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We are now 11 months into the pandemic. Are European banks in good health? Can a banking and financial crisis be ruled out?
Banks were hit just like any other firm by the heavy recession triggered by the pandemic. Over the last decade a great effort has been made to strengthen the financial system, through regulation, by imposing capital buffers and by improving its overall resilience to economic downturns. And now, European banks’ core capital ratios, which supervisors use as one of their main metrics to assess banks’ resilience to possible shocks or a deterioration of macroeconomic conditions, are at the highest level since the establishment of the banking union. This means that banks are in a position to absorb a significant amount of losses and continue supporting households, small businesses and corporates through these difficult times.
It is also worth mentioning that, so far, the sharp decline in economic activity caused by the pandemic has not resulted in an increase of non-performing loans. According to the latest available information, significant banks in the banking union held €485 billion of non-performing loans at the end of September 2020, which is less than 3% of total loans. By contrast, in 2015 non-performing loans stood at almost €1 trillion – more than 7% of total loans.
Let me add, however, that the fallout from the pandemic is not yet fully reflected in banks’ balance sheets. This is why we have been saying that banks must pay further attention to credit risk, as many observers have flagged that there is likely to be an increase in corporate defaults once the government support measures are lifted. It is therefore crucial that banks proactively manage credit risk, reclassify loans on a case-by-case basis and ensure prudent provisioning. They should proactively address the challenges they face so that they can support a speedy economic recovery.
Why are banks not like other companies?
Banks play a central role in our economy. They accept deposits from households and businesses and provide loans to other households and businesses that need to consume or invest. In doing so, banks engage in liquidity and risk transformation: they transform very liquid sight deposits into longer-term loans to support economic activity, and they use financing with instruments considered to be low risk – namely deposits and senior unsecured funding instruments placed in the market – to invest in riskier loans and securities. These functions are essential to support the economy. But the mismatch between the liquidity and risk characteristics of banks’ assets and liabilities, together with the potentially high level of leverage of banks’ operations, could make banks fragile during a recession or a major crisis. To stay safe and protect deposits, banks have to be able to absorb losses and continue fulfilling their essential functions, in good times and in bad. This is where we come in: our job as banking supervisors is to monitor the financial health of banks. And it is in everyone’s interest that banks are resilient and can cope with stress.
Looking at the response to the ongoing coronavirus (COVID-19) crisis in particular, we can say that banks entered this crisis in much better shape than at the start of the global financial crisis. This time banks were not the source of the problem, but they are a key part of the solution: their capacity to absorb losses and to keep lending to the economy is essential for a sustained recovery.
The links between banks and power are historically strong, especially in France. How is this useful? Or is it dangerous? Should the comings and goings between the financial authorities/ ministry of finance and banks’ management (revolving doors) be regulated, or are there advantages to these two spheres being so closely connected?
When I started working as a supervisor in the late 1980s, the public sector, both at the national and local levels, owned a very significant share of the banking market in several Member States. Authorities directly appointed bank managers, often paying more attention to political affiliation than to technical expertise. Even after the banking sector opened to private capital and many institutions became joint stock companies during the 1990s, national governments and financial authorities maintained a certain closeness with local banks. Often, regulatory and supervisory tools were used to favour national players and to ensure that they were better positioned than their European and international competitors. This led to a watering-down of the safeguards put in place to protect against banking crises and helped to create the conditions for the great financial crisis. The regulatory reforms adopted in recent years, following robust international standards and the centralisation of supervisory responsibilities within the banking union, have re-established a healthy arm’s-length distance between public authorities and the financial industry. A truly independent supervisor and a decision-making process sheltered from national interests are a significant improvement on the previous institutional set-up.
The revolving doors between authorities and banks have to be subject to strict scrutiny and internal rules. In principle, it is not a bad thing that former regulators join boards of banks: they could bring a culture of compliance and a greater awareness of the broader public interests at stake in the banking business. Similarly, former bankers could bring much-needed knowledge of banking practices when they join regulatory or supervisory authorities. Still, there is a timing issue and a need to manage a host of potential conflicts of interest. At the ECB we have very strict internal rules. For instance, when I finish my mandate I will be required to wait up to two years before I can take up any job in the financial industry that could raise conflicts of interest.
What will banks look like in the future? Are branch closures and job cuts inevitable in the digital age? Where will banks fit in if a digital euro is launched and big tech becomes more influential in the payments industry?
It is clear that digitalisation will become an integral part of the business models of banks, changing their internal operations and how they do business. Banks will therefore need to invest more in technology and digital transformation. The ongoing digital revolution not only enables banks to enhance the quality of the services they provide to their customers, it also provides opportunities for a much-needed increase in cost efficiency.
It is not an exaggeration to say that the current pandemic has catapulted us into the future. To ensure business continuity, banks have adjusted their operations to accommodate remote working and accelerated their efforts to provide digital products and services. To some extent, this has meant closing some branches which were no longer sustainable and reinforcing the trend towards network rationalisation, which has been ongoing since the global financial crisis. Some banks have not yet addressed the issue of bloated structures and unviable business models, which result in operating costs eating up almost all of their earnings. For these banks the transformation process will also entail some degree of job cuts. But banks will also need new skills and professionals to effectively develop new products and distribution practices.
As for the digital euro, the ECB is currently exploring its potential benefits and challenges, and a lot will depend on the design. This is still a work in progress. The digital euro would allow people to use electronic central bank money directly in their daily transactions and the Eurosystem will try to avoid it having any negative consequences for the financial sector. A digital euro would be a new form of money for retail payments, and certainly a store of value, but it should not become an investment product. Saving is not the purpose of a digital euro, just as it is not the main feature of cash.
Alternative means of payments and platforms are increasingly competing with banks. Therefore, banks must come up with innovative solutions to stay ahead of the curve. By making use of enhanced technological applications and cooperating with technology firms, banks could improve the bundling of products and increase customer satisfaction.
How can European banks restore their profitability?
First and foremost, banks can navigate the challenging environment by reducing costs and improving efficiency. Potential strategies range from more traditional measures, such as downsizing and closing branches, which of course are not easy decisions, to adopting new cost-saving technologies aimed at digitalising financial intermediation services, including increasing reliance on online banking. In addition to cutting costs, banks can also improve their income-generating capacities, again through digitalisation or by enhancing their fee and commission-based activities, for example. Finally, the current environment could also trigger consolidation efforts in the sector, which could lead to synergies and greater efficiency, removing the excess capacity that has been in the sector since the great financial crisis.