Andrea Enria (BCE): “We have observed a deterioration in bank governance since the crisis”

Posted Feb 14 2020 at 6:00 am

You denounce shortcomings in the governance and transparency of European banks. How serious is the situation?

Since the financial crisis, banks have made progress, with a strengthening of their capital and an improvement in the quality of assets on their balance sheets.
But governance is the only area

    in which, on the contrary, a deterioration has been observed. These may include weak internal controls, a lack of oversight by the board of directors, lapses in the fight against money laundering or the inability to report good bank data due to outdated IT systems. I was surprised when I took up my duties at the number of inspections that noted this difficulty within the banks. We have seen a series of cases, one after the other, without the banks taking effective corrective action.

You also point out certain methods of remuneration deemed too aggressive …

The compensation model for managers is perceived as one of the problems linked to the 2008 crisis, since it encouraged them to report short-term profits without paying sufficient attention to long-term risks. Since then, there have been attempts at supervision. I do not want to diminish the successes of these reforms, which have led to more moderation in terms of bonuses. But there is still this obsession on the part of the banks to retain “talents”, the “money makers”, which can lead, even today, to remuneration policies which are not as sensitive to risk as they should.

What is missing from the banks to raise the bar?

The problem may be, in some cases, the composition of the board of directors, the range of skills, particularly in the IT field, its diversity or the presence of independent points of view. In some establishments, it is a real challenge for the board to weigh against a very dominant leader. Despite cases of proven breaches or money laundering, we still do not see the markets exerting pressure on the banks to improve their governance … unless they perceive the risk of a large fine. The shareholders do not exercise sufficient power in this matter. As for the holders of the banks’ debt, what worries them most is whether the banks will repay their debts. The rest do not interest them much. In reality, the only person who can say something is ourselves, the supervisor.

What are you going to ask the banks to fix it?

It is case by case. We ask to take very targeted measures, in particular to strengthen their internal control functions, for which the staff is often insufficient, or to renovate the IT infrastructures. When major failings appear – for example in the area of ​​anti-money laundering – we can study whether the members of the board of directors responsible for these matters have acted as best as they could. If not, then you start to wonder if they are the right people to do the job. We could also require banks to further strengthen their capital. This is of course not the recipe for changing behavior, but if qualitative measures are not enough, I do not exclude it.

You blame the banks for their lack of profitability. But in their eyes, it is the ECB’s low interest rate policy that weighs them down. What do you say to them?

This narrative that there is a contradiction between monetary policy and supervision is misleading. In reality, monetary policy has opened a window for the banking sector to repair balance sheets. Could the banks have sold such bad debt volumes if the rates had been higher? Didn’t the stance of monetary policy favor the expansion of loan volumes, which supported the renewed profitability of banks? I think there is a strong coherence between monetary policy and supervision: the first pursues its own inflation objectives, and the second allows the banks to recover their strength. The two go together.

Banks complain about it, however…

I know that the banks intervene in very difficult market conditions: the rates are low, the margins reduced, and the economic outlook not always bright. There is a lot of competition, and therefore a lot of pressure on profitability, and regulations have become more demanding. In this context, one can continue to complain about the outside world, lose money and burn capital. Or accept the world in which we live. Banks that understand this improve their efficiency and focus their revenue generation on their strengths.

But haven’t the authorities given in to the banks on the Basel III agreements and softened the effects of this regulatory framework?

I resolutely support the new so-called Basel III standards. They are also inspired by the analyzes of the EBA and the ECB on what did not work in the internal models of banks. At the same time, I know that the banks are very worried about the effect of the “output floor” [plancher limitant les avantages que les banques peuvent tirer de l’utilisation de modèles internes pour le calcul des exigences minimales de fonds propres, NDLR]. But the output floor is an essential component of the international agreement. We have to bite the bullet and implement these measures. I see two cases that could lead us to act to avoid the undesirable effects of the output floor. First, for some banks, the pillar 2 requirements [exigences en capital calculées individuellement pour chaque banque, NDLR] today include capital charges for model risk, which may no longer be essential insofar as these risks are adequately covered by the new Basel standards. Second, since pillar 2 requirements are expressed as a percentage of risk-weighted assets (RWA), an increase in RWA due to the output floor could lead to a purely arithmetic increase in pillar 2 requirements, without this reflecting any real increased risk. If this is the case, we will sterilize these effects in our pillar 2 requirement calculations.

Have the banks also obtained an implementation deadline?

Banks have also obtained a rather long transition period for the application of the output floor, which will come into effect gradually until 2027. Personally, I never believed in the benefits of long transition periods (but I was an isolated voice in the matter), because they give the impression that capital requirements are constantly increasing, as if the banks were permanently living under a sword of Damocles.

Does the sector have to consolidate to get out of it?

If I gain height, I see that there is overcapacity, and that this is one of the elements that weigh on profitability. To adapt, banks should refocus their business models, and consolidation can also be a useful strategy. This was the case in many other sectors affected by a global crisis, such as the steel industry or the automobile at some point. This has not been the case for banks in Europe, at least not in the proportions that would be necessary. The explanation is due to the strategy adopted in Europe during the financial crisis: the banks were supported by their national governments, and consequently, either they carried out consolidations at the domestic level, or they were entrenched in their domestic markets after have ceded their presence abroad. We have therefore obtained in Europe too little restructuring and markets that are too segmented according to national borders. Our failure to act at European level has resulted in building a weaker sector.
Consolidation remains in my eyes

    a recipe to remedy these problems.

What can you do to encourage movement?

At my level, what I can do is to see if there are obstacles to consolidation that fall within my perimeter of competence. If banks and investors perceive that we are negative about mergers, that we would systematically impose higher Pillar 2 requirements in the event of a merger (well above the level necessary to cover execution risk), then I must at least change that perception. Our role is to look at the business plans and check whether the bank resulting from the merger would still comply with regulatory requirements, particularly in terms of capital. We also need to clarify the prudential way in which we deal with mergers, for example in terms of badwill treatment. But there are other obstacles for cross-border mergers which are not in our hands, and which are more the subject of debates around the Banking Union. Until these discussions progress, let’s see what we can do to get things done.

Since the crisis, the banks must, in theory, no longer be saved by public money … but the cases are increasing. What should we do?

I totally agree with the resolution authority [l’entité européenne chargée de redresser les banques en graves difficultés, NDLR] which requires more clarity in the rules. The case of ABLV is particularly striking. We considered that the bank’s failure was proven or foreseeable [failing or likely to fail], following laundering lapses which led to liquidity problems. Once we declared the default, the bank went to its country before a court which ruled that it was not insolvent, because its assets were always greater than its liabilities! The legal situation of the ABLV subsidiary in Luxembourg was even more complex.

More broadly, why is the situation so complex?

As bankruptcy law is not harmonized in Europe, the outcome may differ from country to country. In addition, the intervention margins of local deposit guarantee systems vary widely between Member States. This is not how a Banking Union should work. When we consider that the failure of an entity is proven or foreseeable, I need to know what will happen next. There is a perception in public opinion that the promise to no longer save the banks on public money is not kept. And perception in this area matters.

The political context does not seem conducive to advancing European projects such as the Banking Union…

When European debates are blocked, it is because everyone is trying to enter the negotiation room with red lines. And sometimes all the red lines cross. The only way out would be to achieve some sort of balanced disarmament. The way we usually do it in the EU in this kind of case is to agree on a roadmap, with gradual steps that can be checked and lead to the final result. This is what made it possible to achieve the single market, or the single banking supervision in the euro zone. We have to follow the same approach. I remain optimistic because it is absolutely essential to complete the Banking Union and, sooner or later, positions will change in order to achieve this common objective. Red lines are often the result of a short-sighted approach.

In which way ?

I observed it at the time of the financial crisis. I was then in Italy and the Dutch Ministry of Finance proposed a European common fund intended to support the banks after the Lehman crisis, and the position of Italy was negative because this country thought that the Italian banks were not exposed the risks inherent in structured financial products. Then, then, when the bad debt crisis arrived, their position evolved, and paradoxically, the position of the Netherlands had evolved the other way! These political debates can be complicated, but setting up a risk-sharing system is clearly in the interest of EU citizens.