This could foster further consolidation, including across borders, and address the problem of overcapacity in the euro area banking system. Assessing the financial stability of the euro area Beyond regular monitoring activities, financial stability analysis entails assessing the impact on the financial system of risks materialising, including risks related to international spillovers. Such assessments can also help inform the calibration of possible appropriate macroprudential policy responses. The stress-testing framework is an important analytical tool to quantitatively assess financial system vulnerabilities and risks. Stress testing exercises of the banking sector assess the sector’s resilience and how it performs under adverse circumstances, thus providing a measure of the severity of these risks. Individual bank results provide further information about banks’ potential capital needs. Stress tests can therefore show how the financial system will react when risks, such as those relating to spillovers, materialise. In order to enhance its stress-testing capacity, the ECB has invested in an analytical framework that not only tracks the resilience of the banking sector but also accounts for how it interacts with and feeds back in to the economy as a whole.8 This framework complements the EU-wide stress tests conducted under the aegis of the European Banking Authority (EBA), which are predominantly microprudential in nature. Our so-called macroprudential stress testing loosens the assumption that banks’ balance sheets are constant. As banks are hit by, say, negative (spillover) effects from the global environment, they may react by deleveraging their loan books.

As a result, profitability stemming from the maturity transformation business may come under renewed pressure – not least as retail household deposits tend to be bound at zero. Furthermore, should downside risks to the economic outlook materialise, higher loan loss provisions may further compress bank profitability. Accommodative monetary policy has greatly supported bank profitability in past years. In fact, conventional and unconventional measures have improved the quality of credit overall, thereby 2/6  BIS central bankers' speeches  reducing provisioning needs. Our measures have also increased the demand for loans, which has more than offset the negative effect of compressed margins. Furthermore, structural factors are also weighing heavily on euro area banks’ profitability. In an environment where cyclical factors may exert further downward pressure on bank profitability, banks would need to step up their efforts to overcome structural challenges. Such measures may include cost reductions – including lower staffing costs and streamlining of branch networks, enhanced digitalisation – implying initial, one-off large-scale investments, revenue diversification and the reduction of the stock of non-performing loans in the six countries where levels are still high. A number of regulatory and policy measures could help to improve the institutional setting in which the banking sector operates and facilitate banks’ efforts to adjust their business models. Such measures should include completing the banking union (in particular the establishment of a European deposit insurance scheme), the subsequent removal of the remaining non-harmonised national options and discretions, and making progress with the capital markets union.