Werner Hoyer Speaks on the Changing Banking Sector

The following is a speech given at the recent AGI Symposium “Fueling the Recovery: The Role of Capital Markets and Banks” in Frankfurt, Germany by Werner Hoyer, President of the  European Investment Bank. The Symposium featured two panel discussions focused on analyzing the impacts of economic and financial policies in Germany and the United States in order to increase cooperation and understanding in the transatlantic relationship.  Mr. Hoyer was a member of the second panel of the event, “The Changing Banking Sector: What Kind of Banks Do We Need?” during which panelists discussed the changing banking industry, evolving banking regulations, and  differences between the U.S. and European banking climates. 

Dear Jackson Janes, Ladies and Gentlemen, Thank you for inviting me here to this conference.

1. Funding the recovery

1.1. The following discussion will focus on funding the recovery and the role of capital Markets.Let me begin by saying that I am very glad that we finally do see a recovery of the European economy. Yet there can be no room for complacency as many short and long term challenges remain. Among the short term challenges, a key one indeed concerns funding. With demand coming back as uncertainty is reducing, the question is whether the EU financial sector will be able to fuel the recovery in the short run and whether the current institutional arrangements can ensure access to finance needed to European competitiveness in the long run.

1.2. Nearly six years after the start of the Global Financial Crisis which later turned into a sovereign debt crisis, the economies of the United States and the European Union show two different pictures. While the US economy has been growing steadily in the last few years, the EU went through a double-dip recession, now followed by an uneven and mild recovery.

1.3. Although growth is expected to accelerate in 2014 and become positive in each Member State of the European Union in 2015, risks remain tilted to the downside both in the short and long run.

1.4. Why is the recovery in the EU currently weaker than in the US? In addition to institutional and structural challenges that we still face in Europe despite all the historic achievements of the recent years, the slow speed of the EU recovery is often attributed to the differing financial structure.While the European economy heavily relies on bank lending, in the US most funding is being done outside of the banking sector. Bank loans amount to 70 percent of non-financial corporations’ total liabilities in the Euro Area and to less than 20 percent in the US. With banks playing a more important role in Europe, their performance is having a greater influence on the provision of credit. Lending growth to the private sector is still decreasing in the EU while it has been positive in the US in the last two years. As ECB President Draghi argued recently, credit constraints are putting a brake on the recovery in stressed member countries.

1.5. Can the European economy also recover without credit growth? It could. But experience shows that this would be associated with real drawbacks:

•  First, creditless recoveries tend to be substantially weaker and more protracted. On average, output growth is a third lower than in recoveries with credit.
•  Second, in recoveries without credit, economic sectors that are more dependent on external financing tend to grow at a lower rate than self-financing industries. This could lead to a suboptimal reallocation of economic resources and lower the rate of potential growth.
• Third, as the common currency limits the room for differentiated real exchange rate depreciation, finding an 5  external boost to economic growth is more difficult. Yet, this has usually been an important driver for growth in historical successful episodes of creditless recoveries.

2. Policy action

2.1. Many signs including the fragmentation of financial sectors across Member States and the results of the recent bank lending surveys indicate that the European economy is constrained not only by a lack of demand but also by credit supply factors. With demand picking up, we expect the supply constraints to become even more binding. Hence, there is a clear case for policy action to ensure there is sufficient credit to fuel the European recovery. European policymakers can address these supply constraints through two channels:

• Restoring the European banks’ ability to lend
•  Broadening the sources of finance of European companies

3. Strengthening of bank lending

3.1. As a bank-based economy, the European recovery will hinge crucially on the ability of the banks to lend. Therefore, a clear priority needs to be to eliminate the constraints that banks face in their lending activity. Currently, there are three main supply-side impediments to credit growth.

3.2. The first is the quality of banks’ loan portfolios. Non-performing loan ratios are still increasing in some countries, thereby reducing the lending capacity of banks.

3.3. The second is the reduced access of periphery banks to crossborder funding. The dispersion of borrowing costs indicate that fragmentation has decreased only slightly since the peak of the Euro Area sovereign debt crisis in the middle of 2012.

3.4. The third is the new regulatory environment which, by tightening capital and liquidity rules, may affect banks’ ability to offer long-term finance for the private sector. Although an important lesson from the crisis is that appropriate regulation and supervision is essential, policymakers need to beaware of the potential trade-off between the safety of financial systems and economic growth.Above a certain threshold on financial buffers, growth benefits associated with financial safety may diminish.

3.5. What are the main ways of removing these supply-side constraints?

3.6. The ECB’s comprehensive assessment of Euro Area banks,the implementation of the Banking Union and the ECB’s Targeted Longer-term Refinancing Operations will strongly contribute to eliminating them.

3.7. The comprehensive assessment that includes asset quality reviews and stress tests will play a dual role. First, by requiring banks to cover potential capital shortfalls, it improves capital adequacy as well as the ability of banks to resume lending. Second, by credibly demonstrating banks’ asset quality and their shock-absorbing capacity in a transparent and consistent way across countries, it reduces uncertainty about the strength of the banking sector. The resulting higher confidence of investors should then lead 1) to a greater ability for banks to replenish their capital; 2) to decreasing funding costs for banks, thereby also lowering lending rates in distressed countries and improving the efficiency of monetary transmission in the Euro Area.

3.8. The European Banking Union can reduce the fragmentation of banking sectors in a number of ways. By establishing a common and consistent supervisory framework across member countries and improving the overall quality of supervision, the Single Supervisory Mechanism will reduce the uncertainty around the financial strength of banks. This contributes to the re-integration and more efficient functioning of financial markets. The creation of the SSM redresses the lack of common supervision and regulation that is needed for financial stability in highly integrated financial sectors. We need a single supervision for a single European financial market.

3.9. The Banking Union’s second pillar, the Single Resolution Mechanism, is a necessary complement to the SSM due to several reasons. First, it increases the credibility of the SSM by establishing a mechanism for the quick and orderly restructuring of non-viable institutions. Second, it builds the appropriate coordination mechanism between resolution authorities. Third, as a credible financial backstop for banks and the implementer of the Bank Recovery and Resolution Directive, the SRM removes the negative feedback loop between the sovereign and the banking sector.

3.10. But let us not forget: asset quality review and single supervision and resolution are “just” the institutional catching up with financial market integration. At the same time, we still need to deal with the some of the direct consequences of the crisis on the European banks’ balance sheets. Without going into details in this area, let me just state that I believe that creating the right incentives for banks to deleverage, recapitalise and to recognise their impaired assets will be key to real and continued progress.

3.11. Last but not least, the ECB’s newly announced Targeted Longer-term Refinancing Operations will have a sizeable impact on lending to the corporate sector, by easing the funding conditions of banks across the Euro Area.

4. Development of capital markets

4.1. The vulnerability of the European financial system as a whole should not only be reduced by strengthening its key pillar. Our policies should also focus on the development of capital markets in order to diversify the financing sources of companies. Given the importance of SMEs for the European economy and their limited direct access to capital markets, a policy priority should be the diversification of their financing structure, including through the development of securitization markets. The SME segment’s importance is reflected by the fact that SMEs account for around 2/3 of total employment and almost 60 percent of total value-added in the European economy. Still, according to the latest joint survey of the European Commission and the European Central Bank, access to finance remains the second most pressing problem for SMEs.

4.2. The development of the securitisation market of SME loan portfolios could, if properly redeveloped, be beneficial for investors, banks as well as SMEs. First, investors, mostly institutional ones, would gain from the broader set of available asset classes that suit their investment horizon. Second, securitisation would also be beneficial for banks by unlocking capital, thereby increasing their ability to increase lending. Third, SMEs would clearly benefit from the improved access to bank lending.

4.3. Currently, the securitisation market is underdeveloped in Europe as compared to the US. I am not the first person who thinks that some overregulation of asset-backed securities may play a role here. Of course caution is highly warranted when it comes to the global market for ABSs, as they are complex products, thus difficult to understand, and prone to moral hazard. The crisis in securitisation moreover was one of the main causes of the global financial crisis.

4.4. However, these concerns might not be as relevant in the European securitisation market. First, in contrast with the US market, European ABSs have had a strong performance so far, with a default rate below 2 percent since the onset of the crisis. Second, although some securitisation products were indeed inadequately regulated in the past, the situation has already improved thanks to the introduction of “skin-in-the-game” requirements and increased disclosure obligations. These regulatory reforms reduce moral hazard and incentivise investors to conduct due diligence. The current proposals from the ECB and the Bank of England are a further welcome contribution to the development of an improved securitisation market , notably for SMEs and household finances.

4.5. Given the benefits associated with a proper securitisation market, it is, in my opinion, important to avoid regulatory overshooting. A crucial point is to understand that there is no one-size-fits-all solution, as ABSs form a heterogeneous group of securities with different risk profiles. As it was also emphasized by President of the ECB Draghi, it is important to eliminate the undue discrimination of simple and transparent ABSs with underlying assets comprising loans to the non-financial private sector. The ECB Governing Council’s decision to intensify preparatory work related to the purchase of ABSs is therefore, in my view, a crucial step in the right direction.

5. Role of the EIB

5.1. Let me say a few words about the role of public development banks, especially that of the European Investment Bank, in strengthening the recovery. Historically, public development finance institutions have been an important instrument of governments to promote growth both in the short and long run, by offering funding for corporations, including SMEs, whose financial needs were not efficiently served by private commercial banks or capital markets. Furthermore, by increasing the supply of credit to mitigate the negative macroeconomic impact of impaired financial sectors during crisis periods, the countercyclical behaviour of public banks can contribute to strengthening the economic recovery in distressed countries.

5.2. I would say that, relative to the US, the European economy benefits considerably from its significant network of public investment banks whose core remit is to contribute to economic development by structurally strengthening our economies; by their catalytic roles in targeting higher levels of socially beneficial investment and by their ability to act counter-cyclically.

5.3. The EIB contributes to strengthening the European economy both in the short and long run in several ways.

• By increasing its activity during the crisis, the EIB strongly contributes to underpinning the recovery across the member states of the European Union.

•  By extending loans to the periphery countries where companies, especially SMEs, face substantial funding constraints, the EIB limits the fragmentation of the European financial sector. By issuing EIB bonds; by purchasing securitised loans and offering guarantees, the EIB Group contributes to developing both EU and national capital markets.

•  By financing projects that are in line with the long-term economic policy priorities of the EU, the EIB assists policymakers in ensuring high and sustainable growth.

•  By blending EIB and other debt instruments with EU and Member State budgetary resources on a significantly increasing scale, EIB is leveraging the impact of the limited public sector financial resources.

•  By providing its Expertise and Advisory services to the public authorities and private promoters it is improving access to finance and project and policy implementation and the growth of the economy.
• By offering long-term financing to small- and medium-sized enterprises, the EIB will continue supporting SMEs throughout the EU and be an important complement to the shorter-term funding provided under the ECB’s conditional liquidity provision in the Euro Area.

5.4. In addition to these general benefits, let me also emphasize the important role of the EIB in improving SMEs’ access to finance. It has become a European leader in SME financing with having provided EUR 22 bn in loans, guarantees and equity for SMEs in 2013. In partnership with the European Commission, the EIB is also supporting SME lending through two additional instruments: a guarantee facility for new SME loans and a joint securitisation instrument for existing and new SME loans. With this initiative we aim to stimulate private sector capital market investments in SMEs as well as a reduction of the fragmentation of financial markets across Europe.

6. Conclusion

6.1. Let me conclude by mentioning that while restoring and developing credit channels for the EU economy is an essential task, we also have to ensure that the European economy regains competitiveness and a high long term growth potential. Demographic changes indicate that increasing productivity is crucial to ensure economic growth in Europe.

6.2. Against this background it is of real concern that productivity growth fell sharply in Europe in the last few years. While EU productivity grew by an annual average of almost 2 percent in the pre-crisis period, broadly in line with the performance of the US and Japan, Europe has lagged behind these regions with productivity growth only slightly exceeding zero since the start of the crisis.

Clearly, Europe needs to find additional ways to increase productivity if it is to achieve high and sustainable growth. A lot still needs be done to this end, including further improvements in business environment, better access of innovative SMEs to finance, as well as the facilitation of investments in areas such as research, development, innovation and education. 6.3. We need to make sure that we are not only “fuelling the recovery” but also building new economic foundations for sustainable and high long-term growth.

Thank you very much.