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«BLUEPRINT SERIES 25 EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS Dirk Schoenmaker and Nicolas Véron, editors Thomas Gehrig, Marcello Messori, ...»

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• Internal: the Rabobank group wanted to improve its governance structure. The goal of the new structure is to more effectively serve customers, markets and society, while strengthening the cooperative identity.

• Supervision: the central institution and the local member banks held individual banking licences. In the previous arrangement, the

131 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

DNB (and later the ECB) used to supervise the central Rabobank institution in Utrecht, which in turn supervised the local member banks under a special clause in Dutch financial services law. The DNB, and more recently the ECB, wanted direct access to the local banks, particularly because the ECB acts as the licensing authority for all banks under the SSM Regulation.

• Resolution: for regulatory purposes, the group’s capital was divided between the central institution (€7 billion) and the local banks (€20 billion) as of end-2015. The Rabobank entities had explicit cross-guarantees. But the question remained open whether capital, for example, would be up-streamed from the local banks to the central institution in the case of a big loss in the central institution, and vice versa. Such questions are particularly relevant for the triggering of contingent convertibles (CoCos), which Rabobank issued for the first time in 2010, and the implementation of resolution plans, which now require debt holders to take the first hit.

Since 1 January 2016, the ECB and DNB have had full supervisory access to the whole Rabobank group, and regulatory capital is consolidated in the newly-merged Rabobank entity. The Rabobank has kept a cooperative structure, however. The local business is organised through about 100 local banks. These local banks are no longer separate legal entities, since they are part of the unified Rabobank legal entity, but their governance arrangements maintain strong relationships with their customers and local communities. The cooperative customers (leden, or ‘members’) of Rabobank are organised into about 100 departments (afdelingen), based on geographical and other criteria. The chairman of each department’s supervisory body (lokale raad van commissarissen), who is also the chairman of the local members’ council (lokale ledenraad), represents the members from that department in the general members’ council (algemene ledenraad), Rabobank’s highest governing body. Both Rabobank’s executive board 132 | BRUEGEL BLUEPRINT (raad van bestuur) and its supervisory board (raad van commissarissen) are accountable to the general members’ council.

Less significant institutions The experience of Dutch LSIs is that the scope for DNB to follow its own policies has been reduced. The heavy shadow of the ECB is felt in the supervision of LSIs. DNB follows the formats and templates of the ECB, because it has to report to the ECB. DNB also receives instructions from the ECB.

As LSIs generally have higher funding costs than larger institutions, the business model is more challenging for them. Supervision, as a result, has become more intrusive. One noteworthy matter in the Netherlands is wholesale funding. A large part of Dutch household savings goes to pension funds, since participation is mandatory. As a result, there are fewer retail deposits available for banks than in other euro-area countries. The loan-to-deposit ratio in the Netherlands rose rapidly in the past two decades and is currently at 180 percent, way above the euro-area average (around 130 percent) and much higher than in the US or Japan (Jansen et al, 2013). Some LSIs rely for up to half of their funding on wholesale funding, and the larger banks rely heavily on this channel as well. The loss of the asset-based-securities market due to the credit crisis still hurts the Dutch banking sector, and Dutch banks have a considerable funding gap. Secured funding is cheaper than unsecured, but results in asset encumbrance, which is monitored closely by DNB.

Dutch experiences with European banking supervision The new supervisory framework is generally well respected by the Dutch banking community, because the ECB has managed to attract qualified supervisors. However, the banks have had to get used to on-site visits, which are a new feature in the Netherlands, and the multiple data-requests. In fact, it is felt that the ECB acts in a formal and legalistic way. It is also not always clear whether the ECB or DNB

133 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

is in charge of certain issues. While the functioning of JSTs is improving, occasionally decisions are not taken in due time. There are delays between the enquiries conducted by supervisors and the feedback on the results. Also, the follow-up on data requests can be rather long.

More widely, bankers perceive a lack of transparency in the decisions taken by the ECB. Nevertheless, the Dutch banking community is engaging with the ECB to improve processes. Dutch banks fully support further harmonisation of the single rulebook.

Our own assessment is that the ECB is indeed more intrusive than the DNB was previously. This was to be expected, and strengthens the supervisory process. Regarding the multiple data requests, delayed feedback and lack of transparency, the ECB could streamline its own procedures in cooperation with the banks. Notwithstanding the teething problems of the JSTs, the working of the JSTs is a major improvement for the quality and efficiency of cross-border supervision of Dutch banking groups.





Risk weights on residential mortgages Dutch households have a higher exposure to the financial sector than the euro-area average. This is for two reasons. First, the Dutch pension system is capital-based, and pension savings are currently running at 178 percent of gross national product; this excludes life insurance policies which, if added, would amount to 200 percent of GNP (CBS Statline, own calculations). Second is the high proportion of interest-only mortgages with a high LTV. Early in one’s career, these high LTVs are needed since mandatory pension premiums run high at around 20 percent of one’s income. Over one’s lifetime, the two exposures may net out, but they expose Dutch households to considerable uncertainty regarding their future flow of funds during the period of the mortgage. This is one of the reasons why Dutch consumption is more pro-cyclical than in other euro-area countries where pensions are based on a pay-as-you-go system (SER, 2013). However, with the baby boomers now retiring, pro-cyclicality may become a problem in 134 | BRUEGEL BLUEPRINT those countries with a pay-as-you-go system because of pressures on government budgets.

Before the 1990s, Dutch mortgages were primarily funded by life insurers and pension funds. Given the long duration of the liability structure of these institutions, it is only natural that this should be matched on the asset side with mortgages of similarly long duration.

More recently, Dutch pension funds have massively shifted their investments outside the Netherlands for purposes of diversification.

Banks have stepped in and built up large mortgage portfolios over the past two decades. The demand for mortgages also grew because of considerable pension premium hikes and the favourable income tax treatment of debt financing, which explains the high proportion of interest-only mortgages. Demand was further spurred by the growth in two-income households, which can typically apply for larger mortgages. As a result, Dutch banks have come to hold large portfolios of mortgages with high LTV ratios, which are often interest-only mortgages.

Until recently, Dutch banks under the internal ratings-based (IRB) approach were operating with a capital weight of around 18 percent for mortgages. This is considerably lower than the standardised approach under current Basel regulations, which requires a 35 percent risk weight up to 80 percent of the market value and a 75 percent risk weight for the part of the exposure above 80 percent. Under the current standardised approach, KPMG (2015) estimates that the capital requirements of all Dutch mortgages would have a risk weight of about 30 percent.

The combination of high LTVs and low risk weights caught the attention of the ECB, which started to ask questions about the mortgage portfolios of Dutch banks. This did not lead to adjustments in the comprehensive assessment in October 2014, but the ECB is closely monitoring Dutch mortgages. To gain further evidence about the risks and performance of Dutch mortgages, European banking supervision (spurred by DNB) has started an on-site review of mortgage portfolios.

135 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

Prompted by the US supervisors, who prefer simplicity over internal models, the Basel Committee is currently reviewing risk weights for mortgages and has proposed a floor in the IRB approach based on a revised standardised approach. For the Dutch banks, this would increase the risk weighing to 40 percent (KPMG, 2015), a considerable hike from the current 30 percent given the large mortgage portfolio.

For this reason, Dutch banks are currently selling parts of their mortgage portfolios, partly to pension funds and insurers, and have reduced the supply of mortgages. In anticipation of this, and of other housing-related regulation, which requires new homeowners to repay the loan through an annuity, the Dutch housing market has stalled for a number of years. It is only now recovering thanks to the very low interest rates.

Two years ago, about 30 percent of mortgages were in negative equity according to CBS (2015), but that number is declining.

Furthermore, mortgages with negative equity are concentrated in the more recent mortgages of younger families. Nevertheless, the loss rates are less than 0.1 percent, and foreclosures are even lower. The number of households in arrears is also very low. Expected default rates are among the lowest in the EU. One reason for the low loss rates on mortgages is the strong legal position of lenders in relation to borrowers under the Dutch civil code. For this reason, Dutch banks complain that the new rules do not take into account the high-quality payment history on Dutch mortgages and the legal environment. Here the one-size-fits-all approach, which mainly comes from Basel and EU legislation in the aftermath of the credit crisis, is biting. The DNB, however, has not (yet) been able to convince the Basel Committee to take the specific situation of Dutch mortgages into account. It appears that banks will have to live with this new reality, and should continue slimming down their exposure to residential housing or increase their capital. Given this, a revision of the Dutch bankruptcy law might also be considered to make defaults on mortgages easier, which would arguably contribute to the EU objective of capital markets union. In 136 | BRUEGEL BLUEPRINT this sense the one-size-fits-all supervision in the banking union is not promoting the best standards, and supervisors appear to promote a race to the bottom with their unconditional approach that neglects local institutional factors. Recently, DNB has threatened to block stronger capital requirements (in the form of capital floors for mortgages) in the Basel Committee.

Macro-prudential aspects The euro area now has a single monetary policy and a (still incomplete) banking union. The outlines of a capital market union are still being drawn, but the difficulty of harmonising insolvency laws holds back progress in this direction. In such an unbalanced environment, monetary policy can wreak havoc. The ECB, given its responsibilities for monetary policy and banking supervision, has an in-built incentive to support the banking sector without taking due account of the whole financial sector. In a country with high pension savings like the Netherlands, the current low rates pose a problem for pension funds and life insurers. Future liabilities in these entities are discounted at market interest rates. Since these rates are near zero, their solvency is under pressure.

During the gold standard era between 1871 and 1905, countries such as Germany, the UK, the United States and the Netherlands experienced prolonged periods of deflation, but interest rates always remained positive. The current negative interest rate environment is unprecedented, and at least partly policy-induced. It effectively allocates subsidies to dithering governments and weak banks, while creating heavy distortions in parts of the financial markets.

In the Dutch system, tinkering with interest rates has an immediate effect on aggregate demand. A balanced approach should take such ramifications into account. This is why a macro-prudential framework has been developed. Unfortunately, this is left to each country separately. For example, the Netherlands, Sweden and the Czech Republic are the only countries that apply a systemic risk buffer of 3 percent to

137 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

the largest institutions (see Figure 6 in the European Overview). This uneven playing field suggests a race to the bottom. As a result, frictions arise between monetary policy and bank supervision, which are conducted at the euro-area level, while the insurance and pensions sectors remain supervised at the country level. A more balanced evaluation would examine the challenges faced by these financial sub-sectors and monetary policy. This requires establishing European banking supervision within a proper framework of macro-prudential policy for the financial system as a whole. The current preoccupation with the inflation goal overlooks the explosion of credit in other areas of the financial sector. Negative nominal interest rates are hurting insurers and pension funds and are historically unprecedented. A similar process was at work in the run-up to the credit crisis. A reform of the European macro-prudential policy framework is needed to rectify such imbalances.

10 Portugal António Nogueira Leite The Portuguese banking landscape As of September 2015, Portugal had 159 credit institutions, of which 67 were banks, 88 were mutual agricultural credit banks and four were savings banks. On 30 September 2015, they had total assets of €452.7 billion, €261.5 billion in loans and advances to customers, €250.9 billion in deposits, and an average loan-to-deposit ratio of 104.2 percent.

Borrowing from the European Central Bank (ECB) was €25.1 billion. In September 2015, the aggregate Common Equity Tier 1 (CET1) ratio for the system was 11.6 percent103.

In contrast to the euro area as a whole, growth of the assets of

Portuguese banks continued well beyond the start of financial crisis:

the average growth rate between 2009 and April 2011 was 8.7 percent, against a mere 1.8 percent for the euro area. Between the start of the Portuguese assistance programme in May 2011 and September 2015, however, total assets in Portugal’s banking sector decreased by 20.8 percent104.

There are currently four institutions designated as significant, representing roughly 60 percent of the market by any of the usual indicators. The largest is Caixa Geral de Depósitos (CGD), a state-owned 103 CET1 ratio calculated in accordance with the new CRD IV/CRR transitional arrangement. Most numbers in this paragraph are from the Portuguese Banking Association (November 2015 Report) and ECB.

104 Source: ECB.

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