09 November 2016

ECB's Praet: Monetary policy and the euro area banking system

Peter Praet, Member of the Executive Board of the ECB, explains that the struggles of banks are not innocuous from a monetary policy perspective given their integral role for monetary policy transmission and macroeconomic performance more generally.

A resilient banking system is crucial to provide for a smooth transmission of monetary policy in response to cyclical fluctuations and to support economic performance over a longer-term horizon. And, indeed, since the onset of crisis, euro area banks have made important progress in strengthening their financial resilience.

At the same time, this newfound resilience will come under pressure if the current slump in bank profitability were to persist going forward.

The prevailing low interest rate environment is one factor that dampens profitability prospects. But, since the ongoing recovery remains strongly reliant on continued monetary accommodation in the context of a declining natural rate, the constellation of very low interest rates will probably prevail for an extended period of time.

Against this background, the European Central Bank (ECB) will continue monitoring the implications of its monetary policy measures on the position and prospects of the banking system. The analytical underpinnings of the ECB’s strategy, which have granted a prominent role to the bank-based transmission mechanism in the context of our monetary pillar, are well-suited for this task.

At the same time, many other factors, relating to legacy and structural problems, are holding down bank profitability. Hence a durable improvement in the prospects of the euro area banking system requires further efforts outside the realm of monetary policy. These include, notably, the swift and thorough completion of banking union. Additional adjustment in the banking sector towards greater cost efficiency and business models that remain viable in the new regulatory and macroeconomic environment is also needed.

For some parts of the banking system, these adjustment needs have arisen because of regulation discouraging unsustainable pre-crisis business models that were highly reliant on aggressive leverage and maturity transformation, regulatory arbitrage (in particular via off-balance sheet activities), and a lack of transparency and due diligence in the origination of financial products. In others, the adjustment needs reflect structural challenges and over-capacity. In both cases revenue sources will have to be augmented by more sustainable business models that are consistent with the new policy environment.

Beyond the banking sector, policy needs to pave the way for a more dynamic recovery and – even more importantly – a more favourable end-point of that recovery. For the crisis has not just led to an underutilisation of economic capacity, but has also reduced the pace at which economic capacity itself expands – its potential growth. Pre-crisis, the potential growth rate in the euro area, on average, amounted to almost 2% per annum; after the crisis, this growth rate roughly halved.

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