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3 July 2018

Eu­rope must re­duce for­bear­ance risks

The chief economist’s latest newsletter states that regulators have dealt effectively with well-known threats to financial resilience, but they rarely mention the consequences of delays and inaction in dealing with the problems of banks. Ludger Schuknecht and Levin Holle warn this might entail systemic problems.

Dr. Ludger Schuknecht, former Chief Economist at the German Finance Ministry
Ludger Schuknecht, former chief economist at the German Finance Ministry

By LUDGER SCHUKNECHT and LEVIN HOLLE

With 2.4% real output growth in 2017, the euro area has finally joined the global growth party. In fact, the European economy is enjoying its strongest upswing since the start of the financial crisis. Supportive fiscal and monetary policy coupled with pent-up demand after a drawn-out low-growth phase make prospects favourable.

Well-known problems like high public debt, non-performing loans and structural rigidities need to be dealt with to ensure financial resilience. However, the risk of forbearance – delays and inaction in dealing with the problems of financial institutions – are rarely mentioned, even though forbearance resulting from regulatory deficiencies or overly ‘generous’ supervisory action can reach systemic proportions.

Europe has made significant progress on banking union in a very short time. Financial market regulation has been harmonised and regulatory requirements have been reinforced via banks’ internal risk management, the Bank Recovery and Resolution Directive and Basel III, the rules for capital requirements. Supervision has been strengthened by upgrading European supervisory committees to supervisory authorities and by creating the single supervisory mechanism, which makes the European Central Bank the central supervisor of financial institutions.

European policy-makers are discussing ways to reduce forbearance incentives. They include tougher risk provisioning for NPLs and a proposal to improve the effectiveness of insolvency regimes. However, current options do not address some fundamental problems sufficiently.

In several European Union member states, NPLs have been falling over the past year, but at a gross value of more than €850bn, they still pose a risk to financial stability.

Insolvency and foreclosure procedures must function effectively and lead to results in a reasonable amount of time. Strengthening banks’ loss absorption capacity to at least 8% of the balance sheet is essential. Buffers of clearly subordinated debt that can be bailed in are key.

Moreover, eliminating privileges in the regulatory treatment of government debt is necessary to make banks more resilient and address the link with the state. In this regard there is little progress, if any.

Focus on risk reduction

Some claim this risk reduction agenda is too far-reaching. But there is an argument to be made that it does not go far enough. The inherent tension between the positive and negative consequences of supervisory discretion is an important potential source of forbearance. On the one hand, discretion is necessary, as supervisors must assess a bank’s robustness on a case-by-case basis. On the other hand, discretion is vulnerable to political pressure, unequal treatment and regulatory arbitrage. It is important to strike the right balance.

Banking union poses its own problems. The establishment of a single supervisor helped to harmonise the practices of European supervisors as well as the implementation of common rules. However, there are biases in provisioning practices. The requirement of high-quality assets as collateral for central bank liquidity is essential. In conjunction with the prevention of easy and prolonged emergency liquidity assistance from national central banks, it reduces forbearance risk.

Another important point is the way European supervisory institutions work: all members should work in the best European interests while having the necessary expertise at the same time.

The present favourable economic environment should not obscure the importance of implementing this agenda. Households and companies rely on a sound financial sector for growth and stability. Parties come to an end at some point. If we don’t want to wake up with a hangover, we must use the good times to implement reforms.

This article appeared first in the Global Public Investor 2018 published by the Official Monetary and Financial Institutions Forum (OMFIF). It reflects the personal views of Ludger Schuknecht (Chief Economist and Head of the Directorate for General Fiscal Policy and International Financial and Monetary Policy) and Levin Holle (Director General for Financial Markets Policy) at the German Federal Ministry of Finance.