“Don’t kill the goose that lays the golden egg”

The financial sector is going through turbulent times: higher interest rates enable bigger profits to be made, but, at the same time harbor, the risk of loan defaults. Guy Hoffmann, Chairman of the Luxembourg Bankers’ Association (ABBL), discusses the danger of a banking crisis, the role of regulation and his wishlist for politicians in this election year.

Guy Hoffmann, things have been a bit a calmer of late following the collapse of a number of US banks and the forced tie-up between UBS and Credit Suisse. Is the banking crisis over now, or are we simply in the eye of the hurricane and the worst is yet to come?

Right now, it’s still too early to say. These events brought the fundamental problems in the banking sector into sharp relief and created a degree of fear in the market.

On the other hand, I’m firmly convinced that European banks don’t face the same sort of risks as those we’ve seen in the case of US institutions. I’ve always wondered why the Americans abandoned their more stringent regulatory requirements for banks with less than 250 billion dollars in assets under management. These are by no means small banks – they’re actually really big institutions. We don’t have that arrangement in Europe – here, we’ve got very uniform regulation, and it’s also very strictly applied. As things stand, it's fair to say that Europe’s banks are probably in a more solid position than many throughout the rest of the world.

The Credit Suisse case is slightly different. In fact, the bank hadn’t been any less compliant in recent times than it had been two or three years ago. Instead, the crisis was a typical example of irrational thinking and acting by market participants – who, at some point, decided that the bank could no longer be trusted and pulled their money out. As we saw with SVB, the speed at which something like that can take off on social media can become a problem. It then becomes very difficult to get a bank back on course.

You’re surely alluding to the interview with Ammar Al Khudairy, Chairman of the Saudi National Bank, whose comments were interpreted in such a way that the Credit Suisse stock price hit rock bottom in a matter of hours?

Yes, I listened to it, and I think I understood what Al Khudairy was intending to say. But the way it was interpreted on social media was incendiary and sparked an irrational response. It always boils down to the need to retain the trust of customers and market participants – something the banks would do well to remember.

As bankers – and bank CEOs – our challenge is to convince customers and market participants that our institutions are profitable and that we uphold the highest standards of governance. We can’t afford any missteps. In the past, it took longer for trust to be shaken. These days, all it takes is for a bunch of customers to report that they were unable to withdraw money at a branch of the bank. A bank needs to be prepared for that.

To strengthen trust, many experts – including ECB Vice-President Luis de Guindos – have been calling for a common European deposit protection scheme. Where does the ABBL stand on that?

I fully understand the desire behind it, but it wouldn’t be at the top of my list of priorities. Making sure all banks and financial market players are subject to the same supervisory standards is more important. In my view, the Capital Markets Union is a bigger priority than the common deposit protection scheme. That process is underway but has not yet been fully completed.

In the past, we’ve often heard it said by those in the sector – including ABBL – that regulation is too strict and that many smaller banks are overwhelmed. At the same time, you say Europe’s banks are well placed to get through the crisis. Isn’t that mainly because of the strict regulation and high capital adequacy requirements?

You’re right, people shouldn’t be railing against regulation as a whole. There’s a good reason for regulation and the overall direction is also justified. What we as industry professionals criticize is the fact that it’s always a case of additional regulations being imposed on top of existing ones. Over the past 20 years, I’ve never known anything to be dropped or heard anyone say “that doesn’t make sense anymore. We’ve got better tools and newer methods now, and the rules are maybe excessive in several respects.”

MiFID is one example. The approach is correct, but the detailed requirements go too far in many respects. Customers think the banks have gone nuts, or they’re treating them like children. I’m aware that not everyone in the financial sector is an angel, but there are lots of things that have become too strict and inflexible. If you want to make everything idiot-proof, don’t be surprised one day to find you’re only left with idiots. We’re not railing against regulation per se, but we’re rather asking how can we work together to build an intelligent set of rules that really make sense?

I assume you’re passing this feedback on to regulators and legislators. Do you get the feeling they’re listening?

To some extent, yes. But as is so often the case, there’s room for improvement. It’s all about proportionality. The regulatory framework has always made provision for the principle of proportionality; however, this only applies on paper.

The costs involved with regulation will ultimately drive many smaller banks into a corner. And it surely doesn’t make sense if in future we’re only left with huge institutions with the regional banks having disappeared.

Turning to the rise in interest rates. The banks will benefit in the medium term, with balance sheets mostly in very good shape last year. At the same time, they’re having to cope with a difficult transition to significantly higher interest rates. What are your expectations for the banking business this year?

Slightly higher interest rates are always good for business in overall terms, because it makes it easier for us to generate income again. But just like a baker, for example, the bank has no direct control over the price of the raw materials – and in our case, that’s money and the interest rates set by central banks. The banks simply pass these interest rates on to the customer, together with their usual margin.

The problem was that our entire economy has been built on low interest rates in recent years. Many customers – who’re now having to pay interest rates of 3%, 4% or even 5% – are overwhelmed. That applies to corporate as well as private customers, who are simultaneously having to grapple with inflation and higher energy costs.

The banks have set aside huge amounts of reserves over the past year to cushion this if needed. This will continue to be required throughout 2023. We’ve not yet seen most of the consequences of the economic downturn. However, the full effect will become apparent in the second half of the year and into 2024. Right now, companies are still living off their order books and private customers off their savings.

So, do you expect to see more loan defaults?

No. And that’s been confirmed by colleagues from other banks. But even though things aren’t yet reflected in the data, you can feel how tight the situation is.

But I assume it’s affecting the volume of new lending?

Yes, there is evidence of that. And it’s a warning sign – something we need to take very seriously. I’d never have thought that new-build activity in Luxembourg’s key real estate sector would slump by 40% practically overnight.

We’re talking big numbers, and if this lasts for long it will also have an impact on the banks, including in the form of bad loans. So, it would be good to see the banks using the current situation on interest rates as an opportunity to build up their reserves ahead of such a scenario.

What do you believe is better for Luxembourg’s banks? Higher interest rates and more default risk? Or the opposite of that?

Generally speaking, it’s fair to say that the direction of interest rates - currently set by the European Central Bank - is good for the banks. Over the past ten years we've faced very low or even negative interest rates. During this period, the banks have learned to survive with very little critical mass. It’s bit like asking a tire manufacturer to make tires but without using any rubber. This also had its benefits, as the banks were forced to keep a lid on costs so that they could still make money.

This situation has also had its critics. Consumer associations, for example, say the banks are not raising interest rates for savers by the same amount and at the same speed as they are on loans. How do you respond to that?

I don’t think that’s fair, actually. It shows a false understanding of the way banks work. The ECB sets a key interest rate first, but every bank then has its own interest rate calculations to make.

Second, the bank undertakes maturity transformation. That means making sure customers who hold deposits with the bank can access their money at any time. In the form of loans, these funds are then committed by the bank over a 25 or 35-year period. If someone comes and withdraws a million euros from their account, we can’t go to the borrower and say we now need our money back straight away. That’s why it’s normal that the interest rate paid on money that is instantly available isn’t the same as the rate charged for a longer-term liability.

Inflation is proving more stubborn than initially anticipated. How do you currently see things developing in the medium term?

To be honest, I’m not as optimistic as many central banks. I think it’s positive that Europe is seeking to make itself more independent in terms of raw materials and supply chains. But we’ve got to accept that repatriating the production of certain goods will mean us having to pay higher prices. I see the rate of inflation falling again slightly in 2024 or 2025, but I don’t think we will be returning to the 2% level any time soon.

We’re in an election year. What are you hoping to see from the politicians?

Sometimes I envy the steel industry for the fact that in the 1960s and 1970s, it succeeded in making everyone in Luxembourg proud of the industry because we all knew where our wealth ultimately came from. I’m not expecting people to fall over themselves with gratitude towards us, but I do think many people here don’t appreciate the banks. The fact is, the sector generates around 40% of government revenue as well as 75% of income tax and a third of gross domestic product.

Social policy and many of the benefits we enjoy here in Luxembourg are only possible because of the strength of our banks. It also means politicians must deal with the situation and bang the drum for the finance industry from time to time. We’re 95% dependent on the foreign people and companies that invest in our country. These are decisions that are taken abroad, and it’s clear that these decisions are increasingly to the detriment of Luxembourg – for a variety of reasons.

In many areas of taxation, for example, we’re currently way above the European average. In the investment fund industry, we’ve lost market share to Ireland. At some point I think we should be reducing the taxe d’abonnement – that would show how willing we are to defend our market share.

Always distributing income upfront but not doing anything for the sector won’t work in the long run. Businesses will walk away. We’ve got to have an intelligent approach, and make sure we don’t kill the goose that lays the golden egg.