NEWS Release - Challenges for the European banking industry - Lecture by Vítor Constâncio, Vice-President of the ECB, at the Conference on “European Banking Industry: what’s next?”, organised by the University of Navarra, Madrid, 7 July 2016
1. Introduction
Ladies and gentlemen,
I warmly thank the organisers for inviting me again to this important event in Madrid, where I last spoke two years ago, also in the context of the Master in Banking and Financial Regulation of the University of Navarra.[1]
The future of banking is certainly a very topical subject, particularly after the global financial crisis. The 2007-08 episode clearly demonstrated that financial crises, particularly when they involve the banking sector, can be enormously expensive both in terms of direct fiscal costs and associated costs for the real economy. Over the period 2008-14 accumulated gross financial sector assistance by euro area governments amounted to 8% of euro area GDP, of which, so far, around 3% has been recovered.[2] Moreover, the crisis induced the Great Recession and the costs of foregone output have been severe. At the aggregate level, the euro area output is now 20% below the level it would have achieved had the trend growth in the previous 15 years continued after 2007. Considering that the economy would grow from now on at that same trend, the accumulated loss of output until 2030, properly discounted, would represent more than three times the whole output of 2008. The crisis left a permanent economic loss with broad scars in our societies.
In light of these consequences, regulators embarked on an ambitious international regulatory reform programme after the crisis, which has mostly concentrated on making the banking system safer and more resilient. In this respect, significant progress has been made: in the euro area, banks have materially bolstered their capital positions, with the average common equity Tier 1 ratio of significant institutions rising to 13% by end-2015 from around 9% in 2012 and 7% in 2008.
To a large extent, challenges and transformations in the banking sector are of a global dimension, even if I will mostly illustrate it with European data.
The crisis was however not the sole product of banks’ behaviour but also of the shadow banking sector that expanded rapidly in the run-up to the crisis, forming a new market-based credit system. There are unfortunately different concepts of shadow banking that add to confusion. One version relates to all credit intermediation done by non-banks; another, more relevant approach is not based on entities but encompasses all activities of the new market-based credit system. This comprises a vast array of financial services, in which banks are also involved, resulting from the expansion of securitisation; of securities financing transactions (SFTs), i.e. securities lending and repurchase agreements (repos); of collateral management and intermediation; and finally, of risk transformation via transactions using derivative swaps , from credit default swaps to interest rate or forex swaps. Several of these activities can be conducted by regulated banks or by less regulated institutions.
These activities became of extreme importance for two reasons.[3] First, they contributed to the creation of a market-based lending system backed by secured short-term market funding. This is the proper concept of shadow banking or what is also called the new market-based credit system. Second, these activities originated types of liquidity instruments which are forms of money not usually counted in the regular monetary aggregates.
Several authors[4], [5] designate this type of activity as shadow banking. Those features, especially the expansion of credit assets funded with short term securities (e.g. repos or ABCP) led to a significant increase in the leverage of the entire finance activity and created chains of inside liquidity, including by means of re-use of “repo-ed” securities, phenomena which were at the centre of the financial crisis. The markets for these non-deposit short term financial liabilities became very large and were crucial for the excessive leverage and the illusion of abundant liquidity that led to the crisis.
The origins of this new credit system are related to the emergence of very sizeable cash pools looking for safer places to keep that cash in the short-term than in the form of banks’ uninsured deposits.[6] Secured collateral lending and repos as well as risk transformation via swap derivatives (credit, interest rates and forex) were developed for that purpose. Securities lending for shorting and generating collateralised levered transactions for asset managers were also part of the new system. The activities of re-hypothecation and re-use of securities in the repo market amplified the creation of chains of inside liquidity and high leverage with negative consequences when haircuts increased and the repo market turned illiquid as the crisis unfolded.
The international financial regulatory reform has primarily focused on the banking system. It has not yet dealt with these new activities in an appropriate way.[7] One could even say it has aggravated what Charles Goodhart called the “boundary problem”[8], referring to the gap created between the more regulated part of the system, arguably the banks, and other less regulated financial institutions. As he argues “If regulation is effective it will constrain the regulated from achieving their preferred, unrestricted position, often by lowering their profitability.”
A crucial rationale for bank regulation relates to the fact that when they concede credit, banks create money by creating a corresponding deposit. This activity that is at the centre or our credit-money system, involves a significant liquidity transformation as deposits are much more liquid than credits. In a recent book, Mervyn King called this property the “alchemy of banking”[9] and many reforms have been proposed to overcome the fragilities created by banking as we know it. I will examine some of them later.
Directorate General Communications
Sonnemannstrasse 20, 60314 Frankfurt am Main, Germany
Tel.: +49 69 1344 7455, E-mail: media@ecb.europa.eu
Website: www.ecb.europa.eu
page source http://www.ecb.europa.eu/
