Through regulatory reforms and the initiated European Banking Union following the financial crisis in 2008, European financial markets are considered to be more stable. However, ten years after the crisis, banking profitability is still low and could turn into a threat to financial stability. At the Frankfurt Conference on Financial Market Policy 2019 in November, academics, market participants, and policymakers discussed what impact competition in the banking market has on both stability and efficiency.
Kerstin af Jochnick, the newest member of the Supervisory Board of the Single Supervisory Mechanism (SSM) opened the conference and stressed in her keynote that, from a supervisory perspective, the overall resilience of the banking system greatly improved in recent years. However, competition in the banking market would have become a growing concern to supervisors, she said. Persistently low profitability would hamper banks’ capacity to build up capital buffers in the future. Too much competition would reduce market power and translate into low profits: “The European banking sector is probably oversized,” af Jochnick warned. Banks may be encouraged to take higher risks which is considered another threat to financial stability.
Completing the Banking Union for more profitability
“Weak profitability will remain an issue for stability,” af Jochnick said. Deepening the European Banking Union and completing the Capital Markets Union would be essential to make the financial system more stable and increase banks’ profitability. However, rare cross-border mergers and acquisitions would speak for a not fully integrated SSM in European banking markets and economies of scales would not be exploited. Af Jochnick emphasized that legal fragmentation should be reduced. In particular, national insolvency regimes need to be harmonized given that resolution by the Single Resolution Board (SRB) is an exception rather than the rule, she said. Further, especially a common deposit insurance would need progress: “A common deposit insurance would remove the still remaining sovereign-banking nexus,” af Jochnick said. All these steps towards market integration would facilitate consolidation among weak banks and market exits without major disruptions. Market consolidation would automatically restore profitability among the fittest banks.
She highlighted the importance of completing the European Banking Union. “A Banking Union that is not complete can hardly be sustainable,” she said. Her overarching message was that there is an urgent need for more integration of the European market.
How banks will be influenced by digitization is currently unknown, she concluded. New providers of financial services might have a positive impact in terms of innovation and competition, but also raise new regulatory questions. Af Jochnick made clear that the competitive environment is shaped by many factors and passed the question of more or less competition on to the panelists.
A trade-off between competition and stability
The first panel reviewed the trade-off between competition and financial stability. Ignazio Angeloni, Harvard Kennedy School and SAFE, noted that, historically, the liberalization of the banking market has proved to be a threat to financial stability.
Isabel Schnabel, Bonn University and German Council of Economic Experts (GCEE), presented empirical evidence for many aspects brought up in the keynote speech from the recently published Annual Report prepared by the GCEE. Above all, higher capital requirements do not seem to depress banks’ profitability. Instead, the slope of the yield curve, shaped by monetary policy, turned out to be the driving factor. According to Schnabel, there is still room for tighter macroprudential measures.
Schnabel said that cross-border mergers may help to establish a truly European market for banking. The too-big-to-fail problem would be attenuated because any institute would be small relative to the integrated market, she said. Schnabel agreed that tech companies have not gone into more intense competition with traditional banks but digitization will bring structural changes to the market. “Scaling of digital business models requires a European market,” Schnabel concluded.
SAFE Director Jan Pieter Krahnen challenged the SSM’s approach to complete the Banking Union: “Supervisors are at risk to take wrong conclusions,” he claimed. Low profitability would not necessarily mean high risk, he said reminding the audience that before the financial crisis banking was profitable but not stable. The Banking Union was supposed to reestablish market discipline, he said. Improving profitability, instead, should not be an objective to supervisors: “The supervisor is not a coach but a referee,” he visualized. Coaching would imply taking liability for the sustainability of the business model, Krahnen criticized. Recent supervisory activities would suggest that the SSM wants to avoid exit by banks, he argued. However, resolution without disruptions would be key to financial stability.
For Luc Laeven, European Central Bank (ECB), the main goals of the Banking Union are to create a level playing field across Europe, homogenization of rules and stimulating a truly European market. He did not agree with the emphasis on market exit. He took up the fact that economic theory does not offer clear-cut predictions about the trade-off between competition and financial stability. The trade-off will finally depend on the cost of bank failure and how these costs are affected by the market structure. This is hard to tell from the data because, among other obstacles, competition itself is difficult to quantify.
The future of banking
The second panel speculated whether we still need traditional bank services. Tara Rice, Bank of International Settlements (BIS), argued that there are both supply and demand-side reasons for competition in payments services. For example, traditional banks would be better at protecting personal (financial) data. On the other side, tech companies would have generally superior technology and big tech companies even would have a broader customer base and could score with their consumer orientation. Rice concluded that the future of banks depends on their ability to meet customers’ expectations.
The panel agreed that what makes big tech companies a serious challenger to banks is “DNA”: data, networks, and analytics. While banks would be superior with data, for Fintechs the platform and customers would be key, said Andreas Hackethal, SAFE and Goethe University. “It is stunning: An industry that is built on information processing is conquered by firms that have an edge on DNA”, he said. According to Alexandra Hachmeister (Deutsche Börse), the role of data for financial markets and the technological disruption is unprecedented: When markets turned from floor to electronic trading, processes have become more efficient; the underlying task would have remained unchanged. However, this time the infrastructure is going to be decentralized, that is, platform-based, she emphasized. Nevertheless, from her point of view, there is room left for a centralized structure: Trust is key to quality data and technology is not able to build up trust.
In the third panel, Lorenzo Bini Smaghi, Société Générale and LUISS School of European Political Economy, stressed that banks still play a dominant role in financing the European economy which makes their health a primary concern for policymakers. The Banking Union project must eliminate national discretion to restrict the mobility of capital and liquidity, he proposed. Because of rigid labor markets across Europe, adjusting banks’ business models would be associated with high costs. Negative policy rates today would reflect the reluctance to adopt Quantitative Easing earlier, Bini Smaghi argued. “I doubt that we have fully understood the transmission mechanism of monetary policy,” he said.
Olena Havrylchyk, University Paris 1 Panthéon-Sorbonne, pointed out that it is not about the institutions but their functions: “Banking is necessary, but banks are not”, she claimed, quoting Bill Gates. Therefore, the discussion should focus on technological progress in the banking sector, she said. In theory, technology should lower the cost of financial intermediation but in reality, the operating costs have not declined. She argued that regulatory treatment of tech firms entering the European market would not reflect their actual market power: These subsidiaries of big tech companies (e.g., Apple Pay) are treated as Fintechs with low market power. “Regulators should be much more forward-looking,” Havrylchyk claimed. There would be ample evidence that market power can build up fast. To limit the market power of big tech companies, Havrylchyk suggested making financial data stored by banks available to other firms including Fintechs.
Martin Hellwig, Max Planck Institute for Collective Goods, argued that the societal opportunity costs exceed the private ones: “Banks do not want to raise equity,” he claimed. It would offer a benefit to debtholders at the expense of shareholders. Bankers would have an incentive to increase leverage and resist recapitalization, he said. Further, Hellwig argued that, besides many important structural reasons contributing to the low-interest-rate environment, the central bank would act as a competitor to commercial banks as well. “If the risk premium is the only premium banks can earn, they will be willing to be paid for bearing the risk,” he said regarding monetary policy. For Hellwig, artificial barriers to exit are an important driver of poor profitability. The case of the Landesbanken would have proven that there is no viable resolution process.