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Economic and monetary challenges - Review of EU regulations to support the financing of the EU economy and financial stability

Competitiveness and resilience of the EU financial sector

By Lemierre Jean - Chairman, BNP Paribas

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There should be no doubt that the resilience of the European financial sector has been considerably strengthened compared to 2008:
• The quantity of capital available to cover potential losses has doubled over the period, by the combined effect of earnings retention, and capital raising. Significant deleveraging was also implemented to improve capital ratios.
• The quality of this capital has also significantly improved, with Core Equity Tier 1 being now the key measure of capital strength.
• The liquidity risk has receded, as banks constituted huge liquidity buffers as a response to the LCR regulation
• Credit risk, which deteriorated in the period notably in peripheral Europe, is now better covered by provisions, in particular for banks having passed the Asset Quality Review, and being now directly supervised by the SSM.
• Market risk has dropped due to harsher liquidity and capital constraints on trading activities, and the implementation of separation laws in some countries, including France.

In parallel, European bank’s balance-sheets have gained in transparency, through the EBA stress tests, which are now routinely conducted on the largest financial institutions. This should allow investors and other stakeholders to form an educated view on the credit worthiness of their deposits or exposures.

However, looking at prevailing market conditions, it doesn’t seem that European banks are reaping the fruits of this unprecedented collective effort. Equity investors are downgrading RoE expectations, without adjusting the required risk premium. Bank valuations are reaching new lows compared to other sectors, Debt markets have been virtually closed for banks, given the uncertainties created around the regulation of Maximum Distributable Amount and implementation of MREL. Trust in the European Banking sector remains also challenged as the SSM has focussed so far only on130 banks. Recent events have shown that smaller banks can also pose problems, generating suspicion on the whole sector and requiring overproportional support, at a time where the discussions around EDIS show that risk sharing can only occur if risks are correctly measured and managed. The harmonized supervision of smaller and weaker banks is a necessity, as well as the reduction of options and national discretions, when those are not justified by recognized specificities.

In this context, regulators should be extremely cautious and focus on how to help banks weather this delicate transition period. The European economy needs healthy and profitable banks, able to compete with non EU Investment banks, as market-based finance is set to develop in the context of the Capital Market Union.

It is imperative that those additional requirements are compensated by reductions in the overall calibration and/or in Pillar 2 requirements.

Several aspects must be prioritized in order to ensure a level playing field, taking into account the higher proportion of bank intermediation in Europe:
– stabilize the framework as relates to capital and debt instruments. Banks will need to issue significant amounts of AT1, Tier2, Senior unsecured and Senior secured debt in the coming years to reach the imposed ratios. Investors need clarity in terms of risk characteristics of each layer of instruments. Rules applying to coupons and bail-in need to be logical, simple. The articulation between TLAC and MREL, between G-SIB and non G-SIB, must make common sense. The authority in charge of applying them must be fully empowered and accountable for their actions. Investors need to be confident that there is fairness, legal certainty, as little as possible room for interpretation, and no opportunity for political pressure. Europe voted a Recovery and Resolution framework, it needs to implement it consistently and avoid goldplating beyond international standards.
– stabilize the quantity of capital and liquidity needs. As stated by BCBS, there should not be any significant increase in capital requirements. But actually, there remains a major uncertainty given the magnitude of the revisions that are still in the pipeline: Fundamental Review of the Trading Book, IRB floors, review of operational risks, each of those subjects being likely to generate significant RWA inflation. Again, this new wave of regulation will hit disproportionally EU banks vs US peers. Uncertainty on additional capital buffers also remains high: review of SIFIness scoring, entry into force of the Countercyclical Buffer, inclusion in the SREP process of new risks such as CVA, IRRBB, etc. Last but not least, the leverage ratio may also be a threat for EU G-SIBs, if not properly calibrated as a backstop as initially intended. This uncertainty on target capital levels puts at risk the dividend expectations, and weighs, again, on bank ability to attract capital and to finance the economy.

In summary, it is imperative that those additional requirements are compensated by reductions in the overall calibration and/or in Pillar 2 requirements, as suggested by the UK PRA.

Otherwise, a new wave of bank deleveraging will happen, while EU banks will continue to lose market share vs their US competitors, putting at risk, as stated in a recent report by Bruegel, European financial independence.