European Bank Supervisory: an open letter to Mrs. Nouy

Dear All,

Thank you for your interest in bankenanalyse throughout 2013. This year was marked by fundamental changes in bank regulation. In 2014, we look forward to more transparency on the impact on the regulated and shadow banking system. Future research and market adjustments will show if the goal to increase financial stability, as set by the G20 Finance Ministers in 2008, can be reached. The European Banking Supervisory Board will play a crucial role in this.

The next Bankenanalyse posts will appear starting February 2014. We wish you the best for a festive season and a prosperous new year.

Your Bankenanalyse

 

As this year comes to a close, we want to use the opportunity for an open letter to Mrs. Danièle Nouy, appointed chairperson of the Supervisory Board at the ECB, concerning the Single Rule Book with respect to goals and challenges of 2014.

 

Dear Mrs. Nouy,

the responsibility you assumed is probably the most challenging in banking business today. To qualify what is meant by “challenging” , we refer to your role as Chairperson of the Supervisory Board, which does not only require diplomacy, handling various interests which European Economies and Finance Ministers have, but also requires a strong leadership to assure consistent supervisory work which focuses on a harmonised European playing field. As defined by the G20, bank comparability and transparency is crucial to restore confidence in the regulated banking system. This is also valid for the shadow banking activities. Much work has been done so far: the fundament of the European Banking Union, the Single Rule Book, will come into force starting January 1st. To achieve the goals set, political and operational challenges must be addressed.

The potential renationalisation of bank rules presents a huge challenge on the political side. A prominent example of this is the reclassification of Deferred Tax Assets. A basic guideline of the Single Rule Book stipulates that regulatory capital has to be fully paid in. Spanish banks, by contrast, use a reclassification to improve capital ratios. This example should not be construed as fingerpointing. It is simply an example for different economic situations requesting national solutions which may be in contrast to the Single Rule Book.

On the operational level, it will be crucial to understand and react to bank’s market behavior. Let us take the connection between state finance and banks as an example. The Italian sovereign exposures of domestic banks amount to about 9 percent of the assets, mostly in trading and available-for-sales accounts. As the Monetary and Capital Markets Department of the IMF states, „this exposure is relatively large compared to other advanced economies, and Italian sovereign spreads have been experienced periods of above- average volatility. Mark-to-market valuation losses could affect bank solvency, while lower market prices for sovereign bonds would reduce their collateral value for secured funding, including from the ECB. Besides direct effects, the experience of the European debt crisis suggests that acute sovereign distress can have a broader impact on the economy, further aggravating pressures on the financial sector.“ To reduce the exposure towards mark-to-market losses by rising rates, it is plausible to see more and more banks shifting sovereign bond from their available-for-sale portfolios to held-to-maturity, which will mitigate the impact that movements in the bond markets have on their tangible book values and common equity. These adjustments have an impact on key figures. A proper understanding of how figures are interconnected is essential. To remain with the Italian bank example, a high sovereign exposure goes together with a relatively high rate of ECB eligible collateral. This has a positive impact on liquidity ratios. The asset encumbrance ratio for Italian Banks shows two main patterns: first, it significantly increased from 2011 to 2013. Second, government bonds remain the main source of unencumbered assets. A decrease in mark-to-market value may have a significant impact on the asset encumbrance ratio and the possibility to refund in stressed sovereign markets.

 

 

12-2013_ECB eligible collateral

Supervisory Reporting, which is addressed in the Single Rule Book, does reference these connections. It remains a challenge to draw the right conclusions, as each market and jurisdiction, but also each bank’s business model has its own logic. This already becomes evident in the course of the Comprehensive Assessment.

Currently, the ECB collects information in preparation for the Comprehensive Assessment. Key questions, which are basic for restoring confidence in the European bank balance sheets, are still open to be answered. What level of provisions will the ECB require against nonperforming loans? How will it stress test banks’ exposure to sovereign debt? How will it stress test the safety and soundness of bank funding structures, including continued reliance on ECB facilities and the recent sharp rise in ultra short-term market funding? In the words of Simon Nixon (WallStreet Journal): „What is becoming clear is that the Comprehensive Assessment may not be as comprehensive as some had hoped. The ECB will be bound by existing national rules relating to provisions and quality of capital. Indeed, some officials fear the ECB is being burdened with excessively high ambitions: It is unrealistic to expect the Comprehensive Assessment to lead to a miraculous transformation in the euro zone’s financial landscape. Yet without a transformation in the financial landscape, the ECB is likely to come under further pressure to adopt radical measures to ease borrowing costs in the periphery.“

There are many questions to be answered on the course to developing a European financial system.

Bankenanalyse sees two key ingredients which are required to handle these challenges. These are structures allowing swift and decisive decision making as well as staff which is taking responsibility to address operational hurdles and level inconsistencies to reach the defined goals.

With best wishes for a peaceful festive season and a successful 2014,

Bankenanalyse

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