Luis de Guindos: Financial stability in the euro area
Welcome address by Mr Luis de Guindos, Vice-President of the European Central
Bank, at the meeting of the Council of Presidents of BusinessEurope, Madrid, 1 June
2023.
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Yesterday we published the latest edition of the ECB's Financial Stability Review, which
is issued twice a year. In my remarks today, I will provide you with the main findings of
our analysis.
Two key developments have shaped the macro-financial environment over the past six
months. First, there has been some improvement in the growth and inflation outlook
since late last year. Macro-financial conditions have improved on the back of a robust
post-pandemic recovery, fading global supply chain disruptions and lower energy
prices. At the same time, the outlook remains fragile, given downside risks to growth
and relatively sticky core inflation.
A second key recent development concerns financial turbulence witnessed this spring,
with the spotlight increasingly turning on systemic risk concerns following bank failures
outside the euro area. Strains in the US and Swiss banking sectors in March introduced
an element of stress into a highly uncertain environment. While the fallout experienced
by euro area banks was limited, these events have served as a timely reminder of just
how much the preservation of financial stability depends on the shock-absorption
capacity of the financial system. All the more so in an environment where financing
conditions are being tightened to tackle elevated inflation around the world.
Framed by these recent developments, our current assessment is that financial stability
vulnerabilities in the euro area remain elevated.
Tighter financing conditions to address high inflation have contributed to a reappraisal
of the economic outlook alongside an orderly reversal of overly compressed asset price
risk premia.
Euro area bank fundamentals are solid, thanks to the strength of banks' capital and
liquidity buffers under stringent regulation and supervision. At the same time, continued
improvements in asset quality and profitability are contributing to bank resilience.
But there is no room for complacency.
Bank liquidity challenges could yet intensify. Rolling over maturing bonds is pushing up
banks' market funding costs, while competition for deposits is likely to rise and translate
into faster deposit repricing. Haircut and margining risk has also increased due to
higher volatility in government bond markets. Muted economic growth and signs of
weakening credit quality pose downside risks to bank earnings. The outlook for banks
has thus become more uncertain, with liquidity asset quality concerns surfacing.
The non-bank financial sector could also see such risks. While this sector has remained
resilient during the recent banking sector stress and market volatility, its exposure to
liquidity and credit risks remains high. If investment funds were to experience any
sudden liquidity needs, they could amplify adverse market dynamics via procyclical
selling behaviour and forced asset sales, thereby introducing risks to wider financial
stability. Strains in the non-bank sector, which is an important source of bank funding,
could also give rise to additional banking sector vulnerabilities via liquidity and credit
risk spillovers.
Past events, such as the pandemic-related turmoil in March 2020 and the UK gilt
market stress in the autumn of 2022, also vividly illustrate how non-banks can amplify
margin call dynamics in the wider financial system, especially when coupled with
excessive leverage.
On the side of the non-financial sector, the improvement in macroeconomic
developments I noted at the outset have provided key support. At the same time, our
assessment underpins how tighter financial conditions are testing household, corporate
and sovereign resilience.
A strong labour market with unemployment at historical lows has supported household
income. But higher interest rates and the squeeze in real income due to high inflation
are increasingly compromising household debt servicing capacity. This is reflected in an
increase in consumer loans classified by banks as suffering a significant deterioration in
credit quality.
Robust revenues and high profit margins have contributed to strong corporate results.
But firms are also being challenged by tighter financing conditions and the
repercussions in terms of the availability and cost of funding. Euro area firms have
benefited from high profits on the back of a sharp post-pandemic recovery and lower
energy prices. Yet not all firms have benefited equally from the recovery. Highly
indebted, energy-intensive and pandemic-sensitive sectors have often been unable to
increase profit margins. Adverse developments in the corporate sector would have
knock-on effects on bank balance sheets and household employment prospects.
Turning to sovereigns, short-term fiscal pressures remain contained. But medium-term
challenges are adding to financial stability risks. Fiscal fundamentals remain fragile in
some euro area countries, given their high debt levels, rising funding costs and high
short-term refinancing needs. As government bond yields have increased sharply
across the euro area, higher funding costs will ultimately weigh on sovereigns. At the
same time, higher than expected deficits combined with lower growth are limiting fiscal
space and may put debt dynamics on a less favourable path, especially in countries
with high debt levels.
In view of all of the above vulnerabilities, it is clear we are seeing a general turning of
the financial cycle. This is also becoming increasingly evident when looking at the euro
area real estate sector. A clear downturn is visible in commercial property markets,
while after several years of expansion, signs of correction - albeit far less pronounced -
are also now apparent in the residential property market.
While an orderly price correction in residential real estate might be warranted, a
disorderly fall in prices would pose systemic risks. Rising interest rates on new
mortgage lending would increasingly compromise affordability and add to the interest
burden on existing mortgages, especially in countries where variable-rate mortgages
predominate.
At the same time, valuations have continued to decline in commercial real estate
markets in the euro area. An even more pronounced adjustment in such markets could
expose structural vulnerabilities in some open-ended property funds, increase credit
risk for lenders and lower collateral values.
Let me conclude.
Against the background of low growth, high inflation and rising interest rates, signs of a
turn in the financial cycle are clearly emerging.
As the likelihood of financial stability risk materialising has increased, the Financial
Stability Review notes that, in the light of elevated uncertainty amid accumulated
vulnerabilities and a turning financial cycle, macroprudential policy should continue to
focus on ensuring the resilience of the financial system. While there are some
indications of credit supply tightening, driven by higher risk perception and funding
costs, capital requirements are not constraining bank lending, as banks continue to
exhibit sizeable capital headroom.
In fact, many euro area countries have enhanced macroprudential policies since the
pandemic, which has also helped greatly to strengthen bank resilience. Maintaining
macroprudential buffers now preserves the ability of authorities to release such buffers
in response to potential future shocks and support the supply of key services to the real
sector at that time.
Turning to the non-bank financial sector, the increasing risks posed by this lightly
regulated sector, with strong links to banks, requires a comprehensive macroprudential
approach to address structural vulnerabilities, notably in investment funds - especially
targeting liquidity mismatches and overall leverage.
The stress in US and Swiss banking markets has highlighted structural fragilities and
demonstrated the greater speed at which liquidity problems can emerge in the financial
sector. At the same time, it has revealed that the incomplete banking union is a source
of vulnerability for Europe's banking sector. The lack of a complete banking union still
represents a very wide gap in the EU's institutional framework.
Thank you for your attention.