Summary of Closing Remarks by Governor Carlos Costa1
The topic of this conference is a very important one; we must continue to reflect on these issues in the
future.
For the European banking sector to have a role in the recovery, it is very important to ensure that banks’
balance sheets are a mirror of the reality. In particular, impairments must be acknowledged and banks need
to have adequate levels of capital. These important tasks are now under completion with the comprehensive
assessment (Asset Quality Review and Stress Tests).
This process of repairing the banking sector has effects on the credit side. Banks will use part of their capital
to absorb losses and, since their capital is limited, their credit capacity will be affected. Banks’ credit
capacity is constrained by capital and not only by liquidity. So, to ensure there is credit to the economy, it is
not sufficient to provide liquidity to the banking sector but also capital. A credible comprehensive assessment
can contribute to attract capital for European banks.
European banks also need to come back to profitability. In order to increase profitability banks will have to
get rid of unprofitable assets (for instance, mortgage loans with very low fixed spreads, as is the case in
Portugal), to adjust credit to a situation of low leverage in which it is not possible to spread costs across many
loans and to deal with the electronic revolution, which could potentially increase cost efficiency.
In summary, in the short-term the main challenges for European banks are to take into account impairments,
to increase capital or to get capital relief and to increase their profitability.
In the long-term, it is expected that banks in Europe will continue to be important players in the development
of the economy. Indeed it is not easy to change from a bank-based economy to a situation where capital
markets have a dominant role in financing the economy. For European companies to be able to get financing
in capital markets, they will have to go through several changes, namely in terms of their size, access to
information, transparency; in general a different corporate culture will be necessary. So, the perspective is
that for a long period Europe will continue to have a dualistic financial market, in which large companies have
access to capital markets and SMEs rely on bank financing.
The corporate sector is highly indebted; it needs to reduce its levels of debt. Moreover, it is important to
recognize that firms are used to taking advantage of banks’ evergreening practices. We need to ensure that
companies that are not economically viable do not receive further credit. Banks need to distinguish between
companies that are financially stressed but are viable in economic terms and those that are in financial stress
but are not viable. It is very important to impose discipline on the banking sector to trigger the restructuring
process of firms long before viability becomes a problem. The restructuring of viable companies might involve
increasing equity or finding a buyer for the company.
Banks should be encouraged to sell credits given to troubled firms. In order to generate demand for those
credits, it is important that buyers have certain rights. It should be possible for those buyers to convert their
credit into equity or quasi-equity, and therefore to have the possibility to interfere in the management. For
that to be possible the legal framework needs to be changed, for instance in line with chapter 11 in the
United States or in other aspects. The present situation, where banks have more power to influence the
1
This is a condensed transcript of the closing remarks made by Governor Carlos Costa at the Conference “Investment Finance and the Recovery”, on September 5, 2014. management of the company than the buyer of the credit, limits the demand for credit and does not
encourage the restructuring of firms.
For the recovery of the economy, it is critical to prevent viable companies from going bankrupt so as to
preserve the social capital embedded in them. The loss of this capital represents a much higher cost for the
economy than the financial loss associated with bankruptcy. These companies need to have equity and if their
owners have no capacity to attract new capital, it is important to create the incentives for capital to come
from external sources. Moreover, for the recovery of the economy to occur it is essential to have investment,
which involves having long-term financing available.
In summary, the recovery of the economy will entail a two-side exercise, on the one hand to increase the
soundness of the banking sector and on the other hand to create the conditions necessary for companies to
make a good use of capital and loans and to increase their equity if needed.
As regards the second topic of the conference, i.e., the Banking Union and Financial Union, it was emphasized
that even with new rules coming from the Financial Stability Board and from Basel, banks will be limited in
their capacity to lend given they are dependent on interbank short/medium term funding which is not in line
with the financing needs of the economy. Indeed one problem in Europe is that the banking sector is not able
to capture the savings that are needed to lend to the economy. In order to solve this problem, it is important
to move from a narrow banking sector and to get other financial actors into the game, such as pension funds
and insurance companies that capture savings but cannot lend to the economy. The only way to create a
bridge between these long-term institutional investors and banks is by securitization, that is, by lending and
distributing. The securitization of credits by the banking sector and their sale to these other financial
institutions, is a way of taking more savings to the banking sector, and thus enhance the ability of banks to
lend to the economy. This will also contribute to a decline of the maturity mismatch in banks’ balance sheets,
which was one of the reasons banks were so vulnerable to the crisis. For the increase in the importance of
securitisation in Europe it is essential to create an integrated ABS market in European countries, with a
European legal framework and clear rules. This is the only way to create the depth this market needs to
attract investors.
Another important lesson that should be taken from the crisis is that to avoid levels of unsustainable debt by
non-financial corporations, it is very important to change the incentives and in particular to reverse the
present situation in which debt has a better tax treatment than equity.
In summary, for the future we need to have a combination of three things. First, we need to give a trigger
signal that will force banks to think about restructuring the debt of companies before they are under strong
financial stress and their viability is at risk. Second, we need to ensure that all the incentives are in favour of
equity (and subordinated loans) instead of debt. Third, it is important to create the conditions for the
existence of a market for the credits, which implies legal changes to ensure that, when the financial situation
becomes difficult, those buying the credits have the capacity to enter into the capital of firms and hence the
right to interfere in the management. In some cases the best human capital is within the company. Thus, an
alliance between external investors, with the capacity to increase capital, and the available human capital of
SMEs might be the best way to reverse the situation. In this regard it is very important to think about what can
be done to promote MBOs. For many SMEs the solution might be a joint venture between external equity and
MBOs in which both sides are sharing the risk.
Finally, there are limits to the European financing model linked with the fact that banks are not prepared to
finance venture capital because it involves a different type of risk from the “historical” risk they are prepared
to deal with. To put it another way, banks “know” how to deal with the risk associated with the “known”
uncertainty of typical firms (measured by looking at historical statistics), but they are less equipped to deal
with the “unknown” uncertainty which is typical of investment in innovative firms; besides that, banks
privilege established firms of the first type since they are able to obtain additional comfort through real
guarantees, to the detriment of start-ups. For the latter type of firms a different source of financing, able to
evaluate and accommodate the corresponding risks, is necessary. The investors in these risky corporations
should have some sectoral specialization, in order to have a good understanding of the business, and need to
take ventures across national borders in order to increase dimension and reduce the risks. So it is important to
create European venture capital units specialized in some sectors. To promote a recovery based on innovation,
it is necessary to have cross-border mechanisms. In that respect the IEF is an important element since it gives
a European wide perspective.
Unless Europe faces up to the challenge of innovation, the challenge of investment and the challenge of
increasing aggregate demand, it will risk facing a stagflation situation for a long time, which means Europe
will lose its importance in geo-economic and geo-political terms.