Banking in Europe: What went wrong , and how to fix it ?

Banking in Europe: What went wrong, and how to fix it?

Boris Vujčiće-mail: [email protected]

Structure of the presentation

Overview of the European banking sector Lending and asset quality Capital and funding Deleveraging Banks and Sovereigns Government intervention

Reform of the architecture – banking union Single supervisory mechanism Resolution mechanism and deposit guarantee scheme View from a possible opt-in country: to join or not to

join?

Credit activity across the Euro area

Loans to private sector in Euro area stagnated since the start of the financial crisis (cumulative nominal growth in five years amounted to 0.8%, meaning effective decrease).

However, huge differences among countries: stock of loans varies from 60% to 130% of the pre-crisis level – a number of member states experience serious credit crunch.

Overall - stagnation in lending, but large differences between the

Euro zone countries

Cumulative credit growth 9.2008-7.2013

Source: ECB and CNB.

0,88,1

-50

-40

-30

-20

-10

0

10

20

30

40F

inla

nd

Cy

pru

s

Slo

va

kia

Fra

nc

e

Ita

ly

Gre

ec

e

Au

stri

a

Ma

lta

Ne

the

rl.

Ge

rma

ny

Slo

ve

nia

Po

rtu

ga

l

Be

lgiu

m

Est

on

ia

Lu

xe

mb

.

Sp

ain

Ire

lan

d

Eu

ro a

rea

Cro

ati

a

%

Banks’ assets structure and market disintegration in the euro

area Data on lending show that financial markets became

increasingly fragmented.

Moreover, banks in Euro area increased share of domestic bonds holdings with the bulk of domestic bonds purchases referring to Government bonds.

Government bonds, on one hand, seemed like a reasonable (CAR supporting) investment in the period of high risk aversion, credit risk increase and low private sector demand.

However, such an increasing exposure towards domestic governments further strengthened the link between banks and sovereigns.

Increasing home (government) bias in Euro zone and Croatia

Source: ECB.

Government Securities / (Government Securities + Loans to private sector)

Domestic bonds to total bonds

0

20

40

60

80

100

Ireland

Germ

any

Belgium

France

Austria

Portugal

Luxemb.

Spain

Greece

Italy

Netherl.

Finland

Croatia

%

2008Sep 2013Jul

0

5

10

15

20

25

Spain

Portugal

Italy

Ireland

Slovenia

Slovakia

Malta

Austria

Belgium

Germ

any

Cyprus

Netherl.

Luxemb.

Finland

Estonia

France

Greece

Croatia

%

2008Sep 2013Jul

Asset quality of European banks continuously declines

Non-performing loans continue to increase making value adjustment costs decrease unlikely.

Besides NPLs increase, value adjustment costs rise due to a need to further provision the existing NPLs.

US in a better shape.

In Croatia, NPL coverage is lower, but the proportion of recognized NPLs is higher comapred with peers.

Asset quality

8

Non-performing loans coverage

Bank Non-performing loans ratio

Source: IMF, FSI, (bank assets) weighted averagesNote: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia

0

3

6

9

12

15

2008 2009 2010 2011 2012

%

Croatia CEE Eurozone United States

30

40

50

60

70

80

2008 2009 2010 2011 2012%


Bank performance

Bank earnings in Europe strongly affected by deteriorating assets while in US provisions are decreasing and, thus, even supporting the earnings. Accounting/provisioning standards?

Double impact of rising Non-performing loans: value adjustment costs increase and interest income decline.

US banks operating with lower operating profitability but with assets of higher quality, and with less leverage, have more credit potential.

Croatian banks fared well in most of the crisis period; however, prolonged recession started to weight in on the banks performance. Credit risk materialisation plays increasing role in banking with interest income starting to suffer.

Bank performance indicators

10

Bank Return on Assets Bank Return on Assets excluding value adjustment costs


-0,5

0,0

0,5

1,0

1,5

2,0

2008 2009 2010 2011 2012

%


-0,5

0,0

0,5

1,0

1,5

2,0

2,5

2008 2009 2010 2011 2012

%Croatia CEE Eurozone United States

CAR in Europe relatively high, but also high leverage!?

United states traditionally has higher capital ratios.

CA ratios in Europe increased after the crisis mostly due to a risk aversion.

On the other hand, equity to un-weighted assets ratio remains stable (even decreased slightly in Euro zone after 2010) meaning that the fresh capital inflow in the banking sector has been scarce – there has been no deleveraging.

In Croatia, high capital buffers make banking sector much more resilient to the crisis and change of regulatory standards than elswhere.

11

CAR in Europe is improving, but without corresponding decline in

leverage

12

Bank (regulatory) capital adequacy ratio (CAR)

Bank capital to un’weighted assets


10

12

14

16

18

20

22

2008 2009 2010 2011 2012

%


4

6

8

10

12

14

16

2008 2009 2010 2011 2012

%


Costs of financial aid in the EU 2008-2011: costly crisis

27 EU members approved around 4,656 billion Euro of financial aid to banking institutions (with 1,676 billion spent until the end of 2011).

United Kingdom, Germany, Denmark and Ireland approved more the 500 billion EUR while Bulgaria, Czech R, Estonia, Malta, Romania and Croatia did not provide any help to their banks.

Relative to 2011 GDP, highest bank support was provided by Ireland (328 %) and Denmark (258%) with Belgium and Netherlands commiting more than 50% of GDP as well.

The structure of EU-27 bank support shows that countries used mostly guarantees to support banks (27.3%) with recapitalization, buying of troubled assets and liquidity measures amounting to 4.9%, 3.6% and 1.7% of 2011 GDP respectively.

13

Costs of support to financial system

2008-2011

14

0%

20%

40%

60%

80%

100%

Belg

ium

Bulg

aria

Czec

h Re

publ

icD

enm

ark

Ger

man

yEs

toni

aIr

elan

dG

reec

eSp

ain

Fran

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lyCy

prus

Latv

iaLi

thua

nia

Luxe

mbo

urg

Hun

gary

Mal

taN

ethe

rlan

dsA

ustr

iaPo

land

Port

ugal

Rom

ania

Slov

enia

Slov

akia

Finl

and

Swed

enU

nite

d Ki

ngdo

mEU

-27

Guarantee Recapitalization Acquired troubled assets Liquidity meassures

Source: European comission

0100200300400500600700800900

0

20

40

60

80

100

Belg

ium

Bulg

aria

Czec

h Re

publ

icD

enm

ark

Ger

man

yEs

toni

aIr

elan

dG

reec

eSp

ain

Fran

ceIta

lyCy

prus

Latv

iaLi

thua

nia

Luxe

mbo

urg

Hun

gary

Mal

taN

ethe

rlan

dsA

ustr

iaPo

land

Port

ugal

Rom

ania

Slov

enia

Slov

akia

Finl

and

Swed

enU

nite

d Ki

ngdo

mEU

-27

bill.

EU

R

%

Amount approved as yearly average % of GDP Amount approved in absolute terms- rightThe amount of approved financial aid

The structure of approved financial aid

Significant risks remain

Unlike in the USA, European banks’ capital is increasingly burdened with un-provisioned NPL’s.

Even without further NPL increase, resolving the current asset quality issue would take time and implies spending some buffers or gathering additional capital.

Two risks arise from the bank asset quality:a) Fiscal risks arising from the NPL resolutionb) Dampening of the potential credit growth in the following

years

In Croatia, higher burden of capital with NPLs is offset with high capital buffers. Even after correcting the capital ratio for the unprovisioned NPLs – Croatia has relativelly higher capital ratios.

15

Capital ratios are sensitive to NPL coverage

16

Capital ratios, End 2012

Source: IMF, FSI

-10

-5

0

5

10

15

Aus

tria

Belg

ium

Bulg

aria

Croa

tia

Cypr

us

Czec

h Re

publ

ic

Den

mar

k

Esto

nia

Finl

and

Fran

ce

Ger

man

y

Gre

ece

Hun

gary

Irel

and

Italy

Latv

ia

Lith

uani

a

Luxe

mbo

urg

Mal

ta

Net

herl

ands

Pola

nd

Port

ugal

Rom

ania

Slov

ak R

epub

lic

Slov

enia

Spai

n

Swed

en

Uni

ted

King

dom

Uni

ted

Stat

es

%

Capital to assets (Capital-uncovered NPLs) to assets

European banks remain reliant on whole-sale funding (ECB)

Deposits of banks in the USA exceed their loans, with the LTD ratio decreasing continuously.

Euro area banks, on the other hand, even slightly increased their reliance on whole-sale funds (ECB).

CEE countries, started to deleverage in 2012. Before the crisis foreign liabilities share of total liabilities was relatively high due to high penetration of foreign banks.

17

With little new capital, euro area banks remain reliant on whole-

sale funds (ECB)

18

Loan to deposit ratio (Change of Equity) / Assets

Source: CNB and IMF - FSI, (bank assets) weighted averagesNote: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia

-0,5

0,0

0,5

1,0

1,5

2,0

2009 2010 2011 2012

%


60

90

120

150

2008 2009 2010 2011 2012

%


CEE: unlike in the euro-area, higher LTDR – more deleveraging

Change in banks' external debt between March 2013 and September 2008

-30

-25

-20

-15

-10

-5

0

5

Esto

nia

Slo

ve

nia

La

tvia

Hu

ng

ary

Lith

ua

nia

Slo

va

k R

ep

.

Bu

lga

ria

Ro

ma

nia

Cze

ch

Re

p.

Po

lan

d

Cro

atia

as %

of G

DP

in

20

12

Sources: CNB and national central banks.

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2007 2008 2009 2010 2011 2012

EU periphery Central Europe Baltics

SEE Croatia

Loan to deposit ratio

Banking union

20

P. Romer: “A crisis is a terrible thing to waste”!

Incomplete supervisory architecture not the only (not even major) cause of the crisis, but crisis has laid ground for an integration of banking supervision in the Eurozone not only in the form of common rules and

practices, but also as an institutional integration of supervisory authorities.

BU becomes a necessary precondition (although not a sufficient one) of breaking the link between weak banks and weak sovereigns.

BU architecture

21

Link between weak banks and weak sovereigns

The contagion channel between sovereign and banks

IMF (2012), Global Financial Stability Report, April.

Single supervisory mechanism, banking union and the EU

Banking Union – Euro Area

Banking Union – EA including close-cooperation

Non Banking Union

Single Supervisory Mechanism+ Supervisory Manual

National SupervisoryAuthorities

European StabilityMechanism

National stabilitymeasures

National stabilitymeasures

Single Resolution MechanismNational Resolution

Authorities

EBA:• Single Rulebook

• Supervisory Handbook

Source: ECB.

BU advantages in general

Improving the regulatory framework More effective supervision – timely intervention, less likely to be

captured! Common safety nets and backstops – breaking the link between

banks and sovereigns Together, these should eventually reduce social costs of financial

crises

Harmonization of banking regulation and supervisory practices Should improve the assessment of banks and banking systems

Less need for cross-border coordination

Reduced compliance costs

Benefits and costs of macro-prudential policies – internalized on union wide level Potential to restrict ring-fencing activities

24

Advantages for non-euro countries?

Fostering of the financial integration

Providing better information on cross-border banks and improving their supervision Streamlining some of the supervisory colleges

Ensuring greater consistency of supervisory practices Avoiding distortions in the single-market

25

Challenges of SSM participation for non-euro area country

26

Participation in the decision making process - Serious efforts have been made to enhance participation of non-euro MS in decision making bodies, but some restrictions remain.

The final form of the banking union is still not known - We have almost 1½ of the 3 pillars agreed on the paper. Making a decision early is a leap into the unknown, one of the main risks being what future resolution of cross-border bank will look like.

Two different supervisory and bank resolution regimes may tilt the playing field and lead to competitive distortions - But, not even a single supervisory regime is likely to set the level playing fields as non-euro countries participate in SSM only.

Challenges of SSM participation for non-euro area country (2)

27

Accountability and potential costs are major issues - The decision is made within the SSM framework, but national authorities perform resolution and bear the costs.

SSM participation may impede the functioning of national macro-prudential policies.

ECBs lack of supervisory experience and the need to create institutional capacity for supervision or macro-prudential policies at the ECB level.

Subsidiaries operating in small states may get “under the radar”.

Just having a parent in the BU may help reap some of the benefits.

SSM timeline

Q4 2013 Q1 2014 Q2 2014 Q3 2014Q3 2013

SSM Regulation Approval

ConsultationSSM

Framework

Regulation

SSM Framework Regulation

SSM TransitoryPhase

EBA/ECB Stress Test

Conduction of Asset Quality Review

The comprehensive assessment comprises three main components:

Risk Assessment System (RAS) Balance Sheet Assessment (BSA) → „Targeted Asset Quality Review“ Joint Stress Test EBA and ECB

Balance Sheet Assessment

Phase 3Collation, quality

assurance & reporting

Phase 1Risk-based portfolio

selection

Phase 2Execution of Asset Quality

Review(operative phase)

Q4 2013 Q1 2014 Q2 2014 Q3 2014

P1

P2

P3

Operative Start

Asset Quality Reviews

What about other two pillars?

The draft of Recovery and Resolution Directive was recently presented – although it has many sensible elements that will remove some uncertainty and strengthen market discipline, it leaves member states with much discretion, making competitive distortions likely.

Single supervision cannot work properly without an effective resolution authority and a credible financing mechanism. It also needs effective decision-making structures – all of which the SRM does not deliver at this point. Difficult political issue – Juncker: ‘We all know what to do, but don’t know how to go back home after that and get re-elected’

Deposit guarantee scheme - complicated legal and practical issues.

Pan-EU Deposit Guarantee Scheme? Member states use various schemes, so this would mean a longer-term project.

30

Deposit guarantee scheme harmonization

Credible DGS: appropriate coverage, timely payouts and adequately funded.

Harmonization among EU started after 2008 - Directive 2009/14/EC imposed the obligation to explore further elements of harmonization of DGS but set no timeline as regards its implementation.

Further harmonization of EU deposit guarantee schemes has been suspended pending the adoption of EU bank resolution arrangements through a new Directive.

However: The role of the deposit insurance agency varies widely, both within the EU and worldwide.

Lack of common EU funding standards: Nominally, most of the countries have ex-ante (pre-funding) funding Effectively, in many instances (i.e. in a case of systemic events) these

are ex-post funding schemes since pre-funding is relatively modest.

Differences in DGS among countriesFunding mechanisam for DGS

Source: European commision, JRC Report under Article 12 of Directive 94/19/EC

Insured deposits and DGS funds in some EU countries, End 2011

Notes: Eligible deposits is the sum of MFI household and corporatedeposits. Covered deposits applies the EC coverage ratio to eligibledeposits. * DGS or IMF staff info at end-2011, ** Banking associations top up the mandatory scheme, hence coverage ratio is lower bound

Source: IMF Country Report No. 13/66 Technical Note on Deposit InsuranceInsured deposits and DGS funds in Croatia, End 2012 Eligible deposits/GDP 0.86

Covered deposits/GDP 0.44DGS fund size/GDP 1.21

Source: State agency for Deposit Insurance and bank Rehabilitation, Croatian Bureau of Statistics

To conclude

1 Jan 2019 (at latest):

bail-in

Mid-Aug 2013: Revised State Aid Guidelines

1 Jan 2014 (after BRRD): ESM direct recap (active after SSM)

1 Jan 2015: Entry into force of BRRD (except bail-in)

Q3 2014: Results of BSA/ST

1 Jan 2015 (at earliest): Single Resolution Mechanism

2013 2014 2015 2016 2017 2018 2019

To conclude Setting up the BU will take time and effort.

Croatia is very supportive of setting up the BU, but the BU is currently set in such a way to increase the option value of waiting for non-euro member states. Postponing the decision a bit doesn’t entail high costs,

but making the decision now potentially does.

What could make SSM membership for non euro area members more attractive? Access to resolution funds (use of BoP assistance could

be a useful substitute) or liquidity assistance, level playing field when it comes to deposit insurance.

Overall, more complete BU is more attractive than an incomplete one!

Thank you!

Banking in Europe: What went wrong , and how to fix it ?

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