Challenges in banking

Interview with Jan Smets (Director, National Bank of Belgium)

What are the most important accomplishments/benefits  so far of the Twin-Peaks supervision model?

Jan Smets: The Twin Peaks model was not an arbitrary choice, the objective being to provide us with a better supervision on both macro and micro level. The financial crisis illustrated that a single micro view is too narrow to identify and assess all risks. It was a rational choice of the Belgian government to take both views together. The assignment to the Belgian National Bank was motivated by a number of elements. As the banking crisis was a global crisis, frequent international contacts and information-sharing ‑ a permanent feature among central banks ‑ is needed to asses systemic risks. Furthermore, central banks are market players and therefore have a good feeling and understanding of what is happening in the (money) market. Next, central banks are equipped with the necessary economic and statistical know how, helping them in understanding of what is happening in the financial system. Finally, as they are “lenders of last resort” it seems logical that they are also involved in the ex-ante supervision.

The model combines a horizontal and vertical dimension i.e. in-depth supervision of individual institutions combined with a more transversal view on risks. We do this by means of 5 departments: operational banking and investment firm supervision, operational insurance supervision, operational supervision of clearing and settlement institutions and market infrastructures, financial stability and prudential policy, and a support department with specific operational functions like model validation. We also installed 2 important committees, putting the 4-eyes principle into practice. The risk committee is composed of people from different prudential departments and directs the risk analyses: sovereign risk, credit risk, liquidity risk, market risk for financial institutions .... The macro-financial committee is composed of people from prudential supervision, combined with others from the NBB (from credit register, economics, statisticians, financial markets, …). This way we create interaction between prudential supervision and what is happening in the real economy to get a comprehensive view on the financial situation.

With regard to the implementation, which started around 1,5 year ago, we are pleased with the progress we made. The IMF will launch a Financial Sector Assessment Program at the end of the year and enable further benchmarking of our surpervisory environment with the best practices.

How would you evaluate the current state and outlook of the European Banking system at this moment? How does the Belgian Banking system compare to this?

Jan Smets: It is still a very challenging environment for banks to operate in today. We see that profitability in banks did recover from the crisis. However, towards the end of last year we saw a clear slowdown of profitability due a.o. to an economic slowdown, increased provisions and a Greek debt write-off. In Belgium , 2011 was a weak year for banks in terms of profitability with an overall return on equity of only 0.7%. Net interest income went up but profits were impacted by large impairments. Underlying profit generation is going in the right direction but asset quality concerns continue to put pressure on bank profitability.

With regard to balance sheet restructuring, Belgian banks were ahead of Europe: deleveraging started earlier and was faster. If you compare the total assets of Belgian banks now with the situation in 2007 we are already at minus 25% which is an important step forward. This reflected the deleveraging of our big banks which was imposed as part of their restructuring plan with the European Commission. Deleveraging was focussed mainly on non-core businesses (e.g. Asian trade finance activities, US dollar funded business, wholesale funding, etc.).

Will the increased capital requirements imposed on Banks not lead to downsized business and credit portfolio’s, further slowing down the economy?

Jan Smets: This partly relates to the previous question. If you see how banks are deleveraging, then this should not immediately impact credit growth. Again, banks focus deleveraging on their non-core activities in non-domestic markets. The Belgian credit growth to both households and business remains above the Euro-zone average. However, this should not come as a surprise given that the Euro-zone average includes the peripheral countries where there is a serious problem which impacts credit growth. But even when we compare with countries like Germany, France, the Netherlands, …. our credit growth remains at level, certainly for households. We do see a growing tendency, both in Europe and starting in Belgium, for businesses to move towards non-bank funding i.e. direct market financing, mainly because in some cases it has become cheaper than bank financing.

It is true that credit growth slowed down in 2012, but this does not reflect a credit crunch. It is always difficult to assess whether this slowdown is due to supply or demand, but, according to our bank lending survey, banks do not mention regulation or liquidity constraints as factors limiting credit supply. They did become more prudent in their credit decisions but this is more due to the economic slow-down impacting the demand-side’s creditworthiness. But this is a phenomenon we often see during economic slowdown. Similarly, businesses do not signal a real supply constraint yet they do highlight that banks ask for more guarantees. So I would not really attribute a slowdown in credit growth to increased regulation like Basel III but rather to the economic slowdown impacting the demand side.

Given the economic slowdown, the problems in Spain and Greece and the undercapitalization of many European banks, will Basel III be sufficient to stabilize the European Banking system?

Jan Smets: Basel III is absolutely necessary and a key component for a more stable financial system. But it will probably not be sufficient on its own. Basel III provides an adequate response to some of the deficiencies of the past but it will need to be complemented with some other aspects such as the recovery and resolution framework which sets out the necessary steps and powers to ensure that bank failures across the EU are managed in a way which avoids financial instability and minimises costs for taxpayers. Furthermore, a good regulatory and supervision model is needed. Finally, the financial system itself has a responsibility to restructure: costs reductions, assessing profitability drivers,  change in business models, better risk management and governance, , etc. Financial institutions will have to do this exercise themselves.  However, this is quite a challenge given the state of the European economy and political situation. A stable financial system needs a stable European economy with more political union and a better decision process.

What are the most important challenges to evolve towards a true European Banking Union? Is a Banking Union possible in a fragmented European financial landscape we see today?

Jan Smets: This is a very important decision which, according to the roadmap proposed by the European Commission, will already have operational implications next year as the EC proposes that the European Central Bank becomes responsible for supervising all 6000 banks within the euro area, starting with banks which received or requested public financial support and the banks of systemic importance. The idea came up as one saw that the strong correlation between banks and sovereign risks is complicating an efficient response to the crisis. When countries need to bail out banks and banks need to take provisions and impairments on sovereign debt, we enter a vicious circle which is difficult to break, especially given the home country bias in the banks’ sovereign bonds portfolios and the sovereigns responsibility in bailing out banks. Something needed to be done. Specifically, the European Council agreed in direct European support for Spanish banks under the condition of a centralised supervision.

A European Banking Union is also important to stop the process of fragmentation of the EU financial markets which started since the crisis. We made a monetary union to increase free flow of capital but since the crisis that flow almost stopped, especially between the north and the south of Europe. Cross-border banks again became national banks depending on national tax-payers when they ran into trouble. Discussions on banks rescues between countries are often very difficult and cross border lending is restricted. This fragmentation reflex is clearly countering the European goal of an efficient economic system with free flow of capital. A Banking Union is the way to break out of that.

There are still important issues to look at. One conceptual issue is the relation between the Banking Union and the Fiscal and Political union. Apart from the European supervision, two other major elements of the Banking Union have to be prepared, i.e. a European deposit guarantee fund and a European bank resolution scheme. And there are many questions which will have an important operational impact like the role of national authorities, the transfer of information, etc.

What will be the most important challenges for the banking sector for the coming 5 to 10 years? Given the new Basel III rules, is it possible to keep a banking sector still interesting from an investor point of view?

Jan Smets: The main challenge for our banks will be to establish long-term profitability while reducing in size, focusing on domestic markets and operating in an environment with low interest rates, limited economic growth and more stringent capital and liquidity requirements.  Taking also into account the dysfunctional interbank and government bond markets and  the challenging  economic conditions, the restructuring process is going to be very difficult. Therefore, we have to be vigilant that the drive towards long-term profitability under these difficult conditions does not lead to more risk-taking behaviour in banks. The refocus on domestic markets also re-concentrates risks on a limited number of markets. Belgian banks will become more dependent on the European economic situation and financial cycle. In the past, banks were more diversified (be it in the wrong markets or with the wrong products , such as structured products, U.S. mortgage loans, …) than they will be in the future.   How banks are able to handle these huge challenges by internal restructuring, changing business models, cost control etc. will ultimately determine whether they can generate a reasonable level of long-term profitability and be interesting for investors. But it is a real challenge.

The Vlerick - KPMG study showed that the big banks were those that took a lot of risks in the past and got severely hit by the crisis.  Is there a difference in regulatory treatment that is planned for the big banks in Belgium compared to the small ones?

Jan Smets: Large, cross-border banks were indeed at the forefront of the financial crisis. Yet, there are also serious risks involved in domestic retail markets. Until recently Spain had a reasonably strong banking system, but now its banking system is severely hit by the real estate crisis. This shows that making pure retail banks focussed on domestic markets is no guarantee to have a less risky financial system. If competition is fierce on domestic markets this even could increase the risk-taking behaviour of traditional retail banks, which could also lead to problems. So we have to be careful in thinking that all problems, all risks can only come from large banks. That being said, SIFI’s (Systemically Important Financial Institutions), by their systemic nature require additional regulation in order to protect the financial system. For example, in Belgium, for SIFI’s the NBB has the power to oppose any strategic decision: e.g. transfer of activities, M&A’s, sale of certain assets, ….

The NBB released a study, ordered by the government, last June in which we investigated whether foreign initiatives like the Volcker rule and the recommendations of the Vickers Commission ‑ such as distinguishing between commercial and investment banks or ringfencing retail banks ‑ would also be useful for the Belgian financial system. Our conclusions are that in a financial landscape like ours, where we have so many foreign branches operating which we cannot restrict in their activities or intra-group transactions and knowing that foreign subsidiaries could eventually decide to convert into branches, recommendations like Vickers would have major implementation challenges. That is why the NBB formulated another set of recommendations that would contribute to a similar outcome. For example one of the recommendations is to extend the recovery and resolution plans which are now being formulated for global SIFI’s to all domestically important systemic banks. We also recommend new rules relating to intra-group exposure and capital surcharges to banks' trading activities. All these measures should help protecting our economy from excessive financial risk-taking. We are looking for reactions on these proposals. They can be found on the NBB’s website: Interim report - structural banking reforms in Belgium, June 2012.

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