18 Jul 2014

Difficult Times for Europe’s Banking Industry

On 16 July, Ewald Nowotny, Governor of the Oesterreichische Nationalbank and a member of the Governing Council of the European Central Bank, gave a Policy Lecture on “Perspectives on the Structure of Europe’s Banking Industry.” He was invited and introduced by Hans-Helmut Kotz, Program Director of the SAFE Policy Center.

According to Nowotny, the financial crisis marked a watershed in the European macro-financial environment by halting the integration of euro area financial markets. Nowotny considers that Europe’s current situation of low economic growth, low inflation, low profitability for banks, lower asset quality and less short-term funding is a “new normal,” and can thus be expected to persist for some time. In this situation of low growth and of inflation well below the defined target, he noted that an active monetary policy is necessary – and thereby it is reasonable for the ECB to continue its policy of very low interest rates for the foreseeable future. While these low interest rates could risk fueling asset price bubbles in certain fields, with potentially dangerous side effects, Nowotny argued that macro-prudential regulation (and not monetary policy) is the most appropriate means to address the risk of such bubbles.

Since the crisis, a lot has been changed in the EU regulatory framework for the banking sector, through the addition of both micro-prudential and macro-prudential rules. The latter measures seek to mitigate systemic banking sector risks that affect all countries, while the former deal with the specificities of individual banks, including bank resolution. In an integrated financial market, both kinds of rules are needed on the European level. The Governor emphasized the importance of discussing the potential conflicts between monetary policy on the one hand and macro-prudential policy on the other, with the latter being much closer to the political sphere and thereby bearing higher reputational risks.

Nowotny raised the question of whether it makes sense in the long run for both instruments to be in the hands of one institution (as they currently are, at central banks) and noted that he, personally, would prefer a separation. Thus, if Nowotny had his way, he would prefer the centralized bank supervision (Single Supervisory Mechanism, SSM) currently being established under the auspices of the ECB as part of the Banking Union to be a fully separate entity, and indeed hopes the SSM will be separated from the ECB eventually. Nevertheless, he considers establishing a single supervisor (as opposed to a panoply of national ones) to be a significant step in the right direction, and the possible best solution at the moment given current EU legal constraints.

Indeed, Nowotny considers the Banking Union nothing short of a policy revolution for the EU, comparable with the establishment of the Single Market. All three of its elements – the SSM, the Single Resolution Mechanism (SRM) with its unique systemic bail-in provisions, and the harmonization of national-level Deposit Guarantee Schemes – are meant to increase the transparency and credibility of the European banking sector. Only with an integrated European bank regulatory framework could European banks reduce their systemic risk and compete on the international capital market.

As Nowotny sees it, the current situation is already substantially different from the period before the crisis, and there are clear indications that the role of banks is changing. The new bail-in provisions associated with the SRM and the centralization of both supervision and resolution at the European level will reduce the hitherto high (implicit) government support for banks, which in turn will impact the banks’ ratings and increase their funding costs. The role of bank loans as funding sources for companies is already declining and will continue to do so, as there is an increasing tendency to turn to capital market financing, or other funding sources like private equity. This is especially the case for bigger or medium-sized companies, though bank funding remains essential for small and medium enterprises (SMEs). Even SME loans could, of course, be bundled into asset-backed securities (ABS) structures and then sold on capital markets, which could improve their access to finance, as has been much discussed recently.

Finally, Nowotny noted that many banking sector risks did not disappear, as they were often simply transferred, in particular to the shadow banking sector. While Nowotny emphasized that this sector should not be seen as sinister per se and that it might have positive economic effects by providing financial services, he reminded the audience that one should not neglect the fundamental question: what are the risks involved and what is their distribution? As he sees it, the main objective in reforming the financial system should not be to simply shift risk from one place to another, but to reduce the overall amount of systemic risk. In the midst of all these far-reaching reforms, Nowotny ended on a cautiously optimistic note: “It is said that generals always fight the last war – I hope we are well equipped to fight future wars.”