Luis de Guindos: Key vulnerabilities for euro area financial stability
Remarks by Mr Luis de Guindos, Vice-President of the European Central Bank, at the meeting of
the Financial Stability Contact Group, Frankfurt am Main, 2 October 2019.
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Let me start by thanking you all for participating in this meeting of the Financial Stability
Contact Group. These meetings are a key feature of the ECB's market intelligence gathering
activities.
The financial stability environment has certainly remained challenging since this group last
met in March. The global economic outlook has worsened since then, and political and policy
uncertainty has increased in a number of areas.
Taking this into account, we continue to see four key vulnerabilities for euro area financial
stability: (i) first, a risk of mispricing of some financial assets; (ii) second, high public and
private sector indebtedness in several countries; (iii) third, in view of banks' subdued
profitability outlook, we see a risk of hampered bank intermediation capacity; and (iv) fourth,
vulnerabilities stemming from increased risk taking in the non-bank financial sector. We see
the likelihood of these vulnerabilities unravelling in a disorderly manner over the next 18-24
months as remaining largely unchanged. This is because the now widely expected
"lowerfor-longer" interest rate environment mitigates many of the possible triggers for corrections
over the short to medium term.
Let me expand a little on these vulnerabilities:
Repeated downward revisions to the economic outlook and accommodative monetary policy
actions on both sides of the Atlantic have put downward pressure on global bond yields
across the whole maturity spectrum. For the first time in history, large parts of the yield
curve for many euro area sovereign bonds, in particular those issued by governments with
high credit ratings, have entered negative territory.
It is often said that low or negative interest rates inflate asset prices as investors search for
yield and take on more credit and duration risk. Equity and corporate bond prices, for
instance, have appreciated across the globe over the past decade as yields have followed a
path of long-term decline. Abrupt corrections, especially in equity markets and markets for
lower-rated bonds remain a risk, particularly in the face of high economic and political
uncertainty.
Low funding costs can encourage firms to increase their leverage, which might intensify
vulnerabilities in the event of an economic downturn. This risk has increased as the
economic outlook has worsened and the share of triple-B ratings has grown.
Concerning the second vulnerability, in several countries debt in the public and/or
nonfinancial private sectors is lingering at levels that are high by historical and international
standards. This leaves public and private finances exposed to the risk of a sudden change in
market sentiment or deteriorating macroeconomic conditions.
Third, parts of the banking sector continue to exhibit weak performance. Banks have
improved their capital positions and profitability since the euro area crisis, and the stock of
non-performing loans continues to decline at a moderate pace. But further improvements
are needed in parts of the banking sector if banks are to achieve sustainable rates of return.
In particular, overcapacity and cost inefficiencies weigh on many banks' long-term
profitability prospects. The better performance of some banks within the euro area, and in
jurisdictions facing similar economic and financial conditions, illustrates the importance of
addressing structural issues.
The current interest rate environment has various implications for the resilience of the
banking sector. Banks have benefited, and will continue to benefit, from the lower credit risk
for borrowers, and from the higher asset valuations associated with lower interest rates and
better macroeconomic outcomes. This has helped support bank profitability across the euro
area since the deposit facility rate turned negative in 2014. However, the negative interest
rate policy also entails costs for banks, and these could increase the longer negative rates
are in place, the lower policy rates are set and the larger the amount of excess liquidity held
by banks.
These vulnerabilities could crystallize if economic growth is much weaker than expected, or
if weak growth persists for longer than expected. We thus welcome the measures taken by
the banking sector in recent years to improve resilience, and support efforts to further
strengthen resilience while conditions are benign.
There are also vulnerabilities in the non-bank financial sector, which has significantly
expanded its role in financing the real economy in the euro area. Total assets held by
nonbanks have almost doubled over the last ten years, growing from €23 trillion in 2008 to €42
trillion in 2018, while the size of the banking sector stagnated over this period. Non-banks
currently account for around 55% of the euro area financial sector. While a larger non-bank
financial sector has the benefit of helping to diversify the funding sources available to the real
economy, it may also entail rising risk taking in the current market environment.
We are closely monitoring two developments in this context: first, non-bank financing activity
is growing, in particular in higher credit risk corporate financing, where indebtedness is
already higher. Second, as institutional investors are searching for yield, they may amplify
the cyclical underpricing of risk, potentially also taking on more leverage and liquidity risk.
In the euro area investment fund sector, we have observed increasing liquidity risk for some
time. This reflects a falling share of holdings of liquid government bonds and a fall in cash
holdings across the sector. We have recently witnessed cases in which funds holding
considerable amounts of illiquid assets (Woodford, H2O and GAM - all UCITS funds) faced
severe difficulties in dealing with large-scale outflows. These cases had no systemic
repercussions - partly because the outflow triggers were idiosyncratic and partly because
the market environment was benign.
In a more broad-based market downturn, though, we would be concerned that a repricing of
financial assets could trigger sudden and large redemptions from these funds, possibly
resulting in forced asset sales, which could amplify stress in less liquid markets. This would
have wider implications in the form of impaired market liquidity and possible spillovers to the
real economy.
While leverage in the euro area fund sector is low on average, there are also pockets of high
leverage among some types of alternative funds, and these need to be monitored closely.
Even if leverage of UCITS funds is not excessive, it can still add to the procyclical selling of
assets if a fund tries to keep its leverage constant during periods of stress.
I hope that gives you a good perspective on our current assessment of financial stability
risks. I look forward to hearing your own views on these and other vulnerabilities for the euro
area financial system.