Lucas Papademos: Assessment of identified risks to the euro area
financial system and the capacity to absorb disturbances
Opening remarks by Mr Lucas Papademos, Vice President of the European Central Bank, at
the press briefing on the occasion of the publication of the June 2010 ECB Financial Stability
Review, Frankfurt am Main, 31 May 2010.
* * *
I. Introduction
My colleagues and I would like to welcome you to today's press briefing on the occasion of
the publication of the June 2010 edition of the ECB Financial Stability Review.1 The primary
objective of the Review is to identify the main sources of risk to the stability of the euro area
financial system and provide a comprehensive assessment of the capacity of the financial
system to absorb adverse disturbances. The Review integrates the interdepartmental work of
the ECB with that of the Banking Supervision Committee (BSC) of the ESCB. It contains
16 boxes and five special feature articles that address topical financial stability issues in a
more focused and analytical manner. As in the past, we have prepared a summary note that
contains some key messages of our analysis and assessment.
In my presentation, I will highlight the seven main risks and vulnerabilities identified and
assessed in the FSR (slide 3) and the associated financial stability challenges. Four of these
risks stem from outside the euro area financial system, while the other three originate from
within the financial sector.
II. Main risks identified outside the euro area financial system
A main risk to the euro area financial stability is the possibility that concerns about the
sustainability of the public finances persist, or even increase, with an associated crowding
out of private investment (slide 5). The progressive intensification of market concerns about
sovereign credit risks among industrialised economies in the early months of 2010 opened
up a number of hazardous contagion channels and adverse feedback loops between
financial systems and public finances, in particular in the euro area.
The main reason for the severe deterioration of public finances was the activation of
automatic stabilisers as a result of the marked contraction of economic activity which
followed the collapse of Lehman Brothers. At the same time, because the structural fiscal
deficits of a number of euro area countries were sizeable before the financial crisis erupted,
fiscal deficits in those countries rose to very high levels. Added to this were the discretionary
fiscal measures taken by many countries to stimulate their economies, following the adoption
in December 2008 of the European Economic Recovery Plan.
By early May this year, adverse market dynamics had taken hold across a range of asset
markets in an environment of diminishing market liquidity. Ultimately, the functioning of some
markets, such as the government bond markets in countries with a very negative fiscal
outlook, became impaired, thereby triggering a significant widening of government bond yield
spreads in these countries, as shown on Chart 1 on slide 5. This hampered the monetary
policy transmission mechanism and the effective conduct of monetary policy. At the same
time, fears about the implications of growing fiscal imbalances in some euro area countries
and the potentially adverse impact on banks' exposures to higher sovereign credit risk
- including their funding costs and portfolio exposures - led to an increase in perceived
systemic risk for large banking groups in the euro area to the highest levels seen since the
collapse of Lehman Brothers.
To help improve the market functioning and the transmission of monetary policy, the
Governing Council decided on 9 May 2010 on several remedial actions. In parallel, at an
extraordinary meeting on 9/10 May, the Ecofin Council agreed to establish a European
Financial Stabilisation Mechanism. This back-stop financing arrangement will be subject to
strong conditionality. The mechanism will have up to €500 billion of funds to be provided by
euro area Member States at its disposal. The IMF will participate in the financing
arrangements and is expected to provide at least half as much as the euro area countries'
contributions. Following the implementation of these measures, market volatility was
significantly contained.
A second main risk is the possibility of adverse feedback between the financial sector and
public finances continuing. The review summarises various contagion channels through
which persistently large fiscal imbalances could pose risks to financial stability. If government
indebtedness reaches a sufficiently high level that it triggers a loss of confidence in fiscal
sustainability, investors will require additional risk premia to compensate for having to bear
greater sovereign credit risk. The resulting rise in sovereign risk premia can be passed
through to private sector funding costs, especially if there is doubt about the ability of the
public sector to counter adverse disturbances to non-financial and financial sectors.
Chart 2 on slide 6 shows how CDS spreads for large banks have become increasingly
correlated over the past seven and half months with the sovereign CDS spreads of the
countries where these banks have their headquarters. Two snap-shots are shown in the
chart: one for 26 November 2009 and the other for 19 May 2010. As can be seen from the
chart, between these two dates, as sovereign CDS spreads have risen, so have bank
CDS spreads. It is furthermore interesting to note that, in the cases where concerns about
fiscal imbalances have been greater, the co-movement has been substantial.
The third risk we have identified outside the euro area financial system is the possibility of
vulnerabilities being revealed in non-financial corporations' balance sheets, because of high
leverage, low profitability and tight financing conditions. The balance sheet conditions for the
euro area non-financial corporate sector have slightly improved since the last issue of the
FSR, which has translated into a moderate lowering of the expected write-downs facing euro
area banks on their corporate loan portfolios by end-2010. Against the background of the
gradual economic recovery, financial market participants have also become more optimistic
concerning corporate earnings prospects. That said, the high leverage of euro area
non-financial corporations, coupled with low profitability in 2008 and 2009, has translated into
high default rates for non-financial firms. Chart 3 on slide 7 shows patterns of default rates
for euro area firms of all size categories, indicating that, in 2009, bankruptcies reached
historically high levels. There is a large degree of cross-country heterogeneity within the euro
area with some countries having endured annual increases in bankruptcies of more than
70% in 2009.
When considering the outlook, it is instructive to examine past correlation patterns between
bankruptcies and real GDP growth. As Chart 3 shows, insolvencies in the euro area
remained at very high levels after the last downturn (2002-03), even after GDP already
picked up. Hence, notwithstanding a recovery in economic activity, it might still take some
time before a normalisation of bankruptcies would be observed.
The fourth risk identified outside the euro area financial system is the possibility of
greaterthan-expected household sector credit losses if unemployment rises by more than expected.
Over the past six months, the condition of euro area household sector balance sheets has
changed little with only a slight increase in new ECB estimates for write-downs on residential
mortgages and consumer loans up to end-2010. That said, considerable increases in the
rate of unemployment in most countries are expected between the fourth quarter of 2009 and
the fourth quarter of 2010. This means that downside risks for household income and debt-
servicing capacity are likely to persist and that banks could face losses for some time,
although there are important differences across countries. However, on a more positive note,
there are signs that the past sharp falls in house prices, together with low interest rates, have
improved housing affordability. This appears to explain, at least in part, the recent turnaround
in the extension of new loans to households for house purchases, shown in the Chart 4 on
slide 8, although substantial differences in these patterns remain across Member States.
III. Main risks identified within the euro area financial system
Let me now turn to the three main risks that we have identified within the euro area financial
system. The first is the possibility of a setback to the recent recovery of bank profitability.
After the sizeable net losses, which were endured by around half of the euro area large and
complex banking groups (LCBGs) in late 2008, many of them returned to modest profitability
during 2009. Moreover, as shown in the left-side of Chart 5 on slide 10, banks' financial
performances strengthened further in the first quarter of 2010 and all LCBGs which have
reported financial results so far have shown a positive return on equity. The same pattern
can be seen as regards the return on assets.
The leverage ratios of LCBGs have remained broadly constant after a sharp decline in the
first quarter of 2009. These relatively stable ratios, however, conceal some differences in the
ways individual institutions have lowered their leverage ratios. Most of them have increased
their Tier 1 capital, while many have also reduced their assets. Overall, the shock-absorbing
capacities of euro area LCBGs improved substantially during 2009 and in the first quarter of
2010. Even those institutions with the lowest capital ratios managed to enhance their buffers
to levels well in excess of minimum regulatory requirements. At the same time, the capital
buffers in some segments of the euro area banking sector may not have improved as quickly
as has been the case for the LCBGs and will require further strengthening. Conditions in
euro area LCBG funding markets have also tended to improve for much of the past
six months, although the recent rise in sovereign credit risks has led to a setback for
longerterm debt financing costs.
As shown in the right-side of Chart 5, the most important driver of euro area LCBGs' net
income throughout 2009 and in the first quarter of 2010 continued to be net interest income.
By the first quarter of this year, around two-thirds of the total net income of the LCBGs was
generated from this source, while, before the crisis, around half of the total came from net
interest income. The turnaround of the profitability of the LCBGs in 2009 is also attributable
to a remarkable recovery of net trading revenue in the second quarter of 2009, which was
more or less sustained throughout the year and in early 2010, despite a progressive lowering
of market volatility, a tightening of bid-ask spreads and a stalling of the recovery in financial
markets. Finally, income from fees and commissions has continued to produce a stable
revenue flow for euro area LCBGs, and even increasing somewhat in the late 2009 and early
2010, boosted in particular by revenues from underwriting government and non-financial
corporate sector debt securities issuances.
Looking ahead, although their financial performance has much improved, the challenges
facing euro area LCBGs remain considerable. The central scenario is one of subdued
banking sector profitability in the short to medium term for a variety of reasons. First, the
recovery in the financial markets that has taken place in late 2009 has lowered the
ECB estimates of banks' cumulative mark-to-market losses on holdings of securities
throughout the entire period of the financial turmoil. However, the new estimate in the current
FSR indicates that the potential cumulative write-downs on securities and loans for the euro
area banking sector for the period 2007 to 2010 is EUR 515 billion, which is lower than the
estimate published in the December 2009 FSR. Given the sizeable decline in projected
losses on securities, and the large provisions that had already been made against loan
losses by the end of 2009, the potential total future write-downs on securities and loans has
fallen quite substantially.
Chart 6 on slide 11 shows the profile of write-downs on securities and loans over time,
applying the same methodology as in previous assessments published in the FSR. This time
the horizon of the estimates for future losses has been lengthened to 2011 and sizeable loan
losses are still expected next year. The expected write-downs on loans will constitute a
significant and lasting drag on banking sector profitability and will raise the risk that the
recent recovery of profits does not prove durable. At the same time, the pressure on banks to
keep leverage under tight control, the disengagement from public support of banks' balance
sheets and the vulnerability of net interest margins of some banks to the prospect of a
flattening of the yield curve are likely to contribute to keeping profitability moderate.
Regarding the year-by-year distribution of losses by type of exposure, write-downs on
securities exposures were the main contributor to the substantial losses for, and capital
drains on, euro area banks in 2008. Going forward, while the recovery in securities prices
makes valuation write-backs on securities holdings more likely in 2010, write-downs on loans
are expected to remain relatively high. However, in contrast to the uncertainties created by
securities valuations in 2008 and 2009, banks should largely be in good positions to forecast
the loan losses facing them, using their internal models, and they should thus be in a better
position to manage the potential future write-downs without unexpected capital shortages.
The second risk that we have identified within the euro area financial system relates to
vulnerabilities of financial institutions associated with concentrations of lending exposures to
commercial property and to Central and Eastern European (CEE) countries. You may recall
that, in the December issue of the FSR, we drew your attention to these two types of
exposures. Since then, in the commercial real estate sector, prices and rents have continued
to fall in most euro area countries, although at a moderating pace. Reflecting this
deterioration, estimates of losses facing banks on their commercial property loan portfolios
had been revised upwards by almost 50% over the past six months, as shown in Chart 7 on
slide 12, and concerns remain about concentrations of such exposures among some euro
area banks. This increase in estimated losses on commercial property loans is expected to
more than offset the recovery in the valuations of commercial mortgage-backed securities
held by banks in the euro area.
As regards banks' exposures to the CEE region, since December, the economic outlook in
the region has improved. However, new vulnerabilities have emerged, especially a
broadbased deterioration in the fiscal positions in a number of non-euro area EU countries, a
number of which are currently under excessive deficit procedures. As Chart 8 on slide
13 illustrates, it needs to be kept in mind that the stock of outstanding foreign currency loans
in these countries, while no longer increasing, remains sizeable, which makes the quality of
exposed banks' assets vulnerable to exchange rate risks. Given that the exposures to the
CEE region are rather concentrated among some euro area countries' banking sectors, the
risks remain material in these cases.
The third risk that has been identified within the euro area financial system is that of
heightened financial market volatility if macroeconomic outcomes fail to live up to
expectations. Until the increase in volatility experienced this month, the stock markets in the
euro area had broadly stabilised after a strong recovery in 2009, which mainly reflected the
impact of improving macroeconomic news and better corporate earnings prospects. Chart
9 on slide 14 shows that most conventional valuation measures, such as the long-term
price-earnings ratio do not suggest that valuations are particularly high by historical
standards. But there is a risk of heightened financial market volatility, if expectations of
macroeconomic outcomes are disappointed.
I would also like to briefly comment on the current state of the euro area securitisation
markets. The securitisation markets were rendered dysfunctional by the financial crisis for a
variety of micro and macroeconomic reasons. Efforts are being made both by the financial
industry and the policy-making community to address the most important micro issues,
including the lack of transparency, product complexity and inappropriate incentives in the
originate-to-distribute model. However, in recent months there have been some, albeit
nascent, signs of improvement in securitisation activity, in part supported by a narrowing of
spreads on securitised products (i.e. yield on securitised products over Libor). The narrowing
spreads, which reflects the compensation investors are demanding for holding these assets,
could bring prices closer to levels where issuance of ABS securities makes economic sense.
This has been indicated in the responses to ECB bank lending surveys and in lower retention
rates by banks for newly-issued ABS. While it is difficult to disentangle the relative
contribution of micro and macro factors to the improvement, it seems clear that the improved
economic outlook has played an important role.
IV. Overall assessment
Let me now conclude with the overall assessment of the identified risks to euro area financial
system stability (slide 15). Although the main risks to euro area financial stability essentially
remain the same as those to which attention was drawn in the last issue of the FSR, their
relative importance has changed significantly over the past six months. Ultimately, the
significance of risks for financial system stability must be judged by the probability of their
materialisation in combination with their likely impact, both on the financial system and on the
broader economy, in the event that they do materialise. By this criterion the two most
important risks for euro area financial stability at the current juncture are, first, the possibility
of concerns about the sustainability of public finances persisting or even increasing with an
associated crowding-out of private investment and, second, the possibility that adverse
feedback between the financial sector and public finances continues.
Considering other risks, albeit less material, identified outside the euro area financial system
include the possibility of vulnerabilities being revealed in non-financial corporations' balance
sheets - because of high leverage, low profitability and tight financing conditions - and the
possibility of greater-than-expected household sector credit losses, if unemployment rises by
more than currently expected.
Within the financial system, the central scenario is for modest banking sector profitability in
the short to medium term, given the prospect of continued loan losses, lasting pressure on
the sector to reduce leverage and market expectations of higher funding costs (slide 16).
Given this outlook, an important risk is the possibility of a set-back to the recent recovery of
bank profitability and of adverse feedback with the provision of credit to the economy.
Moreover, in view of the considerable near-term funding needs of euro area governments, a
particular concern is the risk of bank bond issuance being crowded out, making it challenging
to roll-over a sizeable amount of maturing bonds by the end of 2012. In addition, the
vulnerabilities of financial institutions associated with concentrations of lending exposures to
commercial property markets and to Central and Eastern European countries remain. There
are also risks of heightened financial market volatility, if macroeconomic outcomes fail to live
up to expectations. A key concern is that many of the vulnerabilities highlighted in my
presentation today could be unearthed by a scenario involving weaker-than-expected growth.
I will now conclude with five policy messages stressed in the Review (slide 17).
First, the measures taken by the ECB to stabilise markets and restore their functioning, as
well as the establishment of the European Financial Stabilisation Mechanism, have lowered
tail and contagion risks.
Second, sizeable fiscal imbalances remain and the responsibility rests on governments to
frontload and accelerate fiscal consolidation, so as to ensure the sustainability of public
finances, not least to avoid the risk of a crowding out of private investment, while establishing
conditions conducive to durable economic growth.
Third, with pressure on governments to consolidate their balance sheets, disengagement
from financial sector intervention means that banks will need to be especially mindful of the
risks that lie ahead. In particular, they should ensure that they have adequate capital and
liquidity buffers in place to cushion the risks, should they materialise.
Fourth, and against this background, the problems of those financial institutions that
remained overly-reliant on enhanced credit and government support will have to be tackled
decisively. At the same time, fundamental restructuring will be needed when the long-term
viability of banks is likely to be threatened by the taking away of state support. This may
involve the shrinking of balance sheets through the shedding of unviable businesses, with a
view to enhancing profit-generating capacities.
Fifth, for the longer-term, a key objective of the agenda for regulatory reform is to strengthen
capital and liquidity buffers so as to ensure a safer financial system that is more robust to
adverse disturbances. Swift completion of the process of calibration and implementation of
these necessary reforms should remove related uncertainties and allow banks to optimise
their capital planning and, where necessary, adjust their business models.
Thank you very much for your attention. I am now at your disposal for questions.
BIS Review 75/2010
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