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Challenges arising from economic developments
A first set of challenges arises from the interaction between the prevailing economic environment and bank business models. In a context where interest rate margins typically account for over half of the total income of large euro area banks, a prolonged period of low interest rates has evidently weighed down on bank profitability. The impact of low rates has been far from uniform across banks, however, as it depends on the underlying structure of assets and liabilities as well as on their ability to adapt to the new environment.
Concerning bank balance sheets, our analysis suggests that the ECB’s non-standard monetary policy measures have had a positive impact through various channels, and that this impact has tended to offset the decline in net interest income. Lower funding costs have not fully offset lower interest income, as deposit rates have tended to be “sticky” at low levels. However, banks have benefited from capital gains on sovereign bonds, from the increased volume of financial intermediation and improved credit quality and also, indirectly, from the improvement in the general economic outlook induced by the monetary easing.
As regards banks’ ability to adjust, evidence shows that some euro area banks have consistently outperformed their peers in terms of bank profitability in recent years. The most evident common trait among best performers is cost efficiency. Average cost-to-income ratio for large banks in the euro area is around 65%, but there is a very large discrepancy between best and worst performers. This suggests that there is still scope for improvement for many banks.
Looking forward, the prospect of a normalisation of the interest rate cycle will bring benefits but also some risks, depending on the timing and speed as well as the banks’ preparedness. Retail banks may look forward to higher revenues from traditional intermediation, but these effects might take time to work through. Temporarily, higher funding costs might accrue before banks are able to benefit on the asset side. Banks may also face a trade-off between higher market risk and lower credit risk.
In this area the ECB is currently engaged in two exercises. First, we are conducting a thematic review of banks’ business models and profitability drivers, also exploring the risks for banks’ business models emanating from fintech and non-bank competition. In this context, the ECB challenges and assesses the consistency of banks’ business models relative to banks’ stated objectives, but does not dictate or prescribe business models, the choice of which remains the responsibility of shareholders and managers. Second, the stress test to be conducted in 2017 on our supervised banks will focus on interest rate risk in the banking book, analysing how different interest rate shocks affect bank assets and liabilities valued at amortised cost. The results of the exercise will feed into our annual assessment of how much capital banks needs to hold (SREP 2017), specifically informing the assessment of so-called Pillar 2 requirements and Pillar 2 guidance.
Challenges arising from balance sheet fragilities
A second set of challenges for banks and supervisors stems from lingering balance sheet fragilities. They relate to both credit and market risk.
Concerning credit risk, the main problem, as is well known, is that of non-performing loans, or NPLs. NPLs, partly a legacy of the recession, are a major hurdle in post-crisis European banking. NPLs in the euro area are very large: in gross terms, they amounted to about €900 billion (third quarter of 2016), or 6.6% of total exposures; net of provisions, they amounted to 3.6% of total exposures. The problem is concentrated in a few countries, some of which are characterised by weaker economic growth and fiscal positions – hence, they are relatively more exposed to a negative loop between public budgets and banking fragility. There has been a modest improvement recently, with average NPL stocks falling by €66 billion in the year to the third quarter of 2016.
The ECB has approached this problem in steps, starting with a fact-finding phase, leading to a public consultation. As a result of that, this week we have published a guide to banks on how they should tackle NPLs, addressing key aspects regarding the strategy, governance and operations relating to bad loans resolution. The guidance promotes consistent recognition, provisioning and disclosure for NPLs, and also requests banks to define and implement policies to reduce NPLs in a quantitative manner. JSTs have already started to liaise with banks to this end. We are aware that the disposal of NPLs takes time, and that there may be a trade-off between speed of disposal and recovery values; but we are also convinced that delaying the clean-up of balance sheets unduly prolongs bank fragility and possibly hurts the economy. Research has shown this to be the case in a variety of countries.
As regards market risk, we conduct supervision from multiple angles. In the SREP, market risk is evaluated as part of the assessment of risks to capital, with risk levels and risk controls being analysed through a combination of quantitative measures and supervisory judgement. Market risks are also assessed in the stress test, specifically by measuring the sensitivity of banks’ fair value positions to changes in the general level and the structure of interest rates. For example, in the 2016 stress test the impact of market risks in the adverse scenario was substantive, slightly greater than that of credit risks. Moreover, during on-site inspections we cover the banks’ internal risk control arrangements and the correct classification of fair value assets and liabilities from an accounting perspective.
Recently, the so-called “Level 3 positions” – referring to assets and liabilities for which neither active market nor indirectly observed prices exist and therefore are priced using internal risk models – have attracted the attention of market analysts. Based on a sample of most euro area significant banks, Level 3 assets amount to roughly €160 billion, or 15% of CET1 capital at end-2016. This amount consists of roughly €50 billion of equity instruments, an equivalent amount of derivatives, plus about €30 billion of debt instruments and €30 billion of loans. Assets are matched by a roughly equivalent stock of liabilities. These exposures are relatively contained in the aggregate, amounting to roughly 1.1% of total exposures of euro area significant banks, but are more sizeable in some countries and banks. Since their prudent valuation is difficult due to the lack of liquidity, care should be taken when interpreting their potential risk impact. It is important to note that Level 3 assets cannot be deemed as “toxic” per se and should not be assimilated to non performing exposures; for instance, a mortgage loan would be probably a Level 3 asset when fair valued. The central issue for the supervisor is to understand if the pricing model that produces their fair value is reliable.
Level 2 positions refer to assets and liabilities that do not have an active market but whose prices are partly or indirectly observed; these positions are larger, with an order of magnitude of roughly 20 times that of the Level 3 assets and 1.5 times that of Level 1 assets. Again, the assets are matched by a similar stock of liabilities. While the volume is quite large, valuation in this case is easier, since an indirectly observed price in principle exists. Many of those positions consist of “plain vanilla” instruments.
A large part of Level 2 and 3 operations is undertaken by banks for financing purposes or to help clients hedge or diversify their risk
ECB Banking Supervision has launched a major project called “Targeted Review of Internal Models” (TRIM), which will help shedding more light, inter alia, on these sources of market risks. TRIM is a resource- intensive project involving a large number of on-site inspections focused on analysing internal risk models both for credit and market risk, each of which can take considerable time. While that project advances, more targeted analyses may contribute to a better understanding of fair value financial instruments at selected banks, and the risks involved. In addition, banking supervisors also acts through on-site inspections and targeted reviews of the valuation and risk control processes pertaining to fair valued instruments.
Challenges arising from regulation
A third set of challenges for banks and supervisors relates to ongoing regulatory changes. The legislative framework which underpins banking supervision consists of the Capital Requirements Regulation (CRR), directly applied to banks, and the Capital Requirements Directive (CRD IV). This legislation allows several elements of flexibility, available to supervisors or Member States. Moreover, since the directive needs to be transposed into national legislation, this opens the door to legislative differences between countries and prevents a truly level playing field within the banking union.
An important example is in the “fit and proper” assessments conducted by the supervisor on the appointment of managers and key function holders. The application of national laws revealed numerous divergences in supervisory practices across Member States, notwithstanding the minimum harmonisation afforded by CRD IV. The ECB has developed a policy stance to achieve a more harmonised and consistent fit and proper supervision under the currently applicable legal framework. At present, however, there is a limit to what this initiative can achieve, since not all countries have fully transposed the CRD IV itself, while in other cases the directive has been transposed in an uneven way. The ECB would like to see not only a full transposition of the CRD IV by all Member States, but also a further alignment of the transposition laws, so that “fit and proper” assessments can use a common yardstick.
The ongoing review of the CRR and CRD IV, which the Commission opened in November 2016 and which is the first review of European banking legislation after the launch of the banking union, offers an opportunity to address level playing field issues. The Commission proposals are now being analysed within the European Council, and subsequently will be examined by the European Parliament. The ECB has had an intensive dialogue with the Commission to ensure that the opportunities provided by the review to strengthen the supervisory action are taken. The ECB will publish, in due course, a formal opinion on the proposals. [...]