FRANKFURT (MNI) – Risks to Eurozone financial stability continue to
outrun regulatory and institutional reform, and the economic slowdown
has intensified the downside for sovereigns and banks, the ECB said
Monday, highlighting the negative feedback links between the two.
“Public finance positions in several euro area countries remain
precarious and sovereign debt strains have spread from the three euro
area countries under EU/IMF programmes to other vulnerable euro area
economies,” the central bank observed in its Financial Stability Review.
“Intensified financial market tensions could arise from a loss of
confidence in the recovery and from downgrades and write-offs of
sovereign debt,” the report warned, anticipating likely events in the
short term.
“These would affect the banking system through the deterioration of
funding conditions for banks and balance sheet impairments,” it said.
“The resulting banking system adjustments in the form of higher lending
margins and deleveraging processes would then constrain the provision of
bank credit and ultimately weigh on investment and private consumption.”
At the same time, slowing economic growth has reduced banks’
capacity to absorb shocks, boosting funding costs and restricting access
to bond markets in some areas, it noted. “The term funding needs of the
euro area financial sector remain challenging, and the situation could
become more difficult.”
Echoing the concerns of ECB President Mario Draghi that bank
deleveraging could restrain lending to the real economy, the report
argued that the central bank’s latest liquidity support measures “should
as such not be a cause of deleveraging pressures.”
“National supervisors need to ensure that banks’ recapitalization
plans, as required by the current EU-wide recapitalization exercise
carried out by the European Banking Authority, do not lead mainly to
unwelcome pro-cyclical deleveraging involving significant constraints on
the flow of credit to the real economy,” it said.
The history of financial crises suggests that economic recovery in
the Eurozone will “remain muted, implying a slow narrowing of the output
gap,” the report said. Fallout for non-financial business could increase
as well, but the aggregate level of Eurozone balance sheet positions
“make it relatively more robust to weather such forces.”
“Some residential property markets are deemed to still be
vulnerable to corrections in prices, which could potentially give rise
to further credit losses for banks,” it noted.
The risk of contagion to more Eurozone sovereigns “remains among
the most pressing risks to euro area financial stability,” the report
said, arguing that “a swift and complete implementation” of EU accords
agreed earlier this month “would mitigate this risk considerably.”
Yet positive market responses to measures taken so far “appear to
have been short-lived,” the report conceded, attributing this in part to
“a bumpy ratification process.” Moreover, “pan-European initiatives
cannot be effective in the absence of sound and sustainable national
policies.”
“To assuage market fears that are at times completely unfounded, a
reactive approach clearly needs to be superceded by a pro-active
approach to determining financial resilience that as such obviates the
onset of financial strain,” it said.
“The recapitalization of the banking sector that is underway in
conjunction with supplementary policy measures should contribute to
strengthening banks’ resilience against future shocks,” it said.
Investors’ confidence in Eurozone assets could be further
undermined by downgrades to the ratings of sovereigns and banks, by
negative news on banks’ profitability and solvency, by uncertainties
about private sector involvement in Greek debt, or by risks linked to
the implementation of the December 9 EU accord and the effective size of
the European Financial Stability Facility, the report said.
Downside risks could be exacerbated by a negative feedback loop,
“whereby a restriction in credit availability prompts a deterioration in
the economic outlook and in the quality of banks’ assets that, in turn,
triggers an additional tightening of credit conditions,” it warned.
Another key risk is an abrupt unwinding of global imbalances that
could result from a sharp economic slowdown, it added. “Progress in
global and regional rebalancing has been limited; thus, vulnerabilities
related to imbalances among key global economies are continuing to
contribute to euro area financial stability risks.”
Dangers stem from uncertainty in the United States over growth
prospects and medium-term fiscal policy, as well as from an interruption
of capital flows to emerging economies and contagion from Europe or even
a hard landing.
“Important steps have been taken to strengthen the framework for
crisis management and resolution,” the report acknowledged. “Ultimately,
both international and EU initiatives should provide the means to
facilitate the management and resolution of bank crises also at a
cross-border level.”
There is still a need to improve the regulation of over-the-counter
derivatives markets, the report observed. “Although some progress has
been made, delays are evident.”
–Paris newsroom, +33142715540; ssandelius@marketnews.com
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