Financial Stability Review December 2009

The extraordinary remedial actions taken by central banks and governments since late last year have been successful in restoring confidence in, and improving the resilience of, financial systems around the world. Financial system support measures have been addressing the funding challenges of key financial institutions and have bolstered their capital positions. These measures, together with sizeable macroeconomic policy stimuli, set in motion a mutually reinforcing process between financial system conditions and real economic performance, fostering improving business cycle prospects, as well as a fading of systemic risk.

An important reason for lowered systemic risk was an abatement of tail risk, thanks primarily to the downside protection by governments of financial institutions’ balance sheets. A recovery of risk appetite, underpinned by lowered systemic risk, contributed to the remarkable turnaround in financial markets since March 2009 and supported the trading income of large and complex banking groups (LCBGs). Many of these institutions also benefited from a considerable boost to net interest income on account of very steep yield curves. These better financial conditions strengthened the profitability of many LCBGs to such an extent that they were able to absorb considerable write-downs on securities and loans while still, on average, reporting material improvements in profitability over three consecutive quarters. Some were even able to return the capital they had received from governments, thus exiting from financial support.

Despite the recovery in financial markets and improved financial performance of euro area LCBGs, there are several grounds for caution in assessing the outlook for financial stability in the euro area. In particular, the main risks identified outside the euro area financial system include the possibility of:

• vulnerabilities being revealed in non-financial corporations’ balance sheets, because of high leverage, low profitability and tight financing conditions;
• greater-than-expected household sector credit losses if unemployment rises by more than expected;
• the surge of government indebtedness raising concerns about the sustainability of the public finances, as well as the crowding out of private investment; and
• an adverse feedback between the financial sector and public finances as a result of financial system support measures, fiscal stimuli and weak economic activity.

Within the euro area financial system, important risks include the possibility of:

• renewed financial strains and that the recent recovery of bank profitability will not prove durable;
• vulnerabilities of financial institutions associated with concentrations of lending exposures to commercial property markets and to central and eastern European countries being unearthed; and
• a setback for the recent recovery of financial markets, if macroeconomic outcomes fail to live up to optimistic expectations.

All in all, the challenges facing the euro area banking sector in the period ahead call for caution in avoiding timing errors in disengaging from public support. In particular, exit decisions by governments will need to carefully balance the risks of exiting too early against those of exiting too late. Exiting before the underlying strength of key financial institutions is sufficiently well established runs the risk of leaving some of them vulnerable to adverse disturbances, possibly even triggering renewed financial system stresses. Late exits, on the other hand, can entail the risk of distorting competition, creating moral hazard that comes with downside protection – including the possibility of excessive risk-taking – as well as exacerbating risks for public finances.

To cushion the risks that lie ahead, banks will need to be especially mindful in ensuring that they have adequate capital and liquidity buffers in place. If the circumstances require it, some banks may need to raise new and high-quality capital. In addition, some banks, especially those which have received state support, may need fundamental restructuring in order to confirm their long-term viability when such support is no longer available. This could involve the shrinking of balance sheets through the shedding of unviable businesses with a view to enhancing their profit-generating capacities. At the same time, banks should take full advantage of the recent recovery in their profitability to strengthen their capital positions, so that the necessary restructuring of businesses and the enhancement of shock-absorbing capacities do not impinge materially on the provision of credit to the economy.

For more information on the December 2009 Financial Stability Review, check: http://www.ecb.europa.eu/pub/fsr/html/index.en.html