Financial Stability Review - December 2011 issue

Presented at the press briefing by Vice-President Mr Constâncio, Frankfurt 19 Frankfurt 2011

The primary objective of the ECB’s Financial Stability Review (FSR) is to identify the main sources of risk to the stability of the euro area financial system and provide a comprehensive assessment of the capacity of the financial system to absorb adverse disturbances.

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.

Four key risks to euro area financial stability
  1. Contagion and negative feedback between the vulnerability of public finances, the financial sector and economic growth
  1. Funding strains in the euro area banking sector
  1. Weakening macroeconomic activity, credit risks for banks and second-round effects through a reduced credit availability in the economy
  1. Imbalances of key global economies and the risk of a sharp global economic slowdown

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 (see the table above).

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 signifi cant strengthening of economic and fiscal coordination and surveillance is now fi rmly in place, and further steps to improve fiscal discipline and deeper economic union will be sought.

Chart 1

The first key risk, arguably the most important, concerns the potential for a further intensification of contagion and the negative feedback between the vulnerability of public finances, the financial sector and economic growth …

… the vulnerability to further contagion remains highest for those countries that are perceived to exhibit a combination of vulnerable fiscal positions, weak macro-financial conditions, and the potential for further significant losses in the banking sector.

Chart 3

A second key risk concerns market funding strains in the euro area banking sector …

… a risk which has been aggravated by an abrupt rise in term funding costs in several euro area countries and significantly lower bank equity prices.

Chart 5

A third key risk concerns an increase in credit risks for banks in conjunction with the slowdown in economic activity, and possible second-round effects through reduced credit availability in the economy …

… financial stability risks stemming from the euro area non-financial corporate and household sectors have increased as a result of the deterioration of economic prospects.

Chart 7

A fourth and last key risk concerns the external environment for the euro area, namely the risk of an abrupt unwinding of imbalances in key global economies that could result from a sharp global economic slowdown …

… specific concerns include fiscal and economic weaknesses in key advanced economies across the globe, and a sudden halt of private capital flows to emerging markets.

Chart 2

Despite several national initiatives aimed at improving fiscal fundamentals, as well as the announcement or adoption of supranational initiatives to stem stress, contagion effects have spread widely across euro area sovereigns and banks …

… the possibility that more euro area sovereigns will, as a consequence, face difficulties in refinancing their debt remains among the most pressing risks to euro area financial stability.

Chart 4

The term funding needs of the euro area financial sector remain challenging, and the situation could become more difficult …

… particularly if headline risk and the market volatility associated with the fiscal and/or financial strains in the euro area persist.

Chart 6

Higher credit risks could be exacerbated further by the possibility of an adverse 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.



  1. Common equity capital, banks’ riskiness and required return on equity
  2. Empirical determinants of non-performing loans
  3. Global liquidity: measurement and financial stability implications
  4. Mapping the state of financial stability
  5. The impact of different bank characteristics on risk and performance