The first one is to successfully complete the set-up of the single supervisor. The operational start of the new authorities is foreseen around mid-2014. To that end, the ECB and the national authorities are working together intensely, focused on the common goal of creating an effective system. The organisational challenge, however, is great and further complexities may emerge during the implementation.

Financial Stability

Feature

The SSM, banking union and the future of prudential policy in Europe

The establishment of a single supervisory mechanism under the ECB will help mitigate a number of threats to Europe’s financial system, writes Ignazio Angeloni. But still more needs to be done

Author: Ignazio Angeloni

Source: Central Banking Journal | 10 May 2013

Categories: Financial Stability

Topics: Macro-prudential regulationSingle supervisory mechanism,ECB

Ignazio Angeloni

The past decade has proven to be an extraordinary period for financial markets in Europe and beyond. Until 2007, a wave of optimism pervaded international financial markets; a phase that today is referred to as one of excessive risk-taking, or risk undervaluation. From the middle of 2007, and even more after September 2008, the pendulum swung violently to the other side. Risk aversion prevailed for several years, occasionally punctuated by phases of genuine ‘risk terror’. Markets for money, bonds, stocks and many financial products malfunctioned, or ceased to function altogether. The euro area no longer represented a genuine currency area, except for the support of the central bank.

Starting from mid-2012, the sentiment changed again and ‘risk appetite’ returned. Spreads and volatilities in some market segments are back to historical minima. But market participants and the general public have not forgotten the ‘great fear’, or at least not yet. Caution and vulnerabilities are still present in financial markets. In the meantime, regulators and supervisors have begun a fundamental rethinking of their approach, leading to the reform process that is now under way, internationally under the umbrellas of the G-20 and the Financial Stability Board, as well as in Europe. These initiatives have the common aim of increasing the resilience of financial markets and making them more responsive to the needs of the real economy.

This article focuses on this reform process from a specific angle, that of banking supervision in Europe. The political leaders of the European Union (EU) have decided, around the middle of last year, to transfer the responsibility for banking supervision from the national authorities to the European Central Bank (ECB). Since then, a preparatory phase has started, that is accelerating now we get closer to the formal approval of the legal texts. The main features of the new supervisory authority will be described, focusing in particular on the need to ensure a better integration of macro-prudential considerations into the traditional work of micro-supervisors. In concluding, other prospective reforms in banking regulation that are considered complementary to the reform exercise of supervision will be mentioned.

Risks and vulnerabilities 
Before focusing on the prudential reforms currently under way in Europe, it is instructive to consider the ECB’s current perspective on risks and the outlook for the European financial system. This assessment of risk underscores the need for the reform of banking supervision.2

There are four main risk factors at present in the financial outlook:

● risks stemming from the weakness of the real side of the European economy, with possible adverse effects transmitted via bank balance sheets and bank profitability;

● risks that those phenomena may be especially acute in countries that have already experienced financial stress, leading to renewed bank funding pressures;

● risks of renewed tensions in European sovereign debt markets, due to low growth and the slow implementation of reform by some national governments; and

● a possible reassessment of risk premia in global bond markets, following a prolonged period of ‘search-for-yields’ in an environment of abundant international liquidity.

These risks can be seen as tail events and not part of a central scenario. It is also clear that they should not be assessed in isolation, because they are closely interconnected. Their potential systemic dimension depends precisely on their inter-linkage and possible correlation.

To start with the first risk, it is well known that the crisis has left a heritage of persistent high uncertainty with regard to macro-financial developments. The weak economy and the uncertainty regarding the depth and duration of the downturn has resulted in increasing risks to banks’ credit exposures, profitability and capital levels in all countries, though it is much more pronounced in some of them.

According to March 2013 macroeconomic projections, the ECB expects real GDP growth in the euro area to range between -0.9% and -0.1% in 2013 and between 0% and 2% in 2014. These average figures, however, conceal a wide dispersion at the country level. For example, private sector forecasters expect GDP growth in the euro area to range from -4.5% in Greece to 0.9% in Ireland in 2013.

Weak economic activity and the progressive worsening of the economic outlook in recent times have triggered vulnerabilities among bank borrowers and in a broad range of bank asset classes. Particularly vulnerable are banks that face high and rising non-performing loan (NPL) levels, low NPL coverage ratios and a weak profit base. Such interaction is most relevant for banks with exposures to highly indebted households and firms, since these are most vulnerable to the downturn and, specifically, to falling property prices, rising unemployment or weak consumer and investor demand.

Just as the growth outlook differs greatly across countries, so do the vulnerabilities within the non-financial private sector. For example, and according to 2012 data, residential property prices showed signs of overvaluation of up to 15–20% in Belgium, Finland and France, whereas in the Netherlands, Portugal and Germany they were around 5–15% below what some fundamental value drivers – such as rents and income levels – would suggest.

Bad forbearance
Banks facing higher credit risks tend to engage in loan forbearance, especially in a low-cost funding environment. Not all forbearance is unjustified; the advantage of banks, as long recognised in academic literature, is precisely to be able to have a longer horizon and to support their borrowers facing transient difficulty. But banks also need to ensure that this is done only with debtors facing temporary problems. Banks should not forbear as a short-term fix to their own balance sheet constraints. Such ‘bad’ forbearance is a cause for concern as it delays the clean-up of banks’ balance sheets and diverts credit away from productive sectors.

To mitigate these risks, provisioning for non-performing assets needs to be strong. Fostering market confidence in the accuracy and soundness of banks’ balance sheets is paramount – and efforts to enhance the transparency of balance sheets, through enhanced asset quality reviews, are a key step towards easing banking vulnerabilities.

Consider the second risk, namely that such macro-financial weaknesses may be especially acute in countries that have already experienced financial stress, leading to renewed funding pressures. The return of investor risk appetite, together with the longer-term refinancing operations offered by the ECB, has led to much better funding conditions for EU banks since last year. Recently, the banks participating in the ECB’s three-year long-term refinancing operations have repaid about a quarter of the €1 trillion ($1.3 trillion) they had originally borrowed. Nevertheless, market fragmentation remains, with funding costs still quite different depending on where banks are headquartered. Persistently high funding costs for banks in stressed countries raise lending costs, weakening the economy further. To illustrate, the interest rates on new loans of up to €1 million to firms were at all-time lows of around 3% in Germany and France in March 2013. In Spain and Italy, on the other hand, the interest rates on corresponding loans are around 4.5–5%. In more extreme cases, this may heighten the risk of accelerated deleveraging, with a loss of strategically important and profitable assets and further damage to the real economy.

Supervisory measures to reinforce confidence in banks, for example, by higher transparency of balance sheets, can help in this respect. Over time, better macroeconomic conditions and the establishment of a banking union will be decisive factors. The ECB, by broadening the range of its operations and the collateral accepted for them, as well as lengthening their maturity, has effectively addressed the most acute phases of fragmentation of funding markets in the euro area.

Returning risk appetite
Turning to the third risk, that of renewed tensions in European sovereign debt markets, it can be noted that risk premia on government bonds in the euro area have receded from their very high peaks in recent months. Risk appetite has returned here too. Markets have reacted positively to policy measures adopted at both the EU and national level, as well as to measures undertaken by the Eurosystem. By April 2013, for example, yields on Spanish and Italian sovereign bonds had declined by around 240 and 180 basis points respectively, since the middle of last year.

Despite these encouraging developments, there remain areas of vulnerability. Sovereign debt and fiscal deficits remain large in many countries and, in some cases, are exposed to contingent government liabilities to support banks. Though fiscal consolidation is challenging in a fragile economic situation, important commitments have nonetheless been undertaken, and significant progress achieved. These commitments include the important steps towards completing a genuine monetary union, which includes strengthening fiscal frameworks and the possibility of recapitalising banks using the European Stability Mechanism.

The final risk, a possible reassessment of risk premia in global markets, is exacerbated by the abundant international supply of liquidity that has prevailed in recent years, which has triggered a search for yield among portfolio investors.

It is difficult to evaluate this risk and, in spite of the frequent references to it in informal exchanges, hard evidence is lacking and views differ. It can be argued that there are more and more signs of overheating in some credit-market segments, for various reasons. First, yields on higher-rated sovereign debt – in the US, Japan, Germany and the UK – have moved below their historical averages, despite potentially worsening fiscal fundamentals. Corporate bond yields have also declined to record-low levels. An average BBB-rated European corporate bond had a yield of 3.5% in March 2013, compared with 8% at the end of 2011. Again, in some cases these developments appear to be out of sync with corporate financial conditions, including expectations of higher default rates. Globally, strong capital flows into emerging markets can be seen, which, although linked to growth differentials, may also reflect a search for yield.

Were it to materialise, an abrupt adjustment in sovereign risk premia could result in a disorderly unwinding of safe-haven flows, losses on fixed-income investments and second-round effects for banks. It could also translate into higher funding costs for corporates, hampering the recovery and putting additional pressure on banks.
So, in spite of a dramatic improvement in the risk assessment since the middle of last year, financial stability continues to be fragile. The adjustment of public finances and the restructuring of the banking sector remain important, together with strong central bank vigilance.

Strengthening European supervision
These risks persist in the context of a financial crisis in Europe that has exposed several shortcomings in the regulatory and supervisory system. From the perspective of establishing a prudential framework for the EU, three such are noteworthy:

● an excessive dependence of national banking systems, especially in times of crisis, on their respective public sectors, with consequent adverse loops of instability, in some euro area countries, between banks needing public support and their respective sovereigns;

● a weak connection between micro-prudential supervision and macro-prudential policy or, indeed, a sheer lack of a macro-prudential dimension in supervision; and

● the lack of international coordination among supervisors and cases of national bias in the conduct of banking supervision.

In the euro area, the mismatch between a single monetary policy and national banking responsibilities has been a destabilising factor throughout the crisis. Growing pressures in funding and lending markets have led to a fragmentation of banking markets along national lines. Links between banks and sovereigns have actually grown tighter during the crisis, due to an increase in home bias in portfolio selection. The result has been a risky embrace between banks in need of support, thereby weakening domestic fiscal conditions, and distressed sovereigns undermining the solidity of the banks exposed to them.

The correlation between bank funding costs and those of the respective sovereigns has increased sharply in peripheral economies. In particular, countries that lost market access became dependent on domestic funding and prone to capital flight. In the end, even implementation of monetary policy can be jeopardised, because its transmission ceases to function properly due to high and volatile spreads.

This explains the extraordinary monetary policy measures that the ECB has announced in recent months, first and foremost, its commitment to outright monetary transactions. But monetary policy can fix only the immediate problem; addressing the underlying flaw – the link between banks and sovereigns – ultimately requires bank safety nets and banking supervision to be at the European level. This is the essence of the reform that goes under the name of ‘banking union’.

The problem with micro-based supervision
Before the crisis, banking supervision was, in most developed countries (not only in the euro area), fundamentally ‘micro-based’, that is focused on ensuring the safety of individual institutions, and taking the rest of the system as given.

There are at least two complications with this approach. The first is that its implicit assumption, namely that a collection of individually stable banks automatically leads to a stable system, no longer holds if actions by individual banks, either spontaneous or induced by the supervisor, affect the solidity of others. In today’s complex and interrelated systems, this is more likely to happen either because some banks are ‘systemic’, or simply because they tend to act together.

Credit institutions can be systemic due to size, cross-exposures and market inter-linkages, or in more subtle ways, such as the intermission of the fiscal sector or the macroeconomy. When this happens, the micro-based approach fails. For example, a supervisor focusing on individual banks alone tends to overestimate the efficiency gains and underestimate the negative externalities from certain types of financial innovation, hence erring on the side of leniency.

The other complication is that a supervisory approach focused on individual bank safety alone may generate expectations that banks will be rescued in all circumstances, encouraging moral hazard and creating reputational risks for supervisors when occasional failures nonetheless occur. If it is readily accepted, as it should be, that banks are private agents operating in free markets, albeit of a special kind, the possibility of individual bank failures should be considered physiological and be regulated so as to occur in a controlled way, without risks for the system. This concept is relatively new and requires an evolution in supervisory culture, and also more thinking. It can be argued that the fundamental question of how to combine micro-safety with systemic stability has not been sufficiently analysed by academics and practitioners, let alone resolved.

Since the onset of the crisis many initiatives have been undertaken in this area. Supervisors have begun to shift their focus to include macro-prudential supervision. Meanwhile, supervisory authority has come under the ‘umbrella’ of central banks in most countries, reversing the earlier trend; for example, restructuring has taken place at the Bank of England, which will see the FSA re-incorporated after many years of deliberate separation. In the EU, the European Systemic Risk Board has been established. European regulation will further be strengthened with the adoption of the Capital Requirements Directive IV/Capital Requirements Regulation, a powerful legal framework that will provide the basis for a range of micro- as well as macro-prudential tools. The latter include higher requirements for capital buffers, as well as more stringent measures aimed at addressing systemic risks, such as capital requirements, sectoral risk weights, large exposure limits, leverage ratios and liquidity requirements, as well as public disclosure commitments. This new battery of instruments is promising, but still untested.

The single supervisory approach
The single supervisory mechanism (SSM) currently being prepared is the cornerstone of the whole banking reform. Its statutory goal is to “contribute to the safety and soundness of credit institutions and the stability of the financial system within the EU and each member state”. This combines micro- and macro-prudential powers. The SSM will operate as a system, with a strong decision-making centre promoting consistency and a level playing field in supervisory practices, combining it with the extensive expertise of the national authorities. It will greatly facilitate the compliance with supervisory requirements of banks operating cross-border. The ECB, as the central authority, will be entrusted with the necessary powers to make decisions across the whole spectrum of the supervisory process: authorisation of banking activity (and withdrawal thereof), authorisation of qualified holdings, collection of information off- and on-site, fit and proper tests, internal risk controls, model validation, plus the consequent powers of translating the results of the supervisory process into capital, liquidity and other prudential requirements.

The institutional scope of the SSM will be broad, covering, for the euro area alone, more than 6,000 individual banks, or about 4,000 banking groups. This is important because not only large banks can pose systemic threats. A differentiated approach is envisaged, with the ECB directly supervising banks that are systemically significant; approximately 130–150 banks for the euro area alone, covering well over 80% of total banking assets in the area.

The SSM will be open to participation by all EU countries. Non-euro area countries that may join will have equal decision-making and voting powers within the SSM policy-making body, the Supervisory Board. We hope, naturally, that several countries outside the euro area will join, because this will help to avoid the segmentation of banking activities in the single banking market of the EU as a whole. The UK has already announced that it will not participate.

The SSM will combine both micro- and macro-prudential powers. The latter are, in the legislation, regarded as a shared competence; the ECB will have the option to apply more stringent macro-prudential measures than those applied by the national authorities, if and when deemed necessary from a euro area or national financial stability perspective. Since the national authorities may choose the macro-prudential tools they will apply, and also use tools that are not included in European legislation, differences across countries may occur. The choice of tools may depend on the specific types of systemic risks and the features of national banking systems; hence differences along national borders are not necessarily unjustified. For example, the UK has proposed a countercyclical buffer and sectoral capital requirements as primary macro-prudential tools, while the SSM may choose to apply a broader set of tools.

The new supervisor will be strongly independent and strongly accountable. In its independence, the ECB is already protected by strong statutory provisions, which will be complemented by those prescribed by the Core Principles of the Basel Committee on Banking Supervision. The counterweight of independence, democratic accountability, is equally strong, at both the European and national levels. When carrying out its supervisory tasks, the ECB shall be accountable to the European Parliament, the Council and also to national parliaments.

Milestones ahead
Looking ahead, a number of clear milestones can be seen on the horizon. The financial crisis has brought instability and recession in the European economy, but is also bearing fruit, in the form of a long-needed rethinking of the European banking regulatory and supervisory system that would not have occurred otherwise. From this viewpoint, the crisis was not wasted. But the reform is as yet incomplete, with several steps still to be undertaken.

The first one is to successfully complete the set-up of the single supervisor. The operational start of the new authorities is foreseen around mid-2014. To that end, the ECB and the national authorities are working together intensely, focused on the common goal of creating an effective system. The organisational challenge, however, is great and further complexities may emerge during the implementation.

Second, a resolution authority is the necessary complement of a single supervisor. A blueprint for this authority should be proposed by the European Commission this year. In the meantime, the Bank Recovery and Resolution Directive should be adopted as a matter of urgency, to provide national authorities with new resolution powers and help their coordination.

Third, the conception of a common backstop was launched last year, with the discussions on direct bank recapitalisation by the ESM. This is of key importance to help break the bank-sovereign loop. The fiscal backstop to the banking union should resemble the arrangements in the US, where the financial sector contributes ex-ante and, if necessary, ex-post, and the Treasury provides a credit line to the Federal Deposit Insurance Corporation.

Fourth, the establishment of a common system of deposit protection, which is realistically a more distant goal, can begin with the adoption of the Commission’s proposal on deposit guarantee schemes, expected by mid-2013. This provides a valid starting point, in the form of a harmonised framework, linking together national insurance schemes and enhancing the confidence in them.

Ignazio Angeloni is director-general for financial stability at the European Central Bank.1

Notes

1. The author gratefully acknowledges the support of Edward O’Brien, Balázs Zsámboki, Cécile Meys and Stefan Wredenborg in preparing this article.

2. This risk assessment draws upon ongoing research at the ECB, conducted in the framework of the semi-annual Financial Stability Review, the next issue of which will be published in May 2013.

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