Banking's Supercop Is Handing In Her Badge

(Bloomberg Opinion) -- There will soon be an important vacancy at the European Central Bank – and, no, it’s not Mario Draghi's job. The ECB president is to leave office in the autumn of next year and speculation is already swirling about who will take over. But a more urgent task for the central bank is to replace the woman who supervises the euro zone’s major banks. 

Daniele Nouy, chair of the ECB’s supervisory board, will retire at the end of 2018. In the past three and a half years, she has played a decisive part in setting up Europe’s “single supervisory mechanism” – which transferred oversight of the region’s biggest lenders from the national to the European level.

The ECB’s first task as supervisor-in-chief came toward the end of 2014, when it had to organize a Europe-wide asset quality review and a stress test together with the European Banking Authority and relevant national authorities. In retrospect, it was probably too lenient. Several Italian banks failed, but the capital increases demanded by the supervisors proved to be insufficient.

Still, Nouy helped the ECB cement a reputation for toughness. In particular, she targeted the non-performing loans that accumulated on bank balance sheets after the financial and sovereign debt crises. 

Nouy went head-to-head with national supervisors, not least in Italy, to get banks to be more honest about the losses on their books. The sales of non-performing loan books have sped up subsequently. Alongside the stronger economy, these disposals have helped cut bad loans from 1 trillion euros ($1.16 trillion) in early 2015 to 721 billion euros at the end of last year. Banks hold much more capital too (and of better quality) than before the crisis.

The race to replace Nouy is wide open. Possible candidates include Sharon Donnery, deputy governor at the Bank of Ireland, Andrea Enria, EBA chairman and Ignazio Angeloni, who sits on the supervisory board. The priority for whomever wins must be to keep the pressure on banks to reduce their stocks of bad loans. The euro zone economy is recovering, so this is the time to ensure that banks will enter the next recession stronger.

Other dangers lurk. Take the so-called “Level 2” and “Level 3” assets sitting on bank balance sheets. These instruments aren’t traded on financial markets. Unlike most non-performing loans, there’s nothing wrong with banks holding them but their lack of liquidity gives lenders the ability to mask their valuations. The ECB has launched a project to assess their riskiness, including on-site inspections. The trouble is that many are being conducted by the relevant national authority because the ECB is overstretched. This is an unwelcome return of self-supervision and hence a defeat of the notion of a banking union. Nouy’s successor needs to ensure proper pan-European oversight.

The supervisory board must also get better at communicating. Of course, transparency can be counterproductive when a lender’s in trouble. If investors catch a whiff of a supervisor looking at a bank, they’ll dash to the exit. But the ECB still needs to provide as much information as it can once it decides to act. In 2016, when the EU agreed to the “precautionary recapitalization” of Italy’s Monte dei Paschi di Siena, it took some time to understand how the ECB had calculated the capital shortfall. That led to accusations of heavy-handedness.

Nouy’s successor may have to do all of this in less benign circumstances too. She deserves great credit for setting up a supervisor from scratch, but recent banking crises have at least been relatively contained. The next chief may not be as lucky and might, for instance, end up having to deal with a large bank failure and the subequent domino effect.

Should that happen, the solidity of Europe’s “banking union” would be truly tested. For all the Super-Mario glamour of the ECB presidency, the less-heralded supervisor job deserves equal attention.

©2018 Bloomberg L.P.