once again given that key fault lines<sup>18</sup> that gave rise to the Euro Area crisis are not yet sufficiently addressed and significant financial market and political tail risks remain compounded by recessionary conditions.

**In the medium term, it is necessary for European banks to deleverage further** as they remain highly levered and reliant on wholesale funding, despite some progress made since 2008 (Exhibits I.1 and I.2). In a recent Deloitte survey, more than 70 percent of European banks indicated that deleveraging will take an additional 5 to 7 years.<sup>19</sup> A protracted deleveraging process is also consistent with past crisis experiences in which credit growth resumed after several years of a stagnant or negative trend (Exhibit III.1). Similarly, at the onset of various past crises, loan-to-deposit ratios were over 100 percent and often fell precipitously for many years before reaching more sustainable levels (Exhibit III.2). These patterns are also more broadly confirmed by past economy-wide deleveraging processes. These episodes can be characterized by a first phase of debt reduction and deleveraging of corporations, households, and financial institutions while the economy is negative and government debt rises. In the second phase, growth is restored and government debt is gradually reduced<sup>20</sup> (McKinsey Global Institute (2012)).

**Deleveraging can affect credit conditions and loan growth, given that the effectiveness of other deleveraging options is currently more limited.** Deleveraging may mostly occur to an important degree via the asset side as liability-side options currently appear to have been largely exhausted or limited due to adverse market valuations and economic conditions, as described earlier. Indeed, over 40 percent of the surveyed European banks have indicated they will deleverage and de-risk by naturally running off their assets, divestments, and constraining asset growth (Exhibit III.3). Most banks also indicate that loan portfolios are an important target of their divestment plans, although weak economic conditions might inhibit this (Exhibit III.4). Since the EU financial sector is more bank based than its US counterpart, the risks of “bad” deleveraging may therefore have worse consequences for the European economy. Small and medium enterprises—which constitute 99 percent of all EU firms—could be most vulnerable given a lack of alternate sources of financing.

**Moreover, offloading loan portfolios to non-bank parts of the financial sector could harbor new risks and sow the seeds for future financial instability.** In the current low interest rate environment, investors have been searching for yield which resulted in a drop of risk assets yields and an increase in capital flows to emerging markets.<sup>21</sup> Various financial corporations

> 18 While the European Monetary Union introduced a common monetary framework, member nations mostly retained discretionary powers over a wide range of financial, fiscal, and economic policies which gave rise to imbalances. Policy makers have started to address this dichotomy by taking the first steps towards greater integration. 19 Deloitte (2012).

> 20 There is some empirical evidence which suggests the impact of a financial crisis on potential output can have long-term effects, particularly when the crisis was severe (Furceri and Mourougane (2009)).

> 21 The high-yield market in the US has rallied since September 2012 and investor demand for some securitized products is back.

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