EU banks

In a speech to the Eurofi Financial Forum in Bratislava on Wednesday, Nouy said European banks have become much more resilient over the past few years, but more steps have to be taken to reduce the burden of bad loans clogging their balance sheets.

"The core indicator for resilience is bank capital, and the relevant capital ratios have increased from 9 percent in 2012 to more than 13 percent today," she said. "The recent stress test conducted by the European Banking Authority and the ECB confirmed… the European banking sector… would withstand even a period of severe stress."

However, this improvement isn't reflected in what the markets think about the banking sector, she added: "So far this year, European bank shares have lost more than 20 percent of their value. Given that banks are more resilient than ever before, what is it that investors are worried about?"

Nouy took the view that what investors worry about is the profitability of banks - a worry she, as Europe's senior banking supervisor, shared: "Only profitable banks can maintain and improve their capital buffers – and remain resilient."

What's weighing down profitability?

Nouy argued that two key factors are hurting banks' long-term profitability, and hence their share prices: Interest rates and NPLs.

Persistently low interest rates define the current era in banking, as does a legacy of NPLs, bad loans that are unlikely ever to be repaid in full, accumulated since the great financial crisis broke out in 2007/2008.

"For large banks in the euro area, net interest income makes up, on average, more than half their total income," Nouy said. "In the short term, low interest rates might actually boost profits," because banks can borrow short-term money more cheaply from money-markets, yet keep the interest rates on long-term loans they make to clients relatively high.

But eventually, those fat spreads will dry up, as clients' old loans are repaid and new loans must be made to clients at lower interest rates in a more competitive banking landscape. "[Banks'] funding costs will hit a lower limit, yields will decrease, and net interest margins will decline - this is what markets anticipate," Nouy said.

Cleaning out the stables

In addition to low interest rates, another issue worrying the markets is that of non-performing loans, she added. Some parts of the European banking sector still have high levels of NPLs, which curb profitability.

"It is the responsibility of the banks to clean up their balance sheets," Nouy said.

That was the point where Nouy's speech went beyond just tallying up current conditions in the European banking sector, and hinted at new policies in development at her agency.

"ECB Banking Supervision will shortly launch a consultation on guidance for banks on dealing with their non-performing loans," Nouy said. "The guidance provides recommendations to banks and sets out a number of best practices we have identified. [It] constitutes the ECB's supervisory expectations" on how banks handle NPLs.

She added that some EU countries could further improve their legal and judicial frameworks to "facilitate the timely workout of non-performing loans."

Controversy over banks' capital requirements

Banks have lobbied hard since 2008 to limit the scope of new regulation affecting them, despite the enormous economic damage caused by the Great Financial Crisis. They were largely successful - the "Basel III" regulatory framework introduced in the wake of the crisis was a cautious, incrementalist package that didn't change banks' business models in any fundamental way.

Reviewing the past several years of regulatory change, especially Basel III's mandated increase in banks' core capital requirements, Nouy said: "What has been done had to be done. Only well-capitalised banks can finance the economy throughout the entire business cycle. If banks are poorly capitalised, they tend to be exuberant in good times and cut back their lending in bad times, making crises more likely and more severe. Studies that compare the costs and benefits of higher capital requirements have shown that, in the end, the benefits outweigh the costs."

Basel III capital requirements now require banks to hold at minimum 4.5 percent of core "tier one" capital, and by 2019 also to hold a 2.5 percent counter-cyclical capital buffer.

But some leading economists and banking experts, including Lord Adair Turner, former head of the UK Financial Services Authority and author of Money, Credit and Fixing Global Finance,' believe Basel III's capital requirements remain far too low.

Adair Turner's frustrations

In an interview with the 'Private Debt Project' in December 2015, Turner, said:

"Anat Admati and Martin Hellwig in their book, 'The Bankers' New Clothes,' argue for far higher [capital] requirements. Banks should, they believe, hold equity capital equal to 20-25 percent of the gross unweighted value of their assets, increasing effective requirements by some four or five times [compared to Basel III levels]. "

Turner added that he agreed with Admati and Hellwig, "but not necessarily for the same reasons they give. The central argument of my book is that we must constrain private credit growth, and I believe much higher capital requirements are essential for that purpose."

But in Bratislava, the woman who oversees eurozone banking supervision from her office high in the ECB's Frankfurt skyscraper said something that will probably be music to the ears of Europe's bankers, though not to Lord Turner's:

"Basel III, the centrepiece of the regulatory reform, will be finalised by the end of the year, and regulators are focusing on not significantly increasing overall capital requirements. The regulatory reform is coming to an end."