European Central Bank: Financial Stability Review June 2010

Many euro area large and complex banking groups (LCBGs) returned to modest profitability in 2009, and their financial performances strengthened further in the first quarter of 2010.rnrnThese developments, together with a bolstering of their capital buffers to well above pre-crisis levels, suggest that most of these institutions have made important progress on the road to financial recovery. The broad-based enhancement of shock-absorption capacities during 2009 meant that systemic risks for the financial system dissipated to some extent and risks within the financial sector became more institution-specific in character. Indeed, the dependence of the financial system, especially of large institutions, on government support and the enhanced credit support measures of the Eurosystem tended to wane. That said, the profitability performances of some large financial institutions in receipt of government support remained relatively weak. rnrnOutside the financial system, the progressive intensification of market concerns about sovereign credit risk among the industrialised economies in the early months of 2010 opened up a number of hazardous contagion channels and adverse feed back loops between financial systems and public finances, in particular in the euro area. By early May, adverse market dynamics had taken hold across a range of asset markets in an environment of diminishing market liquidity. Ultimately, the functioning of some markets became so impaired that, for the euro area, it was hampering the monetary policy transmission mechanism and thereby the effective conduct of a monetary policy oriented towards price stability over the medium term. rnrnTo help restore a normal transmission of monetary policy, the Governing Council of the ECB decided on 9 May 2010 on several remedial measures. Taking into account that these decisions have not only a European but also a global outreach, the G7 and G20 welcomed the ECB’s action in their communiqués. In parallel, the EU Council adopted a regulation establishing a European Financial Stabilisation Mechanism. Subject to strong conditionality, this back-stop device will have funds of up to €500 billion at its disposal. Following the implementation of these measures, market volatility was significantly contained.rnrnConsidering the financial stability outlook, although the profile of ECB estimates of the potential write-downs on loans confronting the euro area banking system displays a peak in 2010, it is probable that loan losses will remain considerable in 2011 as well. This prospect, combined with continued market and supervisory authority pressure on banks to keep leverage under tight control, suggests that banking sector profitability is likely to remain moderate in the medium term. rnrnOverall, although the main risks to euro area financial stability essentially remain the same as those to which attention was drawn in the last issue of the FSR, their relative importance has changed significantly over the past six months. rnrnThe main risks for the euro area financial system include the possibility of: rnrn■concerns about the sustainability of public finances persisting or even increasing with an associated crowding-out of private investment; andrnrn■adverse feedback between the financial sector and public finances continuing. rnrnOther, albeit less material, risks identified outside the euro area financial system include the possibility of: rnrn■vulnerabilities being revealed in euro area non-financial corporations’ balance sheets, because of high leverage, low profitability and tight financing conditions; andrnrn■greater-than-expected euro area household sector credit losses if unemployment rises by more than expected.rnrnWithin the euro area financial system, important risks include the possibility of: rnrn■a setback to the recent recovery of the profitability of large and complex banking groups and of adverse feedback with the provision of credit to the economy;rnrn■vulnerabilities of financial institutions associated with concentrations of lending exposures to commercial property markets and to central and eastern European countries; andrnrn■heightened financial market volatility if macroeconomic outcomes fail to live up to expectations.rnrnA key concern is that many of the vulnerabilities highlighted in this FSR could be unearthed by a scenario involving weaker-than-expected economic growth.rnrnThe measures taken by the ECB to stabilise markets and restore their functioning as well as the establishment of the European Financial Stabilisation Mechanism have considerably lowered tail and contagion risks. However, sizeable fiscal imbalances remain, and the responsibility rests on governments to frontload and accelerate fiscal consolidation so as to ensure the sustainability of public finances, not least to avoid the risk of a crowding-out of private investment while establishing conditions conducive to durable economic growth. rnrnWith pressure on governments to consolidate their balance sheets, disengagement from financial sector intervention means that banks will need to be especially mindful of the risks that lie ahead. In particular, they should ensure that they have adequate capital and liquidity buffers in place to cushion the risks should they materialise. rnrnAgainst this background, the problems of those financial institutions that remain overly reliant on enhanced credit measures and government support will have to be tackled decisively. At the same time, fundamental restructuring will be needed when long-term viability is likely to be threatened by the taking away of state support. This could involve the shrinking of balance sheets through the shedding of unviable businesses with a view to enhancing profit-generating capacities.rn