Risks to euro area financial stability increased considerably in the second half of 2011, as the sovereign risk crisis and its interplay with the banking sector worsened in an environment of weakening macroeconomic growth prospects. Indeed, several key risks identified in the June 2011 Financial Stability Review (FSR) materialised after its finalisation. Most notably, contagion effects in larger euro area sovereigns gathered strength amid rising headwinds from the interplay between the vulnerability of public finances and the financial sector. Euro area bank funding pressures, while contained by timely central bank action, increased markedly in specific market segments, particularly for unsecured term funding and US dollar funding.
While several catalysts were at play in prompting the materialisation of these key risks, a combination of weakening macroeconomic growth prospects and the unprecedented loss of confidence in sovereign signatures were key factors, crystallising in downgrades, both within and outside the euro area, by major credit rating agencies. Positive market responses to European measures aimed at stemming the crisis appear to have been short-lived – indeed, a bumpy ratification process appears to have contributed to additional market uncertainties. At the same time, downward revisions to the outlook for macroeconomic growth contributed to a lower shock-absorption capacity of euro area financial institutions. This environment implied a significant increase in funding costs and also created challenges for selected sovereign and bank issuers in accessing bond markets. Ultimately, the transmission of tensions among sovereigns, across banks and between the two intensified to take on systemic crisis proportions not witnessed since the collapse of Lehman Brothers three years ago.
Amid these rising tensions, a package of measures to restore confidence and address the current tensions in financial markets was agreed by the European Council and euro area Heads of State or Government on 9 December. A swift and effective implementation of all key elements – a new fiscal compact and the strengthening of stabilisation tools for the euro area, including a more effective European Financial Stability Facility (EFSF), the bringing-forward of the implementation of the European
Stability Mechanism (ESM) and a solution for the unique challenges faced in Greece – is pivotal in making a decisive contribution to curtailing the cycle of risk intensification in the euro area that characterised the latter half of 2011. In addition, measures were taken for a durable strengthening of the capital of European banks, while also addressing their funding needs, with the ECB deciding on additional enhanced credit support measures to strengthen bank lending and liquidity in the euro area money market on 8 December.
Mirroring the magnitude of the crisis, vulnerabilities and sources of risk have sprung widely from the euro area macro-financial environment. While remaining uneven across both economic sectors and countries, the breadth of vulnerabilities continues to relate predominantly to the unusual amount of balance sheet adjustment necessary after the widespread credit expansion that presaged the global financial crisis. This applies most acutely to the government sector – with worsening public finances a feature shared by virtually all advanced economies. The non-financial private sector also faces some challenges, notably from an ongoing macroeconomic slowdown, but with aggregate euro area balance sheet positions that make it relatively more robust to weather such forces. In parallel, financial markets exhibited heightened volatility and, on occasion, even extreme turbulences, with sharp adjustments characterising the latter half of 2011. In this environment, financial stability in the euro area has faced strong headwinds. In particular, four related and intertwined risks are key at present:
Contagion and negative feedback between the vulnerability of public finances, the financial sector and economic growth
Funding strains in the euro area banking sector
Weakening macroeconomic activity, credit risks for banks and second-round effects through a reduced credit availability in the economy
Imbalances of key global economies and the risk of a sharp global economic slowdown
The broad-based worsening of financial stability risks has revealed a need for bold and decisive action both within and outside the euro area. The measures announced or adopted by the European Council and Heads of State or Government contain several basic elements that are key for the restoration of financial stability in the euro area – with five being noteworthy and warranting speedy and effective implementation. First and foremost, unequivocal commitments have been made at the national level to ensure fiscal discipline and accelerate structural reforms for growth and employment, commitments that require rigorous implementation. Second, a forceful assertion of the presence of a strong and credible backstop by the EFSF would make a decisive contribution to halting the downward spiral of self-fulfilling dynamics in the pernicious interplay between sovereign, banking and macroeconomic forces.
Third, measures have been taken that are aimed at a durable strengthening of the capital of European banks, while also addressing their funding needs. Fourth, measures have been announced that meet the unique needs of Greece, which faces a set of challenges unlike those confronting any other euro area country. Fifth, the significant strengthening of economic and fiscal coordination and surveillance is now firmly in place, and further steps to improve fiscal discipline and deeper economic union will be sought.
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