Vítor Constâncio: The evolving risk landscape in the euro area
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Bank of
Portugal Conference on Financial Stability, Lisbon, 17 October 2017.
* * *
Ladies and Gentlemen,
I am grateful for the opportunity to address you today at this relevant conference on financial
stability and macroprudential policy and particularly pleased for doing it at a place I consider
my alma mater of central banking.
The world economy is going through a period of sustained moderate growth. In particular, the
cyclical recovery in the euro area is now stronger and broad-based, driven by a virtuous circle of
employment creation and private consumption. All member countries are experiencing economic
growth, the significant current account deficits at the beginning of the crisis in various countries
have turned into surpluses, and in public finance most countries previously under stress are now
showing positive primary surpluses. Since mid-2013, almost seven million jobs have been
created, offsetting the losses during the peak of the crisis and unemployment is at its lowest level
since 2008, albeit still quite high. Business confidence is the highest in a decade suggesting that
we can expect a continued and resilient recovery in the coming quarters. These developments
were and are still strongly supported by the ECB's expansionary monetary policy after the
second recession in 2012-2013.
Notwithstanding these developments, there are concerns regarding possible financial instability
stemming from international market developments that could lead to price corrections. Signs of
general overvaluation in asset prices are however not present in the euro area. There are
localised asset price pressures in a few national housing markets and, in particular, in the
commercial property market. As a result, several countries have adopted macroprudential
policies and are dealing successfully with those tensions.
The overall financial stability situation in the euro area is therefore positive and well underpinned
by the improved fundamentals of our economies. Improvements indicate that the euro area is
now much more resilient and better prepared to cope with potential financial shocks that may
very well happen in the near future.
The more significant risk in the horizon is a possible reversal of risk assessment in international
financial markets with the consequent asset price downward corrections. The ensuing capital
losses incurred by asset holders, including many financial institutions, would have negative
wealth and demand effects. The increase in bond yields would put pressure on the more
indebted economic agents. Part of the possible price corrections are however associated with
the improved economic situation that will eventually lead to higher nominal growth, thus
contributing to debt sustainability.
One of the suggested triggers of market corrections is the recalibration of monetary policies that
is gradually starting to take place in different degrees across important jurisdictions. There are
two points worthwhile making in this respect. The first is that, in spite of being widely predicted in
market commentary, very little is happening in financial markets to anticipate it. Market
participants who are supposed to be forward looking, do not seem to anticipate material changes
in asset prices. The second is that this disconnect between market commentary and concrete
market decisions, could indicate that the simple recalibration of monetary policies is expected to
be smoothly absorbed without generating undue turbulence. Naturally, for this to be possible,
monetary policy recalibration must be quite gradual. That will be the case of the ECB as we have
already said that anyhow "monetary policy will continue to be very accommodative" until we
achieve our goals. If central banks adopt cautious strategies, then presumably only a significant
geo-political event could trigger more material changes in financial and economic conditions.
Nevertheless, one knows that markets are unpredictable and can overshoot, especially in
situations like the present one with many risks and a protracted period of very low volatility in
asset prices.
In the remainder of my remarks today, I will address the evolution of the pricing of risk in the
equity and bond markets during the crisis and its aftermath. This will provide the rationale for the
drivers of the possible incoming changes. I will then reflect on the consequences for the different
asset markets and their respective impact on the various economic agents. I will end with a brief
analysis of what macroprudential policies can do and are doing to safeguard financial stability in
the euro area.
Behaviour towards risk
As expected, the crisis led to a significant rise in risk aversion and a generalised preference for
safety. The depth of the crisis has left behind profound scars not only in the economies'
productive capacity but also in the minds and behaviour of economic agents concerning risk. The
memory of the unexpected materialisation of tail risks lingers. The preference for safety is partly
responsible for the excess demand for safe assets, for the increase of the equity risk premium,
for the reluctance to invest in real productive assets and for the persistent sluggishness of
wages. The elasticities of wage response to the economic slack and of consumption and
investment reaction to the cost of finance have both declined. As a result, the wage Phillips curve
became flatter and the Investment-Saving (IS) curve has become steeper. Several factors
contributed, of course, to this development, in particular, increased inequality contributes to
explain higher savings and lower consumption while shrinking investment opportunities linked to
secular stagnation explains lower investment.
According to the general risk return trade-off, it was to be expected that investors would demand
higher returns to hold riskier assets. This can be illustrated by examining the evolution of the
Equity Risk Premium (ERP) - the excess return that investing in the stock market provides over
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a risk-free rate - in advanced economies (Figure 1) which implied an increase in the cost of
equity
The upward trend in the ERP began already in 2000 in the wake of the Dot-com stock crash
(Figure1, left-hand side (LHS)). The ex-ante ERP is the difference between the required stock
returns and the risk free rate. By depicting the two components, it becomes clear that the
increased ERP resulted both from an increase in the Earnings Yield (EY) and a sharp decline in
the risk free rate (Figure 1, right-hand side (RHS)). Note however the more recent EY decrease
(which corresponds to the inverse of the Price-Earnings (P/E) ratio). This is already reflected in
the recent decrease of the ERP in the U.S. (Figure 2) .2
The two relevant factors contributing to the decline of the risk free rate were the "savings glut" of
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the early 2000s, identified by Bernanke (2005) and the scarcity of "safe assets" underlined by
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Caballero and Farhi (2014) after the crisis. Furthermore, expansionary monetary policies were
also responsible for the decline in nominal interest rates and for the impact on yields and risky
asset prices via rebalancing effects, resulting from Quantitative Easing (QE). As expansionary
monetary policy attempted to reduce the output gap it also helped to fill the risk gap. In order to
successfully avoid a big depression, monetary policy had to lower interest rates until the zero
lower bound was attained. The changes in the IS and Phillips curves have rendered the task
more difficult along the way and put pressure on monetary policy to adopt more unconventional
measures.
More structural elements - related to the persuasive views on secular stagnation and the effects
of globalisation on inflation - helped to consolidate the notion that the advanced economies are
facing a protracted period of low growth and low inflation that central banks are failing to
normalise but have to continue to address. Consequently, search for yield and trust in a sort of
"central banks' put" was the prevalent narrative until last year. Markets are becoming increasingly
aware that central banks will not ensure such a put and are thus starting to recalibrate policy, not
least as a result of the strong recovery now ongoing.
The U.S. elections of last November had already temporarily interrupted the market's belief of the
previous narrative. At the turn of the year, the perception was formed that tax cuts and
deregulation would spur U.S. growth, which would increase earnings' yields, subsequently
leading to higher inflation and higher bond yields. Consequently, we saw the beginning of a
rotation from bonds to stocks with a consequent increase in stock prices and a drop in bond
prices (Figure 3).
Asset price developments
This narrative about a new reflation phase in the world economy petered out last spring,
particularly in what regards bonds whose prices have slightly increased since. However, stock
prices continued to increase, generating fears and warnings about a possible correction (Figure
3) especially in the U.S. where, contrary to the euro area, the cyclical adjusted price earnings is
well above historical averages (Figure 4, LHS). There are already signs that markets are
reflecting concerns with possible downward movements: the probability of a 10% correction in
stock prices extracted from option pricing has recently increased albeit remaining quite low (see
Figure 4, RHS) and the price of shortening the VIX has recently sharply increased.
Nevertheless, we should ponder that equity market corrections are often not very consequential
as the examples of 1987 or 2000 seem to indicate. In general, it is interest rates and fixed rate
debt instruments that exert a wider financial and economic impact. As I mentioned before, there
are no signs of significant changes in yields despite wide expectations of monetary policy
recalibration around the globe. This presumably bodes well for future central banks' decisions.
Figure 5 shows the slow and smooth market expectations extracted from the OIS curve, for
future EONIA for the euro area. The EONIA is expected to go above zero only in 2019 and reach
2% in ten years-time. On the other hand, market expectations of ten years German and Spanish
sovereign bonds yields five years from now are respectively 1.5 and 3.3 and only move to 1.76
and 3.9 when assessed ten years from now (Figure 5, RHS). Indeed, markets expect 10 year
bond rates to remain much lower than in the past for a long period of time.
Yield and spreads of euro area countries' sovereign debt have remained stable or even dropped
with no signs of turbulence (Figure 6).
While these developments are supported by the ECB's expansionary monetary policy, they also
result from the deep adjustment undergone by the countries that were under stress during the
crisis. The change in policies and the structural reforms implemented contributed to a notable
reduction both in their external and fiscal imbalances. This has enhanced the overall resilience of
the euro area against possible economic and financial shocks. Thanks to significant fiscal
consolidation efforts, fiscal deficits across euro area countries have been reduced (Figure 7).
The European Commission expects deficits below 3% of GDP and positive primary surpluses in
almost all euro area countries in 2018.
The increased robustness of the euro area economy is also reflected in the gradual unwinding of
the large current account deficits accumulated by several countries before the crisis. Practically
all those countries are now showing a surplus and the adjustment was mostly of a structural
nature (see the blue bars, Figure 8, LHS). This turnaround was achieved because the initial
dramatic increases in the real exchange rates have largely been corrected (see Figure 8, RHS).
In most former programme countries relative unit labour costs are now below their respective
level in 1999. All these positive adjustments have certainly contributed to underpin the evolution of
sovereign bonds.
Likewise, corporate bond yields have continued to decline in the euro area (Figure 9 LHS, Figure
10 LHS for high yielders). Spreads for the debt of both euro area banks and non-financial firms
relative to risk-free benchmarks have decreased significantly since the beginning of the year.
Similarly to the U.S., this has reflected exceptionally low bond term premia (Figure 9, RHS).
Compressed or even negative term premia may however point to potential significant corrections
if events trigger a change in investors' assessment of risk. Particularly, a revision concerning
future inflation, no matter how unlikely, could lead to significant increases in term premia and
higher yields.
Nevertheless, taking into account the present market configuration and modelling fair value
valuations, excess corporate bond premia in the euro area cannot be detected (Figure 10, RHS).
The excess bond premium is given by the deviation of the corporate credit spreads relative to the
measured default risk of the issuer and the duration risk of the bond. The estimates show that
'excess premia' have declined since end-2015 and are currently negative, implying that investors
require no premium to hedge against adverse economic scenarios.
Looking now to another asset class, our analysis indicates that on the aggregate, residential
property prices are broadly in line with the fundamentals, using various different methods to
assess whether there are overvaluations in the market (see Figure 11). The situation is different
in the case of commercial real estate. In specific areas and large cities, housing prices have
however increased at a faster pace than households' incomes and may show signs of
overvaluation.
On the other hand, property prices and transaction volumes have grown strongly in recent years
and have already reached historical highs in many euro area countries (see Figure 12). Nominal
growth of residential property prices accelerated to around 4% y-o-y in Q1 2017 but remained
below its historical average growth rate and well below pre-crisis values. In real terms, price
increases moderated due to inflation picking up. Residential property prices are demand-driven
and increasingly supported by the recovery in personal income which is expected to continue.
Potential impact of asset price shocks
The analysis of the situation in different asset markets illustrates that generalised overvaluation
does not exist in the euro area. Tensions in some real estate markets are being dealt with by
macroprudential instruments in many countries.
To assess possible financial stability risks we should however try to gauge the possible impact of
the materialisation of an interest rate or yields correction. In the following paragraphs, I will
explore the effects of such a shock calibrated at 100 basis points. Estimates suggest that the
impact of this sizable increase on the non-financial private sector is relatively small, in particular
for euro area households (see Figure 13, LHS). One reason lies in the interest rate fixation period
of loans. Loans with floating rates or rates with rather short fixation periods are more widespread
for euro area non-financial corporations. In contrast, the majority of newly demanded loans by
households have longer interest rate fixation periods, making them more resilient against interest
rate increases (see Figure 13, RHS). The estimates indicate that three years after the interest
rate shock, the impact would represent a burden of 0.5% of household disposable income and
about 2.5% of the gross revenues of non-financial firms, amounts that could be absorbed in the
context of the ongoing recovery.
A sudden repricing in fixed income markets could lead to substantial capital losses for investors
with large holdings of bonds. In the euro area, the impact would be felt in particular by the
nonbank financial sector. For insurers and pension funds, bonds account for almost 40% of their
portfolios. For banks, this share is only around 15% (see Figure 14 RHS). In addition, bond
portfolio valuations have become more sensitive to changes in interest rates in recent years as
duration has continued to increase (see Figure 14, LHS). Currently, a 100 basis point increase in
interest rates would lower the value of outstanding securities by 7%, compared to 5% before the
financial crisis. However, these simple metrics neither take into account any hedging
arrangements nor the impact of any repricing on the value and cost of financial institutions'
liabilities.
Regarding the overall impact on the significant euro area banks that are directly supervised by
the ECB, Figure 15 updates estimates published in the ECB Financial Stability Review in May
2017. The estimates embody a whole range of effects: the capital losses on securities holdings
(without considering any hedging), the increase in credit risk resulting from the estimated impact
on probabilities of default of exposures, the corresponding effects on interest revenues and the
broad impact on net interest income stemming from the increase in credit rates and funding
costs of banks (deposits and wholesale funding).
The estimates are made for two scenarios. The global repricing scenario features, among other
assumptions, an international increase in bond yields of 120 basis points and a 30% drop in
stock prices. The European repricing scenario, induced purely by European developments,
includes an average increase in bond yields of 75 basis points unevenly distributed across
countries (no increase for Germany and more than 200 for some more vulnerable countries),
accompanied by an average drop of 10% in equities. The outcome of the two scenarios indicates
a negative impact on banks' Common Equity Tier 1 (CET1) capital hovering around 200 basis
points in terms of deviation from the baseline scenario. This impact has to be considered against
the comfortable present average CET1 ratio of 14% enjoyed by the euro area banks.
It is also important to recall that market sentiment towards euro area banks has continued to
improve, despite some gyrations that broadly reflect developments in interest rate expectations
(Figure 16, LHS). While contagion from the recent events of bank resolution and liquidation
remained contained, these events have also highlighted the important challenges regarding the
resolvability of weak banks. Notwithstanding some recent progress in non-performing loan (NPL)
disposals, the large stock of NPLs remains a key structural concern in several countries. In
addition, overcapacity and cost inefficiencies continue to weigh on bank profitability in certain
banking markets.
The economic recovery, the expected steepening of the yield curve and even the progress being
made in reducing the NPL level from the average peak of 8% in 2013 to the more recent average
of 5.5%, have improved the market assessment of future banks' profitability. Analysts' earnings
forecasts for 2017 and 2018 have been revised upwards since the U.S. elections, even if net
interest income expectations have changed only marginally, despite improving economic
conditions (volume effect) and (prospective) higher long-term interest rates (price effect).
Analysts revised their earnings forecasts between October 2016 and January 2016 (see Figure
16 black dot in left bar) and between August 2017 and November 2016 (black dot in right bar)
with the respective contributing factors. While forecasted net interest income was a drag on net
income in the first period it contributed positively in the second period. Forecasted loan loss
provisions contributed positively in the second period because they became less negative over
the period November 2016 - August 2017 while forecasted operating expenses increased.
Macroprudential policy
Let me now turn to the role of macroprudential policy in this risk environment.
The objective of macroprudential policy is to prevent and mitigate systemic risk by strengthening
the resilience of the financial system and by smoothening the financial cycle.
Since November 2014, when the ECB was granted macroprudential responsibilities and
competence to top-up the measures taken by national authorities, more than 100 decisions on
macroprudential measures have been taken (see Figure 17). As regards capital buffers to
counter the "too-big-to-fail" problem, the decisions relate to eight globally important banks (in
France, Germany, Italy, the Netherlands, and Spain) and overall, 109 domestic systemically
important financial institutions in all euro area countries.
Decisions also led to calibrations of the systemic risk buffer in four countries (Austria, Estonia,
the Netherlands and Slovakia) and to the activation and the future increase of the countercyclical
5
capital buffer to 1.25% in 2018 in Slovakia.
In addition, to address real estate risks, authorities raised risk weights for real estate
6
exposure and decided the use of Loan-To-Value (LTV) and Debt-To-Income (DTI) type of
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measures. Indeed, overall nine countries have currently activated these borrower-type
measures based on their national legislation (see Figure 18).
These measures influence the provision of credit and raise resilience by curtailing the tails of risk
exposure. Given their effectiveness in curbing excessive credit flows, in December last year the
ECB Governing Council called upon governments to implement the legislative basis for
borrower-based measures in all euro area countries.
In addition, the ongoing review of the macroprudential framework in the EU provides an excellent
opportunity to make these tools available to macroprudential authorities on a common legal
basis. The review also needs to promote a clear allocation of tools between the macro- and
micro-prudential supervisors to ensure a timely activation of the instruments. This implies that
the macroprudential use of Pillar 2 should be abandoned and the procedures for Article 458 CRR
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should be strongly streamlined for an effective use of macroprudential policy.
The capital- and borrower-based macroprudential instruments I just mentioned are targeting
risks among the banking sector and the real economy. But given the structure of our financial
system, they are not sufficient. In fact, a growing fraction of credit intermediation is conducted by
non-bank financial institutions. Their risks are essentially related to maturity mismatch or
leverage. However, the current European macroprudential toolkit grants regulatory authorities
limited possibilities to act on these risks in the non-banking sector. Europe should thus expand
the toolkit to cover these risk areas.
As regards liquidity mismatches, this year's policy recommendations by the Financial Stability
9
Board (FSB) to address structural vulnerabilities from asset management activities have been
an important step in the right direction. The recommendations permit authorities to indicate
adequate liquidity risk management tools in extraordinary circumstances to open-ended funds.
This also includes the suspension of redemptions in times of stress.
The FSB policy recommendations also address issues of measurement and monitoring of
leverage within investment funds, including data collection for calculating synthetic leverage. Both
recommendations are important because of the links between leverage and liquidity risk. For
instance, recent research based on European alternative investment funds has shown that
leveraged funds experience greater investor outflows after bad performance than unleveraged
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funds. By limiting leverage we would be able to reduce these propagation mechanisms in
times of stress.
On the other hand, I see the application of further regulation to Securities Finance Transactions
(SFT) as most pressing for macroprudential policy beyond banking. Authorities should be able to
make macroprudential use of margins and haircuts in securities markets to control the build-up
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of excessive leverage. Importantly, these tools reach beyond the banking system and can
thereby address risks in the rapidly growing parts of the financial system. To safeguard financial
stability in the euro area in the future, it is therefore essential that macroprudential authorities,
particularly central banks, are provided by European legislators with an expanded toolkit.
Let me conclude.
Financial stability in the euro area has improved, accompanying the ongoing economic recovery.
Compared to last year, the euro area financial system is more resilient today. Bank profitability
has recovered somewhat and steps have been taken to address some of the structural
challenges faced by the banking system, although clearly a lot more needs to be done. Monetary
policy, even when recalibrated, will continue to keep a very accommodative stance in order to
attain the price stability objective in a self-sustained way. This implies that, in the present
configuration of risks, Europe and all other advanced economies will have to take
macroprudential policy much more seriously or they will face the risk of other financial crises that
monetary policy cannot prevent.
Thank you for your attention.
1
Daly, K., (2016), "A Secular Increase in the Equity Risk Premium", International Finance 19:2, pp. 179-200.
2
Caballero, R. and A. Simsek, (2017), "A Risk-centric Model of Demand Recessions and Macroprudential
Policy", NBER Working Paper No. 23614.
3
Bernanke, B., (2005), "The global savings glut and the US current account deficit", Sandridge Lecture, Virginia
Association of Economics, Richmond, Virginia, Federal Reserve Board.
4
Caballero, R. and E. Farhi, (2014), "The safety trap", NBER Working Paper No 19927.
5
See "Macroprudential measures in countries subject to ECB Banking Supervision and notified to the ECB", ECB.
6
Belgium, Finland and Luxembourg.
7
Cyprus, Estonia, Finland, Ireland, Latvia, Lithuania, The Netherlands, Slovenia and Slovakia.
8
See "ECB contribution to the European Commission's consultation on the review of the EU macroprudential
policy framework", ECB.
9
See "Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities ", FSB, 12
January 2017.
10
See van der Veer, K., A. Levels, C. Lambert, L. Molestina Vivar, C. Weistroffer, R. Chaudron and R. de Sousa van
Stralen, (2017), "Developing macroprudential policy for alternative investment funds, towards a framework for
macroprudential leverage limits in Europe: an application for the Netherlands"; ECB and DNB Occasional
Paper, forthcoming October 2017.
11
See "Margins and haircuts as a macroprudential tool", remarks by Vítor Constâncio, Vice-President of the ECB,
at the ESRB international conference on the macroprudential use of margins and haircuts, Frankfurt am Main, 6
June 2016.