Under the headline ‘Fragmentation, Interconnectedness and Systemic Risk: Opposing Perceptions or Interaction in a supposedly Single Market?’ policy makers, regulators, academics and industry experts discussed the conditions, impediments and challenges for further integration at the Financial Stability Conference 2018.
Financial Stability Conference 2018
31 October 2018
Panel I – Discussion
Fragmentation, Interconnectedness and Systemic Risk: Opposing Perceptions or Interaction in a supposedly Single Market?
with Prof. José Manuel Campa, Global Head of Regulatory Affairs, Banco Santander; Lorenzo Codogno, Visiting Professor, London School of Economics, and Founder, LC Macro Advisors; Dr. Saskia de Vries-van Ewijk, Head of Department International Financial Architecture, De Nederlandsche Bank; Dr. Daniel Hardy, Chief of the Debt and Capital Market Instruments Division, International Monetary Fund; Dr. Steffen Kern, Chief Economist and Head of Risk Analysis, European Securities and Markets Authority; moderated by Prof. Georg Ringe, Professor of Law and Economics, University of Hamburg
Panel I – Discussion
Georg Ringe opened the discussion by introducing the panelists and providing an introductory statement on the implications of market integration in the European banking sector versus financial stability. Following the EU agenda for a more deeply integrated Single Market, the case to be made for integration is that an integrated market stabilises the currency and therefore it entails a momentum of overall market stabilisation. Yet the downside from too much integration across borders is reflected by systemic risks, especially through the channel of contagion, that are still on the rise today. He pointed out that real world obstacles still impede a full economic ideal of integration including a lack of common political institutions behind the common currency as well as an incomplete market and Banking Union due to political impediments.
Against this backdrop Daniel Hardy noted that empirical evidence suggests a reduction of integration in the banking sector compared to before the crisis with large European banks being less interconnected with each other and instead more so with non-Euro area European and North-American banks. In part, this development reflects a general trend away from unsecured inter-bank lending as well as regulatory efforts for banks to have a net stable funding basis and the central bank‘s policy of providing liquidity obviating the need for inter-bank lending. “However, we also find evidence that you can have more integration and interconnection in a safe way on the condition that banks are especially sound and well regulated.” Banks with sufficient capitalisation and less NPLs are more immune against and less likely to transmit external shocks.
Moreover, Daniel Hardy stressed that the European financial system has become considerably less bank centric with other financial institutions such as non-banks, non-insurances and non-pension funds constituting one quarter of the financial sector and generating major growth. Finally, Daniel Hardy acknowledged the importance of integration at the corporate level, since large non-financial corporates are less dependent on banks and conduct more sophisticated treasury operations. Specifically, the development of corporates receiving more funding from other non-banks while lending more among each other is based, inter alia, on the growing importance of knowledge-intensive industries in the private sector. As this process is likely to continue due to innovations and technological progress, the public sector plays the role of advancing the Capital Markets Union and even promoting a diverse investor base and the willingness to invest in new products across Europe.
Subsequently, Saskia de Vries-van Ewijk affirmed that the right balance is crucial in order to achieve the Single Market‘s goal of a more integrated European financial sector minding the risk of jeopardising financial stability. Advantages of integration relate to private risk sharing between Member States, which could mitigate pan-European shocks, and greater diversification might reduce the bank-sovereign nexus. In line with Georg Ringe, potential drawbacks are the risk of contagion along with imbalances and a growing number of “Too Big To Fail” institutions that become increasingly hard to resolve, she noted.
The past crisis demonstrated that having a halfway financial integration without an appropriate institutional setup is very problematic. Banks were “Too Big To Fail”, not properly capitalised and operated on a global level while supervision was still organised nationally. To some degree wholesale funding and other non-sustainable forms of cross-border activities and integration took place. Crisis response included the two directions of, on the one hand, adjusting regulation to the increase in global financial integration in terms of Basel III, G-SIB regulation, TLAC and the European Banking Union. On the other hand, there was a move by banks as well as regulators towards more fragmented markets. “As a result, the European system is far more stable than it was before, but we are still in a somewhat intermediate situation.”
Saskia de Vries-van Ewijk advocated a deeper integration if properly managed, which could improve financial stability due to more private risk sharing. This, however, requires the right balance, firstly between liability and control. This encompasses a complete Banking Union while ensuring effective NPL reduction measures, a reform of the regulatory treatment of sovereign exposures, an effective resolution regime including sufficient buffers for bail-in as well as progress on EDIS. Secondly, it needs the right balance between Europe and the Member States as well as among Member States themselves as to exclude power asymmetries over certain political matters. Finally, a more balanced mix in Europe between bank-based and market-based finance is important.
From a macroeconomic perspective, Lorenzo Codogno considered Europe‘s monetary union to be intrinsically fragile and to stand at a crossroads of either moving towards more integration or in the opposite direction. In his view, the drive for further integration has lost momentum while risks of systemic shocks prevail. The often opposed argument of having joint liabilities should actually help to achieve more control at common EU level and is at the basis of further integration. Although huge progress has been made since the last crisis in terms of governance and institutional framework, both fiscal and monetary policy tools are currently less effective to tackle future problems. At the same time, idiosyncratic risks in the form of Brexit and the situation in Italy are on the rise. As a final wave of the crisis, there is a political counter shock situation. At present, the consequences from an additional economic shock would be harsh and the respective transmission channel would, again, be the banking sector. As in Italy, the doom loop between banks and the sovereign still prevails, not merely due to a large stock of government bonds in banks‘ portfolios, but also because banks are exposed to the overall economic situation. With an idiosyncratic shock to a single country, the banking sector will suffer, affect the real economy and transmit spill-over effects to the rest of Europe.
From a micro level, José Manuel Campa declared that banks benefit from macro-level effects of the still incomplete Banking Union ever since it was announced through lower funding costs across the Euro area. In contrast, micro-level benefits of the Banking Union are less dominant, since there is a lack of cross-border integration and capital flows as well as the ability to move liquidity across borders. The provision of national waivers for liquidity, capital and large exposures are crucial to improve such micro integration. At last, the completion of the Banking Union is needed as a clear signal of confidence of national authorities, such that given a resolution decision at European level, then European instead of national authorities are to pay for it.
Secondly, José Manuel Campa pointed towards a huge amount of excess capacity in the European banking sector varying across countries and which can be explained by a declining role of banking relative to finance as well as prospective lower growth rates and shares. Hence, restructuring of those banks needs to be facilitated especially given their fading profitability, but a lack of willingness to engage and instead a certain degree of complacency can be noted in several jurisdictions. The third and from an investor‘s perspective most important aspect is technological transformation as well as proper access and regulation to it. This does not just concern shadow banking but, going forward, the role of technology in shaping banks and providing banking-like services by alternative new entrants.
Subsequently, Steffen Kern provided a EU regulatory perspective saying that much progress has been made on financial stability in the non-banking sector considering that 50 percent of EU legislative activity in response to the crisis targeted non-banking and merely 25 percent targeted banking. For instance, a regulatory framework exists for the growing issue of asset management providing for a maximum of two times of leverage for regular retail investment funds and restrictions on liquidity and risk management in order to contain any potential risks. Conduct rules and key prudential requirements were established in the hedge fund sector while central counterparties (CCPs), trade repositories and tight regulations on the use of derivatives by banks and institutional investors in the EU exist for the derivatives markets. The regulatory framework for shadow banking is one of the tightest worldwide controlling for securities financing transactions and hedge funds and including a direct supervision of credit rating agencies. With this, a lot has been accomplished even with some remaining regulatory gaps for unknown future risks.
Steffen Kern went on to specify that market integration in Europe is conducive to financial stability by avoiding regulatory arbitrage amongst Member States and gold plating in the application of European laws, which requires greater supervisory convergence. “Rules may be much more aligned these days, but how is it implemented from a supervisory perspective? This is of great concern and a key task for the ESMA.” Going forward, in the light of Brexit, the important project of completing the Capital Markets Union will have to be reassessed in terms of what the Capital Markets Union should look like after a share of up to 80 percent of banking activity has been filtered out of the EU. Hence, Brexit constitutes a key risk regarding both the event itself as well as managing related systemic and contagion risks and resolving UK‘s long-term third country status, Steffen Kern said. Moreover, work remains to be done on managing risks of unforeseen contingencies, against which the CCP recovery and resolution programme is still in the legislative process, and asset management requires greater convergence of liquidity management tools. Within the monitoring framework it is important to predict where the market is moving, especially by means of exploiting regulatory, that is EMIR and derivatives, data. “Finally, it is all about identifying the risks that will cause the next crisis”, Steffen Kern noted.
As a follow-up question Georg Ringe inquired whether transnational crisis responses such as ESMA and other institutions have grown strong enough to endure another crisis. Steffen Kern pointed to the political consensus among Member States that rigid supervision should be and evidently is a national activity. Given the market expertise and proximity to market participants, national authorities are a great asset for supervision. At European level, ESMA‘s direct supervisory powers over trade repositories and credit rating agencies are embedded in a high-end supervisory system. Moreover, ESMA‘s role lies in coordinating and providing supervisory convergence and in bringing different stakeholders around the table to make the most of the existing European supervisory expertise. Turning to Saskia de Vries-van Ewijk, Georg Ringe asked whether there was a risk of more integration without an appropriate institution building at EU-level given the declining enthusiasm for the European project, idiosyncratic risks and fading crisis memories. Saskia de Vries-van Ewijk opposed by saying that in spite of difficulties and a certain degree of complacency by markets and politicians it is time to act towards further integration. This could include progress on EDIS, specifically by moving forward with liquidity sharing while saving loss sharing for later in order to create some positive dynamics.
Resuming Daniel Hardy‘s remark on missing integration, Georg Ringe asked whether this might also be beneficial given the lack of common European institutions and the current trend of de-regulation in Europe and the US. Daniel Hardy reaffirmed that while an over-reliance on wholesale funding constitutes no desirable form of integration, it is about well-integrated business activities and capital being allocated most efficiently across the EU and globally. However, the current environment of low interest rates and ample liquidity will restrain banks towards securitisation of lending as a form of integration, simply because it is not worthwhile. Nonetheless, low capital costs hold the opportunity for banks to build up their bail-inable liabilities according to MREL.
Recognising the need for more control at a centralised level Georg Ringe called into question the respectively needed steps. In response, Lorenzo Codogno mentioned the finalisation of the Banking Union with its missing pieces of a common backstop and EDIS. Secondly, challenging Daniel Hardy‘s suggestion that the perfect time for banks to acquire MREL-bonds is now, he warned that at present Italian banks face higher funding costs than any other Member State given a spread above 300 basis points. He therefore criticised the lack of a level playing field in Europe‘s banking sector. Moreover, the issue of NPLs remains unresolved in Italy and other peripheral Member States. In spite of considerable action to improve the situation, Italian banks suffer from regulatory uncertainty and an adverse attitude of the current government, which announced two thirds of its budget to be deficit financing with a remaining third of taxation on banks and insurances. Another measure currently under discussion by the Italian government is to no longer allows banks to take losses of write-offs in the same fiscal year making the reduction of NPLs all the more difficult. Finally, the problem of a large sovereign bonds stock keeps on feeding into the bank-sovereign doom loop, Lorenzo Codogno concluded.
Reflecting on the shared consent on stronger EU institutions and greater banking integration, Georg Ringe questioned whether too much centralisation across different European financial and market cultures is desirable or if there is a virtue in diversity from a macro perspective. Lorenzo Codogno highlighted the importance of accounting for national specificities in policy design taking the BRRD as an example of a theoretically sound programme, which, however, neither allowed for sufficient transition periods nor considered national preconditions in practice. “The more of a level playing field there is, the better. Otherwise we don‘t take advantage of the Single Market, which is what the economic and monetary union is all about.”
On the issue of diversity, José Manuel Campa critically pointed out that there is a bias against certain banks across different Member States. “A good Italian bank today is considered not as good, just because it is Italian.” Drawing on the contrast between German and Italian banks, he criticised that inherently equivalent institutions are not equally treated. In this respect, Daniel Hardy noted that apart from regulatory efforts one also has to accept market discipline taking its path. Therefore, differentiated funding costs between countries and institutions can reflect the result of market discipline and in turn require banks to reduce their risks and increase profitability.
Referring to the feasibility of taking supervision to a European level as mentioned by Georg Ringe, Steffen Kern highlighted the example of the SSM for establishing a supranational and powerful supervisory framework within a short period of time. Thus, such EU projects are feasible, but hinge on the political will and strength in the EU and among Member States. According to José Manuel Campa, the perception of banks on more capital market integration is generally positive in view of the Capital Markets Union agenda. Integration should go hand in hand with increased risk sharing in the private sector, which previously was channelled through the public sector due to the crisis.
Finally, Georg Ringe turned to Daniel Hardy asking whether technology could help with the right degree of integration and confidence in financial markets as it improves cross-border information flows and facilitates supervisory practices. Daniel Hardy replied that so far banking was all about information asymmetries, which would change profoundly with new information technologies. Uncertainty relates to the issue that technological solutions do not exist in a national vacuum, but have a legal existence in one or another jurisdiction generating spill-over risks. José Manuel Campa stressed that cyber risk constituted the number one risk for financial stability at the moment followed by data management and related financial crime, which supervisors should be considerate of.
In a round of final statements, Steffen Kern identified managing Brexit at exit date and reinventing a considerably reduced capital market with new regulatory and industry prospects as a top EU priority. José Manuel Campa suggested a more pragmatic approach towards completing the Banking Union by taking short-term steps such as micro waivers from capital and liquidity. In addition, Saskia de Vries-van Ewijk summarised the urge for action to effectively treat NPLs, reform the regulatory treatment of sovereign risk and ensure effective resolution. Lorenzo Codogno considered anti-Euro parties as a great political risk in the upcoming European elections, since they might not derail economic and monetary integration, but impede the legislative process. At last, Daniel Hardy stressed appropriate banking resolution including the operational capacity and political determination to intervene early and decisively with the necessary liquidity in place not only in times of crisis. “Good crisis management and resolution is risk reduction.”
Turning to the audience, the first remark from the floor challenged the merit of the much consented cross-border consolidation of European banks, since it would increase the problematic “Too Big To Fail” phenomenon. Saskia de Vries-van Ewijk replied that this entails the question over the type of banks desirable for Europe and whether pan-European mega-banks or rather small regional banks present a reasonable solution. In addition, Steffen Kern emphasised the development of the global financial landscape with growing sizes of American banks, innovative Chinese credit and non-banking institutions.
Another question reiterated the scepticism towards ESMA having sufficient powers to ensure supervisory convergence given that the common rule book is applied inconsistently across countries and governance problems prevail, as Member States oppose to grant additional powers to ESMA, EBA and EIOPA based on national interests. Steffen Kern admitted that supervisory convergence constitutes one of the most difficult tasks. Due to its institutional set-up, ESMA does not impose requirements on national competent authorities, who in turn embody the central governance body themselves and discuss decisions on supervisory convergence. This makes for complicated dynamics, which the European Commission is focussed on solving.
Referring to whether cross-border consolidations might aggravate instead of alleviate the problem of stigmatization attached to banks from less creditworthy countries, Lorenzo Codogno considered the problem not as stigma but simply higher funding costs for banks. With a maverick government like the Italian one at present, the remaining system is left to pay for the consequences, jeopardising the EU level playing field.
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