Report on EU banking sector stability

The European Central Bank (ECB) has today published a report on EU banking sector stability that was prepared by the Banking Supervision Committee of the European System of Central Banks (ESCB). This Committee comprises representatives of EU national central banks and banking supervisory authorities and the ECB.

The report reviews the financial condition of the banking sectors of the 27 EU Member States in 2006 and the first half of 2007, primarily on the basis of balance-sheet data. Regarding the potential impact of the recent financial market turbulence on EU banks’ performance, the report presents a tentative first assessment based on qualitative supervisory information that covers the third quarter of 2007. The report also discusses the main risks surrounding the outlook for the EU banking sector, supported by market-based information, and provides an assessment of the financial soundness and shock-absorbing capacity of banks. It contains a special section dedicated to an analysis of risks to EU banks stemming from their exposures to residential property markets, placing particular emphasis on the lower end of the mortgage credit quality spectrum.

The contents of the report can be summarised as follows:

The financial condition of the EU banking sector continued to develop positively throughout 2006, the latest year for which full-year consolidated financial results for the EU banking sector are available. Indications based on a set of large EU banks are that this continued in the first half of 2007. Differences in the pace at which the International Financial Reporting Standards (IFRS) are being introduced for supervisory purposes in individual countries complicate the analysis at the current juncture. As in last year’s report, data from IFRS and non-IFRS reporting countries are not aggregated for reasons of data integrity.

The profitability of EU banks increased further in 2006, although the average performance conceals marked differences among banks. While the return on equity of medium-sized and especially large banks increased significantly from the previous year, profitability according to this measure increased to a lesser extent for small banks that follow the new accounting standards and even decreased for small banks still reporting under the old accounting rules. This was possibly the result of the strong competitive environment in the primarily retail domestic markets where small institutions’ activity is mainly focused. Throughout 2006 favourable economic conditions supported the growth of banks’ recurrent revenue across the EU as lending volumes continued to rise at a rapid pace. Strong trading results and high net commission income substantially increased net non-interest income, indicating that EU banks’ income growth was generally broad-based. Also contributing to the strength of profitability in 2006 and in the first half of 2007 were the persistently low level of impairment charges and well-contained costs. The solvency position of EU banks in 2006 and in the first half of 2007 remained stable, with ratios well above the minimum regulatory requirements.

The market turmoil which started in July and August 2007 is likely to have repercussions on the earnings of many EU banks in the second half of 2007. This is because over recent years a significant share of banking sector profitability has been driven by fee, commission and trading income, a substantial fraction of which may be of a non-recurrent nature. Increasing funding costs, coupled with tightening lending criteria, may also contribute to a slowdown in profit growth in the medium term. This notwithstanding, the sound profitability of EU banks over several consecutive years, which has underpinned robust solvency positions, should have generated adequate buffers against both expected and unexpected losses.

The solid financial position of EU banks was underpinned by a macroeconomic environment that remained supportive throughout 2006 and in the first half of 2007, with gradually accelerating GDP growth and low unemployment rates in most EU countries. In 2006, corporate insolvencies generally continued to fall against a background of steady growth in corporate profits and high returns on capital. At the same time, household sector indebtedness, measured in terms of debt-to-asset ratios, continued to rise in the majority of EU countries, although in some large countries it remained stable or even decreased with respect to the previous year.

The annual growth rates of loans to the corporate sector and households in most EU Member States remained high in the third quarter of 2007, despite different developments in lending growth across countries. The results of the October 2007 euro area bank lending survey, which covered the first months of the recent financial market turmoil, show that bank lending standards have been tightened, particularly on loans extended to enterprises. Regarding the existing debt stock, the aggregate levels of indebtedness of EU households and firms relative to GDP remain moderate by international standards, though they mask large variations across countries and borrower categories.

Among the main vulnerabilities for EU banking sectors is the likely evolution of the credit cycle – which could be affected by the recent re-pricing of credit risk, should it prove lasting – and its impact on borrowers’ credit quality and banks’ credit risk. The rise in demand for liquidity, in the context of the recent turmoil, has also increased concerns about banks’ liquidity and credit commitments, which has underlined the importance of banks’ liquidity risk management, including stress-testing and contingency planning. In addition, for large banks in particular, there are uncertainties about the extent to which their financial performance could be impaired by declining revenues from non-interest income sources if, for instance, activity in the market for securitised loans were to remain depressed for a more protracted period. Finally, the continued expansion of foreign currency lending to households in some EU countries could be posing increasing risks to the banks involved if housing market developments are reversed in the countries affected or if exchange rate volatility increases. In 2006 EU banks also further raised their exposures to emerging market economies, searching for revenues that are less correlated with domestic income sources.

The forward-looking assessment based on market indicators, which partially takes into account the possible impact of the market turbulence in the second half of 2007, suggests that near-term risks facing the banking sector have increased. Uncertainties among market participants about the banking sector’s earnings prospects have also increased, and this could be further aggravated by unexpected developments in the US sub-prime mortgage market and if the problems in structured credit markets were to spill over to the broader credit and capital markets.

Section 5 of the report analyses EU banks’ exposures to residential property markets, focusing on the lower end of the mortgage credit quality spectrum and on the sustainability of households’ mortgage debt. The results suggest that, while pockets of vulnerability have grown in the EU mortgage markets, particularly with respect to rising household mortgage indebtedness, the risks to both households and banks’ balance sheets are rather limited. Nevertheless, such relatively benign conditions may be masking a build-up of risks that has been driven, to a certain extent, by a general easing of banks’ credit standards.

The report can be downloaded from the “Publications” section of the ECB’s website ( http://www.ecb.europa.eu/pub). Printed copies are also available free of charge from the ECB’s Press and Information Division at the address given below.