Bundesbank’s Dombret says trust restored in European banking system

Andrew Capon
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In an interview with Euromoney, Bundesbank board member Andreas Dombret sounds an upbeat note on the rigour of the ECB’s asset-quality review (AQR) and the eurozone’s resolution arrangements, but issues a sharp warning over banks’ risk-free treatment of sovereign debt.

Andreas Dombret-envelope

In this year of anniversaries, it is perhaps forgotten that 60 years ago West Germany won its first (of many) football World Cups.

During a conversation with Euromoney columnist Andrew Capon, after the results of the European Central Bank’s AQR and stress tests were revealed, Bundesbank board member Andreas Dombret summoned the spirit of Germany’s legendary 1954 coach and part-time philosopher Sepp Herberger.

Herberger famously said: “Nach dem Spiel ist vor dem Spiel” – after the game is before the game.

Dombret chose those words carefully. He also sits on the Financial Stability Board of the G20, which this week published its recommendation that the total loss-absorbing capacity for the world’s biggest banks should be the equivalent of a quarter of risk-weighted assets.

The G20 communiqué this weekend welcomed this proposal. The re-regulation game moves on apace and Dombret argues there is still unfinished business. However, he is not entirely unsympathetic to banks or deaf to fears of the unintended consequences of the regulatory backlash.

After the stress tests and the AQR, are you confident that the European banking system is safer today than it was 12 months ago?

The exercise in itself was a success even before the results were published on October 31 because, in preparation for the AQR and stress tests, the banks devoted special care to the way their 2013 earnings were reported and to the way they assessed the situation of their balance sheets because they knew that independent auditors would subject them to rigorous scrutiny.

The banks also concentrated on reducing risk-weighted assets, raising equity and retaining earnings. A number published by the ECB says that, over the last 12 months, more than €200 billion in new equity has been created, not just through capital-raising but also by the other means I just mentioned. There is more equity in the banking system, and that is good news.

Has stability come at too high a cost for the banks and might that ultimately be detrimental to the wider economy?

If you define stability as being something measured by CET1, then we are in a safer place. Ultimately, equity is the most important shock absorber in the financial system. But it is certainly true that profitability has not increased. In the long run, it is important for banks to earn the cost of equity.

German banks do not operate in a capital markets-based economy like the UK and US. Germany has a lending and credit-based economy, so banks here are much more sensitive to interest rates. And the very low interest-rate environment poses a challenge for bank profitability, and hence for the stability of the financial system as well. Safety and the proper functioning of the banking system should not be defined solely by the amount of equity.

How have the stress tests helped the banking system function better?

There are a lot more data, and transparency is greatly improved. Broadly speaking, the system has been given the thumbs up, a clean bill of health. Banks should feel a lot more secure about lending to each other and to the economy at large.

I think we are beginning to see that already in bank-lending surveys. Ultimately, lending decisions should be based on an assessment of creditworthiness, and not on a bank’s CET1. But restoring trust was an important step.

How do you counter the criticism that the stress test did not address the biggest threat in the eurozone, a debt deflation spiral?

It was only fair to the banks to set the parameters early on. As it turns out, the inflation figure envisaged in the stress test was almost exactly where we are now. Maybe the test was not perfect in hindsight. But the real question is not whether the inflationary scenario was tough enough, but rather was the overall test tough enough?

The European stress test stands up well in comparison with the tests conducted in the US and was at least as rigorous.

I would also like to echo the words of Sepp Herberger, the manager of the German football team that beat Hungary 3-2 in the 1954 World Cup Final. If he were in my shoes today, he perhaps would say: “After the stress test is before the stress test.” This isn’t the end. It is the beginning. There are many more stress tests yet to come.

Are you disappointed that the single supervisory mechanism for Europe’s biggest banks has begun without a parallel single resolution mechanism?

I won’t mince my words. It’s not ideal. But the issues of ‘too big to fail’ and living wills are complex. The direction of travel is positive. In some ways, having a single resolution mechanism without changing the law in terms of who is liable to pay, was probably premature, and the right legal framework will be in place by the beginning of 2016.

The principles are also clear, as the case of Banco Espírito Santo demonstrated. Bail-ins are in and bail-outs are out. I don’t think that bail-outs are at all a likely prospect ahead of the single resolution mechanism. If a bank were to get into difficulty, the framework is clear and any bail-out could expect to face a robust legal challenge.

Is there a new nexus of contagion between banks and sovereigns? Banks are being forced to hold sovereign debt as risk-free capital. Is it really risk-free?

This is a risk that is underestimated. The stress tests and the improved transparency have helped to shed more light on this topic, but I still fear it is little understood. There is a lot of public debt. The idea that a sovereign in the developed markets cannot default is not something I would subscribe to.

A study by the Bundesbank suggests that the banks holding the most sovereign debt tended to be the ones lacking a substantial deposit base and those most reliant on short-term funding. That is worrying.

At the end of the day, this is a matter for the Basel Committee, but I am confident that we are far more globally coordinated than ever before, which is why bodies such as the Financial Stability Board will continue to be important.