ECB looks beyond capital in urging banks to cut costs, merge

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23 March 2016. By John Rega.

The European Central Bank's supervisory arm has started behaving like a life coach for eurozone lenders.

Earn more money, the ECB is saying. Clean house. Lose weight. Find a partner.

Going beyond the standard supervisory fare of capital and liquidity standards, the ECB is exhorting banks to improve their profitability, work off bad loans and cut costs. Lenders should also consider mergers in Italy and other markets where business is spread across many small banks, leaders in Frankfurt say.

After moving to shore up the capital of banks after the global financial crisis, authorities in Europe and beyond have shifted attention to lenders' ability to earn money and provide credit despite low or even negative interest rates.

Holistic picture

Danièle Nouy, chairwoman of the ECB's banking oversight board, sounded the theme at a European Parliament hearing in Brussels yesterday and again in Frankfurt today.

"Many investors worry about the ability of banks to adjust their business models and sustain their profitability," she told journalists today while presenting the ECB's supervisory priorities for the year.

The more holistic picture of banks' health also shows how Nouy's nascent supervisory operation reflects the views of its parent organization, the central bank, despite the firewalls between them.

Sabine Lautenschläger straddles both sides, as a member of the ECB's executive board for monetary policy, and vice-chairwoman of the ECB's banking oversight board. Speaking in today's news conference alongside Nouy, she came back to the profitability themes, when asked about the pressure banks face as the ECB pushes interest-rate targets below zero.

Banks have weathered periods of negative real rates before, Lautenschläger said. "We need to have viable business models [for banks] that can cope with competition coming from digitalization, coming from the shadow banking market," she added.

Cut costs

Nouy, the French regulator who's led the eurozone supervisor since it began operating in November 2014, took the negative-rates question as a chance to encourage banks to cut expenses.

"They have room to maneuver," she said of the banks. Costs "could go down and the banks could be more efficient."

Lenders could deliver more services online, Nouy added, like the technology-minded competitors that Lautenschläger cited.

"Digitalization is also a new possibility for the banks," Nouy said. "There are many customers that would like to receive banking services through digitalization. This is also helping to be more efficient, to have lower cost-to-income ratios."

In coaching banks through a spring-cleaning of their loan books, the ECB is pushing best practices suggested by International Monetary Fund as well as Irish officials who oversaw a cleanup of the country's debt-fueled housing bubble.

Cleanups, mergers

After being the first eurozone country to enter a bailout, Ireland forced lenders to own up to losses on loans with no chance of being repaid. Banks in the 18 other euro countries are showing "a lot of momentum" in doing the same, Nouy said.

Lenders have built up "reasonable" levels of provisions in a past ECB review, she added, downplaying questions about the need for more massive write-offs.

Banks may still need to find suitors to pair with, cut costs and consolidate into stronger providers, Nouy said.

"Mergers are desirable" in insufficiently concentrated parts of Europe, she said. Top of the list is Italy, where Banco Popolare and Banca Popolare di Milano are seeking the ECB's approval to combine into the country's third largest bank. Others may follow.

Italy has "room for mergers to have more profitable banks, more sustainable business models," Nouy said.

Regarding the "Popolari" banks in merger talks, Nouy said that the ECB will assess the proposal based on prudential grounds — capital adequacy — while remaining interested in their plans to create a sustainably profitable franchise.

"The supervisory board asked for a business plan and still wants to see one, but [it's] not a precondition to moving forward with the discussions," she said.

Sovereign risk

In other regulatory matters, Nouy today said that world and European banking authorities are making progress in having banks recognize risks from their government debt holdings.

At issue is how to require banks to set aside capital for those exposures, which now typically bear a "zero" risk weight within the formulas of capital requirements.

EU and global authorities are discussing "a hybrid approach," she said. Risk weights would be applied based on how much of a bank's holdings are concentrated in sovereign debt, "and also the asset quality."

The ECB meanwhile has received a clarification from the European Commission, Nouy said, on rules that curb banks' ability to pay dividends or some discretionary bond coupons, if capital buffers fall short of certain targets in excess of "pillar 1" basic requirements.

The EU should further clarify the rules in law, to give banks and investors greater certainty, she added.

The ECB is still working out how to set each bank's "Maximum Distributable Amount," using a combination of binding "pillar 2" orders to banks, and informal guidance.

Lautenschläger said, "We're still making a list of questions to the commission."

That's the life coach speaking again. Not satisfied with counseling banks, the ECB now seems to be telling the entire EU to shape up its legislation.