European Supervisors Tell Banks to Be More Efficient
Commentary by Steven Lofchie
The European Supervisory Authorities ("ESAs") overseeing securities ("ESMA"), banking ("EBA") and insurance and occupational pensions ("EIOPA"), published a joint report on cross-sectorial vulnerabilities and developments in the EU financial system. The ESAs' report determined that the following conditions have "persisted since March 2015":
- a low-interest-rate environment and its impact on the profitability and business model sustainability of financial institutions;
- the continued search for yield by financial institutions and the associated mispricing of assets;
- political and economic risks caused by residual uncertainty about Greece's financial situation;
- financial market volatility and structural concerns about the economic prospects of emerging market economies, particularly in China; and
- reductions in market liquidity.
On the subject of banks, the report found that "the viability of financial institutions business models in a context of low growth, low interest rates, subdued profitability and increased competition remains a supervisory concern, not least since potential drivers to boost profitability in a sustainable manner remain vague." Because of these threats to the survival of individual banks, supervisors must be "vigilant that banks' plans to address costs focus on increasing efficiency rather than outright reductions, [thereby] avoiding potentially compromising critical functions such as in risk management and IT security," the report stated.
Regarding the future, the report identified "some potential risk drivers for the developments ahead," which include the following: (i) the possible reemergence of concerns on sovereign debt sustainability that "could trigger a change in market sentiment if a further tightening in credit spreads would not be in line with future economic developments" and (ii) "increasing international risks, e.g., following heightened market volatility, structural concerns about China's economy, fluctuations in commodity prices or divergence of monetary policy conditions between major jurisdictions."
Commentary
The ESA's report is bleak. It is interesting to note that many of the financial sector problems identified in the report are traceable to governmental action. For example, governments forced interest rates down to levels that make lending money unprofitable. Resulting bubbles in asset values are vulnerable to collapse. Governmental borrowing, like that of (but not limited to) Greece is allowed despite the fact that such entities are not financially solid in the long term. The report warns against investment in "illiquid" assets, but at the same time indicates that increased regulation makes more assets illiquid. With no obvious path to profitability, the report cautions banks not to take risks to increase their profitability, and also not to cut their compliance and supervisory expenses; instead, the report tells banks to become more efficient. But how feasible is that on the scale that the report suggests?
The report may be interpreted as saying that: (i) governmental policies intended to support the economy will make it impossible for financial institutions to make a profit; (ii) although financial institutions will attempt to survive by taking on more risk or cutting fixed costs, regulators will discourage their doing so; and (iii) financial institutions will fail, which will likely result in government imposing more regulations.