, as
opposed to their supply by the banking sector. Other measures may include additional capital
requirements by supervisors for individual banks that are considered by authorities to be
particularly exposed to certain types of risks (e.g. concentration risk in housing markets).
Furthermore, intensified supervision, accompanied by specific stress tests may also
contribute to more cautious lending policy by banks.
In addition, enhanced transparency and more efficient communication of risks to customers
(including increased financial literacy) may also support a better-informed decision making in
housing finance and a more cautious behaviour of clients in this field. The experience of
many East European countries over the past decade of widespread borrowing by households
in foreign currencies as remote as the yen for the financing of housing purchases clearly
points to insufficient financial literacy.
Before concluding my speech, let me recall that macroprudential policy is not the only
instrument available to central banks which is being considered in order to prevent and
contain systemic risks. Increasing awareness that: (1) price stability, while being a necessary
precondition, is not sufficient for financial stability, and that (2) in regimes of low and stable
inflation with firmly anchored inflation expectations, ample liquidity conditions and
unsustainable economic expansions seem to manifest themselves first in the build-up of
financial imbalances rather than in immediate inflationary pressures has re-opened the
debate about the opportunity of pursing a "leaning against the wind" approach to monetary
policy.
Leaning against the wind can be defined as a strategy whereby a central bank would decide,
for instance, to set a somewhat tighter monetary policy stance than would be the case under
a similar macroeconomic outlook and more normal financial market conditions in the
absence of concerns about the emergence of an asset price bubble.
This subject deserves a speech on its own, so you will excuse me if I do not elaborate
further. I would like just to point out that at the ECB we believe that our monetary policy
strategy - with its medium-term orientation for the definition of price stability and the explicit
introduction of money- and credit-related considerations into the policy decisions - ensures
that longer-term risks to price stability, which emanate from evolving financial imbalances,
are not overlooked in the assessment of risks to medium-term price stability. At the same
time, the empirical link between monetary developments and evolving imbalances in asset
and credit markets implies that the money pillar can help to detect these imbalances at an
early stage, providing for a timely and forward-looking response to any risks to financial and
macroeconomic stability.
IV. Conclusions
Let me now conclude. The future of the banking sector in the post-crisis macroeconomic and
financial environment is an issue of crucial importance for our economic welfare, given the
fundamental role played by banks in most European countries. This is why it is important to
stress that there is still much work to be done before we can exit from the crisis.
In an economic and financial context which is still fragile, the adjustment towards a "new
normal" continues posing important challenges and needs. It is essential that we continue
making progress in reforming both the microprudential and macroprudential regulatory and
supervisory framework. At the same time, the banking sector must continue addressing with
perseverance, rapidity and determination the vulnerabilities in strategies and business
practices of individual institutions revealed by the crisis. This is the only way in which the
banking sector will become part of the solution to the problems that still represent obstacles
to economic growth and employment creation.