ECB Financial Stability Review June 2007

An overarching theme, pertaining to several sources of risk and vulnerability in the financial markets, is the abundant liquidity that characterises global markets. Indeed, there appears to be a consensus among market participants that market liquidity has reached unprecedented levels. Financial market liquidity is a measure of the ability of market participants to undertake securities transactions without triggering large changes in their prices. The concept of financial market liquidity is distinct from the concept of monetary liquidity, but there can be links between the two. Although the measurement of market liquidity is rather complex, symptoms of the abundance of liquidity include high leverage, low yields, low market volatility, narrow credit spreads and high market turnover. Overall, abundant liquidity seems to be intertwined with the “search for yield” that has been discussed in past issues of the Financial Stability Review and appears to be dependent on confidence remaining in the smooth functioning of the market.

The chart on the left of slide 6 introduces a composite indicator of financial market liquidity in the euro area equity, bond, foreign exchange and credit markets. It is constructed to gauge three different dimensions of market liquidity. The first dimension is tightness , i.e. the magnitude of risk premiums required by market-makers for holding inventories of securities, which is measured by the bid-ask spread. The second dimension is depth and resiliency , i.e. the degree to which the volume of transactions impacts on asset prices, which is measured by using ratios of asset price movements to transactions. The third dimension relates to liquidity risk premia, i.e. the compensation required by investors for the risk that attempts to unwind positions could be challenged by uncertain market conditions in the future. This is measured using yield spreads between securities which are known to have varying degrees of liquidity.

The evolution of this indicator over time confirms that financial market liquidity in the euro area has increased significantly since 2001. It rose sharply in 2003 and 2004, and markets have remained very liquid since then. The increase in market liquidity may reflect structural changes in global financial markets, e.g. the liberalisation of international flows of capital, the securitisation of loans, the development of new financial instruments and the rapidly growing market presence of highly active financial market participants, such as hedge funds.

However, buoyant market liquidity could also reflect an excessive risk appetite, indicating that liquidity risk could be under-priced, as well as high leverage. To the extent that a high risk appetite is an important determinant of market liquidity, the currently favourable liquidity conditions could suddenly, and unexpectedly, fade away, if there were a loss of confidence or an abrupt and lasting increase in risk aversion. This could expose several underlying vulnerabilities in the financial system on which I will elaborate later on.

Turning to global financial institutions, with the exception of the fact that the hedge fund industry has grown further in size, all other backward-looking indicators suggest that potential risks to financial stability posed by hedge funds have not changed materially since the Financial Stability Review of December 2006.

However, market risks posed by hedge funds remain. They arise largely from information which suggests that over-capacity, and – indeed – over-crowding, could be taking place in the sector after a simultaneous increase in the number of funds and a reduction of profitable trading opportunities over the last few of years. On the one hand, as illustrated in the chart on the left of slide 7, average hedge fund returns have been on a downward trend since the early 1990s. This trend could point to overcapacity and to a consequent lowering of the amount of profitable investment opportunities available, although other explanations are also possible. At the same time, the degree of correlation between hedge fund returns across different strategies, shown in the chart on the right of slide 7, remained around the same relatively high level as in mid-2006. There are concerns about the implications for market dynamics if there was to be an event that would prompt many funds to “rush towards the exit” at the same time due to the crowding of trades, i.e. the fact that many funds are positioned similarly.

Let me now focus on the euro area corporate sector. Against a background of strong economic conditions, low financing costs and abundant market liquidity, the pace of borrowing by the euro area corporate sector began to quicken after mid-2005. As a result, key indicators of the leverage of the sector had reached unprecedented heights. However, as analysed in Box 7, the recent re-leveraging in the euro area corporate sector has not been broad-based, but has rather been concentrated among unlisted firms – including not only small and medium-sized enterprises, but also firms which have been de-listed through private equity deals. Data is obviously lacking on unlisted firms, but comparing trends in the debt-to-asset ratio for listed non-financial corporations and the debt-to-GDP ratio for the non-financial corporate sector suggests that a sharp rise has taken place in the debt-to-asset ratio of unlisted firms in the period since 2004 (see chart on the left of slide 8).

Increasing corporate sector leverage in the euro area has also begun to raise questions about the likelihood of an adverse turn in the credit cycle and its possible consequences for the financial system. Although closely related to business cycles, credit cycles are also driven by the criteria applied by banks and other investors when extending credit. By this yardstick, a long period of inertia in bank lending standards since mid-2004 and the persistent tightness of credit spreads suggest that euro area firms have not been facing financing constraints (as shown in the chart on the right of slide 8). On the contrary, as banks placed greater emphasis on the so-called “originate and distribute” business model, new opportunities have emerged for other financial institutions to acquire exposures to credit. This development has further improved firms’ access to bank credit.

Turning to the euro area household sector, the pace of net borrowing by the household sector has slowed since spring 2006, but has remained at high levels (see the chart on the left of slide 9). There have also been signs of a moderation of house price inflation in a number of euro area housing markets. The risk of potentially disruptive property price declines in the future appears to be limited in the euro area as a whole, although differences continue to exist between individual Member States. However, concerns remain about the sustainability of unprecedented levels of mortgage-related leverage in those parts of the euro area where, ceteris paribus, housing valuations appear stretched, where the debt build-up has been pronounced and where the majority of debt is financed at variable interest rates.

While measures of leverage compared to income can provide a rough indication of the ability to service debt, it is also important to evaluate sustainability vis-à-vis assets, as this can provide an indication of the capacity of households to repay their debts in full at an aggregate level. The value of household assets – which is much higher than that of their debt – has grown more than their liabilities, especially after 2002, as the stock market has recovered the losses incurred when the high-tech bubble burst and as house prices have also risen. As a result, as shown in the chart on the right of slide 9, households have seen a notable rise in their net wealth over this period, driven in particular by the housing wealth component, which accounted for about 60% of total household wealth in 2006.

The financial soundness of large and complex banking groups (LCBGs) in the euro area strengthened further in the second half of 2006, consolidating the steady and broad-based improvement from 2003 onwards. Profitability continued to rise, underpinned by favourable macroeconomic conditions and, for the most part, very low levels of financial market volatility. The chart on the left of slide 10 shows that, compared with the situation in 2005, the distribution of returns on equity for LCBGs has become more compressed around the mean, with the profitability of institutions in the lower quantiles remaining unchanged or increasing slightly. At the same time, Tier 1 capital bases comfortably exceeded the regulatory minima for solvency ratios, pointing to a reassuring shock-absorbing capacity. Risk management among LCBGs is expected to improve further as the Basel II capital rules are being implemented in the course of the current year.

Several central banks have developed analytical frameworks for stress-testing the resilience of the banking system to shocks that originate from the operational environment. Special Feature articles B and C in this edition of the Financial Stability Review illustrate one such model for stress-testing the resilience of euro area LCBGs in response to a wide range of adverse shocks to the global macro-financial environment. The results suggest that the corporate credit quality of LCBGs tends to deteriorate as a consequence of negative shocks to GDP and unanticipated increases in oil prices, as well as in response to an unexpected appreciation of the euro against the US dollar. The worsening credit quality, in turn, can have a rather marked negative impact on banks’ Tier 1 capital ratios, depending on the sectoral and geographical composition of their corporate loans.

In recent years, euro area LCBGs have faced challenges in increasing, or at least maintaining, interest income as a share of total income, but they have enjoyed further improvements in their fee, commission and, especially, trading income. Indeed, the share of banks’ trading income in their net operating income rose significantly in 2006. For some LCBGs with sizeable capital market operations, trading income accounted for nearly half of their net operating income in 2006 and corresponded to more than 45% of their Tier 1 capital, as shown in the chart on the right of slide 10. Special Feature article A looks at the relationship between bank income diversity and systemic risk. It finds that a measure of systemic risk is positively correlated with the bank size and the share of trading income, while it is negatively correlated with revenues from (traditional) interest income sources.

In the euro area insurance sector, there was a broad-based improvement in profitability in 2006 (see the chart on the left of slide 11). The positive assessment is further supported by the fact that the profitability of the weaker performers in 2005 also improved in 2006. Underlying this improvement was a strengthening of investment income, mainly on account of buoyant stock markets and higher interest rates.

Moreover, favourable developments in the financial conditions of primary insurers and reinsurers in 2006, together with a greater focus on risk management and risk-adjusted prices, support a positive outlook for the euro area insurance sector as a whole. These positive developments continued to be priced into expected default frequencies (as shown in the chart on the right of slide 11). However, risks and challenges for the sector remain, as greater financial market risks could pose a challenge to the life insurance and non-life insurance sectors.