It’s been just over a year since the European Central Bank became the prime supervisor of banks on the European continent. The central bank for the 19 nations in the euro zone has been busy getting familiar with the 120 large banks under its watch and ensuring that none of them could be the trigger for a new financial crisis.
Over the next year, however, the ECB plans to take its growing oversight operation one step further. The Frankfurt-based central bank will examine not just how to prevent a financial collapse but at how banks can earn their living as well.
“We have conducted a survey on the profitability expectations of the banks,” said the ECB’s top watchdog, Danièle Nouy, at a Handelsblatt-sponsored conference this week in Frankfurt.
In 2016, the ECB will more closely assess the drivers of profitability at individual banks and their various business models. “That is very clearly an important part of the regulatory focus,” she said.
Ms. Nouy’s words indicate just how concerned banking regulators are about the financial sector’s precarious earnings situation. Many banks have been burdened by the ECB’s extremely low interest rates, which makes loaning out money less worthwhile. Another fundamental problem is the anemic growth outlook for the single-currency economic bloc.
The fear of the central bank and other regulators is that, if left unchecked, this could turn into a major crisis for the European financial sector.
“If the current environment becomes the new normal, that will become a great danger for the financial system.”
Not everyone agrees with the added scrutiny by the ECB, especially since many banks blame regulators for getting them into trouble in the first place.
Today’s realities have sparked a debate over whether euro-zone banks are extending too little credit because they are too tightly regulated. Frustration has boiled over in part because once-beleaguered rival banks in the United States such as JP Morgan are once again supremely profitable.
Ms. Nouy disputes this. The difference between European and U.S. banks, she said, has to do with the banks’ own crisis management and not overreaching regulation.
“U.S. institutions had the advantage that they decided to reduce their bad debt faster,” she said, noting that stricter rules were also imposed early on in the United States.
“This path is more painful, but things also return to normal faster,” said Ms. Nouy, a French national, who advocates a more determined reduction of Europe’s own lingering toxic liabilities. Such bad debt is hindering the ability of banks to finance the economy, she said.
Irmfried Schwimann of the E.U. competition commission also does not believe the banking regulations are too strict. And even if they are strict, anything else would hardly have been acceptable to European taxpayers, she said.
But Burkhard Eckes, who leads the banking unit at consultancy PricewaterhouseCoopers made clear just how difficult the new regulations are on top of low interest rates.
“Banks have forecast what happens if interest rates remain low in the next three to five years,” he said. The result: many of them will be writing in red ink by 2018 or 2019.
Even if regulators won’t necessarily take the blame, these dangers are clearly raising some red flags for policymakers. Othmar Karas, a European parliamentarian from Austria, called for “a comprehensive evaluation of the effects and consequences of regulatory measures” on the banking industry.
The European Commission is also having something of a re-think – Financial Regulation Commissioner Jonathan Hill said at a recent ECB conference that regulators had to get the balance right between managing risks and encouraging growth.
Whoever is to blame, the negative pressure on banking-sector profit is clearly placing their business models under intensified scrutiny. “Naturally, it is in the interest of a bank’s management to make sure their business model is profitable. But a healthy business model, one that leads to profitability, is also essential from a regulatory perspective,” Ms. Nouy said.
Banks tend to complain that investment banking has borne the brunt of the scrutiny and extra regulation to date. Many banks are cutting down their investment banking operations as a result. But banking supervisors dispute the notion that they are pushing banks into particular preferred business models.
“We don’t know what the ideal business model looks like,” said Adam Farkas of the European Banking Authority, or EBA. The deciding factor is that it is profitable long term, he added.
The next litmus text for euro-zone banks is the 2016 stress test by the ECB and EBA. Around 53 banks will take part, among them 39 ECB-regulated banks.
For the first time, banks will not be judged by whether or not they reach a certain common equity ratio, so banks will not actually fail. But the results will flow into the ECB’s own annual review of each bank under its watch.
Last year’s stress test – the first one with the ECB’s participation – was uneventful. Of the 120 ECB-regulated banks, very few large banks had less capital than required.
Ms. Nouy said that about 10 of these still don’t have “the necessary capital, but the great majority will have it if they generate profits this year.”
Such exercises don’t go nearly far enough, according to Sven Giegold, a Green Party member in the European Parliament. He considers it dangerous if the current situation remains unaltered, in which even ultra-low interest rates do not lead to an increase in investment activity.
“Politicians cannot take a neutral stance on this,” Mr. Giegold said, adding that they must boost sustainable investments. “If the current environment becomes the new normal, that will become a great danger for the financial system.”
Yasmin Osman covers supervisors and banks for Handelsblatt in Frankfurt. Frank Drost covers financial regulation from the political capital Berlin. To contact the authors: firstname.lastname@example.org and email@example.com