View of a Central Banker on the Future of Banking
Speech by Yves Mersch, Member of the Executive Board of the ECB,at Slovenian Banking Day,Brdo, 6 November 2015
Dear Dr Arhar,
Ladies and gentlemen, 
It is a pleasure to be here today at the Slovenian Banking Day.
I will discuss the challenges facing the European banking sector and the right policy responses. The main point I would like to make is that we need a balanced approach – supporting the healthy forces of creative destruction, while at the same time protecting consumers and the essential functions of banks in servicing the economy.
The future for the European banking sector is currently characterised by some uncertainty. European banks are coming out of the crisis facing disruptive forces from all sides. They confront three main challenges to their business models.
The first is dealing with the legacy effects of the crisis on their balance sheets.
Since the Lehman shock banks have been going through a prolonged process of resizing and deleveraging: shedding non-core business lines, writing down impaired assets and increasing provisions. The total assets of the euro area banking sector at the end of 2014 were almost 16% lower than in 2008. That restructuring process has been costly both in terms of lower profits and diverted management time. Many banks also still have to work through their large stock of non-performing loans (NPLs), which further weighs on earnings prospects.
The second challenge is adapting to the new wave of regulation since the crisis.
Banks have been required to improve both the quantity and quality of their capital, which has, in the short-term at least, led to a de-risking of banks’ balance sheets to improve risk-weighted assets. The incoming leverage ratio, which will put a cap on balance sheet size, is also obliging banks to make difficult decisions over how to allocate assets and which business lines to maintain. And reform proposals are on the horizon that will limit cross-subsidisation between banking and trading activities, which will require some adaptation in the business models of Europe’s universal banks.
Third, banks are faced with profound structural changes.
As evolving customer preferences interact with new technology, for instance in the growth of internet and mobile banking, barriers to entry into banking are falling. Banks with large branch networks are being exposed to competition from lower cost and less regulated operators. We see this already in the emergence of peer-to-peer lenders and technology firms offering banking services. There is also increasing competition in banking services more generally, as firms like Paypal become well-established in markets like retail payments that were previously the preserve of high street banks.
On top of this, the trend towards more capital market-based financing in Europe – supported by the new initiative on Capital Markets Union – will inevitably weaken banks’ market power, especially for larger firms that can easily substitute bank and market finance. And though still relatively small in quantitative terms, we are also seeing a greater role of “shadow banks” in direct lending – asset managers, pension funds, private debt funds – that heralds a shift towards a less bank-dominated financing mix.
Taken together, this represents a uniquely challenging environment for European banks, and this is visible in their generally weak financial performance: price-to-book ratios, though rising, still remain below 1, and for many banks profitability remains meagre. Many banks have a cost of equity exceeding their return on equity. Moreover, while the recovery is ongoing, headwinds have recently increased, and our monetary policy will remain accommodative for an extended period of time. Banks will therefore have to return to profitability in the context of a slow recovery with low net interest margins.
So, should we be concerned about how banks will fare in this difficult climate? In my view we need a nuanced stance. What are costs for the banking sector are, in some cases, benefits for society at large. Many banks grew too quickly before the crisis and developed unsustainable business models, so a period of consolidation is desirable. The overall direction of the regulatory agenda, which is to make banks more resilient and reduce the cost of bank failure, is also fully justified in light of the burden of the crisis on society.
And the ongoing structural changes confronting the sector are part and parcel of a functioning capitalist economy. If we believe in the benefits of creative destruction for real economy firms, then we must also believe in it for financial firms. Innovation that raises competition in retail lending, and leads to better and cheaper services for customers, is a net gain for the economy. So, a priori, I do not see any role for regulators in protecting banks from new operators – on the contrary, innovation should be nurtured and encouraged.
Equally, more contestability between banks and capital markets – which is the promise of Capital Markets Union – is clearly in the public interest. It would benefit, in various ways, financial stability, access to finance and entrepreneurship. In particular for equity risk capital, which is critical for innovative young firms, market fragmentation in Europe creates a self-fulfilling brake on progress. Venture capital firms do not have a large enough deal flow to cover the majority of investments that will fail, meaning fewer investments are made
Drawing comparisons with the US market provides some useful insights, particularly as the two regions are similar in terms of economic power – both the EU and the US have an annual GDP of around €17 trillion. In 2014, business angels in the US invested €19.9 billion in SMEs, compared to only €5.5 billion in Europe. Similarly, venture capitals invested €43 billion in US SMEs, compared to only €9 billion in Europe.
It becomes apparent that Europe needs to work towards a genuine single market for all forms of financing – for loans, bonds and equity.
Still, despite these positive aspects, we must also acknowledge that the process of adaptation and structural change in the financial sector could have unwelcome consequences. We cannot therefore be agnostic about how that process evolves. Indeed, there are at least two possible outcomes from this changing environment that we need to be particularly careful to avoid.
The first is that innovation comes at a cost to consumer protection.
We have already seen in some European countries the risks posed by the emergence of new actors with little official oversight – internet payday lenders, for example. And such activities by unregulated non-banks can create pressure for a race-to-the-bottom among more regulated banks, which would also be detrimental consumer security. We therefore need to ensure the right balance between innovation and regulation. The regulatory landscape should not stifle new operators or protect the rents of banks, but it also needs to be consistent and fair.
The second outcome we need to avoid is that the pressures of the new environment cause bank lending to fall too much and then stay too low.
I say this not because there is any ex ante preference for bank lending over other forms of credit. I say it because, whether we like it or not, banks have a vital social function in Europe in taking the credit risk to lend to small- and medium-sized enterprises (SMEs). And even with a more diversified financing mix in Europe, this function is essentially irreplaceable by non-banks. It is only banks that have the relationship networks and screening and monitoring processes to manage the information asymmetries associated with smaller firms. For non-banks obtaining adequate information is simply too costly and resource intensive.
Thus, were banks to respond to regulatory and structural changes and weak profitability by taking less credit risk vis-à-vis SMEs, or shifting their asset allocation to mortgages or securities, non-banks could not easily fill the gap. And as SMEs account for around 85% of total employment growth in the EU, and have a much higher employment growth rate (1% annually) than large enterprises (0.5% a year), the costs for the European economy would be very high. So how can we avoid this scenario?
Above all, banks themselves need to face the challenge; they need to reinvent themselves and reinvigorate their business models. Many banks have already begun this process, for example by shifting focus from trading and wholesale banking to retail banking and asset management. Cost-cutting efforts are also continuing. All this is an important part of adapting to the new environment.
Yet in my view banks must also be careful that, in responding to short-term pressures, they do not compromise their longer-term viability. Specifically, if they elect to cut costs and boost profits through underinvestment, over time they will not be able to keep up with technological change and evolving customer demands – and in the end they will not have a business model.
Most importantly, retail customers now expect to be able to move seamlessly across digital channels such as online and mobile banking, which requires adequate investment in digital platforms. And if these expectations not met, they are also now increasingly prepared to switch accounts, causing banks to lose a cheap source of funding. In short, more than ever banks need to innovate to keep their customers loyal.
But alongside the banks themselves, other policymakers also have an important role to play in creating an environment where bank lending to the real economy remains profitable – that means supervisors, regulators and economic policymakers.
First of all, banking supervisors have a central role in establishing a framework for the banking sector where an optimal market structure can emerge – which is to say, where banks can reach their optimal size and level of geographic diversification without impediments creating by supervisory divergence. According to most indicators this is not currently the case in the euro area: there are too many banks relative to the size of the market, and many banks remain largely focused on domestic markets.
The crisis has led to some rationalisation of the banking sector – on a non-consolidated basis, the number of credit institutions in the euro area has declined by 1,160 (-17 %) between 2008-14 – but this has also been accompanied by a renationalisation of their activities. Indeed, from 2008 to 2014, the overall value of banking M&A transactions decreased from about €39 billion to about €8 billion, with cross-border transactions seeing the steepest decline.
The launch of European supervision should, in principle, represent a structural break in these trends. The whole point of the SSM is to bring an end to the era of “national champions”, heralding increased external competition in national banking markets and new opportunities for diversification and consolidation. But that will only happen if, in practice, the SSM leads to a genuinely level playing field in the setting and application of rules. If beneath the surface a patchwork of national rules and exemptions remains, it will implicitly sustain home bias. The huge potential benefits of a single euro area banking market will be diminished.
Next, banking regulators can also assist the transition of the euro area banking sector to more sustainable business models by providing more regulatory clarity. Despite the many benefits of the regulatory agenda in terms of increasing the safety and resilience of the banking sector, it has also clearly put a large burden on banks, and at some point that becomes costly. For example, if banks are simultaneously aiming to lower operating costs while raising the resources they dedicate to regulatory compliance, there must be a consequence elsewhere. For instance, IT resources may be diverted away from innovation. If banks are to adapt successfully to the new regulatory environment, they need to know how it will look.
Regulators can also support banks’ function of lending to the real economy in another way: by improving the framework for instruments that allow banks to reduce the idiosyncratic risk of lending to SMEs. In particular, a well-functioning asset-backed security market means more bank lending. There are many issues involved in reviving that market in Europe, which I have discussed at length elsewhere , but one of the most important is improving information for investors. The ECB is playing its part here through its loan-level initiative, but over the medium-term I am convinced that regulators need to work towards a pan-European central credit database. This would facilitate multiple country SME ABS, which would provide many of the same diversification benefits as European banks.
Finally, the efforts of national economic policymakers are vital to ensure that the banking sector continues to be able to serve the real economy. That means, as a priority, improving national frameworks to resolve the legacy of bad debts left by the crisis, which would in turn both free up bank capital for productive lending to firms, and free up private sector balance sheets for renewed borrowing and investment.
The ECB’s Comprehensive Assessment of bank balance sheets has already laid the ground for this by forcing banks to provision for non-performing exposures. Now, more needs to be done at the national level to make NPL workouts more efficient, like improving intercreditor mediation or in- and out-of-court restructuring frameworks, as well as increasing judicial capacity. For example, to complete insolvency proceedings in Italy takes on average 1.8 years, while in Ireland it takes just 0.4 years. Such differences also make it harder for banks to get NPLs off the balance sheet, as investors are less likely to buy into distressed debt if they have to wait years to have their claims processed by the judicial system.
Alongside this, national economic policymakers have a crucial role to play in improving the macroeconomic environment through introducing structural reforms that will raise long-term growth. Recent empirical work by the ECB finds that, though there may be some material bank-specific and structural impediments to higher profitability, the main challenges to profit generation are cyclical.  A strong economy is therefore part and parcel of a well-functioning banking sector. The ECB will also support this process by ensuring that inflation returns back towards our objective.
Let me conclude.
The European banking sector is facing profound challenges that are reshaping financial intermediation in Europe. These are in principle positive forces and we should not stand in their way. It is banks that need to respond and face the challenge.
But we should also not be short-sighted: we need strong banks in Europe to support our economy, and policy has a role to play to achieving that. This does not mean helping individual banks or promoting national champions, it means creating an environment where the optimal banking sector for the euro area can emerge that can support the real economy. Then, banking will have a solid future in the emerging European financial landscape.
This speech was inspired by an earlier talk: The Future of Banking – a Central Banker’s view Speech by Yves Mersch, Member of the Executive Board of the ECB, at the Economist Future of Banking Summit in Paris, 10 March 2015; https://www.ecb.europa.eu/press/key/date/2015/html/sp150310.en.html
See speech by Y. Mersch, “Next steps for European securitisation markets”, Barcelona, 11 June 2014.
See ECB (2015), “Bank profitability challenges in euro area banks: the role of cyclical and structural factors”, Special Feature B, Financial Stability Review May 2015. Financial Stability Review, Special Feature.