EUROPEAN SEMESTER THEMATIC FACTSHEET BANKING SECTOR AND FINANCIAL STABILITY

1. INTRODUCTION continued despite the improving conditions in the economy and for . The financial sector plays an important role in a modern economy by ensuring Liquidity conditions remained benign for financial intermediation, i.e. the the banking sector in general. Across channelling of funds from savers to Europe, banks were building up their investors. A sound and efficient buffers to comply with the new EU sector encourages accumulation of savings regulatory requirements and many made and enables their allocation to the most progress on resolving the stocks of non- productive investments, thus supporting performing . innovation and economic growth. In Europe, banks are the main financial The soundness of banks can be assessed intermediaries in all countries. through such indicators as the ratio of non-performing loans to total loans (the Banking is also used to finance the NPL ratio), the capital adequacy ratio needs of households, in particular to (CAR) and the average return on equity smooth out their consumption pattern (RoE ratio): over time and help them invest in real estate. An excessive growth of credit for  The NPL ratio relates the nominal house purchases may cause price bubbles value of non-performing loans to all in the real estate market. The subsequent loans. The EU definition of a non- bursting of such a bubble may be very performing is one whose destabilising for the financial sector and instalments are not paid for over 90 the economy as a whole. days. The ratio shows the extent of deterioration of the quality of loans Given the risk of credit-driven asset price granted by the banks. The higher the bubbles, in particular in the real estate ratio, the worse the quality of the segment, monitoring the soundness of the assets, and consequently the higher banking sector is a crucial part of the expected losses. assessing the stability of national financial  The capital adequacy ratio (CAR) systems. The Member States are pursuing shows the solvency of banks. It relates various policies to contain potential risks. the value of regulatory capital, i.e. capital instruments recognised by the 2. CHALLENGES banking regulation, to risk-weighted assets. It is an indicator of banks' 2.1. Banking sector soundness capacity to absorb losses. The higher In 2016, post-crisis adjustment of the the ratio, the more the banks can banking sector was still continuing in the absorb losses without endangering EU. In 21 out of 28 Member States, the their solvency. banking sector was shrinking, illustrated  The RoE ratio relates banks' net by falling total assets relative to income (i.e. profits after tax) to total GDP. This so called 'deleveraging trend' capital. It is an indicator of banks'

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overall profitability. A high profitability not being paid back regularly. In 2016, the suggests that banks are in a NPL ratio further deteriorated in Greece, favourable position to increase their but improved in Cyprus. capital buffer in the immediate future, namely through retained earnings. In five countries the NPL ratio was above 10%. This group consisted of Italy, Generally, European banks' asset quality Portugal, Bulgaria, Ireland and Croatia. All improved in 2016. Banks that suffered of them, however, managed to lower their most in the financial crisis continued to NPL ratios in 2016. So did almost all other repair their portfolios. The exceptions are Member States. Slovenia, Hungary and Cyprus and Greece: in both countries, Romania made major progress on NPLs, slightly over one third of all loans were still all moving below the 10% benchmark.

Figure 1 — Non-performing loans as % of total loans, 2016

Source: ECB

The capital adequacy ratio (CAR) further high level. This was caused by one of the improved in most EU countries. All countries country's largest banks, which paid out had an average CAR of at least 12%, much dividends at the beginning of the year. above the regulatory minimum of 8%. Dividends are payed from the retained earnings, which make up part of a bank's In half of the Member States the CAR was capital. above 19%. The median moved up by one percentage point from the previous year. The overall sufficient capitalisation hides The highest ratio was observed in Estonia differences between countries and banks. (34%), followed by Sweden and Ireland. The capitalisation of some banks is still sub- Lithuania recorded the biggest drop in 2016, optimal in countries such as Portugal, Italy although the CAR there still remained at a and Spain, hampering new lending.

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Figure 2 — Capital adequacy ratio: regulatory capital as 77% of risk-weighted assets, 2016

Source: ECB

Bank profitability improved in most Greece, although its average RoE markets, despite the low interest rate remained still in negative territory. environment. In 2016, half of Member Croatian and Hungarian banks also States had a return on equity (RoE) of at improved their profitability a lot. least 8%. The median RoE improved by one percentage point from the previous Profitability deteriorated most in Italy and year. Countries in central and northern Portugal. Next to Greece, those were also Europe are the most profitable EU banking the only banking markets in Europe markets. making losses in 2016. Making provisions for non-performing loans was Average profitability soared in three the main reason for this. countries. The biggest jump happened in

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Figure 3 — Return on equity (%), 2016

Source: ECB

2.2. Credit growth In seven countries, Slovakia, Romania, the Czech Republic, Belgium, Lithuania, Malta, Credit growth can be gauged by the year- Luxembourg and Sweden, it exceeded the on-year percentage increase in the stock benchmark1 considered by the of bank loans to the private sector. The Commission as a trigger for closer faster bank credit expands, the higher the examination of risks. risk of an asset bubble. Excessive mortgage lending driving up house prices High lending to households, especially for and private is a typical example of house purchases, is driving up house such a situation. prices and private indebtedness in several countries. This creates concerns, On the other hand, negative credit growth especially in countries where private debt is likely correlated with difficulties for is already high, such as Belgium, Sweden businesses' access to credit, especially for and the Netherlands. SMEs. Ideally, loans to the private sector should grow enough to provide sufficient finance for investment, but not excessively, so as to prevent the emergence of asset price bubbles.

Lending for house purchases stepped up in most Member States. The median mortgage credit growth rate increased from 1.5% in 2014 to 3.8% in August 2016 and further to 4.4% in June 2017.

1 6.5% year-on-year growth, according to the Macroeconomic Imbalances Procedure Scoreboard.

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Figure 4 — Housing credit growth (% y-o-y), June 2017

Source: ECB

Lending to companies increased in the The divergent credit growth trends in the vast majority of Member States. EU indicate differences in businesses' investment opportunities. The median credit growth rate increased from -0.2% in August 2015 to 2.3% in In countries with high economic growth, August 2016 and to 3.8% in June 2017. business expansion stimulates investment Six countries (Malta, Hungary, Slovenia, and demand for credit (e.g. in central Romania, Bulgaria and Croatia) moved European countries like Slovakia, Poland, from negative to positive growth. Hungary and the Czech Republic).

The discrepancy between countries with In other countries, like the Netherlands, the strongest credit growth (17% in Portugal and Ireland, the accumulated Luxembourg, 10% in Slovakia) and those debt in many firms often hampers their with the biggest credit contraction (-6% in access to finance. the Netherlands, -3% in Portugal) also diminished compared to the previous year.

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Figure 5 — Corporate credit growth (% y-o-y), June 2017

Source: ECB

2.3. Liquidity and funding In 2016, the EU banks' funding structure remained broadly stable. The LTD ratio The funding structure of a bank tells us was above 100% in only five countries. how its business, primarily lending, is These included Denmark, with its unique financed. Typically, banks collect deposits mortgage banking model2, and also to finance loans they grant. Hence, the Sweden, the Netherlands, France and loan-to-deposit ratio (LTD ratio) is a Italy. common indicator that helps assess whether banks have stable funding. The Deposits grew at a slightly higher pace LTD ratio relates total loans granted by than loans in most countries. The median banks to total deposits they received from LTD ratio for 28 Member States went their customers. In other words, it shows down slightly from about 99% in 2014 to the share of the loan book that is covered 96% by August 2016 and 89% in June by deposits, presumed to be a stable 2017 (Figure 6). funding source. Since the financial crisis, a new funding Banks that find themselves in trouble model has emerged in the banking often ask for help from their central bank. markets of central, eastern and south- The share of borrowing from the central eastern Europe. Previously, the foreign bank in total bank liabilities shows the owned bank subsidiaries in the region extent to which banks had to rely on such financed their lending to a large extent by support. In other terms, it indicates a loans from their parent banks based, for shortage of private funding and is therefore something that needs to be kept under surveillance. Central bank liquidity 2 In Denmark, the mortgage loans are should only constitute a significant share granted by specialised mortgage banks that of commercial bank liabilities in fund loans with corresponding mortgage bonds. exceptional, temporary circumstances. This system is regarded as very safe in terms of funding structure.

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example, in Austria, Italy, Sweden or deposits fully covered the loan portfolios in Germany. After the crisis, the bank all of the central and eastern Europe subsidiaries gradually replaced the parent banking sectors. bank funding with local deposits. In 2016,

Figure 6 — Loan-to-deposit ratio (%), 2016

Source: ECB

Benign market conditions and low interest support economic growth. A sound rates allowed for a further reduction in banking sector and capital markets that central bank financing across the EU. In fulfil smoothly their role as financial 2016, most national banking sectors intermediaries help to achieve this. borrowed little from the central bank, with a share in total liabilities below 2%. Member States' policy measures focus on:

Greece stood out as the country with the  enhancing access to finance by highest share of central bank borrowing, cleaning the bank balance sheets of amounting to one quarter of the banking non-performing loans; sector balance sheet. Nevertheless, Greece,  removing barriers to development followed by Cyprus, significantly reduced and integration of capital markets; their central bank reliance in 2016.  addressing deficiencies in national supervisory and regulatory frame- On the other hand, Italy and Spain works and improving corporate increased the use of central bank credit, governance in some institutions; while Finnish and Belgian banks increased  addressing specific risks related to their reliance on central bank funding. credit exposures in foreign currency; 3. POLICY RESPONSES IN THE  containing imbalances in some MEMBER STATES housing markets fuelled by private debt growing at an excessive pace. Member States' common policy objectives are to preserve financial stability and to

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3.1. Resolving NPL stocks a cost, but it allows banks to unburden their balance sheets and give out new The large stock of bad may explain loans. NAMA4 in Ireland, BAMC5 in the sluggish credit growth in some Slovenia and SAREB6 in Spain have helped countries. NPLs are a burden on banks' to achieve significant reductions in NPL balance sheets and impair banks' ratios. Support for NPL sales may also be profitability by causing lost revenues. They organised by the banking sector itself also lock up part of banks' capital, thus (with the help of state guarantees, such as diminishing banks' ability to grant new is the case with the Atlante scheme in 3 loans . Italy).

A boost to new lending requires further The role of national supervisors and progress on cleaning up banks' balance regulators is fundamental when it comes sheets and restoring adequate capital to resolving the NPL stocks. Such bodies buffers. The amount of NPLs is still large in regularly check the quality of banks' many EU countries and runs into double assets, monitor resolution of arrears and digits in Greece, Cyprus, Italy, Portugal, impose adequate loan-loss provisions and Bulgaria, Ireland and Croatia. capital buffers.

Banks strive to achieve viable loan 3.2. Developing alternative sources restructuring or the foreclosure of non- of funding for companies performing assets. However, this needs to be supported by a functioning legal To improve access to finance also through framework for debt enforcement and asset non-bank sources, Member States are foreclosure. Many countries are working taking various actions to develop their on improving their insolvency frameworks capital markets. At EU level, these and the functioning of the judiciary to initiatives are encouraged by the Action ensure more rapid debt restructuring. For Plan on implementing Capital Markets example, Greece has introduced electronic Union, adopted in September 2015 and auctions for collateral sales. Another way updated by the Mid Term Review in June forward is through out-of-court 2017. Targeted technical support is restructuring solutions, based on voluntary offered to national authorities by the cooperation of banks and debtors. Commission's Structural Reform Support Service. Especially those countries where If loan restructuring fails, banks may capital market development lags behind consider getting rid of the impaired assets. (many of them in central and eastern NPLs could be sold on specialised Europe) are currently taking a broad set of secondary markets, either as they are or measures to support their equity and bond as securitised products. National markets, private equity and venture authorities are making efforts to support capital funds, and modern approaches to such markets by removing regulatory securitisation. obstacles, adjusting tax regimes, offering dedicated NPL management platforms and National authorities are also taking specific providing state guarantees for senior measures to support the development of tranches of securitised loans (the latter for local capital markets. Some have designed example in Italy). comprehensive national strategies to tackle this issue (Bulgaria, Latvia, To deal with the legacy of NPLs, some Lithuania, the Czech Republic, Poland). countries have set up asset management companies (AMCs), also known as 'bad banks', so that banks could transfer their portfolios of NPLs to them. This is done at 4 National Asset Management Agency. 5 Bank Assets Management Company. 6 'Sociedad de Gestión de Activos 3 All loans and other assets held by a bank procedentes de la Reestructuración Bancaria' generate specific a , i.e. the (Company for the Management of Assets amount of capital that the bank must hold as a proceeding from Restructuring of the Banking buffer for unexpected losses. System).

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Such strategies promote development of technical support: this is the case for local niche markets (e.g. fintech, private capital market supervision in Romania. equity) by favourable regulation and create regulatory incentives for local Some other countries launched reforms of institutional and retail investors (e.g. new corporate governance in particular instruments, favourable tax treatment). segments of their financial sector. Italy is They offer various forms of support for pursuing corporate governance reform of SMEs interested in accessing the capital the large cooperative banks and small market (e.g. co-financing of listing costs). mutual banks, which is key to streamlining Last but not least, the strategies put in the banking system. Slovenia is taking place appropriate financial education measures to consolidate and restructure programmes. its banking sector, improve the governance of state-owned banks and Some countries also undertake cross- ensure proper governance of BAMC, its border initiatives. One example is the bank asset management company. work on a harmonised legal framework for Croatia, meanwhile, is carrying out an covered bonds and securitisation in the asset quality review of the Croatian Bank Baltic States. Another project aims to for Reconstruction and Development facilitate clearing and settlement of (HBOR) by independent auditors. This may securities between stock exchanges that lead to changes in HBOR's regulatory are members of the SEE Link platform. framework and governance structures. This includes Slovenia, Croatia and Bulgaria, as well as non-EU countries 3.4. Tackling the risks related to FYROM7, Serbia, Montenegro, Bosnia and loans in foreign currency Herzegovina. In addition, Bulgaria is creating opportunities for domestic issuers The strengthening of the Swiss franc once and investors to access other EU markets again emphasised the risks of lending in through the creation of 'Bulgarian Stock foreign currency ('FX lending'). The turbu- Exchange International', a dedicated lence caused by the strong appreciation of market on the local stock exchange. the Swiss franc was most prominent in Croatia, Hungary and Poland. In Romania, 3.3. Strengthening bank supervision, where most FX loans are in EUR, the regulation and corporate governance impact was smaller. The countries concerned have already adopted various The strong increase in NPLs during the measures to aid FX borrowers, sometimes crisis highlighted some cases of imposing substantial costs on banks. inadequate supervision or regulation. Weaknesses were revealed also in credit In Poland, the relevant proposals are still risk assessment and the corporate being fine-tuned in discussions between governance of many financial institutions. the relevant authorities (the President's Office, the Ministry of Finance, the Some countries are pursuing an overhaul financial supervisory authority and the of their financial supervision. Examples central bank), pending adoption by include: Parliament. Taking into account the experiences of other markets, policy-  comprehensive reforms of banking makers are seeking a balance between and non-banking supervision in helping indebted households and Bulgaria; preserving the financial soundness of  integration of insurance and pension banks and financial stability in the country fund supervision in Cyprus; as a whole. Social justice arguments are  improving supervision of international another aspect of the debate. businesses of banks in Malta. 3.5. Addressing housing market- Countries are also investing in enhancing related vulnerabilities through supervisors' skills, for instance through macro-prudential policy

Financial stability risks related to real 7 Former Yugoslav Republic of Macedonia. estate markets in the EU have

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materialised in the past and are still a borrower's total debt exceeds 400% of potential problem in a number of income before tax. countries. Overvaluation in property prices tends to go hand in hand with high private The evidence to date suggests that while sector debt. Banks' exposure to mortgage bank-based measures have strengthened credit often surges in line with loosening financial-sector resilience in a number of lending standards. Low interest rates and Member States, increased capital require- continued competition between banks for ments have been insufficient to stem new loans increase the pressure. soaring housing prices in some countries such as Denmark, Luxembourg and Several Member States have actively used Sweden. macro-prudential policy, i.e. policy aimed at preserving stability of the whole In addition to bank-based instruments, financial system, to address vulnerabilities national authorities have implemented stemming from the real estate sector. lending restrictions under national law that Their primary objective is to dampen the target borrowers. Among such borrower- pro-cyclical dynamics between property based measures the most frequently used lending and housing prices. They also aim include limits on loan-to-value (LTV), loan- to enhance the resilience of the banking to-income (LTI) or debt-to-income (DTI) and household sectors to financial shocks. and debt-service-to-income (DSTI) ratios. Macro-prudential measures can take the Other instruments in the toolbox include form of bank-based measures or loan maturity restrictions and require- borrower-based measures. ments for amortisation.

Measures targeting banks typically aim at Borrower-based instruments directly ensuring appropriate capital requirements. target lending standards at origination Some of the buffers target economy-wide (i.e. the standards that apply to borrowers systemic risk. But others can be directly when they first apply for a loan). related to exposures to real estate, for Especially if implemented in a well- instance by aligning the risk weights8 for designed package of mutually supporting mortgage loans on banks' balance sheets actions, borrower-based instruments are with the risk profiles. More specific capital effective in restricting risky lending add-ons9 for mortgage portfolios have practices across a wide number of been introduced in a number of Member jurisdictions. Apart from reducing vulnera- States (e.g. Austria, Belgium, Estonia, bilities to property price-related shocks on Slovakia and Sweden) amid heightened households' balance sheets, they can also real estate-related vulnerabilities. Finland increase bank resilience. Their design is will introduce an institution-specific risk- flexible and allows for parameters to be weight floor10 for mortgages on houses on adjusted to influence housing and credit its territory as of January 2018. In March market conditions. The complementarity of 2017 Denmark's Systemic Risk Council borrower-based tools with capital-based recommended the limitation of housing macro-prudential instruments is particularly loans at a variable rate and/or with pertinent during the upswing of credit deferred amortisation11 for the cycles. At such times, measures which Copenhagen and Aarhus regions if the directly target lending standards at origination can reduce banks' incentives to engage in riskier (high-LTV/high-LTI) lending.

8 Regulatory ratios indicating how much Date: 16.10.2017 capital banks have to hold for each type of asset in their portfolio. 9 Additional capital requirements, above the standard regulatory minimum. 10 Minimum standard risk weight, that may be higher than the risk weight calculated by a bank in its internal capital adequacy model. 11 Loan including a period where the borrower pays back only interest and not part of capital.

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