Lucas Papademos: Opening remarks at the press briefing on the
occasion of the publication of the December 2008 ECB Financial Stability
Review
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the press
briefing on the occasion of the publication of the December 2008 ECB Financial Stability
Review, Frankfurt am Main, 15 December 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 December 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 the "cut-off" date of 28 November. The Review
examines in some detail the main trends and events that characterised the euro area
financial system over the past six months and it contains 14 boxes and five special feature
articles that address topical financial stability issues in a more focused and analytical
manner. The central objective of the ECB 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.
For this edition of the Review, we made an additional effort to provide a summary that makes
the key messages of our analysis more accessible. In my presentation, I will broadly follow
this summary, but also provide additional explanations on some of the most topical issues. I
will start with a brief review of the overall impact of the financial market turmoil on the global
banking system and the current macroeconomic outlook. 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 our
overall assessment of risks to euro area financial stability in the period ahead.
II. The financial market turmoil: overview
Since the publication of the previous Financial Stability Review in June 2008, the financial
crisis has intensified. Banks had to absorb further asset valuation write-downs in an
environment where wholesale funding costs remained elevated. At the same time, the global
economic outlook deteriorated and became more uncertain, risk aversion among financial
market participants surged, and the prices of most financial assets fell.
The persistent liquidity stresses in the early phases of the turmoil eventually gave way to
deeper concerns about creditworthiness and the adequacy of capital buffers. Following the
bankruptcy of Lehman Brothers, investors and creditors lost confidence in the ability of some
financial firms to meet their obligations. As a result, many key financial firms faced mounting
challenges in accessing short-term funding and capital markets, which triggered sharp drops
in their stock prices. Some of the world's largest financial institutions were affected by this
adverse dynamic and a number of them were ultimately declared bankrupt, purchased by
other financial institutions, or provided with government support.
Central banks and governments have taken extraordinary remedial actions, which aim at
addressing liquidity stresses and strengthening capital positions, thus contributing to
restoring confidence in and improving the resilience of financial systems. These measures
have succeeded in stabilising the euro area banking system. Over time, as some
government measures are being fully implemented, they should contribute to lowering
funding costs of banks and facilitate the provision of credit to the broader economy.
After these introductory remarks, let me first present the latest available figures regarding the
total turmoil-related income losses and the new capital raised by major global banks since
the beginning of the second quarter of 2007 up to and including the third quarter of 2008.
Over this period, the total mark-to-market losses amounted to USD 720 billion globally. This
figure includes losses related to holdings of structured finance instruments and mortgages
which are reflected either in net income or in the value of equity or in other comprehensive
income.1 As shown in Chart 1, the share of European banks in this total was 37% (or USD
239 billion). Euro area banks reported losses of USD 131.3 billion, which represented 18% of
the global amount. North American banks bore the bulk (59%) of the global mark-to-market
losses.
Within the same period, major global banks raised USD 765 billion in new capital, that is,
more than the losses reported (see Chart 2). The capital raised includes common stock,
preferred stock, and hybrid securities that are accepted as capital by regulators.2 The share
of European banks in the total new capital raised globally is 39% and that of euro area
financial institutions is 18%. These shares are, respectively, somewhat higher or the same as
the corresponding figures for the total losses. However, bank losses in the euro area seem to
be more widely spread across individual institutions than is the case in the US and other
countries. This notwithstanding, the intense stresses that emerged after the failure of
Lehman Brothers raised serious doubts among investors about the asset quality and the
adequacy of the capital buffers of some euro area institutions and resulted in an abrupt and
significant deterioration in money market conditions. Consequently, government and central
bank actions were necessary to help stabilise the banking system.
Since September this year, tensions have increasingly spilled over from the financial sector
to the real economy. In the euro area, a number of the downside risks to economic activity
that had been previously identified materialised. The significant weakening of economic
activity could have a negative effect on borrowers' ability to service their debt and thus on the
credit risk faced by banks.
According to the December 2008 Eurosystem staff macroeconomic projections for the euro
area, global economic weakness will persist in the coming quarters; thereafter we expect a
gradual recovery, supported by the fall in commodity prices and assuming that the external
environment improves and the financial tensions weaken (see Chart 3).
1
Losses related to banks' operating activities are not included, to the extent that investments in related assets can be
segregated from operating losses. If a bank's core business involves mortgage-loan origination, securitisation, or otherwise
requires the firm to hold related assets, these losses are included. Losses from investments in all other banks or firms are
included only if the firms or banks in question are not included in the data used to compute these figures, or if the loss
affects cash flows, as in the case of fixed income securities. Figures are pre-tax and net of any relevant financial
hedges and off-setting gains, unless a bank does not report these factors. Most recorded losses are the quarterly or
accumulated losses that were reported at quarter-end. One important exception is when the company reports provisions for
credit losses and charge-offs. In this case, the year-over-year increase in provisions or charge-offs are used instead, in
order to minimise the impact of normal operations on the figures. Unless it is certain that loan charge-offs are not included in
new provisions for losses, these charge-offs are only recorded for 2007. The underlying assumption is that charge-offs after
the end of 2007 are already included in previously recorded provisions. Some banks do not expect to fully realise these
write-downs, especially in the case of unrealised losses, mark-to-market losses, and loss provisions. Inclusion in the
figures is not meant to imply that the firm has already incurred such losses, and any reversals or realised gains are included
to mitigate the effects on write-down figures.
2
Gains and losses from asset sales (gains/losses from assets sold) and divestitures (value of quantity sold) are also
included. The after-tax gain on asset sales is reported so as to provide a more accurate picture of its effect on equity, if this
data is provided by the firm. Otherwise, pre-tax gains or total proceeds from sales are used. A capital infusion may also be
excluded if sufficient information is not available. Information on write-downs and capital raised is limited by the
In general, data is included from the first quarter in which the bank
individual bank's willingness and ability to report it.
reported related losses on, and the first observations are for Q2/2007.
BIS Review 159/2008
III. Sources of risk and vulnerability
This leads me to the second part of my presentation that focuses on the main sources of risk
and vulnerability that may affect the euro area financial stability outlook over the next six to
twelve months.
III.1 The global macro-financial environment
Let me start with the risks and vulnerabilities we have identified in the global macro-financial
environment. Global imbalances, notably the persistently large US current account deficits
and the recycling of surpluses from emerging Asia and oil-exporting countries continue to
pose substantial risks to global financial stability. The cumulated net capital inflows to the
United States remained relatively stable (as shown in Chart 4), because the lower capital
inflows from private investors were counterbalanced by important official inflows stemming
from the continued accumulation of foreign exchange reserves by major oil exporters and
other surplus economies.
Another important source of risk stems from the US housing market which has been the
epicentre of the financial market stresses. The outlook for US house prices is shown on
Chart 5 using the Case-Shiller futures price indices. The market expects that house prices
will bottom out in 2010, about six months later than had been expected at the beginning of
2008. The narrow index which measures developments in the largest US cities, also
indicates that house prices are expected to drop to a level that is more than 30% below the
peak recorded in mid-2006, before they start to stabilise. Estimates of the existing excess
supply in the housing markets put the housing overhang at around 1 million houses. At the
current rate of housing starts, it would take up to two years to eliminate the excess supply.
Box I of the Review provides a more in-depth assessment of the current and expected future
valuations in the US housing markets.
At the same time, the outlook for the US corporate sector has, on balance, also weakened
substantially. By mid-September, corporate profits growth and default rates had already
deteriorated rapidly. As financing conditions have tightened significantly, even some of the
largest corporations have reported shortages of cash. As shown in Chart 6, the rest of the
world has remained the only positive contributor sustaining corporate profit growth in the US.
It is likely, however, that the slowdown of the global economy will also curb this contribution
in the period ahead, while declining domestic demand will continue to depress corporate
profits.
A further source of risks to financial stability has been the continued worsening of the
average hedge fund investment performance amid prolonged and heightened financial
market volatility. During times of stress, many hedge funds reduced risk-taking and instead
concentrated on capital preservation, either voluntarily, or due to the reduced availability of
bank funding and investor withdrawals. The deleveraging in the hedge fund sector has been
widespread and rapid as illustrated in Chart 7. Looking forward, if hedge funds fail to retain
their investors and cases of hedge fund closure become more frequent, the possibility of
further sizeable position unwinds by the sector may pose a challenge to financial markets.
In a context of global de-leveraging and mounting risk aversion, foreign investors also
markedly reduced their exposures to emerging market financial assets. Persistent turbulence
in financial markets weighed on those emerging economies that rely on external financing to
fund their current account deficits, particularly in Central and Eastern Europe. This is of
relevance for financial stability also in the euro area because of the sizeable cross-border
vis-à-vis
exposures of European banks new EU Member States. The pertinent facts and
potential risks are presented in Box 2 of the Review. The share of assets in new EU Member
States was the highest for banks in Austria, Greece, Sweden, Belgium and Italy, while other
euro area countries were less exposed (as shown in Chart 8). In 2007, the growth of euro
area banks' assets in this region was, on average, 35 percentage points higher than their
total asset growth. Furthermore, given the higher profit margins that can be realised in the
banking markets of new EU Member States the contribution of some euro area banks'
subsidiaries in the new EU Member States to group profits have been substantial. Some
large banks that are active in the region could, therefore, be negatively affected if
macroeconomic conditions in new EU members were to deteriorate.
III.2 The euro area corporate and household sectors
euro area household
In the sector, pockets of vulnerability may have grown in the mortgage
markets, mostly stemming from developments in income and house prices. Regarding the
latter, Chart 9 indicates that house prices in the euro area - with the exception of Germany -
increased more strongly than housing rents over the last decade. The 45-degree line depicts
equal growths rates of house prices and rents. Box 5 of the Review analyses developments
in selected euro area housing markets using a dynamic asset pricing model. The main
findings are, first, that while the bulk of the variability of house price movements can be
attributed to changes in rental yields, a generalised decline in expected returns on housing
investments may permeate the housing markets of all euro area countries, irrespective of the
evolution of fundamentals. A further interesting finding of this analysis is that house prices
tend to overreact to news, especially when fundamentals are deteriorating. While the
ongoing slowdown in the annual growth rate of euro area residential property prices has
remained gradual so far, the possibility of a market overreaction to negative news might well
apply to house price dynamics in some regions at the present juncture.
Euro area non-financial corporations tend to exhibit, at present, stronger balance sheets than
just before the last credit cycle downturn. However, their operating environment has become
more challenging and less favourable than six months ago. In the near term, balance sheets
are likely to deteriorate due to the expected slowdown of earnings growth, in an environment
of weak economic activity, persisting high leverage, and difficult funding conditions for the
corporate sector. Reflecting this outlook, Chart 10 depicts forecasts of private entities which
suggest that the default rates for European firms are likely to rise from the current low level
over the next 12 months.
Many euro area financial institutions have large lending and investment exposures to euro
area commercial property
markets. In most euro area countries, commercial property
inflation continued to decline in the first three quarters of 2008, and prices were even falling
in seven out of the 12 countries for which data are available. Prices were affected by reduced
commercial property investment activity in the latter part of 2007 and in 2008. Chart 11
shows that investment volumes declined by 63% in the third quarter of 2008 compared to the
same quarter of the previous year although wide variations were observed across euro area
countries. As a result of these developments, income risks for many commercial property
investors have increased. Funding costs and risks have also grown, raising costs for
leveraged property investors and, in turn, contributing to the observed negative price
dynamics in some markets.
III.3 The euro area financial system
euro area and other major money
Turning to the euro area financial system, conditions in the
markets deteriorated significantly in mid-September, as the default of Lehman Brothers
fuelled concerns about counterparty credit risk and challenged the widely-held view that any
large bank, which was considered too big or too interconnected to fail, would be supported
by public authorities. This event triggered a sharp increase in the spreads between Euribor
and EONIA swap rates across all maturities (as shown in Chart 12). Banks hoarded liquidity
(or lent only for the shortest maturities) in view of growing concerns about the
creditworthiness of counterparties and heightened uncertainty about their own liquidity
positions. Conditions in money markets in other advanced economies exhibited similar
developments.
Since mid-September, central banks have stepped up the already remarkable levels of
cooperation and provided liquidity in coordinated actions. Moreover, the ECB and also other
central banks have made extensive efforts to provide refinancing at longer maturities and to
expand the lists of assets that are eligible as collateral in credit operations. Not least thanks
to these actions, the recent weeks have seen a noticeable improvement in the euro money
market. For example, in the past week, the spreads between term deposit and overnight
index swap rates declined considerably, by 15 to 20 basis points along all maturities,
reflecting the continued fall in the Euribor rates. The spreads fell to 80 basis points for the
one-month maturity and 160 basis points for the 12-month maturity.
An interesting analysis related to the current problems in the money markets is presented in
Box 7 of the Review which highlights the link between market liquidity and funding liquidity
risk, on the basis of evidence from recent data. The results show that a negative relationship
between high funding liquidity risk and low market liquidity was established only after the
financial turmoil had erupted, while in "normal" times, there is no obvious relationship
between the two measures. This supports the theoretical proposition (advanced by recent
academic research) that interactions between the two measures emerge only when banks
face funding constraints, that is, when shocks to banks' funding liquidity can lead to forced
asset sales and may depress asset prices, with dire consequences for market liquidity.
The tensions in the money market, and more generally the fallout from the financial crisis,
have had a significant negative impact on large and complex banking groups in the euro
area. In the first three quarters of 2008, their profitability suffered further due to the
unfavourable financial market conditions and, increasingly, by rising credit costs (i.e.
gradually increasing provisions and loan losses). Chart 13 shows that the wide dispersion in
the rate of return on equity across euro area LCBGs observed in the second half of 2007
persisted also in the first three quarters of 2008. Institutions in the lowest quartile of the
profitability distribution of these major banks continued to see significantly lower profitability.
Moreover, those LCBGs that suffered substantial losses in the second half of 2007 remained
among the weakest ones in the first three quarters of 2008.
At the same time, however, the regulatory capital buffers of euro area LCBGs improved
moderately as a consequence of additional capital raised and slower growth in risk-weighted
assets (as shown in Chart 14). While this was largely due to the actions of individual banks
aimed at reducing risks in their balance sheets, it also reflected, to a certain degree, the
impact of the implementation of Basel II. In addition, some of the newly attracted capital
came in the form of hybrid financing which is reaching prudential limits. Nevertheless, the
actions that have been taken by governments and central banks since October 2008 to
support the banking systems in euro area countries, despite comfortable solvency ratios,
highlight the perceived fragility of the global financial markets.
Box 9 of the Review analyses alternative ways in which LCBGs can reduce leverage in the
process of restoring their balance sheets. It shows that by cutting their dividend pay-out
ratios, LCBGs could generate rather substantial additional capital buffers. On the other hand,
if the banks decided to de-leverage mainly by shedding assets, this could imply a sharp
contraction of credit to the private sector. It is therefore essential that banks use available
opportunities to raise new capital, either from private sources or from the public funds
provided by governments in the euro area.
The outlook for euro area insurers also deteriorated, as financial performance has weakened
and some pre-existing risks facing the sector increased and some started to materialise.
Investment income was reduced by the falling values of structured credit products, corporate
bonds and equities. In addition, some insurers suffered losses on investments in commercial
property. All in all, the information available for the first nine months of 2008 suggests that
the shock-absorption capacity of euro area insurers in terms of their solvency positions has
not been significantly affected, which should help them to cope with the possible
materialisation of the risks they face.
The size of euro area insurers' exposures to structured credit products differ considerable
across institutions, as shown in Chart 15. In some cases, exposures to non-sub-prime
structured credit products are rather large. This is a source of vulnerability in the event that
the credit market problems were to affect also the valuations of prime or near-prime
assetbacked securities. Since insurers can hold investments until maturity (to back liabilities), the
key risks from insurers' credit exposures are not temporary losses in value but defaults.
Nevertheless, sharp downgrades of the ratings of structured credit products could force
insurers to reduce their holdings or recognise impairments, which would affect their results
and capital positions.
A summary measure of the risks faced by the euro area banking sector is provided by a
market-based systemic risk indicator which is depicted in Chart 16. In September 2008,
systemic risk increased sharply, driven by a further widening of banks' credit default swap
(CDS) spreads. However, it is important to emphasise that, since July 2008, participants in
the CDS market have started to increasingly discriminate across institutions. This could be
seen as first sign that the market is on its way to a gradual recovery, because the market no
longer "penalises" all banks across the board with similarly high spreads. That said, CDS
spreads are likely to remain high for some time to come. Following a series of defaults or
near defaults of several global financial institutions after September 2008, the systemic risk
indicator decreased substantially, as central banks took coordinated actions, guarantee
schemes were approved and some euro area LCBGs were recapitalised. Nevertheless, the
indicator has remained above the levels of summer of 2008, which suggests that market
participants continued to assign a relatively high probability to systemic defaults by both euro
area and global LCBGs.
The extraordinary measures that have been taken by central banks and governments since
October 2008 are summarised in the table on this slide and are described in detail in the
Review. In the euro area, the actions taken and the commitments made have helped to
stabilise the banking system and should further mitigate counterparty credit risks from trading
in the unsecured interbank money markets. Over time, and once they have been fully
implemented, these measures should improve the functioning of the term money markets
and the access of banks to wholesale funding markets. This should lower the cost of bank
funding and facilitate the provision of credit to the economy. That said, in order to revive the
process of efficient financial intermediation, financial institutions will need to play their part in
the adjustment process by taking advantage of these measures to effectively recapitalise and
repair their balance sheets.
IV. Overall assessment
Let me conclude with our overall assessment of financial stability at the current juncture: the
euro area financial system has undergone a further significant test of its shock-absorbing
capacity since the finalisation of the June 2008 Financial Stability Review. At the same time,
there are a number of risks and vulnerabilities lying ahead with which the financial system
may have to cope, notably the possibility of:
•
a further deterioration in the US and the euro area housing markets and the impact
this may have on banks' loan quality and the value of securities backed by
mortgage-related assets;
•
a deeper and more prolonged slowdown in both the global and the euro area
economy than currently expected that could cause a sharper and broader
deterioration in borrowers' ability to service their debt;
• a more pronounced de-leveraging by banks, due to persistently high funding costs
and concerns about the adequacy of capital buffers, which could negatively affect
the flow of credit extended to the broader economy; and
•
an increase in financial market volatility caused by a further unwinding of positions
by hedge funds.
All in all, given the risks that lie ahead, banks will need to be especially watchful in ensuring
that they have adequate capital and liquidity buffers in place to cushion the challenges
ahead.
Thank you very much for your attention. I am now at your disposal for questions.
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