The second keynote at the Financial Stability Conference 2018 delivered Danièle Nouy, Chair of the Supervisory Board of the European Central Bank. She shared some thoughts on the conference topic of risk reduction versus risk sharing towards the end of her term after a long career in central banking.
Financial Stability Conference 2018
31 October 2018
Keynote II – State of Play
Risk Reduction and Risk Sharing – Two Sides of the Same Coin
Danièle Nouy, Chair of the Supervisory Board, European Central Bank
Danièle Nouy opened her keynote with the common slogan “One money, one market”, which was prominent when the Euro was first discussed. A single currency was seen as a means of supporting the Single Market. But the reverse is also true: A single currency needs support itself, the support of a single financial market. And indeed, once the Euro was introduced, financial markets in the Euro area started to knit more closely together. But the fabric was frail, and when the crisis hit in 2008, it started to tear apart. Markets began to fragment along national borders, showing that more was needed to keep the fabric intact. It became clear that only a strong institutional framework could support the integration of financial markets and the idea of a Banking Union was born. Almost to the day four years ago, supervision of banks at the European level was initiated. This is the first pillar of the Banking Union. The second pillar ensuring the orderly resolution of failing banks at the European level was established in 2016. Over the past four years, European banking supervision has made banks safer and sounder. Moreover, it has deepened the integration of the banking sector, devised harmonised supervisory standards as well as methods and also has helped to harmonise the regulatory framework. All of this has contributed to levelling the playing field for banks, which lies at the core of an integrated market. The European banking supervision has helped to reduce risks in the banking sector, boosted the sector’s resilience and brought it closer together.
Danièle Nouy acknowledged that much has been achieved, but further steps are needed going forward. Firstly, there are things that can be improved still and secondly, what has been achieved so far might prove fragile unless it is further consolidated. She recalled, that the weaknesses revealed by the crisis triggered the Euro area’s journey towards a Banking Union and its decision “to cross the river”. Europe has left national supervision and resolution behind, but it has not yet reached the other side. We are now in the middle of the river and that is not a good place to be when the flood comes, she illustrated. We have to make it safely to the other side, Danièle Nouy highlighted. The goal and vision should be a truly European banking market that is closely integrated, but still comprises different kinds of banks. Such a market would have room for all types of banks that are small and large, specialised and universal, listed as well as mutual and cooperative, she described. After all, no specific type of bank has a monopoly on success. From the beginning of European banking supervision, there were about two dozen banks constantly and consistently outperforming their peers. These banks differ regarding their size, business model, financial structure and country they originate from. The one thing they have in common is that they are able to take the right decisions and implement them, Danièle Nouy underlined. In the words of a supervisor, the boards and the senior management of these banks combine better steering capacity with good execution capacity.
She stressed that striving for a truly European banking sector does not take away diversity, but a diverse European banking sector would be home to all types of banks and serve companies and households across the entire continent. Customers could choose from a wide range of banks, while banks could tap into a large pool of customers. Such a market would offer many benefits, ranging from economies of scale to faster innovation, Danièle Nouy affirmed. And it would offer new ways to deal with old problems, she added.
One of the most serious problems that European banks are facing is a lack of profitability. A number of banks still do not earn their cost of capital and this does not present a sustainable situation, Danièle Nouy said. One path that could provide a way out of this situation is consolidation, and a truly European banking market would make it easier to take this path. As banks could more easily reach across borders, they would have a wider choice of potential partners for mergers. Such cross-border mergers would also create a few large European banks, in other words “European champions”, which could then successfully compete on the global stage, she said. They would be able to support European companies in exporting their goods and services around the world. She stressed that it would not be safe if large European companies had to rely solely on non-European financial actors to meet their investment banking requirements. Hence, the vision is to have a truly European banking market, but it is not there yet. In 2017, 86 percent of Euro area bank lending to firms and households was domestic, which does not represent a particularly integrated market.
Danièle Nouy suggested that there are three main stumbling blocks in the way of a truly European banking sector being the fragmented nature of the regulatory framework, the prevalence of ring-fencing and complacency. Firstly, regarding the regulatory framework there is the issue of national options and discretions as well as 19 different ways in which EU directives are transposed into national law, she pointed out. There are other examples of regulatory fragmentation, one for instance relates to the European framework for crisis management that was set up after the crisis to deal with banks that run into difficulties, she added. Naturally, European banking supervision plays a role here. The question is how European is this “European framework” in reality. The answer suggests that it is much less European than one would expect. There are European institutions such as the Single Resolution Board and the Single Resolution Mechanism framework, but in the process for dealing with a troubled bank, it is only the very first step that is a European one, Danièle Nouy underlined. And that step is deciding whether it is in the public interest to resolve a bank that was declared failing or likely to fail. If the Single Resolution Board decides that it is in the public interest, it will resolve the bank, but it will do so in line with one of the 19 national resolution manuals, she said. This results from the 19 national transpositions of the Bank Resolution and Recovery Directive. She pointed out that the fact that banks from different countries will be resolved in different ways is no genuinely European approach. If the Single Resolution Board decided that it is not in the public interest to resolve the bank, then national authorities will step in liquidating the bank under national bankruptcy laws given that the bank can be liquidated, which in turn cannot be taken for granted, she said.
On top of that, there is also uncertainty regarding bail-ins, which is a key point for investors. More specifically, there is uncertainty about the exact hierarchy of liabilities, which might differ from country to country depending on the national legal arrangements. In the event of a bank failure, investors would face different risks of being bailed in, she noted. Uncertainty has a price, and this price is paid by the banks. Hence, they have to offer higher coupons to investors who buy instruments that contribute to the bank’s total-loss absorbing capacity or minimum requirement for own funds and liabilities, she said. More importantly, the uncertainty created by a fragmented legal framework is likely to trigger overreaction by market participants, thereby reducing the banking sector’s resilience in times of crisis, she added.
Secondly, there is the issue of ring-fencing, which became more prevalent during the last crisis. At that time, it was considered reasonable to fence off national banking sectors, Danièle Nouy recaped. However, such a territorial approach comes at a cost, not only for banks. It harms efficiency across the entire system and an inefficient financial system puts a burden on the economy, she emphasised. Consequently, the fences should be removed, as they are out of place within a Banking Union where the concept of home and host supervisors has disappeared and where the supervisors of the 19 Euro area countries take supervisory decisions together in a single European supervisory board, she said.
Last but not least, another stumbling block is a psychological one and refers to complacency. The crisis has passed and many reforms have been undertaken. While these are great accomplishments, there is no reason for the European project to rest on its laurels, since a lot more needs to be done and the best time to act is while the sun is still shining, said Danièle Nouy. Crises do happen, and it is just a question of time before the next one strikes, but by then it will be too late to prepare. Therefore, the time to act is now, she stressed.
Related efforts and measures relate to regulatory fragmentation and in particular crisis management. One option would be to change the BRRD from a EU directive into a EU regulation to allow it to be applied directly in all Member States. There would then be a single version of the BRRD instead of 19 different ones, she noted. Going even further, Danièle Nouy said that lawmakers should generally rely more on regulations and less on directives. Also at the global level fragmentation remains an issue, which is why further fragmentation of global regulation has to be avoided as well. It is crucial that Europe adheres to what it committed to in international fora, she underlined. Hence, it must faithfully implement the final Basel agreements, such as the fundamental review of the trading book.
Danièle Nouy carried on in saying that as for the issue of ring-fencing, in a Banking Union, there will be even less need to do so once a European back-up for the Single Resolution Fund as well as a European Deposit Insurance Scheme is in place. Already today, supervisors should be able to grant cross-border waivers for solvency, liquidity and large exposures. They should be able to do so whenever it makes sense, and with appropriate conditions attached, she stressed. Liquidity waivers are a case in point, because they already lie in the hands of the supervisors, who can grant them subject to certain conditions. Nonetheless, the supervisors’ power is limited because the large exposure waivers on intra-group lending are in the hands of the national legislators, who have no incentive to authorise them. And this leads back to national options and discretions, she pointed out. The option to set up large exposure limits should be left to the national supervisory authorities, hence to European banking supervision, she said. That might be an easy win with a big impact, as intra-group lending accounted for 70 percent of cross-border lending in the Euro area in 2017. Putting an end to ring-fencing would help to promote a truly European banking market that could better support the European economy, she assured.
Moreover, to bring about a European banking market, requires building the right institutional framework, Danièle Nouy made clear. Some parts of that framework are already in place, such as European banking supervision and resolution. A more harmonised rulebook would also fit in neatly and make the framework more stable. But Danièle Nouy queried that, however, with EDIS, the third pillar of the Banking Union, a major part of the framework is still missing. This element of solidarity is still needed, she said. Almost everyone agrees that the Euro area needs EDIS, but some argue that it should start with a clean slate. The idea is to first reduce risks in the banking sector before starting to share them. The question is when the risks are low enough, and Danièle Nouy suggested that risks have been reduced enough for EDIS to start. Now is the right time to set it up and to consider some solidarity. And in the end, it’s not just about sharing risks through a common deposit insurance. It is also about enjoying the benefits of a single jurisdiction that will more than make up for the money that might have to be spent through EDIS, she underlined.
At the same time, a degree of solidarity will make the next crisis less costly, such that the “European bill” is likely to be much smaller. And it is just not realistic to assume that a “European bill” can be avoided by postponing institutional solidarity, Danièle Nouy stressed. There were many crises in which countries were not able to handle their problems on their own and in the end Europe still had to pick up the bill, which was, however, higher and probably much higher than it would have been if some solidarity agreements had been put in place upfront, she said.
Finally, according to Danièle Nouy, liability and control have to be aligned. When it comes to banking supervision, control now lies at the European level, but it is still the national deposit insurances that would have to bear the costs of a crisis. Introducing EDIS would restore the balance between liability and control by placing both dimensions at the European level, she said. Besides risk sharing through deposit insurance, a major feature of any integrated market is that it supports many positive risk sharing channels. Banks could further develop cross-border lending, and investors could further invest in shares of foreign companies, for instance. This would help to diffuse shocks that hit one country or region and make the market more stable, she pointed out. On this aspect, Europe still needs to catch up, as by comparison with the US, risk sharing through such channels is still quite limited. The European Capital Markets Union is thus another important project.
To sum up, Danièle Nouy highlighted two things. Firstly, European countries need to strike a balance between sharing some of each other’s risks and enjoying the benefits of a single jurisdiction, that is a truly European banking market able to reliably serve the economy. Secondly, speed is important, since the biggest risk for Europe may be doing too little too late. This would not only make another crisis more likely, it would also make it more costly. Reasonable, well-designed and timely solidarity, on the other hand, is not only likely to reduce the costs of crises. In good times, it will also increase the benefits of a union, she underlined. At last, “One money, one market” will actually entail a stable currency paired with a stable and efficient market.
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