Vítor Constâncio: Banking Union and the European crisis
Opening remarks by Mr Vítor Constâncio, Vice-President of the European Central Bank, at
the 6th Santander International Banking Conference, Madrid, 5 November 2013.
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Ladies and gentlemen,
Thank you for inviting me to speak today at the Santander International Banking Conference
that has become over the years a very relevant event.
A window of opportunity is currently open for the banking sector in Europe. We have the
possibility to change how the banking sector serves the economy; to implement adequate
regulation and ensure its stability and efficiency; and with banking union, to reform how
banks are supervised and resolved. If we make the most of this opportunity, we can put the
banking sector on a sounder footing for a generation. We therefore face a profound
responsibility as policymakers to get these changes right.
Today's conference includes many expert speakers who will go into detail on the on-going
reforms of the banking sector. I would therefore like to use my remarks today to recall why
the Single Supervisory Mechanism (SSM) was the necessary response to the crisis and how
the design of the SSM is addressing some of the weaknesses in the initial architecture of
EMU.
The point I will emphasise is that one of the main drivers of the crisis was private imbalances
financed by banks in both core and peripheral countries. For this reason, one of the most
important lessons we can take from the crisis is the importance of building a genuine banking
union.
The crisis narrative
Indeed, the importance of banking union is related with the role of the banking sector in the
development of the European economic crisis.
As you know, there are many explanations for the crisis: some observers like to focus on
unsound fiscal policies and excessive sovereign debt; others on competitiveness losses
engineered by uncontrolled unit labour costs; and others still see the crisis more as a
traditional balance of payments crisis in a "fully fixed" exchange rate regime.
But there is one narrative that connects these explanations and it is oldest narrative of the
crisis. It states there was essentially nothing wrong with the initial design of EMU, and the
crisis resulted mostly from the fact that several peripheral countries did not respect that
design - in particular the fiscal rules of the Stability and Growth Pact (SGP). In this story, the
root of the crisis lays mostly with fiscal indiscipline in an over-heating economy. This led to
wage and price increases, which implied a loss of competitiveness, which in turn led to the
balance of payment crises.
This narrative is internally coherent, but in my view it exaggerates the role of fiscal policies as
an initial cause of the crisis.
To begin with, it does not seem that fiscal soundness, as measured by compliance with the
SGP, is particularly correlated with later developments in the crisis. Germany and France did
not respect the Pact in 2003-4, while Spain and Ireland respected it more or less fully until
2007. Indeed, Spain was running a budget surplus before the crisis.
Neither does it seem that fiscal policies played a primary role in driving the economic cycle
before the crisis. There was no uniform rise in government debt ratio in the euro area before
the crisis, and in several countries debt-to-GDP ratios actually fell. In Spain, for instance, the
public debt ratio fell from 62% of GDP to 36% from 1999-2007 and in Ireland from 47% to
25%.
The more important factor driving the economic imbalances up to 2007 was the increasing
private financial deficits - or put differently, rising private debt levels financed by the banking
sectors of both core and peripheral countries.
Contrary to public debt ratios to GDP, private debt was increasing much more rapidly in all
peripheral countries before the crisis. In Portugal the private debt ratio to GDP increased by
49% from 1999 to 2008, in Spain by 75%, in Ireland by 101% and in Greece by 217%. To
fund this expansion of private debt, cross-border lending between euro area banks increased
significantly, encouraged by the absence of exchange rate risks after the introduction of the
euro. The exposures of banks from core to peripheral countries more than quintupled
between 1999 and 2008.
These developments largely explain the evolution of fiscal, current account and
competitiveness positions before the crisis. As a significant part of the credit growth was
being financed from abroad, countries built up large capital account surpluses and
corresponding large current account deficits as the mirror image. The mechanism that
connected these financial and real trade flows was the loss of competitiveness - that is, an
appreciation of the real exchange rate caused by economic over-heating.
As this audience knows well, all these developments later implied major problems in the
financial sector in peripheral countries when the cycle turned. On the asset side, loan quality
deteriorated, while on the liability side, those loans could no longer be funded from abroad. It
was only at this point, due to the economic downturn and the need to backstop banks, that
sovereign debt began its steep rise and became a driver of the crisis in itself.
Drawing the right lessons for the euro area
In emphasising this private debt-focused narrative for this crisis, my aim is not to negate the
importance of fiscal policies. Fiscal policies certainly should not have been pro-cyclical, and
fiscal discipline today is essential to ensure sustainable debt levels in the future. My aim is
rather to ensure that we recognise the central role played by the financial sector in the crisis
and so draw the right lessons for the future.
The most important such lesson is that the euro area needs stronger governance of financial
policies - an ability to identify and curb cross-border financial flows and hence prevent
debtdriven imbalances. The decentralised system of supervision we had before the crisis, based
on loose cooperation between national supervisors, simply did not permit this.
It is therefore misleading to say that the crisis was solely the result of periphery countries
living beyond their means as a matter of policy. The authorities had to respect the single
market rules and could not contain alone the large capital inflows that were fueling the
imbalances. Indeed, with a national approach to supervision, the forces driving financial
developments lay largely outside the legal capabilities of national supervisors.
In saying this, I do not deny that supervisors were also too slow to react, due in part to a
belief in self-regulating markets. Yet had they tried to contain these financial inflows, it is
questionable whether they could have done so successfully.
The conclusion I draw is as follows: to have an integrated financial market and overall
stability there cannot be purely national supervision. Instead, there has to be supervision at
level of the market - that is, at the European level.
Let me therefore turn to the Single Supervisory Mechanism.
The benefits of the Single Supervisory Mechanism
The SSM, which will formally take over supervision in November next year, is being designed
to solve the "financial trilemma"1 created by national supervision - that is, to support financial
integration and maintain financial stability by moving supervision to the European level. It will
address both the institutional and macro-prudential limitations that supervisors faced before
the crisis.
Starting with the institutional limitations, the key innovation of the SSM is that it creates
genuinely European supervision, by which I mean supervision on both core and peripheral
banks. From November next year, every bank in Europe will be part of the same system.
This puts supervisors in a better position to prevent boom-bust cycles caused by excessive
cross-border lending - and if they fail to do so, there will be collective responsibility for that
failure.
In line with the subsidiarity principle, European supervision will involve centralised and
decentralised elements. For the big significant banks (around 130), the ECB will be the direct
responsible supervisor, but supervision will take place at both the European and national
levels. We will integrate these levels by setting up Joint Supervisory Teams (JST) for each
significant bank.
Let me use the example of Santander to illustrate how this will work.
For the parts of the banking group resident within the SSM, there will be a core supervisory
team comprising of staff from both the ECB and the national competent authorities (NCAs) in
the countries where Santander is active - that is 9 within the euro area. Within this team
there will be a national coordinator for each country, drawn from the respective NCA, and an
overall coordinator, who will be an ECB staff member. The national coordinators will manage
the permanent experts working at the national level, while the ECB coordinator will ensure
quality and take responsibility for output sent to the Supervisory Board.
In this way, the expertise in the NCAs will be fully utilised, while final decisions will rest with
the ECB - in keeping with the objective to have a European approach to supervision.
For less significant smaller banks, the balance will be tipped more towards decentralisation.
The responsible supervisor will remain the national authority. However, banks will still be
integrated into the single system of the SSM. They will be supervised according to a single
supervisory model that we are currently developing, which will be approved by the future
Supervisory Board, and the ECB has the legal right to take over direct supervision of any
bank at any moment.
Turning to the macro-prudential limitations, the SSM will create new possibilities to make use
of macro-prudential policies to curb pro-cyclicality in credit supply and volatility in
crossborder flows. It will introduce two important changes to macro-prudential policy-making at the
European level.
The first change is related to instruments. As part of the Capital Requirements Directive
IV/Capital Requirements Regulation, the SSM will gain a series of new macro-prudential
powers. These include, among others, the counter-cyclical capital buffer, the systemic risk
buffer and the macro-prudential elements from Pillar 2. These instruments are designed to
help cool credit-led booms and/or provide additional buffers in downturns to mitigate credit
crunches.
There is some scepticism in academic circles as to the effectiveness of these tools, but a
recent study on the Spanish experience with dynamic provisioning suggests we should be
more optimistic. It finds that the buffers created by dynamic provisioning somewhat
contracted credit availability in good times and helped expand it in bad times. The reason
these provisions were insufficient to stop the credit boom was that they needed to be applied
more evenly and aggressively.2
The second change is related to decision-making. As a European decision-maker, the SSM
will be able, if needed, to apply prudential measures to banks in both borrowing and lending
countries. This is important because, to the extent that macro-prudential measures mitigate
credit booms by raising banks' cost of equity, this effect can be offset if there are large
inflows from abroad that lower banks' cost of debt. Indeed, one can suppose that this was an
additional reason that dynamic provisioning in Spain was not enough to avert the credit boom
and the housing bubble.
The ECB's comprehensive assessment of the main European banks
Taken together, I am confident that these institutional and macro-prudential changes will help
strengthen financial governance in the euro area. We will have the right supervisory powers
at the right level of action - the European level. Before we start actually our supervisory
tasks we will conduct a comprehensive assessment of the significant banks in the euro area.
This assessment will consist of three elements. First, a supervisory risk assessment which
will identify the key risks in banks' balance sheet; second, a point-in-time Asset Quality
Review (AQR) to enhance transparency over asset quality, provisioning and capital; and
third, a stress test to examine the resilience of banks' balance sheet to stressed scenarios.
The assessment will conclude with a single disclosure of the outcomes, which will be
published before the ECB assumes its supervisory role in November 2014.
As the ECB has recently released a communication about this exercise, I will not go into
more detail on its features today. Let me however stress that the exercise will be rigorous
and transparent and will involve private expert firms, such as external auditors, consultants
and specialised asset evaluators. Their presence, together with the announced "strong
central governance structure", will enhance the credibility of the exercise.
National Supervisors and private firms involved in the assessment will work within the terms
of a detailed framework defined by the ECB and their final output will be subject to a central
review to assess their quality and analyse their consistency across banks and countries.
We of course do not know what the assessment will find. But we trust that the euro area
banks are today better prepared to undergo such an exercise. They are much stronger than
in recent years. They have significantly strengthened their capital positions and now compare
reasonably well with US banks in that respect.
In terms of risk-weighted assets, the median Core Tier 1 ratio of the largest euro area banks
currently stands at 12.7%, above their American counterparts. The majority of significant
euro area banks already comply with the minimum capital requirements of the fully
implemented Basel III framework.
In terms of leverage - as measured by the ratio of equity over total assets - EU banks may
at first sight appear to have lower ratios than their US peers, but as FDIC Vice Chairman
Thomas Hoenig has showed, if the same accounting standards are applied then the median
of the leverage ratios of large EU and US banks are quite similar.
In terms of absolute nominal size, if we look at the 20 largest banks in the EU and the US,
the EU banks now have a capital level approximately 100 billion dollars larger.
Where euro area banks do not compare so favourably with their US peers, however, is in
their low profitability and fragile investor confidence. Investors seem to be uncertain whether
banks have proper asset valuations and are adequately provisioned. But this is precisely the
issue the comprehensive assessment should address - it is an exercise in removing
uncertainty by giving investors all the facts.
I said some time ago that markets had an excessive negative perception of European banks.
In fact, euro area bank share prices, as well as price-to-book ratios, have been rising in
recent months in part in anticipation of the assessment. This would suggest that investors
expect the clarity provided by the exercise to be clearly positive for the euro area banking
sector.
Regarding the response to the exercise, if some capital shortfalls are revealed, the private
sector is today in a position to play a major part in filling them. This is more feasible than in
recent years given the improvement in market conditions.
Indeed, since last year banks have been improving the robustness of their balance sheets by
increasing capital and provisions in anticipation of our comprehensive assessment. In this
sense, the exercise is already producing results - and it indicates the willingness of banks to
resolve existing problems within the sector itself.
In the same vein, given the number and size of European banks, there is scope for some
consolidation within the banking sector without reinforcing the so-called "too-big-to-fail"
problem. Our recent "Banking Structures Report" shows that this trend is already ongoing in
Europe. Nevertheless, as a last resort, confirming the existence of public backstops is
important to reassure all stakeholders of the credibility of the whole assessment exercise.
Conclusion
Let me conclude.
Although various explanations exist for the crisis, I am pleased that what I view as one of its
important lessons is now being learned. This lesson is that a single financial market with a
single currency needs a single system of supervision - and alongside this, a Single
European Resolution Mechanism (SRM).
The SRM is an essential component of banking union. It helps break the bank-sovereign
nexus by allowing banks to be resolved at the European level with minimum use of taxpayer
funds. And it adds credibility to the European supervisor by providing reassurance that banks
can be resolved in an orderly and efficient manner without creating financial instability -
especially large cross-border banks.
With the development of banking union, we are creating the conditions for a more stable
financial sector in the future and a better functioning monetary union. But we also need a
banking sector that takes responsibility. As supervisors, we expect the banks to be better
capitalised and less leveraged, more stable and efficient, to perform their indispensable role
in financing the economy and supporting the on-going, fragile economic recovery.
Because the crisis of the European economy is not over. It is true that modest growth has
returned in the last six months and that countries under stress have gone through a painful
but successful adjustment, reducing their deficits, correcting their initial loss of
competitiveness in terms of unit labour costs and even achieving external accounts
surpluses. At the same time, the recession has been deep and has left unprecedented and
unacceptably high unemployment. Until economic growth is able to significantly reduce
unemployment, the authorities should not become complacent in their efforts to continue the
structural and institutional reforms essential to overcome the crisis.
It is clear that for the successful completion of the rebalancing process Europe needs more
investment and higher domestic demand growth. We therefore need a more coordinated
approach to macroeconomic policy at the euro area level to achieve higher demand growth,
as well as the continuation of structural reforms in all member countries in order to increase
growth and facilitate a more encompassing rebalancing process.
At the same time, to support national structural reforms in stressed countries, the enactment
of the announced contractual programmes with financial means to support their
implementation should play a significant role.
Finally, it would be important if a future decision could be reached to implement at the euro
area level what is referred in the President Van Rompuy's Report "Towards a genuine
Economic and Monetary Union" as "....the establishment of a fiscal capacity to facilitate
adjustment to economic shocks. This could take the form of an insurance-type mechanism
between euro area countries to buffer large country-specific economic shocks. Such a
function would ensure a form of fiscal solidarity exercised over economic cycles, improving
the resilience of the euro area as a whole and reducing the financial and output costs
associated with macroeconomic adjustments".
In the view of the President Van Rompuy's Report, a stable EMU needs to be built on four
pillars: financial union, fiscal union, economic union and political union.
Member States have been able to decide a remarkable sequence of reforms in the past few
years and there is now a much clearer vision of what rules and institutions are essential for
monetary union to function more effectively. The single currency needs strong common
institutions. Strong institutions to supervise and stabilise the financial market; to guide fiscal
policies; to coordinate economic policy, guarantee competitiveness and encourage
sustainable growth.
This is the vision that should guide us in all our endeavours to definitely overcome the
European crisis.
Thank you for your attention.