Lucas Papademos: ECB Financial Stability Review December 2006
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 December 2006 ECB Financial Stability Review,
Frankfurt am Main, 11 December 2006.
* * *
I. Introduction
Welcome to this press conference for the fifth issue of the ECB's semi-annual Financial Stability
Review which is being published today.
The financial stability assessment contained in the December 2006 issue of the Review is based on
close collaboration between ECB staff and the ESCB Banking Supervision Committee. In addition, this
particular issue draws upon information that was obtained from a series of informal discussions that
were held with investment banks, hedge funds and credit rating agencies. It reflects information that
was available up to 3 November 2006.
This issue of the Review broadly follows the structure that was adopted in previous issues, although
the assessment of the hedge fund sector is now included in the first Chapter in an expanded section
on global financial institutions.
Some thematic financial stability topics are addressed in a total of 16 boxes and there are also five
Special Feature articles in this issue. These are concerned with the following topics: (i) a methodology
for identifying a set of large and complex banking groups for financial system stability assessment; (ii)
an analysis of the information content of credit default swap index tranches for financial stability
assessment; (iii) a methodology for analysing episodes of dynamic credit growth in Central and
Eastern Europe; (iv) an assessment of systemic risk in the insurance sector and (v) a review of the EU
arrangements for financial crisis management.
In presenting the main findings of the analysis, I will broadly follow the structure of the Review - as
outlined on slide 2. In particular, I will discuss the main sources of risk and vulnerability for euro area
financial stability we have identified in: (i) the external environment; (ii) global and euro area financial
markets; (iii) the euro area corporate and household sectors and (iv) euro area financial institutions.
Then I will conclude with an overall assessment of the outlook.
II. Developments since the June 2006 assessment
Before doing this, let me start by recalling our assessment of last May when the June FSR was
finalised and what has happened since then. In May, several vulnerabilities had been assessed as
being capable of posing material risks to the euro area financial system. Given these vulnerabilities,
there had been some concern that the shift to less accommodative monetary policies in the major
economies and the occurrence of a number of shocks could have resulted in disorderly adjustments in
asset prices by exposing "stretched" asset valuations in some markets and "overextended" balance
sheets. This did not happen.
The gradual shift to less accommodative monetary policies in all major economies proceeded
smoothly. The system endured several shocks over the past six months. For instance, there was a
bout of volatility across a broad range of financial markets during May and June but the markets
comfortably absorbed the disturbances and no major financial institution was significantly impacted by
the event.
It should also be recalled that there had been some anxiety that disruptive asset price dynamics could
have been triggered by an idiosyncratic collapse of a large hedge fund. However, the plunge into
financial distress in September 2006 of Amaranth Advisors had little discernible impact on markets.
Against this background, in the euro area over the past six months, conditions for raising funds in the
credit and equity markets remained favourable, there was a further and broad-based improvement in
the profitability of banks, and the balance sheets of insurance companies were strengthened further.
In addition, key financial infrastructures - including payment systems such as TARGET, and securities
clearing and settlement systems - remained robust and continued operating smoothly.
III. Overview of the main risks and vulnerabilities
III.1 External environment
Turning to the current assessment and starting with the external environment, a global source of
medium-term risk for the stability of financial systems continues to be the large global financial
imbalances, despite some rebalancing of global growth patterns and recent declines in oil prices [see
slide 3].
While there are indications that global financial imbalances have been widening at a slower pace than
before, they are not expected to narrow significantly in the short term. The prolonged accumulation of
expanding US current account deficits has been a source of unease because the financing of these
deficits relies on the continuation of capital inflows from surplus emerging market economies and
oil-producing countries [see chart on the left of slide 3].
Commodity price swings, especially in the oil markets, can also pose risks for financial stability through
various channels both indirectly and directly. Indirect effects pass through macroeconomic channels
as high and volatile oil price levels pose risks for economic growth and inflation with potential adverse
effects on asset prices. As regards direct effects, there are indications that speculative activity in the
markets for derivatives on oil as well as in other non-oil commodities has been increasing. An example
of the risks that can be posed by such activity in non-oil commodities markets was the episode
involving the Amaranth Advisors hedge fund that collapsed in September. The fund ran into difficulties
after its leveraged bets in the natural gas futures market - which had been predicated on expectations
of hurricane frequency and intensity that did not materialise - suddenly turned sour.
Regarding oil spot prices, after reaching new historical highs in early August, they subsequently
declined substantially but have remained at high levels. The decline was mainly attributable to a
reduction in geopolitical tensions, a receding threat of hurricanes in the Gulf of Mexico and an easing
of petrol market tightness. All of these factors led to a decline in speculative positions which
contributed to the rather abrupt downward adjustment in the price of oil. Looking forward, the implied
probability distribution of future oil prices, extracted from options contracts, indicates that considerable
uncertainty surrounds near-term oil futures prices, with very wide confidence intervals. Moreover, the
balance of risks is tilted towards the upside [see chart on the right of slide 3].
III.2 Global and euro area financial markets
When assessing the potential risks in the two main sources
global and euro area financial markets,
of vulnerability can be identified. The first concerns the persistently low levels of long-term interest
rates and credit spreads which have been associated with a "pricing for perfection" in corporate sector
capital (credit) markets and emerging economy debt markets in the sense that valuations in these
markets appear to be based on very favourable expectations regarding future economic outcomes and
low risk premia. The second concerns the growth in the volume and complexity of credit derivatives
markets, coupled with the increasing presence of hedge funds in these markets.
An abundance of liquidity in global financial markets, although its rate of growth has moderated,
together with very high saving rates in some emerging market regions relative to domestic investment
opportunities partly explain why long-term interest rates and credit spreads have been remarkably
unperturbed by the shift to less accommodative monetary policies in the G3 economies and the
resulting withdrawal of global liquidity. Rising short-term interest rates have instead produced flatter, or
inverted, market yield curves in the six months following the finalisation of the June 2006 FSR. [see
chart on the left of slide 4] The renewed "conundrum" of low long-term government bond yields seems,
in part, related to very low risk premia. It should also be noted that several demand-related factors,
such as bond purchases by euro area insurance corporations and pension funds, might have played
some role in keeping long-term bond yields at low levels, although it is difficult to quantify the impact
with precision.
As already noted, the bout of volatility across a broad range of financial markets during May and June
2006 was comfortably absorbed both by markets and institutions. However, to the extent that the
"search for yield" in a low interest rate environment has led to this "pricing for perfection" in other
financial markets, long-term rates and risk premia could have been driven too low especially in credit
markets and those of emerging market economies [see chart on the right of slide 4]. This means that
valuations in these markets could prove vulnerable to several potential unanticipated adverse
disturbances including a renewed spike in oil prices, a pick-up in the demand by non-financial firms for
external funds should profitability weaken, or a change in global asset allocation. Such triggering
events could have the potential to bring about possible abrupt increases in bond yields, spreads and
risk premia across mature and emerging capital markets.
If a triggering event of sufficient severity were to occur, it could bring about an abrupt increase in
longterm yields, and credit and equity risk premia across mature capital markets and emerging market
economies. This would imply significant asset portfolio losses for banks and other financial institutions.
More importantly, it could also raise the counterparty risks some banks face vis-à-vis hedge funds in
case it would trigger a cluster of hedge fund failures.
As to the second issue for financial markets, credit derivatives markets have been growing at an
exponential rate over recent years, not only in terms of size but also in terms of the complexity of
products. [see slide 5] The development of these markets is undoubtedly contributing to the efficiency
and stability of the financial system by allowing financial intermediaries to measure and manage their
credit risks more efficiently and effectively, primarily by buying protection in the credit default swaps
(CDS) market.
At the same time, there have been concerns that rapidly increasing credit risk transfer (CRT) activity
may be leading to concentrations of risk among agents who might not be able to bear it in a more
challenging environment, particularly in the case of the more complex structured credit products where
investors may have been attracted by high short-term returns.
In 2003, the Banking Supervision Committee undertook an important survey on CRT activity. But so
much has happened since then - especially in terms of the substantial growth of the market and the
increasing participation of hedge funds in taking on credit risk exposures - that at the current juncture,
the available data are insufficient to make a sound assessment of these risks. Should current trends
continue, they will imply fundamental changes in the methods for assessing the ability of the financial
system to cope with unexpected credit cycle deterioration.
After the finalisation of the June 2006 FSR, some hedge funds endured financial losses, mainly as a
consequence of turbulence in financial markets during May and June. Subsequently, there were some
highly publicised adverse developments in the hedge fund sector related to the collapse of Amaranth
Advisors, a large multi-strategy fund. Nevertheless, the hedge fund sector continued to benefit from
steadily increasing investor demand. [see slide 6]
Capital under management by hedge funds has been growing very rapidly and has reached close to
one trillion US dollars. [see chart on the left of slide 6] Given this size of the sector, a growing concern
is that trades are becoming increasingly crowded. Higher correlation of hedge fund returns could be an
indication of this. During the first half of 2006, correlations among and within hedge fund strategies
remained relatively stable.
It is noteworthy that the collapse of Amaranth Advisors in September did not lead to wider turbulence,
despite the fact that the total loss experienced by the fund was much larger than that incurred by
LTCM in 1998. The ability of the system to absorb the shock demonstrated that the hedge fund sector
has become more mature and has the ability to repair itself in the event of idiosyncratic distress.
However, it should also be recalled that this event occurred against a backdrop of rather benign
market conditions, and it cannot be excluded that in a more challenging market environment, such as
that which characterised markets after the Russian crisis in August 1998, the impact of such an event
could have been more disruptive.
New risks have emerged related to what could be called a "triangle" of vulnerability connecting the
state of the credit cycle (which could deteriorate in the future), credit derivatives and hedge funds [see
slide 7]. On the one hand, a marked adverse turn in the credit cycle, triggered either by a large and
unexpected credit event, such as the collapse of a large corporation, or by a cluster of defaults by
smaller and highly leveraged low-quality corporations, could lead to substantial payment obligations
for counterparties which have provided credit risk protection. If these counterparties were found not to
be in a position to sustain the losses, credit risk "insurance" might not be available when claims are
ultimately made. On the other hand, if the functioning of the credit risk transfer market were impaired,
for instance if financial market volatility rose unexpectedly, this could have an adverse impact as
banks might not then be able to lay-off their credit risk in the way they have become accustomed
which could, in turn, induce greater caution in their lending to lower quality borrowers in particular.
III.3 Euro area corporate and household sectors
Turning to developments in the euro area corporate sector, over the past six months there have been
mounting signs that an adverse turn in the credit cycle seems increasingly likely, driven by factors
such as rising leverage ratios, a further tightening of monetary conditions and expectations of a future
slowdown in the pace of profit growth.
A favourable economic environment together with the persistently low cost of issuing corporate sector
debt and greater investor appetite for lower quality credit have created conditions that have been
conducive to a surge in global merger and acquisition (M&A) activity [see chart on the left of slide 8],
and in particular of leveraged buy-outs (LBOs). Such transactions have become an important source
of growth in leveraged loans.1 [see chart on the right of slide 8] The rapid growth in the value of LBO
transactions has taken European leveraged loan issuance beyond levels last seen at the height of the
telecom boom of the late 1990s. At the same time, the average degree of leverage in these loans -
measured by debt-to-EBITDA ratios2 - has increased substantially. As a result, the credit quality of
issuing companies has deteriorated. It cannot be excluded that certain features of the leveraged loan
markets, such as debtor-friendly re-payment structures and an increasing tendency by lenders to
accept breaches of loan covenants, could have contributed to a perpetuation of the benign credit
cycle, while at the same time increasing the risk of clusters of defaults in the event that liquidity
conditions deteriorate.
Because of the high yields they offer, leveraged loans have become popular assets for inclusion in
complex structured credit derivatives products and the riskiest parts of them are often sold to hedge
funds. Disturbances in the leveraged loan market could therefore also trigger spill-over effects via the
aforementioned "triangle".
Looking ahead, rapidly rising leverage, the increasing recourse to short-term funding and the surging
interest payment burden have left firms' balance sheets vulnerable to adverse disturbances. [see slide
9] Although the increase in euro area corporate sector leverage should be considered in conjunction
with the continued strength of profitability, it seems nevertheless to have contributed to deterioration in
some yardsticks of credit quality. These include a higher proportion of rating agency downgrade
actions than upgrades and a rising number of firms being placed on review for a rating downgrade
visà-vis firms facing a possible rating upgrade. This seems to be at least partly related to the
aforementioned growing LBO, as well as share buyback, activity both of which can weaken the
position of existing corporate debt holders and increase the affected firms' vulnerability to changes in
financing conditions.
A significant deterioration in corporate sector credit quality would not only imply greater loan losses for
banks, but could also trigger an asset price adjustment in credit markets, especially if the frequency of
unexpected idiosyncratic corporate defaults were to rise.
Euro area household sector leverage has reached unprecedented heights. Thus, past experience is
not relevant for assessing its sustainability. Although household sector debt ratios in the euro area on
average have remained lower than those in other mature economies, risks are not evenly spread
across the euro area. Indeed, there are continuing concerns regarding balance sheet vulnerabilities in
countries where debt-ratios are well above the euro area average, especially if debt is predominantly
financed at variable interest rates. [see chart on the left of slide 10]
Regarding risks to household income, survey evidence reveals that euro area households have
become less pessimistic concerning their future employment prospects but have remained pessimistic
about their financial outlook. [see chart on the right of slide 10] All in all, however, considering the
outlook for economic growth, the likelihood of a decrease in household income in the near term is
judged to be low.
On the asset side of euro area household sector balance sheets, price-to-rent ratios in some countries
suggest that a slowdown in the pace of future house price inflation, or even a correction, cannot be
excluded. Banks in many Member States appear, by and large, to have carefully managed the risks
inherent in the collateral used to secure mortgages, even though signs of intensifying competition may
have led to a loosening of credit standards. This means that euro area households would probably
have to bear the brunt of any property price reversal.
III.4 Euro area financial institutions
Turning to developments in the euro area banking sector, the analysis of the sector in this issue of
the Review focuses on the performance of, and outlook for, a set of large and complex banking groups
(LCBGs). The methodology used to identify these institutions, which is far more rigorous than the
methods used in the past, is explained in detail in Special Feature A.
The latest data show that the financial condition of euro area LCBGs continued to improve in 2005 and
the first half of 2006 consolidating the already steady improvement that had been underway since
2003. [see slide 11] The broad-based strengthening of profitability was driven by lending growth,
which compensated for the further erosion in lending margins as a result of intense competition.
Non-interest sources of income also contributed to bottom-line. At the same time, cost-containment
continued and loan impairment charges declined further. Solvency ratios of euro area LCBGs
remained comfortable despite declining slightly in the first half of 2006, which was due to a rise in
risk-weighted assets. From a financial stability perspective, it is encouraging that those institutions with
the lowest capital ratios in the past also improved in the first six months of 2006.
The assessment of credit risks is becoming complicated by recourse to CRT markets. For instance,
the impact of a potential turn in the credit cycle on banks might be more muted than in earlier
downturns, albeit not necessarily on other parts of the financial system since the risks themselves do
not disappear. Other risks facing the banking sector mainly relate to interest rate risks, where the flat
yield curve environment limits banks returns in their core business. There is a concern that this could
encourage them to seek more risky ventures in an effort to boost profits, resulting in increased
operational and counterparty risks from their growing exposure to unregulated financial institutions.
Notwithstanding the risks identified, market analysts are expecting that the profitability of euro area
LCBGs is likely to strengthen further in the short term, underpinned by a favourable economic outlook
and benign credit conditions. [see slide 12]
Forward-looking market indicators for the credit risk of euro area LCBGs reflect this broadly positive
assessment. For instance, the distance-to-default indicator continued to rise, including for the weakest
banks. While this may reflect the low probability assigned by market participants to the materialisation
of the risks and vulnerabilities identified by our analysis, it could also signify a favourable assessment
of the shock-absorbing capacity of the banking system, supported by comfortable solvency ratios and
improved risk management.
Euro area insurance firms have placed greater focus on risk management, risk-adjusted pricing and
core profitability, all of which have continued to support a positive outlook for the sector, especially for
large firms. Ongoing improvements in asset liability management, together with an overall optimisation
of the capital structure have underpinned a generally positive assessment by market participants, as
witnessed by the recent moderate over-performance of the insurance index relative to the broad stock
index. [see slide 13]
However, there are a number of risks facing the industry in the period ahead. For the non-life
insurance sub-sector, increased competition is likely to weigh further on underwriting income, which
could drive further consolidation within the sub-sector. For the life insurance sub-sector, ongoing
challenges include the closing of balance sheet mismatches in an environment of persistently low
long-term interest rates and the effective management of longevity risk.
IV. Overall assessment
Let me now turn to the overall assessment. [see slide 14] The central scenario for euro area financial
stability remains broadly favourable. This is assessment is based on the following four factors:
First, the resilience of the system was confirmed by its ability to comfortably absorb some adverse
disturbances;
Second, global economic activity is becoming more evenly balanced and the gradual shift to less
accommodative monetary policies is proceeding smoothly;
Third, the credit quality of the key counterparties of banks - households and firms - generally remains
high and;
Fourth, euro area banks (LCBGs) are very profitable, their solvency ratios are comfortable and risk
management continues to improve.
Nevertheless, some previously identified sources of risk and vulnerability have grown, and their
relative likelihood could have changed. [see slide 15]
First, a global source of medium-term risk for the stability of the financial system continues to be the
large global financial imbalances, despite some rebalancing of global growth patterns and recent
declines in oil prices.
Second, in global and euro area financial markets long-term yields and credit spreads remain very low,
and thus vulnerable to a reappraisal of risk. At the same time, important risks may be developing -
although they are extremely difficult to quantify - related to credit risk transfer markets in which hedge
funds have become increasingly present.
Third, concerning sectoral risks in the euro area, there has been rapid re-leveraging in some parts of
the corporate sector, induced in part by a surge in LBO activity, and household sector financial
imbalances continue to grow and are especially sizeable in a number of countries.
For these reasons, the comforting central outlook for financial stability should not give rise to
complacency because there are several possible low-probability but potentially high-impact events that
could occur and that would, if they were to crystallise, create material risks for financial stability.
Thank you very much for your attention.