Market developments potentially requiring the use of Article 459 CRR

This report is to inform the European Parliament and the Council on market developments potentially requiring the use of Article 459 of the Capital Requirements Regulation (CRR) in the past year. It is based on an assessment provided by the European Systemic Risk Board (ESRB).

1.Background

Article 459 CRR provides that the Commission, assisted by the ESRB, has to submit a report, at least on an annual basis, to the European Parliament and the Council on market developments potentially requiring the use of this Article. Pursuant to Article 459 CRR, the Commission may impose, for a period of one year, stricter requirements concerning the level of banks' own funds, large exposures, or public disclosure, under specific conditions, in particular upon the recommendation or the opinion of the ESRB or EBA. The required conditions are that these measures are necessary to address changes in the intensity of micro-prudential and macro-prudential risks which arise from market developments in the Union or outside the Union affecting all Member States, and that the instruments of the CRR/CRDIV are not sufficient to address these risks.

2.Conclusion and way forward

The European Commission has not yet seen any circumstances that would warrant the use of Article 459 CRR, considering in particular that this Article allows only for tightening measures, the priority of the other CRR/CRDIV instruments and the fact that measures under Article 459 CRR may only be imposed where the respective market developments affect all Member States. In accordance with this assessment, neither the ESRB nor the EBA have recommended to the Commission to take action under Article 459 CRR at this stage.

The Commission will continue to monitor in close cooperation with the ESRB relevant market developments in the Union or outside the Union potentially requiring the use of this Article.

3.Analysis

3.1.General overview

The Commission considers the situation of the EU financial system in the past year to be considerably different from circumstances warranting measures under Article 459 CRR. More specifically, there is no credit-driven overheating of the economy. Leverage in the economy, whilst high by both historical and international standards, is not increasing, nor is there evidence of increasing leverage in the banking sector. This trend can be expected to continue.

The EU economy is on a subdued growth path, which means that the risk of overheating in the economy is limited. According to the latest Commission forecast, real GDP growth will be below 2% in 2016 and 2017 in the EU and euro area. The output gap will remain negative and consumer price inflation is forecast to stay below the 2% threshold that the ECB considers consistent with price stability. Consistent with low rates of inflation and the subdued growth environment, central bank rates have reached very low levels. This, together with asset purchases by central banks, has translated into low interest rates on bond and credit markets. Despite low interest rates, debt of non-financial corporations and households, relative to GDP, is not increasing in most EU Member States, and a downward trend is expected to set in once economic growth picks up. In the current subdued growth environment demand for credit should not boost excess leverage in the financial sector. External developments are unlikely to lead to overheating pressure in the EU economy in the near term as both world GDP and world trade are forecast to grow substantial below long-term trends. The outcome of the UK Referendum about the country's membership in the EU significantly increased uncertainty (as measured by the Baker-Bloom index) has added downside risks to the growth prospects of the EU economy and may curtail many actors' desire to become more indebted. The banking sector, which forms the backbone of the EU financial system, is not increasing leverage. Banks' regulatory capital ratios picked up during 2015 and remained at about the same level during 2016 according to preliminary EBA data. This holds for both Core Equity Tier (CET) 1 ratios and total capital ratios. The weighted average EU CET1 ratio stood at 13.5% in mid-2016, and less than 5% of banks had a ratio of below 11%. ECB statistics suggest that the total balance sheet size of monetary financial institutions (MFIs) excluding the European System of Central Banks (ESCB) barely increased during 2015 and 2016. For comparison, in the pre-crisis period 2001-2008 MFI total asset growth was about 10% p.a. Banks' lending has also been subdued in the EU. For example bank lending to the private sector in the euro area has grown by less than nominal GDP in 2015 and 2016. The ESRB measure of the credit GDP gap is negative and may have just bottomed out in 2016. High levels of non-performing loans (NPLs) act as a break on credit growth. They imply costs for banks in managing loans, thereby reducing incentives to expand credit supply. They are also an indication of debt overhang in the corporate and household sectors. Corporations or households with bad debt may think twice before investing, knowing that banks will charge a higher credit cost to compensate for the risk

According to the results of the 2016 EBA stress test, the aggregate EU banking sector is satisfactorily resilient to shocks. In the adverse scenario, which combines a severe recession with large shocks to a wide set of financial asset prices, the average CET1 ratio would fall to 9.4%. This is higher than the comparable 8.5% outcome of the 2014 stress test and means that the EU banking sector has continued to build up considerable buffers to use in case of adverse economic developments. What is more, the stress test revealed considerable heterogeneity of banks' exposure to adverse shocks across institutions. Hence, changes of risks in this area could be more appropriately addressed by national measures under CRR/CRDIV than by broad-brush measures under Article 459 CRR.

3.2.EU financial stability risks identified by the ESRB

Over the past year, the ESRB has identified four overarching risks for the European economy. These risks are the re-pricing of risk premia in global financial markets, amplified by low market liquidity, further weakening of banks’ and insurers’ balance sheets, deterioration of debt sustainability in sovereign, corporate and household sectors, and shocks and contagion from the shadow banking sectors. The potential relevance of these risks for measures under Article 459 CRR is assessed in more detail below.

(a)Re-pricing of risk premia

The possible re-pricing of risk premia in global financial markets, amplified by low liquidity, is being considered as a major macrofinancial risk in the European financial sector.

This risk is inter alia motivated by high prices in a number of asset classes relative to historical averages. High asset prices are to a significant extent driven by a low interest rate level, which spurs a search for yield among many investor classes. Although there are signs of high risk-taking in some corporate bond markets and real estate markets, they are heterogeneous across market segments and Member States. This is particularly valid for signs of overheating that are present in real estate markets in some Member States, but virtually absent in others.

Capital positions of financial institutions subject to CRDIV/CRR should be sufficiently high to weather a materialisation of this risk. In the EBA stress test, market risk in the adverse scenario curtailed the CET 1 ratio by just 1 percentage point, out of a total drop by 3.8 percentage points in the adverse scenario. Hence, market risk was not the main contributor to the capital erosion identified in the stress test. Of course, the market risk can materialise in a different form than assumed in the stress test. It is, however, reassuring that over recent years the financial sector has shown sufficient resilience during episodes of sharp adjustments of risk premia on global markets. Such events were the flash rally in US Treasuries in October 2014, the sell-off in the German Bund in May/June 2015, the exchange and share price adjustment after the UK Referendum in June 2016 and the sudden increase in Japanese yields in August 2016. These left a short-lived trail in other financial asset prices and did not cause havoc in any financial institution. A further notable market development relates to occasional sharp reactions of EU banks' share prices. While one may regret that exposures to market risk are difficult to monitor, policy proposals in this area are under way with the fundamental review of the trading book initiated in the Basel framework and are expected to be more effective than any measure towards more transparency under Article 459 CRR.