16 May 2019

Ignazio Visco: The economic and financial outlook of the euro area -halfway down "the long and winding road"

The Governor of the Bank of Italy said "that the most immediate steps should be: completing the banking union, rethinking the management of banking crises, and establishing a well-functioning capital markets union."

The financial sector: progress and open issues

In the euro area banks' capital position has strengthened considerably. Between mid-2015 and end-2018 the capital (CET1) ratio of the so-called "significant institutions" - those under the direct supervision of the ECB, which account for around 80 per cent of the area's banking assets - increased from 12.7 to 14.3 per cent. For the entire Italian banking system it stands at 13.3 per cent.

In Italy the stronger capital position of banks has been accompanied by a substantial improvement in the quality of their assets, mainly thanks to large disposals of non-performing loans (NPLs). The deterioration in credit quality recorded during the global financial crisis and the European sovereign debt crisis was due for the most part (about 90 per cent according to our estimates) to the negative developments in the macroeconomic outlook. As of end-2018 the ratio of NPLs, net of provisions, to total loans had fallen to 4.3 per cent, more than halving with respect to mid-2015, when it had reached 10 per cent; in the same period, the value of net NPLs diminished from almost €200 billion to €90 billion. According to the plans requested from all banks by the supervisory authorities - the ECB for the significant institutions and the Bank of Italy for the others - the net NPL ratio should decline further, to around 3 per cent at the end of 2021.

Notwithstanding significant progress in Italy and in the rest of the euro area, much remains to be done. Four areas require special attention: banks' profitability, where intermediaries need to tackle the difficult challenges posed by technology; the appropriate treatment of risks on the asset side of banks' balance sheets; the management of higher funding costs (and the need to satisfy the new requirements on "bail-inable" liabilities); and the framework for managing banking crises, which has turned out to be rather complex in recent years.

Profitability. Despite recent improvements, the profitability of European banks remains weak: the average return on equity (around 6 per cent for the major intermediaries) is barely in line with the cost of equity in the euro area (and is somewhat lower in Germany and in Italy). The reasons are not only those related to the weak economic outlook.

Indeed, in Europe the role of banks in financing the economy has been diminishing for over a decade, making it difficult to increase revenues by expanding credit volumes. The transition towards a more market-based financial system is necessary in a modern economy. In this respect, in the euro area non-financial companies continue to be excessively dependent on bank credit. The ratio of bank loans to total financial debts is 36 per cent in the euro area (56 per cent in Italy), against 33 and 27 per cent in the United States and the United Kingdom. By contrast, the share of bonds is still about 10 percentage points lower than in the United Kingdom and 30 points less than in the United States. The market capitalisation of listed non-financial companies is also insufficient: at end-2017 it stood at 25 per cent of GDP in Italy and 60 per cent in Germany, against around 125 per cent in the United States.

In order to raise profitability banks must contain costs, diversify the sources of income, and find ways to significantly raise efficiency levels. The changes that are currently taking place in the financial sector pose novel challenges, but also provide fresh opportunities for well-managed financial intermediaries, among which banks can certainly be included. FinTech and Big Tech companies are offering new financial services and exploiting innovative technologies and massive amounts of data. Banks are responding by expanding the range of products provided through digital channels. It is a process that is bound to continue, as more intensive use of new technologies is necessary to compete effectively in the market and achieve adequate levels of profitability.

Risks on the assets side. We can draw a number of lessons from Italy's double-dip recession and the consequences for its banking system of both the global financial crisis and the sovereign debt crisis. The first lesson concerns the treatment of impaired assets, an area where Italy's experience has been especially important. Following the large-scale disposals of bad loans completed in recent years, in Italy more than half of banks' total NPLs currently consist in exposures to firms whose difficulties may prove to be temporary (loans defined as "unlikely to pay"). Their management should aim at maximising the probability that these loans become performing again. On the one hand, significant benefits could be obtained if non-financial firms, where necessary with the collaboration of banks, resorted to specialised operators such as "turnaround funds", able to provide the knowledge and resources to relaunch impaired enterprises. On the other hand, supervisory and regulatory authorities should consider how best to support these strategies, including through the adoption of new specific measures.

The current European regulation on minimum coverage of new NPLs, for instance, imposes increasing provisions on loans based only on the time that has elapsed since their classification as non-performing (known as "calendar provisioning") and distinguishes only between guaranteed and non-guaranteed loans. The difference between bad and unlikely-to-pay loans is instead overlooked. There is therefore the risk of creating perverse incentives for banks to hold fire sales or liquidate NPLs, amplifying losses for both the banks and their customers and discouraging an active management of the credit relationship. This is an area in which regulation could be improved.

Another lesson regards the debate that has intensified in the aftermath of the sovereign debt crisis about the so-called "bank-sovereign nexus" (or "doom loop").

Some have proposed that the prudential treatment of banks' sovereign exposures be made more restrictive. These recommendations are built on the premise that a capital requirement or the assignment of a risk charge would break the link between banks and the State. But this link goes well beyond the holding of sovereign bonds. Indeed, it is the real economy that provides the most important connection: a restructuring of the public debt, for example, might be so disruptive that firms and households could be swept away by it, damaging the entire banking system regardless of its capitalisation or its holdings of government bonds. These proposals, moreover, overlook the stabilising role that banks, by acting as contrarian investors, can play on bond markets in periods of tension.

For these reasons, after almost three years of work and intensive discussions, at end-2017 the Basel Committee decided to maintain the current regulation.

The reduction in sovereign risk must ultimately come from sound government policy, as it cannot be obtained by simply shifting sovereign bonds from the balance sheet of one economic sector to that of another. This requires not only balanced and prudent fiscal policies but, most importantly, structural reforms aimed at regaining sustained GDP growth. The latter, in turn, would help make loans to households and firms more attractive, and reduce the share of government debt in banks' balance sheets.

While there has been a heated debate about NPLs and sovereign bond holdings, much less attention has been paid on the risks deriving from the stock of illiquid and opaque assets in banks' balance sheets, including the instruments classified as Level 2 and Level 3 assets in the fair value hierarchy. These risks are not easy to measure, but available estimates put them broadly on a par with those associated with NPLs. The Single Supervisory Mechanism has recently adopted some initiatives aimed at defining the most appropriate interventions to take adequate account of these risks. These efforts must be intensified.

The increase in the cost of funding is the third area that should not be neglected. In the coming years all large banks will have to raise a significant amount of "bail-inable" liabilities in order to fulfil the new global and European regulation on total loss-absorbing capacity (TLAC) and the minimum requirement for own funds and eligible liabilities (MREL). Raising funds may indeed pose a difficult challenge. Regulators and supervisors have to strike the right balance between the need to set appropriate criteria in order to stop taxpayers bearing the cost of future banking crises, on the one hand, and, on the other hand, the need to be sufficiently rigorous, with the risk, in persistently adverse market conditions for many intermediaries, of ultimately increasing the probability of future banking crises. The principle of bailing-in creditors makes sense but its concrete application requires care, especially in the current circumstances.

The management of banking crises. Italy's experience has revealed serious drawbacks in the new European regulation governing small-and medium-size intermediaries which, under the new rules, cannot access the facilities embedded in the so-called "resolution" procedure. For these banks - the vast majority of the roughly 3,000 euro-area institutions - a piecemeal liquidation is the only option currently available in the absence of interested buyers. But liquidation threatens the continuity of the supply of financial services, may imply large losses for both creditors and debtors and, due to potential contagion effects, may pose serious risks to overall financial stability. More must be done in this field, and from this perspective the experience of the United States is especially important. The US Federal Deposit Insurance Corporation - a government entity whose reserves are made up of private funds, but which can activate a large line of credit with the US Treasury - has successfully managed the crisis of almost 500 financial intermediaries since 2007, minimising the harm for the economy at large. It is a lesson that merits careful consideration. [...]

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