I must begin by acknowledging that, while the first public address of the year always entails additional effort, having the opportunity to deliver it in this wonderful city is a privilege that completely eliminates that effort, transforming it into genuine pleasure. Everyone knows by now, at this point, about my Aragonese origin, specifically from Teruel. But few people know that my father is a pure-bred Andalusian, so 50% of my genetic material vibrates when I am in the South.
The beginning of the year is conducive to reflections on the recent past and on what lies ahead in the coming year. And this is my intention today: to reflect on the milestones of the year we leave behind, but above all on the bumps in the road ahead. Because, indeed, 2014 is the year that marked the beginning of the economic recovery process and also the end of the restructuring of the Spanish banking sector. But this should not lead us to complacency or abandonment: the depth and length of the crisis has not only left a profound mark on our economy and society, but it completely changes the parameters under which we operated before the crisis. Nothing will ever be the same, and the environment in which all economic agents will operate will be much more demanding. This is not a pessimistic attitude, a result of the 7 years of crisis experienced, but, quite the contrary, a call for realism so that we persevere on the correct path we have already embarked upon.
To be clear: it is an undisputed fact that the worst of the crisis is over, but it would be a mistake to think that nothing remains to be done to repair its consequences. On the contrary, we have years, if not decades, of persevering on the path undertaken to reduce the vulnerabilities of the Spanish economy in fundamental aspects, such as unemployment, public debt, and external debt.
But let’s return to the year we left behind. 2014 marks the end of the recession and job destruction process that lasted six years. Indeed, and although growth in the 2% range may seem meager in a historical context, we must not forget that Spain, among the large Eurozone countries, is exhibiting the highest growth. And, what is more valuable, this level of GDP growth is enabling significant job creation: we are now able to generate jobs with more moderate growth rates, something that did not happen before the crisis.
Furthermore, 2014 is the year in which it has been demonstrated that the structural reforms undertaken in recent years, though tough and costly, are yielding results. Allow me to focus on what is my responsibility: the financial system. The restructuring of the sector has been very intense, and has involved not only the transformation of a part of the sector, that of savings banks, into banks configured as public limited companies with voting shareholders, but also a very significant reduction in the number of banks operating in Spain. This process has been tough and demanding for the entire sector, and has required significant increases in provisions and capital, carried out, in the case of AEB banks, without public aid. But this process is paying off, both cyclically and structurally. Cyclically, because credit supply restrictions have been left behind, so that banks—both old and newly created—are in a position to finance the economic recovery process. Structurally, because the sector that emerged from the crisis is more efficient (due to the smaller number of entities), with corporate governance similar across all entities, and also more solvent and with better liquidity. But, above all, with a business model that our banks have not needed to change after the crisis, which has withstood its onslaught well and has demonstrated its economic and social value, because it serves the productive economy and the real interests of clients, with whom it establishes long-term relationships to provide quality services through various channels.
From an international perspective, 2014 probably marks the end of the financial sector re-regulation process launched after the crisis. From Basel II, which required higher quality capital (voting shares and reserves) of only 2% of risk-weighted assets, often estimated with internal models of the entities, we have moved to Basel III, where this requirement increases to 7%. But that is only the beginning: total capital (Tier1 and Tier2), quality capital (T1), even higher quality capital (Common Equity Tier 1 or CET1), capital buffers above the minimums (conservation, counter-cyclical, and that required for systemic banks), a short-term and long-term liquidity ratio, a leverage limit, and a resolution requirement (double for international banks) are also demanded. In short, we have moved from one capital ratio to ten different indicators, and traditional solvency supervision is now joined by macroprudential and resolution supervision: banks face a demanding and complex regulatory landscape.
But, without a doubt, the most relevant event of 2014, and not only for the financial system, is the launch of the Banking Union, with three defining elements: prudential supervision of Eurozone banks by the ECB, the creation of a Single Resolution Board, and the establishment of a Single Resolution Fund. Although of the three pillars of the Banking Union, the most relevant is, without doubt, the emergence of the ECB as the solvency supervisor for Eurozone banks, it is probably those related to bank resolution that represent a more profound change.
We must acknowledge that in the financial system, both intermediaries and regulators, we have the very bad habit of ‘Hispanizing’ too many English terms with little respect for the language. What do we mean by this Anglicism ‘bank resolution’? That banks, like any other company, cannot continue to operate when their liabilities are greater than their assets. And that, unlike other companies, an ordinary liquidation process is not suitable, for several reasons, two of which I will highlight. Firstly, banks must operate with minimum capital, as required by banking solvency regulations, so there are problems not only if liabilities exceed assets, but also when the difference between assets and liabilities is less than the minimum required own funds. Secondly, the special role of banks in payment systems, together with the existence of such particular creditors as depositors, means that, de facto, an ordinary insolvency process is not transferable to banks.
Before 2007, these problems were known but not specifically addressed in regulation, which forced the bailout of entities with public money once the crisis erupted. To avoid future distortions introduced by the difficulties of dissolving banks, specific regulation has been put in place, subjecting troubled entities to an administrative resolution process that preserves market discipline, without causing collateral damage to financial stability. Furthermore, a specific supervisor, the Single Resolution Board for systemic Eurozone banks, is tasked with both the ex-ante planning of this administrative resolution and its ex-post execution in case of problems, functions that in Spain will be carried out by the Bank of Spain and the FROB, respectively.
Having recalled this important regulatory and supervisory novelty, it is nevertheless the supervision by the ECB of all Eurozone banks that holds greater symbolic and practical value. Because not only does the reference supervisor change, but the supervision itself will be carried out with a supervisory philosophy different from that applied by national supervisors, incorporating the best practices of each of them. Of course, this does not mean the disappearance of the role of the Bank of Spain, but rather that it becomes, on the one hand, a piece of a larger mechanism (just as happened with the launch of the euro) and, on the other hand, from an operational point of view, the largest piece of the mechanism for Spanish banks.
But let’s leave the past year behind and look to the future. What can we expect from 2015? In terms of the economic situation, the uncertainties regarding the recovery process, basically geopolitical and external (such as the evolution of Greece or the crisis in Russia), seem to be smaller than the elements that can boost it.
Among the latter, we can mention the favorable evolution of oil prices, with estimates of a half-point boost to global GDP growth, with an asymmetrical distribution, of course, between producing countries, which lose, and importing countries, which gain. Furthermore, in the Spanish case, our economy’s special energy dependence makes the impact particularly relevant: at current prices, the energy bill would fall by no less than more than one point of GDP. This means that families and businesses have an enviable cushion for consumption and investment, always, of course, provided that the moderation in oil prices continues throughout 2015.
But this is not the only positive element. The depreciation of the euro, the continuation of wage moderation in an environment of low prices, or the greater availability of financing at very reduced costs all point in the same direction of shoring up the recovery process.
Regarding downside risks, the situation in Greece is subject to the greatest uncertainty. Allow me to dedicate some time to this matter. The first reflection to make is that we must await not only Sunday’s results, but also the positions of the new Greek government. For now, what we know is that the majority of the Greek population supports remaining in the euro, as do the main political parties. Let’s be clear: what is best for Greece, for Europe, and for the euro is that the conditions for its permanence in the single currency are met.
This does not preclude acknowledging the very different situation the Eurozone faces this time. Not only do we have more buoyant economies in the countries that suffered most from the crisis (consider that Spain’s growth in 2014 was the highest among the large Eurozone countries), but, above all, a series of institutional changes have occurred that have improved Eurozone governance in the short, medium, and long term. Therefore, we are better prepared to face potential problems.
Therefore, the evolution of the economy will undoubtedly favor both banking entities and their clients: families and businesses. The entities, thanks to higher levels of liquidity and solvency, will have, and already have, more than sufficient capacity to meet the demand for solvent credit, although total credit figures will probably continue to show some moderation as the deleveraging process of families and businesses still needs to continue in the future.
The recent measures by the ECB, specifically the reduction in intervention rates and the TLTROs (Targeted Longer-Term Refinancing Operations), which are long-term bank financing operations linked to private sector credit growth, only serve to support this improvement in the economy’s financing conditions. In this regard, it should be remembered that Spanish banks have made intensive use of these new financing schemes.
As I have said on many occasions, low interest rates alleviate the financial tensions of over-indebted economic agents and boost consumption and investment decisions of agents with healthier balance sheets. But we must not ignore the impact that low interest rates have on bank margins, depressing them. This is because the floor, more de facto than de jure, for deposit remuneration is zero. That is, when rates fall, the average cost of liabilities decreases but to a lesser extent than the asset rate, i.e., loans. If we are also in such a low-rate environment, this difference between loans and deposits is accentuated, and margins are compressed even further.
With credit volumes recovering, but slowly and selectively, and margins falling, the pressure on the income statement is evident. Only the lower provisioning needs resulting from the improved economic environment and a continued effort in cost containment will somewhat alleviate these pressures on profits.
However, it is not absolute profit levels that are relevant, but return on equity, or ROE. This is because the provision of capital by investors is associated with a minimum required return: we are referring to the cost of capital. Currently, ROE is at very moderate levels, and while a decrease from pre-crisis levels is not only logical but reasonable (after all, banks are now less leveraged and safer institutions), the truth is that it is still necessary to increase profitability in the medium term.
Regarding the regulatory environment, which I have already mentioned, it must be said that banks face a demanding, redundant, complex, and uncertain regulatory and supervisory environment in many practical aspects. And let’s be clear: we perfectly understand that the experience of the crisis, with very high social costs, necessitated strengthening banking regulation and supervision.
The new regulatory approach introduces significant doses of redundancy. Some reiteration is always healthy: if one system fails, the other redundant systems compensate for the failure. In complex systems, such as commercial aircraft, it is a strategy that helps reduce accidents, so its application to the financial system is by no means unreasonable. However, there are limits, and while a “belt and braces” strategy may be reasonable, the addition of regulations based on different ratios (I have already mentioned the nine arising from the reform) and increasingly complex ones can be counterproductive. For example, the short-term liquidity ratio requires banks to hold a buffer of liquid assets, and the most liquid of all asset classes are sovereign bonds, representing government debt, which are also the lowest-risk assets. But the leverage ratio, which requires a fixed percentage of capital regardless of asset risk, penalizes holdings of low-risk assets. Regulations are not only redundant but sometimes contradictory. Furthermore, their multiplicity increases complexity when it comes to “piloting” the bank, as the effect of each transaction on each regulatory ratio must be considered. Complex and redundant regulation, in short, forces managers to pay increasing attention to it, to the detriment of the necessary dedication to business management.
Because, let’s not forget, we need solvent and liquid banks, but also profitable ones. Without profitability, any private business languishes: if banking shareholders do not find adequate profitability, they will seek other sectors to invest their money, and banks will gradually shrink, the financing of the real economy will weaken, and long-term growth will suffer. Profitable banks, on the contrary, are a guarantee of a thriving economy. There is no economic success without a healthy financial system, and therefore, one capable of financing development.
In any case, the most counterproductive effect of the regulatory reform is that it remains incomplete seven years after this process began. Specifically, although the main features of bank resolution rules are already known, it remains to be defined how these will affect different banks and even different banking models. Or, another example, how the integrity and homogeneity in the use of internal models will be guaranteed. Or the impact of the revision of the standard method for capital calculation (since it seems that it can be used as a reference, and even a floor, in capital calculation). Or the revision of capital charges for trading book activities. Although what I am saying may sound like incomprehensible bureaucratic jargon, believe me when I tell you that each of these elements, and much more their combination operating together, can have a decisive impact on the viability of different business models. Regulatory uncertainty must disappear in the short term.
This aspect, related to business models, is highly relevant. It is evident that a good number of banking business models (those with high leverage, high risk, excessive complexity, etc.) are no longer viable after the crisis and, above all, the new regulation. It is also accepted that Europe, with a greater presence of banks financing the real economy than the United States, must diversify the financing of the real economy by promoting financing through markets and other non-bank agents. This should facilitate banks reorienting their business strategy in the medium term.
As we have already mentioned, uncertainty does not help, especially when a change of this type requires long-term planning and careful multi-year execution. But the environment is not exactly favorable.
As we have already stated, the environment of historically low interest rates, which may remain with us for a long time, puts significant pressure on the income statement. Of course, the fact that the efficiency of Spanish banking is among the best internationally undoubtedly helps. But if, in addition, it is necessary to rethink the business, the pressure increases, since any restructuring, however limited, has short-term costs, which are more than offset by medium-term benefits. For example, in Spain, the decrease in employees and branches of deposit institutions has been 25% and 30% (compared to 2008, the year in which the maximum was reached), but operating expenses have not yet reflected this decrease due to the cost associated with these processes. In the medium term, however, once the process is complete, we will have more efficient and solid entities.
However, while the regulatory environment and the lessons from the crisis compel a rethinking of banking business models, they are not the only factors influencing them. Specifically, information technologies, with their immense development in recent years, represent a considerable pressure point that will undoubtedly force banks to react.
A first front concerns changes in how we interact with customers. Increasingly, the relationship between the institution and its clients is channeled through internet channels. And this is not merely a generational phenomenon; rather, the proportion of clients operating online is increasing across every age segment. In short, this trend is unstoppable. This not only obliges institutions to develop IT solutions to effectively meet this growing demand, but also to address the new security challenges posed by this entire new world. Furthermore, it forces a rethinking of the role that branches, the traditional environment in which banking transactions with clients were carried out, play in this new operating environment.
The challenge is not only to know what changes are coming. It is to understand what the appropriate reaction should be and the opportune moment to implement it. That is, not reacting leads to decline, but reacting too soon can also lead to it: it is not enough to see it coming, but one must know when to react.
But a second front is posed by the penetration of technology operators into the financial services sector. It is not only their technical capacity that should be feared: this technological power is coupled with the fact that these new operators do not have pre-existing platforms (“legacy systems”) and can therefore design new financial services platforms from scratch. Banks, on the other hand, already have powerful, albeit costly, platforms, which have proven effective in the past but will need to be optimized to compete. This phenomenon is not new: consider, for example, that a well-known online payment platform has been operating for over ten years now. And, furthermore, we should not expect a step effect, but rather increasing competitive pressure. In addition, banks have strengths they can exploit to face this growing competition: here we can mention, for Spanish banking, their strong IT platforms and the potential exploitation of Big Data related to their customer relationships.
Leaving the field of new technologies, but not that of potential competitors, a particularly delicate problem is that of the shadow financial system, that is, non-bank operators who finance credit risk with borrowed or third-party resources over shorter terms than assets, and with leverage. It cannot be ignored that regulatory and capital arbitrage is an unavoidable reality of financial systems. If regulatory requirements on banks are increased, there will be more credit risk financed outside the banking system. If this is done stably, through own resources, it can even be positive, as it diversifies the financing sources of the real economy. But the very experience of the crisis has shown us that certain developments in “shadow banking” can jeopardize the financial stability of the system as a whole. Although I will not elaborate further on this problem, which would merit an entire conference dedicated to it, it is vital to understand that regulatory and capital arbitrage, combined with financial innovation, can create new non-bank institutions that endanger the system as a whole. It is not enough to increase regulatory pressure on banks: public authorities must ensure that this pressure does not lead to relaxations of standards, solvency, or consumer protection in emerging segments of financial markets.
Allow me to conclude: the year 2015 presents significant opportunities to consolidate the improvements already seen last year. Although this is, without a doubt, great news for various economic agents, including banks, they remain subject to significant pressures. Some of these are cyclical, such as the low interest rate environment or the uncertainties of an still-open regulatory reform, and others are more structural, such as a much more demanding regulatory environment or the impact of information technologies. But we must all hope that Spanish banks will be able to navigate the path ahead, which can lead to a more robust financial system with stronger, more efficient, and more profitable banks. After all, there is no healthy and thriving economy that does not have a powerful financial and banking sector.
Thank you very much.
José María Roldán, Chairman of the Spanish Banking Association
