Erkki Liikanen: Europe without banks? The future of financial sector
Keynote speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the Alpbach
Financial Market Symposium, Alpbach, Austria, 28 August 2014.
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Introduction
I thank the organizers for assigning me such a thought-provoking title. For a start, to me it is
clear that we continue to need banks also in the future - especially in Europe, where the role
of banks in financing households and SMEs is crucial and important also for other
enterprises.
However, we have needed and we need a change. We have just experienced and are still
recovering from the biggest financial crisis of our generation. The social costs of the financial
crisis have been enormous: the losses in the GDP and the increases in unemployment have
been very high. If policymakers, in central banks and in governments, had not learned from
the policy mistakes made during the Depression in the 1930s, the crisis could have been
even more destructive.
To avoid such crises in the future, we need a more stable and resilient banking and financial
system in Europe. To that end, we need better regulation and supervision of banks and other
financial institutions. Well-designed regulation would provide banks with the right incentives
to choose their business model, scope, and size efficiently to best serve the society.
Before the crisis, financial regulation was too lax and the supervision of financial institutions
too fragmented. Many important steps have been taken or are being discussed to repair the
regulatory and supervisory framework, some of which I shortly discuss in my remarks.
Some observers have argued that the new regulation has gone too far. I disagree. It is a key
responsibility of our generation to make the financial system much safer than it has been. To
be sure, we do not need to return to the repressive regulation of the post-war period. But we
do need to find a better balance between rules and flexibility in regulation than we have had.
The rest of this speech is organised as follows. First, I discuss what the European financial
system looked like before the crisis. Then I discuss what it should look like in the future.
Finally, I provide some suggestions on how we can get there.
What the European financial system looked like?
As convincingly argued in the recent report by the Advisory Scientific Committee of the
European Systemic Risk Board, over the past 20-25 years banking systems in Europe have
become, too leveraged, too concentrated, and sometimes also too big. Hence they created a
major risk for the stability of the European financial system.
Let me present some evidence provided by the ESRB. First, consider the amount of lending.
In the 1950 ́s, bank loans to the domestic private sector as a proportion to the domestic GDP
were almost equal in Europe, US and Japan, at about 25 per cent. In 2010, the figure for
Europe was well over 100 per cent of the GDP, while that in Japan was about 90% and in the
US only close to 50%.1
Second, European banks' balance sheets have ballooned. The total assets of the EU
banking sector were over three times the EU GDP in 2013. In several EU countries, the ratio
is much bigger. The Japanese banking sector is more than half of the relative size of the
European banking sector, but the US banking sector is only a quarter of the size of its
European counterpart.
Third, the European banking system has also become more concentrated. Since 2000, the
share of the three largest domestic banks of the national banking system total assets - the
so-called C3 ratio - has increased in all major EU countries except Italy. (In Finland, of which
I am the most familiar with, the C3 ratio is close to 90%, one of the highest figures in the EU.)
Fourth, European banks dramatically increased their leverage before the crisis. For example,
as documented by the ESRB, in the late 1990's the median equity to assets ratio of the
largest 20 listed banks in the EU was around 6%. By 2008, this median level was only just
over 3%. Because of the deficiencies of the Basel II capital rules, banks were able to halve
their equity ratios without any increase in their risk-weighted regulatory capital requirements.
The increases in bank sizes and bank lending have not been matched by an equivalent
increase in market-based funding. For example, the ratios of stock market capitalisation to
bank credit have decreased considerably in the 2000s in the biggest EU countries, much
more so than in the US. As a result, the European financial structure has become even more
bank-based than before.
The large reliance of European firms - especially the SMEs - on bank finance has recently
been a drag on the recovery of the European economy as banks ́ ability to lend has been
weak in many EU countries in the aftermath of the crises.
It is now obvious that many of the developments in the European banking since the 1990's
sew the seeds of the banking and sovereign debt crisis:
- Too-big-to-fail and too-big-to-save problems became more severe;
- Banks misallocated too much funds in asset markets fostering unsustainable
bubbles;
- Weakly capitalised banks ́ resilience to shocks became poorer;
- Increased concentration of the banking system made banks more interdependent
and vulnerable to contagion.
Some recent research suggests that a banking sector beyond size may also be harmful to a
long-term economic growth. There are several potential reasons for that:
- An overexpansion of banking may lead to a misallocation of financial capital towards
housing loans and away from corporate lending.
- The overexpansion may also lead to a misallocation of human capital as an
excessive share of talented individuals is employed in the financial industry rather
than elsewhere in the economy. Financial sector needs talent individuals, so do the
other sectors.
- Larger banking systems tend to experience more severe financial crisis.
What the European financial system should look like?
Given the developments in the European banking and financial markets over past 20 years
and given the legacy of the crisis, the policymakers face both short and longer-term
challenges in financial market policies.
In the short-term, we must find ways to boost bank lending especially to SMEs to invigorate
economic growth in Europe. The most recent results of the ECB ́s quarterly euro area Bank
Lending Survey are encouraging in that respect: for the first time in seven years, euro area
banks reported a net easing in credit standards in loans to enterprises in the second quarter
of 2014. Despite that, banks ́ credit supply is clearly insufficient in many European countries.
Another short-term concern is the sorry state of the European securitisation markets: public
issuances in the European ABS markets remain low, trading is thin in some market
segments and the whole market carries a stigma in spite of the fact that most European
structured finance products performed well throughout the crisis.
In the short-term, we need to stimulate ABS markets to stimulate credit creation. In the
longer-term the revitalisation of ABS markets would, among things, (i) allow better risk
sharing among investors (ii) help banks to diversify their funding structure thus increasing
their resilience, and (iii) make firms less reliant on bank finance.
In the longer term, we need to reverse the unwelcome trends in banking documented by the
ESRB. We need a banking system that is better capitalised, less concentrated, less
procyclical, and relatively smaller than it is today. Thus, we need a financial structure in
which financial markets play a larger role than today in allocating funds to final customers.
How to get there?
As you are well aware, we are in the process of implementing a comprehensive supervisory
and regulatory reform to make the European financial system safer. We are likely to discuss
many of these reforms in this panel.
In these remarks, let me focus only on some of the most recent policy developments and
initiatives.
Concerning short-term challenges, the Governing Council of the ECB decided in June to
carry out targeted longer-term refinancing operations (TLTROs) in the coming months. The
aim of these operations is to enhance the functioning of the monetary policy transmission by
supporting lending to the euro area non-financial private sector, excluding loans to
households for house purchase. The Governing Council has also intensified preparatory
work related to outright purchases of asset-backed securities.
The ECB, together with the Bank of England, also published a short issues paper in April and
a longer Discussion Paper in June to foster discussion on how to build a better functioning
securitisation market in the European Union. In particular, these two central banks suggest
that authorities should create standards for the so-called high-quality securitisations to
identify low-risk ABS products that are simple, robust and transparent.
Concerning regulatory reforms, let me have a few words on the state of the reform of banking
structures.
The Expert Group that I chaired saw the need to simplify the structure of large and complex
banks to shield the deposit-taking bank from an excessive risk-taking in trading activity, to
facilitate monitoring and supervision of these banks and to make the recovery and resolution
measures easier to impose. At the same time, we wanted to preserve the universal banking
model that, by and large, has well served the European economy.
Given these starting points, we proposed a mandatory separation of a deposit entity and a
trading entity within a banking group. Based on this recommendation, the European
Commission presented its proposal for the Regulation on structural measures January this
year. The objectives of the Commission ́s proposal are similar to ours. However, the
Commission ́s proposal leaves more discretion to the authorities concerning the separation
process. In addition, the Commission ́s proposal includes an outright ban on organised
proprietary trading as in the Volcker reform.
I welcome the Commission ́s proposal and I am pleased that the Council working group has
been negotiating of the proposal throughout the summer. Of course, more progress will be
made in the autumn, when the new Commission and Parliament start their work.
Concluding remarks
Banks play an important role in the economy as the key financiers of households and
companies, among other tasks. Banks ́ role is especially important in Europe, as they are by
far the most important source of finance for small and medium-sized enterprises.
One of the principal aims of the ongoing regulatory reforms and other policy actions is to
enhance the ability of the financial sector to provide loans and other financial services
efficiently and without compromising financial stability. Being successful in these aims would
improve the long-term growth prospects of the European economy and thus the welfare of
European citizens.
Banks ́ reputation and the public confidence towards banks have suffered badly since the
financial crisis. That has harmed not only banks but also the wider economy. We must
rebuild the confidence on financial institutions and financial markets. The regulatory reforms
advance that aim. I strongly believe that the ongoing reforms will benefit us all - the citizens,
the wider economy, but also the financial institutions.