Will the Eurozone caucus on financial regulation?

Speech by Julie Dickson, Member of the Supervisory Board of the European Central Bank, at a lunch discussion organised by the Centre for European Reform, at Morgan Stanley, London, 1 September 2015.

Summary

The implementation of rules by supervisors matters just as much as the rules themselves, Julie Dickson, member of the Supervisory Board of the ECB, tells an audience in London at an event organised by the Centre for European Reform.

She highlights that the emphasis being placed by the ECB on the quality of supervision in Europe is refreshing and that the day to day efforts of supervisors in addressing bank risks are key to contributing to the safety and soundness of credit institutions and the stability of the financial system.

She points to four key areas of focus: the ECB’s aim for consistent supervisory practice in the area of non performing loan recognition, coverage and write-offs; conducting a public consultation in the autumn to work towards harmonising over 150 options and national discretions available at national level; the unified application of the 2015 supervisory review and evaluation process methodology which she says, will become more robust over time as the ECB’s knowledge of the banks it supervises increases; and finally a targeted review of internal models at banks that will aim to ensure that capital held reflects underlying risks - a task she says is complex and will take several years to complete.

Ms Dickson also acknowledges that improving the quality and consistency of supervision requires not just supervisory convergence but also convergence on European bank regulation. She identifies areas where harmonising some approaches hold more challenges than others. In the area of consistently applying fit and proper requirements for members of the banks’ boards and senior management, she says the ECB is confronted with very different national rules and practices. She also cites a German draft law on banking regulation that delegates to the German Federal Ministry of Finance certain competences to issue regulations which would replace the administrative guidelines issued by the competent German authority, BaFin. She emphasises that if such practices increase, the harmonisation and the establishment of uniform conditions would be hampered significantly.

She concludes that through the Single Supervisory Mechanism, Europe is moving quickly to harmonise supervisory approaches. ‘The ECB is taking banking supervision very seriously’, she concludes. ‘It’s a challenging, full time job and we’re doing everything possible to make banking union a success.’

Introduction

The topic I was asked to speak on is “Will the Eurozone caucus on financial regulation?”

It is an excellent topic, but I think it would be better to ask whether Europe will caucus on financial regulation and supervision, because the two go hand in hand. In fact, you could go further and add banking resolution. You could even ask whether Europe will also caucus on ideas that have been floated in the context of the capital markets union and are very important to supervisors, such as harmonising bank accounting rules and company insolvency laws.

So there is much to discuss. But there has been so much focus on regulation that I think we need to broaden the debate and discuss topics that matter in terms of reaping the benefits of any harmonised regulation. The related topic I want to focus on today is supervision, specifically how it will develop in Europe and how it is very much tied to European regulation.

Supervision and regulation

In creating the SSM, Europe is certainly working together on supervision, although much more remains to be done. Today I will fill you in on the progress made and the challenges faced in this regard.

As for regulation, I think the entire world – not only Europe – is working together on regulation, via the G-20, the Financial Stability Board (FSB) and groups such as the Basel Committee on Banking Supervision. This global effort has been in full swing since the global financial crisis, even though organisations like the Basel Committee have been operating for much longer than that.

Working together on regulation after the crisis made sense because of the global impact of the crisis and the evidence that the existing rules had been woefully inadequate. Rules can, of course, be changed very quickly and in full view of a public that wants to see change, so focusing on regulation in the aftermath of the events of 2008 made a lot of sense.

While it is often difficult to get global agreement, the amount of cooperation that took place and the agreements that were produced were significant. Although attention often focused on the big announcements, such as systemic risk buffers or counter-cyclical capital buffers, there were some incredibly useful basic agreements. One good example is the set of FSB principles for sound residential mortgage underwriting practices which were issued in 2012. Real estate is often associated with systemic crises, yet no one had ever agreed to time-honoured real estate lending practices. This led to serious trouble when banks did not adhere to such practices. The argument was always that no agreement was possible, as mortgage markets vary between countries. However, the FSB principles show that, while markets may vary, the basics are the same everywhere: have a strong appraisal process, pay attention to loan-to-value ratios and assess a borrower’s capacity to repay under current and possible future conditions. In fact, many of us benefited from the experience of other countries in terms of learning about the type of risky practice that can occur.

Global regulatory efforts are continuing. Indeed, more regulation is coming, with topics currently on the agenda including TLAC (Total Loss Absorbing Capital) and risk weights for sovereign debt.

Global regulatory agreements to date have been compromises, which meant that not everyone was happy. Indeed, in the many FSB or GHOS (Governors and Heads of Supervision) meetings I attended, it was often the case that half the group felt the changes being discussed were too soft, and the other half felt they were too tough.  In short, you never get everything you want. But most people recognise that more is at stake and that there are benefits of reaching global agreements when the financial system is so interconnected.

In my view, one of the less noted but most significant outcomes of this post-crisis regulatory exercise was the realisation that implementation of rules by supervisors matters just as much as the rules themselves. Furthermore, there was a recognition expressed in FSB and G-20 documents that quality of supervision in general was critical. Supervision goes far beyond regulation. Supervisors assess the risks and controls (of banks), which are critical to solvency.

Importance of supervision

That is why supervision is important. Rules are important, but the day-to-day efforts of supervisors are just as important.  Most of the staff at supervisory agencies do not write the rules. They are supervisors, focusing more on what banks are actually doing in areas such as risk management, internal audit, corporate governance, the selection of businesses they choose to be in, and the internal models they choose to develop for capital purposes. 

The financial crisis showed that many supervisory agencies had neither the resources, nor the mandates and independence to do what was necessary. IMF financial sector assessments showed that, while supervisory activity is a core activity, it is often the weak spot in country assessments.

In Europe, the SSM began operating in November 2014. The vast majority of SSM staff are supervisors. Our goal is to contribute to the safety and soundness of credit institutions and the stability of the financial system as a whole within the euro area.

This implies ensuring that consistent high-quality supervisory practice is applied to banks operating in the participating Member States (19 countries at present, coinciding with use of the euro). 

From my perspective, the emphasis that the ECB is placing on the quality of supervision in Europe is refreshing.  

Now that the SSM is in operation, working together on the quality of supervision takes collaborating to a whole new level in Europe. For each significant banking group we supervise, there is a joint supervisory team (JST) responsible for conducting supervision. Heads of JSTs are ECB employees located in Frankfurt, and are normally nationals of a country other than the one in which the bank is incorporated. For example, the JST head in charge of Deutsche Bank is French, whereas the JST head for Crédit Agricole is German. Around 75% of JST members are employees of the country in which the bank is located. This model achieves centrality of vision and absence of national bias, as well as allowing us to leverage on experience across Europe. 

We are creating a common supervisory culture across Europe. This means that all 123 banks we supervise should be treated the same: with tough but fair supervision. 

What has the SSM achieved so far, and what are some of the challenges it still faces?

It is well known that, just prior to the ECB formally taking over responsibility for supervision on November 4, 2014, a comprehensive assessment of close to 130 banks was carried out, comprising an asset quality review (AQR) and a stress test.  The exercise was as transparent and comparable as possible across banks and countries. In particular, the AQR resulted in the improved and harmonised identification of non-performing exposures (NPEs). It also resulted in an upward adjustment in the amount of NPEs of €136 billion. A capital shortfall of almost €25 billion was identified. Banks had until July 2015 to address the shortfall.

The ECB fully outlined the limitations of the review. Chapter 8 of our report covered the amount of deferred tax assets and deferred tax credits that were allowed as capital under national laws. Furthermore, the stress test only covered asset quality and sensitivity to shocks – not issues such as the quality of risk management and internal controls, governance and the sustainability of business models.

Notable work currently underway

Supervisors have been focusing on many of these areas since November 4. For example, we are close to completing a horizontal review of corporate governance practices across 123 banks.

Credit risk management functions, including specific weaknesses identified in the AQR in relation to methodologies, policies and incorrect classifications of non-performing exposures and provisioning models, are being carefully tackled.

Another stream of work focuses on the viability of business models and profitability drivers.

Bank IT systems, including whether there is underinvestment in IT and in the risk management of cyber security, are also being looked at.  

Much of the work identified above is the same type of work that any supervisory agency would do.

But in Europe, there are a few notable differences. The most obvious is that some banks in Europe are experiencing the type of questioning and review that we are carrying out for the first time. Furthermore, given the number of banks we supervise, the ability to conduct horizontal reviews can bring unprecedented benefits to the system. While it is still early days, one of the biggest benefits a supervisor can provide is knowledge about best practice. When there are 123 banks involved, the sample size is rich, providing an unparalleled opportunity globally to compare practices and determine strong versus weak practice. This is a major strength of the SSM.

Horizontal reviews conducted by the SSM have huge potential, but there are four other areas of ongoing work that are also worth noting. 
The first of these is work on non-performing exposures. Elevated levels of non-performing loans (NPLs) are a serious concern in Europe. This is an area in which we are aiming for more consistency with respect to the supervisory approach. We will be analysing current national regulations, legal frameworks, accounting regimes and supervisory practices relating to NPLs. Ultimately, we are aiming for consistent supervisory practice in the area of NPL recognition, coverage and write-offs. The work will help supervisors assess the NPL situation and drivers for individual banks, and develop NPL resolution plans tailored to individual banks.

The second is work on capital quality. We know that there is still a significant margin for discretion at a national level, which has important implications for the quality and composition of banks’ capital.  SSM banks have less harmonisation on this front than non-SSM banks in Europe. A large part of this discrepancy can be addressed within the context of the SSM. This is because, since the SSM has been in operation, the ECB has had the right to exercise the options and discretions (ONDs) provided for in the Capital Requirements Regulation (CRR), and which form the most important part of ONDs related to capital adequacy and liquidity requirements for prudential supervision. 

In cooperation with the national competent authorities and the EBA, the ECB has launched a project to explore and assess the possibility of harmonising – rigorously and only where appropriate – the exercise of both transitory and permanent supervisory options and national discretions. This is in the light of the objective of the banking union to promote financial integration and financial stability.

We have identified over 150 ONDs across Europe, many of which can be decided on by the SSM.  The ultimate aim is to foster convergence to the highest prudential standards, consistent with international rules, and provide certainty to banks, investors and supervisors.

However, some ONDs are enshrined in national legislation, where the SSM has no powers. It is our hope that the relevant countries will ultimately consider changing the relevant national laws as a result of this exercise.

This autumn, the ECB will conduct a public consultation on the ONDs for which the SSM is responsible. It will work together with the European Commission and EBA, and further follow-up work will probably involve the Commission, the European Parliament and certain national parliaments, given their authority over some ONDs.

The third is work on the supervisory review and evaluation process (SREP) for credit institutions. For the first time, all 123 banks have been subjected to the same supervisory methodology, which involves looking at an institution’s business model, governance and risk management, risk to capital, and risk to liquidity and funding. The process ultimately leads to the ECB proposing the mix of capital, liquidity and other supervisory measures that can best address the specific situation of each firm. Over time this process will become more robust as our knowledge of the institutions – which were often previously subjected to very different assessments in terms of depth and rigour – increases.

The fourth is work on the internal models that are used by banks to produce capital requirements. We are launching a targeted review of those models that are used by the banks we supervise. Our project, a complex exercise, that will take several years to complete, will aim to ensure that the capital held reflects the underlying risk – not unwarranted differences in models.

The work on NPLs, ONDs, the SREP and models enhances harmonisation across the euro area. But to fully achieve the SSM objective of improving the quality and consistency of supervision, we need to achieve more convergence, not only on supervisory practices, but also on European bank regulation.

Harmonisation challenge

The ECB has noticed that achieving harmonisation of practice and a level playing field is more challenging in some areas than in others.

I have already noted the example of ONDs, where considerable progress is being made, but where legislative change would be needed to deal with certain differences in the way the Capital Requirements Directive and Regulation were implemented nationally before the establishment of the SSM.

There are other examples, based on the lack of maximum harmonisation in CRD IV and rules that go beyond it. When it comes to directives, Member States are free to choose the form and method of implementation. It is unavoidable that there will be many divergences in the way different national provisions implement the directive.

For example, it is difficult for the ECB to consistently apply fit and proper requirements to members of the banks’ boards and senior management, as required under European law. When the ECB has to assess the suitability of new members of the board, it is confronted with very diverse national rules and practices:

- some authorities make use of questionnaires to be answered by the candidates (which, when they exist, are not harmonised from one country to another);

- some authorities conduct interviews with new members of the board;

- the criteria laid down in CRD IV to assess the suitability of the management body are interpreted differently in national law;

- the national timelines for conducting the assessment also differ greatly.

This is something that is difficult for the SSM to change, as harmonisation can only be achieved in the longer term by changing national law. In areas like fit and proper assessments, best practices are therefore not easy to spread across the 19 SSM countries. [1]

There are also examples of uncertainty as to whether national provisions implement or complement the directive. For instance, amendments to a bank’s articles of association (essentially covering what banks can and cannot do) have to be approved by the ECB in certain Member States, but some national competent authorities want to continue to exercise this competence based on their own interpretation. Other examples are the approval of some mergers (depending on their type) and the approval of loans to related parties (e.g. managers), which require the prior approval of the competent authority in some jurisdictions.

Another issue relating to the interaction between EU and national law is the trend we have observed whereby the national legislator converts non-binding supervisory guidelines into binding legal acts: one recent example is the German draft law on banking resolution that delegates to the Federal Ministry of Finance certain competences to issue regulations in the areas of internal governance, risk management, outsourcing and the recovery plans of credit institutions, which will replace the existing administrative guidelines issued by the competent German authority (BaFin), notably the Minimum Requirements for Risk Management (so-called MaRisk). In my opinion, national legislation empowering national authorities to issue binding prudential legislation interferes with the ECB’s competences within the SSM and fragments the prudential rules applicable to credit institutions within the banking union. If this practice increases, the harmonisation and the establishment of uniform conditions of competition will be hampered significantly.

It is the ECB’s view that it should be the exclusive competent authority to exercise supervisory powers vis-à-vis significant banks, including those powers that are laid down in national law. Other approaches would result in fragmentation and inconsistency in the supervision of significant banks in the SSM, which would be at odds with the objectives of the banking union.

Conclusion

In conclusion, I think that Europe and indeed the whole world have been working together on financial regulation. I think this will continue, although it may ebb and flow.

In creating the SSM, Europe is moving quickly to harmonise supervisory approaches. The ECB is taking banking supervision very seriously. At the same time, this is a challenging, full-time job that requires considerable attention over the long term. We are doing everything possible to make banking union a success.

We are calling for a degree of additional convergence in European bank regulation to help us meet our goals.

Regulation and supervision are just two parts of a bigger system. Bank resolution, the possibility of European deposit insurance, and the capital markets union – which will include some important issues for supervisors, such as greater harmonisation of accounting practices and insolvency laws – make for a rich agenda on which to make further progress.

[1]The EBA recently published a peer review report discussing the application by national competent authorities of its guidelines on assessing the suitability of members of the management body and key function holders. It noted that the current guidelines have not led to convergent supervisory practice and that CRD IV has not prevented this divergence (e.g. in terms of assessing the reputation of a board member, their experience, etc.). The EBA is of the view that a legislative initiative is necessary to remedy some of the issues identified in the review.