Europe’s banks are more resilient than we think

#CriticalThinking

Picture of Howard Davies
Howard Davies

Howard Davies is Chairman of the Royal Bank of Scotland

It took a while for policymakers in Europe to appreciate that the financial crisis, while it was triggered by a collapse in the US sub-prime mortgage market, was not just ‘Made in America’. The balance sheets of European banks had been expanding even more rapidly than those of their American counterparts, and on average their leverage ratios were higher.

Some economists have ascribed Europe’s difficulty in escaping from the recession and achieving sustained growth principally to its over-reliance on bank finance. In Europe, banks supply over two-thirds of the external financing needs of non-financial companies – the comparable figure in the United States is nearer 20%. The US stock and bond markets are able to step in to fill the gap left by retrenching banks. But when EU banks catch a cold, and are obliged to rein in their lending, the real economy unavoidably contracts. Strengthening European banks has therefore been a very high priority for policymakers in the last eight years, but how far have they succeeded?

To assess the state of Europe’s banks today, it is useful to consider three different yet interacting elements: institutional reform, reform of the rules and standards imposed on banks, and the practical achievements in terms of the measurable strength of banks’ balance sheets.

Severe stress tests assuming a domestic UK recession and a severe slowdown in China have shown that British banks could now survive

On the institutional front, it became clear as the reasons behind the crisis were examined that the EU’s regulatory architecture was in need of attention, in the single financial market as a whole, but particularly in the eurozone. The De Larosière report of 2009 made an initial attempt at a solution, proposing three new Authorities, for banking, securities and insurance, to replace the existing network of committees. In the absence of a new treaty, these authorities – one of which being the European Banking Authority in London – were endowed with only modest powers. But despite that, the EBA was charged with working towards a single rulebook for the EU, and with setting the terms of pan-European stress tests to determine just how robust banks would be in the event of a new recession or market disruptions.

The stress tests did identify some weak institutions in need of more capital, but they largely failed to restore confidence, as many market participants believed that national supervisors lacked the will to highlight domestic vulnerabilities. The problem was particularly acute in the single currency area, as the European Central Bank (ECB) was the only institution capable of supplying euros to illiquid banks, but had no direct oversight of them. The Single Supervisory Mechanism has in less than 18 months injected new discipline into bank governance, and has scrupulously rooted out supervision inconsistencies across the continent.

But what matters more than the institutional arrangements is the nature and rigour of the capital rules that supervisors police. Most of the new capital rules have been developed on a global basis in the Basel Committee, but they are implemented in Europe by means of directives, which ought to ensure thorough and even implementation. The EU’s fourth Capital Requirement Directive in fact goes further than Basel requires, and was complemented by a new Banking Recovery and Resolution Directive, which harmonises the rules and procedures for dealing with a banking crisis.

I have little doubt that the regulatory environment is far tougher now than it was before the crisis, but it would be wrong to think that all its imperfections have been ironed out. Speaking to the European Parliament in February, Daniele Nouy, the Chair of the ECB’s supervisory board, acknowledged that many national discretions and much of the implementation inconsistencies remain, even in the eurozone. As she put it, ‘these divergences distort the level playing field and make our lives as supervisors more complicated.’ Some may feel that complicating supervisors’ lives is a small price to pay for the justified application of the subsidiarity principle, but it presents a real problem for the banking industry as a whole if the system lacks full credibility.
Legislative action is urgently needed to end these divergences, which often go to the heart of the viability of a bank – differing treatment of tax assets or loan impairments, for example. But the most important point has to be whether there is solid evidence that European banks are indeed adequately robust with reserves to carry them through the next real-life stress test. The market disruption at the beginning of this year, and its severe impact on European banks’ share prices, put that question into sharp relief. The data suggest that, in aggregate, EU banks are indeed stronger. The Common Equity Tier I ratios of systemically significant companies have increased from 9% in 2012 to 13% since the latest EBA stress test, and are set to rise further. But there are still weak outliers, especially in southern Europe.

Individual banks will need to be strengthened, but instigating an aggressive approach across the board would be dangerously destabilising

Loud voices in academia are arguing that the improvements so far made are not enough. Sir John Vickers, author of a report for the British government on banking reform, argued in February that the volatility in bank stocks shows that even more reserves are needed, and that the Bank of England has diluted the reforms he proposed in 2011. He claimed the Bank ‘is proposing a substantially milder equity requirement for British banks’ than he believes necessary. The Bank of England, though, firmly rejected the criticism, maintaining that severe stress tests assuming a domestic UK recession and a severe slowdown in China have shown that British banks could now survive in very challenging economic conditions. Both the Bank of England and the ECB have reached the view that the reforms already implemented should be allowed time to bed in.

That seems a wise conclusion, at least for the time being. There is certainly a theoretical case for banks to hold much higher equity capital; but to do so, a bank would either have to raise new equity or cut back on lending. In a heavily bank-based economy, doing the latter will have important implications for growth. The long-term answer is to develop stronger alternative sources of finance, and the Capital Markets Union is designed to achieve that, but it will take a long time to change the habits of European banks and, more importantly, of their clients. The right priority for now is to ensure that all the changes made to date are fully implemented, and are consistent between countries. There are individual banks that will need to be strengthened and perhaps restructured, but instigating an even more aggressive approach across the board would be dangerously destabilising.

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