Banking in Europe: What went wrong, and how to fix it? Boris Vujčić e-mail: firstname.lastname@example.org 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 40 30 20 8,1 10 -10 -20 -30 -40 Source: ECB and CNB. Croatia Euro area Ireland Spain Luxemb. Estonia Belgium Portugal Slovenia Germany Netherl. Malta Austria Greece Italy France Slovakia Cyprus -50 Finland % 0,8 0 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 Government Securities / (Government Securities + Loans to private sector) Domestic bonds to total bonds 100 25 80 20 60 15 % % 40 10 20 5 Source: ECB. 2013Jul 2008Sep 2013Jul Croa tia Greece Fra nce Estonia Finla nd Luxemb. Netherl. Cyprus Germa ny Belgium Austria Ma lta Slovakia Slovenia Ireland Ita ly Portuga l Croatia Finland Netherl. Italy Greece Spain Luxemb. Portugal Austria France Belgium Germany Ireland 2008Sep Spa in 0 0 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 Non-performing loans coverage Bank Non-performing loans ratio 12 70 9 60 % 80 % 15 6 50 3 40 0 30 2008 2009 Croatia CEE 2010 Eurozone 2011 2012 United States 2008 2009 Croatia CEE 2010 Eurozone 2011 2012 United States Source: IMF, FSI, (bank assets) weighted averages Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia 8 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 Bank Return on Assets Bank Return on Assets excluding value adjustment costs 2,0 2,5 1,5 2,0 1,5 % % 1,0 1,0 0,5 0,5 0,0 2008 2009 2010 2011 2012 -0,5 0,0 2008 2009 2010 2011 2012 -0,5 Croatia CEE Eurozone United States Croatia CEE Eurozone United States Source: IMF, FSI, (bank assets) weighted averages Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia 10 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 Bank capital to un’weighted assets 22 16 20 14 18 12 16 10 % % Bank (regulatory) capital adequacy ratio (CAR) 14 8 12 6 10 4 2008 2009 Croatia CEE 2010 Eurozone 2011 2012 2008 2009 United States Croatia CEE Source: IMF, FSI, (bank assets) weighted averages Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia 2010 Eurozone 2011 2012 United States 12 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 Belgium Bulgaria Czech Republic Denmark Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden United Kingdom EU-27 Belgium Bulgaria Czech Republic Denmark Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden United Kingdom EU-27 % Amount approved as yearly average % of GDP 100 80 60 40 20 0 900 800 700 600 500 400 300 200 100 0 Guarantee The structure of approved financial aid Source: European comission Recapitalization bill. EUR Costs of support to financial system 2008-2011 Amount approved in absolute terms- right The amount of approved financial aid Acquired troubled assets Liquidity meassures 100% 80% 60% 40% 20% 0% 14 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 resolution b) 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 -5 Sweden Spain Slovenia Slovak Republic Romania Portugal Poland Netherlands Malta Luxembourg Lithuania Latvia Italy Ireland Hungary Greece Germany France Finland Estonia Denmark Czech Republic Cyprus Croatia Bulgaria United States Capital to assets United Kingdom -10 Belgium Austria % Capital ratios are sensitive to NPL coverage Capital ratios, End 2012 15 (Capital-uncovered NPLs) to assets 10 5 0 Source: IMF, FSI 16 European banks remain reliant on wholesale 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) Loan to deposit ratio (Change of Equity) / Assets 150 2,0 1,5 120 % % 1,0 0,5 90 0,0 2009 60 2008 2009 Croatia CEE 2010 Eurozone 2011 2012 United States Source: CNB and IMF - FSI, (bank assets) weighted averages Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenia 2010 2011 2012 -0,5 Croatia CEE Eurozone United States 18 CEE: unlike in the euro-area, higher LTDR – more deleveraging Change in banks' external debt between March 2013 and September 2008 Loan to deposit ratio 2.3 5 2.1 0 1.9 as % of GDP in 2012 1.7 1.5 1.3 1.1 0.9 0.7 -5 -10 -15 -20 -25 Sources: CNB and national central banks. Croatia Poland Czech Rep. Romania Bulgaria Slovak Rep. Baltics 2012 Lithuania Central Europe Croatia 2011 Hungary 2010 Latvia EU periphery SEE 2009 Slovenia 2008 Estonia -30 2007 Banking union 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. 20 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 closecooperation Single Supervisory Mechanism + Supervisory Manual European Stability Mechanism National stability measures Single Resolution Mechanism EBA: • Single Rulebook • Supervisory Handbook Source: ECB. Non Banking Union National Supervisory Authorities National stability measures National Resolution Authorities 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 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. 26 Challenges of SSM participation for non-euro area country (2) 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 macroprudential 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.27 SSM timeline Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 SSM Regulation Approval Consultation SSM Framework Regulation SSM Framework Regulation EBA/ECB Stress Test SSM Transitory Phase 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 Q4 2013 Q1 2014 Q2 2014 Phase 1 Risk-based portfolio selection P1 Phase 2 Execution of Asset Quality Review (operative phase) P2 Phase 3 P3 Collation, quality assurance & reporting Operative Start Asset Quality Reviews Q3 2014 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 expost funding schemes since pre-funding is relatively modest. Differences in DGS among countries Funding 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 corporate deposits. Covered deposits applies the EC coverage ratio to eligible deposits. * 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 Insurance Insured deposits and DGS funds in Croatia, End 2012 Eligible deposits/GDP Covered deposits/GDP DGS fund size/GDP 0.86 0.44 1.21 Source: State agency for Deposit Insurance and bank Rehabilitation, Croatian Bureau of Statistics To conclude 2013 2014 2015 2016 2017 2018 2019 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) 1 Jan 2015 (at earliest): Single Resolution Mechanism Q3 2014: Results of BSA/ST 1 Jan 2019 (at latest): bail-in 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!