Financial Stability Review, May 2019

The Financial Stability Review (FSR) assesses developments relevant for financial stability, including identifying and prioritising the main sources of systemic risk and vulnerabilities for the euro area financial system – comprising intermediaries, markets and market infrastructures. It does so to promote awareness of these systemic risks among policymakers, the financial industry and the public at large, with the ultimate goal of promoting financial stability.

Financial stability can be defined as a condition in which the financial system – which comprises financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances. This mitigates the likelihood of disruptions in the financial intermediation process that are systemic, that is, severe enough to trigger a material contraction of real economic activity.

The FSR also plays an important role in relation to the ECB’s microprudential and macroprudential competences. By providing a financial system-wide assessment of risks and vulnerabilities, the Review provides key input to the ECB’s macroprudential policy analysis. Such a euro area system-wide dimension is an important complement to microprudential banking supervision, which is more focused on the soundness of individual institutions. While the ECB’s roles in the macroprudential and microprudential domains have a predominant banking sector focus, the FSR focuses on the risks and vulnerabilities of the financial system at large, including – in addition to banks – activities involving non-bank financial intermediaries, financial markets and market infrastructures.

In addition to its usual overview of current developments relevant for euro area financial stability, this Review includes three special features aimed at deepening the ECB’s financial stability analysis and broadening the basis for macroprudential policymaking. The first special feature examines financial stability risks stemming from climate change, in particular examining the exposure of financial institutions to climate risk-sensitive assets. The second sets out new ways to model the risk of contagion spreading through the euro area banking sector. The third considers how macroprudential policy responses might take account of changes in macroeconomic conditions. The Review has been prepared with the involvement of the ESCB Financial Stability Committee, which assists the decision-making bodies of the ECB in the fulfilment of their tasks.

Luis de Guindos
Vice-President of the European Central Bank

The euro area financial stability environment has become more challenging. Risks to economic growth are tilted to the downside and remain prominent. Volatility in financial markets around the turn of the year illustrated risks that could arise from global and euro area growth surprises. Persistent downside risks to growth reinforce the need to strengthen the balance sheets of highly indebted firms and governments, as well as a euro area banking sector beset by weak profitability.

Risks to economic growth remain tilted to the downside

Euro area economic growth prospects have softened somewhat, in tandem with a weakening of growth prospects around the globe. ECB projections confirm a weakening in economic growth prospects in the first half of the year, consistent with downward revisions by analysts, with a growing cross-country dispersion of growth prospects this year (see Chart 1, left and middle panels). Looking ahead over the medium term, a gradual dissipation of global and domestic headwinds is expected, allowing fundamental factors to help the euro area expansion regain traction. In fact, supportive financing conditions and solid wage growth continue to underpin the ongoing euro area expansion. This baseline scenario is, however, subject to persistent downside risks – notably uncertainty in the global economy spilling over to the external sector (see Chart 1, right panel). This could include uncertainty arising from political processes relating to global trade or a disorderly Brexit (see Box 1). Taken together, the available data suggest that the economic recovery in the euro area has been delayed but not derailed.

A materialisation of downside risks to the growth outlook would intensify public debt sustainability challenges

A prolonged period of low growth may unearth debt sustainability concerns. Although the aggregate stock of public debt in the euro area has fallen somewhat since the peak of 2014 (standing at around 87% of GDP in 2018), the stock has continued to increase in some of the highly indebted countries. Should downside risks to growth materialise, financing costs for vulnerable sovereigns are likely to increase and may unearth debt sustainability concerns. In addition to the high level of debt and large fiscal deficits, some countries could face rollover risks if market participants reassess sovereign risk (see Chart 2, right panel). A sound medium-term approach to public finances, as expected under the Stability and Growth Pact, is key to containing public financing costs, which would support debt sustainability.

Recently, stress in euro area sovereign bond markets has been limited and country-specific. Most sovereign bond spreads relative to risk-free rates have been broadly stable since November 2018. Upward pressure on sovereign spreads stemming from the weakening growth outlook has been counterbalanced by the continued accommodative monetary policy of the ECB. The composite indicator of systemic stress in euro area sovereign bond markets (SovCISS) suggests that financial markets see no imminent debt sustainability concerns for the euro area as a whole (see Chart 2, left panel). However, country dispersion remains high.

Renewed market concerns in sovereign bond markets could potentially have repercussions for the financial system and broader economy. A sharp increase in sovereign bond spreads could have an adverse impact on banks, insurance companies and other financial institutions with elevated levels of sovereign bond exposure (through the mark-to-market impact on banks’ capital and income statements and higher market-based funding costs) (see Chart 3, left panel). While banks with larger domestic sovereign exposures do not seem to face closer credit default swap (CDS) spread correlations with their sovereign than their peers with smaller exposures (see Chart 3, right panel), it is likely that all domestic exposures would be affected by the deterioration in macroeconomic conditions triggered by sovereign stress. To alleviate some of these vulnerabilities, banks and other financial firms with high domestic exposures are encouraged to increase the geographical diversification of their assets.

Signs of vulnerability in corporate credit markets

The low interest rate environment of recent years has contributed to a build-up of vulnerabilities in some segments of the euro area corporate sector. Generally, low corporate interest payment burdens, high liquidity buffers and a relatively diversified financing structure alleviate near-term financial stability risks for the euro area corporate sector. But the favourable financing conditions in most advanced economies have also allowed firms with weaker balance sheets to increase their leverage. For example, the share of issuance by firms rated one notch above non-investment-grade has increased rapidly across the globe and the euro area BBB markets have doubled in size over the past five years (see Chart 4, left and middle panels). This trend partly reflects a diversification of firms’ financing sources. In fact, market-based funding sources have gained in importance in recent years, thereby improving the resilience of corporate financing to shocks stemming from the banking sector. Expected default rates have increased slightly in recent quarters, but remain low overall (see Chart 4, right panel). A sharp deterioration of the growth outlook could lead to a turn in the global credit cycle. There is a particular risk that companies on the edge of the investment-grade spectrum may face refinancing challenges if they were to be downgraded to the high-yield segment.

Risk-taking is particularly pronounced in higher risk segments, such as the leveraged loan markets. Weak underwriting standards have become commonplace in the US and European leveraged loan markets (see Chapter 2). This trend entails two broad risks. First, it may keep very weak firms alive for longer. Second, deteriorating underwriting standards may also generate lower future recoveries (compared with the past) in the event of defaults. That said, in the euro area, the share of leveraged debt issued by firms (the sum of leveraged loans and high-yield bonds) is around 8% (net of inter-company loans and trade credit), which is not particularly high.

Search for yield, liquidity risk and leverage in the non-bank financial sector could amplify the wider financial cycle

Investment funds appear to be the sector most directly exposed to corporate risk. In search of higher yields, euro area funds and insurers have increased their exposures to BBB-rated and high-yield bonds over the last five years (see Chapter 4). Accordingly, BBB bonds now represent a large and increasing part of non-banks’ holdings of non-financial corporate bonds, i.e. 40% for insurance corporations and pension funds and 35% for investment funds as at end-2018, compared with 33% and 31% as at end-2013, respectively. Furthermore, euro area asset managers and investment funds are among the main holders of low-rated collateralised loan obligations (see Box 4). In the event of an economic downturn or a sudden correction in risk premia, these often highly leveraged companies could face difficulties in servicing their debt, with possible downgrades to high-yield bonds. This may, in turn, amplify the effects of the downturn through higher borrowing costs and default rates.

A growing role for euro area non-banks in real economy financing went hand in hand with an increase in risk exposure and a growing financial market footprint of these firms. A shift of real economy financing away from banks towards market-based funding has continued. While this helps diversify the funding sources for the real economy, two risks result. First, much of the implied financing activity has been concentrated in the lower part of the credit quality spectrum, amid high indebtedness in some segments of the corporate and government sectors. Second, non-banks may amplify the cyclical underpricing of risk as they search for yield, potentially also taking on more leverage and liquidity transformation. Should these risks unwind in a disorderly manner, this could lead to a drying-up of funding flows and affect the funding conditions of the real economy more broadly.

Potential for asset price corrections and an unwinding of the considerable investment fund inflows over the last decade

Greater economic and policy uncertainty has contributed to bouts of high volatility in financial markets. In December last year, global stock markets and the riskier parts of the corporate bond markets sold off sharply after a prolonged period of rising asset prices. Concerns about the economic cycle and – in some cases – high valuations triggered the corrections. While the December turmoil was orderly and without immediate widespread consequences, the episode illustrated that investor sentiment can prove unpredictable. In the first four months of 2019 market sentiment improved and the financial assets affected by the turmoil recovered most or all of the earlier losses. The greater risk appetite in financial markets was partly attributed to central bank communication assuring market participants of a continued accommodative stance. More recently, concerns about escalating trade sanctions between the United States and China once again prompted declines in equity and corporate bond prices, as risk premia increased.

High valuations in some asset classes may trigger future market corrections. The favourable market sentiment in early 2019 highlighted an increasing divergence between financial markets and the deteriorating economic growth prospects. For some asset classes, prices seem detached from their underlying fundamentals. For example, based on the cyclically adjusted price/earnings ratio, US equity prices look stretched and may be subject to further adjustment. Furthermore, compressed corporate bond spreads in some advanced economies leave room for rapid corrections (see Chart 5, left panel).

Low market liquidity and unpredictable investor behaviour could amplify any further volatility in markets. The December turmoil showed that market liquidity can dry up quickly in periods of stress. In the euro area corporate bond markets, liquidity conditions remain fragile despite the recovery in bond prices in 2019 (see Chart 5, middle panel). Furthermore, rapid portfolio reallocations could augment future asset price corrections. During the December turmoil, portfolio shifts from equity funds and riskier corporate bond funds to government bond funds were unusually large compared with similar episodes in the past (see Chart 5, right panel).

A sudden and abrupt repricing of financial assets could trigger fund outflows, possibly resulting in forced asset sales amplifying stress in less liquid markets. Overall, the investment fund sector seems to have coped well with outflows during the high volatility episode in December 2018. At the same time, liquidity and credit risks are still high in some parts of the sector and pockets of high leverage may build up in the alternative investment fund sector (see Chapter 4). A sudden and abrupt repricing of risk could lead to forced asset sales. Such sales have the potential to amplify the original shock to asset prices in less liquid markets.

Property prices could correct if downside risks to growth were to materialise

Real estate prices in the euro area have continued to rise despite the more challenging macroeconomic outlook. House prices in the euro area grew by 4.2% in 2018, contributing to signs of mild overvaluation for the euro area as a whole. Moreover, the post-crisis decline in household indebtedness appears to have slowed down significantly.

In commercial real estate markets, price and transaction volume trends also remain strong, with signs of stretched valuations in particular in prime segments. However, the price and transaction volume dynamics decelerated somewhat in recent quarters compared with the peak levels observed in 2016 and 2017. The high share of non-euro area transaction inflows contributes to the vulnerability of commercial real estate markets. A potential change in global financial conditions resulting in a relative shift of returns in euro area and non-euro area markets might result in outflows from commercial real estate by international investors, which have played a crucial role in driving market activity in recent years.

Structural profitability challenges for the euro area banking sector

The prospect of weaker economic growth has weighed further on structurally weak profitability expectations for euro area banks. The return on equity for euro area banks stood at around 6% in 2018, broadly unchanged from a year earlier (see Chart 6, left panel). Profitability continues to fall short of the returns required by investors for the majority of euro area banks. The cost of equity for most of the largest listed European banks is estimated to lie in the range 8-10%.^[1] Consistent with a situation in which the cost of equity is higher than the return on equity, most euro area banks are trading at price-to-book ratios that are lower than those of their international peers. The low growth and interest rate environment could further dent profitability stemming from the maturity transformation business – not least as retail household deposit interest rates tend to be bound at zero.^[2] That said, subdued bank profitability mainly stems from structural challenges in the form of low cost-efficiency, limited revenue diversification and high stocks of legacy assets in some jurisdictions. Near-term profitability forecasts provided by market analysts have been revised down in recent quarters, which can probably be attributed to the slowdown in economic growth (see Chapter 3). Furthermore, a comparison with other major economies reveals that euro area banks’ creditworthiness lags behind that of their main global competitors (see Chart 6, right panel).

The lower profitability of euro area banks compared with their global peers partly stems from the weak growth environment and high non-performing loans (NPLs). GDP growth in the euro area has been lagging behind that in other major economies in recent years (see Chart 7).^[3] As a result, euro area banks have had to manage a large stock of NPLs. Over the past two years, however, euro area significant institutions’ aggregate NPL ratio has fallen by around 2 percentage points, to around 4% in late 2018. That said, the level of NPL ratios remains high in some countries and further efforts are needed to bring them down. Apart from stepping up loan loss provisions, a more active secondary market – including NPL transaction platforms – for impaired assets could support the process.

In order to return to sustainable profitability, euro area banks need to tackle a number of structural challenges (see Chart 7). Persistent low bank profitability is a concern from a financial stability perspective as it makes capital raising difficult in case of need and constrains internal capital generation, thus limiting the build-up of buffers against unexpected shocks. A significant part of the profitability gap vis-à-vis international peers is explained by lower cost-efficiency as measured by cost-to-income ratios. On the cost side, euro area banks compare unfavourably with many banks in other advanced economies on metrics such as the number of inhabitants per branch and staff costs. While there is no one-size-fits-all strategy for business model adjustment, one way for banks to improve cost-efficiency would be to speed up the digital transformation and shift away from physical branch networks. Governments may facilitate such a transformation by enhancing internet usage among the general public. On the revenue side, a further shift towards fee and commission-based activities could pave the way to higher profitability. Such a shift may be particularly important for banks that rely heavily on net interest income which may come under further pressure if interest rates were to stay low for longer. In fact, there is evidence that banks which have performed better in recent years (in terms of profitability and cost-efficiency) have been able to diversify their income towards fee-based sources.

Some banks could face funding cost pressure if economic growth surprises on the downside. Market-based funding costs for euro area banks have remained volatile over the past six months. Spreads widened in the latter part of 2018, but tightened by similar magnitudes in the first months of 2019. Going forward, funding conditions may come under further pressure as a result of a sharper than expected cyclical downturn or a re-emergence of sovereign stress in countries that face debt sustainability challenges. Furthermore, rating downgrades are relatively likely for some banks which might also put further pressure on banks’ funding costs. The issuance of new bail-inable debt might also prove challenging for some banks, in particular for those with lower ratings. In addition, while the launch of the new series of targeted longer-term refinancing operations (TLTRO-III) should help banks refinance maturing TLTRO-II funds, some banks with weaker funding profiles need to develop plans for eventually replacing central bank funding with longer-term market funding, which could add to funding cost pressures for these banks in the medium term.

Regulatory capital ratios of euro area banks appear resilient to an adverse macroeconomic scenario. Euro area significant institutions’ aggregate Common Equity Tier 1 (CET1) ratio remained broadly stable in the last three quarters of 2018 at around 14%. Over the last four years the aggregate CET1 ratio for euro area banks has increased by around 3 percentage points, driven by both an increase in CET1 capital and a reduction in risk-weighted assets. The results of a stress test based on a scenario with a prolonged period of low economic growth showed that despite the 340 basis point depletion of the CET1 capital ratio, banks still had 10.5% CET1 at the end of 2021. This suggests that the euro area banking sector as a whole should be resilient to a range of downside risks.

Policy responses to ensure resilience

Macroprudential policy action

A number of jurisdictions have activated or increased the countercyclical capital buffer. Over the last year a number of euro area countries have implemented macroprudential policy measures to address the build-up of systemic risk. In particular, the countercyclical capital buffer was activated or increased in France, Ireland, Lithuania, Luxembourg and Slovakia. Despite the economic headwinds, further increasing macroprudential policy space in some countries appears desirable to build bank resilience and insure against the materialisation of tail events. Nevertheless, macroprudential policy should take into account the risk of inducing procyclical effects, which is most relevant in countries where macroeconomic conditions are relatively weak and downside risks to the economic outlook are more prominent. Model-based analysis for the euro area as a whole suggests that procyclical effects from tighter macroprudential policy would be contained if the baseline macroeconomic projections were to materialise (see Special Feature C). However, procyclical effects could emerge in a scenario in which macroeconomic conditions deteriorate strongly and financial conditions tighten substantially.

A number of euro area countries have activated macroprudential instruments over the past years to address residential real estate-related vulnerabilities. Twelve countries (i.e. Austria, Cyprus, Estonia, Finland, Greece, Ireland, Latvia, Lithuania, the Netherlands, Portugal, Slovakia and Slovenia) have activated borrower-based instruments, such as loan-to-value (LTV), debt service-to-income (DSTI), loan-to-income (LTI), debt-to-income (DTI) and maturity limits, usually with the aims of strengthening household and bank resilience, as well as ensuring that lending standards remain appropriate. In addition, five countries (i.e. Belgium, Finland, Ireland, Luxembourg and Malta) have capital measures in place, such as risk weight floors or add-ons on mortgage loans, with the primary objective to increase banks’ resilience to shocks in the housing market. Since mid-November 2018 two countries have notified macroprudential policy changes to address residential real estate risks. Malta announced the introduction of binding limits on LTV and DSTI ratios and on maturity at loan origination (which will become effective in July 2019), while Slovenia extended the existing recommendation on LTV and DSTI limits on mortgage loans to consumer loans and complemented these limits with maturity requirements on consumer loans.

While macroprudential policies targeting residential real estate appear sufficient in most of the euro area countries, in some, the policy stance may need to be adjusted and further policy actions should be considered by national authorities. In particular, at the current stage of the cycle, it is important to monitor the quality of lending standards in order to ensure that new mortgage borrowers are resilient to income and interest rate shocks, and that banks are resilient to accumulated vulnerabilities in some of the euro area countries. To ensure the resilience of borrowers going forward, national authorities should require banks to test the debt servicing capacity of borrowers at loan origination against plausible income and interest rate scenarios. More generally, national authorities should provide (or enhance) public guidance to banks on prudent lending standards and consider, at least, indicative quantitative limits on key ratios (e.g. LTV, DTI and DSTI) if this is deemed necessary in order to address the identified risks.

Strengthening the regulatory framework

Regulatory initiatives at the international and EU levels are vital in establishing a sound and robust framework for financial institutions, markets and infrastructures. A key achievement in this regard was the political agreement reached on the EU banking reform package in February 2019. The package includes the revision of the Capital Requirements Regulation and Directive (CRR/CRD IV), which will implement the Basel capital and liquidity standards (Basel III) in EU law, including the leverage ratio, the net stable funding ratio and the revised market risk capital framework. The CRR/CRD IV review also introduces major changes in the macroprudential regulatory and policy framework by: (i) clearly delineating the responsibilities of micro- and macroprudential authorities; (ii) enhancing the flexibility of the toolkit; and (iii) streamlining the activation and coordination mechanisms. These changes will allow macroprudential authorities to address systemic risks in a more effective and targeted manner in the future. Furthermore, political agreement has also been reached on the revision of the ESRB Regulation, which will improve the transparency and functioning of the European Systemic Risk Board, while maintaining its proximity to the ECB.

Removing the remaining barriers to the banking union and making further progress towards a genuine capital markets union are key to facilitate a more complete pan-European market. In this regard, further steps need to be taken to foster a higher level of financial integration and to assess its potential impacts on financial stability. The development of a common institutional framework – including the establishment of a European deposit insurance scheme as the third pillar of the banking union – and reducing remaining obstacles to cross-border banking activities can help improve operating cost efficiency and revenue diversification of European banks.

Strengthening the regulatory framework for non-bank financial intermediation is crucial in order to limit regulatory arbitrage and enhance the resilience of the broader financial system. Non-bank financial intermediation has been growing in the euro area, which has potential implications for financial stability and the financing of the real economy more broadly. The increasing size of non-banks has been accompanied by rising liquidity and credit risks in their investment portfolios. While existing rules in the EU provide a robust framework to address investor protection and entity-specific vulnerabilities, there are growing concerns over cyclical risks associated with increased liquidity transformation, risk-taking and leverage affecting the sector more broadly. Against this background, it is necessary to broaden the macroprudential toolkit and operationalise existing tools^[4] for non-bank financial intermediation – and for investment funds in particular – to address new and emerging risks from non-bank financial intermediation. At a global level, it is important to develop a consistent reporting framework for leverage in investment funds, with a view to gaining a system-wide perspective on evolving risks, in line with the recommendations of the Financial Stability Board (FSB) to the International Organization of Securities Commissions.^[5] Looking ahead, in the context of the FSB’s work on the evaluation of post-crisis reforms, it would be useful to assess the effectiveness and completeness of the regulatory measures taken in relation to the non-bank financial sector.

1.1 Weaker near-term euro area growth outlook coupled with persistent downside risks

The euro area economy lost some momentum in late 2018. Notwithstanding a rebound of GDP growth at the start of 2019, survey indicators continue to point to a subdued economic expansion in the near term. The slowdown in euro area growth (see Chart 1.1, left panel) can be attributed to weaker impetus from external demand as well as some country and sector-specific factors, such as disruptions in the German car industry and adverse confidence effects of the political and policy uncertainties in Italy. That said, the ECB’s accommodative monetary policy has continued to underpin domestic demand. Ongoing favourable labour and housing market trends have also buttressed private consumption, while benign financing conditions and relatively resilient corporate and household fundamentals underpinned business and residential investment.

The euro area expansion is expected to regain traction amid supportive fundamentals. Looking ahead, growth of the euro area economy is projected to gradually strengthen, reflecting the favourable impact of very accommodative monetary policy, rising wages, a recovery in foreign demand and some fiscal loosening. The March 2019 ECB staff macroeconomic projections foresee real GDP growth strengthening in the medium term from the moderate rate of 1.1% in 2019 to 1.6% in 2020 and 1.5% in 2021. Weaker economic growth prospects in the near term together with lower HICP inflation outturns since the publication of the previous FSR (see Chart 1.1, right panel) translate into more muted headline HICP inflation forecasts of 1.2% in 2019, followed by 1.5% in 2020 and 1.6% in 2021. This nominal growth path in the euro area contrasts with more favourable economic prospects in the United States, despite a deterioration of the 2019 growth and inflation outlook for both jurisdictions (see Chart 1.2).

Growth of the global economy slowed at the turn of 2018-19, but is set to stabilise in the medium term. The slowdown has been fairly pronounced in the manufacturing sector against the backdrop of the maturing business cycle in key advanced economies, while global trade decelerated sharply (see Chart 1.3, left panel) amid slowing industrial activity and heightened trade tensions. The slowdown in global growth went hand in hand with lower global inflationary pressures and more accommodative monetary policy expectations by market participants in most major advanced and emerging market economies (EMEs) (see Chart 1.3, middle panel). Global growth is expected to stabilise over the medium term as slowing cyclical momentum in advanced economies, as well as a gradual slowdown in China’s GDP growth, are largely offset by the recovery of key EMEs from deep recessions (e.g. Russia, Brazil). The accommodative stance by central banks globally has also eased global financing conditions (see Chart 1.3, right panel), creating a more benign environment for EMEs.

Persistent downside risks cloud the global and euro area growth outlook. Alongside waning fiscal and structural reform efforts in some euro area countries, downside risks to euro area growth mainly relate to global factors. In particular, uncertainties regarding the course of the economy and fiscal policies in the United States, a further rise in (geo)political and policy uncertainty across the globe, including in relation to growing trade protectionism and a disorderly no-deal Brexit, as well as renewed tensions in EMEs, may weigh on the euro area growth momentum.

A more severe slowdown of the US economy could adversely affect global growth and financial markets. The US economy is currently in its second longest expansion on record, buttressed by fiscal stimuli in the late phase of the business cycle. While near-term recession risks in the United States appear to be limited, the equity market corrections at the turn of the year, the ongoing US-China trade dispute, vulnerabilities associated with elevated corporate leverage (see Chapter 2) and weaker global growth prospects have led to continued market concerns regarding the downside risks to US economic growth. In addition, while the negative impact of the partial federal government shutdown earlier this year is expected to be moderate, the current expansionary fiscal policies may trigger public debt sustainability concerns (see Chart 1.4, left panel) and a repricing in US and global bond markets. Nevertheless, the dominant role of the US dollar as an international reserve currency is expected to continue attracting international investors, thereby mitigating the risk of a near-term repricing of US government debt.

Heightened political and policy uncertainty may weigh on global sentiment. Political and policy uncertainty remained elevated at the turn of 2018-19 across the globe (see Chart 1.4, middle panel). Alongside continued uncertainties surrounding economic and fiscal policies in some major euro area countries, a further escalation of trade tensions between the United States and China could have a significant impact on global trade and growth, especially if direct trade effects were to be compounded by indirect confidence effects stemming from increased uncertainty about future trade policies and trading relations. At the same time, the continued lack of clarity on the future relations between the United Kingdom and the European Union also implies uncertainty surrounding financial market sentiment and the growth implications of the UK leaving the EU (see Box 1).

Vulnerabilities in emerging market economies remain a cause for concern. The most acute tensions observed in a number of EMEs in 2018 have subsided, but pockets of vulnerability remain across EMEs, as illustrated by the renewed heightened volatility in the most vulnerable economies (e.g. Turkey and Argentina). Despite market participants’ more benign view of emerging markets lately, the fragility of macroeconomic fundamentals – in particular high current account deficits and a strong reliance on US dollar funding – together with limited room for policy support leaves some EMEs exposed to changes in investor sentiment and sudden flow reversals. Moreover, financial and real shocks associated with China’s rebalancing process towards a more consumption-driven growth path and/or its trade dispute with the United States may adversely affect other Asian and Latin American economies with close trade and financial links to the Chinese economy. In addition, such shocks could spark broader-based risk aversion vis-à-vis emerging markets at large, with significant implications for global financial markets and economic activity (see Chart 1.4, right panel).

The materialisation of downside risks to growth could challenge euro area financial stability. In particular, it might spark tensions in global financial markets and prompt a disorderly unwinding of global search-for-yield flows. A weaker than expected growth environment could also trigger the materialisation of any of the main risks to euro area financial stability and could amplify global risk repricing, further challenge bank profitability or fuel debt sustainability concerns.

1.2 Fragile public debt sustainability

Stress remained subdued in euro area sovereign debt markets, but uncertainties at the country level prevail. Despite the signs of slower economic growth, the composite indicator of systemic stress in euro area sovereign bond markets (SovCISS) has declined somewhat since the turn of 2018-19. This largely reflects the subsiding of acute stress in Italian government bond markets and the continuing positive news flow (e.g. sovereign rating upgrades) on some euro area countries that were more affected by the crisis (e.g. Greece, Portugal). Cross-country dispersion still remains though (see Overview), as markets continue to discriminate between sovereign vulnerabilities at the country level. In terms of the drivers, somewhat lower correlations among input variables exerted downward pressure on the indicator (see Chart 1.5, left panel).

Slower than expected growth and a looser fiscal stance could put pressure on fiscal fundamentals. The aggregate euro area fiscal deficit declined from 1.0% of GDP in 2017 to 0.5% of GDP in 2018 (see Chart 1.5, right panel). This improvement was chiefly driven by favourable cyclical conditions and lower interest payments. However, the aggregate deficit is projected to increase this year for the first time since 2009 on account of lower cyclical support and more expansionary policies than previously expected in several of the largest euro area countries. The projected deterioration of structural balances in 2019 may further challenge the compliance with the medium-term budgetary objectives of a number of highly indebted countries, where fiscal space for countercyclical action is more limited. At the same time, for all euro area countries, shifting expenditure to the most growth-enhancing categories (e.g. investment, education or health) or the tax burden to the less distortive tax bases of consumption and property can positively affect output growth and reduce inequalities.^[9]

Heightened political and policy uncertainty could also add to public debt sustainability concerns. Supported by favourable macro conditions, the euro area aggregate government debt-to-GDP ratio has been on a decreasing path since the peak in 2014, reaching 87.1% in 2018. Looking ahead, beyond slower growth, several other factors may challenge the sustainability of public finances. First, a further rise in political and policy uncertainty at both the country (e.g. elections, economic policies) and EU (e.g. Brexit, upcoming EU elections) levels may cause shifts in market sentiment and trigger a repricing of sovereign risk (see Box 2). In particular, a lack of fiscal discipline, the delay of fiscal and structural reforms, or even the reversal of past reforms, may reignite pressures on more vulnerable sovereigns (see Chart 1.6, left panel). In fact, if weaker economic growth prospects were to be coupled with an interest rate shock stemming from a sovereign risk repricing, that would increase debt sustainability concerns in highly indebted countries and amplify the adverse feedback loop between debt levels and underlying macroeconomic dynamics (see Chart 1.6, right panel). Second, pockets of risk surrounding the sovereign-bank nexus may represent a challenge to public finances in some countries. In the medium-to-long run, these challenges are compounded by vulnerabilities related to the potential rise in interest rates/yields, lower potential GDP growth and ageing-related costs.^[10]

Sovereign financing conditions have remained favourable in terms of both pricing and duration. Despite higher sovereign bond yields in some countries, pricing conditions remained relatively benign for euro area sovereigns amid ongoing Eurosystem reinvestment of principal payments from maturing securities purchased under the asset purchase programme. At the same time, benign conditions have also allowed sovereigns to issue at favourable terms. In particular, the trend towards longer durations has continued, with strong issuance activity beyond the 15-year horizon. Countries with high levels of outstanding government debt securities have engaged more in maturity prolongation than those with lower levels (see Chart 1.7, left panel), but not all highly indebted countries have taken advantage of the current favourable financing conditions to the same extent. In terms of the underlying interest rate structure, a reduction in zero-coupon and floating rate debt and the concurrent increase in fixed rate debt allow governments to lock in long-term financing at low costs and to capitalise on historically low interest rates.

A sovereign risk repricing may trigger rollover risks in countries with continued high refinancing needs. The overall shift in net issuance activity towards the long end of the maturity spectrum in recent years has helped to reduce the gross financing needs of euro area governments from over 27% of GDP at the height of the euro area sovereign debt crisis to 21.6% in the first quarter of 2019. However, the euro area aggregate conceals a considerable degree of cross-country heterogeneity. Debt servicing needs remain high for several – in particular the most highly indebted – euro area countries. This may suggest possible pockets of rollover risk in terms of both the availability and the cost of funding in the event of a possible sovereign risk repricing (see Chart 1.7, right panel).

In sum, weaker economic growth and a further rise in political uncertainty could intensify sovereign risks. While favourable financing conditions in terms of both pricing and duration continue to mitigate sovereign risks, weaker than expected macroeconomic conditions may bring underlying fiscal vulnerabilities to the fore again. In fact, public finances remain fragile in a number of countries. Looking ahead, waning fiscal consolidation efforts, particularly in combination with higher long-term interest rates as a result of a sudden sovereign risk repricing or deteriorating macroeconomic conditions, may pose a challenge to the sustainability of public finances. The materialisation of any of these risks may reignite concerns regarding public debt sustainability in the more vulnerable euro area countries.

1.3 Euro area households resilient, but some country-level vulnerabilities prevail

Euro area households’ income position has so far been fairly resilient to the slowdown in economic activity. Households’ real and nominal gross disposable income growth remained above long-term average rates in 2018 (see Chart 1.8, left panel) primarily bolstered by further improvements in labour market conditions and the related robust growth in labour income. Despite slowing towards the end of the year on account of losses on financial assets due to the correction in global stock markets, growth in household net worth remained solid throughout 2018 buttressed by valuation gains on property holdings amid sustained housing market momentum (see Chart 1.8, middle panel, and Section 1.5). Despite some deterioration over the course of 2018, households remain confident about their financial situation and unemployment prospects, consistent with the relatively robust consumer confidence (see Chart 1.8, right panel).

Household indebtedness has stabilised for the euro area as a whole, while remaining a cause for concern in some countries. On aggregate, the indebtedness of euro area households has stabilised at slightly below 58% of GDP in 2018 – a level that was last observed in early 2006 and is slightly below the estimated threshold associated with debt overhang based on the macroeconomic imbalance procedure. This figure is also relatively low by international standards. The euro area aggregate continues to mask a considerable degree of cross-country heterogeneity though, with the household debt-to-GDP ratio ranging from 21% in Latvia to slightly over 100% in the Netherlands. In terms of changes, there has been continued balance sheet repair (in both absolute and relative terms) in some euro area countries that were more affected by the crisis, e.g. Cyprus and Greece. Most other countries saw an increase in the absolute level of household debt over 2018, but only a few countries have seen debt grow faster than nominal GDP (see Chart 1.9, left panel).

Debt sustainability concerns are mitigated by the low level of interest rates. A relatively resilient income position and improved net worth coupled with record low interest burdens bolster euro area households’ debt servicing capacity for the time being (see Chart 1.9, middle panel). The low interest rate environment has encouraged a shift towards longer rate fixation periods across countries. However, in the event of an interest rate shock without a commensurate boost to household income, more vulnerable households might be challenged going forward in countries where loans at floating rates or rates with rather short fixation periods predominate (see Chart 1.9, right panel). Continued balance sheet repair in countries with elevated levels of household debt should help mitigate the risks related to an eventual normalisation of interest rates and the ensuing rise in debt servicing costs, which are relatively high in some countries (see Chart 1.9, left panel).

Lending flows to households stabilised at moderate levels, but underlying dynamics vary across countries and according to the purpose of lending. Overall, lending to euro area households continues to be supported by borrowing costs close to historical lows (see Chart 1.10, left panel), further improvements in labour market conditions and mature housing markets. At the country level, lending growth remained lacklustre in some countries (e.g. Cyprus, Greece and Latvia), while in others, such as Slovakia, Malta and Lithuania, household credit expanded briskly. Looking at the different lending types, consumer credit remains the most dynamic component of loans to households, but its pace of expansion has decelerated as consumption of (highly cyclical) durables has slowed and supervisory scrutiny has increased. Loans to households for house purchase continued to expand at a moderate pace. Going forward, banks expect weaker demand and tighter supply conditions for loans for house purchase than for consumer credit (see Chart 1.10, right panel).

So far, euro area households have been resilient to the slowdown in economic activity, but stock imbalances remain high in some countries. Relatively solid income and net worth growth coupled with continued favourable financing conditions support households’ debt servicing capacity. A more severe and prolonged economic growth slowdown could, however, translate into deteriorating labour market conditions, a moderation in wage growth and/or a possible correction in housing markets in some countries, thereby challenging euro area households’ income and net worth positions and, thus, their capability to repay debt. At the same time, a sudden rise in interest rates may spark debt sustainability concerns in countries with elevated levels of household debt and a predominance of floating rate contracts.^[12] Finally, while not an immediate source of concern, the continued buoyancy of consumer lending in some euro area countries warrants monitoring.

1.4 Legacy imbalances leave firms vulnerable to weaker growth

Cyclical headwinds indicate somewhat higher risks to corporate earnings and credit risks. Mirroring the weaker economic growth prospects, corporate sentiment deteriorated further in the euro area at the turn of 2018-19. While remaining well above long-term averages, corporate order books have become thinner, gradually translating into poorer capacity utilisation in manufacturing and lower corporate profits (see Chart 1.11, left panel). Heterogeneity across sectors of economic activity is considerable though. Some (mainly export-oriented) industries (e.g. the car industry) appear to be more exposed, while others, such as construction, are relatively more shielded from the current slowdown in economic activity and heightened trade-related uncertainty. Alongside higher corporate earnings risks, market price-based measures, such as the expected default frequency and distance to distress, also signal a pick-up in credit risks for the euro area non-financial corporate (NFC) sector, but remain much less pronounced than at the height of the euro area sovereign debt crisis given more resilient corporate balance sheets and continued favourable financing conditions (see Chart 1.11, right panel).

Legacy balance sheet concerns continue to burden the euro area non-financial corporate sector. The consolidated NFC debt-to-GDP ratio stabilised at around 77.5% for the euro area as a whole in 2018. While being roughly on a par with that of international peers (see Chart 1.12, left panel), the indebtedness of the euro area corporate sector remains high by historical standards and is still somewhat above the estimated benchmark level of 75% of GDP derived from the macroeconomic imbalance procedure threshold for non-financial private sector debt. On a non-consolidated basis (i.e. including inter-company loans), the level of indebtedness was higher at 108.5% of GDP. Heterogeneity at the country level remains considerable in terms of both the level of debt and its underlying dynamics, as renewed debt accumulation in some countries contrasts with continued deleveraging in countries which had built up large amounts of debt in the run-up to the global financial crisis, e.g. Portugal and Spain (see Chart 1.12, middle panel). The same holds true for developments at the sector level, where overindebted sectors, such as construction and real estate services, continue to deleverage more strongly than less-indebted ones such as industry or trade (see Chart 1.12, right panel). In fact, differences in the financial health of firms across sectors of economic activity may have important implications for banks’ asset quality (see Box 3). That said, other leverage measures at market value such as debt-to-total assets and debt-to-equity ratios for euro area NFCs paint a more favourable picture of firms’ balance sheet situation, hovering around levels observed in the early years of EMU given strong equity price increases in recent years.

Low corporate interest payment burdens, high liquidity buffers and a more diversified financing structure alleviate corporate debt sustainability concerns. Corporate interest payments have touched record lows in both gross and net terms (see Chart 1.13, left panel), thereby bolstering the debt servicing capabilities of euro area NFCs. However, given the relatively high share of variable rate debt in corporate balance sheets, further balance sheet repair would help offset any risks related to a potential repricing of risk and the resulting rise in market interest rates and debt servicing costs.^[13] Moreover, euro area NFCs have piled up sizeable liquidity buffers in the magnitude of some 30% of GDP in recent years (see Chart 1.13. middle panel), likely driven by precautionary motives (i.e. mitigating the risk of limited access to external financing in the future) and the low opportunity cost of holding liquid assets. Together with a shift towards longer-term debt financing, these ample liquid asset holdings may help mitigate rollover risks should the current economic slowdown prove more prolonged and access to credit be hampered, but could also make an important contribution to reducing leverage. Finally, the financing structure of euro area NFCs has become more diversified since the onset of the global financial crisis (see Chapter 4). This higher recourse to alternative funding sources has improved the resilience of firm financing to shocks stemming from the banking sector (see Chart 1.13, right panel). NFCs now also tend to finance their expansion to a larger extent with internally generated funds than in the past. That said, the greater importance of direct market-based finance may have further increased the interest rate sensitivity of the corporate sector to higher volatility in market rates.

Firms’ external financing flows moderated in line with the economic slowdown, but overall financing conditions remain benign for euro area NFCs. Despite some deceleration in recent months on account of a weaker economic momentum (see Chart 1.14, left panel), bank lending flows to euro area NFCs remained solid as they were bolstered by still favourable credit standards and the record low cost of bank borrowing. This aggregate picture continues to mask considerable cross-country heterogeneity though, as buoyant credit growth in some countries (e.g. Belgium, Austria, France and Germany) contrasts with more muted developments in others (e.g. Spain, Italy and Greece). Looking ahead, the resilience of bank lending to NFCs could be challenged by less favourable credit supply conditions and weaker credit demand as a result of cyclically lower corporate financing needs (see Chart 1.14, middle panel). In terms of the external financing flows from non-bank sources, debt and equity issuance by euro area NFCs was dampened by weaker economic growth prospects and increases in the cost of market-based debt and equity at the turn of 2018-19 due to a pick-up in risk premia and lower corporate profits (see Chart 1.14, right panel). The net issuance of debt securities has recovered since the beginning of 2019, but issuance activity has remained concentrated within the investment-grade segment, reflecting continued uncertainties surrounding the short-to-medium-term economic growth path.

All in all, euro area NFCs face cyclical headwinds, but remain resilient to a short-lived economic slowdown. The operating environment has become more challenging for euro area NFCs, with the slowdown in economic momentum weighing on firms’ profit-generation capacity. At the same time, legacy stock imbalances continue to linger in a number of countries and sectors. Debt sustainability concerns are, however, currently alleviated by low interest payment burdens and high liquidity buffers, while the financing conditions of euro area NFCs remain favourable and supportive of both investment and debt servicing. The euro area corporate sector should be able to withstand the current moderation in growth dynamics, but a more severe and prolonged economic slowdown than currently projected and a major risk repricing in financial markets could challenge corporate fundamentals going forward.

1.5 Sustained momentum in euro area property markets

Euro area residential property markets maintained strong momentum in 2018. Despite the slowdown in economic activity, euro area house prices continued to rise at a steady, but robust rate of over 4% in nominal terms in 2018 (see Chart 1.15, left panel) and 2% in real terms. Supported by the low interest rate environment, almost all euro area countries have been in an upturn phase of the housing cycle. However, the pace of expansion varies across countries, and country-level developments are further nuanced by diverging regional price dynamics. Price rises in large and/or capital cities outpace price trends at the national level in several countries amid a stronger apparent link to the economic cycle. While the euro area housing market as a whole is not characterised by exuberant investment activity,^[16] there are some signs of a slight price overvaluation (see Chart 1.15, middle panel). The extent of estimated over- or undervaluation is also heterogeneous across countries (see Chart 1.15, right panel). Furthermore, residential investment and building permits remain below long-term averages, suggesting scope for a continued recovery in housing activity and a possible mitigating impact on house prices.

Ongoing yield compression in euro area commercial property markets has been driven by price increases. Price dynamics and transaction volumes reflect continued strong activity in euro area commercial property markets. While the increase in commercial property prices is broad-based across countries, there have been significant differences in the pace of price growth. There is also a continued bifurcation between muted developments in the non-prime segment and strong price increases in prime markets (see Chart 1.16, left panel). Against the backdrop of overall robust price growth, yields on prime commercial property have been on a declining trend, reaching a new low in the current cycle. This marked compression of prime commercial property yields across the euro area might be indicative of possible overvaluation in commercial property markets (see Chart 1.16, middle panel). Transaction volumes have remained strong, but decreased from the recent peak in line with a maturing cycle (see Chart 1.16, right panel). While the appetite from US and UK investors has been muted since 2016, euro area commercial property markets have experienced net foreign inflows on the back of strong activity by Asian investors. Non-European investors could be sensitive to global financial conditions and rebalance out of European commercial property markets if relative returns shift, thereby triggering a correction in commercial property prices.

All in all, the ongoing momentum of residential and commercial property markets in some countries and market segments warrants monitoring. There are limited signs that the ongoing recovery of euro area residential property markets might translate into broad-based rapid housing loan growth in the euro area. That said, in some countries, the combination of house price rises and strong new lending and/or household indebtedness warrants closer monitoring in the context of the current low-yield environment. Worse than expected macroeconomic outcomes and/or tighter financing conditions in terms of both the availability and cost of funding could adversely affect the debt servicing capacity of households and commercial property investors. In turn, this may represent a risk for banks in countries with high property-related exposures. However, macroprudential policy actions, such as extra capital buffer requirements or controls on loosening borrower terms, can help mitigate possible risks to financial stability at the country level. A number of countries have already introduced such measures.^[17] Given its macroprudential mandate, the ECB is monitoring property market developments too and may top up capital-based national macroprudential measures if needed, in accordance with the SSM Regulation.

2.1 Financial markets proved sensitive to concerns about global economic growth

Signs of a deteriorating global economic outlook and related shifts in expectations about monetary policy triggered a period of heightened market volatility. Towards the end of 2018 global equity indices declined, risk premia rose materially and major economy sovereign bonds benefited from flight-to-safety flows (see also Chapter 4). While the correction was largely orderly, the episode illustrated the sensitivity of investor sentiment to monetary policy expectations. Since the start of 2019 the combination of higher equity prices in the United States, lower US bond yields and US dollar depreciation suggests that expectations of a more accommodative US monetary policy stance were a major driver of the rally in asset prices (green bars in Chart 2.1; see also Box 2 in the November 2018 FSR). Global investors’ risk appetite has improved, providing an additional boost to US equity prices (red bars). In the same period corporate bond spreads declined amid a reversal of previous flight-to-safety flows. Overall, the slowdown of the US economy that triggered the market correction and the subsequent pause in monetary policy tightening remained key drivers of asset prices (blue bars).

Spillovers from global developments were a key factor driving euro area financial markets. The composite indicator of systemic stress in euro area financial markets exhibited a progressive increase in the fourth quarter of 2018 and spiked towards the end of the year, in line with market concerns about euro area medium-term growth prospects. The indicator started to decline in January, when tensions in global financial markets subsided. The breakdown of the composite indicator shows that tensions were mainly confined to equity markets.

Global equity markets exhibited high volatility, mainly reflecting downward revisions to the growth outlook and trade tensions. Global stock prices dropped in December amid rising downside risks to global growth and falling earnings’ expectations. While also significant in Japan and China, the sell-off was most pronounced in the United States (see Chart 2.2, top-left panel). Cautious communication by the Federal Reserve calmed market participants in January and share prices recovered subsequently. Trade tensions between the United States and China returned in May, prompting equity market volatility. The effect was larger for US sectors that are more integrated in global trade (see Chart 2.2, top-right panel). Only in a scenario in which trade tensions broaden to a global scale are risk premia expected to increase in a more pronounced and broad-based manner (see Special Feature B in the November 2018 FSR). In the euro area, the deterioration of the economic growth outlook weighed on valuations of cyclical sectors relative to defensive sectors (see Chart 2.2, bottom-left panel). A model-based decomposition of changes in euro area equity prices suggests that, since the start of the year, worse earnings growth expectations have been more than offset by a fall in both the equity risk premium and risk-free rates. This may explain the rebound in euro area equity prices (see Chart 2.2, bottom-right panel).

Euro area corporate bond spreads increased moderately. US corporate bond spreads widened in the last quarter of 2018. In the same period euro area spreads widened by less, possibly because they had increased more gradually throughout 2018. Since January financing conditions for riskier corporate borrowers, as measured by spreads between non-investment-grade and investment-grade corporate bond yields, have improved, although the spreads are still wider than in October last year (see Chart 2.3, left panel). A model-based decomposition of euro area corporate bond spreads confirms the relevance of the role of spillovers from the United States and other global factors (see Chart 2.3, right panel). Over the reference period euro area-specific factors, such as the worsening of the domestic macroeconomic outlook, appear less important.

Conditions in the leveraged loan market worsened, indicating rising market concern over the potential scale of losses. The spike in leveraged loan and high-yield bond spreads observed in December was larger in the United States than in Europe but, overall, it was modest compared with previous episodes of volatility (see Chart 2.4, left panel). In the US, prices were also affected by outflows from, and associated sales by, mutual funds and exchange-traded funds (see Chapter 4). Since the start of the year spreads for both leveraged loans and high-yield bonds have partially retrenched (see Chart 2.4, middle panel). Spreads on collateralised loan obligations (CLOs), which repackage leveraged loans into debt securities, rose towards levels not seen since 2016, before declining in January (see Chart 2.4, right panel, and Box 4), with CLO equity spreads even exceeding the peaks of three years ago, highlighting increasing market concerns.

Euro area sovereign spreads remained broadly stable, despite the downward revisions in growth prospects. Indicators of systemic stress in sovereign bond markets remained fairly stable at low levels over the review period (see Chapter 1). Italian sovereign bond yields were more volatile and remained at a higher level than in early 2018, despite declining during the review period. The spread of the German Bund against the overnight index swap (OIS) rate has recently become less negative, probably signalling some unwinding of safe-haven flows, consistent with the improvement in risk appetite.

The functioning of the repo markets in the euro area continued to show signs of improvement. Overall, the spread between repo rates on transactions collateralised with German and Italian sovereign bonds continued to compress over the review period, pointing to a better availability of collateral in the repo market. In particular, the decline in repo rates around balance sheet reporting dates for transactions collateralised with German and French sovereign bonds has become more contained. Meanwhile, rates on equivalent transactions secured with Italian sovereign bonds have exhibited signs of divergence since the second half of 2018, registering increases around such dates.

The benchmark rate reform in the euro area continued. With regard to the ongoing euro area benchmark rate reform, the working group on euro risk-free rates proposed that the ECB’s short-term rate (the €STR) replace EONIA. To facilitate a gradual transition, it also proposed that EONIA be calculated as a fixed spread over the €STR for a limited period of time. Subject to the approval of the Financial Services and Markets Authority in Belgium, the recalibration of EONIA will start as soon as the ECB begins the daily publication of its euro short-term rate on 2 October 2019 (referring to the rate for 1 October 2019).^[18]

2.2 A weaker economic outlook could trigger further corrections in asset prices

Risks of further abrupt price adjustments could arise from lower than expected economic growth or shifts in monetary policy expectations. The most prominent risk to global financial markets is that slower growth could interact with existing vulnerabilities, including high leverage in the corporate sector or sovereign debt sustainability concerns (see Chapter 1). But even with a more positive growth outlook, changes in monetary policy accommodation could trigger large adjustments in financial markets. In particular, market contacts highlight a perception of current heightened sensitivity of asset prices to policy accommodation and central bank communication. Finally, political uncertainty is particularly elevated, in relation, for example, to Brexit or trade tensions, and could pose risks to financial stability.

The inversion of the US Treasury yield curve signals moderate recession risks, although the predictive power of this market indicator may have decreased. Historically, a flat or even negative slope of the term structure of risk-free Treasury yields has often preceded economic downturns (see Chart 2.5). However, the most recent flattening of the term structure for US Treasuries and German Bunds can be almost entirely attributed to a compression of term premia. To a large extent, these have been driven down by structural rather than cyclical factors, including central banks’ purchases of sovereign bonds. Model-based recession forecasts exploiting a larger variety of financial market variables, including corporate bond spreads and equity market volatility, highlight an increasing but still moderate recession risk in the United States and the euro area over a one-year horizon (see Chart 2.5). Moreover, the upside surprise in US GDP growth in the first quarter should have contributed to a decline in the market perception of recession risks.

Negative global growth shocks could reinforce debt sustainability concerns for highly leveraged corporates. Lower corporate profitability, higher funding costs and higher default rates could amplify the magnitude of any downturn. Forecasts of earnings growth in 2019 have continuously been revised downwards over the review period, most noticeably for US listed corporates (see Chart 2.6, left panel). Lower corporate profitability and, more generally, lower growth would interact adversely with NFC leverage, which in the United States has reached historically high levels (see Chart 2.6, right panel), and with the associated elevated refinancing needs. Although declining over the last years, the indebtedness of NFCs also remains high in the euro area (see Chapter 1). Corporate leverage also contributed to the higher correlation of corporate bond spreads with equity prices observed in recent months.

A further deceleration in growth could prompt mark-to-market losses for some investors. While the risk of tighter financial conditions has fallen in recent months, rating downgrades typically translate into higher corporate bond spreads (see Chart 2.7, left panel). In the euro area, corporate issuance in the lowest part of the investment-grade spectrum has increased over the last years (see Chart 2.7, right panel). BBB-rated debt could be particularly affected following a downgrade, as the non-investment-grade bond market has a smaller investor base and is associated with lower levels of liquidity (see Chapter 4). Corporate debt affected by issuer downgrades from A to BBB in the United States increased sharply in the fourth quarter of 2018. The impact of downgrades on bondholders could be exacerbated by limits on their rights that allow companies to postpone default for a longer time. In particular, a prolonged downturn scenario could lead to delayed waves of concurrent defaults.

The CLO market is particularly exposed to an increase in corporate default rates (see Box 4). CLO issuance in US dollars and, to a lesser extent, in euro has increased sharply over the past two years (see Chart 2.8, left panel). At the same time, the credit quality of the underlying loans has deteriorated significantly and the leverage of high-yield corporates has increased. In Europe, the share of covenant-lite loans rose to 70% in the course of 2018 (see Chart 2.8, right panel). In an economic downturn, in addition to the potential for large losses by holders of lower-rated and equity CLO tranches, disruptions in this market would also limit the availability of financing for some corporate activities via leveraged loan markets.

While an economic contraction remains a key risk for euro area financial markets, volatility can also arise from other sources. Equity markets remain very sensitive to expectations about global growth and the future path of US monetary policy. While average volatility in US equity markets has not increased significantly since 2018, trading sessions with high volatility have become more frequent (see Chart 2.9, left panel). By contrast, in the euro area, average volatility has decreased and, more importantly, days with high volatility have become less common (see Chart 2.9, right panel). Nevertheless, the risk of an abrupt repricing in euro area financial markets is more broadly related to the increasing importance of global factors in driving euro area equity and credit markets (see Chart 2.3 and Chart 2.4).

Several risks, such as a no-deal Brexit, a breakdown in trade negotiations, a slowdown in China or a resurfacing of sovereign debt sustainability issues, could have financial stability effects. Over the last year a number of policy risks have crystallised, as reflected by the progressive increase of global policy uncertainty indices (see the Overview and Box 2 in Chapter 1). Threats to the multilateral system of global trade still weigh on the global growth outlook and could adversely affect equity and corporate bond markets. Trade negotiations between the US administration and China have continued and risks associated with trade disputes and a resumption of protectionist pressures remain substantial.

3.1 Prospects of banks addressing weak profitability may be diminished by a worsening cyclical outlook

Banks’ profitability in 2018 was supported by lower impairments, but operating performance remains subdued

Euro area banks’ profitability remained low in 2018, as a continued fall in the cost of risk was offset by still subdued operating performance. Euro area significant institutions (SIs) recorded an aggregate return on equity (ROE) of 6%, broadly unchanged from a year earlier (see Chart 3.1, left panel). Amid a maturing business cycle, the cost of risk fell to a new post-crisis low in 2018, suggesting only limited upside deriving from this factor going forward (see Chart 3.1, middle panel). At the same time, banks’ pre-impairment operating profits, at less than 0.75% of total assets, remain well below pre-crisis levels.

The dispersion of bank profitability remains wide, with little improvement at weaker performing banks. In 2018, within a balanced sample of 100 SIs, around half of the banks recorded an ROE below 6% (see Chart 3.1, right panel). In the period between 2015 and 2018 there was a high persistence of weak performances, with many institutions remaining in the below-median ROE group for at least three of the last four years. Moreover, there is a large cohort of very weak performers, with a quarter of banks recording an ROE below 3%, although with some improvement in the tail of the distribution.

Core banking revenues have improved slightly, but this was more than offset by the weakness of trading revenues (see Chart 3.2, left panel). After two years of declines, the contribution of net interest income (NII) growth to overall revenues turned slightly positive in 2018. A decomposition of NII growth in the last few years reveals that the negative impact of narrowing margins has abated since 2016. In fact, in 2018 it was outweighed by the positive impact of a pick-up in loan growth (see Chart 3.2, right panel). In contrast, growth in net fee and commission income (NFCI) slowed in 2018, possibly due to the negative impact of heightened financial market volatility on investment fund flows and securities underwriting activity. Finally, other non-interest income declined for the third consecutive year, weighed down by the weakness of trading income in the last quarter of the year due to a spike in market volatility.

Euro area banks’ cost-efficiency has deteriorated since 2015 and compares unfavourably with that of some of their international peers. Significant banks’ cost-to-income ratio reached nearly 66% in 2018, a 3 percentage point increase over the last three years. As a result, euro area banks continue to lag behind some of their international peers in terms of cost-efficiency, as a significant efficiency gap persists or has developed in recent years vis-à-vis Nordic banks and US banks respectively (see Chart 3.3, left panel). The increase in significant banks’ cost-to-income ratio in the last few years was mainly driven by a drop in revenues, which could not be offset by modest progress in banks’ cost containment (see Chart 3.3, middle panel). At bank level, the best-performing banks – in terms of cost-to-income ratio declines in the last three years – benefited mainly from stronger revenue growth and, to a lesser extent, also from cost-cutting. By contrast, banks with the largest deterioration in cost-efficiency tended to show both weak revenue performance and above-average growth in operating expenses (see Chart 3.3, right panel).

Banks’ profitability prospects and their ability to build up shock-absorption and lending capacity could be dampened by deteriorating growth expectations, adding to structural weaknesses. Persistently low profitability can limit banks’ ability to generate capital, thus restraining the build-up of buffers against unexpected shocks as well as their capacity to fund loan growth. Amid expectations of an economic slowdown, market analysts have revised downwards their profitability forecasts in recent months and project a small deterioration in listed banks’ ROE in 2019 relative to 2018 levels (see Chart 3.4, left and middle panels). Analysts’ downward revisions, which followed a pattern similar to those in the ECB baseline projections for 2019 (see Chart 6 of the Overview), reflected less optimistic revenue expectations, while the aggregate loan loss provision forecasts were revised slightly upwards (see Chart 3.4, right panel). Mirroring weak current and expected profitability, a number of banks continue to display depressed market valuations (see Box 5). Banks with low market valuations could find it very costly, or even prohibitively expensive, to raise capital from market sources should the need arise.

Cost-cutting measures by banks, such as the streamlining of branch networks, as well as consolidation via mergers and acquisitions (M&As) could be possible avenues for reducing overcapacity in the system and enhancing profitability. Notwithstanding a general trend of branch network reductions, a wide dispersion remains across countries in terms of capacity indicators such as the number of branches (see Chart 3.5, left panel) or bank employees expressed in terms of population. Similarly, market concentration varies widely across euro area countries, with operating profitability (as measured by cost-to-income ratios) typically higher in more concentrated banking sectors (see Chart 3.5, right panel). This may suggest that – in particular in more fragmented banking systems – there may be scope for profitability gains through M&As by, for instance, increasing pricing power or, in some cases, improving economies of scale.

However, bank mergers are not a panacea for profitability problems and obstacles still need to be overcome to facilitate cross-border consolidation in the euro area. First, while there is scope for M&As that can reduce costs through lower administrative expenses or branch rationalisation, empirical evidence on the success of European bank mergers in terms of profitability and efficiency gains is mixed.^[24] This highlights the importance of a viable and sustainable business model for the merged banks, with a focus on not only potential cost savings but also longer-term revenue-generation capacity. Second, in order to facilitate larger-scale bank M&As within the euro area more progress is needed to complete the banking union, overcoming prevailing obstacles by, for example, harmonising insolvency laws and taxation regimes and removing national options and discretions (e.g. regarding capital and liquidity). Furthermore, from a financial stability perspective, special attention should be paid to the emergence of potential risks of too large and too complex institutions that may result from the M&A process.

Among other structural challenges, banks need to further adapt their business models to cope with the rapid pace of technological innovation in financial services as well as to strengthen their resilience to cyber threats. From a profitability perspective, increased digitalisation may offer significant cost-saving opportunities for banks (e.g. a further shift away from physical branch networks to digital banking), at least in the medium-to-long term. That said, the pace of digital transformation in the banking sector varies widely across countries and banks’ ability to exploit cost-saving potential from increased digitalisation will depend on structural factors, such as labour laws, population density or the overall degree of digitalisation in the society. At the same time, the increased adoption of digital technologies in banking services, together with the higher interconnectedness and complexity of the financial system, makes banks more vulnerable to cyber threats, which are continuously evolving and becoming ever more sophisticated. In this regard, thematic reviews by ECB Banking Supervision found that there is room for improvement at banks regarding cyber governance and highlighted deficiencies in IT security risk management at several banks as well as concentration risks stemming from increased IT outsourcing.^[25]

The improvement in asset quality continues, but further efforts are needed to reduce NPLs

Euro area banks’ asset quality continued to improve in 2018, with non-performing loan (NPL) reductions becoming more broad-based. Significant institutions’ aggregate NPL ratio has declined at a steady pace, to below 4% at end-2018 from 6.2% in 2016. Looking at the different sectors, the decline in NPL ratios was mainly driven by business and commercial property loans (see Chart 3.6, left panel). Progress in NPL reduction was broad-based across all high-NPL countries in 2018 (see Chart 3.6, right panel). Notwithstanding these improvements, dispersion remains wide within this group of countries, with significant banks’ NPL ratios ranging from 5.5% to 41%, indicating that further efforts are needed to bring down NPL stocks to manageable levels.

But further progress on NPLs could be hampered by weaker economic growth reducing cure rates and creating new loan performance issues, and by signs that the secondary market for NPL sales may have peaked. Over the last two years the decline in NPL ratios has mainly been driven by NPL reduction measures other than sales, such as write-offs, cures and renegotiations with a combined 70% share in gross NPL reduction (see Chart 3.7, left panel). In the last three quarters of 2018 cure rates^[28] were exceeded by inflows of assets into the Stage 3 (broadly corresponding to non-performing) category (see Chart 3.7, middle panel), pointing to higher write-off rates driving NPL reduction in this period. This suggests that euro area banks may not have taken full advantage of supportive macroeconomic conditions in 2018 and had difficulties in reducing their NPL stocks by curing impaired assets without recognising further losses. Trends in deal size and trade volume suggest that the NPL sales market might have peaked in volume terms, and that the scope for large portfolio sales has shrunk. The number of transactions did increase in 2018 compared with a year earlier, partly driven by a pick-up in sales activity in previously less active NPL markets such as Greece, Cyprus and Portugal. However, the average deal size dropped in 2018, and the gross volume of NPL sales fell by more than 30% (see Chart 3.7, right panel). In addition, ongoing deals to be realised in the future are also shrinking. This is likely to be because the largest and easier-to-execute portfolio transactions have mostly been completed by now.

The provisioning coverage of remaining NPLs also improved year on year, although trends diverged somewhat across countries. Significant banks’ aggregate coverage ratio notably improved in the first quarter of 2018, as a number of banks increased provisions under the transitional arrangements for IFRS 9, but declined thereafter. This suggests that some of the additional provisions that had been made in early 2018 were consumed by NPL reductions during the year. Trends in coverage ratios diverged somewhat across high-NPL countries after the first quarter of 2018, ranging from a significant decline in Ireland to a further increase in Portugal (see Chart 3.8, left panel). Dispersion also remains wide across countries in the coverage of “underperforming” (i.e. Stage 2) assets, with a shift towards slightly lower coverage levels during 2018 (see Chart 3.8, right panel).

From a policy perspective, a further reduction in banks’ NPLs and the prevention of their renewed build-up could be supported by the timely implementation of proposals contained in the European Commission’s package of measures that would help tackle high NPL ratios.^[29] In this regard, the European Commission’s package includes proposals for: (i) a directive on credit servicers, credit purchasers and the recovery of collateral, which would remove legal impediments to the transfer of NPLs by banks to non-banks, including harmonisation of the licensing requirements for third-party loan servicers; (ii) an amendment of the Capital Requirements Regulation (CRR) to introduce minimum levels of provisioning for future NPLs; and (iii) a blueprint for the setting-up of national asset management companies. From a macroprudential perspective, borrower-based measures, among others, seem well suited to avoiding or mitigating the vulnerabilities in the first stage of the life cycle of potential NPLs.^[30]

Improvements in banks’ capital ratios paused in 2018, mainly reflecting the one-off impact of IFRS 9 adoption

Improvements in euro area banks’ regulatory capital ratios paused in 2018, mainly due to the introduction of IFRS 9 at the beginning of the year. Banks’ Common Equity Tier 1 (CET1) ratios experienced a one-off decline in the first quarter of 2018, mainly reflecting the impact of IFRS 9 first-time adoption, but remained broadly stable thereafter (see Chart 3.9, left panel). The negative gap between the capital ratios of countries more affected by the crisis and those of the other countries widened further, reaching more than 2 percentage points at end-2018. Since 2015 changes in the main drivers of capital ratios have markedly differed between the two country groups as deleveraging and de-risking was the main positive driver of capital ratio changes in countries more affected by the crisis, as opposed to increases in CET1 capital in the other countries (see Chart 3.9, middle panel). Bank risk-weighted assets (RWAs) began to increase on aggregate in 2018, on the back of a pick-up in lending growth. Looking at the different risk types, credit RWAs drove the overall growth of risk exposures, with an increase in market RWAs also contributing to a lesser extent (see Chart 3.9, right panel).

Breakdowns of capital requirements and buffers by size also reveal substantial heterogeneity, with buffers generally positively correlated with (past) profitability. An analysis of the different size groups shows that, on average, the largest banks hold the lowest capital buffers relative to minimum requirements (see Chart 3.10, left panel). The observed differences in capital buffers could be due to a number of factors, including more efficient management of capital at larger banks, currently limited access to profitable investment opportunities for smaller banks, as well as differences in the cost of capital.^[31] In general, buffers are positively correlated with past profitability, as measured by average ROE in 2015-17. In fact, the median buffer for banks with the highest profitability was nearly twice as large as the median for banks in the lowest profitability quartile (see Chart 3.10, right panel).

Similar to risk-weighted ratios, the improvement in euro area banks’ leverage ratios also paused in 2018. While the median transitional leverage ratio of significant institutions was broadly unchanged from a year earlier, there was a drop in the fully loaded ratio (see Chart 3.11, left panel). Differences between global systemically important banks (G-SIBs) and other banks persisted as the median transitional leverage ratio for euro area G-SIBs stood at 4.8% at end-2018, compared with a median of 6.1% for the whole sample. Furthermore, euro area G-SIBs’ leverage ratios continue to compare unfavourably with the ratios of many of their global peers (see Chart 3.11, right panel).

Looking ahead, the final Basel III revisions will require further adjustments in banks’ capital in the future. The recently published impact assessment by the European Banking Authority (EBA) showed that, based on June 2018 data, the implementation of Basel III would likely increase the minimum required capital for relevant EU banks by nearly 20%, corresponding to a decline of more than 3 percentage points in the aggregate CET1 ratio relative to the fully phased-in CRR/CRD IV ratio.^[32] According to the EBA’s impact assessment, the output floor and operational risk frameworks are the two main drivers of higher capital requirements under the final Basel III framework, followed by credit risk and credit valuation adjustments (CVAs), with the relative importance of these factors varying across different groups of banks.

Benign cyclical conditions supported banks’ credit quality in 2018, but market-based measures signal increasing credit risk albeit from low levels

Credit risk measures reported by banks remained subdued in a maturing business cycle, but expectations of a slowdown in economic growth point to higher risks in the future. Credit risk measures, such as reported probabilities of default and expected loss ratios, did not signal an increase in the riskiness of banks’ credit portfolios, with the exception of a small uptick in risk measures for small and medium-sized enterprise (SME) loans in the latter part of 2018 (see Chart 3.12). These trends are consistent with economic growth having remained supportive to low default rates in much of 2018.

Market-based measures and loan loss provisioning forecasts point to some worsening in the credit risk outlook for 2019-20. Expected default frequencies for listed euro area companies have signalled a pick-up in credit risk since mid-2018 (see Chart 1.11 in Chapter 1), although they remained below their long-term averages. Similarly, forecasts of loan loss provisioning for 2019-20 have been raised by market analysts and in the ECB baseline projections, pointing to a deterioration in the credit risk outlook in line with expectations of a deceleration in economic growth (see Chart 3.4, right panel, and Chart 3.20 in Section 3.2).

Credit growth remained robust in the banking sector, although showing signs of moderation. The annual growth rate of euro area monetary financial institutions’ adjusted loans in the non-financial corporation (NFC) and household sectors remained in the range of 3-4%, but the pace of NFC loan growth moderated slightly (see Chart 3.13, left panel). Consumer lending continued to be the fastest-growing segment, but growth rates have slowed somewhat since mid-2018, possibly reflecting both demand-side factors and increased supervisory scrutiny (see Section 1.3). Results of recent euro area bank lending surveys suggest that the easing of credit standards may have come to an end in recent quarters, while rejection rates for loans to NFCs and households continued to increase.^[33]

In some segments, banks with stronger lending growth report somewhat higher credit risk measures. Bank-level data (for IRB portfolios) suggest that banks with stronger consumer and SME lending growth since end-2015 have tended to take on higher credit risk, as illustrated by higher median expected loss ratios for banks with above-median growth rates (see Chart 3.13, right panel). No such relationship between growth and risk can be seen in large NFC and residential real estate (RRE) portfolios. Overall, this suggests that pockets of risk may have been developing in a benign credit environment, which could be unearthed in the event of a more severe and prolonged economic slowdown than currently anticipated.

Funding market conditions improved, but the need to build up bail-inable buffers may pose challenges for some banks

On aggregate, euro area banks’ funding structures and liquidity ratios have remained stable. The funding mix of euro area banks remained broadly unchanged in 2018, while their aggregate liquidity coverage ratio (LCR) slightly increased year-on-year (see Chart 3.14). That said, heightened volatility in government bond markets in the second and third quarters of 2018 had a negative, albeit small, impact on some banks’ LCRs through the revaluation of sovereign bonds held as high-quality liquid assets. Banks’ aggregate net stable funding ratio (NSFR) remained above 100%, but NSFRs continued to vary widely across banks, with some banks still having shortfalls.^[34] While the NSFR is expected to become a binding requirement only from 2021 under the CRR II/CRD V, it could lead to higher issuance needs for some banks in the future.

Following a marked deterioration in late 2018, market funding conditions eased in the first half of 2019. Bank bond spreads have tightened since early 2019 across all seniorities and bond types, reversing much of the funding cost increases observed in late 2018 and reducing cross-country differences (see Chart 3.15). These improvements notwithstanding, the cost of issuing bank bonds is still above the lows observed in early 2018 and remains vulnerable to abrupt changes in risk sentiment, including a possible aggravation of sovereign risk concerns.

Benefiting from improved funding conditions, euro area banks stepped up their debt issuance activity in the first few months of 2019. An increase was seen in most instrument classes, from covered bonds through non-preferred senior debt to additional Tier 1 (AT1) instruments (see Chart 3.16, left panel). Looking at country developments, banks in France, Italy and the Netherlands accounted for most of the year-on-year increase in issuance, with Italian banks benefiting from a positive spillover from improved sovereign funding conditions (see Chart 3.16, right panel).

Notwithstanding these improvements, banks’ need to issue more TLAC/MREL-eligible bonds may pose challenges for some banks over the next years. While the refinancing of maturing bonds over the next three years appears manageable, the issuance of new TLAC (total loss-absorbing capacity)/MREL (minimum requirement for own funds and eligible liabilities)-eligible debt might prove challenging for some banks, in particular smaller banks^[35] and/or those banks with lower ratings (see also Box 6). A possible increase in funding costs might complicate these banks’ efforts to build up the necessary loss-absorption capacity and could weigh on their profitability. Furthermore, while the launch of the new series of targeted longer-term refinancing operations (TLTRO-III) should help banks to refinance maturing TLTRO-II funds, some banks with weaker funding profiles still need to develop plans for replacing central bank funding with market funding, at least in part, which could add to funding cost pressures for these banks in the medium term.

For some banks, a deterioration in bond funding conditions might also be triggered by possible rating downgrades. While the majority of euro area banks maintain stable credit rating outlooks, negative rating outlooks outweigh positive outlooks in many countries (see Chart 3.17, left panel), suggesting that, over the next 12 months, downgrades are likely to follow. The impact of possible downgrades may be most pronounced for those banks whose ratings may be pushed into non-investment-grade territory. Due to the non-linear relationship between a bank’s rating and its funding costs, this might lead to substantially higher funding costs (see Chart 3.17, right panel) and lower issuance volumes.

Late-cycle market volatility has the potential to negatively affect banks’ capital ratios, in particular through the revaluation of sovereign bond portfolios

Banks’ exposures to domestic sovereign debt were broadly stable on aggregate, but some banks remain vulnerable to a possible aggravation of sovereign risk concerns. Banks’ holdings of domestic sovereign debt remain elevated or have even increased since early 2018 in some euro area countries, including Italy and Portugal (see Chart 3.18, left panel). Despite some moderation in sovereign risk perceptions over the last few months (see Chapter 1), the capital positions of banks with sizeable holdings of fair-valued sovereign bonds remain vulnerable to sudden increases in sovereign risk premia. At the end of 2018 around two-thirds of significant institutions’ total government bond portfolio was subject to mark-to-market valuation, meaning that the possible negative impact of revaluations feeds through directly to equity or to their income statement. Despite some decline in their share during the year, fair-valued government bonds still comprise the biggest part of the total sovereign debt portfolio in many countries, including those with higher sovereign risk perceptions (see Chart 3.18, right panel).

More broadly, possible increases in financial market volatility have the potential to negatively affect banks’ capital ratios through their impact on risk-weighted assets. Heightened equity and debt market volatility in the fourth quarter of 2018 contributed to an increase in banks’ market risk exposures as measured by value at risk (see Chart 3.19, left and middle panels). In turn, gyrations in financial markets could also have an effect on banks’ capital ratios via their impact on capital requirements for market risk. In fact, historical correlations between volatility measures and banks’ market risk exposures show that an increase in stock market volatility tends to increase market risk-weighted assets for most institutions, while the impact of a widening of credit spreads on capital requirements varies widely across banks (see Chart 3.19, right panel). Finally, heightened volatility may also aggravate lingering market liquidity risks, resulting in migrations of fair value assets to categories characterised by higher uncertainty with regard to liquidity and the observability of valuation inputs (e.g. Level 3 assets) (see Box 7).

Recent developments and open issues regarding the review of the European System of Financial Supervision and the EU banking reform package

Revisions to the macroprudential regulatory framework are enhancing the governance and efficiency of macroprudential policy in the European Union. Key developments in this regard include the review of the European System of Financial Supervision (ESFS) and of the Capital Requirements Regulation and Directive (CRR/CRD).

The political agreement reached by the EU co-legislators on the ESFS review in March 2019 is generally welcome. The establishment of both the European Supervisory Authorities and the European Systemic Risk Board (ESRB) was a significant achievement, which improved the coordination of financial regulation and supervision in the European Union. However, the experience gained so far suggests that the institutional framework would benefit from further adjustments, such as the acknowledgement of the establishment of the banking union in the ESFS framework, to ensure effective and consistent micro- and macroprudential supervision across Europe. The review of the ESRB is of particular importance from a macroprudential perspective. The agreed compromise will strengthen the governance of the ESRB by enhancing the role of the First Vice-Chair, providing the representatives of ECB Banking Supervision and the Single Resolution Board with non-voting membership in the ESRB General Board and increasing the transparency of the ESRB’s work. It is welcome that the ESRB’s governance will continue to reflect the importance of central banks’ role in the functioning of the ESRB and the fact that the ESRB relies on expertise, resources and infrastructure of the ECB.

The EU co-legislators also reached a political agreement on the EU banking reform package in February 2019. The finalised revision of the CRR/CRD IV will implement the Basel III framework in EU law, including the leverage ratio requirement, the net stable funding ratio requirement and the revised market risk capital framework. The details of the package were examined in previous issues of the FSR and in a related ECB Opinion.^[38]

Going forward, the EU co-legislators need to aim for a full, consistent and timely implementation of the remaining elements of the Basel III regulatory package. Several elements of the Basel III framework, including the fundamental review of the trading book and the “Basel III finalisation package” agreed by the Group of Central Bank Governors and Heads of Supervision in December 2017, still need to be implemented in EU law. These elements will form part of a separate legislative proposal by the European Commission and will include further amendments to the CRR II/CRD V.^[39] Full, consistent and timely implementation of Basel III, and agreed G20 reforms more broadly, is important to ensure that the G20 framework remains functional and delivers internationally consistent regulatory outcomes. The Basel III finalisation package delivers a better prudential framework overall by improving the balance between model-based elements and standardised elements and enhancing calibration of the standardised approach.

The targeted review of the macroprudential framework in the CRR/CRD IV primarily aims to clearly delineate the responsibilities of micro- and macroprudential authorities and improve the operational efficiency of the framework. Removing the use of the Pillar 2 requirements for macroprudential purposes is a key element of the new framework. Furthermore, in order to ensure that macroprudential authorities have sufficient tools available to effectively address systemic risks, new instruments and mechanisms have been introduced. For example, the capital buffer framework has been revised to allow the sectoral use of the SRB and the calibration range of the O-SII capital buffer has been increased. In addition, activation procedures have been streamlined (e.g. the notification procedures for the CCyB have been simplified), and a general review clause for the macroprudential framework has been introduced (with the review foreseen by 2022). A detailed overview of the ECB’s stance on these changes has been provided in a dedicated article in the ECB’s Macroprudential Bulletin.^[40]

Looking ahead, a comprehensive review of the macroprudential framework is warranted to enhance the effectiveness of macroprudential policy. The targeted changes to the current framework already incorporate some of the lessons learned from experience. However, this should only be the first step towards a more thorough revision of the framework by 2022. A comprehensive review could reduce complexity, further streamline procedures, broaden mandatory reciprocity arrangements, enhance the coherence of the policy framework and extend the framework to include new tools where necessary.

In particular, it should be explored whether the macroprudential policy framework could be made more comprehensive by complementing capital-based instruments with borrower-based instruments in the EU legislation. Such instruments include limits on loan-to-value, loan-to-income or debt service-to-income ratios, which can be used to target vulnerabilities in mortgage markets. Given the synergies and complementarities among instruments, a comprehensive set of these tools should be provided for in the CRR/CRD, while taking into account the specific characteristics of national real estate markets. This would allow macroprudential authorities to act in an efficient, effective and timely manner.

Moreover, the comprehensive review should also allow the extension of the macroprudential framework to cover non-banks. Here, the framework and the powers of the related authorities at the EU level need to be strengthened to address possible risks emerging in the securities markets and in the insurance and pension sectors. While more work in the area of macroprudential tools for the non-bank sector is needed, such instruments could include margin and haircut requirements for derivatives and securities financing transactions, and leverage and liquidity requirements for investment funds.

3.2 Evaluating the resilience of the euro area banking sector through scenario analysis

This section provides a quantitative assessment of the resilience and profitability of euro area financial institutions under both a baseline and an adverse scenario. The assessment of the impact of macro-financial scenarios on euro area banks is based on a macroprudential simulation exercise involving top-down stress-testing models and using bank-level granular supervisory data.^[41] The analysis covers about 100 large and medium-sized banking groups directly supervised by the ECB. Owing to methodological, scenario and sample differences, the results presented in this section are not comparable with the results of supervisory stress-test exercises, such as those coordinated by the European Banking Authority (EBA) and ECB Banking Supervision.

Evaluation of banks’ resilience and profitability under the baseline scenario

Real GDP growth in the baseline scenario has been revised down by 0.6 percentage points in 2019 (see Table 3.1). ^[42] As discussed in Chapter 1, the latest Eurosystem and ECB staff macroeconomic projections, which are based on market expectations, imply significantly weaker growth and also lower short and long-term interest rates. According to the March 2019 ECB staff projections, compared with the December 2018 Eurosystem staff projections, short-term interest rates are projected to be 20-30 basis points lower by 2021, and long-term interest rates about 40 basis points lower over the entire scenario horizon.

Weaker growth in the baseline scenario points to a potential decline of 0.7 percentage points in banks’ ROE by 2021. Based on the March 2019 macroeconomic projections, banks’ profitability is projected to slightly decline from 6.2% at end-2018 to 5.5% in 2019 and to then recover somewhat – driven primarily by an increasing slope of the yield curve – to 6.1% in 2021 (see Chart 3.20, left panel). This would nevertheless be some 0.7 percentage points below the level projected based on the December 2018 macroeconomic projections.^[43] The more subdued projected developments in bank profitability stem mainly from the combination of lower growth and lower short and long-term interest rates, which negatively affects net interest income (see Chart 3.20, right panel). The analysis assumes that some parts of the P&L account, such as administrative expenses and other operating income, stay constant over the projection horizon.^[44]

Under the baseline scenario, the solvency position of the sample of euro area significant institutions is projected to improve somewhat, reflecting weak but still positive economic growth forecasts. The aggregate CET1 capital ratio is projected to increase by about 1.8 percentage points to 15.7% by the end of 2021 (see Chart 3.21). This improvement is driven by retained net interest income and an increase in net fee and commission income which would lead to positive growth in pre-provision profits of about 5.5 percentage points, despite the negative impact from administrative and other operating expenses (-12.4 percentage points in total). As mentioned above, the results are not comparable with the EBA/ECB supervisory stress tests. For instance, the pre-provision profits are somewhat higher than what was observed in the 2018 EBA/ECB stress test for euro area banks^[45], which is mainly due to the fact that in the results reported here profits are supported by the removal of caps and floors on net interest income and that net fee and commission income is allowed to increase. The overall positive contribution of pre-provision profits would still outweigh the negative one of credit losses amounting to 1.8 percentage points.^[46]

Evaluation of banks’ resilience under the adverse scenario

The adverse scenario assumes a severe deterioration of global macroeconomic conditions in the context of very low interest rates. The adverse scenario is a tail event, designed with the ECB models also used for the EBA stress-test scenarios.^[47] Events in the scenario reflect the materialisation of the systemic risks presented in the Overview.

The adverse scenario results in a maximum year-on-year decline of euro area real GDP of about 2.7 percentage points (see Table 3.2). Sovereign credit spreads would widen by up to 40 basis points in the majority of euro area countries and widen by about 100 basis points in countries where political uncertainty or debt sustainability concerns are higher (see Table 3.2). Following the drop in demand, residential property prices would decline by about 11% from 2018 levels (see Table 3.2) and stock prices by about 30%.

On aggregate, the euro area banking sector is assessed to be resilient to the materialisation of the main financial stability risks, but could face losses amounting to 3.4 percentage points of capital.^[48] The aggregate risk-weighted CET1 ratio falls from 13.9% to 10.5% by 2021 in the adverse scenario. Loan losses and lower net interest income are the main drivers of the CET1 ratio depletion compared with the baseline (see Chart 3.22). Thus, under the adverse scenario, loan losses are 2 percentage points higher in CET1 terms, while pre-provision profits are 4.1 percentage points lower compared with the baseline. The majority of euro area significant institutions would remain above the average CET1 capital demand of 10%^[49] under the adverse scenario. Only a few small banks would face severe solvency difficulties under the adverse scenario, falling below a 6% CET1 ratio.^[50]

4.1 Non-bank financial institutions continued increasing their financing of the euro area economy

Euro area non-bank financial institutions have increased their share of credit provided to the real economy over the last six months. The size of the non-bank financial sector – which includes investment funds (IFs), money market funds (MMFs), financial vehicle corporations, insurance corporations, pension funds and remaining other financial institutions (OFIs) – increased only slightly in 2018, due to low inflows and valuation effects. At the same time, non-banks continued to provide significant financing to households, non-financial corporations (NFCs) and governments in 2018, both within and outside the euro area (see Chart 4.1). Investments in non-euro area debt securities represent a large part of non-bank financing flows. But loans and debt financing flows to most euro area sectors increased over the last year, primarily driven by lending to the corporate sector by funds and other financial institutions. Considering a longer horizon, non-financial corporations in the euro area have steadily increased their use of market-based funding. For example, the share of monetary financial institution (MFI) loans in total euro area NFC financing^[51] shrank from around 65% to 46% in the last ten years, while the share of debt securities issuance and non-bank loans increased from 24% to 36% (see Chapter 1).

The expansion of the non-bank financial sector has been accompanied by increased risk-taking. The low interest rate environment has led to low investment returns on relatively safe assets. In this context, there is evidence which points towards broad-based risk-taking by non-banks, especially investment funds, but also private equity and private debt funds globally. In particular, euro area funds and insurers have increased their exposures to BBB-rated and high-yield bonds over the last five years, and they have also extended the residual maturity of their bond portfolios (see Chart 4.2).^[52] So they are (potentially) more exposed to credit and liquidity risk than in the past, despite some recent de-risking during late 2018, including around the period of heightened market volatility. Recent evidence shows that there are pockets of high leverage in the (alternative) investment fund sector, which could amplify the impact of market volatility on funds’ portfolios. Insurance companies have increasingly ventured into various types of alternative assets, such as infrastructure and private equity funds and real estate loans. Procyclical risk-taking by non-bank financial institutions may contribute to wider financial sector exuberance and renders them more vulnerable to potential shocks in global financial markets.

Low credit quality and high indebtedness in some segments of the corporate sector, combined with new concerns over the euro area growth outlook, result in large exposures of non-banks to vulnerable assets. The investor base in the global NFC bond market has shifted towards non-banks over the last five years, partially driven by a de-risking behaviour of banks (see Chart 4.3). The holdings of global NFC bonds by euro area insurance corporations and pension funds (ICPFs) and investment funds have increased by almost 65% since the end of 2013, compared with an increase in banking holdings by 4%. While the share of high-yield corporate bonds held by non-banks slightly decreased over the last six months, levels remain elevated. And BBB bonds represent a large – and increasing – part of their NFC bond holdings, i.e. 40% for ICPFs (compared with 33% in the fourth quarter of 2013) and 35% for IFs (31% in the fourth quarter of 2013) at the end of 2018. Euro area asset managers and funds are also among the main holders of low-rated collateralised loan obligations (see Box 4). In the event of an economic downturn or a sudden correction in risk premia, these highly leveraged companies could face difficulties in servicing their debt and suffer downgrades to high-yield status. This may in turn amplify the effects of the downturn on the balance sheet of non-banks through higher borrowing costs and default rates.

Euro area insurance corporations and pension funds – and to a lesser extent investment funds – play an important role in the financing of euro area sovereigns. Despite decreasing in recent quarters, non-banks’ holdings of euro area government bonds are more than twice as much as banks’ holdings and amounted to 30% of the total outstanding sovereign debt at the end of 2018, i.e. €2.4 trillion (see Chart 4.4, left panel). ICPFs play a particularly important role in providing long-term financing to (higher-rated) euro area sovereigns (see Chart 4.4, middle and right panels). While sovereign bond holdings of investment funds are widely diversified, banks’ and insurance corporations’ holdings are more domestically concentrated.

Concerns about government debt sustainability and political uncertainty in some euro area countries could result in pressure on non-banks to sell if there is an abrupt increase in sovereign bond yields or broad-based rating downgrades. The sensitivity of non-banks’ asset holdings to changes in market yields has increased recently (see Box 8). A large repricing of sovereign bond premia may drive non-banks to rebalance their portfolios towards more highly rated bonds, while selling riskier securities. Similarly, rating downgrades of sovereign bonds from investment grade to high yield could create strong selling pressures on ICPFs and IFs with rating-based investment mandates, as they often set internal limits on the proportion of low-rated bonds that can be held in the portfolio. Any such rebalancing could have significant implications for long-term debt sustainability.

Non-banks may also contribute to systemic risk through connections with the banking system, including via ownership links. Looking at the corporate structure of euro area financial institutions, banks and insurance corporations tend to be controlled by institutions within the same sector. But they are often the majority investors in the largest investment funds and the owners of asset management companies, which manage a large number of funds (see Chart 4.5).^[57] Financial conglomerates, which diversify their activity across sectors, are typically led by a bank, although insurance corporations increased their M&A activities involving asset management businesses in the last years. Ownership links may be beneficial for the holder company in periods of market distress and represent a source of income diversification. But they can also result in possible channels of contagion via reputational spillovers and step-in risk if there are credit lines and contingency arrangements between holder and asset management companies, and could have negative repercussions on the holder company.

In addition to ownership interlinkages, banks and non-banks are highly interconnected through other channels. First, euro area MMFs, IFs and OFIs represent an important source of funding for the banking sector – and also for the real economy – notably through debt and equity financing.^[58] These holdings amount to around 5.5% of their assets (€598 billion as at end-2018). This can drive procyclical risk-taking in the banking sector and contribute to wider financial sector exuberance in some parts of the real economy. Also, it may create credit risks for non-banks related to the low profitability of the banking sector (see Chapter 3). Second, banks are often the only counterparties for ICPFs and IFs in over-the-counter transactions in derivatives and repo markets.^[59] Third, investment funds tend to have high overlapping exposure with other sectors, in particular the pension fund sector, given the high diversification of their portfolio. By contrast, banks show the lowest degree of overlap with other sectors in their portfolios, mainly due to their tendency to invest in domestic securities.^[60] Such high interconnectedness can amplify risk transmission during periods of stress and may have significant implications for financial stability through funding and credit risk channels.

Non-bank financial sectors are closely connected with each other via direct balance sheet exposures. In the current low interest rate environment, euro area insurers have been increasing their holdings of investment fund shares and alternative assets. At the end of 2018 ICPFs’ holdings of investment fund shares amounted to €3.4 trillion, i.e. 34% of ICPFs’ financial assets. Part of these holdings consists of private debt, private equity and infrastructure funds, which increases ICPFs’ exposure to alternative and illiquid assets (see Box 9). Intra-sectoral holdings of funds’ shares slightly decreased in the last six months and now amount to about 18% of investment fund portfolios. But an emerging trend is for investment funds to increasingly use exchange-traded funds (ETFs) to complement their portfolios, mainly for cost and liquidity considerations. ETFs are perceived as highly liquid instruments and may be used by funds as an additional means to manage exposures and portfolio liquidity, notwithstanding the possibility that ETF liquidity may deteriorate in periods of stress.

Overall, the share of non-bank financial intermediation has been growing in the euro area, with potential implications for financial stability and the financing of the real economy more broadly. The growing size of non-banks has increased the diversification of funding sources for the real economy and the whole financial system, which is now less dependent on banks than it used to be before the financial crisis. But it has been accompanied by rising liquidity and credit risk in non-banks’ investment portfolio. Procyclical risk-taking by non-banks may contribute to wider financial sector exuberance and could amplify potential shocks in global financial markets. In addition, if the economy were to slow down, thus impairing debt sustainability in the public and private sectors, interconnectedness and vulnerabilities of non-banks could amplify a possible repricing of risk premia in financial markets.

As the share of non-bank financing is likely to increase further, prudential policies need to ensure that the sector is able to absorb shocks, rather than amplifying exuberance and stress. The capital markets union (CMU) project will be pivotal in promoting a broader and deeper capital market in the European Union, with tangible benefits for the euro area economy as a whole. Specifically, a more integrated and deeper European capital market will help promote a more diversified funding base for real economy borrowers. This will in turn increase the resilience of the euro area to funding stress in the banking sector and asymmetric shocks in single countries or financial sectors. But to reap the full benefits of a deep and integrated capital market in Europe, non-bank financing needs to develop in a sustainable and resilient manner. In particular, solid prudential standards in the non-bank financial sector need to be maintained and these standards should not be weakened in the context of CMU. Moreover, there is a need to develop macroprudential policies to mitigate the build-up of risks at system level, before they materialise. These policies should help ensure that non-bank financing will be able to absorb shocks, rather than amplifying exuberance and stress.

4.2 Increased volatility of fund flows highlights the risks that investment funds could pose to liquidity in financial markets

Significant inflows into the riskier bond funds suggest returning confidence after a period of strong outflows and shifts to safer assets over the last year. Global corporate bond funds – including high-yield and investment-grade funds – experienced significant outflows over the last year, while government bond and money market funds continued receiving large inflows (see Chart 4.6, left panel). In particular, high-yield global bond funds have experienced outflows every month from November 2017 to December 2018, with a cumulated outflow of over USD 130 billion. In addition, global money market funds have received relatively large inflows – almost USD 250 billion from October 2018 to February 2019. Overall, these flight-to-safety portfolio shifts were large compared with similar episodes observed in the past (see Chart 5 in the Overview). Since the beginning of this year, inflows have risen again in both the investment-grade and the high-yield segments, with European funds lagging behind their US peers (see Chart 4.6, right panel).^[61] Likewise, inflows into emerging market funds rebounded strongly in 2019, while money market funds experienced outflows in March and April.

Global equity funds continued to experience net outflows throughout most of the reporting period, despite rising stock prices during the first four months of this year. Large outflows were triggered in December last year by a sharp drop in US equity prices, while outflows from euro area equity funds continued their negative trend since mid-2018 (see Chart 4.7). A slowing global economy, unresolved trade issues and political uncertainty are among the factors that have led to sustained outflows from global equity funds since December last year, which did not reverse despite rising stock prices between the end of last year and the beginning of May.

Asset price declines in 2018 also caused hedge funds to suffer their worst year in terms of performance since the global financial crisis. Around 60% of active hedge funds in a sample based on data provided by Preqin delivered negative net returns last year. This triggered outflows, especially from European-domiciled groups. Estimates of market betas for an indicative sample of hedge funds show that the sector has been increasingly exposed to common risk factors, including correlated exposures and leverage (see Chart 4.8). Overall, the investment fund sector seems to have coped well with outflows during the high volatility episode. At the same time, liquidity and credit risks are still high in some parts of the sector and could act as a shock amplifier if a future repricing were to materialise.

Recent volatility in fund flows highlights that investment funds can be subject to the procyclical behaviour of investors and asset managers. Net inflows tend to increase when fund returns are high and decrease when they are low. This effect seems to be non-linear and stronger in periods of large price movements. In addition, the sensitivity of fund managers to changes in yields has increased in the low-rate environment (see Box 8). Over the medium term, procyclical behaviour of investors and asset managers may thus contribute to wider market exuberance and risk-taking in a market upswing and amplify any response to a larger financial repricing in a downturn.

A shock to bond prices would precipitate first and second-round losses for bond funds, particularly those invested in less liquid assets. Sector-wide data point to a broad-based decrease in funds’ most liquid positions, including bank deposits and debt securities issued by euro area governments (see Chart 4.9). A sudden and abrupt repricing of financial assets could trigger investor outflows, possibly resulting in forced asset sales, which could amplify stress in less liquid markets, especially if other types of investors were not willing or able to step in immediately. Such sales have the potential to amplify the original shock to asset prices, with wider financial stability implications in the form of impaired market liquidity and possible spillovers to the real economy, e.g. via a sharp increase in the cost of corporate bond issuance.

In the European Union, investment fund activities are regulated and supervised, so there is less concern about the viability of individual investment funds in general. Mutual funds are governed by the UCITS Directive and the Alternative Investment Fund Managers Directive,^[62] providing EU-wide standards for transparency, concentration risk, leverage and liquidity. The recently introduced Money Market Fund Regulation (MMFR), which came into effect in January 2019, aims to reduce liquidity and other risks in the MMF sector. It introduced three distinct fund categories subject to specific requirements: constant net asset value (CNAV), variable net asset value (VNAV) and low-volatility NAV (LVNAV) funds. In particular, CNAV funds became subject to new requirements regarding redemption gates and fees as well as liquidity requirements. The sector did not show significant shifts between MMF types, or within fund portfolios. This was expected partly because the MMFR did not materially affect the cash-equivalent status of CNAV funds – a feature that investors in those funds value.

Pockets of high investment fund leverage could also amplify the impact of investor outflows or losses on assets, notably in the less strictly regulated alternative investment fund (AIF) sector. The leverage of mutual funds is restricted under the UCITS Directive, but there are no binding constraints on leverage for some types of AIFs. Leverage in some AIFs can be much higher than the average^[63] and the providers of this leverage are often unclear, making it difficult to assess how stress in leveraged funds may propagate in the financial system. In principle, authorities in the EU can impose macroprudential leverage limits on AIFs, but these tools need to be operationalised in line with the recommendation of the European Systemic Risk Board (ESRB) earlier last year.^[64] And there may be significant pockets of leverage in funds domiciled outside the EU, to which the euro area financial system could be exposed.

The development of globally consistent measures of fund leverage is thus important. The International Organization of Securities Commissions (IOSCO) published a consultative report on leverage in November 2018 as part of its operationalisation of the Financial Stability Board (FSB) recommendations.^[65] IOSCO’s consultation document presents a range of potential consistent leverage metrics and elaborates on their respective pros and cons.^[66] Such consistent measures should comprise metrics based on a gross and a net notional exposure and should be supplemented by risk measures to capture potential losses stemming from leverage and potential liquidity demands from margin calls. In line with the FSB recommendations to IOSCO, globally consistent measures of leverage still need to be devised with a view to gaining a system-wide perspective on evolving risks.

While existing rules in the EU provide a robust framework to address investor protection and fund-specific vulnerabilities, the macroprudential toolkit for investment funds needs to be further developed. In particular, investment funds may increase the riskiness of their asset portfolios, perform liquidity transformation and take on leverage in a procyclical manner. These vulnerabilities should be monitored and assessed from a holistic perspective, taking into account interdependencies within the financial system and the real economy more broadly. To the extent that risks can evolve at the system level, with possible implications for real economy financing, there is a need to address risks in the investment fund sector also from a macroprudential perspective.

4.3 Insurers’ investment income is expected to deteriorate further in the low-yield and low-growth environment

Although insurers’ equity valuations declined in line with global equity markets at the end of 2018, they gained around 6% over the full review period. The gains were particularly pronounced in the non-life and reinsurance segments (see Chart 4.10, right panel). On 14 December 2018 the European Insurance and Occupational Pensions Authority (EIOPA) also published the results of its insurance stress test. The limited impact on insurers’ equity valuations suggests that the results were broadly in line with market expectations (see Chart 4.10, left panel).^[67]

A positive market outlook for the insurance sector was supported by strong underwriting revenues and stable solvency positions in the second half of 2018 (see Chart 4.11). For large euro area insurers, the median annual growth rate of life premiums exceeded 3% in the second half of 2018, up on recent quarters (see Chart 4.11, left panel), while the growth rate of non-life premiums remained above 4%. Despite strong underwriting revenues, insurers’ median return on equity dropped modestly to below 8% in the last quarter of 2018 (see Chart 4.11, middle panel). This may be attributed to above-average natural catastrophe losses and very weak investment income in that quarter. The profitability drop in the last quarter only had a limited impact on Solvency Capital Requirement (SCR) ratios, which remained stable and well above the regulatory requirement of 100% for all large euro area insurers throughout 2018.

In 2018 large euro area reinsurers withstood the costs of a historically high number of natural catastrophes globally. As highlighted in Special Feature A, the frequency of weather-related catastrophes worldwide has been rising steadily and their number reached almost 800 for the first time in 2018 (see Chart A.2 in Special Feature A). The insured costs from natural disasters around the globe reached USD 80 billion in 2018, above the ten-year average (USD 61 billion) and almost twice as much as the 30-year average (USD 41 billion).^[68] Wildfires and hurricanes in the United States and typhoons in Asia were the most significant contributors to these costs in 2018. Since large euro area reinsurers operate globally, they bore a portion of these costs. This weighed on their profitability and pushed up their combined ratios to a level close to (but still below) 100% in the last quarter of 2018.^[69]

Consistently weak investment income represents a major challenge for insurers. In 2018 the total return on average investments of large euro area insurers remained at historically low levels (see Chart 4.12, left panel, boxplots). This is because euro area insurers are heavily invested in low-yielding fixed income assets such as government and corporate bonds (see Section 4.1). The ongoing low interest rate environment has contributed to the reduction of the average yield on euro area insurers’ bond portfolios from around 3-4% in 2010-12 to around 1% over the last three years (see Chart 4.12, left panel, blue line).

Going forward, insurers’ investment income may deteriorate further, as (older) high-yielding bonds in portfolios mature and are replaced by (newly issued) lower-yielding bonds. For the next three years, euro area insurers are still likely to hold almost one-fifth of bonds in their portfolios with a yield to maturity of over 3% at issuance (see Chart 4.12, right panel). But, if the low-yield environment prevails beyond this horizon, the yield to maturity at issuance of almost all bonds in insurers’ portfolios would drop below 3%, further eroding insurers’ investment income.

Some insurers are searching for yield, and income, through greater exposure to credit, liquidity and term risks. Over the last five years euro area insurers increased their exposures to BBB-rated and high-yield bonds from around 35% to 41% of their bond portfolios (see Chart 4.13, left panel). They are also venturing into various types of alternative assets such as infrastructure and private equity funds and real estate loans (see Box 9). In addition, they slightly reduced the share of highly liquid securities, from around 34% to 32%, and extended the residual maturity of their bond portfolios from around 8.1 to around 8.4 years. These portfolio adjustments can bring diversification benefits and help close insurers’ negative duration gaps, but they also suggest that insurers tend to reshuffle their portfolios to earn higher credit risk, liquidity and term premia, thereby boosting their yields.^[70]

The recent increase in exposures to BBB-rated and high-yield bonds correlates with life insurers’ profitability challenges. In particular, some life insurers have difficulties in generating investment returns above the average guaranteed rate on existing business, with the latter exceeding the former in several euro area countries at the end of 2017 (see Chart 4.13, right panel).^[71] In turn, these difficulties correlate with the increase in exposure to BBB-rated and high-yield bonds over the last five years across countries, with the lower profitability being associated with a greater increase in risky exposure. While a causal link is difficult to establish, this descriptive evidence and market analysts’ reports suggest that the need to boost investment income is likely to be one of the factors which pushes insurers to move down the credit quality spectrum. Since the issuers of low-rated bonds could be particularly vulnerable to the recent deterioration in the economic outlook and possibly hit by rating downgrades and/or defaults, the credit risk exposures of euro area insurers require close monitoring. This is particularly important as insurers’ investment behaviour currently tends to contribute to the wider financial sector exuberance and may turn procyclical in distress periods, potentially amplifying price corrections.^[72]

While credit risk and market risk are key risks explicitly covered by and monitored under the Solvency II framework, this is less so for liquidity risk. There are, however, several factors suggesting that this type of risk may have increased recently. Beyond the decrease in high-quality liquid assets in insurers’ portfolios, insurers may also face elevated liquidity risks on the liability side. This is because life insurers tend to offer policies with a low investment return to their policyholders in the current low-yield environment, owing to the combination of low guaranteed rates for recently sold products and low discretionary benefits. Should interest rates rise abruptly and strongly, some policyholders could surrender these policies.^[73] Furthermore, the different liquidity requirements in the banking and insurance sectors leave room for potential regulatory arbitrage. For example, regulatory arbitrage can take place within a group which has both a banking and an insurance entity, whereby the highly liquid assets (e.g. needed by banking entities to meet the liquidity coverage ratio) may be shifted from the insurance to the banking entity.

In light of these developments, the current debate on potential macroprudential measures for insurance considers inter alia macroprudential tools that would help monitor and tackle insurers’ liquidity risks. For instance, a recent EIOPA report highlights the need for additional quantitative reporting under Solvency II as the current reporting does not contain sufficient information to enable the monitoring of liquidity risk at a sectoral level for macroprudential purposes.^[74] And a recent ESRB report suggests further work on explicit liquidity requirements for insurers, such as a potential liquidity buffer and a discretionary power for authorities to intervene in exceptional circumstances, for instance in the event of mass lapses/surrenders.^[75] Moreover, the UK’s Prudential Regulation Authority has recently launched a public consultation through which it is seeking views on its expectations for liquidity risk management by insurers, including its expectations regarding the design and conduct of a liquidity stress-testing programme.^[76] In this context, further efforts to enhance thinking on the macroprudential toolkit for insurers are important.

A Climate change and financial stability

Prepared by Margherita Giuzio, Dejan Krusec, Anouk Levels, Ana Sofia Melo, Katri Mikkonen and Petya Radulova^[83]

This special feature discusses the channels through which climate change can affect financial stability and illustrates the exposure of euro area financial institutions to risks from climate change with the help of granular data. Notwithstanding currently limited data availability, the analysis shows that climate change-related risks have the potential to become systemic for the euro area, in particular if markets are not pricing the risks correctly. A deeper understanding of the relevance of climate change-related risks for the euro area financial system at large is therefore needed. Better data availability and comparability and the development of a forward-looking framework for risk assessments are important aspects of this work going forward.

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B Economic shocks and contagion in the euro area banking sector: a new micro-structural approach

Prepared by Giovanni Covi, Mattia Montagna and Gabriele Torri^[84]

The financial system can become more vulnerable to systemic banking crises as the potential for contagion across financial institutions increases. This contagion risk could arise because of shifts in the interlinkages between financial institutions, including the volume and complexity of contracts between them, and because of shifts in the economic risks to which they are commonly exposed. Analysis of the euro area banking system’s interlinkages, using the newly available large exposure data, suggests that the system could be more vulnerable to financial contagion through long-term interbank exposures than noted in other studies. That said, common exposures to the real economy – a standard contagion channel in the literature – represent a potential source of individual bank distress and non-systemic events. This analysis also provides an insight into the changes in contagion risk in the system over time, helping us to interpret changes in market indicators of systemic risk, such as aggregated credit default swap (CDS) prices.

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C Macroprudential space and current policy trade-offs in the euro area

Prepared by Matthieu Darracq Pariès, Stephan Fahr and Christoffer Kok

The countercyclical capital buffer (CCyB) is one of the centrepieces of the post-crisis reforms that introduced macroprudential policy instruments. Macroprudential instruments aim to protect the resilience of the financial system throughout the financial cycle. While many measures have been implemented to structurally raise capital in the banking sector, only a few euro area countries have activated the CCyB. This implies that macroprudential authorities currently have limited policy space to release buffer requirements in adverse circumstances. Against this background, this special feature provides some insights into the relevant macroprudential policy response under different macroeconomic conditions. It is argued that, barring a severe economic downturn, even under a scenario of moderate economic growth a gradual build-up of cyclically adjustable buffers could be considered to help create the necessary macroprudential space and to reduce the procyclicality of the financial system in an economic and financial downturn.

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