Challenging times – what lies ahead for the banking sector Speech delivered at the ceremony marking the centenary of the Association of German Public Sector Banks
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Ladies and gentlemen
The number of centenarians in Germany is growing – and quickly. There are already some 20,000. And now the Federal Association of German Public Banks (VÖB) has officially “joined the club”. Congratulations!
Another way of seeing this, however, is that there are hardly any Germans alive who have known life without the VÖB.
I hope you don’t take it too personally if I voice the assumption that most Germans are probably not aware of this fascinating fact. After all, banking associations by their very nature do not play a major role in most people’s everyday lives. Then again, associations’ focus is on policymakers and experts.
The VÖB is undoubtedly one of the Bundesbank’s key points of contact for all matters relating to public sector banks in Germany, and it is also an esteemed discussion partner. Our latest executive board-level exchange of views took place in Frankfurt nearly two weeks ago. As always, it was held in a constructive and issues-oriented atmosphere.
I am therefore very pleased to be here today and congratulate you warmly on the centenary of your association, and wish you every success in your work – over the next century as well.
When preparing this celebratory speech, I was wondering what a Bundesbank president could talk about without spoiling the mood. For instance, about the, for many, surprising election of Donald Trump as President of the United States of America?
I would initially counsel people to be calm and maintain a sense of serenity. Let us simply take the President-elect at his word – and I mean the words spoken after his election victory.
He told us – and I quote – “We will deal fairly with everyone, with everyone – all people and all other nations. We will seek common ground, not hostility; partnership, not conflict.”
Fair partnership has, since time immemorial, been the basis for all international relations, and particularly trans-Atlantic relations. And it should stay that way.
But let me return to the question I was asking myself earlier: what should I talk to you about without spoiling the party?
The current monetary policy regime, for instance, is coming up against mounting criticism in the banking industry. Many banks are feeling stifled by the increasingly tighter regulatory regime, and if we talk about the need for a structural change in the banking industry, some might also take that as a challenge.
But I should probably not dwell on the issue too much, especially not after having read the following:
“Any time a central banker talks about structural change in the banking industry, he does so less from a commercial or business point of view but primarily from a macroeconomic point of view. There are two issues of particular interest here. First, the old but recurring question of the role to be played by banks in the financial framework, or, in more technical terms: their function in the monetary policy transmission process. Second, we need to ask ourselves how stable and sound the banking system and its individual market participants are. After all, monetary policy depends on a functioning banking sector. A monetary stability-oriented lending policy can be painful at times; an inverted term structure and meagre earnings opportunities from maturity transformation will have differing effects on individual banks and, on the whole, presuppose a healthy banking system in order to be able to overcome even such periods.”
One could be forgiven for thinking, ladies and gentlemen, that these observations are referring to the current state of affairs of the German banking system. However, this quotation is, in fact, nearly a quarter of a century old. It was uttered by one of my predecessors, Helmut Schlesinger, in remarks delivered on the occasion of the 75th anniversary of the VÖB.
For me, there are two takeaways from this quotation: the first is that one is also allowed to broach serious topics at VÖB jubilee events, and the other is that today’s topics aren’t all that new anyway. Notwithstanding the very festive nature of this evening, I therefore do not wish to shy away from discussing challenges which I believe the banking industry is currently facing.
2 On the role of (public sector) banks
Ladies and gentlemen
In the light of the financial crisis and technical innovation – think “fintechs” – some are currently casting a critical eye on the role played by banks. To put it polemically: Why do we need banks anyway? And public sector banks at that?
A saying popularly attributed to Mark Twain is: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”
The textbook answer to the first question is friendlier, if not exactly glamorous: banks make it easier to allocate resources efficiently within a market economy. They make sure that savings find their way to those who need funding.
What that means in particular is: banks offer investors safe investment vehicles and lend money to households and enterprises – precisely those enterprises with no access to the capital market – which holds for the vast majority of firms.
In our Mittelstand-dominated economy, this makes banks a crucial source of funding, though their role in corporate finance is not quite as dominant as many might believe: bank lending accounts for a mere 15% of the total capital of non-financial corporations in Germany and the rest of the euro area.
This is still nearly twice as much as in the United States, where bank loans make up around 8% of total capital. On the other hand, market financing of non-financial corporations, which is composed of bonds and listed equities, makes up 41% of total capital in the market-based US financial system, compared with a little over 27% in Germany.
One of the special features of the German banking sector is certainly the high market share of public-law institutions, be they savings banks, Landesbanken or promotional banks.
Why are public sector institutions necessary? The textbook answer to this question is that such banks step in where the private market is not working, or not working well enough.
Investments which, although they are in the public interest, cannot be funded by private sector banks alone or at reasonable terms and conditions, are a typical example. And one of the particular raisons d’être of promotional banks is that these institutions can make such investment possible through loans and guarantees. And, by anti-cyclically adapting their credit supply, promotional banks could help stabilise the economy.
Indeed, promotional banks can prde themselves on having helped prevent credit supply bottlenecks in Germany during the financial crisis.
At the same time, public sector banks – and Landesbanken probably even more than promotional banks – are sometimes caught between a public mandate (and the possible returns expected by their public sector owners) and competition with private sector entities. There is no one-size-fits-all answer to the question of the right balance; it has to be examined on the basis of each individual case.
The consolidation process in the Landesbanken sector is, in a sense, also a consequence of such a readjustment. It was triggered by pressure from the financial crisis and involved, in particular, the dismantling of what was known as synthetic lending business.
This trend is very difficult for those affected to cope with and, particularly for the employees, undoubtedly painful. At the same time, though, I still find it necessary and proper, not only out of fundamental considerations relating to Ordnungspolitik but also in terms of financial stability.
Ladies and gentlemen
All banks, not only public sector banks, are facing huge challenges. Thus, for instance, the persistent low-interest-rate environment is weighing on institutions’ earnings, while regulation is becoming ever more challenging and the advance of digitalisation is requiring massive investment in technical infrastructure.
Banks are in a situation akin to that of an athlete who needs to improve his stamina despite suffering from a cold. But: whereas the athlete would probably be advised to take a break from training, banks ultimately do not have such a luxury.
3.1 Low-interest-rate setting
For all banks, but especially for credit institutions whose livelihood depends mainly on deposits and lending business, the low-interest-rate setting is a challenge which is growing greater the longer this situation persists: while, on the assets side, higher-returning legacy business has to be replaced by new business at lower rates of interest, the scope on the liabilities side for further cutting interest rates is limited.
Falling profitability is naturally a topic for banking supervisors. Therefore, together with BaFin, we conducted a broad survey on the low-interest-rate environment in 2013 and 2015. As a result, supervisors have been following particularly vulnerable institutions more closely.
Under the assumption of a constant term structure over the medium to long term, the surveyed banks expected profitability to be down by around 25% in 2019, and by even much more than that if interest rates continue to fall.
In the meantime, banks have taken measures to combat falling profitability. At the same time, though, the term structure has seen a renewed downward shift, which is weighing further on profitability. And this is why a revised survey is being planned for next year.
But what can a bank do in the current low-interest-rate environment?
Well, one option is to carp loudly about it. However, that doesn’t change the fact that monetary policy is bound by its mandate – which is price stability.
This term obviously means not too much inflation. But it also means not too little inflation. Figuratively speaking, that would mean monetary policy not having enough water under its keel. It keeps bumping up against the zero lower bound with its policy rates and is thus, in a sense, running aground. This is why the ECB Governing Council’s target is an inflation rate of below, but close to, 2%.
By this yardstick, inflationary pressures in the euro area have for some time been too weak, and falling oil prices are not the only reason. Core inflation – inflation excluding energy and food prices – is, at just under 1%, likewise well below the target level of below, but close to, 2%. This indicates that domestic price pressures are likewise low. However, there is also a significant margin of safety to the deflationary developments many were afraid would happen, and which were the justification for the non-standard measures.
Incidentally, according to the ECB’s forecast for the euro area, inflation is set to gradually pick up again. On the whole, by the end of the forecast horizon we will have returned to a rate of below, but close to, 2%.
Therefore, in order to ensure price stability, an expansionary monetary policy will remain necessary. On the other hand, we should not forget that the rising inflation rates will lead anyway to a further reduction in real short-term interest rates and thus to a perceptible additional monetary policy easing. And reasonable people may disagree about the vehemence of monetary policy actions.
As Helmut Schlesinger put it in his remarks at the VÖB’s 75th anniversary: “A monetary stability-based lending policy can sometimes be painful.” Admittedly, at that time we were in a phase not of low interest rates but of high interest rates. But even when interest rates are high, earnings can come under pressure if the term structure is flat – or even inverted.
One of the main reasons the term structure is so flat in the current environment is because the Eurosystem’s unconventional measures are targeted directly at the longer end of the term structure. The ECB’s massive asset purchases are depressing capital market rates. However, the low long-term interest rates are also a reflection of diminished growth expectations. Persistently higher interest rates are likewise predicated on a more growth-friendly policy.
However, pronounced political uncertainty is currently weighing on the outlook for growth. It is not only the currents and sentiments behind the vote to leave the EU but also, more recently, the outcome of the US presidential election which have posed the question as to what extent protectionism and barriers will dictate the political agenda.
However, a considerable portion of our prosperity is founded on open markets and functioning institutions. A challenge we all have to face is to convince people of the benefits of an open market economy, to take their fears seriously and to avoid losing sight of the distributional effects of globalisation and technical progress.
As you know, sovereign bond purchases were one particular issue I have been sceptical of from the very outset. Yet I would not condemn the instrument out of hand; however, under the particular conditions of a monetary union in which each nation is responsible for its own fiscal and economic policy, it is very problematic.
It is therefore also crucial that the current public sector purchase programme (PSPP) does not provide for any loss sharing, nor should it introduce communitised liability for sovereign debt through the back door. Moreover, there must be certain limitations and “lines in the sand” to ensure a sufficient safety margin to monetary financing of governments.
In monetary policy, but also elsewhere, one of the salient features of a red line is that it is not moved back whenever it is approached, but that it is defended with greater determination.
However, it is also clear that accommodative monetary policy must not be allowed to become permanent therapy. It needs to be ended once there are visible signs that inflation is sustainably approaching the level of below, but close to, 2% over the medium term.
Incidentally, I see no justification for a targeted inflation overshooting to make up for the low inflation of the past few years. Rather, that idea reminds me a little bit of an old statisticians’ joke: “If a hunter misses the rabbit on the left and then again on the right, on average the rabbit is dead.”
Though of course it may not be – not by a large margin.
Yet I wouldn’t rule out the possibility that, in theory, a monetary policy rabbit could be killed in this manner. The experts call it price level targeting. This approach, however, would not be compatible with the ECB Governing Council’s current monetary policy strategy. It is precisely in the current environment that a strategy shift could cause massive damage to the credibility of monetary policy.
On top of that, ultra-accommodative monetary policy must not be maintained any longer than necessary simply because the risks and adverse side-effects increase while the desired benefits will tend to subside over time.
The side-effects include the erosion of profitability of the banking sector I mentioned earlier. This, in turn, is making it more difficult for banks to build up additional capital, creates financial stability risks and, as a result, can ultimately also reduce the effectiveness of monetary policy. After all, banks that don’t have capital reserves cannot issue any new loans.
The banks therefore need to rethink their business models, open up new sources of income and reduce their costs. And monetary policy makers must not blind themselves to these impacts on the monetary transmission process.
The digitalisation of the banking industry, at least, is offering an opportunity to realize considerable savings in operating costs, whether in retail business or in interbank business.
However, digitalisation represents an additional challenge to banks, for two reasons. One is that, in the form of “fintechs”, new, highly innovative competitors have entered the scene, giving banks a run for their money. The other is that, in this era of digitalisation, banks are having more and more difficulty maintaining customers’ loyalty over the long term. A modern and efficient IT infrastructure is therefore a significant competitive factor.
“Banks still mired in the swamp of outdated computer technology” – that was a headline seen recently in the FAZ newspaper. Although that might seem a bit over the top, I share the impression that action in this area is urgently needed. Supervisory reviews of IT systems have certainly identified a considerable need to catch up.
This is also the background against which I would frame the complaints about regulators’ perceived hunger for data and the attendant effort spent on investigations, which is not to say that I am not aware of the burden imposed by data delivery.
The perceived or actual hunger for data is admittedly not the only aspect of regulation of which the industry has been critical.
Regulation has undoubtedly been tightened perceptibly since the financial crisis.
For banks to live up to their role as a source of funds for firms, they need to be sufficiently solvent and the banking system sufficiently stable. The raft of regulatory reforms was designed to achieve both preconditions. On balance, they have made Germany’s banking system more resilient.
But regulatory approaches, too, should be macroeconomically optimised. And this is why the stability gains of additional regulation need not only to be positive but also to exceed the costs they imposed, such as through a decline in lending. I believe this condition has been met thus far.
The pending finalisation of Basel III is causing a certain anxiety in the financial industry. One of the most recent aspects of controversy has been the future of internal ratings-based (IRB) approaches for measuring credit risk.
Practice had shown that banks have often priced similar risks in, in some cases, very different ways, often holding much less capital against these risks than in the standardised approach for credit risk. Therefore, I believe it makes sense to counteract any excessive downward swings. However, it would be wrong to allow excessively high lower parameter bounds, effectively abolishing model-based procedures.
Moreover, the reform must not be allowed to cause an additional significant increase in minimum capital requirements. This was recently reaffirmed by the group of central bank governors and supervisory authorities. Basel III must not turn into Basel IV!
However, nor should we turn back the regulation clock to pre-crisis days. By this, I mean that we must not dilute the Basel III rules, either.
At the same time, I think it is important for long-term financing to remain intact. After all, bank loans with long maturities and fixed terms and conditions make it easier to plan major investments and thus often make such investments possible in the first place. This is why, when designing the net stable funding ratio (NSFR) under Basel III, we made sure that due attention was given to the long-termism of traditional business models. And we will likewise bear this in mind when finalising Basel III.
In short: we need rules that do not place an undue strain on entrepreneurial risk-taking, yet at the same time protect financial stability effectively.
An issue where we at the Bundesbank see an urgent need for reform is the preferential regulatory treatment of exposures to sovereigns. We have therefore been, for some time, beating the drum for risk-sensitive capital backing of these exposures which addresses both credit risk and concentration risk. We are aware that such changes would also impact on public sector banks in Germany.
The VÖB, too, considers a review of the treatment of sovereign exposures to be “fundamentally correct”. Moreover, we are in fundamental agreement that “transitional periods” would be necessary “to avoid turmoil in government finance”.
I think such a reform is indispensable if we wish to sever the unhealthy sovereign-bank nexus once and for all. The question here is how to enforce the liability principle in the monetary union if the banking system is unable to cope with a sovereign default. Relying all too much on European taxpayers or even central banks to ensure sovereign solvency cannot be the answer.
Ladies and gentlemen
According to a survey conducted by the YouGov public opinion research institute, 41% of Germans agreed with the statement that “everything was better in the past”. By contrast, only 4% believed that everything was worse in the past. The 1970s, 1980s and 1990s were given particularly positive marks.
Unfortunately, the institution did not break its figures down by groups of professions. However, better-educated, higher-income respondents agreed in disproportionately large numbers with the statement that everything was better in the past. Consequently, it stands to reason that people employed in the financial sector might take on an even rosier view of the past than the average member of the general public.
In light of the challenges banks are currently facing, which I have only partly addressed today, that might even be understandable.
However, we must also bear in mind that one of the primary reasons interest rates are so low is that the euro-area economy has not entirely regained its footing in the aftermath of the global financial and debt crisis. How quickly toxic assets can be removed from banks’ balance sheets in some euro-area countries is another factor that determines the speed of recovery from post-financial-crisis economic slumps.
Regulation also had to be tightened because we saw that financial market deregulation and liberalisation led to excesses and unwanted developments – including in the public banks’ sector.
Regulatory reform must be designed to correct these unwanted developments and, on balance, strengthen the resilience of the banking sector.
Resilience, however, is not an end in itself but must enable banks to reliably discharge their key macroeconomic task – and that is precisely the topic of the ensuing “power talk”.
“I wish the association and its affiliated credit institutions every success in discharging the tasks that lie ahead. I thank you for your kind attention.”
This is how Helmut Schlesinger closed his remarks 25 years ago, and I see no reason to put it any differently today.
In short: good luck and thank you very much!