Speech by Boštjan Vasle, the Governor of the Bank of Slovenia, at the Banking conference

Dear ladies and gentlemen, I wish you a warm welcome. After a long-term cooperation with the Banks Association, I am pleased to be with you again, this time in a slightly different role. 

The euro area in general, and Slovenia in particular, have traditionally been bank-driven economies as regards the provision of credit.¹  The banking sector has an important financial intermediation role in channelling funds from savers to borrowers, and thus supporting economic growth through credit. A malfunctioning banking system can have significant ramifications for the economy and the wellbeing of society as a whole.

Essentially, a stable banking system supports the smooth flow of savings from households to firms to fund their investment projects. Disruptions in the ability of financial intermediaries to perform their role as credit providers and deposit takers can have stark consequences for the economy.

Banks currently provide almost half of total debt financing of non-financial corporations in the euro area and Slovenia.²  During periods of bank fragility, this reliance on bank lending is conducive to a pronounced procyclical pattern in investment. Furthermore, it can have long-term consequences, which have already manifested themselves in Slovenia. In the absence of a steady supply of credit, firms have moved towards internal sources to finance their investment. Low demand for credit in turn has an adverse effect on banks’ profitability.³

Households’ credit-backed consumption, including housing, would also be impacted negatively should such a disruption occur. Moreover, the erosion of trust in the banking system as a safe keeper of their deposits could result in abrupt changes in their saving behaviour. This is especially important in the case of the Slovenian banking system, where banks have recently moved towards a higher reliance on household deposit financing, which currently constitutes almost half of their total liabilities.⁴  Effective banking regulation must therefore uphold this trust. This should include not only deposit insurance schemes, but also policies that target excessive risk-taking behaviour in the market.

However, central banks monitor financial stability not only because of its implications for economic performance, but also for its effects on the conduct of monetary policy.

This is because a well-functioning bank lending channel is an integral part of the transmission of monetary policy to the real economy. The interaction between stability of the banking sector and monetary policy has several important implications. Recently, research⁵  has found that sounder banks respond less to monetary policy tightening. Larger, more liquid and better capitalised banks are more resilient to monetary tightening, since they can more easily substitute an outflow of deposits for cheaper sources of funding. This leads to a less pronounced decrease in lending. With bank characteristics affecting the transmission of monetary policy, it is important for the Eurosystem to contemplate regulation to achieve its monetary policy goals. Furthermore, variations in banking sector soundness across the euro area can lead to varied outcomes in the real economy. The average core tier 1 capital ratio in the euro area, for instance, has varied substantially across countries. In a monetary union with a common monetary policy, this is an additional challenge.

To add further complexity, the effects of bank characteristics on monetary policy transmission works in both directions. Central bank measures other than regulation affect bank balance sheets, and thus could affect bank profitability. However, in recent research,⁶ non-standard monetary policy measures, implemented following the financial crisis, have been found not to have adverse effects on profitability when the macroeconomic environment is taken into account.

From a policymaker’s perspective, it is therefore crucial to assure financial stability, not only in itself, but also for ensuring price stability.

Over time, the regulatory and supervisory environment follows a path similar to that of the business cycle, albeit with a lag. As the memory of economic and financial crises fades away, regulation becomes less tight, leaving more room for market participants and the economy to self-regulate with little interference from policy institutions. We experienced this in recent decades in the US and euro area. Examples of this evolution include the 1995 and 2004 Basel. In pre-crisis Europe, this resulted in some significant banks having extremely low leverage ratios. Excessive expansion of banking, as well as of even less regulated “shadow banking”, rendered the financial system more vulnerable to negative macroeconomic developments – such as the collapse of the housing market. This was compounded by the increased interconnectedness and size of financial intermediaries.

This less restrictive phase of the regulatory cycle ends abruptly when the next crisis emerges. In the euro area, the recent financial crisis has left its mark on the economy. Savers and investors lost money, firms could not sufficiently borrow and, ultimately, many banks faced severe problems. According to recent research at the IMF, this resulted in substantially lower output and significant fiscal costs in Slovenia and the euro area, when compared to their pre-crisis trends.⁷

In the aftermath of the crisis, policymakers worked on improving the regulatory and supervisory environment by implementing, amongst other measures, the Basel III framework and establishing the Single Supervisory Mechanism. These were set out to standardise regulation and supervision, and introduce policies to lean against the financial cycle.

To sum up, regulation brings about banking stability, which is beneficial to society’s wellbeing and a prerequisite for a successful monetary policy. Unfortunately, previous financial cycles have proven regulatory pushes to be highly procyclical. Both Slovenia and the euro area are currently in a mature phase of the cycle.⁸  However, banks now are much less fragile than they were before the previous financial crisis thanks to advances in regulation, which aims to be countercyclical. Adhering to this prudent approach to regulation will reduce the likelihood of another major financial crisis occurring.

Boštjan Vasle,
The Governor of the Bank of Slovenia

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¹In the euro area, the ratio of bank loans to corporate debt is 3-to-1, and 9-to-1 in Slovenia for non-financial corporations.
²Source: ECB
³ ibid.
⁴ Financial Stability Review, December 2018, Bank of Slovenia
⁵ Altavilla, C., Andreeva, D., Boucinha, M., & Holton, S. (2019). Monetary policy, credit institutions and the bank lending channel in the euro area. ECB Occasional Paper, (222).
⁶ Bottero, M., Minoiu, C., Peydro, J. L., Polo, A., Presbitero, A., & Sette, E. (2019). Negative Monetary Policy Rates and Portfolio Rebalancing: Evidence from Credit Register Data (No. 19/44). IMF.
⁷ Laeven, L. & Valencia, F., 2018, Systemic Banking Crises Revisited. IMF Working Paper No. 18/206, International Monetary Fund, Washington DC.
⁸ Slovenian GDP grew by 4.5% in 2018, HICP rose by 1.9%. Euro area GDP grew by 1.8%, HICP rose 1.8%.