12 August 2020

SSM blog: “Consolidation can secure safe and sound banks”

ECB Banking Supervision recently published a draft guide on the supervisory approach to bank consolidation. Why should the European banking sector consolidate? Edouard Fernandez-Bollo outlines the ECB’s supervisory expectations for mergers and acquisitions...

Edouard Fernandez-Bollo, ECB representative to the Supervisory Board, outlines the ECB’s supervisory expectations for mergers and acquisitions, which are aimed at ensuring that consolidation increases resilience in the banking system.

ECB Banking Supervision recently published a draft guide on the supervisory approach to bank consolidation. Why should the European banking sector consolidate?

Euro area banks have been struggling to earn their cost of equity for quite a while. I think that Europe missed an opportunity to clean up its banking sector via consolidation after the great financial crisis of 2008. Over a decade later, we have a situation where weak banks are dragging on instead of exiting the market. This puts pressure on margins for other banks and, in turn, on the overall capacity of the banking system to continue lending to serve the real economy through the cycle.

Consolidation is one way to facilitate an exit from the market. It can help Europe’s banks to boost their profitability by achieving economies of scale and becoming more cost-efficient. Bigger banks would also have more resources to invest in digital transformation, which is more or less a prerequisite for remaining competitive in these times. When business combinations are well designed and well executed, they can contribute to the overall financial soundness of the banking system.

More consolidation will eventually create fewer but bigger banks. How can we avoid the emergence of banks that are “too big to fail”?

Consolidation does not always result in banks of an unmanageable size. It can actually be a means to secure a safe and sound bank, through the impact it has on business model sustainability.

In any case, the supervisor’s role is not to actively promote or avoid any form of bank consolidation. Instead, we focus on ensuring that new entities resulting from business combinations have sustainable business models, comply with regulatory and supervisory requirements and have sound governance and risk management arrangements in place.

We also cooperate closely with the relevant national supervisors and financial stability authorities, including the Single Resolution Board, which monitors euro area banks’ resolvability – i.e. their capacity to fail in a safe and orderly fashion – and has the power to remove impediments to this.

How will you calculate the capital requirements for banks that result from mergers?

We will start with the weighted averages of the banks’ Pillar 2 requirements (P2R) and Pillar 2 guidance (P2G) before consolidation. Then, depending on the situation, we can adjust these upwards or downwards. For example, if the merged bank fails to make sufficient improvements to its risk profile or if the merger involves unmitigated significant execution risks, we can increase the levels of P2R and P2G. We might lower the levels if the merged bank demonstrates that it has improved its risk profile or made its business model more resilient. For example, it might have achieved greater diversification by combining its credit portfolios or it might have cut costs related to funding, back-office functions, IT and other shared services.

In the draft guide, you clarify ECB Banking Supervision’s approach to badwill. What exactly is badwill in this context, and how do you intend to deal with it?

Badwill is an intangible asset gained when a bank purchases another bank for less than its fair-valued assets and liabilities. While we recognise duly verified accounting badwill, we expect merged banks to use it effectively to improve their business model sustainability, for example by increasing provisions for non-performing loans, when relevant, or helping to absorb transaction costs or integration costs.

We therefore expect merged banks not to distribute any profits from badwill to their shareholders until sustainable business models have been firmly established.

What approach will you take to the use of internal models by merged banks?

We will allow a merged bank to continue using the internal models that were in place before the merger, but only for a limited period of time. In the meantime, it will need to provide us with a credible internal models roll-out plan that addresses any internal model-related issues created through the merger. We may also impose other conditions if appropriate.

Taking this approach means we avoid the unnecessary supervisory burden that would be created if the merged bank were to temporarily revert to the standardised approach, which would lead to volatility in its risk-weighted assets and a reduction in its risk sensitivity.

Do you look at the impact of a merger on the rest of the banking sector? What should banks do if they are considering a merger?

We don’t assess whether mergers are beneficial as such. This needs to be decided by market participants. Our task is to make sure that the resulting entity complies with regulatory and supervisory requirements and effectively manages its risks.

We encourage any banks that are considering a merger to get in touch with us as soon as possible, preferably before publicly informing market participants. If the banks provide us with sufficient information, we will be able to give them preliminary feedback on the project – including whether or not it will require approval via a formal decision – so they can adjust it if necessary and further develop their plan. Sufficient information includes the merger’s key characteristics and a credible integration plan.

How can consolidation help Europe to withstand the challenges of the coming decades?

Consolidation can reduce the challenge of market exits in the European banking sector. This promotes healthy competition. At the same time, consolidation can help banks to reap the economies of scale of a single banking market and lower marginal costs owing to digital technologies. This benefits both consumers and bank profitability.

Europe needs efficient banks. Efficiency allows capital to be built up quickly, be it through retaining earnings or by attracting outside equity. Efficient banks are more resilient banks. And at the moment we are seeing how important it is to have a financial system that can act as a shock absorber rather than as a shock amplifier.

Efficient banks are also able to finance transformations of the broader economy – and these are sure to come. Take climate change, for example. The transition to a low-carbon economy will mean leaving no stone unturned and we will need financing commensurate with the scope of the challenge.

No matter what the future has in store, we will be better equipped to deal with it when our banks are efficient and resilient. Consolidation, when properly planned and executed, can play an important role here.

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