Banking in Europe: What went wrong,
and how to fix it?
Boris Vujčić
e-mail: boris.vujcic@hnb.hr
Structure of the presentation

Overview of the European banking sector






Lending and asset quality
Capital and funding
Deleveraging
Banks and Sovereigns
Government intervention
Reform of the architecture – banking union



Single supervisory mechanism
Resolution mechanism and deposit guarantee scheme
View from a possible opt-in country: to join or not to join?
Credit activity across the Euro area

Loans to private sector in Euro area stagnated since the start
of the financial crisis (cumulative nominal growth in five years
amounted to 0.8%, meaning effective decrease).

However, huge differences among countries: stock of loans
varies from 60% to 130% of the pre-crisis level – a number of
member states experience serious credit crunch.
Overall - stagnation in lending, but large
differences between the Euro zone
countries
Cumulative credit growth 9.2008-7.2013
40
30
20
8,1
10
-10
-20
-30
-40
Source: ECB and CNB.
Croatia
Euro area
Ireland
Spain
Luxemb.
Estonia
Belgium
Portugal
Slovenia
Germany
Netherl.
Malta
Austria
Greece
Italy
France
Slovakia
Cyprus
-50
Finland
%
0,8
0
Banks’ assets structure and market
disintegration in the euro area

Data on lending show that financial markets became
increasingly fragmented.

Moreover, banks in Euro area increased share of domestic
bonds holdings with the bulk of domestic bonds purchases
referring to Government bonds.

Government bonds, on one hand, seemed like a reasonable
(CAR supporting) investment in the period of high risk
aversion, credit risk increase and low private sector demand.

However, such an increasing exposure towards domestic
governments further strengthened the link between banks and
sovereigns.
Increasing home (government) bias in
Euro zone and Croatia
Government Securities / (Government
Securities + Loans to private sector)
Domestic bonds to total bonds
100
25
80
20
60
15
%
%
40
10
20
5
Source: ECB.
2013Jul
2008Sep
2013Jul
Croa tia
Greece
Fra nce
Estonia
Finla nd
Luxemb.
Netherl.
Cyprus
Germa ny
Belgium
Austria
Ma lta
Slovakia
Slovenia
Ireland
Ita ly
Portuga l
Croatia
Finland
Netherl.
Italy
Greece
Spain
Luxemb.
Portugal
Austria
France
Belgium
Germany
Ireland
2008Sep
Spa in
0
0
Asset quality of European banks
continuously declines

Non-performing loans continue to increase making
value adjustment costs decrease unlikely.

Besides NPLs increase, value adjustment costs rise
due to a need to further provision the existing NPLs.

US in a better shape.

In Croatia, NPL coverage is lower, but the proportion of
recognized NPLs is higher comapred with peers.
Asset quality
Non-performing loans coverage
Bank Non-performing loans ratio
12
70
9
60
%
80
%
15
6
50
3
40
0
30
2008
2009
Croatia
CEE
2010
Eurozone
2011
2012
United States
2008
2009
Croatia
CEE
2010
Eurozone
2011
2012
United States
Source: IMF, FSI, (bank assets) weighted averages
Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic,
Slovenia
8
Bank performance

Bank earnings in Europe strongly affected by deteriorating assets while in
US provisions are decreasing and, thus, even supporting the earnings.
Accounting/provisioning standards?

Double impact of rising Non-performing loans: value adjustment costs
increase and interest income decline.

US banks operating with lower operating profitability but with assets of
higher quality, and with less leverage, have more credit potential.

Croatian banks fared well in most of the crisis period; however, prolonged
recession started to weight in on the banks performance. Credit risk
materialisation plays increasing role in banking with interest income starting
to suffer.
Bank performance indicators
Bank Return on Assets
Bank Return on Assets excluding value
adjustment costs
2,0
2,5
1,5
2,0
1,5
%
%
1,0
1,0
0,5
0,5
0,0
2008
2009
2010
2011
2012
-0,5
0,0
2008
2009
2010
2011
2012
-0,5
Croatia
CEE
Eurozone
United States
Croatia
CEE
Eurozone
United States
Source: IMF, FSI, (bank assets) weighted averages
Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic,
Slovenia
10
CAR in Europe relatively high,
but also high leverage!?

United states traditionally has higher capital ratios.

CA ratios in Europe increased after the crisis mostly due to a risk
aversion.

On the other hand, equity to un-weighted assets ratio remains stable
(even decreased slightly in Euro zone after 2010) meaning that the
fresh capital inflow in the banking sector has been scarce – there
has been no deleveraging.

In Croatia, high capital buffers make banking sector much more
resilient to the crisis and change of regulatory standards than
elswhere.
11
CAR in Europe is improving, but without
corresponding decline in leverage
Bank capital to un’weighted assets
22
16
20
14
18
12
16
10
%
%
Bank (regulatory) capital adequacy ratio
(CAR)
14
8
12
6
10
4
2008
2009
Croatia
CEE
2010
Eurozone
2011
2012
2008
2009
United States
Croatia
CEE
Source: IMF, FSI, (bank assets) weighted averages
Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic,
Slovenia
2010
Eurozone
2011
2012
United States
12
Costs of financial aid in the EU
2008-2011: costly crisis

27 EU members approved around 4,656 billion Euro of financial aid to
banking institutions (with 1,676 billion spent until the end of 2011).

United Kingdom, Germany, Denmark and Ireland approved more the 500
billion EUR while Bulgaria, Czech R, Estonia, Malta, Romania and Croatia
did not provide any help to their banks.

Relative to 2011 GDP, highest bank support was provided by Ireland (328
%) and Denmark (258%) with Belgium and Netherlands commiting more
than 50% of GDP as well.

The structure of EU-27 bank support shows that countries used mostly
guarantees to support banks (27.3%) with recapitalization, buying of
troubled assets and liquidity measures amounting to 4.9%, 3.6% and 1.7%
of 2011 GDP respectively.
13
Belgium
Bulgaria
Czech Republic
Denmark
Germany
Estonia
Ireland
Greece
Spain
France
Italy
Cyprus
Latvia
Lithuania
Luxembourg
Hungary
Malta
Netherlands
Austria
Poland
Portugal
Romania
Slovenia
Slovakia
Finland
Sweden
United Kingdom
EU-27
Belgium
Bulgaria
Czech Republic
Denmark
Germany
Estonia
Ireland
Greece
Spain
France
Italy
Cyprus
Latvia
Lithuania
Luxembourg
Hungary
Malta
Netherlands
Austria
Poland
Portugal
Romania
Slovenia
Slovakia
Finland
Sweden
United Kingdom
EU-27
%
Amount approved as yearly average % of GDP
100
80
60
40
20
0
900
800
700
600
500
400
300
200
100
0
Guarantee
The structure of approved
financial aid
Source: European comission
Recapitalization
bill. EUR
Costs of support to financial system
2008-2011
Amount approved in absolute terms- right
The amount of approved
financial aid
Acquired troubled assets
Liquidity meassures
100%
80%
60%
40%
20%
0%
14
Significant risks remain

Unlike in the USA, European banks’ capital is increasingly burdened with
un-provisioned NPL’s.

Even without further NPL increase, resolving the current asset quality
issue would take time and implies spending some buffers or gathering
additional capital.

Two risks arise from the bank asset quality:
a) Fiscal risks arising from the NPL resolution
b) Dampening of the potential credit growth in the following years

In Croatia, higher burden of capital with NPLs is offset with high capital
buffers. Even after correcting the capital ratio for the unprovisioned NPLs
– Croatia has relativelly higher capital ratios.
15
-5
Sweden
Spain
Slovenia
Slovak Republic
Romania
Portugal
Poland
Netherlands
Malta
Luxembourg
Lithuania
Latvia
Italy
Ireland
Hungary
Greece
Germany
France
Finland
Estonia
Denmark
Czech Republic
Cyprus
Croatia
Bulgaria
United States
Capital to assets
United Kingdom
-10
Belgium
Austria
%
Capital ratios are sensitive to NPL
coverage
Capital ratios, End 2012
15
(Capital-uncovered NPLs) to assets
10
5
0
Source: IMF, FSI
16
European banks remain reliant on wholesale funding (ECB)

Deposits of banks in the USA exceed their loans, with the LTD
ratio decreasing continuously.

Euro area banks, on the other hand, even slightly increased
their reliance on whole-sale funds (ECB).

CEE countries, started to deleverage in 2012. Before the crisis
foreign liabilities share of total liabilities was relatively high due
to high penetration of foreign banks.
17
With little new capital, euro area banks
remain reliant on whole-sale funds (ECB)
Loan to deposit ratio
(Change of Equity) / Assets
150
2,0
1,5
120
%
%
1,0
0,5
90
0,0
2009
60
2008
2009
Croatia
CEE
2010
Eurozone
2011
2012
United States
Source: CNB and IMF - FSI, (bank assets) weighted averages
Note: CEE countries: Bulgaria, Croatia, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic,
Slovenia
2010
2011
2012
-0,5
Croatia
CEE
Eurozone
United States
18
CEE: unlike in the euro-area,
higher LTDR – more deleveraging
Change in banks' external debt
between March 2013 and September
2008
Loan to deposit ratio
2.3
5
2.1
0
1.9
as % of GDP in 2012
1.7
1.5
1.3
1.1
0.9
0.7
-5
-10
-15
-20
-25
Sources: CNB and national central banks.
Croatia
Poland
Czech Rep.
Romania
Bulgaria
Slovak Rep.
Baltics
2012
Lithuania
Central Europe
Croatia
2011
Hungary
2010
Latvia
EU periphery
SEE
2009
Slovenia
2008
Estonia
-30
2007
Banking union

P. Romer: “A crisis is a terrible thing to waste”!

Incomplete supervisory architecture not the only (not even
major) cause of the crisis, but crisis has laid ground for an
integration of banking supervision in the Eurozone
 not only in the form of common rules and practices, but
also as an institutional integration of supervisory
authorities.

BU becomes a necessary precondition (although not a
sufficient one) of breaking the link between weak banks and
weak sovereigns.
20
BU architecture
21
Link between weak banks and weak sovereigns
The contagion channel between sovereign and banks
IMF (2012), Global Financial Stability Report, April.
Single supervisory mechanism, banking union
and the EU
Banking Union – Euro
Area
Banking Union – EA
including closecooperation
Single Supervisory Mechanism
+ Supervisory Manual
European Stability
Mechanism
National stability
measures
Single Resolution Mechanism
EBA:
• Single Rulebook
• Supervisory Handbook
Source: ECB.
Non Banking Union
National Supervisory
Authorities
National stability
measures
National Resolution
Authorities
BU advantages in general

Improving the regulatory framework
 More effective supervision – timely intervention, less likely to be captured!
 Common safety nets and backstops – breaking the link between banks and
sovereigns
 Together, these should eventually reduce social costs of financial crises

Harmonization of banking regulation and supervisory practices
 Should improve the assessment of banks and banking systems

Less need for cross-border coordination

Reduced compliance costs

Benefits and costs of macro-prudential policies – internalized on union wide
level
 Potential to restrict ring-fencing activities
24
Advantages for non-euro countries?

Fostering of the financial integration

Providing better information on cross-border banks and improving
their supervision
 Streamlining some of the supervisory colleges

Ensuring greater consistency of supervisory practices
 Avoiding distortions in the single-market
25
Challenges of SSM participation for non-euro
area country

Participation in the decision making process - Serious efforts
have been made to enhance participation of non-euro MS in decision
making bodies, but some restrictions remain.

The final form of the banking union is still not known - We have
almost 1½ of the 3 pillars agreed on the paper. Making a decision
early is a leap into the unknown, one of the main risks being what
future resolution of cross-border bank will look like.

Two different supervisory and bank resolution regimes may tilt
the playing field and lead to competitive distortions - But, not
even a single supervisory regime is likely to set the level playing
fields as non-euro countries participate in SSM only.
26
Challenges of SSM participation for non-euro
area country (2)

Accountability and potential costs are major issues - The
decision is made within the SSM framework, but national authorities
perform resolution and bear the costs.

SSM participation may impede the functioning of national macroprudential policies.

ECBs lack of supervisory experience and the need to create
institutional capacity for supervision or macro-prudential policies at
the ECB level.

Subsidiaries operating in small states may get “under the radar”.

Just having a parent in the BU may help reap some of the benefits.27
SSM timeline
Q3 2013
Q4 2013
Q1 2014
Q2 2014
Q3 2014
SSM
Regulation
Approval
Consultation
SSM
Framework
Regulation
SSM
Framework
Regulation
EBA/ECB
Stress Test
SSM Transitory
Phase
Conduction of
Asset Quality Review
The comprehensive assessment comprises three main components:

Risk Assessment System (RAS)
 Balance Sheet Assessment (BSA)
 → „Targeted Asset Quality Review“
 Joint Stress Test EBA and ECB
Balance Sheet Assessment
Q4 2013
Q1 2014
Q2 2014
Phase 1
Risk-based portfolio
selection
P1
Phase 2
Execution of Asset Quality
Review
(operative phase)
P2
Phase 3
P3
Collation, quality
assurance & reporting
Operative Start
Asset Quality Reviews
Q3 2014
What about other two pillars?

The draft of Recovery and Resolution Directive was recently presented –
although it has many sensible elements that will remove some uncertainty
and strengthen market discipline, it leaves member states with much
discretion, making competitive distortions likely.

Single supervision cannot work properly without an effective resolution
authority and a credible financing mechanism. It also needs effective
decision-making structures – all of which the SRM does not deliver at this
point. Difficult political issue – Juncker: ‘We all know what to do, but don’t
know how to go back home after that and get re-elected’

Deposit guarantee scheme - complicated legal and practical issues.

Pan-EU Deposit Guarantee Scheme? Member states use various schemes,
so this would mean a longer-term project.
30
Deposit guarantee scheme harmonization

Credible DGS: appropriate coverage, timely payouts and adequately funded.

Harmonization among EU started after 2008 - Directive 2009/14/EC imposed
the obligation to explore further elements of harmonization of DGS but set no
timeline as regards its implementation.

Further harmonization of EU deposit guarantee schemes has been suspended
pending the adoption of EU bank resolution arrangements through a new
Directive.

However: The role of the deposit insurance agency varies widely, both within
the EU and worldwide.

Lack of common EU funding standards:
Nominally, most of the countries have ex-ante (pre-funding) funding
Effectively, in many instances (i.e. in a case of systemic events) these are expost funding schemes since pre-funding is relatively modest.


Differences in DGS among countries
Funding mechanisam for DGS
Source: European commision, JRC Report under
Article
12 of Directive 94/19/EC
Insured deposits and DGS funds in
some EU countries, End 2011
Notes: Eligible deposits is the sum of MFI household and corporate
deposits. Covered deposits applies the EC coverage ratio to eligible
deposits. * DGS or IMF staff info at end-2011, ** Banking
associations top up the mandatory scheme, hence coverage ratio is
lower bound
Source: IMF Country Report No. 13/66 Technical Note on Deposit Insurance
Insured deposits and DGS funds in Croatia, End 2012
Eligible deposits/GDP
Covered deposits/GDP
DGS fund size/GDP
0.86
0.44
1.21
Source: State agency for Deposit Insurance and bank
Rehabilitation, Croatian Bureau of Statistics
To conclude
2013
2014
2015
2016
2017
2018
2019
Mid-Aug 2013: Revised State Aid Guidelines
1 Jan 2014 (after BRRD): ESM direct recap (active after SSM)
1 Jan 2015: Entry into force of BRRD (except bail-in)
1 Jan 2015 (at earliest): Single Resolution Mechanism
Q3 2014:
Results of BSA/ST
1 Jan 2019
(at latest):
bail-in
To conclude

Setting up the BU will take time and effort.

Croatia is very supportive of setting up the BU, but the BU is currently
set in such a way to increase the option value of waiting for non-euro
member states.
 Postponing the decision a bit doesn’t entail high costs, but making
the decision now potentially does.

What could make SSM membership for non euro area members
more attractive?
 Access to resolution funds (use of BoP assistance could be a
useful substitute) or liquidity assistance, level playing field when it
comes to deposit insurance.
 Overall, more complete BU is more attractive than an
incomplete one!
Thank you!