Joachim Wuermeling: Frankfurt has potential to become EU’s anchor financial centre Interview published in “Handelsblatt”

Interview conducted by Yasmin Osman and Andreas Kröner.

Mr Wuermeling, Great Britain left the EU’s single market at the beginning of the year, meaning that Brexit has become a reality once and for all. How have financial markets come to terms with the split?

As it turned out, Brexit was almost a non-event for banks on both sides of the English Channel. Fears that there would be major upheaval proved unfounded, mainly because banks and other market participants were so well prepared. Banking supervisors had a part to play in this. But still, the changes that have already occurred and those that have yet to come will have a disruptive impact on Europe’s banking market.

How do you mean?

Even before the end of 2020, financial institutions had moved holdings worth €675 billion from the United Kingdom to Germany, and those figures can multiply quickly. According to banks’ current plans, asset relocations will rise to €1.2 trillion by the end of next year alone. Business areas like equity and derivatives trading have seen substantial shifts to EU financial centres, but also to other destinations. Profound structural movements are now underway.

What does this mean for Germany as a financial centre?

Some global banks that responded to Brexit by relocating their European base to Frankfurt are now already as big as a medium-sized German Landesbank in terms of their total assets. If these institutions move more of their operations as scheduled, it won’t be long before they catch up with Germany’s leading banks. So Germany’s banking market looks set to see significant structural changes – and Frankfurt could well become even more global and significant as a financial centre.

Frankfurt is vying with places like Paris, Dublin and Amsterdam for Brexit business. How has Frankfurt been faring so far?

It isn’t easy to make a comparison with locations elsewhere in the EU, and even if we did, it would only give us a snapshot. Banks are still hard at work mapping out their strategic plans for the future. Those that have set up or expanded branches in Frankfurt have shifted something like 2,500 jobs from London so far. We can’t put a precise number on how many of these positions are based here in Frankfurt and how many are at sites elsewhere in Europe. But we do need to look beyond the rivalry among financial centres on the continent and also consider how competitive the EU is relative to other global financial centres.

And what’s your take on this so far?

Frankfurt has put in a good showing so far. Up until now, banks have mostly been busy setting up the infrastructure they need on the continent for regulatory reasons. Around 60 financial service providers chose to do this in Germany, and they have been granted the appropriate licences. But only time will tell where business from London will migrate to in the longer run. That’s also the view in London, by the way, as reports from the past few weeks show. Now it’s up to Germany to decide whether it wants to play a leading role in the European and global financial market, and if so, to do what needs to be done.

What’s on the agenda, in your view?

Frankfurt has the potential to become the EU’s anchor financial centre, but a raft of additional steps still need to be taken in order for this to happen. According to market participants, these include legal issues surrounding general business conditions, tax matters, and good infrastructure for people relocating to Germany from abroad. Policymakers and financial supervisors need to consider how far they are willing to accommodate the legitimate needs of banking multinationals.

Are you considering loosening the financial market rules, say, as a way of attracting more business to Germany?

No, we certainly won’t be playing any part in a deregulation race to the bottom, be it in Germany or the EU. That said, there are operational issues relating to outsourcing or the division of labour within banks where we are facing a dilemma. On the one hand, we want the EU entities of global banks to be able to operate independently and not be managed from outside the bloc. On the other, the business rationale of multinational banking groups is built around the idea of running key management functions centrally and dividing tasks within the group. Striking the right balance between these competing interests remains a difficult task.

In your view, how likely is it that a lot of financial transactions in London will end up being shifted not to the EU, but to Asia or the United States? Some derivatives trading has already shifted to the United States.

Global institutions needed to relocate part of their business from London to the EU for regulatory reasons. But there are operations at clearing houses and in equity trading or derivatives business, say, that can be relocated to other parts of the world as well. You see, unlike the United Kingdom, those trading venues have been given equivalence status by the EU. That’s why it’s clear that not all the business will migrate wholesale from London to the continent.

What can the EU do to attract as much business as possible?

We need to focus on being able to fund the European economy under our own steam. The European Commission made a very clear commitment in this regard recently. On the other hand, though, we need to be careful not to become isolated. You see, being open is crucially important for any financial centre of global importance. And we stand to benefit from this openness as well because we can participate in global financial flows to suit our needs.

Clearing euro-denominated derivatives – or euro clearing, for short – ranks among the most controversial topics. Up until now, euro clearing has mainly taken place in London, but the European Commission is looking to relocate more of this business to the continent. How do you see the state of play?

It’s still the case that European banks are very reliant on UK clearing houses, so it’s good that credit institutions will continue to be allowed to use UK clearing houses until mid-2022 under a temporary access arrangement, as an abrupt relocation might jeopardise financial stability.

Would you say European banks now need to shift more of their clearing operations from London to the EU?

Recently, the European Commission repeated its clear message to the industry: financial entities are expected to reduce their exposures to UK CCPs by June 2022. That’s why banks need to be ready to face a situation after that date where the EU no longer grants London-based clearing equivalence. This would impact banks in a number of ways, one being that they would lose the regulatory benefits of clearing through recognised clearing houses. For example, they would need to set aside far more capital for these transactions than they do for trades routed via clearing houses that enjoy equivalence status.

Bearing this in mind, will you be pressuring European banks to relocate more of their clearing business to the EU?

Let’s put it this way: all the banks with large exposures to London will at least have to be able to demonstrate that they can meet the significantly higher capital requirements if the temporary access arrangement is abolished. Whether things pan out this way is a decision for the European Commission to make, not banking supervisors.

Let’s now turn our attention to the coronavirus crisis. How risky is the fallout for Germany’s banks?

Banks have a tough year ahead of them. Some of the damage we’re talking about here has already materialised in the real economy; some has been postponed by the government support measures. It hasn’t yet shown up on banks' balance sheets, but it will.

How much of a threat is the second lockdown for banks?

Some firms are running low on reserves, which suggests that insolvencies will spike in the next few months. That’s a grim fate for the people affected. But for many enterprises, the second lockdown didn’t make the situation any worse than it already was. You see, only a relatively small number of sectors, like accommodation and food service activities and recreational facilities, are directly affected by the constraints. While the impact on these sectors is evident all around us, in aggregate terms the share of the economy directly affected by the current lockdown is only small – well below 10% of gross value added, to be precise. And many firms have learned how to cope with the lockdown.

Some experts are saying that the sectors hit particularly hard are more likely to be funded by regional institutions like savings banks or people’s banks. Will the crisis affect small institutions more than others?

That’s too much of a generalisation. Of course, cafes and restaurants are often on the small side, and they might be more inclined to approach a local credit institution for a loan. But every sector of the economy has major players operating alongside small firms. Large hotel chains, tourism groups or operators of shopping centres will tend to be funded by bigger credit institutions.

Both Commerzbank and Aareal Bank raised their risk provisioning forecasts at the beginning of the year. Was that just the beginning?

The level of risk provisions a bank needs depends on its portfolios. But let’s put matters into perspective. It’s true that additions to risk provisions have roughly tripled overall, coming to around €6 billion in the first nine months of 2020. However, the strong increase in percentage terms can quite simply be put down to institutions’ risk provisioning requirements being comparatively low last year. Incidentally, non-performing loans as a percentage of the loan book have barely changed overall. That’s why I don’t think the provisioning situation alone is any reason to believe that matters are getting worse. That said, we do advise financial institutions to be meticulous in monitoring their exposures. They really should check their loans on an ongoing basis, one customer and one loan at a time.

How successfully will credit institutions manage this?

All in all, the banks are well aware of the dangers. But of course differences do exist. Some institutions lack the necessary resources and infrastructure. In the past few years, banks have had hardly any non-performing loans that they would have needed to process. On the other hand, there are banks that, from the outset, developed monitoring systems that have enabled them to continuously monitor truly every single customer.

Isn’t that taking the level of monitoring to extremes?

No, it makes sense. Measures such as government guarantees, moratoria or the suspension of the obligation to file for insolvency mean that, at present, some warning lights which would otherwise serve as early warning indicators of impending payment problems are not flashing. The pandemic and the lockdown are also creating different economic drivers of insolvencies than conventional recessions. Past experience is therefore only of limited usefulness, too. This is why banks need to adapt their risk management framework.

Will the coronavirus pandemic put so much pressure on individual banks that they will either be toppled or forced to merge with a healthy institution in order to survive?

On the whole, German banks are resilient. However, even before the crisis, some individual institutions were already on somewhat shaky ground. Credit defaults which a healthy bank could easily withstand would become an existential threat for these banks. Yet my greatest overall concern is less about the issue of whether German banks will weather the storm.

But rather?

Cleaning up afterwards. The banks will need the strength to restore their previous resilience by repairing the damage. This crisis will destroy a sizeable amount of capital which the banks will then need to replenish. For this to succeed, they will need adequate returns and have to operate at a profit. Reconstruction will expose the German banks’ difficult situation.

Because German banks are notorious for their low profitability?

Banks are having to contend with many things at once: low interest rates, overdue investment in digitalisation in order to be able to compete with fintech and bigtech firms. And there is a further issue: after the pandemic, all economies, including Germany’s, will have to undergo a major transformation in order to cope with the surge of digitalisation and the transition to a low-carbon economy. This could create a considerable need for funding.

That sounds first and foremost like good news for banks.

That is naturally also an opportunity for German banks. However, these investments could also harbour more risk than the conventional banking business of yesteryear. If the banks support this trend with loans, they themselves will need more capital – because the riskier a loan, the more capital a bank needs to set aside for it.

Deutsche Bank has proposed that KfW assume a portion of liability for innovation loans, as is currently the case now for coronavirus assistance. Is this a good idea?

I currently see no reason for government intervention. Granting loans – including loans for risky investments – is one of banks’ underlying economic functions. The higher risk then has to be reflected in the pricing of the loans, i.e. in higher interest rates. This market economy mechanism has always worked well in Germany in the past. The decisive factor here is market discipline: higher interest rates need to be charged for higher risks. Admittedly, this has sometimes been lacking in the past few years.

All in all, Germany’s banks are not known for being highly profitable. Where will the capital needed for reconstruction come from?

Institutions will have to generate sufficient profits. This will probably require painful measures above and beyond those being conducted at present, on both the cost and earnings sides. This includes possibly scaling back services or making them more expensive. We as banking supervisors have a vested interest in banks operating profitable business models. That is the only way they can live up to their economic task of funding the economy in the long term.

Are mergers a solution?

Of course, banks always have to scrutinise how they are positioned. However, it isn’t the job of banking supervisors to foster consolidation. Nor is it their job to hamper structural change in the aftermath of a crisis. These are things that we will certainly pay particular heed in our supervisory activities this year.

If more capital is what is needed, then the ECB’s ban on dividend payments is certainly anything but helpful, isn’t it?

As a crisis measure, the ECB’s recommendation is providing short-term stability to institutions’ capital base. In the long run, however, it has to be ensured that investors continue to make capital available to banks. That’s why the dividend recommendation will expire in September 2021. I think it’s important that we set this end date in 2020 and communicated it, and that we mean it as well. In doing so, we have sent a signal to banks and investors that the dividend recommendation was intended only to address absolutely exceptional circumstances at the onset of the pandemic.

Until September, banks are only permitted to distribute 15% of their earnings for 2019 and 2020. Yet at the same time the distribution payments are not supposed to exceed 0.2 percentage point of Common Equity Tier 1 capital. Are all German banks complying with the ECB’s recommendations?

The new recommendation the ECB made in December is considerably softening the impact of the first, more stringent recommendation. The big German banks can undertake roughly half of the distributions they had planned. German bankers’ distribution policy leans more towards conservatism anyway.

Aareal Bank is splitting its dividend into two parts: one of which it will pay out after its shareholders’ meeting already and another once the ban on dividends expires. Could this catch on?

I would advise banks to generally err on the side of caution. Owing to the high level of uncertainty, there is no way they can truly know what shape they will be in in September.

How many large German banks have notified the ECB that they intend to distribute a dividend in 2021?

Discussions with the large banks directly supervised by the ECB are still ongoing. As things currently stand, we assume that fewer than half of Germany’s 21 significant institutions will take advantage of the opportunities set out in the adjusted dividend recommendation and undertake limited distributions by September 2021.

Let’s turn our attention to analysing the Wirecard scandal. What are the lessons that financial supervisors need to learn from the fiasco?

In my view, Wirecard showed that financial reporting needs to be organised in a more effective manner. The Act to Strengthen Financial Market Integrity (Gesetz zur Stärkung der Finanzmarktintegrität) already represents a substantial policy response. It makes sense to me, for instance, that the competent authority can turn to some sort of specialised agency if there are suspicions that it is not able to investigate on its own. Particularly with regard to internationally interconnected financial conglomerates, national agencies often lack the resources and expertise to track down, prove and prevent illicit transactions. We need to strengthen international cooperation here.

Some of the critics of the financial watchdog BaFin are calling for control over banks and other financial groups in Germany to be transferred entirely to the Bundesbank. What do you think of this proposal?

Unlike BaFin, we do not pass any administrative decisions. We still believe that the division of tasks between BaFin, the Bundesbank and the ECB is working well. At the Bundesbank, our core competence is analysing and investigating financial issues. Our current banking supervisory remit is thus a good fit with our competences as a central bank and our mandate.

Will there be an internal post-mortem of the Wirecard scandal at the Bundesbank? In 2017 and 2019, your inspectors conducted ad hoc inspections at Wirecard Bank but apparently found no evidence of the system of fraud at Wirecard.

Like all other parties involved, we are naturally asking ourselves whether we could have identified some issues sooner and more effectively. In our ad hoc inspections, we examined credit standards and found some deficiencies which the institution then rectified. However, the accounting fraud took place not at the bank, but at the bank’s owner, Wirecard AG. Even in retrospect, we think it was correct that, for supervisory purposes, [Wirecard AG] was not classified as a financial holding company in light of the fact that the Wirecard group mainly provided technological services. At any rate, however, banking supervisors’ powers are primarily focused on the bank and only to a lesser extent on its owners.