“The banking union has not yet passed an endurance test”

(This interview appeared in SAFE Newsletter Q2 2019)

In this interview, Rainer Haselmann, Professor at Goethe University Frankfurt and SAFE Program Director for Financial Institutions – Stability and Regulation, talks about reforms to European financial market regulation since the financial crisis. Working with Mark Wahrenburg and Jan Krahnen, he examined the macroeconomic and financial effects of the regulatory reforms for the Federal Ministry of Finance.

Is the German banking system more stable today than it was ten years ago?

There has been an enormous number of measures during this period and banking supervision has changed dramatically. With the new European banking supervision, large banks are now being overseen much more intensively. At the same time, the capital equity requirements have increased and as a result, it can be said that the financial system in Germany is more stable today. Yet, at the same time, regulation has become much more complex.

There are complaints from the financial sector because of the complexity and the burden of regulation. Are they justified?

For very small banks and for very large banks, the costs of regulation are indeed disproportionately high (see figure). The financial industry is probably the one with the highest regulatory costs in Germany. Yet there are also other reasons for the weak profitability of German banks, such as the low interest rate environment, digitization, and automation, which have all changed the branch business. These factors often get mixed up in the discussion. Surprisingly, the regional savings and cooperative banks have proven better able to deal with costs through their association structures. However, the core problem is that there are simply too many banks in Germany; this is one reason why banks are not as profitable as they could be. The German banking sector has to consolidate further.

How do you assess the stricter equity capital requirements?

In principle, it is a good thing that capital requirements have become both higher and more stringent in the definition of what really can be considered as capital. For me, it is the complexity of capital regulations which constitutes a problem. It has two negative effects: the first is that high costs occur in order to meet all the requirements; secondly, high complexity leads to less transparency. This can create leeway that is more difficult for the supervisor to grasp.

You propose to increase incentives for optional capital buffers. What measures could be suitable?

Banks should have a choice: If they voluntarily hold a certain amount of equity capital beyond minimum capital requirements, then other regulatory measures should not apply. Banks could thus be more stable – which is in the interest of supervision – while, at the same time, reducing the high costs of regulation. It would also be conceivable to dispense with certain regulatory measures if, for example, banks were to separate investment banking from their lending business. That could be a step into the future to further reduce systemic risk in the financial sector.

Is there progress towards a credible resolution regime for large banks due to reforms?

We have examined whether market discipline has improved. Investors no longer expect that only the taxpayer would finance a resolution of a medium-sized bank. This is a positive result, but it hardly applies to very large banks. There are also mixed experiences with the SRM, the European Single Resolution Mechanism. Resolution has worked for smaller banks. However, there are also loopholes which have already been exploited. In this respect, there is a clear need to make improvements. It is also unclear to what extent bail-in would work. There is the concept of ‘total loss-absorbing capacity’ (TLAC): to put it simply, banks write their wills and have to define which parts of their liabilities would be available in the case of difficulties. What we do not yet know, however, is whether this works in practice.

Non-performing loans on many banks’ books are considered problematic. What should supervision do about it?

At the European level, rules have been laid down that banks need to, at certain intervals, write off loans becoming non-performing. The problem is with the classification: when does a loan become non-performing? That depends, for example, on accounting standards. Banks have leeway and so the classification can be interpreted differently depending on the states. Nevertheless, the ECB initiative to harmonize rules for non-performing loan write-offs is a step in the right direction. Banks, however, are supposed to provide insurance functions to their clients and thus accompany firms through recessions, which is different from market-based capitalization. If the rules are too strict and banks have to write off loans immediately, the institutions would have to give up part of their insurance function. That is why this is a double edged sword: the room for maneuver must not become too large, if a loan will obviously not recover, then the bank needs to write it off.

In the study, you suggest reviewing the European stress test. Where do you see a need for improvement

The stress test was introduced as a temporary measure to restore confidence in financial markets. It is now established, and this shows a general problem with regulation: it is relatively easy to introduce measures, but extremely difficult to give up existing measures. From our point of view, the test is very complex and relatively non-transparent. On the other hand, the significance of the test is very low and the market hardly shows any reactions. Given the high costs, the effort involved, and the not particularly informative result, I believe that European stress tests should be reviewed; European supervision has now taken over most of the tasks that the stress test was supposed to do in any case.

Many of the national measures were introduced on the basis of European directives. How well is this harmonization of financial market regulation working?

In all member countries today, single European banking supervision regulates the majority of banking assets: The European banking union is a great achievement. In banking supervision, care must be taken not to get into conflict with the interests of the member states (vis à vis public debt, for example). If there were to be another crisis, there could be problems here, similar to those with the euro. The banking union has not yet passed an endurance test, but the system is now established and accepted by the member states.

The paper “Evaluierung gesamt- und finanzwirtschaftlicher Effekte der Reformen europäischer Finanzmarktregulierung im deutschen Finanzsektor seit der Finanzkrise“ was published as SAFE Policy Report No. 1 and is available here.