Banking union is urgently needed

In the recent „Financial Stability Report" the IMF warned that the largest European banks may be forced to shed up to 4,5 trillion dollar of assets in 2013. How big is that risk and what could be the potential consequences?

The IMF stressed that this is what could happen in a weak policy scenario, which has been defined as a situation, in which all the reforms in the euro-zone that have already been agreed upon are not realized. So this is a scenario, in which we don't move towards the banking union and the countries that committed to structural reforms, don't fulfill these commitments. This indeed would be a very negative scenario, which at this point I consider rather unlikely - we saw that the last European Council reaffirmed a commitment to decide on the banking Union and finalise the CRD4 framework by the end of this year.

It is also worth remembering, that banks can deleverage either by reducing assets or by raising capital. In this sense, our recapitalization exercise brought European banks a long way down the necessary deleveraging path. Banks strengthened their capital base by 200 bln euro, which is equivalent to a 2,2 trn euro reduction in risk-weighted assets. This is equivalent to the 2,8 trn dollar reduction which the IMF forecasts in its baseline scenario. Of course, if major mistakes or delays happen at European level, more deleveraging will happen, which could be harmful for European economy.

Is deleveraging enough to achieve stability in the European banking sector? Maybe this sector is simply too large and banks need to get smaller in nominal terms, not only less leveraged?

It's clear that banks need to deleverage. They entered the crisis with not enough capital, too much debt and inappropriate funding structures. But the need for deleveraging and the need to reduce the size of bank's balance sheets depends also on the scope of the safety net. If you compare the size of European banks assets to the GDP of their home countries, then indeed the ratio is often way to high; if you take the GDP at European level, European banks are roughly aligned with their US peers. This means that if we manage to have a banking union there will be less need for deleveraging at large banks.

Nevertheless, the commission under the lead of Erkki Liikanen recently came to a conclusion, that "banks too big to fail" are serious problem for Europe and recommended to break them up.

Dealing with the problem of banks "too big to fail" means that we should not consider any institution "too big too fail". In other words, we can have large and complex institutions, but they must be able to fail without generating problems for taxpayers and hurting the whole financial system. All banks need to be resolvable, and we are making progress in that direction. The European Commission put on the table in June a proposal on bank recovery and resolution. Under this proposal, supervisors - if they are not convinced that a large bank is resolvable - can impose a breakup of its activities. However, this is not an easy decision. Therefore, a structural segregation of retail and capital markets activities might be appropriate. I think that the proposal of Liikanen's group goes in a right direction.

Do you see that politicians, who immediately after the crisis started were eager to impose stricter regulations on banks, are now trying to dilute them because they see that this might hurt the economy?

When you have a financial crisis everybody wants them to be tougher, but once over the real economy slows down, pressure mounts to relax the requirements on banks, so that they can lend more. But I think that the trade-off between stability and growth is often overemphasized. When banks are weak in terms of capital, they are unlikely to finance the economy. Only banks which have a strong capital base can easily attract funding and so are capable of supporting the real economy.

Coming back to the idea of banking union, do you think that this is the right path to alleviate the fiscal crisis? How should it be structured to fulfill its role?

The banking union is urgently needed. Currently there is an interconnection between banks and their respective sovereigns, which is still adversely affecting bank funding and the financing of the real economy in the euro area. As a result, we are in a situation, in which one euro of deposits in Greece is not equivalent to one euro deposited in bank in Germany. This makes deposits potentially volatile, which is very damaging for the single currency area. To fix this, the solution is to have a banking safety net at a European level.

As it comes to the structure of the banking union, there are two important issues. First, the banking union must by an open architecture, so that countries from outside the eurozone can participate. Second, although it would not apply to all the 27 member states, it has to be designed keeping in mind the single market dimension. At the single market level, we need to have the same rules and the same supervisory methodology for all the banks.

Is it advisable to make ECB the main supervisor of this banking union?

Different choices would have been possible. The Treaty on the functioning of the European Union already envisaged the possibility to move some regulatory responsibilities to the ECB. So this choice allows fixing the problem in a quick way, and we are in need of a quick fix. Of course, it poses the issue of close coordination between ECB and EBA, which will remain responsible for the rulemaking for the single market and for mediating between national supervisors in case of conflict. The EBA will also remain responsible for overseeing risks in the single market as a whole and conducting EU-wide stress tests.

As it comes to the stress tests, they were criticized for not being strict enough. It was pointed out, that the banks were allowed to use their own models for risk-weighting of assets and that the assumptions about the development of bond prices were too optimistic. Will that be changed in the next round of stress tests in 2013?

In my view the methodology that we used was quite strong. The fact that banks use their internal models to define their capital needs is consistent with the legislation. However, we made it more challenging for the banks, as we required a strong peer review in order to make sure that the outcomes are consistent throughout the EU.

There was one area in which the methodology was widely criticized and it was the treatment of sovereign exposures at the time. It was difficult to follow a different approach at that time. However, shortly after the stress test results were published in July 2011, the EU agreed on private sector involvement in the restructuring of the Greek debt and we saw an escalation of the sovereign crisis. For this reason, the EBA decided to review the treatment of sovereign exposures. In October we adopted a new recommendation as part of a one-off recapitalization exercise and ask the banks to build up a specific capital buffer vis-à-vis their sovereign exposures (on the top of the higher requirement of 9% CT1). This led to a massive recapitalisation of the banking sector, which was concluded in June this year.

Having said that, we are constantly reviewing out methodology, maintaining a dialogue with banks and market participants to understand their views. This is especially important as we are moving towards Basel III that will radically change the regulatory framework for banks.

Do you think that this new regulatory framework is complete, in that it will prevent the crisis from repeating, or something was missed?

Basel III is quite a strong package. It includes stronger definition of capital, it raises capital requirements and introduces liquidity standards. It also deals with the problem of systemically important institutions, which will facee even tougher requirements. It has to be viewed together with the proposal on recovery and resolution, which aims at ensuringe that even large and complex banks, if they fail, a will exit the market smoothly. However, there are two areas, in which further work is needed. One is the calibration of the liquidity requirements. This is very important, because these standards will be the ones, which will drive the change in the business models of European banks. The EBA has been mandated to study the impact of the new liquidity ratios and we are committed to deliver to the European Commission a thorough report. The second issue is the proper structure of  banks. In this matter, the recommendations from the Liikanen report have to be discussed.

Do you agree with quite a popular view, that ECB's actions – escpecially the LTRO's – made the sovereign exposures problem even worse than it was before?

No. I think that the adoption of the extraordinary measures by the ECB, especially of the unlimited provision of liquidity to banks, for a longer maturity, was absolutely needed. Banks were facing a wall of redemptions:  there was a lot of bank debt maturing in 2012, and the funding market was frozen because of the sovereign debt crisis. So if it wasn't for the ECB, we would have experienced a major credit crunch. Furthermore, if you look at the data we disclosed recently it is clear that banks' sovereign exposures remained in aggregate broadly stable between September 2011 and June 2012. However, there has been some changes in the exposures structure, because banks tended to sell foreign bonds and buy domestic ones. This has led to segmentation of the bond market, which is not a positive outcome, but it's not the role of the ECB to deal with it.