Lucas Papademos: ECB Financial Stability Review June 2008 - opening
remarks
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 2008 ECB Financial Stability
Review, Frankfurt am Main, 9 June 2008.
* * *
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 2008 edition of the ECB Financial Stability Review. The financial
stability assessment contained in the Review has been prepared with the close involvement
of the ESCB Banking Supervision Committee. It is for the most part based on information
that was available up until 8 May, the "cut-off" date for this Review.
It is now ten months since the eruption of the market turmoil which was triggered by the
surge in delinquencies on US subprime mortgages. The financial systems of the euro area
and other advanced economies are still undergoing further adjustment as the processes of
risk repricing and de-leveraging continue. The stresses on financial systems have persisted
longer and they have become broader and deeper than anticipated six months ago.
Although there have been some signs of easing tensions in certain markets since mid-March,
elevated pressures remain in others, notably in the term money markets of major currencies.
Moreover, high uncertainty surrounds the future dynamics of property and other asset prices,
the magnitude of possible further asset valuation write-downs by financial institutions and the
effects of the market turmoil on the broader economy.
Let me recall that the primary objective of the ECB's Financial Stability Review is to identify
the main sources of risk and vulnerability to financial system stability and to provide a
comprehensive assessment of the capacity of the euro area financial system to absorb
adverse disturbances. The June 2008 issue of the Review also examines in some detail the
main trends and events that characterised the operating environment of the euro area
financial system over the past six months and it contains 17 boxes and three special feature
articles that address topical financial stability issues in a more focused and analytical
manner.
I will start my presentation with a brief review of the current state of some parts of the global
financial system that have been significantly affected by the ongoing financial market turmoil.
I will then examine the risks and vulnerabilities in: (1) the global macro-financial environment;
(2) the euro area corporate and household sectors and; (3) the euro area financial system.
Finally, I will conclude with the overall assessment of risks to euro area financial stability in
the period ahead.
II. The financial market turmoil: overview
Over the past two months, money, credit and other financial markets appear to be sending
mixed signals. The term money market spreads between euro deposit and EONIA swap
rates have remained high and close to record levels, for maturities from three to twelve
months (as shown in the left chart of slide 3). There was a considerable easing of tensions in
the money markets at the beginning of this year in the wake of extraordinary measures taken
by central banks in the context of year-end concerns last December. But new strains
emerged in advance of the first quarter of 2008 and money market spreads in the euro area
and elsewhere reached record levels, especially during the Bear Stearns collapse and
rescue. After that, an easing of counterparty credit risk worries has been observed but very
large liquidity risk premia have remained in money market interest rates. Tensions in the
term money market continue to be a global phenomenon. Currently, the spreads between
three-month deposit and overnight-indexed swaps (OIS) rates are virtually the same in the
euro, US dollar and pound sterling money markets, although pressures have somewhat
eased in these latter two markets in recent weeks (as shown in the right chart of slide 3). In
the credit markets, greater risk awareness by banks and increased bank funding costs have
been reflected in the significant and general further tightening of lending standards in the
euro area, the US and the UK.
At the same time, credit default swap (CDS) indices in Europe and the US have declined
since mid-March (as shown in the left chart of slide 4), corporate bond spreads have
narrowed across-the-board, and the availability of bank credit to households and
nonfinancial corporations has not been significantly affected by the financial market turbulence.
Moreover, the functioning of the leveraged loan market is showing some tentative signs of
improvement.
The narrowing of the CDS spreads of financial institutions, which reflects an easing of
concerns about counterparty credit risk, and, at the same time, the persisting high levels of
term money market spreads may appear to be a puzzle at first sight. One way of reconciling
these seemingly mixed messages is to examine the relative contributions of counterparty risk
and liquidity risk factors to money market spreads. A decomposition of the one-month euro
area term money market spread into counterparty credit risk and other components, mainly
liquidity risk, is plotted in the chart on the right of slide 4. It shows that the role of credit risk
seems to have diminished, while the contribution of other factors increased after mid-March,
as liquidity concerns in money markets rose following the collapse of Bear Stearns, which
induced banks to hoard more liquidity. Box 10 of the FSR elaborates on these issues.
With regard to the impact of the market correction on bank profits, you may recall that
towards the end of last year, there was optimism that the extent of the size and spread of the
costs of the turmoil across financial institutions and financial systems would be largely known
once audited full-year 2007 financial statements had been published. As it turned out, the
write-downs disclosed by many financial institutions went far beyond the expectations of late
last year. The chart on the left of slide 5 shows that although major euro area banking groups
did report large write-downs, these were significantly smaller than the income losses
disclosed by their European peers from outside the euro area and by large US banking
groups. After the disclosure of full-year 2007 financial statements, more write-downs were
expected to be revealed over the following few quarters, and these expectations were
broadly confirmed by the financial results for the first quarter of 2008.
This brings me to one key lesson from the turmoil, namely that full and meaningful disclosure
of exposures and losses is desirable, in order to reduce market pressures and restore
confidence in financial institutions globally. It was precisely the lack of knowledge about
banks' exposures and the great uncertainty about the valuation of these exposures which
were key factors with pronounced impact on market indicators throughout the episode thus
far. To illustrate this point, the chart on the right of slide 5 shows the CDS spreads for global
and euro area large and complex banking groups (LCGBs): they increased after the start of
the turbulence, and further widened sharply towards the end of 2007 and in early 2008.
Subsequently, they narrowed again significantly in conjunction with the more comprehensive
reporting of banks' financial results, with the measures taken by the Federal Reserve in
March and also with the indications that the financial institutions most hit by the turmoil were
taking determined action to restore their balance sheets. That said, we should not
overinterpret these positive developments in CDS spreads as signs of banks' improved
creditworthiness. There are a number of risks with potentially adverse effects on banks'
profitability and capital positions.
II. Sources of risk and vulnerability
This leads me to the second part of my presentation, namely the main sources of risk and
vulnerability that may affect the euro area financial stability outlook over the next six to twelve
months.
II.1. The global macro-financial environment
Starting with the global macro-financial environment, future developments in the US housing
market remain a crucial determinant of the financial stability outlook also for the euro area.
Two interrelated factors are of relevance in this respect: first, the likelihood that
delinquencies on residential mortgages and foreclosures may rise in the coming quarters
and, second, the future trajectory of US house prices. The factors that will affect US house
prices in the period ahead include an overhang of unsold homes, which is close to its highest
level in decades and which could increase further because delinquencies are likely to rise in
the course of 2008. That said, the uncertainty surrounding the future course of US house
prices is considerable and there is a very wide range of estimates of the total losses that
financial systems will eventually have to absorb. The chart on the left side of slide 6 shows
that the futures prices for the S&P500/Case-Schiller index imply an expected significant
further fall in US house prices during 2008 and 2009. These futures prices factor in a
peakto-trough decline of close to 30%.
Conditions in the US housing market could deteriorate further in the course of 2008 because
around two-fifths of the outstanding stock of subprime adjustable rate mortgages (ARMs) are
scheduled to reset to higher interest rates during the year and the credit quality of these
mortgages is known to be inferior to the ARMs that were reset in 2007. Even though the
Federal Reserve cut interest rates by a cumulative 3.25 percentage points since summer
2007, which has lowered the rates to which these mortgages will reset, repayment burdens
are expected to increase and, hence, delinquencies and foreclosures are likely to rise in the
period ahead. The chart on the right of slide 6 illustrates the paths of subprime mortgage
rates under different money market rate assumptions. Box 1 of the Review elaborates on the
relationships between money market rates, mortgage resets and delinquencies.
In assessing the potential implications of such future developments on the financial system, it
is important to take into account that the affected related securities have already priced in a
rather severe scenario for US house prices and that financial firms have taken much of the
implied losses through their income statements.
A further source of risk to the financial stability outlook is the potential of a broadening of
stresses in the credit markets, which could thereby amplify the deterioration in the credit
cycle. The sources of potential pressure relate to both the household and the corporate
sectors. Let me mention three:
•
First, so-called charge-offs1 and delinquencies on US consumer loans other than
sub-prime mortgages continued to rise until the end of the fourth quarter of 2007
(the latest observation available) which indicates a deteriorating financial position of
households and a declining capacity to service their debts.
•
Second, there are signs that conditions in commercial real estate markets are
weakening on both sides of the Atlantic. The significant tightening of lending
standards especially for commercial real estate loans (as shown on the chart on the
left of slide 7), can be expected to accelerate unfavourable developments in a sector
to which bank exposures are relatively large.
•
Third, although the balance sheets of US firms are considerably stronger than they
were before the last credit cycle downturn, the significantly tightened credit
standards and financing conditions will cause firms that have very low profitability
and are highly-leveraged to face debt-servicing problems. This, in turn, increases
the probability of corporate defaults Indeed, rating agencies are predicting a surge in
defaults by both US and euro area speculative-grade firms in the near term. Past
experience also strongly suggests that the persistent and substantial rise in oil
prices can further contribute to a higher probability of corporate defaults. All these
developments and expectations have resulted in a widening of spreads on
investment-grade corporate bonds since the turn of the year, as shown on the right
side of slide 7. Although these spreads have narrowed considerably since
midMarch, they have remained at high levels.
Finally, global financial imbalances, while still a matter for concern, seem to have diminished
somewhat, reflecting macroeconomic developments especially in deficit countries. In
particular, the US current account deficit narrowed to 5.3% of GDP in 2007 - the first decline
since 2001 - and is projected to diminish further in 2008. Nevertheless, the prospect of a
continued gradual correction remains fragile. Looking forward, the main source of uncertainty
relates to the durability of current account developments, notably in deficit economies, and
particularly when considering developments in oil prices and financial markets.
Turning to other risks in global financial markets, a significant factor behind the loss of
market liquidity in the second half of 2007 was the rapid and substantial de-leveraging
imposed on the hedge fund sector as prime brokers tightened margin requirements and
terms on their lending for the funding of leveraged positions. Nevertheless, the hedge fund
sector proved remarkably and unexpectedly resilient in the first phases of the turbulence. An
important reason for this was that exposures of the sector to the sub-prime and related
securities markets appear to have been more limited than initially feared. Other reasons put
forward included, first, a much narrower, and therefore more specialised, investment scope
than that of banks allowing more focused risk management approaches and, second, the
alignment of hedge fund managers' incentives with those of investors due to the
coinvestment of their own money (see chart on the left of slide 8).
As growing uncertainties about possible adverse second-round effects of the market turmoil
on real economic activity started to percolate into broader asset markets - especially
highgrade corporate credit and equity markets - in early 2008, hedge fund performances began
to suffer, as shown in the chart on the right of slide 8, and incidences of failure rose. Hedge
fund losses have set in motion a further round of de-leveraging and prime brokers may
further raise margin requirements on collateralised lending. Hence, at present, the risks to
financial market stability related to growing balance sheet vulnerabilities within the hedge
fund sector seem to have increased.
II.2. The euro area corporate and household sectors
After this review of the global aspects of our financial stability assessment, let me now turn to
risks and vulnerabilities in the euro area non-financial sectors. The first - positive -
observation is that most available financial market indicators suggest that the balance sheets
of euro area firms have remained reasonably strong. Firms seem to have been able - so far
- to weather the financial market tensions and deteriorating macroeconomic outlook that
have continued to adversely affect the global economy. Looking ahead, however,
corporations could face problems absorbing further shocks to their balance sheets as net
income growth could be levelling off and financing costs and leverage have continued to
edge up over the recent past.2 In particular, also in the euro area a fringe of highly-leveraged
firms with very low profitability are expected to face much higher refinancing costs than
before. As already mentioned, rating agencies currently expect an increase in default rates
by European speculative-grade firms in the period ahead as shown in the left chart of slide 9.
Another source of vulnerability stems from the euro area commercial property markets where
the overall outlook remains uncertain. Downside risks have increased and may have started
to materialise. Higher funding costs and stabilising or, in some cases, falling property prices
have reduced investor demand which could further weaken (as shown in the chart on the
right of slide 9). Demand has fallen most in those countries where investment volumes have
grown rapidly during recent years and where property prices have started to stagnate or fall.
Moreover, the deteriorating economic outlook in some parts of the euro area has the
potential to negatively affect demand for rented commercial property, thus increasing
vacancy rates and lowering rents. In addition, the market turmoil has had a sizeable impact
on the issuance of commercial real estate-backed securities.
In our overall assessment, highly-leveraged firms and commercial real estate corporations
may entail significant risks to euro area financial stability not only because of potential asset
price reversals, but especially because several euro area large and complex banking groups
have large lending and investment exposures to these corporations. Developments in these
sectors therefore need to be closely monitored in the period ahead.
For euro area households, the property market is of particular relevance. Residential
property prices in the euro area as a whole continued to rise at a moderating rate, as is
shown in the chart on the left of slide 10. Despite the recent moderation in house price
inflation in the euro area on average, there are still indications of increasing overvaluation in
the residential property market in some member states during the past six months (as can be
derived, for instance, from house price-to-rent ratios). In those countries where overvaluation
appears to be most acute, the housing market represents a source of risk to household
sector balance sheets. From a broader financial system perspective, lending to households -
even though on a declining path - remains an important business for most euro area banks.
For some of them, loans to households represent a sizeable proportion of their overall loan
portfolios and total assets, as shown in the chart on the right of slide 10. Hence, household
sector net worth and creditworthiness - which at the euro area level remain rather
comfortable despite the existence of previously identified pockets of vulnerability - are
important in assessing the overall risk profile of these institutions.3
II.3 The euro area financial system
For the assessment of the financial stability outlook, the euro area large and complex
banking groups are of particular importance. The disclosure of their full-year 2007 financial
results revealed that the subprime-related turmoil has had a material impact on their
profitability. In fact, banks' profitability declined for the first time since 2003. The good news
is that their capital buffers remained largely intact in 2007. Looking ahead, it can be expected
that the profitability of these institutions will be adversely affected this year as the process of
de-leveraging continues and as spillovers to asset markets and the real economy
materialise. The expected slowdown in profit growth - which is shown in the chart on the left
of slide 11 - is a consequence of possible further valuation losses, increased funding costs,
as well as declining non-interest income from securitisation and capital market activities.
Since the financial market turmoil has not led - thus far - to a material erosion of the capital
buffers of euro area large and complex banking groups, there appears to be only a rather low
risk of a significant shortage of credit in the economy as a result of de-leveraging on the part
of these institutions. Up to now, banks have responded to the market turmoil and the
resulting exceptionally challenging operating environment by retrenching from risk-taking.
Banks have tightened their credit standards, as shown in the chart on the right of slide 11,
either by limiting, or by even cutting, exposures to riskier business lines, such as commercial
real estate lending, leveraged buy-out financing and the provision of prime brokerage
services to hedge funds.
For euro area banks, the financial market turmoil has underlined the importance of an
adequate management of funding liquidity risk. In particular, many euro area LCBGs
continue to show a positive customer funding gap and the median funding gap even
increased in 2007. Although there are wide differences across LCBGs, with some large
banks maintaining a deposit surplus or a relatively narrow positive funding gap, overall large
euro area banks have become more vulnerable to adverse changes in the cost of, and
access to, market-based funding.
The sharp increase in the spreads of bonds issued by banks suggests that debt issuance
could have become very expensive for many lower-rated banks. Moreover, the decline in
banks' issuance of medium and long-term debt, as well as the significant decline in
securitisation activities, may also result in a decrease in the average maturity of banks'
liabilities, thereby possibly increasing rollover risk. The chart on the right of slide 12 shows
that recent debt securities issuance activity by euro area MFIs indicates a slowdown in
longterm debt issuance coupled with a rapid rise in short-term debt issuance. Overall, these
developments in capital markets have accentuated the pressures towards tighter financing
conditions for banks.
Finally, in the euro area insurance sector developments have been generally favourable .
Insurance companies had relatively limited exposures to structured credit products
associated to US sub-prime mortgages, and, as a result, most of them faced limited
writedowns in the second half of 2007, especially when compared to those recorded by many
euro area large and complex banking groups (as shown in the chart on the left of slide 13).
Exposures to other, non-sub-prime, structured credit products are, however, in some cases
large. They therefore constitute a source of vulnerability in the event that credit market
problems were to spread further. Moreover, some euro area insurers could face losses from
their links to the troubled US "monoline" financial guarantors, which are discussed in detail in
Box 4 of the Review. As illustrated in the chart on the right of slide 13, some euro area
insurers have (i) built up rather large exposures to securities insured by financial guarantors,
(ii) invested in the guarantors themselves, or (iii) used the financial guarantors as a source of
reinsurance.
III. Overall financial stability assessment
Let me conclude my presentation with the overall assessment of euro area financial stability,
as we see it at the current juncture. The information which has become available since the
December 2007 Financial Stability Review suggests that the global and euro area financial
systems have undergone further substantial adjustment to the financial turmoil. In the euro
area, asset valuation write-downs disclosed by large banking groups in 2007 materially
impacted on their profitability, but their capital buffers have been maintained largely intact.
Some of the risks to euro area financial system stability previously identified have
materialised, and risks on balance have increased over the past six months, for several
reasons, including:
1. conditions in the US housing market have further deteriorated;
2. the valuation losses endured by mature economy banking systems were larger than
anticipated six months ago; and
3. banks have tightened their lending standards significantly.
The current financial stability outlook is highly uncertain and will depend, inter alia, mainly on
the following three factors: first, how conditions in the US housing market develop; second,
how banks respond to a much more challenging operating environment; and third, the extent
to which initiatives and measures aimed at restoring confidence and strengthening financial
system resilience are eventually implemented.
It is probable that the adjustment process within the financial system will be protracted as
banks continue to strengthen their liquidity and capital positions. This means that balance
sheet expansion is likely to be somewhat curtailed in the period ahead. In a negative
scenario, the adjustment could risk perturbing the smooth intermediation of credit in the
economy. So far, however, the availability of bank credit to households and non-financial
corporations has not been significantly affected by the financial market turbulence. At the
same time, the financial system may be more vulnerable than before to the crystallisation of
other risks that have been identified in previous issues of the Review and that remain
relevant.
Given the heightened uncertainty and an environment in which balance sheet conditions
could change unexpectedly, vigilance by financial institutions and market participants is of
the essence and those with relevant exposures will need to step up their efforts to effectively
manage the risks that may lie ahead.
I would like to conclude on a positive note by recalling that the losses disclosed so far by the
financial institutions affected by the turmoil are mostly mark-to-market losses on
hard-tovalue assets. If the outturns for implied credit losses ultimately prove less severe than
currently expected, then it cannot be ruled out that those financial firms still holding these
assets will see some offsetting valuation gains in their portfolios.
Thank you very much for your attention. I am now at your disposal for questions.
BIS Review 75/2008
BIS Review 75/2008
BIS Review 75/2008
BIS Review 75/2008
BIS Review 75/2008
BIS Review 75/2008
BIS Review 75/2008