Banking Union and the funding of the Portuguese Economy

1. The stability of the financial system and soundness of its financial institutions affect growth and social and economic development.
   
   The degree of interconnection between the financial sector, the economy and society is the reason why healthy banks are essential. The truth is that the banks are the heart of the economy, which needs credit to be pumped out easily but sensibly.
   
   We know that the banking system in Europe is responsible for around 3/4 of the funding for the economy, almost three times more than in the United States, where securitisation and the capital market play an important role.

   It is therefore necessary for a banking system to be strong, modern and reliable in the service of the people and the economy. This means that banks must:

    a) be well capitalised

    b) have balance sheets that accurately reflect their assets

    c) have access to funding on normal conditions

    d) carefully manage risk  and risk-weighted assets

    e) offer attractive returns to investors and stakeholders

    f) be able to ensure development and technological innovation

    g) have good governance

    h) have good practices and transparency for a friendly, trustful relationship with customers

   This requires proper regulations that are defined and implemented very sensibly, after the impacts and consequences have been considered. Effective supervision is also vital.

2. The 2008-2009 financial crisis that began in the United States forced governments to intervene massively in support of their financial institutions, to stimulate the economy, revise regulations and step up prudential and behavioural supervision and monitoring of banks.

   The measures taken in the regulation and supervision of the financial sector are designed to fill in the gaps detected at several levels:

   • resiliency and resolvability of institutions
   • architecture and quality of supervision
   • institutions' governance
   • good banking practices
     
     

3. When the European sovereign debt crisis broke out in 2010, Europe's financial fragmentation increased considerably.

   This fragmentation and the different situations in different member countries are clear if we assess the sovereign risk in EU Member States. In the first quarter of 2013, there were eight European countries among the world's 10 with best rating and lowest sovereign risk. But there were also four Eurosystem countries among those with the highest sovereign credit risk.

   The greater difficulties felt by the most affected countries, even those with the very resilient banking systems, like ours, resulted in downgrades of their ratings and consequent lack of access to the markets.

   The greater difficulties felt by the most affected countries, even those with the very resilient banking systems, like ours, resulted in downgrades of their ratings and consequent lack of access to the markets. At the same time, these countries' inability to access the markets for their own funding forced them to resort to domestic banks to place their sovereign debt. Their banking systems suffered due to the fall in balance sheet value of their sovereign debt assets and the resulting impact on their solvency.

   These interconnected risks appear at a time of fragmentation of national-level supervision processes and the standards that guide them, resulting in different degrees of accuracy and transparency in analyses.

   This new context makes it necessary to step up regulation and supervision:

   • laying down uniform prudential rules
   • using the same supervision criteria in all Member States
   • pass appropriate legislation on rapid recovery or liquidation of financial institutions and minimise costs to taxpayers
     
     

   Hundreds of new regulatory measures have been taken and others are in the pipeline, particularly those associated with:

   - the Capital Requirements Directive and Regulation, in effect since 1 January 2014, which is the transposition of the Basel Commission Recommendations, or Basel III

   - new short-term (LCR) and long-term (NSFR) liquidity requirements 

   - a leverage ratio

   
   Banking Union, with its three pillars –single supervisory mechanism, single resolution mechanism and single deposit guarantee system - is a response to the interconnection between sovereign risk and credit institution risk. It jeopardises competition in the banking market, which is supposed to be integrated. This adversely affects financial institutions in more vulnerable Member States because of lack of access to international markets and more expensive funding. These two factors result in high general financing costs for the business sector and the economy as a whole.

   An example of fragmentation is the fact that in December 2013 average interest rates on new loans to non-financial firms were 5.08% in Portugal and 2.19% in Germany and those of loans in general were 4.35% and 3.17%, respectively.

4. A lot of good work has been done, but there are worrying aspects to this wave of changes, a kind of regulatory tsunami, not to mention massive technological, behavioural and governance changes in companies, which have led to a need to adjust banks' business models.
   
   The first very worrying aspect is the possibility of over-regulation in Europe or hasty implementation. This has direct consequences at at least four levels: 
   
   
   • Firstly, the joint impact of all these changes is uncertain. [and the fact that they are all happening together and are not phased will hinder diagnosis or correction of measures.]
   • Secondly, level playing field issues between European and other banks may arise. The latest Basel Committee report on the implementation of its recommendations was written in September 2013. It stated that such important countries as the United States and Russia had not yet implemented the Basel II or 2.5 recommendations, while here in Europe we were already beginning Basel III.
   • Thirdly, there has been a highly substantial increase in reporting obligations with highly significant impacts in terms of banks' time and human and financial resources. The vast numbers of often overlapping issues opened for public consultation with very short time limits do nothing to favour their fine-tuning or in-depth discussion.
   • Fourthly, the ability of many banks to absorb and implement so many complex, demanding measures in often unrealistic time frames is doubtful.
     
     

   On this subject, I would like to mention a speech made by Jacques de Larosière (former governor of Banque de France) at a European Savings and Retail Banking Group conference on 30 October 2013. He was the leader of the High Level Group on Financial Supervision in the EU that set out the general lines of the new regulatory framework published in February 2009.

   
   The report, entitled “A WORD OF WARNING: BANKING REGULATION IS ABOUT TO CREATE PRO-CYCLICAL DAMAGE” is worth close attention.

    Here are some of its main points:

   - The gross annual interest rate on loans to non-financial companies has been falling since 2012. This reflects not only the deleveraging that always follows a credit boom and a recession, but also the responsibility of regulation.

   Regulation caused euro area banks to substantially increase their own funds (€620b between January 2009 and July 2013), accompanied by a massive 9% reduction in their balance sheets between May 2008 and July 2013. There can be no doubt that, in a scenario in which capital is scarce and hard to get, it is necessary to reduce capital ratio denominators, i.e., assets (including loans) and their risk.

   The pressure to implement Basel III, which can be phased in by 2019, created the problem just when the European economy was in recession. The drop in new loans to SMEs is worrying, especially in countries like Ireland, Spain and Portugal. New loans to SMEs in Spain fell from €21b at the start of 2010 to €8.5b in August 2013 (ECB figures).

   - The new liquidity coverage ratio, which is coming in January 2015, will be very tough on some European banks. Estimates are of a shortfall in €400b as at 31 December 2012. According to the EBA, long-term liquidity requirements will result in a very large shortage of stable funding that will affect long-term investment.

   - The Basel III leverage ratio (3%) will hit many banks hard. A very recent study showed that 46% of the banks in a significant sample would not reach the target and would have to reduce their balance sheets again.

   - We are experiencing a paradox. On the one hand, the central banks are creating plenty of liquidity while on the other they are making bank loans harder with regulation. This regulation must be properly calibrated and its timelines and transition periods well thought out. The specific economic and financial situations that some countries that received assistance are currently experiencing are another cause for concern.

   Shouldn't their huge competitive disadvantage be taken into account? If so, how?

   Finally, I feel that the success of Banking Union depends on implementation and proper operation of its three pillars. For now, the only one that has been guaranteed in full is the single supervisory mechanism. The single resolution mechanism lacks consensus among the European authorities and the single deposit guarantee system is still over the horizon.

5. The European banking system has therefore been operating:
   

   - In this complex, cumbersome regulatory framework

   - In an environment of low growth and interest rates and accommodative monetary policy 

   - With very low rate of return, e.g. European banks' ROE fell from 16.1% in 2005 to 7.8% in 2008 and 3.1% in 2012 (in the United States the figures were 17.8%, -1.6% and 11.6%). How attractive are European banks to investors? Return is recovering, but will never go back to previous levels.

6. Here are some newsflashes about the Portuguese banks:
   

    a)They showed great resilience in the 2009-2010 crisis and were one of the European banking sectors that requested the fewest public resources from the state, and only in the form of guarantees. They were not affected by toxic or speculative products;

    b)They met the state's funding needs when the markets would not. They were victims of the sovereign crisis, which damaged their ratings, but not responsible for the crisis (the BPN and BPP cases had other causes);

    c) They had to fulfil stricter prudential capital requirements than their peers in other European countries due to the adjustment programme;

   d) Their lack of access to the international markets and a dramatic fall in their share prices (their market capitalisation fell by around 90% from 2007 to 31 December 2011) kept investors away and some banks had to turn to the state to increase their capital, (as provided for in the adjustment programme). Even so, they paid exorbitant interest on CoCos, on which the state raked in over €450m in 2013. The taxpayers' contribution has much higher remuneration than other investment alternatives.

    e)Even with large losses in 2011, 2012 and 2013, the effective tax rate was always over 25%. They also pay an annual contribution to the state and a resolution fund.

    f) Their deleveraging was exemplary and they achieved the goal set for the end of 2014 by the end of 2013, with a 12% reduction in loans to businesses from 2011 to 2013.

    g) The banks' results were also severely affected by the economic crisis (defaults, impairments and provisions), by a very low interest rate indexer (Euribor fell from 5.2% in 2008 to 0.3% at the moment and the REFI rate from 4.25% to 0.25%) causing a drastic reduction in banks' financial margins, and by the cost of funding and capital. The banks' ROE fell from +17.7% in 2007 to -6.3% in 2011 and -7.8% in 2013. We should also note that the banking sector has transferred substantial income to households in the form of mortgages, acting as a social buffer.

    h) They have met new regulation, supervision requirements, including market conduct.

    i)Although they have been operating at a considerable competitive disadvantage (against their European peers), the banks' liquidity situation is now reasonably comfortable and their capital ratios are the highest ever (allowing them to absorb losses). The banks have been closely scrutinised by the regulator, aversion to risk has been falling and they have an appetite for granting loans to companies and projects that meet acceptable risk assessment criteria (to improve their return, for one thing), and interest rates on new loans are falling.

   Their biggest problem, return, which is expected to be negative overall in 2014, may come out of the red in 2015, if the economic situation keeps improving, even though their financial margin at the current Euribor is still under great pressure.

7. Economic growth will depend on investment, good use of existing production capacity, and improving many companies' balance sheets to facilitate their access to credit. Investment, lending and recapitalisation are key factors in sustaining economic growth. 
   

   This ongoing Banking Union will certainly contribute to resuming financial integration and improving conditions for funding the economy.

Fernando Faria de Oliveira,
President of Associação Portuguesa de Bancos
Lisbon - Senate Room - Portuguese Parliament, 26 February 2014