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# Foreword

The Financial Stability Review (FSR) assesses developments relevant for financial stability, including identifying and prioritising the main sources of systemic risk and vulnerabilities for the euro area financial system – comprising intermediaries, markets and market infrastructures. It does so to promote awareness of these systemic risks among policymakers, the ﬁnancial industry and the public at large, with the ultimate goal of promoting financial stability.

Financial stability can be defined as a condition in which the financial system – which comprises financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances. This mitigates the likelihood of disruptions in the financial intermediation process that are systemic; that is, severe enough to trigger a material contraction of real economic activity.

The FSR also plays an important role in relation to the ECB’s microprudential and macroprudential competences. By providing a financial system-wide assessment of risks and vulnerabilities, the Review provides key input to the ECB’s macroprudential policy analysis. Such a euro area system-wide dimension is an important complement to microprudential banking supervision, which is more focused on the soundness of individual institutions. While the ECB’s roles in the macroprudential and microprudential domains have a predominant banking sector focus, the FSR focuses on the risks and vulnerabilities of the financial system at large, including – in addition to banks – activities involving non-bank financial intermediaries, financial markets and market infrastructures.

In addition to its usual overview of current developments relevant for euro area financial stability, this Review includes three special features aimed at deepening the ECB’s financial stability analysis and broadening the basis for macroprudential policymaking. The first special feature examines how banks can reach sustainable levels of profitability. The second examines the financial stability implications stemming from a resurgence of trade tariffs. The third discusses the rapid growth in exchange-traded funds and their potential for transmitting and amplifying risks within the financial system.

The Review has been prepared with the involvement of the ESCB Financial Stability Committee, which assists the decision-making bodies of the ECB in the fulﬁlment of their tasks.

Luis de Guindos
Vice-President of the European Central Bank

# Overview

The euro area financial stability environment has become more challenging since the publication of the previous Financial Stability Review in May. On the positive side, a growing economy and improved banking sector resilience have continued to support the financial stability environment in the euro area. Furthermore, a series of volatility events have not spread to the broader global financial system. At the same time, downside risks to the global growth outlook have become more pronounced since May relating to a resurgence in protectionism and stress in emerging markets. Vulnerabilities in financial markets continue to build up amid pockets of high valuations and compressed global risk premia. In the euro area, political and policy uncertainty have increased over the review period.

Looking ahead, four key risks to euro area financial stability could materialise over the next two years. First, the most prominent risk stems from the possibility of a disorderly increase in global risk premia. Second, the risk of renewed debt sustainability concerns has increased over the last six months. Third, legacy issues from the financial crisis continue to dampen bank profitability and could hamper banks’ intermediation capacity. Fourth, possible liquidity strains in the investment fund sector constitute a growing risk. These four risks are all clearly intertwined and would, if they were to materialise, have the potential to be mutually reinforcing.

Tail risks to GDP growth have been creeping up from low levels, amid intermittent bouts of financial stress. The composite indicator of systemic stress in financial markets has exhibited flare-ups, as sovereign tensions in Italy have risen and some emerging market economies (EMEs) have experienced stress. At the same time, the risk of a sharp fall in GDP growth has been inching up from low levels (see Chart 1).

## Risk of a disorderly increase in risk premia

Risks stemming from financial market developments remain material. Over a risk horizon of two years, the main triggers that could unearth a disorderly increase in risk premia relate to both domestic and external factors. These include disorderly market reactions to political or policy uncertainty in the euro area, further stress in EMEs with possible spillovers to advanced economies and a sharp turnaround in US macro-financial prospects. Pockets of high asset price valuations and high correlations across global financial asset prices may amplify a potential pick-up in global risk premia.

Italian financial market losses amid political uncertainty have not meaningfully spilled over to other euro area countries. In the second half of May, increased market concerns about debt sustainability – triggered by rising fiscal policy uncertainty in Italy – contributed to higher volatility in domestic financial markets (see Chart 2). Sovereign bond yields in Italy increased sharply, amplified by deteriorating liquidity conditions. Some domestic spillover to the non-financial and financial sectors was also observed. At the same time – in contrast to euro area financial stress episodes in 2011-12 – contagion to other euro area countries was limited. Subsequently, market sentiment stabilised somewhat, but Italian sovereign bond yields and stock prices remained volatile throughout the review period. Financial market tensions combined with protracted budgetary negotiations have culminated in credit rating actions. The stress in the Italian sovereign debt markets in May serves as a reminder of how quickly policy uncertainties can lead to shifts in market sentiment and a repricing of risk. In the latter part of the review period, rising bond yields in the United States triggered a rise in global risk premia with some limited spillover also to the euro area.

The impact of Brexit on euro area financial markets has remained limited. So far, aside from some bouts of volatility in the sterling exchange rate, growing uncertainties related to the Brexit process have not driven any significant repricing in financial markets. While an orderly withdrawal of the United Kingdom from the European Union poses a limited overall risk to the euro area’s financial stability, the uncertainty triggered by a cliff-edge Brexit could have the potential to pose a more significant downside risk to financial stability (see Box 6). In light of the risks, timely preparations on the part of banks and other financial institutions are needed for any possible outcome, including the possibility of a no-deal outcome.

At the global level, some EMEs with significant external imbalances are facing difficulties in adapting to tightening financial conditions. A stronger US dollar and heightened trade tensions unearthed pre-existing vulnerabilities in Argentina and Turkey, triggering renewed stress in EMEs in recent months. A number of EMEs endured significant increases in bond spreads, falling stock prices and large currency depreciations (see Chart 3). However, the EME sell-off was more muted and contained when compared with the widespread stress that occurred during the “taper tantrum” episode in 2013.

Looking ahead, more generalised stress in EMEs could materialise. The sell-off in May illustrates that global risk sentiment remains fickle. Several EMEs have accumulated large US dollar-denominated debts and would face very high credit risk in the event of a sharp US dollar appreciation. Thus, a quicker than expected US policy normalisation and a subsequent appreciation of the US dollar may trigger an abrupt and broad increase in risk premia on EME financial assets. The expansionary fiscal policy in the United States could aggravate a potential pick-up in risk premia. Widespread contagion across EMEs could also be triggered by rising trade tensions and/or a failure to rein in the high credit growth in China, leading to a hard landing. Contagion across economies (including to advanced economies) could be amplified due to the interconnected nature of global financial markets (see Chart 4).

A maturing cycle in the United States has led to brittle valuations. Developments in the US economy and financial markets, in turn, have continued to exert a dominant influence in global financial markets. The US economy has continued to grow at a brisk pace in 2018, supported by a favourable job market. The strong fiscal stimulus has added further momentum to the US business cycle and contributed to prolonging the current economic expansion which is now significantly longer than historical norms and the second longest in US modern history (see Chart 5). Looking ahead, a number of market indicators appear to signal downside risks to the macro-financial cycle in the United States. First, the slope of the US yield curve has flattened significantly in recent quarters. In the past, this has been a harbinger of future recessions. Second, investors seem to have become increasingly concerned about price increases in “riskier” US asset classes, stock markets in particular. Despite low volatility, the SKEW index, which gauges the cost of insuring against large drops in stock prices, has increased sharply in recent months as stock prices have risen.

There is a risk of a snapback from an unprecedented compression of term premia. Potential misalignments in asset price valuations are being closely monitored by financial stability authorities, as they represent vulnerabilities in the form of possible asset price corrections. Along with the cyclical recovery in recent years, global valuations across a broad range of asset classes have increased strongly. In the global bond markets, the prolonged period of accommodative monetary policies has contributed to keeping interest rates low across most types of debt instruments. In the sovereign bond markets, US and euro area term premia continue to hover at very low levels, making them susceptible to any reversal of market sentiment (see Chart 6). The risk of a near-term snapback in term premia is, however, higher in the United States owing to the ongoing normalisation of the monetary policy stance. The large US fiscal deficit and the high stock of sovereign debt could amplify increases in term premia. If it were to materialise, an abrupt increase of long-term interest rates in the United States could also spill over to the euro area.

There are pockets of stretched valuations in global corporate bond and stock markets. Euro area equity markets appear broadly fairly valued according to standard valuation metrics such as the cyclically adjusted price/earnings (CAPE) ratio. In the United States, however, the CAPE ratio is hovering at levels significantly above its historical norm (see Chart 7). As for corporate bonds, although model-based methods signal broadly fair valuations, spreads in the riskiest non-investment-grade segment are still clearly below the historical average in both the euro area and the United States. At the same time, leveraged loan markets continue to expand amid compressed spreads and weakening underwriting standards. The United States still remains the dominant region in which leveraged lending activity is concentrated, with corporates accounting for around three-quarters of the total volume of the outstanding amount of global leveraged loans. Amid these pockets of richly valued assets, investor sentiment remains fickle – leading to risks in the event of broader asset price corrections with possible spillovers to euro area assets.

As the current economic expansion matures, the favourable market environment observed over the past few years may quickly change. Risk management by financial institutions should be taking into account the possibility of an abrupt repricing of risk, including different possible scenarios, or a deterioration in liquidity conditions.

## Increased debt sustainability concerns

The expansion of the euro area economy has continued since May. Economic growth in the euro area has slowed down somewhat in 2018, but the recovery still remains broad-based. Going forward, the euro area economy is expected to grow at continued solid rates in the coming years, supported by improving labour market conditions and stronger sectoral balance sheets. Downside risks to the euro area growth outlook have gained more prominence recently, mainly relating to global factors. Uncertainties regarding the course of US fiscal and monetary policies, a further rise in geopolitical risks across the globe, including those relating to growing trade protectionism, as well as a further intensification of stress in EMEs, may weigh on the global and euro area growth momentum.

Within the euro area, debt sustainability concerns have remained country-specific. The composite indicator of systemic stress in the euro area sovereign bond markets (SovCISS) picked up slightly in May and remained stable thereafter (see Chart 8). The key driver for the somewhat higher systemic stress was related to political developments in Italy and, in particular, to market concerns about the government’s deficit targets for the coming years and the resulting implications for debt sustainability. Overall, the SovCISS still continues to fluctuate at low levels, indicating no generalised near-term debt sustainability concerns for the euro area as a whole.

A large public sector debt overhang leaves several countries vulnerable to higher funding costs. Public sector debt in almost all of the largest advanced economies is significantly higher today than the levels prevailing before the eruption of the global financial crisis (see Chart 9, left panel). Looking ahead, a failure to rein in fiscal deficits would place debt trajectories on a clear upward path in countries where debt ratios are already above 90% (see Section 1.2). Furthermore, private sector debt levels remain high by both historical and international standards and are above thresholds ordinarily associated with a debt overhang, although debt dynamics have continued to benefit from the strong cyclical momentum of the euro area economy combined with very favourable financing conditions.

Momentum is building up in real estate markets across the euro area. The robust dynamics of house prices continue to feed into mild signs of overvaluation for the euro area as a whole amid strong cross-country differences (see Chart 10, left panel). Despite only moderate growth in the stock of mortgage lending overall, it is important to monitor both the growth and quality of new lending, in particular in countries with stronger dynamics. In some countries, the state of household balance sheets contributes to risks in real estate markets. At the same time, while residential investment is trending upwards, there are no indications of overheating in the euro area as a whole. Since the current expansionary commercial real estate (CRE) cycle began in 2009, in almost every euro area country the compression of prime CRE yields has been driven by price increases which have significantly outpaced actual CRE rental price growth. Hence, yields on prime commercial property have been on a declining trend, reaching a new low in the current cycle. The observed yield compression might be indicative of possible overvaluation in CRE markets (see Chart 10, right panel).

## Risk of hampered bank intermediation capacity

Bank profitability in the euro area has remained persistently weak, ten years after Lehman Brothers filed for bankruptcy. The banking crisis and subsequent recession that followed the failure of Lehman Brothers contributed to a sharp fall in global banks’ profitability. Euro area banks’ earnings have been particularly weak (see Chart 11). The low bank profitability in the euro area over this period is partly related to the fact that the crisis in the euro area was more protracted than that in other mature economies. Apart from cyclical factors, structural elements of the euro area banking system have also probably contributed to the underperformance – including overcapacity in certain domestic banking markets and high operating costs (see also Special Feature A). Looking at the most recent data and a broad set of banks, the annualised return on equity of euro area significant institutions slightly dropped in the first half of 2018 from a year earlier, but remained above 7%. Continuing the trend of the last few years, a fall in impairment costs was the largest positive contributing factor in the first half of 2018, helped by a favourable macroeconomic environment and banks’ continued efforts to reduce their non-performing loans. All in all, profitability prospects still remain weak and constitute a key risk to financial stability in the euro area since weak profitability can hamper banks’ intermediation capacity.

Euro area bank stock prices were lower, in part owing to higher political uncertainty. Euro area banks’ stock prices fell sharply, by about 25% since early May, owing to earnings expectation downgrades, while higher political uncertainty in Italy and renewed market turmoil in EMEs drove up the risk premia required on bank stocks. Across countries, Italy stood out with the Italian bank index dropping by about 37%. Furthermore, co-movements between government bond and bank stock prices in Italy recently reached levels not observed since the peak in 2011-12 (see Chart 12, left panel). Apart from global factors, the sharp repricing of Italian bank stocks likely reflected the sector’s holdings of domestic sovereign bonds (see Chart 12, right panel). In addition, spreads on Italian bank bonds increased, with the largest spread widening having taken place for the most credit-sensitive asset classes (see Box 7).

The exposure of euro area banks to EMEs is contained. Euro area banks have remained fairly resilient to the renewed stress in EMEs. Overall, the exposures are relatively small (on-balance-sheet exposures to all EMEs amounted to €1.5 trillion or 7% of total assets in early 2018). As shown in Chart 13, exposures to emerging Europe account for around 41% of euro area banks’ EME exposures, followed by exposures to Latin America (37%), while euro area banks appear to be much less exposed to emerging Asia (13%) and the Middle East and North Africa (9%). Even if the overall EME exposures are limited, the resilience of some individual euro area institutions may be tested should the EME turmoil continue. In fact, ten euro area significant institutions account for 93% of the total exposures to selected EMEs (i.e. Argentina, Brazil, China, Indonesia, Malaysia, Mexico, South Africa and Turkey).

The steady decline in the non-performing loans (NPLs) of euro area banks has continued. In the second quarter of 2018, euro area significant institutions’ aggregate NPL ratio stood at 4.2%, down from 6.4% two years ago. The NPL reduction process either accelerated or continued apace in the majority of high-NPL countries. A granular decomposition of changes in NPL ratios over this period shows that the bulk of the reductions in NPL ratios were linked to cures, liquidations and write-offs (see Chart 14). At the same time, a more active secondary market for impaired assets also contributed significantly to NPL reductions. Across countries, disposal activity continued to be strongest in Italy and Spain. Notwithstanding the increased transactions, liquidity in the secondary markets for NPLs continues to be afflicted by several types of market failures. NPL transaction platforms could help in overcoming market failures by offering the prospect of greater transparency in NPL markets, fostering wider investor participation and addressing coordination issues.[1]

## Risk of liquidity strains in the investment fund sector

The euro area investment fund sector has expanded rapidly since the global financial crisis, due to persistent net inflows and rising asset valuations. Over the past ten years, total assets in the euro area investment fund sector have more than doubled from €5.7 trillion at the end of 2008 to €13.8 trillion in June 2018 (see Chart 15). The investment fund sector now accounts for nearly 20% of total assets held by the euro area financial sector and is around 45% of the size of the banking sector. The growing share of asset management activities has potential implications for financial stability and the financing of the real economy through securities markets.

Concerns are rising over increased risk-taking by investment funds, including liquidity, credit and duration risk. In particular, investment funds have increased their holdings of bonds with relatively low liquidity to 25% of their bond portfolio in June 2018 (see Chart 16). At the same time, funds’ holdings of risky assets have further increased, but their cash buffers have declined, raising the sector’s vulnerability to potential shocks in global financial markets. While existing rules in the EU provide a robust framework to address investor protection and fund-specific vulnerabilities, there are growing concerns over cyclical risks associated with increased liquidity risk-taking and a growing market footprint of the sector as a whole. As risks mainly stem from liquidity mismatches and leverage, macroprudential tools intended to limit these vulnerabilities need to be developed further.

The potential for forced asset selling into illiquid markets affecting market conditions more widely is growing. The more recently observed outflows from bond funds did not cause major disruptions in the underlying markets. However, going forward, an abrupt and sizeable adjustment of global risk premia could give rise to first-round losses for bond funds that trigger outflows, which could be particularly severe for funds investing in less liquid assets. Liquidity risks may be unearthed in situations of forced asset sales to meet investor redemptions. Asset managers can, in principle, limit redemptions in periods of stress through fund suspensions and redemption gates. However, during past periods of stress this option has rarely been used in a timely manner.

Risks stemming from the investment fund sector have increased since the previous assessment. The more challenging risk environment, coupled with increased risk-taking strategies and reduced liquidity buffers, underlies this assessment.

## Scenario analysis

The European Banking Authority (EBA) published the results of its 2018 EU-wide stress test on 2 November 2018, which encompassed many of the risks highlighted in this Review. The EBA adverse scenario was very severe, with increased risk premia and worsening macroeconomic conditions driving bank losses. It encompassed a severe drop in GDP, a substantial rise in long-term interest rates and a pronounced fall in property and stock prices. The results suggest substantial capital depletion across euro area banks, leading to a decline in the Common Equity Tier 1 (CET1) capital ratio in the adverse scenario by 380 basis points to 9.9% at the end of 2020. Notwithstanding the magnitude of the impact, the euro area banking sector remains resilient, also reflecting improvements in capital ratios in recent years. To cater for the long time lag between the launch of the EBA stress-test exercise at the start of 2018 and the publication of the results, the Review includes supplementary sensitivity analyses for risks which have become prominent over the course of the year, such as the risks of an abrupt downturn of the most relevant EMEs for euro area banks and additional tension in sovereign debt markets. The results of these sensitivity analyses indicate that the materialisation of these risks would have a limited impact on the banking system, with an implied scope for further deterioration of the results of around 30 to 70 basis points of CET1 capital in addition to the capital depletion of 380 basis points.

## Policy considerations

Ten years after the outbreak of the global financial crisis, the main regulatory reforms are close to completion. The focus is set to gradually shift to full and consistent implementation of the agreed measures. In this regard, the ECB has provided substantial contributions to various regulatory initiatives at both the international and EU levels, and continues to support the strengthening of the regulatory architecture and the establishment of a sound and robust regulatory framework for financial institutions, markets and infrastructures. While substantial progress has been made over the past decade, there are still a number of legal and institutional challenges to overcome before European banks can operate within a truly integrated financial framework. As regards the ongoing review of the institutional set-up, the ECB supports a limited number of targeted changes to the governance and operational framework of the European Systemic Risk Board (ESRB) proposed by the European Commission, which aim at enhancing the ESRB’s efficiency and effectiveness. Going forward, EU co-legislators should make progress towards completing the banking union by establishing: (i) a fully fledged European deposit insurance scheme as the necessary third pillar to underpin the confidence of all depositors in the financial system and thereby safeguard financial stability; and (ii) a common backstop to the Single Resolution Fund which will buttress the credibility of the resolution framework.

The implementation of the Basel III regulatory reforms for banks is expected to be concluded by the end of this year. The revisions will introduce into EU law the leverage ratio requirement, the revised market risk capital framework, and the net stable funding ratio requirement. In this context, EU co-legislators should consider an ambitious set of targeted changes to the macroprudential framework, with the aim of making it more coherent, consistent and operational. In the medium term, a comprehensive review of the macroprudential framework is still warranted to further streamline procedures and to complement it with tools addressing risks in the real estate and non-banking sectors. The reform package also includes additional revisions to the EU crisis management framework which are essential for strengthening the resilience of the EU banking sector. As further experience with the post-crisis reforms is gained, progress should be monitored through a comprehensive evidence-based evaluation. In this regard, the ECB closely collaborates with the Financial Stability Board and other standard-setting bodies to evaluate whether the G20 financial regulatory reforms are achieving their intended outcomes.

Further efforts are needed to strengthen the regulatory and supervisory framework for the non-bank financial sector. For instance, in view of the strong growth in the role of investment funds in financial intermediation and indications that the sector is assuming more risk, authorities need to be equipped with relevant powers to be able to mitigate structural vulnerabilities arising from asset management activities, in particular for situations where measures available to asset managers themselves would not be sufficient to address these vulnerabilities. EU co-legislators should introduce macroprudential tools designed to address systemic risks related to liquidity mismatches and the use of leverage in investment funds. Moreover, the European Commission’s review of the prudential treatment of investment firms sets out a prudential framework that is better adapted to the risks and business models of investment firms, as well as subjecting systemically important investment firms to the same prudential rules as banks. Investment firms that are significant market participants, engage in cross-border activities or are connected to credit institutions could function as shock amplifiers, irrespective of their size. Consequently, certain macroprudential tools could be developed to address specific risks that smaller investment firms could also pose to financial stability.

# 1 Macro-financial and credit environment

## 1.1 Continued euro area expansion, but risks are on the rise

Broad-based euro area growth continued amid some loss in momentum. The slowdown in euro area growth since the end of last year has been largely related to a weaker impetus from net exports, reflecting weakening global trade and the past appreciation of the euro. Domestic demand remained the main engine of economic growth, reinforced by the ECB’s monetary policy measures. Favourable labour and housing market developments continue to bolster private consumption, while benign financing conditions and rising corporate profitability underpin business investment. The economic expansion has remained broad-based across countries and sectors of economic activity, underpinning the resilience of the underlying cyclical momentum.

Fundamentals remain in place for a continued euro area economic expansion. The euro area economy is projected to grow at a pace slightly above potential, reflecting the favourable impact of the accommodative monetary policy, improving labour market conditions and stronger sectoral balance sheets. The September 2018 ECB staff macroeconomic projections envisage a slight moderation in real GDP growth from 2.0% in 2018 to 1.7% in 2020 amid a weaker stimulus from world trade and growing labour supply shortages. This euro area outlook continues to contrast with more buoyant developments in the United States, where uncertainties surrounding the outlook are higher given the late phase of the business cycle (see Chart 1.1).

Nominal pressures are building up gradually in the euro area. Headline HICP inflation has inched up to slightly above 2% since the publication of the previous FSR (see Chart 1.2, left panel), mainly reflecting higher contributions from energy inflation. While measures of underlying inflation remain generally muted, domestic cost pressures are expected to strengthen and broaden amid high levels of capacity utilisation and tightening labour markets, which are pushing up wage growth (see Chart 1.2, right panel). The September 2018 ECB staff macroeconomic projections for the euro area foresee average headline inflation of 1.7% in both 2019 and 2020.

Global growth has become more uneven. Growth dynamics have become less synchronised across the globe since the beginning of the year (see Chart 1.3, left panel), as buoyant developments, in particular in the United States, contrast with a decelerating thrust in other advanced economies and emerging market economies (EMEs). Advanced economies outside the euro area continue to benefit from accommodative monetary policies and fiscal stimulus (in the United States). While higher (albeit more recently somewhat decreasing) oil prices have helped stabilise activity in many oil-exporting EMEs, tighter financial conditions as a result of idiosyncratic shocks are muting the cyclical momentum in some EMEs. Over the medium term, global economic activity is expected to expand at a pace close to potential growth, as output gaps close in most advanced economies amid gradually diminishing policy support and China transitions to a lower growth path.

Global risks cloud the baseline euro area growth outlook. Several downside risks to the euro area growth outlook relate to global factors. Uncertainties regarding the course of the US economy and monetary policy, a further rise in political and policy uncertainties across the globe, including those relating to growing trade protectionism, as well as a further intensification of stress in EMEs, may weigh on the global and euro area growth momentum. On the upside, domestic demand momentum could turn out stronger than expected, reflecting lower unemployment risk, a low saving ratio and improving earnings.

A turn of the US business cycle could affect global financial stability. The expansion of the US economy is currently the second longest on record, while it is operating at full employment – historically a herald of future downturns (see Chart 1.3, middle panel). The enacted fiscal stimuli make the risk of a cyclical turn less imminent, but higher inflationary pressures in the late phase of the business cycle may lead to faster than anticipated US monetary policy tightening. The ensuing tighter financing conditions and slowdown in growth in the United States could spill over to global financial markets and adversely affect the world economy. The current loose fiscal policies may also reignite public debt sustainability concerns and lead to a reassessment of US sovereign risk, triggering a repricing in global bond markets.

Rising political and policy uncertainties could dent confidence and sentiment. Political and policy uncertainties both within and outside the euro area appear to have increased lately. Despite limited spillovers so far, the stress in Italian sovereign debt markets illustrates how quickly policy uncertainties and the ensuing sudden shift in market sentiment can unearth risks to financial stability via higher risk premia and rising public debt sustainability concerns. The remaining lack of clarity on the future relations between the United Kingdom and the European Union also implies uncertainty surrounding the sentiment and growth implications of the UK leaving the EU. Finally, a potential intensification of tensions in geopolitical hotspots (e.g. the Middle East) may have a severe impact on the world economy via deteriorating sentiment and a rise in global risk aversion.

A further escalation of trade tensions has the potential to weigh on global trade. Risks of trade protectionism have partly materialised with the intensification of strains in US-Chinese trade, but the amount of global trade affected remains contained (see Chart 1.3, right panel). While the tariffs could weigh somewhat on activity in the United States and China, their global impact is judged to be small. A possible further escalation of trade tensions could, however, significantly impact global trade, growth and asset prices, especially if direct trade effects are compounded by indirect adverse confidence effects stemming from increased uncertainty about future trade policies and trading relations (see Special Feature B).

Vulnerabilities in EMEs remain a cause for concern. A combination of rising interest rates as a result of the ongoing normalisation of US monetary policy and a stronger dollar led to a broad tightening of financial conditions in EMEs (see Chart 1.4, left panel), highlighting the risk of sudden stops in capital flows to EMEs (see Box 1). More pronounced tensions were largely limited to Argentina and Turkey, i.e. countries with high current account deficits and a heavy reliance on US dollar funding (see Chart 1.4, right panel). Some spillovers to other EMEs have been observed though, with sovereign spreads rising and downward pressures on local currencies increasing. Unlike during previous episodes of EME stress, differences in underlying fundamentals have given rise to market discrimination across EMEs so far (see Chart 3 in the Overview). There is, however, the risk that idiosyncratic, country-level events – such as financial and real shocks associated with China’s rebalancing process or its trade dispute with the United States – spark a broader-based increase in risk aversion vis-à-vis EMEs at large, with significant implications for global financial markets and economic activity.

All in all, financial stability in the euro area could be challenged in the event of the materialisation of downside risks. These factors may not only undermine the sustainability of the global and euro area growth momentum, but also have the potential to trigger tensions in global financial markets and prompt a disorderly unwinding of global search-for-yield flows. A weaker than expected growth environment could trigger the materialisation of any of the main risks to euro area financial stability and could reinforce global risk repricing, further challenge bank profitability or fuel debt sustainability concerns.

Based on an indicator of cyclical systemic risk, medium-term risks appear to be low, while increasing in some countries. The composite domestic cyclical systemic risk indicator, designed to signal risks of a financial crisis over the medium term, has remained broadly stable below the long-term mean (see Chart 1.5), implying a low likelihood of cyclical systemic risks to the euro area materialising in the medium term. However, the dispersion across countries has continued to narrow amid a rise in risk indicators for countries with more subdued cycles.

## Box 1 Explaining the slowdown in portfolio flows to EMEs

Prepared by Maurizio Habib and Thomas Kostka

Portfolio flows to EMEs have declined significantly in the course of 2018, largely as a result of increased investor sensitivity towards EME asset markets and rising protectionist pressures. After a spell of strong and stable foreign purchases of debt and equity instruments issued by sovereigns and corporates in EMEs throughout 2017, aggregate portfolio flows to EMEs have dipped notably since February 2018 (see Chart A, left panel). Global investors started to reassess the potential negative effects of a tighter US monetary policy and a stronger dollar on financial conditions in EMEs and the downside risks to global growth stemming from mounting protectionist pressures. EMEs appear to be particularly exposed to these risks. Several EMEs borrow heavily in international markets and are affected by the tightening of US dollar funding conditions. Moreover, EMEs are generally more open to trade than advanced economies, relying on policies geared towards free trade to support economic growth. This box aims to disentangle the role of these global factors in driving the recent slowdown in portfolio flows to EMEs from country-specific vulnerabilities, which may have exacerbated the impact of global risks.

On aggregate, the slowdown in portfolio flows so far has been less abrupt compared with previous periods of market tensions in EMEs. In particular, non-resident purchases of EME portfolio instruments turned negative in May and June, but these outflows did not reach the intensity of previous similar episodes, such as the global financial crisis, the “taper tantrum” episode in 2013 and the correction in global commodity markets and Chinese equity markets in 2015. At the same time, the slowdown has been relatively sustained over time, marking the start of a new period of lower global appetite for the risky asset class of emerging market equity and debt.

While on aggregate portfolio flows to EMEs have shown some resilience to rising volatility, some large EMEs have experienced outflows approaching “sudden stop” levels. Notably, some of the largest EMEs have experienced sizeable portfolio outflows in the course of this year. Foreign flows out of bond and equity markets in Indonesia and South Africa, and to a lesser extent in India, Thailand, Malaysia, Turkey and Brazil, have been in a range from slightly above to somewhat below a threshold that defines a sudden stop according to popular metrics in the international finance literature (see Chart A, right panel).

From an aggregate viewpoint, the slowdown in flows to EMEs can be explained by a tightening in global financial conditions as well as by domestic factors. There are two broad categories of factors explaining portfolio flows into EMEs.[2] Push factors comprise popular indicators of global risk and financial conditions, coming in particular from the United States, which are deemed key determinants of investors’ liquidity and risk appetite towards EMEs.[3] Pull factors, such as the strength of domestic growth and macroeconomic fundamentals, are also important factors in explaining investments in EMEs, beyond global financial conditions. A simple econometric model that decomposes recent dynamics in aggregate portfolio flows to EMEs into these two broad factors attributes the bulk of the recent slowdown to a stronger negative contribution from a set of push factors (see Chart B), notably the strengthening of the US dollar in 2018, several further US monetary policy rate hikes and, to a lesser extent, increases in equity market volatility from the extremely low levels observed in previous years.[4] Moreover, domestic factors have also increasingly contributed to the outflows. In particular, economic surprises have recently been on the downside and inflation rates have increased.

In sum, the slowdown in foreign portfolio flows to EMEs was driven by both push and pull factors. Higher interest rates for US dollar-denominated bonds and a stronger dollar have tightened financial conditions for a number of EMEs, exacerbating external vulnerabilities for corporate and sovereign borrowers that rely on dollar funding without sufficient hedges. Also, the news flow about the economic situation in EMEs has generated selling pressure for global portfolio investors. Finally, it should be noted that the aggregate analysis, presented here, masks important cross-country heterogeneity in respect of country-specific vulnerabilities, such as political uncertainty or the extent of external imbalances (see Chart 3 in the Overview).

## 1.2 Re-emerging sovereign debt sustainability concerns

Stress in euro area sovereign debt markets flared up. Sovereign debt sustainability concerns have come to the forefront since the previous FSR, triggered by heightened political and policy uncertainties surrounding the formation of a new Italian government in May/June this year. The related pick-up of the composite indicator of systemic stress for euro area sovereign bond markets went hand in hand with an increase in cross-country dispersion to levels last observed in early 2016 (see Chart 8 in the Overview). Contagion to other countries has remained relatively contained though, amid strong cyclical conditions and a continued positive news flow from countries more affected by the global financial and euro area sovereign debt crises, related for example to sovereign rating upgrades (e.g. for Cyprus, Greece, Spain) and the conclusion of the third economic adjustment programme for Greece.

Favourable cyclical and financing conditions mask underlying fiscal vulnerabilities. The aggregate euro area headline fiscal deficit declined from 1.6% of GDP in 2016 to 1.0% of GDP in 2017, and is set to drop further to 0.6% of GDP in 2018, while deteriorating slightly in 2019-20. The improvement in 2018 has been chiefly supported by continued strong (albeit somewhat softening) economic growth and the low interest rate environment. However, the positive cyclical component is more than compensated for by the projected structural loosening. Fiscal efforts continue to fall short of commitments under the Stability and Growth Pact (SGP) in several (in particular highly indebted) euro area countries (see Chart 1.6, left panel). Overall, the reliance of the projected improvement in fiscal balances on benign cyclical conditions renders the fiscal outlook particularly sensitive to changes in the growth and interest rate environment.

For highly indebted countries, addressing debt sustainability concerns requires active fiscal consolidation. The euro area aggregate general government debt-to-GDP ratio has been on a downward trajectory since the peak in 2014, reaching 88.9% in 2017. More recently, the stock of debt has continued to increase in several highly indebted countries, despite the downward effect of supportive macro and financial conditions. Hence, failure to rein in fiscal balances and to comply even with minimum SGP requirements would place debt trajectories on a clear upward path in most countries with debt ratios above 90% (see Chart 1.6, right panel). The strong reaction in Italian sovereign bond markets in May/June this year illustrates how quickly shifts in market sentiment can reignite pressures on more vulnerable sovereigns. Pressure on sovereign financing costs, in combination with a lack of sufficient fiscal consolidation efforts, may put the debt ratio on an unsustainable path in highly indebted countries.

Favourable sovereign financing conditions imply that rollover risks are concentrated among a few vulnerable issuers. Despite the spike in Italian government bond yields, overall pricing conditions have remained relatively benign for euro area sovereigns against the backdrop of ongoing Eurosystem asset purchases. The average residual maturity of outstanding euro area government debt securities continued to be extended (see Chart 1.7, left panel). The increase in fixed rate debt issuance allows governments to lock in long-term financing at low costs and to capitalise on historically low interest rates. The debt servicing obligations of euro area sovereigns have declined on aggregate. Nevertheless, they remain high for some highly indebted euro area countries (see Chart 1.7, right panel). This may suggest possible rollover risks in terms of both the availability and the cost of funding in the event of a reassessment of sovereign risk by market participants.

In sum, sovereign risks have increased since the previous FSR. Sovereign debt dynamics continue to benefit from the ongoing solid economic expansion and favourable financing conditions in terms of both pricing and duration. However, public finances remain fragile in a number of euro area countries, exposing them to the risk of a sudden change in market sentiment or deteriorating macroeconomic conditions. Waning fiscal consolidation efforts, particularly in combination with higher long-term interest rates, would fuel public debt sustainability concerns in more vulnerable euro area countries.

## 1.3 Solid household fundamentals, but pockets of vulnerability remain

Favourable cyclical conditions have bolstered euro area households’ income position. Households’ disposable income continued to grow at above long-term average rates (see Chart 1.8, left panel). Rising euro area aggregate income growth has been mainly driven by ongoing job creation and the related robust growth in labour income. Labour market conditions remain heterogeneous across countries amid increasingly binding labour supply shortages in some countries and still elevated unemployment rates in others (see Chart 1.8, middle panel). Tighter labour market conditions and an upward trend in wage growth, coupled with strong valuation gains on property holdings, are boosting household incomes and net worth and, ultimately, household spending. A higher propensity to consume is also reflected in a saving ratio close to the record low (see Chart 1.8, right panel).

The indebtedness of euro area households has stabilised at pre-crisis levels, but vulnerabilities at the country level remain. The indebtedness of euro area households stabilised at slightly below 58% of GDP in the first half of 2018. While this is not particularly high by international standards, it is still somewhat above the estimated benchmark level of 53% of GDP derived from the macroeconomic imbalance procedure (MIP) threshold for non-financial private sector debt. The euro area aggregate continues to mask marked cross-country heterogeneity though, with the household debt-to-GDP ratio ranging from about 20% in Latvia and Lithuania to above 100% in Cyprus and the Netherlands (see Chart 1.9, left panel). From a flow perspective, continued deleveraging (in both absolute and relative terms) in some euro area countries that were more affected by the crisis (e.g. Cyprus, Greece, Ireland and Spain) contrasts with signs of releveraging in most others. However, only in a few countries, notably Belgium and France, does the pace of new debt accumulation outstrip nominal GDP growth.

Debt sustainability concerns are mitigated by the low level of interest rates. An improved income position coupled with record low interest payment burdens support euro area households’ debt servicing capacity. Simulation results suggest that a 100 basis point increase in short and long-term market rates would have a fairly limited impact on household debt-to-GDP ratios and gross interest payments (see Chart 1.9, right panel). However, especially in the event of an interest rate shock without a commensurate boost to household income, more vulnerable households might be challenged in countries where loans at floating rates or rates with rather short fixation periods predominate. Further balance sheet repair in countries with elevated levels of household debt should help mitigate the risks related to an eventual normalisation of interest rates and the ensuing rise in debt servicing costs.

Lending flows to households have recovered further amid signs of buoyancy in some lending types and countries. On aggregate, lending to euro area households is supported by very favourable financing conditions, improvements in labour markets, an ongoing upturn in housing markets and growth in both residential investment and private consumption. At the country level, lending dynamics have continued to be muted in some countries that were more affected by the crisis (e.g. Cyprus, Greece, Ireland and Spain), while in other euro area countries (e.g. Slovakia, Lithuania, Luxembourg and Malta) developments were more buoyant (see Chart 1.10, left panel). The continued rapid growth of consumer lending in some countries is not an immediate source of concern from a financial stability perspective. Nevertheless, it may indicate a niche of increased risk-taking by banks due to higher margins in that business segment (as reflected by the still comparatively high lending rates) and thus warrants monitoring going forward (see Chart 1.10, right panel).

All in all, while euro area households are benefiting from cyclical tailwinds, stock imbalances remain a vulnerability in some countries. Improving income positions coupled with continued favourable financing conditions are supporting households’ debt servicing capacity. However, a sudden rise in interest rates may spark debt sustainability concerns in countries with elevated levels of household debt and a predominance of floating rate contracts. The buoyancy of certain types of bank lending in some euro area countries requires monitoring.

## 1.4 High corporate indebtedness remains a challenge

Cyclical tailwinds are alleviating credit and earnings risks for euro area non-financial corporations (NFCs). The expected default frequency and distance-to-distress measures currently signal relatively low levels of balance sheet risk for euro area NFCs that were last observed back in early 2008 (see Chart 1.11, left panel). Improved creditworthiness is buttressed by solid corporate profit growth and the related decline in earnings risks (see Chart 1.11, right panel). Well-filled order books and high levels of capacity utilisation, coupled with low interest rates, bode well for further improvements in corporate profitability. A sudden deterioration in economic growth prospects or a cost shock could, however, undermine corporate profitability, while rising trade protectionism may hamper the profit-generating capacity of export-oriented firms.

A large stock of legacy debt continues to weigh on the euro area non-financial corporate sector. On aggregate, the indebtedness of euro area NFCs remains high by both historical and international standards. The falling trend observed since early 2016 appears to have come to an end, with the consolidated NFC debt-to-GDP ratio stabilising at 82% for the euro area aggregate – a level that is still above thresholds associated with a debt overhang (see Chart 1.12, left panel). Heterogeneity across the euro area remains high in terms of both debt levels and the underlying dynamics, as debt accumulation in some countries contrasts with continued deleveraging in others. Other leverage measures at market values such as debt-to-total assets and debt-to-equity ratios for euro area NFCs point to more favourable developments though, having approached or even fallen below the levels observed at the start of EMU given higher share prices and the related positive denominator effect.

Corporate interest payment burdens have dropped to fresh historical lows. Currently, euro area NFCs’ debt servicing capabilities are underpinned by record low corporate interest payment burdens (see Chart 1.12, middle panel). Still, further balance sheet repair would help offset any risks related to a rise in interest rates and the ensuing rise in debt servicing costs. In fact, unlike in the household sector, loans with floating rates or rates with rather short fixation periods continue to be the dominant type of loan for euro area NFCs. The related interest rate risk is partly mitigated by the ongoing shift of firms towards market-based funding amid strong issuance activity at the long end of the maturity spectrum at fixed rates in recent years. Simulation results suggest that a 100 basis point increase in short and long-term market interest rates would translate into a fairly limited increase of NFC debt and debt servicing burdens (see Chart 1.12, right panel). This is because higher interest rates would restrict nominal debt financing growth by almost the same amount as nominal GDP growth. Higher interest rates would have a somewhat more pronounced upward impact on firms’ than on households’ indebtedness and debt servicing costs, which would still remain at modest levels.

External financing of euro area NFCs remained favourable in terms of both the availability and cost of funding, while internal financing sources remained ample. Bank lending flows to euro area NFCs have strengthened gradually further (see Chart 1.13, left panel), supported by the continued easing of credit standards and a decline in the relative cost of bank borrowing. Developments have remained uneven across the euro area though, as more dynamic lending activity in euro area countries that were less affected by the crisis contrasts with more muted developments in countries that were more affected by the crisis. In terms of the external financing flows from non-bank sources, the net issuance of debt securities has remained relatively strong against the backdrop of the ECB’s corporate sector purchase programme and the low, but slightly increasing, cost of market-based debt financing. By contrast, the issuance of listed shares by NFCs continued to be rather modest given the relatively high cost of quoted equity (see Chart 1.13, right panel). Liquidity buffers of euro area NFCs have remained ample at some 29% of GDP as at mid-2018, suggesting that euro area NFCs can also rely on these buffers as a financing source, in addition to bank and non-bank sources of external finance.

All in all, euro area NFCs continue to benefit from strong macro fundamentals and low funding costs, but underlying vulnerabilities remain. Firms’ profit-generation capacity is underpinned by the still robust underlying economic momentum. Reinforced by the very accommodative monetary policy stance of the ECB, the financing conditions of euro area NFCs remain favourable and supportive of both investment and debt servicing. However, the predominance of variable rate lending, as well as historically and internationally high corporate debt levels, may expose euro area NFCs to a risk repricing in financial markets and a sudden deterioration in macroeconomic conditions. At the same time, a sharp correction in stock prices and decline in firms’ asset values could lead to a significant increase in leverage ratios based on market values.

## 1.5 Sustained momentum in euro area property markets

The cyclical upturn in euro area residential property markets has maintained its momentum amid some signs of overvaluation. Buttressed by the low interest rate environment and the solid economic expansion, euro area residential property markets continued to expand at rates above long-term averages, while developments across the euro area have continued to become more broad-based (see Chart 1.14, left panel). In terms of valuations, euro area residential property prices are estimated to show signs of slight overvaluation on aggregate, with the degree of uncertainty surrounding the range of valuation estimates gradually decreasing (see Chart 10 in the Overview). Developments across countries and in some cases across regions within a country are heterogeneous, largely depending on the depth and length of the correction phase in the aftermath of the crisis in each country, if any. Potential pockets of vulnerability warrant closer monitoring in some countries, in particular if brisk house price developments are also mirrored by exuberance in credit and the build-up of household debt (see Chart 1.14, right panel). Macroprudential policies may help mitigate possible risks to financial stability at the country level.

Strong price developments in euro area commercial property markets suggest stretched valuations in some segments. Activity in these markets remains robust as indicated by both price dynamics and transaction volumes. Price developments continue to be driven mainly by the prime commercial property segment, which has remained particularly ebullient in the context of the current low-yield environment and the ongoing search for yield. Commercial property price inflation appears to have exceeded dynamics implied by fundamentals in recent years (see Chart 1.15, left panel). As a result, valuations might be currently stretched, especially in the prime segment. Transaction volumes have remained strong, but have decreased from peak levels in recent quarters in line with a maturing cycle (see Chart 1.15, right panel).

All in all, the underlying dynamics of residential and commercial property markets may warrant monitoring in some countries and market segments. In terms of the risks, an adverse economic or financial shock may challenge the sustainability of the ongoing upturn in property markets. In particular, deteriorating economic growth prospects, tightening financing conditions or rising long-term interest rates could worsen the debt servicing capacity of households and commercial property investors, and may represent a risk for banks in countries with high property-related exposures.

# 2 Financial markets

## 2.1 Increased risk aversion and strong US growth are dominant factors in financial markets

Global markets have been driven by heightened investor sensitivity, as strong US growth has hinted at a swifter policy normalisation by the Federal Reserve. Initially, financial conditions remained accommodative both in advanced economies and emerging market economies (EMEs) despite Fed interest rate hikes and US dollar appreciation. Financial conditions tightened considerably in EMEs in August, as US Treasury yields crept up. A global risk shock, strong US growth and monetary policy normalisation appear to have underpinned these movements in global financial markets (see Box 2).

## Box 2 Assessing global asset price developments through the lens of a structural BVAR model

Prepared by Johannes Gräb, Thomas Kostka and Fabrizio Venditti

This box describes a simple structural Bayesian vector autoregression (BVAR) model that uses sign restrictions to determine the relative importance of distinct economic and financial shocks in shaping the co-movement of key global financial variables. The model provides intuitive and economically plausible interpretations of gyrations in key US and global asset markets over the past six months. The model ascribes them to a multitude of factors, including strong nominal US demand, heightened investor risk aversion as well as the prospect of higher US inflation and tighter monetary conditions.

The model can be used to disentangle the underlying causes of market movements and to infer the macroeconomic implications of such movements. For instance, in the past six months, trade tensions and currency crises in some emerging market economies (EMEs) caused price corrections in EME financial markets, while putting downward pressure on US Treasury yields reflecting flight-to-quality dynamics. At the same time, tightening US monetary policy, robust growth (supported by expansionary fiscal policy) and rising inflation pushed US Treasury yields up. Strong nominal growth also provided support to US equity prices and to the dollar. Without a structural model, the macroeconomic implications of these asset price movements would remain challenging as some developments push financial asset prices in different directions.[5]

The structural model considers a small set of financial variables and structural shocks. In particular, developments in five important financial variables are modelled jointly: (i) US equity prices, scaled by the current level of annual earnings; (ii) a basket of EME bond yields for US dollar-denominated sovereign debt; (iii) yields of US Treasury bonds with ten-year maturity; (iv) the US nominal effective exchange rate (NEER); and (v) US inflation expectations, derived from long-term inflation swaps. The model explains the co-movement of these variables by a linear combination of four structural economic and financial shocks, identified by means of sign restrictions (a summary of the sign restrictions can be found in Table A):

• US monetary shock: A US monetary shock is identified as an innovation in long-term US bond yields (and thus also dollar-denominated EME bond yields). A monetary shock triggers a decline in equity prices, a fall in inflation expectations and an appreciation of the exchange rate given wider yield differentials vis-à-vis other major currencies.
• US demand shock: Positive news about aggregate demand in the US economy raises domestic bond yields and inflation expectations, leads to an appreciation of the US dollar and boosts equity valuations. The increase in Treasury yields also leads to an increase in dollar-denominated EME bond yields.
• US inflationary shock: Inflationary shocks in the US economy raise inflation expectations and bond yields and depress equity valuations. The increase in bond yields also leads to tighter financial conditions in EMEs.
• Global risk shock: A fall in investors’ risk appetite leads to a reduction of their exposure to risky assets, namely EME sovereign bonds (implying an increase in yields) and US equities. At the same time, investors turn towards safe-haven assets, namely US Treasury bonds (leading to a decline in yields) and the US dollar.

Heightened investor risk aversion, strong US demand, as well as the prospect of higher inflation and tighter monetary policy, have governed global financial markets over recent months. The model identifies a multitude of underlying drivers behind developments in global financial markets over the review period (see Chart A). Most prominently, positive US demand shocks, reflecting inter alia fiscal stimulus measures as well as large repatriations of foreign profits, put upward pressure on US Treasury yields, US equity prices and the US dollar. At the same time, a global risk shock, associated with uncertainty about global trade policies, put selling pressure on risky assets. EME sovereign bonds were particularly hard hit, but also the rise in US equity prices was dampened by higher investor risk aversion. The associated flight to safety contributed to the appreciation of the US dollar and kept a lid on US Treasury yields. In October, a renewed increase in risk aversion (global risk shock) put downward pressure on both US Treasury yields and equity valuations. At the same time, a swifter than anticipated US monetary policy tightening (US monetary shock) added downward pressure on equity prices, while limiting the decline in US Treasury yields.

In euro area financial markets, political events and spillovers from global developments were the key factors driving periodic spikes in market tension. After increasing in February on the back of high volatility in US equity markets, the composite indicator of systemic stress in euro area financial markets exhibited a series of renewed spikes in late May and then again in recent months (see Chart 2.1). Driving factors include market concerns about rising policy uncertainty in Italy and adverse developments in some EMEs. A breakdown of the composite indicator suggests widespread market tension across financial intermediaries, bond markets and equity markets.

Bond markets have remained calm in most euro area countries, despite higher spreads and volatility in Italy. In the last six months, a rise in Italian sovereign yields contrasted with limited changes for other euro area countries (see Chart 2.2, left panel). The spread between the ten-year Italian sovereign yield and the overnight index swap (OIS) rate increased above 2.5% in May and then again in recent months, a level not seen since 2013, but well below that experienced during the height of the sovereign debt crisis. Spillovers to other euro area countries were limited. In corporate bond markets, spreads increased slightly, mainly reflecting a repricing of risk from historical lows, as shown by rising excess bond premia.

Activity in the European leveraged loan market remains strong. At the global level, US corporates are estimated to account for around three-quarters of the outstanding amount of leveraged loans (see Chart 2.3, left panel), a segment that constitutes roughly half of the €4 trillion high-yield debt market. Risk appetite in leveraged finance remained very strong, with spreads on European leveraged loans tightening over the period, moving closer to post-crisis lows. Spreads on high-yield bonds slightly increased, amid a rotation from fixed rate high-yield bonds into leveraged loans (see Chart 2.3, right panel). Developments in leveraged loan markets may have direct and indirect effects on the broader financial system and pose financial stability risks (see Section 2.2).

While euro area bond markets have remained calm overall, uncertainty has had a more pronounced impact on equity markets. The EURO STOXX 50 Index is down by roughly 15% since January (see Chart 2.4). Banks weighed heavily on the overall index. Uncertainties over global trade policies, spillovers from EMEs and further signs of a growth slowdown hit Chinese equities, with the Shanghai Composite Index 25% down year to date. By contrast, solid growth prospects, strong corporate earnings and the fiscal stimulus contributed to the rally of US equities during the summer. Nonetheless, since October, a spike in volatility drove the US equity market down as well, wiping out 2018 gains. Stocks of technology companies have been particularly under pressure.

Foreign exchange markets witnessed isolated cases of elevated volatility. The current risk-sensitive environment and associated flight-to-safety flows triggered a strong US dollar appreciation. The euro has depreciated by 5% against the US dollar this year (see Chart 2.5, left panel). In the same period, the volatility of the euro/Swiss franc exchange rate, traditionally a good barometer of safe-haven flows, has increased. Globally, EME currencies were the most affected by the US dollar appreciation, with collapses in the Argentinean peso and Turkish lira. Concerns over Chinese authorities’ willingness to allow the renminbi to depreciate added to market anxiety. Although the observed dynamics are not compatible with a scenario of broader contagion to other EMEs, signs of market stress are already visible. In particular, the ratio of the implied volatility of emerging market currencies to that of advanced economy currencies has reached in recent months levels observed during the global financial crisis (see Chart 2.5, right panel).

The availability of US dollar funding improved, driven by both supply and demand factors. Strong US dollar cash supply has been supported by inflows into US prime money market funds (MMFs), as the latter became more appealing in a context of rising interest rates. On the demand side, Japanese investors, which traditionally drive the marginal demand for US dollar funding, increased their euro-denominated asset holdings at the expense of US dollar assets, thereby reducing demand pressure on US dollar funding. As a consequence, since May, the US dollar funding premium against the euro declined progressively, as expressed in a narrower EUR/USD cross-currency basis. FX swap transactions covering the year-end continue instead to exhibit a significant premium.

Euro area money markets are functioning smoothly, both in the secured and unsecured segments. The activity in euro area repo markets continued on the mild upward trend that started in mid-2016. Transaction data reveal that liquidity-driven secured activity (General Collateral or GC) slightly declined relative to collateral-driven transactions (non-GC). The share of GC volumes returned to higher levels during the summer, mostly reflecting the higher activity on the Italian GC repo market. Repo rates also exhibited significant convergence in the euro area. In September, the spread between German and Italian repo rates declined below 20 basis points. Smooth conditions were also reflected in the low volatility of repo rates at quarter-ends.

## 2.2 Disorderly increases in risk premia remain a prominent risk to euro area financial stability

Euro area financial markets may experience further bouts of volatility as a result of tightening global financial conditions and political uncertainty. Although financial conditions in the euro area have remained favourable and accommodative, global developments and the growing collection of idiosyncratic risks increasingly deserve close monitoring. Potential triggers that may pose risks to financial stability are both global and domestic. An escalation of trade tensions and a further shift in investor risk sentiment could induce an abrupt increase in risk premia and an unintended tightening of global financial conditions. Higher interest rates in the United States and a further appreciation of the US dollar could spill over to the euro area, both directly by driving up term premia and indirectly by triggering more generalised stress in EMEs and a slowdown in global growth. Near-term risks in Europe and in the euro area mainly include geopolitical factors. Uncertainties surrounding the future relationship between the UK and the EU27 and developments in Italy may have wider financial stability implications.

While markets have been fairly resilient to trade tariff announcements, escalations could lead to a large increase of risk premia. Uncertainty related to trade policies has already increased substantially since January (see Chart 2.6 and Special Feature B). Portfolio flows to EMEs declined significantly. If tariffs were to be extended to other goods and affect a larger set of countries, higher uncertainty and lower global growth prospects could trigger sizeable corrections in global asset prices (see Box A in Special Feature B). Concerns over global trade could adversely interact with other existing vulnerabilities. Geopolitical tensions propelled Brent crude oil prices beyond USD 80 per barrel in October, before falling sharply more recently.

Further increases in US bond yields could contribute to higher term and risk premia, also in the euro area. Higher US yields might materialise in the context of stronger growth, higher inflation expectations and a more aggressive tightening of monetary policy. Other factors that may add upward pressure on US Treasury yields include a higher supply of US Treasury bonds, in the context of expansionary fiscal measures, and sales of US Treasuries by central banks in EMEs. While spillovers from US Treasuries to the German Bund have so far been contained, US factors are increasingly important in explaining developments in euro area term premia, as captured by the ten-year OIS rate (see Chart 2.7, left panel). Increasing yields in the United States already seem to be affecting global risk appetite as well. In EMEs and, to a lesser extent, in the euro area, financing conditions for more risky corporate borrowers, as measured by spreads between non-investment-grade and investment-grade corporate bond yields, have steadily worsened (see Chart 2.7, right panel). Looking ahead, lower US bond market valuations might also make investors rethink their relative portfolio allocation and prompt a correction in global equity prices.

Rising global risk aversion could directly affect euro area markets through fluctuations in the EUR/USD exchange rate. Investors traditionally unwind long positions when a risk-off sentiment prevails. This explains why the correlation between risk sentiment and the EUR/USD exchange rate depends on how the market is positioned. When investors are long euro, the latter tends to depreciate when volatility increases and risk-off sentiment materialises. This mechanism is likely to have been an amplifier of euro exchange rate movements until mid-August (see Chart 2.8). More recently, net speculative positions have turned negative and, in the near term, the euro exchange rate is more likely to trade as a safe asset and appreciate when volatility increases.

A continued tightening of US monetary policy, combined with a further strengthening of the US dollar, could generate more widespread contagion in EMEs and could indirectly affect the euro area. A strong differentiation between EMEs still persists and stress remains contained to countries with external vulnerabilities (see Chapter 1). But below the surface, signs of spillovers and market nervousness are increasingly becoming visible. Recent events may have already increased investor sensitivity to both macroeconomic and political news from emerging markets, a potential early warning indicator of wider contagion and systemic stress. A counterfactual analysis suggests that the increase in EME sovereign spreads has gone well beyond the rise implied by the deterioration in the EME economic and political landscape (see Chart 2.9, left panel). Although the cross-section of asset price developments in different EMEs is still reflective of each country’s fundamentals, the timing of the sell-off in assets in some other large EMEs coincided with the market crashes in Turkey and Argentina. Models gauging asset price spillovers among EMEs suggest a notable pick-up in the contribution of the dynamics in Argentinean and Turkish sovereign bond markets to those in other EME sovereign bond markets (see Chart 2.9, right panel). More generalised stress in EMEs could trigger a global repricing of risk premia and would adversely affect global growth.

Investors in leveraged finance remain exposed to the risk of a sharp repricing and developments in the sector may spill over more widely (see also the Box 5 in the May 2018 FSR). Underwriting standards of leveraged loans have remained poor, with covenant-lite loans estimated to account for about 70% of total issuance in the third quarter of 2018 (see Chart 2.10, left panel). The year-to-date primary market issuance of collateralised loan obligations (CLOs), which repackage leveraged loans into debt securities, has been sustained in the United States and, to a lesser extent, in Europe (see Chart 2.3, right panel). Leveraged loans still represent a small share of total loans granted by euro area banks; nevertheless, some lenders are more active than others in that market and are therefore likely to be more exposed.[6] Beyond direct holdings, funding for CLO loan warehousing and other facilities provided to other investors represent additional channels through which some banks are exposed to the leveraged loan market. At the global level, risks extend more broadly to high-yield debt markets, considering the record-high leverage of high-yield corporates, the growth of direct lending outside the traditional bank syndication channel and the progressively larger unsophisticated high-yield investor base. From a system-wide perspective, unexpected developments in the market, such as spikes in corporate default rates and sharp repricing, may trigger wider sell-offs and contagion to other high-yield markets, as well as investment-grade and other markets. In May 2017, ECB Banking Supervision issued guidance on leveraged transactions that applies to all significant credit institutions supervised by the ECB.[7]

While concerns over a no-deal Brexit still persist, the effects on financial markets have been mainly limited to the foreign exchange market. To date, most of the Brexit uncertainty has been concentrated in sterling/euro exchange rate volatility. While further market tensions have been limited, uncertainties surrounding the future relationship between the EU27 and the UK in the area of financial services may yet entail financial stability consequences, notably in the case of a no-deal outcome (see Box 6).

Volatility in the Italian government bond market also reflected increased investor sensitivity towards macro vulnerabilities. Alongside global shocks, recent domestic developments pose risks to financial stability. In October, volatility returned to the Italian government bond market. Albeit to a lesser extent than in 2012, shocks have been partially transmitted to credit default swap (CDS) spreads of Italian financial and non-financial firms (see Chart 2.11) While there has been little contagion to the rest of the euro area, increased market tensions could spread to other government bond markets in the event of further Italian stress.

Cross-market activity between cash and derivatives markets may become impaired in a highly volatile environment, as recently observed in Italy. At the end of May, dealers became temporarily reluctant to provide liquidity in the cash market for Italian sovereign bonds. In the same period, worsening short-term expectations, as shown by the spike in open positions in short-term BTP (Buoni del Tesoro Poliennali) futures (market open interest in the left panel of Chart 2.12), contributed to the drop in the price of the short-term futures and the flattening of the Italian sovereign yield curve (see Chart 2.12, right panel). This episode shows that while cross-market activity contributes to liquidity and price discovery on the cash market in normal times, positive spillovers from the derivatives to the cash market may cease to exist during periods of high uncertainty.

Liquidity conditions in the Italian sovereign debt market deteriorated sharply in May, possibly also reflecting a changed liquidity environment at the global level. Trading volumes in Italian government securities halved during the summer, driven only partially by seasonal effects, before stabilising in September at levels well below those recorded at the beginning of the year. Signs of lower than usual liquidity persist. Box 3 looks in more depth at the liquidity conditions on the Italian sovereign bond market and argues that some structural developments may have contributed to reducing more globally the capacity of the financial system to absorb liquidity shocks. Box 4 discusses the findings of an ECB survey of large financial intermediaries on credit terms and conditions in euro-denominated securities financing and over-the-counter derivatives markets. Intermediaries reported a tightening in terms and conditions since 2015 and, as key drivers, they flagged the reduced balance sheet capacity of banks, decreased market liquidity and some new market conventions.

## Box 3 Liquidity conditions in the Italian sovereign bond market since May

Prepared by Katharina Cera, Alexander Düring and Simon Kördel

Liquidity in the Italian sovereign bond market deteriorated sharply at the end of May. Heightened political uncertainty led to a rise in Italian sovereign bond yields and triggered a short-lived flattening of the yield curve (see Chart 2.12, right panel). At the same time, liquidity conditions deteriorated significantly. On 29 May intraday bid-ask spreads increased to levels not seen since the height of the euro area sovereign debt crisis in 2011 (see Chart A, left and right panels). On the interdealer MTS platform specialised in the Italian market[8], the ratio of the bid-ask spread to the mid bid-ask price for the most recently issued ten-year (on-the-run) bond – a measure that moves inversely with market liquidity – rose from below 0.1% to above 5%. The resilience of the market has been adversely affected too. Orders larger than €50 million could no longer be executed at the best five prices quoted by participating dealers, according to intraday order-book data.

A temporary breakdown of the arbitrage relationship between cash and futures markets for Italian government bonds is likely to have negatively affected liquidity on the cash market. Valuations in the two markets diverged significantly on 29 May, as arbitrage relationships temporarily ceased working. Since market-makers commonly use futures to hedge their exposures on the cash market, the increased basis risk has contributed to an even further widening of bid-ask spreads in cash markets (see Chart 2.11, left panel). Since then, overall liquidity conditions on the Italian sovereign bond market have significantly improved, partially reversing the deterioration experienced in May (see Chart A, middle panel).[9]

Bouts of market volatility and illiquidity have become more common in recent years in global financial markets. Recent episodes which affected traditionally very liquid markets include the 15 October 2014 “flash rally” in the US Treasury market and the sterling “flash event” of 7 October 2016. What makes the recent developments in the Italian sovereign bond market stand out is that the signs of market illiquidity were not restricted to a single day but persisted intermittently, albeit less severely, over the months after the initial turbulence (see Chart A, middle panel).

This and other recent episodes of market volatility and illiquidity raise questions about the possible drivers that may have contributed to a change in liquidity conditions at the global level, in addition to idiosyncratic developments. Several elements suggest that structural changes in global financial markets are contributing to the frequency and magnitude of volatility bouts. The increased use of electronic trading has strengthened the linkage between cash and derivatives markets, thereby increasing market participants’ responsiveness to news. Automated trading strategies by mechanically propagating fluctuations and trends across markets may contribute to amplification. The increased popularity of high-frequency traders, which tend to profit from increasing market volatility, can amplify market corrections at times of increasing uncertainty. The structural shift of the investor base from banks to non-bank financial intermediaries may have affected the liquidity and trading environment and contributed to the observed bouts of volatility. In particular, unlike banks, non-banks do not operate as market-makers for their clients.

## Box 4 Recent trends in credit terms and conditions in euro-denominated securities financing and over-the-counter derivatives markets based on information from the SESFOD survey

Prepared by Paola Antilici and Giulio Nicoletti

SESFOD is a quarterly survey launched in 2013 as a Eurosystem initiative to collect information on changes in credit terms and conditions on euro-denominated securities financing and over-the-counter (OTC) derivatives markets. The survey is based on 28 large banks, comprising 14 euro area banks and 14 banks with head offices outside the euro area. Banks answer questions at a quarterly frequency regarding how they changed the terms and conditions (both price and non-price) offered to their clients, as well as providing a ranking of the motivations underlying their decisions. The information collected in the survey is useful to assess financial stability, market functioning and the monetary policy transmission mechanism. The survey provides useful insights into the ability of financial intermediaries to secure funding and hedge risks. Buoyant conditions and loose terms may lead to high leverage, while excessively tight terms may provide insights into possible market dysfunctionalities.

This box presents an index summarising financing and hedging conditions, which is derived by aggregating the changes reported in SESFOD. According to such an index, financing and hedging conditions have tightened since mid-2015, following two years of progressive easing (see Chart A, left panel). Evidence from SESFOD is in line with the “financial cycle” indicator (the blue line in the left panel of Chart A), which measures broad financial conditions in bond markets.

The SESFOD index was consistent with financing conditions for non-financial corporations (NFCs) until the inception of the ECB’s corporate sector purchase programme (CSPP). Overall credit terms, as measured by SESFOD, and spreads on corporate bonds (where the latter are a proxy for funding conditions for NFCs) exhibited similar trends until the end of 2015. Since then, financing and hedging conditions for financial institutions have continued to tighten, while the CSPP has contributed to compressing NFC bond spreads (see Chart A, right panel).

Banks reported that reduced balance sheet capacity of financial intermediaries, as well as market liquidity and functioning, were the main factors responsible for the tightening of price and non-price conditions. Regarding the non-price terms and conditions, additional factors contributing to their tightening were the adoption of new market conventions and the new risk management practices introduced after the global financial crisis (see Chart B). New market conventions included the protocols introduced by the International Swaps and Derivatives Association (ISDA). Risk-taking and competition contributed to the easing of the price and non-price terms and conditions, respectively.

The tightening of financing and hedging conditions was particularly strong for transactions with hedge funds (see Chart C, left panel), as reported by surveyed banks. Looking across the different types of counterparty, the SESFOD survey shows that dealers changed their conditions in a heterogeneous manner. Most of the tightening in conditions was concentrated on hedge funds, followed by investment funds, while conditions eased for NFCs.

Recently, financing and hedging conditions applied to hedge funds in the euro area have differed from those applied to hedge funds in the United States (see Chart C, right panel). According to the US Senior Credit Officer Opinion Survey (SCOOS), the price terms and conditions of financing and hedging applied to hedge funds started to tighten in the course of 2014. The same development occurred for hedge funds in the euro area about six months later. However, price conditions in the United States started to ease after the first quarter of 2017, when competition to provide funding intensified in the United States, amid the increase in policy rates. Surveyed banks report that euro area banks and dealers have instead continued tightening price terms and conditions for hedge funds. By contrast, financial institutions headquartered outside the euro area started to ease credit conditions for euro-denominated transactions with hedge funds in 2017, in line with what happened in the United States. Regarding the non-price terms and conditions applied to hedge funds, they eased over the whole reference period in the United States, with a marked acceleration in the course of 2017, while they tightened in the euro area.

The uncertainty surrounding two widely used euro area benchmarks, EONIA and EURIBOR, is still significant. In their current form, both benchmarks are deemed not compliant with the requirements of the EU Benchmarks Regulation (BMR). If not reformed, their use in new contracts will be prohibited as of 1 January 2020. Box 5 discusses the challenges related to the transition from EONIA – to which more than €20 trillion of interest rate derivatives and securities are linked – to ESTER. As far as EURIBOR is concerned, the European Money Markets Institute (EMMI) – the administrator of the benchmark – is still working to bring EURIBOR into line with the requirements of the BMR. Looking ahead, the viability of the benchmark will depend on a combination of factors, including the successful change in the calculation methodology[10], the authorisation from the Belgian FSMA (the relevant regulator of EURIBOR) and the continuing voluntary support of the contributing banks. The working group on euro risk-free rates[11] will continue its work on the construction of risk-free term rates that could serve as fall-backs for EURIBOR in the future, while users should ensure that their contracts can sustain a material change in or a cessation of the benchmark.

## Box 5 ESTER – the new overnight rate for the euro money markets

Prepared by Philippe Molitor, Pascal Nicoloso and Vladimir Tsonchev

ESTER (euro short-term rate) is the alternative euro risk-free rate administered by the ECB, which will replace EONIA (euro overnight index average) in 2020. The European Money Markets Institute (EMMI), the administrator of EONIA, concluded that under current market conditions, EONIA’s compliance with the EU Benchmarks Regulation (BMR)[12] by January 2020 “cannot be warranted”.[13] This implies that the usage of EONIA, at least in new contracts, may be prohibited by law as of 1 January 2020.

ESTER will be based entirely on actual individual transactions in euro reported by banks in accordance with the ECB’s money market statistical reporting (MMSR). It will reflect wholesale euro unsecured overnight borrowing costs of euro area banks resulting from trades conducted with banks and non-bank financial counterparties according to MMSR reporting instructions. The rate will be published for each TARGET2 business day based on transactions conducted and settled on the previous day with a maturity date the next business day and which are deemed to be executed at arm’s length. For this reason, it will reflect market rates in an unbiased way.

The methodology to compute ESTER is robust, having benefited from feedback and insights from two public consultations. ESTER is calculated as a volume-weighted trimmed mean on the basis of all eligible transactions that have passed quality and plausibility controls. The ECB has also envisaged a contingency computation algorithm, which will apply for days when underlying data are not sufficient for a robust rate calculation. The ECB will endeavour to follow the IOSCO Principles for Financial Benchmarks[14] to ensure consistency with the best market practices.

ESTER should bring many benefits in terms of transparency and rigour. The recommendation, made unanimously by a private sector working group established with the support of the ECB, the European Securities and Markets Authority, the European Commission and the Financial Services and Markets Authority (FSMA), followed a public consultation and was largely grounded on four elements: (1) the unsecured nature of the new rate, thus making it similar to EONIA and easier to understand and communicate to clients; (2) the compilation methodology applied to MMSR data, leading to sufficient and robust volumes; (3) the low volatility of the rate; and finally (4) the fact that ESTER is administered by the ECB, an EU public institution (see Chart A). Following the recommendation of the working group, ESTER will become the key interest rate benchmark for euro money markets once daily production will start, expected at the latest by October 2019.

The transition from EONIA to ESTER, by 1 January 2020, constitutes a complex challenge. More than €20 trillion of interest rate derivatives and securities are linked to EONIA. EONIA is used for the valuation of contracts and the remuneration of collateral and margin accounts at clearers, as well as serving as a statutory rate. A broad-based coordination across market participants and benchmark users is therefore necessary to prepare the transition to ESTER, from both a legal perspective – to ensure contract continuity – and a technical perspective – to guarantee that systems and trading venues can handle the new rate. To support the transition, the ECB is publishing the so-called pre-ESTER, a data series calculated using the same methods as those defined for ESTER, once every maintenance period. These data allow market participants to assess the suitability of the new rate and start early preparations for its use in contracts as well as in internal valuation and risk management processes.

The working group is carrying out technical analyses to evaluate different transition paths and scenarios. More specifically, the group is focusing on two broad options. One is the “market-led transition” scenario. In this scenario, an ESTER derivatives market would be developed in parallel to the current EONIA market, so as to facilitate a market-driven switch before the end of the BMR transition period. The other is the “successor rate” scenario. This scenario envisages that all existing contracts are switched to the new reference rate as of a transition date. A criterion that all viable options should fulfil is that they should enable a full migration from EONIA to ESTER of the markets currently using EONIA and minimise resulting transfers of value and litigation risks.[15] These analyses will be the basis for a recommendation, to be issued by the working group in early 2019.

Market participants using contracts linked to EONIA are expected to amend their contracts in due time. The selection of ESTER as a replacement of EONIA is only the first step in the transition process and a lot of work remains to be done, including changes in contracts and systems. It will involve each user of the benchmark looking at its own contracts and taking decisions on how to follow the recommendation of the working group and any subsequent initiatives by industry associations. While the financial industry has further stepped up its efforts to ensure a smooth transition to the new interest rate benchmark environment, vigilance is needed to identify any potential for mispricing, segmentation or undue increases in basis risk.

The reform of European MMFs may have market implications. The new EU Regulation on money market funds will enter into force by January 2019.[16] This piece of legislation responds to recommendations on the non-bank financial system issued by the G20 and the Financial Stability Board and is the equivalent of the US MMF reform. In the United States, a migration from prime to government-only MMFs took place in October 2016, when new rules came into force. The migration was large, as government-only MMFs guarantee constant net asset value (NAV) and are not subject to liquidity fees or redemption gates. In Europe, a part of the MMF industry could be affected by the mandatory conversion from constant net asset value (CNAV) to the new categories of MMFs, i.e. LVNAV (low volatility NAV), public debt CNAV and VNAV (variable NAV).[17] Nevertheless, the overall market impact of the reform should be limited. Indeed, in contrast to the US case, European public debt CNAV MMFs will be subject to liquidity fees and redemption gates and therefore less appealing to investors. This should limit the scale of the migration from other MMFs to CNAV funds. Still, these developments merit further monitoring in the coming months.

# 3 Euro area financial institutions

## Box 6 Assessing the risks to the euro area financial sector from a disruptive hard Brexit

An orderly withdrawal of the United Kingdom from the European Union poses a limited overall risk to euro area financial stability. But the uncertainty accompanying a cliff-edge Brexit could have the potential to pose a more significant downside risk to financial stability.

Cross-border clearing of derivatives contracts is one area where financial stability risks may arise in a cliff-edge Brexit scenario without sufficient mitigating actions. If UK central counterparties (CCPs) become non-recognised third-country entities after March 2019, euro area clearing members of UK CCPs will be exposed to legal risks if they continue to use UK CCPs to clear both new and existing trades. While euro area clearing members of UK CCPs are establishing connectivity with alternative CCPs to clear new transactions in advance of Brexit, a vulnerability remains with their significant legacy positions at UK CCPs. Euro area clearing members as of 31 October 2018 had positions of over €58 trillion in over-the-counter contracts with UK CCPs, of which €43 trillion matures after March 2019. A forced large-scale transfer to alternative CCPs in a short period could be operationally challenging, given the large amount of individual positions that would need to be closed out in one CCP and replaced in another, and might generate material one‐off costs. Risks would be exacerbated if the transfer were to take place in a compressed time frame or in volatile market conditions. These potential risks have now been addressed through the assurance provided by the European Commission that, if necessary, it will allow EU firms to continue to clear derivatives contracts with UK-domiciled CCPs, under strict conditionality and with limited duration.[18]

Some uncertainty also remains over the treatment of the stock of MREL[19] securities issued under UK law, in the event that the UK decides not to recognise the resolution powers of the Single Resolution Board (SRB). Euro area credit institutions should follow European Banking Authority and SRB guidance that calls on issuers to issue MREL securities under EU27 law or insert contractual clauses in securities issued under UK law.[20][21] Yet, without further mitigants, these measures would not tackle the uncertainty over the treatment of the outstanding stock of MREL securities issued under UK law which does not roll off before the UK becomes a third country. A mitigating factor for MREL shortfall risk is the case-by-case approach that would be taken by the SRB, which may entail extending the affected banks’ transitional periods to meet MREL requirements. The UK could also solve the issue by unilaterally recognising the resolution actions of the SRB, and thus continuing to comply with the Key Attributes of Effective Resolution Regimes for Financial Institutions developed by the Financial Stability Board.[22]

The continuity of servicing uncleared cross-border derivatives contracts is unlikely to pose significant risks to financial stability provided that the private sector takes sufficient action. For uncleared derivatives contracts between UK and euro area counterparties, the performance of many contractual obligations agreed before March 2019 (most notably payments and settlements) is unaffected by Brexit. The risk of a sudden mass termination of contracts is, therefore, negligible. The performance of certain life-cycle events and the exercise of certain options are, however, subject to authorisation in certain euro area countries. But the private sector can take a range of actions to mitigate risks associated with no longer being able to carry out life-cycle events on the affected contracts. These include: (i) trading-related strategies including bilateral novations; (ii) holding contracts to maturity and using other mechanisms with non-UK counterparties to adjust hedges; (iii) early terminations; (iv) actions based on statutory schemes for the collective transfer of business to the EU27; or (v) pursuing authorisations based on EU national regimes designed to enable the cross-border provision of services from a third country. The European Securities and Markets Authority has proposed regulatory technical standards in order to facilitate the novation of certain non-centrally cleared OTC derivatives contracts to EU counterparties during a specific time-window, in case of a no deal scenario.[23]

Similarly, financial stability risks are not expected in the area of cross-border insurance contracts, nor as a consequence of changes to the legal regime for cross-border personal data transfers within the financial services sector. UK insurance undertakings will lose their authorisation to conduct business in the euro area (and vice versa) in a cliff-edge scenario. But UK insurance companies servicing euro area policyholders have a number of options available to them to mitigate any disruption. These include portfolio transfer, establishment of a third-country branch, relocation of a European company (Societas Europaea) or termination of contracts. These options are being actively used by firms. The vast majority of outstanding cross-border insurance contracts are covered by credible contingency plans, with the residual contracts primarily pertaining to non-life insurers.[24] Potential disruptions to personal data flows should also be negligible as financial institutions are advanced in their planning and intend to rely on mechanisms available to them under the data protection legal framework, such as, for example, standard contractual clauses.

Despite heightening political uncertainty, any notable impact on financial markets has thus far been largely limited to currency markets. Market prices do not currently reflect the implications of a cliff-edge Brexit, but – should such a scenario materialise – the market adjustment could be more broad-based. In particular, a hard Brexit could trigger a rise in risk aversion, which – in turn – could lead to an increase in risk premia and volatility. Any resulting tightening of financing conditions, including haircuts and margins, and rising funding costs could add to existing pressure on parts of the euro area financial system.

ECB analysis indicates overall limited risks to the capital position of the euro area banking sector from its direct lending exposures to the UK, from indirect exposures via its lending to euro area exporters, or due to the application of positive risk weights on sovereign exposures. Direct exposures to the UK, including to UK financial institutions, make up approximately 7% of SSM significant institutions’ assets and have declined since the Brexit referendum. As such, direct credit risk effects are likely to be limited at an aggregate level, particularly if a hard Brexit does not trigger significant immediate increases in credit risk. But exposure is concentrated within a small number of banks with significant credit exposures, which could be more vulnerable if the UK experiences a material economic downturn following a hard Brexit. Regarding indirect exposures, losses are not expected to be large enough to pose risks to banks’ capital positions. A hard Brexit could also lead to the sudden application of positive or higher risk weights to the UK sovereign exposures of euro area banks and insurance corporations if the UK sovereign were to be downgraded significantly at the same time. But ECB analysis finds that the impact on Common Equity Tier 1 capital ratios for SSM banks from such a scenario is likely to be very limited. And should UK banks be required to apply positive risk weights to euro area sovereign exposures, the effect on the euro area is also expected to be limited.

Financial institutions are strongly encouraged to step up contingency planning and act upon those plans in a timely manner. The City of London currently plays an important role in financial services for the whole of the EU. Transition to a new equilibrium will imply adjustment costs and may entail risks of frictions in some market segments if the transition is not adequately managed. In the event of a hard Brexit, managing a smooth transition could prove difficult if financial institutions have not sufficiently prepared for such an outcome. But the risk that the euro area real economy would be deprived of access to financial services following the UK’s departure from the EU appears limited. Some services are likely to continue to be provided out of the UK, some will be provided by EU27-domiciled entities instead, and/or some of these activities and entities will relocate to within the EU27. As such, the impact of Brexit on financial services in the euro area is likely to be mainly reflected in the cost of external finance rather than in a reduction in available services.

## 3.1 Improving cyclical outlook for euro area banks but structural headwinds remain

### Banks’ profitability benefited from lower impairments, but operating performance remains subdued

Bank profitability remained broadly stable in the first half of 2018. On aggregate, the annualised return on equity (ROE) of significant institutions slightly dropped in the first half of 2018 from a year earlier, but remained at around 7%. Continuing the trend of the last few years, a fall in impairment costs was the largest positive contributing factor to profitability in the first six months of 2018, helped by a favourable macroeconomic environment and banks’ continued efforts to reduce their non-performing loans (NPLs). However, this positive impact was more than offset by a decline in operating profits (mainly driven by lower trading revenues) and in non-recurring revenues.

Banks’ performances remained rather heterogeneous, although the gap between better and worse-performing banks closed somewhat over the last two years. Splitting the bank sample into two groups,[25] the aggregate profitability of banks that had overperformed two years ago slightly dropped, but remained at a level above 7%. At the same time, the overall profitability of underperforming banks improved, even if still remaining at a low level. Lower impairment costs supported the performance of both groups and that of less profitable banks in particular. However, patterns in operating performance starkly differed between the two groups. Better-performing banks benefited from a solid growth of their core revenues[26], driven by non-interest income, in contrast with a significant shrinkage at underperforming banks, in particular in net interest income. Conversely, cost-cutting was a positive profit driver for less profitable banks, while more profitable banks saw their operating costs increase over the last two years (see Chart 3.1).

Overall, banks continue to face challenges in revenue generation, although better-performing banks tended to benefit from robust credit growth and fee income growth. A key differentiating factor between over- and underperforming banks concerns their net interest income performance. Net interest income remained broadly stable for the more profitable banks over the last couple of years as the negative impact of margin compression was largely offset by robust growth in interest-earning assets (see Chart 3.2, left panel). By contrast, underperforming banks saw their net interest income decline materially, driven by a shrinkage of interest-earning assets. The latter reflects continued deleveraging and de-risking at a number of banks in this group, also including the impact of significant NPL reductions at some banks.[27] Moreover, the revenue growth of overperforming banks was also aided by a healthy increase in net fee and commission income, supported by a pick-up in fee income, mainly from asset management activities (see Chart 3.2, right panel).

Banks’ profitability paths over the last few years also varied significantly depending on the level of NPL ratios and the pace of NPL reduction. In particular, the median provisioning ratio of high-NPL banks with faster NPL reduction converged towards that of banks with low/medium NPL ratios, while it remained elevated at those high-NPL banks that reduced their NPLs at a slower pace (see Chart 3.3, left panel). In a similar vein, the median ROE of banks with faster NPL reduction gradually improved in the last few years, contrasting with a persistent low (or negative) profitability of banks with slower NPL reduction (see Chart 3.3, right panel).

Looking ahead, analysts’ forecasts continue to suggest a gradual improvement in profitability over the next two years. Improving profitability prospects for 2019 and 2020 (relative to 2018) have been mainly driven by higher net interest income expectations, in particular for 2020. This may be related to expected improvements in interest rate margins – as the timing of the ECB’s first rate hike is anticipated by market participants in the third quarter of 2019 – or to expected increases in interest-earning assets in light of the economic outlook. In addition, non-interest income growth and cost-cutting are also expected to support the recovery of bank profits (see Chart 3.4, left panel). On aggregate, analysts anticipate a slight increase in loan loss provisions over the next couple of years, although this masks some heterogeneity. While a decline in impairment costs is expected to be a positive driver for high-NPL banks (in line with expected NPL reductions), provisioning costs are projected to increase for other large listed banks from current, historically low levels, for instance due to higher expected credit losses on some emerging market economy (EME) exposures.

Still, future earnings expectations have worsened somewhat since the beginning of the year which is also mirrored in lower bank equity valuations (see Chart 3.4, right panel). Analysts’ earnings forecast downgrades for 2019-20 were mainly due to the changes in net interest income expectations (i.e. net interest income growth compared with 2018 was expected, but at a lower rate than anticipated at the beginning of the year), while expectations for non-interest income also abated somewhat. Banks’ price-to-book ratios also trended downwards partly due to a slight downward shift of future earnings expectations, as well as to country-specific factors (in particular, heightened policy uncertainty in Italy) and concerns about some EMEs (see Chart 3.4, right panel). Worsening market perceptions particularly affected banks with high NPL ratios, suggesting persisting concerns about these banks’ profitability prospects (see left panel of Chart A.1 in Special Feature A).

Overall, recent profitability developments and analysts’ expectations suggest that a sustainable recovery in bank profits is predicated on improved operating performance. As discussed in detail in Special Feature A of this Review, while cyclical factors are expected to further support bank profitability in the 2018-20 period, a number of banks need to take decisive action in tackling structural challenges. That said, there is no one-size-fits-all strategy and, according to a recent ECB Banking Supervision review of profitability and business models, banks’ strategies going forward strongly reflect their current state of profitability in that weaker banks are trying to reduce their costs and NPLs, while better performers tend to focus on growth. [28]

### Progress in NPL reductions continued in 2018

Banks made further progress in cleaning up their balance sheets in the first half of 2018. Significant banks’ aggregate NPL ratio declined further to 4.4%, including improvements in most high-NPL countries, while banks also made progress in reducing the stock of foreclosed assets (see Chart 3.5, left panel). Since end-2014, the total NPL stock of significant institutions has declined by around one-third and the (gross) NPL ratio has nearly halved. However, the pace of NPL reductions continued to vary across countries (see Chart 3.5, right panel). In the last 18 months, the NPL reduction process either accelerated or continued apace in most of the high-NPL countries, contrasting with meagre progress elsewhere (particularly in Greece).

The reduction of NPL stocks was also helped by robust NPL sales activity. Since mid-2016, NPL sales are estimated to have contributed more than 40% of significant banks’ gross NPL reductions (see Chart 14 in the Overview) with the rest coming from other sources (e.g. cures, liquidations and write-offs).

The provisioning coverage of NPLs generally also improved in high-NPL countries in the first half of 2018, largely due to the first-time adoption of IFRS 9. As of 1 January 2018, a number of banks took advantage of the transitional arrangements under IFRS 9 and raised provisions in particular on Stage 3 assets (see Chart 3.6, left panel) given that the new reporting standard’s impact on capital can be phased in over five years. Coverage increased across most NPL categories, including both shorter- and longer-dated NPLs (see Chart 3.6, right panel).

According to banks’ initial reporting under IFRS 9, the share and coverage of Stage 2 loans are widely dispersed across countries.[29] Generally, banks in high-NPL countries tend to display higher shares of Stage 2 loans than those located in other countries (see Chart 3.7, left panel). At the same time, the coverage ratios of Stage 2 loans vary in a wide range in both high-NPL and other countries, which may partly reflect differences in the underlying credit quality of loans. In fact, the variance of Stage 2 loan coverage appears to be partly driven by the share of loans that have been delinquent for more than 30 days (see Chart 3.7, right panel), although other factors may also be at play (e.g. the share of collateralised loans).

### Capital positions have been negatively affected by higher provisioning related to the first-time adoption of IFRS 9

The multi-year trend of improving capital ratios halted in the first half of 2018. In fact, significant banks’ aggregate fully loaded Common Equity Tier 1 (CET1) ratios declined, with more pronounced decreases observed in countries more affected by the crisis where capital ratios had been already lower (see Chart 3.8, left panel). This was mainly driven by an erosion of CET1 capital that was only partly offset by the positive impact of risk-weighted asset declines which, in turn, reflected a drop in the average risk weight of banks’ exposures (see Chart 3.8, right panel).

The drop in capital levels mainly reflected the impact of IFRS 9 first-time adoption, while some banks (notably in Italy) experienced declines due to valuation losses on their sovereign bond holdings in the second quarter of 2018. The negative impact of the first-time implementation of IFRS 9 mainly stemmed from increased provisions aimed at improving the coverage of problem loans (see asset quality part above), although the reclassification of assets also played a role for some banks. In the second quarter of 2018, CET1 ratios decreased for some banks (mostly in Italy) due to the revaluation of sovereign bonds. Looking ahead, banks’ capital positions remain sensitive to worsening sovereign risk perceptions due to a possible aggravation of debt sustainability concerns.

### Benign cyclical conditions support banks’ credit quality, but some banks face the risk of higher losses on EME exposures

Aggregate credit risk continued to decline further, although some differences between the most troubled banks and the rest persist. Risk measures such as risk weight density, the global charge and aggregate probability of default (PD) reported by banks on their internal ratings-based (IRB) portfolios continued to decline in the first half of 2018, pointing to a reduction in credit risk in banks’ loan books amid improving cyclical conditions. Although these trends are widespread across euro area banks, available evidence suggests that improvements in credit risk measures reported by banks with weak asset quality (as measured by the NPL ratio) are much larger than those reported by the healthier part of the banking sector. This is largely driven by the decreasing riskiness of the NFC sector.

Standardised risk weights have drifted further away from those used in internal models since late 2017. The widening of the gap is driven by the NFC sector as the risk weight density of banks’ standardised portfolio in this sector increased in recent quarters, while that of the IRB portfolio decreased. In spite of concerns that IRB risk weights may reflect very benign cyclical conditions and model optimisation, banks’ share of exposures towards risky borrowers (e.g. PD above 5%) also fell further (see Chart 3.9, left panel). The shift towards safer portfolios is also confirmed by the data on lending flows, where the largest increases in the safest category of borrowers (PD below 0.1%) are reported for the large NFCs and financial firms instead of central banks and governments.

However, differences in riskiness in some loan segments still persist between the two groups of banks. For instance, banks with high asset quality report flat risk weights on consumer loans since end-2016, while those weights reported by more vulnerable banks saw some increases recently (see Chart 3.9, right panel). Considering that these loans are unsecured and usually provided to mid-to-low-income borrowers, an adverse change in macroeconomic conditions might entail severe consequences for the already troubled banks. While this remains a concerning sign, the share of consumer loans (when measured as a percentage of total exposure) remains largely unchanged for these banks, thereby limiting the possible impact.

Turning to credit risks stemming from banks’ foreign operations, the overall exposure of euro area banks to EMEs is moderate, but is concentrated in a few euro area countries and significant institutions. Euro area significant institutions’ exposures to all EMEs amounted to €1.5 trillion or 7% of their total assets in the second quarter of 2018, with exposures to emerging Europe (including Russia and Turkey) and Latin America accounting for nearly 80% of the total (see Chart 3.10, left panel). Euro area significant institutions’ exposures to a subset of important EMEs (including Argentina, Brazil, China, Indonesia, Malaysia, Mexico, South Africa and Turkey) account for €660 billion or roughly 45% of the total EME exposure. Across these EMEs, euro area banks are most exposed to Brazil, Turkey, Mexico and China (see Chart 3.10, right panel). Euro area banks’ EME exposures are concentrated in a few euro area countries and significant institutions, with the largest euro area economies (i.e. Spain, France, the Netherlands, Germany and Italy) and ten euro area significant institutions accounting for 98% and 93% of euro area significant institutions’ total exposure to this group of EMEs, respectively.

The risks faced by euro area banks in relation to EME vulnerabilities are most likely to stem from USD-denominated loans. In particular, loans granted by euro area banks to EME households and firms in non-domestic currencies might become non-performing as borrowers might not be hedged against the weakening of their currency. More difficult to quantify are the effects through indirect channels such as higher volatility in financial markets and adverse global confidence effects which could arise from more widespread risk aversion vis-à-vis emerging markets.

The aggregate exposure of euro area banks to the two most strongly affected EMEs, Turkey and Argentina, is small but highly concentrated in a few large banks. In recent months, two EMEs have been particularly strongly afflicted by sharp currency depreciations: Turkey and Argentina. With around 0.8% of total assets, the exposure to Turkey is rather limited for euro area banks on aggregate, but more sizeable for some large banks. While these banks’ NPL ratios on Turkish exposures are rising, their current level (4.6%) does not yet signal elevated risks. Looking ahead, however, banks face increased credit risk mainly due to the foreign currency denomination of the exposures. Exposure to Argentina, at around 0.1% of total assets, is significantly lower than that to Turkey and is concentrated in a few large banks.

Overall, the direct effects of distress in Turkey and Argentina are likely to be contained, owing to the limited exposure of the euro area banking sector. Should the distress spread to other EMEs, however, the impact would be broader, in terms of affected banks and aggregate losses of the euro area banking sector. Moreover, if euro area exporters are faced with a drop in EME demand for their goods and services, banks that lend to these exporters may be indirectly affected, through higher credit losses on their corporate exposures in the euro area. At the same time, risks related to direct EME exposures are mitigated by the fact that some of the banks most exposed to EMEs perform their activity via subsidiaries in local currencies.

### Funding-side vulnerabilities relate to renewed sovereign debt concerns and to the high USD funding reliance of large banks

The costs of banks’ debt market funding have increased since May, but remain broadly favourable for most banks. While average spreads on debt and hybrid instruments have increased due to the re-emergence of debt sustainability concerns in Italy, this was mainly driven by higher bond spreads for Italian banks (see also Box 7), with limited spillovers to banks’ funding costs in other countries. The widening of spreads was differentiated across debt instruments of different seniority (see Chart 3.11) and was most pronounced for Additional Tier 1 (AT1) debt, which also reflected a general increase in risk aversion towards high-yielding debt. However, the effects of this increase in bank debt spreads on the composite funding costs of banks have been contained so far given the limited share of debt issuance in the composition of bank funding sources.[30]

The re-emergence of sovereign risk concerns could negatively affect the cost and availability of debt market funding. The correlation between bank and sovereign credit default swap (CDS) spreads strengthened in the period since May 2018 relative to the earlier part of the year, driven by developments in the Italian sovereign bond market (see Chart 3.12), although this increase was less pronounced than that observed during the sovereign debt crisis in 2012. That said, spreads on Italian bank debt markedly increased across all instruments (see Chart C in Box 7). Another channel for negative spillovers from sovereigns to banks is via diminishing the value of collateral available for secured interbank borrowing.

Overall debt issuance increased somewhat year on year, but issuance patterns varied across countries and debt instruments. By country, debt issuance by banks in most large euro area countries remained broadly stable or even increased, while Italian banks’ issuance activity has been negatively affected by increased risk aversion (see Chart 3.13, left panel). By debt type, the issuance of AT1 and Tier 2 (T2) instruments has been negatively affected by periods of heightened volatility in credit markets, while the issuance of non-preferred senior debt and covered bonds increased year on year (see Chart 3.13, right panel).

Banks’ future funding activity in debt markets could potentially be affected by the winding-down of central bank funding support in 2020-21. Based on a recent European Banking Authority (EBA) report on banks’ funding plans, over the forecast period (2018-20), euro area banks plan net debt securities issuance amounting to €378 billion, compared with total outstanding TLTRO (targeted longer-term refinancing operation) volumes of €503 billion maturing in 2020. This suggests that banks aim to replace TLTRO-II funding mainly with debt securities, but it also implies that some of the maturing central bank funding may no longer be needed (e.g. due to the winding-down of carry trades). The implementation of banks’ debt issuance plans may be susceptible to abrupt changes in market sentiment, possibly resulting in higher costs or reduced availability of funding via debt markets.

Turning to potential vulnerabilities stemming from funding in foreign currencies, while euro area banks’ reliance on US dollar funding is limited in aggregate, it is quite sizeable for some global systemically important banks (G-SIBs). The short-term, wholesale nature of US dollar funding creates vulnerabilities to market stress. While euro area banks’ reliance on US dollar funding remains limited in aggregate at 11% (see Chart 3.14, left panel), there is substantial heterogeneity at bank level, with some euro area G-SIBs exhibiting a US dollar funding share of up to 29%. As most euro area banks do not have a US branch network to collect US dollar deposits, the vast majority of this US dollar funding is obtained via wholesale markets (see Chart 3.14, middle panel). Decomposing the US dollar wholesale funding further reveals that the bulk of it is rather short-term (i.e. with a maturity below 12 months) and it is split between unsecured funding from financial corporations (46%), unsecured funding from NFCs (21%) and repurchase agreements (32%) (see Chart 3.14, right panel).

Current levels of the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) suggest potential vulnerabilities for US dollar exposures of euro area banks. While the LCR and the NSFR for all currencies are above 100%, both ratios are below this threshold for the US dollar exposure – in particular the estimated NSFR (see Chart 3.15, left and middle panels).[31] In addition, while some of the banks have LCR values above 100% for their US dollar exposures, their NSFR values might still be below 100% which suggests that those institutions are only prepared for a relatively short period of funding stress (see Chart 3.15, right panel), mirroring the short-term, wholesale nature of the US dollar funding. While banks are not explicitly required by regulation to meet these liquidity requirements at the level of individual currencies[32] and could use currency swaps to convert euro liquidity to dollar liquidity in case of need, the LCR and estimated NSFR suggest potential vulnerabilities for some euro area banks with respect to their US dollar exposures. Banks typically rely on short-term currency swap markets to roll over their US dollar funding, making them susceptible to stress and a potential drying-up of these swap markets.

## Box 7 Bond funding of euro area banks: progress in the issuance of loss-absorbing instruments

Prepared by Benjamin Klaus and Beatriz Sotomayor

Global and European regulation is progressively introducing the requirement for banks to have sufficient loss-absorption and recapitalisation capacity, extending beyond equity capital. From 2019 onwards, G-SIBs need to have a minimum volume of total loss-absorbing capacity (TLAC), while all banks in the EU are being progressively informed about their bank-specific minimum requirements for own funds and eligible liabilities (MREL), subject to individual transitional periods. Against this background, this box presents developments in euro area bank bond issuance and spreads over the past years and discusses possible financial stability implications.

Euro area gross bank bond issuance has been on a declining trend since 2006. While the global financial crisis led to an initial reduction in gross bank bond supply, this trend accelerated from end-2011 onwards following, among other factors, the Eurosystem longer-term credit operations and the sovereign debt crisis (see Chart A). The aggregate gross issuance volume of bank bonds is expected to increase in 2019 and 2020, as shown by the recent funding plans of EU banks.[33] From a financial stability perspective, the more diversified currency composition of bond issuance over the past five years could be seen as pointing to increased resilience of issuance to idiosyncratic shocks through a broader investor base.

Despite the overall decline in recourse to the bond market by the sector as a whole, euro area G-SIBs have kept their issuance broadly stable since 2010. Their funding mix, however, has changed in favour of bail-inable debt at the expense of covered and senior unsecured bonds ahead of the January 2019 TLAC deadline (see Chart B, left panel). More recently, and as most have reached their minimum interim TLAC requirements,[34] the focus of G-SIBs has shifted towards optimising their capital structure to reduce funding costs. Accordingly, their supply of senior non-preferred (SNP) debt and/or debt issued by a holding company has increased considerably, and some G-SIBs have even announced their intention to substitute some of their hybrid capital (Additional Tier 1 and Tier 2) with SNP debt. This trend has been reinforced by the progressive harmonisation of MREL with the TLAC rules, including the amendments to the Bank Recovery and Resolution Directive (BRRD) in November 2017 introducing SNP debt in all EU Member States.[35]

In contrast to G-SIBs, the overall gross issuance volume from other euro area banks has roughly halved since 2010. Two observations underpin this development. First, other banks are on aggregate significantly less advanced in building up their (more costly) bail-inable debt, which accounts for less than 20% of their annual bond issuance on average (see Chart B, right panel). The volume of bail-inable debt issued by other euro area banks in 2018 amounted to €30 billion, which compares with an aggregated MREL shortfall of €117 billion, as estimated by the SRB at the end of 2017.[36] However, the MREL shortfall could be significantly higher as a result of the review of MREL rules envisaged in the upcoming BRRD2 and in relation to the adoption of a stricter methodology when computing the MREL eligible liabilities. The slow progress in issuing bail-inable debt might be partly explained by the more limited access to and higher cost of capital market financing for smaller banks, and by the uncertainty about the MREL requirements and timelines up until recently. Second, other banks have also reduced their issuance of covered bonds and senior unsecured debt by around 50% since 2010. Many of these banks are expected to slowly return to the bond market, e.g. to replace maturing TLTRO-II[37] funding, which will require rebuilding an investor base, initially in secured markets before moving into bail-inable debt. This notwithstanding, the aggregate volume of bond issuance by the other banks is expected to remain below pre-crisis levels, given the steady growth in their capital and deposit base, their deleveraging and the lengthening of the average maturity of their issuance over the past three years to roughly 7.5 years (i.e. 2.5 years longer than the average maturity in 2008-14).

The slow progress in building up bail-inable buffers by other euro area banks exposes them to the risk of having to meet the requirements in a more challenging market environment. The spreads of senior unsecured bank bonds remain low across the euro area from a long-term perspective (see Chart C, left panel). While the spread required by investors to buy bail-inable debt issued by lower-rated or smaller banks is higher, until recently it was also low by historical standards. Political uncertainty and debt sustainability concerns in Italy, however, have contributed to an increase in bond spreads since end-May (see Chart C, middle panel), in particular for Italian banks alongside a temporary halt in Italian bank bond issuance in June. Market participants have differentiated between seniorities, with the largest spread widening having taken place for the most credit-sensitive asset classes (see Chart C, right panel). This episode serves as an illustration that changes in market conditions can be abrupt and can result in banks having to issue bail-inable debt to meet MREL requirements at significantly higher costs, which in some cases may even prove to be prohibitive.

All in all, while most G-SIBs have fulfilled their minimum TLAC requirements, other banks are less advanced in building up their bail-inable debt. This might pose financial stability challenges going forward as some of the other banks may face limited market access and would have to progressively (re)build an investor base. At the same time, the combination of replacing maturing TLTRO-II funding and the need to issue MREL-eligible debt will lead to a sizeable volume of debt that will need to be absorbed by the market. In addition, as shown by the recent episode, funding costs are susceptible to sharp increases should risks be repriced, which would further complicate efforts to build up the necessary loss-absorption capacity.

### Banks remain vulnerable to sudden increases in sovereign risk premia, while hard-to-value assets require continued monitoring

Recent episodes of heightened volatility in government bond markets (notably in Italy) served as a reminder of vulnerabilities linked to the sovereign-bank nexus. Bank exposures to the domestic sovereign remain elevated, or have even increased since end-2017, in a number of euro area countries (see right panel of Chart 12 in the Overview). In particular, banks with sizeable holdings of (fair valued) sovereign bonds face the risk of capital erosion via valuation effects in the event of sudden increases in sovereign risk premia. For example, the negative impact of sovereign spread widening on Italian banks’ CET1 ratios ranged from 25 to 84 basis points in the second quarter of 2018 (based on public disclosures).

In general, banks’ exposures to market risk remain low relative to other risk categories. A relative decline in the share of market risk in total risk exposures was observed in portfolios using both standardised and IRB approaches (see Chart 3.16, left panel).[38] The aggregate value at risk (VaR) of the banks that report under the IRB approach has decreased by 19% since the second quarter of 2017, while the stressed VaR indicator remained broadly unchanged (see Chart 3.16, right panel). The largest decrease in VaR took place in the foreign exchange portfolios. At the same time, banks’ trading books increased by 7%, suggesting that the decline in VaR can be largely attributed to the still subdued volatility over the VaR calculation horizon.[39]

Banks’ fair value assets continued to decline in the twelve months up to mid-2018, although trends differed somewhat across categories.[40],[41] Overall, financial assets measured at fair value dropped by 7% since mid-2017. This fall was driven by a decrease in Level 1 assets, as Level 2 assets remained broadly stable, where an increase in loans was offset by a decrease in derivatives. Level 3 assets, on the other hand, recorded some increase which was mainly driven by Level 3 loans (see Chart 3.17). These developments should be viewed in the context of the introduction of IFRS 9 accounting standards, which became effective as of January 2018 for annual periods.[42] The SSM continues to assess the accompanying valuation risks, especially inherent to the complex and opaque Level 3 instruments with the highest uncertainty related to observability of prices and liquidity.

## 3.2 Exposures of the non-bank financial sector to market risks have increased

The size of the non-bank financial sector increased slightly in both absolute terms and relative to the size of the total financial sector in the first half of 2018. Investment funds and financial vehicle corporations (FVCs) expanded by around 3% in the first half of 2018, continuing their long-term growth. By contrast, the total assets of money market funds (MMFs) and pension funds slightly decreased in the same period (see Chart 3.18). When looking at debt holdings and lending to euro area NFCs, the role of non-banks in financing the euro area economy remained stable despite the credit expansion by monetary financial institutions (MFIs).

Increasing risk-taking by non-banks renders them more interconnected and vulnerable to potential shocks in global financial markets. Non-banks have continued to reduce their liquidity buffers over the review period, as well as their holdings of highly liquid assets. At the same time, they have increased their exposure to securities with longer maturity and higher credit risk. This trend is reflected in their bond portfolio, as the holdings of long-term and low-rated bonds have increased on average. Overall, investment funds have increased their exposure to securities issued outside the euro area. In some respects, this higher degree of international diversification gives funds a greater ability to absorb losses – reducing idiosyncratic risk – but exposes them to foreign exchange risk. As a result of common risk-taking behaviour, non-banks are also interconnected through overlapping portfolios, which may represent a contagion channel in the event of a financial market shock.

Regarding liquidity risk, changes in the portfolios of euro area non-banks suggest that risk-taking has increased (see Chart 3.19). Non-banks and, in particular, investment funds have slightly reduced their relative holdings of liquid securities. At the end of June 2018, highly liquid assets only accounted for around 16% of investment funds’ securities portfolio, down from 20% in December 2015. Liquidity transformation activities by investment funds may generate systemic risk in the event of large redemptions by end-investors. In particular, if funds are unable to cope with outflows and need to liquidate parts of their portfolios, the shock may propagate to other sectors through the so-called market price channel, whereby large liquidations can lead to price declines and thus losses in the trading books of other financial intermediaries holding the same assets.

Euro area investment funds continued to increase their holdings of lower-rated bonds over the review period, while insurance corporations and pension funds (ICPFs) slightly reduced the riskiness of their portfolios. Over the past three years, non-banks have rebalanced their portfolios towards lower-rated debt securities, seeking higher returns in the current environment of continued low interest rates (see Chart 3.20).[43] The aggregate exposure of investment funds to credit risk also increased in the first half of 2018, as the share of low-rated debt securities in their portfolio increased. By contrast, banks, insurers and pension funds have started reinvesting in higher-rated bonds. This de-risking trend is particularly significant for pension funds.

The exposure of investment funds to interest rate risk increased in the first half of 2018, alongside the longer residual maturity of aggregate portfolios (see Chart 3.20). A larger share of long-term bonds increases the sensitivity of investment funds to changes in interest rates and may amplify the maturity mismatch between the assets and the liabilities of funds offering daily redemptions. By contrast, the increase in the residual maturity of securities held by ICPFs may reflect an attempt to reduce duration risk on their balance sheet, given the long-term nature of their liabilities.

Non-bank financial intermediaries have increased their holdings of government bonds, in contrast to banks. The bond portfolio of banks and insurers is highly concentrated in domestic euro area government bonds, which accounted for over 30% of their total assets in the second quarter of 2018 (see Chart 3.21). By contrast, the sovereign bond holdings of investment funds, and, to a certain extent, of pension funds, are widely diversified and their exposure towards short-term non-euro area government bonds has increased in recent years. ICPFs have increased their relative holdings of long-term low-rated bonds issued by euro area non-domestic governments, possibly seeking higher returns in the current low interest rate environment.

Given these developments, abrupt changes in government debt yields could have important implications for the stability of the financial system. Political uncertainty and abrupt changes in government bond markets may lead some financial institutions to liquidate riskier securities and rebalance their sovereign bond portfolios towards highly rated bonds. For instance, between March and June 2018, euro area non-bank financial intermediaries reduced their holdings of Italian government bonds amid rising fiscal policy uncertainty in Italy.[44] And recent movements in the sovereign bond market highlight that widespread portfolio reshuffling can impair market liquidity and amplify market adjustments (see Chapter 2).

A high degree of international portfolio diversification exposes euro area investment funds to foreign exchange risk. While the holdings of ICPFs and banks are highly concentrated in securities issued in the euro area, investment funds’ portfolios are mainly invested in non-euro area markets. In particular, holdings of US securities increased to €1.9 trillion in June 2018 (see Chart 3.22) and accounted for 24% of the aggregate investment fund portfolio. The likely driver of this significant shift towards US dollar-denominated securities was the monetary policy normalisation in the United States, alongside higher valuations in the US equity and corporate debt markets (see Chapter 2). Against this background, the exposure of investment funds to exchange rate risk has increased. At the same time, the higher degree of international portfolio diversification increases the resilience of the investment fund sector to a local shock.

In recent years, euro area investment funds have somewhat increased their exposure towards EMEs, which now account for 7% of their total assets. Investment fund holdings of securities issued by selected EMEs, including Turkey and Argentina, amounted to more than €350 billion in June 2018, but exposures to China, Mexico, India and Brazil are the largest (see Chart 3.23). ICPFs invest only 1% of their assets in EMEs, mostly in sovereign bonds. Although such exposures are relatively small, the bulk of these holdings are denominated in local currencies. This results in higher foreign exchange risk arising from local currency depreciation. Moreover, protracted periods of US dollar appreciation could weaken EMEs, since their relatively large share of liabilities denominated in US dollars could result in financing constraints for local borrowers. A combination of a strong US dollar and weakening economic conditions in selected EMEs could increase investors’ global risk aversion and give rise to a repricing of risk in other EMEs, potentially exposing euro area non-bank financials to greater risk (see Chapter 2).

Non-bank financial sectors are closely connected with each other and with the banking sector through direct balance sheet exposures. Euro area investment funds, MMFs and other financial institutions represent an important source of funding for the banking sector.[45] They hold an increasing share of euro area bank bonds –€456 billion in June 2018, i.e. 10% of their bond portfolio. By contrast, euro area banks invest less than 1% of their assets in investment funds. ICPFs are major holders of investment fund shares, accounting for 35% of their total assets. In addition, as discussed in Box 8, derivative exposures also increase the degree of interconnectedness between banks and non-banks.

The increasing risk-taking behaviour of non-bank financial intermediaries exposes them to similar risks and results in higher interconnectedness through overlapping portfolios. The investment portfolios of the main financial sectors largely overlap (see Chart 3.24). In particular, investment funds invest about 80% of their aggregate portfolio in securities which are also held by other sectors. Insurance corporations and pension funds share over 60% of their securities holdings, while banks show much lower commonalities with the other sectors. This reflects the different investment strategies of different financial intermediaries. While investment funds and, to a certain extent, ICPFs tend to diversify their portfolios across countries and sectors, banks invest a larger share of their assets in domestic securities.

Overlapping portfolios increased in the first half of 2018 and may represent an important contagion channel during times of low market liquidity. After an adverse shock, if a financial intermediary liquidates a large part of its portfolio, it is likely to impact the market price of these assets, depending on their level of liquidity. Then, other financial intermediaries holding the same assets may suffer a loss in their balance sheet. Examples of adverse exogenous shocks are large outflows from investment funds, mass lapses in the insurance sector or bank runs that force institutions to liquidate their assets. The larger the share of common assets among financial institutions and the lower the degree of liquidity of these securities, the higher the price impact of large liquidations, everything else held equal.

### 3.2.1 Increasing risk-taking, coupled with liquidity and maturity transformation, in the investment fund sector

Increasing risk-taking, coupled with liquidity and maturity transformation in the investment fund sector, continues to pose a risk to euro area financial stability. Sector-wide data point to a broad-based increase in risk-taking among bond funds, which, over the past four years, have increased their holdings of lower-rated bonds and extended the duration of their bond portfolios (see Chart 3.20). At the same time, liquidity transformation in euro area bond funds has gradually increased, while cash buffers available to absorb large outflows have been shrinking (see Chart 3.25 and Chart 16 in the Overview). Liquidity transformation arises to the extent that investment funds issue shares callable at short notice, while not necessarily backing these potential claims by liquid assets.

Pockets of high leverage may be building up in some investment funds. In the EU, the leverage of retail investment funds is restricted under the UCITS Directive and leverage in the investment fund sector is low on average (see Chart 3.25).[46] But there are no binding constraints on leverage for alternative investment funds (AIFs), for which leverage can be much higher than the average suggests. For example, data for the Netherlands collected under the AIF Managers Directive show a tail of highly leveraged hedge funds and bond funds with leverage multipliers above thirty.[47] Such high leverage is a concern as it increases counterparty risk among banks and other lenders. Higher-leveraged funds are also more likely to be forced to deleverage in a market downturn, which can create adverse spillover effects. In principle, authorities in the EU can impose macroprudential leverage limits on AIFs, but these tools need to be operationalised as recommended by the European Systemic Risk Board earlier in the year.[48]

Asset managers and investors in some bond funds tend to behave procyclically with respect to changes in asset prices and fund returns. Over the medium term, euro area fund flows have displayed some cyclicality, increasing in size when fund returns are high and decreasing when they are low (see Chart 3.26). At the current juncture, the values for 2017-18 are well below the long-run averages. Incremental outflows triggered by poor fund performance are likely to be met by existing cash buffers. But in a larger market-wide shock, procyclical investor behaviour could amplify market liquidity risks, especially if other investors were not willing or able to immediately absorb the asset sales from funds. In addition, cyclical investor behaviour may contribute to wider market exuberance and risk-taking across the financial system in an upswing.

Investment funds’ vulnerabilities potentially expose the sector to redemptions, which could trigger asset sales into relatively illiquid markets, thereby affecting market conditions more widely. An abrupt and sizeable adjustment of global risk premia could give rise to losses for bond funds, including via wider contagion across the system and particularly for funds invested in less liquid markets and for funds with low liquidity buffers. While asset managers can, in principle, limit redemptions in periods of stress through fund suspensions and redemption gates, their incentives might prevent a timely activation of such tools. The tools might also not be readily available to market supervisors, limiting their ability to intervene in a timely manner. Moreover, the tools can only be used ex post and are not suited to preventing the build-up of vulnerabilities ex ante, which emphasises the need for additional macroprudential liquidity tools (see Chapter 4).

#### Some outflows from bond funds as the sector copes with increased volatility and a changing market environment

Outflows from bond funds have broadened across asset classes, while outflows from the high-yield funds slowed. The number of bond funds which contracted over the past 12 months has increased steadily since the beginning of 2017, reflecting increased volatility and a changing market environment (see Chart 3.27). But large outflows have, to date, been confined to specific episodes of market distress. In particular, some bond funds invested in emerging markets, government debt and investment-grade corporate debt experienced higher net outflows than in the previous review period, while outflows from the high-yield fund segment slowed.

Significant withdrawals followed valuation losses in global bond markets in late September and early October 2018. It remains to be seen how exchange-traded funds (ETFs) and other funds weather these periods of high market volatility and outflows. In principle, ETFs are designed to provide superior liquidity to end-investors in all market conditions. But liquidity in ETFs depends largely on active trading by authorised participants, market-makers and other liquidity providers. If these market participants were to withdraw from the market under adverse conditions, ETFs’ liquidity would suffer. Special Feature C discusses potential risks in ETFs, focusing in particular on issues related to liquidity and counterparty risk.

More generally, net inflows into the aggregate euro area investment fund sector have steadily slowed since the beginning of the year. The euro area fund sector as a whole continued to receive net inflows over the review period, although to a lesser extent than in the first half of 2018 (see Chart 3.28). Net inflows into equity funds, mixed funds, hedge funds and other funds continued, while bond funds experienced outflows on a net basis. A large and increasing proportion of euro area investment fund shares is held by non-euro area investors, which represented about 28% of the investor base in September 2018.

Outflows from European high-yield funds have slowed since mid-2018, following an initial repricing of risk and accelerated outflows earlier in the year. Some large European bond funds using absolute return strategies suffered significant outflows in the first half of 2018.[49] Investors also continued to redeem shares in European corporate bond funds as credit spreads widened from very low levels. But recent figures show a slowdown in outflows from the riskier high-yield segment (see Chart 3.29, left panel, and Chart 3.27, right panel). The recent increase in Italian sovereign bond credit spreads did not have a significant impact on euro area government bond funds (see Chart 3.27, right panel).

At the global level, some reallocation of bond fund flows has benefited funds invested in the United States. While outflows from US high-yield bond funds decelerated, US investment-grade funds received net inflows, in contrast to their European peers (see Chart 3.29, left panel). The increasing interest rate differentials between the United States and the euro area probably explain these diverging developments, as they make US investment-grade corporate debt seemingly more attractive, when abstracting from exchange rate risk.

Emerging market bond and equity funds experienced broad-based outflows, reflecting recent distress episodes since April 2018. Debt sustainability concerns and increased market volatility in some EMEs have resulted in higher outflows over the past few months (see Chart 3.29). In particular, the continued tightening of US monetary policy and a renewed strengthening of the US dollar have raised concerns over rising funding costs of sovereign and corporate borrowers in EMEs. The sectors that predominantly rely on US dollar funding but hold assets in local currency were the most affected by these developments. While the outflows from emerging market funds were broad-based, acute stress in asset markets remained limited to Turkey and Argentina.

### 3.2.2 Euro area insurers benefit from solid economic growth but some are exposed to risky assets

Despite some volatility, market valuations for euro area insurers have tended to develop more favourably than for peers in other sectors. In particular, euro area insurers’ share prices outperformed the general stock market index over the last six months (see Chart 3.30, left panel). Across segments, equity prices of reinsurance and other non-life insurance companies developed more favourably than those of life insurance companies, though the latter still performed somewhat better than their peers globally (see Chart 3.30, right panel).

The outlook for non-life insurers was supported by benign insured losses and solid underwriting revenues in the first half of 2018. Following the volatile results of reinsurers in 2017, which were adversely affected by the exceptionally high catastrophe costs in the third quarter of 2017, reinsurers’ return on equity stabilised at a solid level in the first half of 2018 (see Chart 3.31, left panel). This was facilitated by benign insured losses from natural catastrophes[50] and modest increases in the pricing of reinsurance policies in 2018, in the light of elevated demand for reinsurance after the above-average 2017 catastrophe costs.[51] Solid economic growth also helped primary non-life insurers underwrite new business, so that the median annual growth rate of non-life premiums exceeded 5% in the first two quarters of 2018 (see Chart 3.31, middle panel). Solid underwriting revenues and benign catastrophe costs also pushed down combined ratios, which remained well below 100% in the first half of 2018 for the vast majority of large insurers.[52]

Weak investment income expectations weighed on the profitability outlook for life insurers. In the prevailing low interest rate environment, the total return on average investments of large euro area insurers remained at historically low levels in the first half of 2018 (see Chart 3.31, right panel). At the same time, overall profitability – as measured by return on equity for a median company (see Chart 3.31, left panel) – was above 8%, which suggests that many large euro area insurers are coping well with this environment, owing to their focus on cost optimisation and underwriting. Still, weak returns on investments continue to be a source of concern for the business model of traditional life insurers in some euro area countries, as the average guaranteed rate on existing business tends to be higher than the average returns on their portfolios.[53]

Amid weak investment returns, exposures to real estate have increased, which leaves insurers vulnerable to drops in valuations in these markets. Exposures to real estate are strongly concentrated in life and composite insurers, which hold more than 85% of the sector’s exposures. According to recently published data from the European Insurance and Occupational Pensions Authority (EIOPA), these exposures are particularly high in the Netherlands, while exposures in Cyprus, Belgium, Austria, Finland and Germany also exceed the euro area average (see Chart 3.32, left panel).[54] In most of these countries, insurers are exposed to both residential and commercial real estate markets. Moreover, four of these countries (Austria, Belgium, Finland and the Netherlands) received a warning on residential real estate vulnerabilities from the European Systemic Risk Board (ESRB) in 2016. The size of the exposures also tends to be correlated with property valuations (see Chart 3.32, right panel).[55] Since price drops are more likely to occur in overvalued markets, this underlines the potential vulnerability of insurers to such markets. It also suggests that insurers in some countries may have contributed to exuberance in property markets.

Life insurers are also significantly exposed to investment funds, even though a large part of the related investment risk is carried by policyholders. In mid-2018, more than one-third of life insurers’ financial assets were placed in investment funds, compared with around 20% for composite and non-life insurers and 5% for reinsurers (see Chart 3.33). In terms of volumes, life insurers’ holdings of investment fund shares represent more than half of the insurance sector exposure. Since investment funds have taken on more liquidity and credit risks (see the previous section on investment funds), insurers may have become more exposed to these risks indirectly through their holdings of investment fund shares. At the same time, the new Solvency II data published by EIOPA reveal that around half of life insurers’ holdings of investment fund shares are concentrated in unit-linked life insurance policies. As the investment risk of these policies is borne by policyholders instead of insurers, the balance sheets of life insurers are less vulnerable to changes in investment funds’ valuations than the overall exposures would imply.

The elevated exposures of insurance companies to certain riskier asset classes are also stimulating a debate on potential macroprudential measures for insurance. In particular, to enhance the current macroprudential framework in the EU, EIOPA proposes considering a number of exposure-based and liquidity-based macroprudential tools.[56] A recently published report of the ESRB also suggests further work on macroprudential instruments which could help to tackle insurers’ investment and liquidity risks. These include a liquidity buffer and symmetric capital requirements for cyclical risks.[57]

## Box 8 Insurance companies and derivatives exposures: evidence from EMIR data

Prepared by Linda Fache Rousová and Elisa Letizia

Insurance companies’ derivative exposures are recognised to be a potential source of risk.[58] For instance, in the midst of the global financial crisis, the global insurance conglomerate, American International Group (AIG), was rescued because of the significant losses on the credit default swap (CDS) portfolio held by its Financial Products subsidiary.[59] Yet, there is limited evidence on the derivative exposures of European insurers.[60] This box helps fill this gap by providing information on euro area insurers’ derivative exposures, and the counterparties with which transactions take place. The analysis is based on transaction-by-transaction data collected under the European Market Infrastructure Regulation (EMIR).[61]

Euro area insurers make fairly limited use of derivatives on aggregate, but derivative transactions are concentrated within a few countries and insurance companies. According to EMIR data, euro area insurers held about 50,000 derivative contracts at the end of September 2018, with an aggregate gross notional amount of around €1.30 trillion. Insurers domiciled in France and the Netherlands each held around one-third of this notional amount, while German and Spanish insurers held approximately 11% and 9%, respectively (see Chart A, left panel). However, the gross market value was overall only €55 billion, or less than 1% of euro area insurers’ total assets, although there are notable differences across countries and individual insurance companies.[62] For instance, the gross market value of derivative contracts for Dutch insurers was equal to about 4% of their total assets, while the share was close to 0.2% for German insurers. Looking at individual company data, roughly 48% (73%) of the derivative notional amounts are concentrated in 10 (20) insurance companies. For some insurers, the gross market value of derivatives exceeds 10% of their total assets, while around 81% of insurance companies do not engage in derivative trading at all.[63]

Interest rate derivatives account for almost three-quarters of insurers’ derivative exposure in terms of the notional amount. Specifically, interest rate swaps and options constitute about 42% and 11% of insurers’ total derivative notional amount, respectively (see Chart A, right panel). The extensive use of interest rate derivatives by (life) insurance companies is related to their business model, as the duration of their assets is typically shorter than the duration of their liabilities, which are mainly made up of long-term insurance policies. Interest rate derivatives can thus help insurers hedge the risk arising from the duration mismatch between assets and liabilities. In general, a comprehensive assessment of insurers’ exposure to interest rate and duration risk should account for the impact of hedging achieved through the use of interest rate derivatives.[64]

Foreign exchange forwards are the third most frequently used derivative product, while the use of CDS is fairly limited. Exposures to foreign exchange forwards and CDS account for 10% and less than 1% of the notional amounts respectively. In particular, euro area insurers’ aggregate exposure to CDS, with a notional value of around €11 billion, is negligible in comparison with that of AIG’s CDS portfolio, which totalled USD 527 billion at the end of 2007. The limited use of CDS may be related to Solvency II requirements, which only allow the use of derivatives insofar as they “contribute to a reduction of risks or facilitate efficient portfolio management”.[65]

The network of derivative exposures shows a highly concentrated market, since insurers make transactions with a relatively small number of counterparties, which are mainly banks (see Chart B). In particular, more than 57% (79%) of the notional amounts are traded with the top 10 (20) counterparties, which are predominantly large dealers and/or clearing members. Insurers are often clients of clearing members because EMIR requires central clearing for certain types of contract (e.g. standard interest rate swaps)[66] and insurers typically do not meet the conditions for holding an account with a central counterparty or the scale of their trading activity does not justify the cost of such an account.

Small insurers typically trade with one bank only, while large insurance groups make transactions with many different counterparties. Furthermore, the exposures of large insurance groups are usually spread across several subsidiaries. This suggests that subsidiaries of large groups may have easier access to the derivatives market than small stand-alone insurers, possibly benefiting from arrangements made at the group level. Moreover, around 27% of the transactions (23% in terms of notional amounts) are intragroup, i.e. they involve insurers and banks belonging to the same group (identifiable as nodes and edges with the same colour in Chart B). Since smaller insurers typically trade with very few clearing members, this may affect their market access if the business relationship terminates or a clearing member exits the market.

#### Chart B

Network of insurers’ derivative exposures

To sum up, although euro area insurers make relatively limited use of derivative contracts on aggregate, insurers’ exposure to this market may not be entirely innocuous for financial stability. For example, there is evidence of concentration risk since the bulk of the derivative contracts are held by a limited number of large insurers. Furthermore, derivative exposures also increase the degree of interconnectedness between the insurance and banking sectors. This evidence suggests that it is important to regularly monitor developments in insurers’ derivative exposures.

## 3.3 Assessment of vulnerabilities in the euro area banking sector

The European Banking Authority (EBA) published the results of its 2018 EU-wide stress test on 2 November 2018. The exercise, which for the first time incorporates IFRS 9 accounting standards, provides supervisors, banks and other market participants with a common analytical framework to consistently compare and assess the resilience of EU banks to economic shocks. This section focuses on the results of the exercise from a financial stability perspective and provides complementary sensitivity analysis of banks’ resilience to currently emerging risks that featured less prominently in the EBA adverse scenario.

Increased risk premia and worsening macroeconomic conditions are the primary risks driving bank losses in the 2018 EBA EU-wide stress-test exercise. The adverse scenario of the EBA stress test reflects the main systemic risks to the stability of the EU financial sector when the exercise was launched (i.e. January 2018). Within the scenario narrative, the abrupt repricing of risk premia constitutes the most significant risk which then entails spillover effects on global economic growth.

Overall, compared with previous EBA EU-wide stress-test exercises, the adverse scenario of the 2018 stress test is the most severe to date. Under the adverse scenario, at the end of 2020 EU real GDP is projected to decline by 8.3% (compared with the baseline). This compares with a 7.1% drop in the 2016 EU-wide stress test. Moreover, long-term rates in the EU are foreseen to increase by 83 basis points, while residential property prices decline by 13.8% and stock prices by 29.9%.

The adverse scenario leads to substantial capital depletion across euro area banks, but the sector remains resilient, also reflecting improvements in capital ratios in recent years. Across a sample of 33 significant institutions in the euro area, the aggregate fully loaded Common Equity Tier 1 (CET1) ratio declines by 3.8 percentage points, from 13.7% in 2017 to 9.9% at the end of the adverse scenario horizon in 2020. It is 4.8 percentage points lower compared with the baseline scenario.

Total capital depletion is mostly driven by credit losses, reduced net interest income (NII) and losses stemming from market risk. The main drivers of the decline in the fully loaded CET1 ratio in an adverse scenario are loan impairments (contributing 398 basis points to the CET1 ratio depletion), losses related to market risk[67] (99 basis points) and lower net interest income[68]. However, the results differ across banks due to their different business models, risk appetite and geographical exposures. Global systemically important banks (G-SIBs) and universal banks face relatively lower depletion as they benefit from a higher degree of asset diversification and better hedging. On the other hand, depletion is comparably higher for corporate and sectoral lenders due to reduced income levels and a sharper increase in risk-weighted assets (see Chart 3.34).

Losses related to credit risk strongly contribute to banks’ capital depletion under the adverse scenario. Under the adverse scenario, the aggregate non-performing loan (NPL) ratio rises from 3.6% to 7.7%. In general, banks with higher starting NPL ratios or higher risk density tend to experience larger losses, thus reflecting the link between stronger risk appetite and higher default rates in an economic downturn. Loan loss rates vary depending on the business model, from 0.4% for sectoral and retail lenders to 2.6% for diversified lenders, which tend to hold relatively riskier assets, as measured by their higher starting NPL ratio. At the portfolio level, due to their lower level of collateralisation unsecured retail and corporate portfolios carry the largest losses, whereas losses on secured retail loans are the lowest.

Most portfolios continue to earn positive interest income from margins[69] in an adverse scenario even after subtracting loan loss impairments. While earnings from interest margins compensate for the impairment losses for household portfolios and, to a lesser extent, for large corporate portfolios, the compensation effect is comparably smaller for the corporate SME (small and medium-sized enterprise) portfolios, which consequently appear the most vulnerable (see Chart 3.35).

A rise in global interest rates leads to a reduction of banks’ net interest income.[70] Although the yield curve steepens in the adverse scenario, the funding spread also increases due to the increase in short-term interest rates. As banks’ liabilities typically reprice faster than assets due to their lower average maturity, interest expenses increase relatively more (by 45%) than interest income (by 31%), compared with the baseline. This leads to a compression of net interest income under the adverse scenario.

The larger the asset-liability gap, the more net interest income is reduced under the adverse scenario. The maturity gap between assets and liabilities is a key factor driving the impact on individual banks’ net interest income under the adverse scenario (see Chart 3.36). Furthermore, the net interest income compression is smaller for banks with larger exposures to countries experiencing a stronger steepening of the yield curve over the scenario horizon, which supports the traditional maturity transformation function of banks. In addition, a steeper yield curve is relatively more beneficial to banks that issue predominantly fixed rate loans (rather than floating rate loans) as they are repriced with the higher interest rates at the longer end of the yield curve.

Market risk losses increase in line with the rise of interest rates and risk premia in financial markets. The impact of market risk amounts to 1.0 percentage point capital depletion. It results mainly from the revaluation of mark-to-market assets as interest rates and risk premia are foreseen to increase globally in the adverse scenario. The revaluation impact is dominant across all business models, but relatively larger for corporate lenders and G-SIBs, which also have the highest share of market risk exposures on their balance sheets (see Chart 3.37). Furthermore, larger banks, such as G-SIBs, universal banks and corporate lenders tend to face relatively more impact from increases in liquidity reserves, but gain relatively more from client revenues.

Sensitivity analyses of banking sector resilience to emerging market risks and euro area sovereign debt concerns complement the EBA stress-test results. The EBA EU-wide stress-test exercise is a long process, which can inevitably result in some “scenario drift” in the sense that certain systemic risk factors may become more prominent during the period between the launch of the exercise and the publication of its final results.[71] For instance, since the launch of the exercise at the beginning of 2018 risks related to EMEs, as well as risks related to turmoil in the market for euro area sovereign debt, have arguably become more pervasive. For this reason, a sensitivity analysis is performed to assess the resilience of the euro area banking sector to a more adverse configuration of EME shocks and to sovereign yield shocks, respectively, compared with what is embedded in the EBA scenario.

A first sensitivity analysis is carried out by assuming a more extreme scenario for selected EMEs. These EMEs – Argentina, Brazil, China, India, Mexico, Russia and Turkey – have been selected on the basis of their relevance in terms of loan book exposures (at least 0.5% of the aggregate loan book) and on the basis of financial stability risks which have either materialised already in 2018 or are likely to materialise. The adverse scenario for each country was calibrated such that the decline in real GDP growth was significantly more severe in the affected countries compared with the 2018 EBA adverse scenario and also the 2016 EBA adverse scenario. The estimates only relate to credit risk under a static balance sheet assumption, whereas other effects such as the ability of banks to generate pre-provision profits under such a scenario are not considered.

A second sensitivity analysis examines the implications of a rise in sovereign credit spreads. It comprises an increase of the spread of Italian government bond yields against the German benchmark in isolation and a situation where the increase of Italian sovereign credit spreads spills over to other euro area countries. The sensitivity analyses were calibrated assuming that Italian ten-year sovereign bond yields reach 4.5% by the end of 2018. The analysis does not take into account other effects on profits and losses, such as the negative impact on credit losses and on funding costs, as well as the potentially positive impact on lending margins, nor does it take into account banks’ hedging positions against sovereign credit spreads.

The joint materialisation of the risks considered in the sensitivity analyses could lead to an overall capital depletion of around 30 to 70 basis points in addition to the overall EBA 2018 CET1 ratio depletion of 380 basis points.[72]

# 4 Regulatory framework

## Strengthening the institutional set-up

A common institutional framework for macroprudential policy should reinforce financial stability at both the global and EU levels. The establishment of the European Systemic Risk Board (ESRB), the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) were important milestones in this regard. Moreover, considerable regulatory steps have been taken to improve the overall resilience and resolution of banks (e.g. Basel III, the Capital Requirements Regulation and Directive (CRR/CRD IV) and the Bank Recovery and Resolution Directive (BRRD)), strengthen financial markets and infrastructures and bring unregulated or under-regulated sectors within the scope of regulation.

Targeted changes to the ESRB’s governance and operational framework would further improve the coordinated response to systemic risks in the EU. While the establishment of the European Supervisory Authorities (ESAs) and the ESRB were significant achievements in improving the coordination of financial regulation and supervision in the EU, the institutional framework would benefit from further adjustments. Building on the experience gained so far, the ongoing review of the ESAs and the ESRB aims to ensure effective and consistent micro- and macroprudential supervision across Europe. The review of the ESRB is of particular importance from a macroprudential perspective.

The changes to the ESRB’s governance and operational framework proposed by the European Commission should enhance the ESRB’s efficiency and effectiveness. At the same time, the ESRB’s governance should continue to reflect the importance of central banks’ role in the functioning of the ESRB and the fact that the ESRB relies on expertise, resources and infrastructure of the ECB.[73]

A strengthening of the single market supervision at the EU level is still needed, particularly in the context of the capital markets union (CMU) agenda. Although the establishment of the European Securities and Markets Authority (ESMA) has been a major step towards fostering convergence of national supervisory practices, the supervision of securities markets remains at the national level, which may cause an uneven application of EU legislation. ESMA could play a larger role in ensuring consistent transposition and effective enforcement of rules agreed at the EU level and could provide a locus for single decision-making on these issues. To complete CMU and give ESMA a stronger supervisory role at the EU level, it is also necessary to further harmonise the different legislation existing in the EU, particularly in the fields of insolvency and company law.

More also needs to be done to complete the banking union, with a view to safeguarding financial stability in the euro area. The establishment of the SSM and the SRM was key in addressing the causes of the crisis. In order to establish a fully operational and effective framework, the banking union now needs to be completed with a credible backstop to the Single Resolution Fund (SRF) and its third pillar, a European deposit insurance scheme (EDIS). The ECB welcomes the agreement reached at the Euro Summit in June that the backstop to the SRF should be provided by the European Stability Mechanism (ESM). Going forward, effective decision-making should be put in place to ensure a swift deployment of the backstop when needed.[74] In addition, further work is needed to agree on a roadmap for political negotiations on EDIS, with a view to completing the banking union.

Establishing EDIS should remain a main goal for the completion of the banking union, to be embedded in a redefined roadmap for parallel progress on risk reduction and risk sharing, which are mutually reinforcing. A fully mutualised EDIS also covering losses would contribute to ensuring a uniform level of depositor confidence across the banking union, bring benefits in terms of pooling resources at the EU level against asymmetric shocks, ensure the provision of sufficient short-term liquidity in times of crisis and contribute to weakening the bank-sovereign nexus. ECB staff analysis indicates that the increase in banks’ loss-absorbing capacity in the aftermath of the global financial crisis, the introduction of a super priority for covered deposits, and an appropriate design of risk-based contributions would contribute to shielding a fully fledged EDIS from unwarranted cross-border subsidisation in the sense of certain banking systems systematically benefiting more from EDIS than they would contribute to it.[75] Rather, EDIS would lead to risk sharing only in extremely severe scenarios, which is in line with its main purpose. Completing the banking union would require agreement on a revised roadmap containing the key steps needed in terms of risk reduction to address legacy issues which are still weighing on the stability of the banking sector and a commitment to increasing risk sharing towards a fully fledged EDIS with a clear timeline.

## Strengthening the resilience of the banking sector

The establishment of the international capital and liquidity standards (Basel III) in December 2010 and their finalisation in December 2017 were important steps towards restoring confidence in the banking system. The initial Basel III package of December 2010, which has been implemented in the EU via the CRR/CRD IV, has already contributed to improving banks’ capital ratios – both in terms of their level and quality – as well as increasing banks’ liquidity buffers that enable them to withstand short- and longer-term liquidity shocks. The December 2017 Basel III finalisation package will enhance the robustness and risk sensitivity of the approaches used to calculate risk-weighted assets, set a finalised leverage ratio, including a leverage ratio buffer for global systemically important banks (G-SIBs), and introduce a revised capital floor.

A full and timely implementation of the finalised Basel III package across all jurisdictions would reduce regulatory uncertainty and ensure a level playing field. Deviations across jurisdictions can compromise the objectives of such standards, as they could render institutions more exposed to risks, hamper comparability between banks, and create an uneven playing field. The implementation process should be carefully monitored through comprehensive evidence-based evaluation.

The Basel III framework is being implemented in the EU via the revision of the CRR/CRD IV, where discussions among EU co-legislators are ongoing. The revisions will introduce into EU law the leverage ratio requirement, the revised market risk capital framework, and the net stable funding ratio requirement (the NSFR is discussed in more detail in the following section). The details of the package were examined in previous issues of the FSR and a related ECB Opinion.[76] Importantly, the majority of the revisions related to the finalisation of Basel III agreed in December 2017 will form part of a reform package that is separate from the ongoing CRR/CRD IV review.[77]

In November 2016 the European Commission published its comprehensive package of reforms to further strengthen the resilience of EU banks. The ECB’s key messages on the reform package, including revisions to the BRRD and the SRM Regulation, were discussed in greater detail in a dedicated article in the ECB’s Macroprudential Bulletin.[78] From a macroprudential perspective, a robust and properly designed regulatory framework is a precondition for the effective conduct of macroprudential policy and for strengthening the resilience of the banking sector. This is even more important in the euro area, where macroprudential policy plays a key role in addressing country-specific risks and vulnerabilities. In this regard, the ECB supports an ambitious set of targeted changes to the EU macroprudential framework, with the aim of making the current framework more coherent, consistent and operational.[79]

The targeted review of the macroprudential framework in the CRR/CRD IV is primarily aimed at clearly delineating responsibilities between micro- and macroprudential authorities. Eliminating the use of the Pillar 2 requirements for macroprudential purposes is a key element of this review. This should, however, not result in gaps in the framework such that authorities do not have sufficient tools available. Therefore, the macroprudential toolkit must be extended, e.g. by sectoral capital buffers and borrower-based measures, to ensure that macroprudential authorities can effectively address systemic risks. Furthermore, the usability of existing capital and liquidity-based measures – which are currently part of the macroprudential toolkit for banking – should be enhanced. In particular, increasing flexibility in the calibration of capital buffers for systemically important institutions at the level of parent undertakings and subsidiaries, as well as streamlining the activation and coordination procedures, would be necessary.

The macroprudential policy framework should be made more comprehensive by complementing capital-based instruments with borrower-based measures in the EU legislation. Such measures include, inter alia, limits on loan-to-value (LTV), loan-to-income (LTI) or debt service-to-income (DSTI) ratios, which can be used to target vulnerabilities in mortgage markets. Given the synergies and complementarities among individual instruments, a comprehensive set of tools should be available. Whereas these measures exist in a number of jurisdictions, they are not provided for in the CRR/CRD IV. Therefore, the ECB calls for a comprehensive macroprudential review in the medium term which should give consideration to embedding borrower-based measures in European legislation, while taking into account the peculiarities of national real estate markets, thereby allowing macroprudential authorities to act in an efficient, effective and timely manner.

The ongoing revision of the EU’s crisis management framework is also essential for strengthening the resilience of the banking sector in the EU. The EU legislators have made proposals for implementing international standards, such as the Financial Stability Board (FSB)’s total loss-absorbing capacity (TLAC) standard for G-SIBs, and for further revisions to the EU’s crisis management framework. This will help to build up further resilience in the banking sector to financial crises and enable authorities to conduct an orderly resolution of banks which are determined to be failing or likely to fail. The aim is to finalise the discussions by the end of the year so that implementation can start thereafter. The ECB made some suggestions on how to address specific issues in the crisis management framework in its November 2017 Opinion.[80] These proposals were further explained in an article in the ECB’s Macroprudential Bulletin.[81]

Swift progress on the legislative proposals contained in the European Commission’s package of measures would help further tackle high non-performing loan (NPL) ratios.[82] As described in greater detail in Chapter 3, despite some progress in NPL resolution, the burden of legacy assets remains heterogeneous across countries. In this regard, the European Commission’s package includes proposals for: (i) a directive on credit servicers, credit purchasers and the recovery of collateral, which would remove legal impediments to the transfer of NPLs by banks to non-banks, including a simplification of the licensing requirements for third-party loan servicers; (ii) an amendment of the CRR to introduce minimum levels of provisioning for future NPLs; and (iii) a blueprint for the setting-up of national asset management companies (AMCs).

## Implementing regulatory reforms for financial market risks

The global financial crisis illustrated the importance of sound liquidity risk management rules, which were introduced for the first time in the Basel III standards. To improve banks’ short-term resilience to liquidity shocks, the Basel Committee on Banking Supervision (BCBS) introduced the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) as part of the Basel III post-crisis reforms. The LCR, which entered into force as a binding minimum requirement in the EU in 2015, is designed to ensure that banks hold a sufficient amount of high-quality liquid assets (HQLA) to allow them to survive a period of significant liquidity stress lasting 30 calendar days. The LCR is complemented by the NSFR, which will reduce excessive maturity transformation and promote funding stability. The NSFR ensures that any maturity mismatch between a bank’s assets and liabilities is not excessive, making banks’ liquidity positions more resilient to disruptions to their funding sources. The European Commission’s proposal to implement the NSFR in EU law largely reflects the BCBS’s NSFR framework, but also includes several technical deviations.[83] While these changes would reduce the impact of the requirement and of potential unintended consequences on market functioning, they might also prevent the full reduction in funding risk anticipated by the previously agreed Basel standard.

The proposed EU standard on market risk in the CRR/CRD IV review[84] will address weaknesses in the current capital framework for trading activities. In particular, the reform package will introduce a revised boundary between the regulatory banking and trading books to reduce incentives for arbitrage in the allocation of instruments between these books. The new standard will also enhance the internal model-based approach by capturing risks in a more coherent and comprehensive way, by making the model approval process more granular, and by introducing new constraints on the capital-reducing effects of hedging and portfolio diversification. The reform package will also introduce a revised standardised approach, which will be a credible fall-back to banks’ internal model-based approaches and improve the consistency and comparability of reporting of market risk across banks.

## Addressing risks in the non-bank financial sector

The post-crisis reform agenda has addressed some of the risks in the non-bank financial sector. For instance, the reforms in the EU have addressed risks concerning money market funds and securitisation activities.[85] They have also addressed transparency issues in derivatives and securities financing markets,[86] whose opacity represented a challenge during the financial crisis. Regarding non-bank activities which contributed to the global financial crisis, the financial system is currently in a much better situation than before. Still, even when the new framework is fully implemented and working as designed, it will not be enough to handle all risks and therefore vigilance about new and emerging vulnerabilities in the non-bank financial sector is needed.

For example, a better understanding of the risks from the rapidly growing asset management industry is needed. In the EU, these activities are regulated and supervised, but they can still amplify shocks through liquidity mismatches, leverage or interconnectedness. As highlighted in the Overview and in Chapter 3, substantial liquidity transformation among euro area investment funds and growing concerns over their market impact in a possible future stress event are one of the key risks to financial stability. These risks need to be closely monitored and the macroprudential toolkit for these entities needs to be enhanced. As highlighted in the latest issue of the ECB’s Macroprudential Bulletin, existing macroprudential liquidity tools for investment funds should be operationalised and further instruments should be explored.[87] At the global level, the International Organization of Securities Commissions (IOSCO) is tasked with identifying and developing consistent and meaningful measures of leverage in investment funds as part of its operationalisation of the FSB recommendations to address risks associated with asset management activities. This will enable consistent monitoring and assessment of leverage in the investment fund sector globally. At the same time, the European Insurance and Occupational Pensions Authority (EIOPA) and the ESRB are also working towards developing additional macroprudential tools and measures for insurance companies that could enhance the current framework in the EU in view of the ongoing Solvency II review (see also Chapter 3).

There remains a need for a macroprudential perspective on investment firms. The ECB Opinion on the European Commission review of the prudential treatment of investment firms,[88] published on 22 August 2018, supports the objectives of setting out a prudential framework that is better adapted to the risks and business models of different types of investment firms, as well as subjecting systemically important investment firms to the same prudential rules and supervision as credit institutions. This guarantees the application of prudent and consistent supervisory standards and ensures a level playing field for firms similar to credit institutions. Smaller investment firms that are significant market participants, engage in cross-border activities or are connected to credit institutions could also function as shock amplifiers. In order to identify and mitigate potential financial stability risks arising from smaller firms, certain macroprudential tools could be developed. This would be in line with European Banking Authority (EBA) recommendations on the need for a macroprudential perspective on investment firms.[89] The Commission proposals envisage a threshold to identify systemic investment firms based on their total assets. This threshold could be complemented with other criteria, including for example a revenue criterion, the significance of cross-jurisdictional activity or interconnectedness. These criteria could be designed on the basis of an underlying methodology for assessing systemic risk posed by investment firms, to ensure that the threshold achieves its objectives and does not result in excessive unintended consequences, for example through regulatory arbitrage.

## Strengthening financial market infrastructures and technologies

Enhancing the supervisory architecture for central counterparties (CCPs), given their increased importance, continues apace. The ongoing EU initiatives to enhance the supervisory architecture for CCPs, including for third-country CCPs, and to establish legislation for CCP recovery and resolution are expected to further strengthen the regulatory framework. On the basis of the experience gained with the application of the regulation implementing the G20 reforms for over-the-counter (OTC) derivatives markets in the EU (mainly through the European Market Infrastructure Regulation and the CRR review), some areas have been identified where the legislative framework could benefit from fine-tuning. In addition, the UK’s decision to withdraw from the EU also necessitated a review of the current EU supervisory framework, especially with regard to third-country CCPs. Furthermore, the EU legislative framework is being revisited to take into account the recent further guidance by global standard-setters concerning CCP resilience, recovery and resolution.

A harmonised EU-wide approach towards innovative technologies is essential for maximising their benefits and advancing CMU. The European Commission’s FinTech action plan, published in March 2018, is an important step forward as it aims to improve the clarity of the regulatory framework and promote harmonisation of national approaches so as to ensure a level playing field and avoid regulatory arbitrage across and beyond Member States.[90] It is also important to ensure that new fintech business models are subject to the same regulation if they entail the same risks. From a financial stability perspective, the increased adoption of new technologies needs to be accompanied by an updated regulatory and supervisory approach to identify, assess and control emerging risks.

Finally, global efforts are under way to monitor crypto-assets and assess the need for regulatory action. While crypto-assets currently do not pose a material financial stability risk within the existing environment, they raise a number of challenges in terms of protecting consumers and investors, preventing illicit activities and ensuring market integrity. The G20 finance ministers and central bank governors reaffirmed their commitment to vigilant monitoring of crypto-assets at their meeting in July 2018. The FSB has established a monitoring framework as part of these efforts, while the BCBS plans to start a regular collection of data on banks’ exposures to crypto-assets and to clarify the prudential treatment of such exposures. The ECB continues to support these multilateral initiatives.

# Special Features

## How can euro area banks reach sustainable profitability in the future?

Prepared by Magnus Andersson, Christoffer Kok, Harun Mirza, Csaba Móré and Jonas Mosthaf[91]

On aggregate, bank profitability in the euro area has improved in recent quarters along with the cyclical recovery. However, the level of earnings for many banks is still below that required by investors and bank profitability is still vulnerable to a possible turnaround in the business cycle. This special feature looks at possible avenues for banks to reach more sustainable levels of profitability in the future. It highlights the need to overcome structural challenges in the form of low cost-efficiency, limited revenue diversification and high stocks of legacy assets (in some jurisdictions).

More

## The resurgence of protectionism: potential implications for global financial stability

Prepared by Allan Gloe Dizioli and Björn van Roye

The intensification of trade tensions this year has raised concerns about the potential adverse impact on global growth and asset prices. So far, the isolated effects of introducing tariffs on selected goods on asset prices have been adverse mainly for specific companies that rely heavily on international trade. At the same time, global financial markets have overall been fairly resilient to the announcements and implementation of tariff measures. This special feature finds that an escalation of trade tensions could trigger a global repricing in asset markets. For the euro area, asset prices would be strongly affected in the event of a full-blown global trade war, in which all countries impose tariffs on each other, while the impact of a regionally contained trade dispute escalation would be rather subdued.

More

## Counterparty and liquidity risks in exchange-traded funds

Prepared by Michael Grill, Claudia Lambert, Philipp Marquardt, Gibran Watfe and Christian Weistroffer

Over the last decade, exchange-traded funds (ETFs) have grown at a fast pace both globally and in the euro area. ETFs typically offer low-cost diversified investment opportunities for investors. ETF shares can be bought and sold at short notice, making them efficient and flexible instruments for trading and hedging purposes. At the same time, the wider use of ETFs may also come with a growing potential for transmission and amplification of risks in the financial system. This special feature focuses on two such channels arising from (i) liquidity risk in ETF primary and secondary markets and (ii) counterparty risk in ETFs using derivatives and those engaging in securities lending. While ETFs still only account for a small fraction of investment fund asset holdings, their growth has been strong, suggesting a need for close monitoring from a financial stability and regulatory perspective, including prospective interactions with other parts of the financial system.

More

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1. See Fell, J., Grodzicki, M., Krušec, D., Martin, R. and O’Brien, E., “Overcoming non-performing loan market failures with transaction platforms”, Financial Stability Review, ECB, November 2017.
2. For an overview, see Koepke, R., “What Drives Capital Flows to Emerging Markets? A Survey of the Empirical Literature”, MPRA Paper 62770, University Library of Munich, 2015.
3. In the light of the importance of the US dollar for the majority of EMEs, US financial conditions are a key determinant of financial conditions in EMEs and hence of capital flows; see for instance Rey, H., “Dilemma not trilemma: the global cycle and monetary policy independence”, Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, 2013, pp. 1-2.
4. As the strengthening of the dollar and the increase in US policy rates had already commenced in previous years, the model is not fully capable of explaining the full extent of the recent slowdown, nor can it fully explain the strong inflows observed in 2017.
5. For instance, fears of a slowing-down of the global business cycle would put downward pressure on US long-term Treasury yields, while expansionary US fiscal policy and monetary policy tightening push them upwards.
6. Information on holdings of leveraged loans is still largely incomplete. Euro area banks’ holdings of syndicated loans rose by €25 billion during the second quarter to €550 billion at the end of June. Leveraged loans are estimated to account for about one-quarter to one-third of this amount.
7. The guidance sets minimum supervisory expectations regarding loan origination, loan identification and the leveraged lending risk control framework for the banks under its remit. ECB Banking Supervision also identified leveraged finance as one of the credit risk focus areas in its supervisory priorities for 2019.
8. MTS is the Mercato all’ingrosso dei Titoli di Stato and represents a fraction of the overall market turnover. However, bid and ask quotes in the MTS order book are executable and therefore representative of overall over-the-counter market developments.
9. Other liquidity measures, besides those considered in this analysis, are necessary to make a full assessment of market depth and resiliency.
10. According to the new methodology, the calculation of EURIBOR is, to the extent possible, based on real transactions. EMMI launched a public consultation on the final blueprint for the new EURIBOR methodology, after a viability test on this methodology had been successfully completed. EMMI plans to phase in the methodology in the course of 2019.
11. In September 2017, the ECB, the European Securities and Markets Authority, the Belgian FSMA and the European Commission established a private sector working group with a mandate to identify a euro risk-free rate and develop plans for its adoption and the transition to the new reference rate. The working group is chaired by a private sector representative (Chief Risk Officer of ING, Steven van Rijswijk) and the ECB provides the secretariat. The working group is made up of representatives of 21 credit institutions as voting members, five institutions as non-voting members (EMMI, the ISDA, the International Capital Market Association, the Loan Market Association, and the European Fund and Asset Management Association) and one institution as an invitee (the European Investment Bank).
12. Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014 (OJ L 171, 29.6.2016, p. 1).
13. “State of play of the EONIA review”, European Money Markets Institute, February 2018.
14. See “Principles for Financial Benchmarks: Final Report”, The Board of the International Organization of Securities Commissions, July 2013.
15. The spread between EONIA and pre-ESTER is around 8-9 basis points, which implies a transfer of value for existing contracts as of the transition date.
16. In December 2016, an agreement was reached amongst EU institutions on the Regulation on money market funds. On 16 May 2017, the act was adopted by the EU Council after the European Parliament had passed it in April. The entry into force was scheduled to take place within 12 months for new funds (by 21 July 2018) and 18 months for existing funds (by 21 January 2019).
17. LVNAV funds will operate as CNAV funds, but will convert to VNAV when their value deviates by more than 20 basis points from constant NAV. Public debt CNAV funds keep the NAV constant, but can invest in government bonds only.
18. See “Preparing for the withdrawal of the United Kingdom from the European Union on 30 March 2019: a contingency action plan”, 13 November 2018.
19. MREL, which stands for minimum requirement for own funds and eligible liabilities, is a requirement under the Bank Recovery and Resolution Directive aimed at ensuring that in the event of bank resolution there are sufficient bail-inable instruments for loss absorption and recapitalisation of the bank.
20. See “Opinion of the European Banking Authority on preparations for the withdrawal of the United Kingdom from the European Union”, 25 June 2018.
21. See “Single Resolution Board expectations to ensure resolvability of banks in the context of Brexit”, 15 November 2018.
22. See “Key Attributes of Effective Resolution Regimes for Financial Institutions”, Financial Stability Board, October 2014.
23. See “ESMA proposes a regulatory change to support the Brexit preparations of counterparties to uncleared OTC derivatives”, 8 November 2018.
24. See “EIOPA calls for immediate action to ensure service continuity in cross-border insurance”, 5 November 2018.
25. The split of the sample into two groups is based on 12-month trailing ROE levels in the second quarter of 2016 (for a balanced sample of 84 significant institutions).
26. Core revenues are defined as the sum of net interest income and net fee and commission income.
27. Under IFRS (International Financial Reporting Standards) rules, it is possible for banks to book interest income on certain parts of NPLs. The median share of interest income accrued on impaired loans was 7.6% within the group of high-NPL banks in the first half of 2018, with the variation across banks broadly in line with the level of NPL ratios.
28. “SSM thematic review on profitability and business models”, ECB Banking Supervision, September 2018.
29. Under IFRS 9, Stage 2 loans are defined as loans with a significant increase in credit risk since initial recognition but which are not credit-impaired.
30. On aggregate, bonds represented 17% of euro area significant banks’ funding sources.
31. As euro area banks are currently reporting the NSFR ratios to the SSM for their total exposure only (i.e. across all currencies), the NSFR ratios for the significant currencies (such as the US dollar) are estimated based on the NSFR proxy tool developed by the EBA. The results derived from the NSFR proxy tool might differ from the actual NSFR values for US dollar exposures.
32. While the EU LCR Regulation does not explicitly require banks to comply with the 100% LCR minimum requirement in foreign currencies, it requires them to ensure that the currency denomination of their liquid assets is consistent with the distribution by currency of their net liquidity outflows (though without any explicit quantitative limit). In this regard, competent authorities may (where appropriate) require banks to restrict currency mismatch by setting limits on the proportion of net liquidity outflows in a currency that can be met during a stress period by holding liquid assets not denominated in that currency. Such restriction may only be applied for the reporting currency or a significant foreign currency.
33. See “EBA Report on Funding Plans”, European Banking Authority, September 2018.
34. G-SIBs are expected to meet a minimum TLAC of 16% of the resolution group’s risk-weighted assets as from 1 January 2019 and at least 18% as from 1 January 2022.
35. One exception to this general trend is the case of German banks, given the recent amendment to the BRRD allowing German banks’ senior unsecured debt to rank pari passu with the new SNP debt issuance, and that the German legislation enabling the introduction of senior preferred bonds only came into force on 21 July 2018.
36. See “6th Industry Dialogue: 2017 MREL Policy”. The sample used by the SRB to estimate the aggregated MREL shortfall covers 76 European banks comprising small and large institutions.
37. TLTRO-II refers to the second series of targeted longer-term refinancing operations, introduced by the ECB in March 2016.
38. Credit risk accounts for the largest part of total risk exposures (85%), followed by operational risk (11%).
39. In fact, 12-month averages of volatility measures in most financial market segments decreased over the VaR calculation horizon, i.e. between end-June 2017 and end-June 2018, compared with a year earlier.
40. The analysis of fair value assets is based on a balanced sample of 79 significant institutions which accounted for 96% of the total fair value assets for all significant institutions in the second quarter of 2018.
41. Level 1 assets are those for which the prices are quoted in active markets and thus the uncertainty related to the fair value is minor. For Level 2 assets, the fair value is determined on the basis of observable data and prices as inputs and thus the uncertainty related to valuation is limited, while for Level 3 assets inputs are unobservable (i.e. market data are not available or not reliable).
42. Under IFRS 9, instruments that are held to collect contractual cash flows which are solely payments of principal and interest can be recorded at amortised cost. As the choice of designation had to be recorded at the moment of transition to the new rules, it resulted in a reclassification in the first quarter of 2018 as a result of IFRS 9 adoption.
43. The shift in portfolio composition was largely driven by an actual reduction in holdings of higher-rated bonds relative to holdings of lower-rated bonds, rather than a decline in the rating quality of the securities held.
44. According to SHSS data, the aggregate euro area non-bank financial sector reduced its holdings of Italian government bonds by 5% (€36 billion) between March and June 2018.
45. See EU Shadow Banking Monitor, No 3, European Systemic Risk Board, September 2018, and Financial Stability Review, ECB, May 2018.
46. Undertakings for collective investment in transferable securities (UCITS) account for roughly 60% of the EU funds, while AIFs account for the remaining 40%.
47. See van der Veer, K., Levels, A., Lambert, C., Molestina Vivar, L., Weistroffer, C., Chaudron, R. and de Sousa van Stralen, R., “Developing macroprudential policy for alternative investment funds – Towards a framework for macroprudential leverage limits in Europe: an application for the Netherlands”, Occasional Paper Series, No 202, ECB, November 2017, p. 20, Chart 5.
48. See the Recommendation of the European Systemic Risk Board of 7 December 2017 on liquidity and leverage risks in investment funds (ESRB/2017/6) published on 14 February 2018.
49. Absolute return strategies seek to make positive returns in all market conditions, e.g. by employing leverage, short-selling, futures, options or other derivatives.
50. Insured losses from natural catastrophes in the first half of 2018 reached around USD 17 billion, which is in line with the 30-year average (USD 17.5 billion), but less than those of the previous year (USD 25.5 billion). See “Natural catastrophe review for the first half of 2018”, Munich Re, July 2018.
51. The reinsurance rate increases were fairly limited as tough competition in the sector continues to exert long-term downward pressure on reinsurance rates. In particular, alternative sources of reinsurance capital such as catastrophe bonds continued to grow at a fast pace. Year on year, the outstanding amount of the catastrophe bond and related insurance-linked securities (ILS) market in the third quarter of 2018 increased by USD 6.7 billion, or 22%, to around USD 37 billion. See “Q3 2018 Catastrophe Bond & ILS Market Report – New perils help cat bond market to record Q3”, Artemis.
52. Combined ratios measure incurred losses and expenses as a proportion of premiums earned, so that values below 100% indicate that insurers manage the balance between the costs and underwriting profits of their ongoing business in a sustainable manner.
53. Although life insurers have been adapting their business models by shifting towards unit-linked products in recent years, the traditional saving policies with guaranteed rates (non-unit-linked policies) continue to dominate life insurers’ liabilities. For more details, see Financial Stability Review, ECB, May 2018, Section 3.2.
54. For more details about the large and increasing exposures in the Netherlands, see Financial Stability Review, ECB, May 2017, Box 7.
55. See “Vulnerabilities in the EU residential real estate sector”, ESRB, November 2016.
56. See “Other potential macroprudential tools and measures to enhance the current framework”, EIOPA, July 2018.
57. See “Macroprudential provisions, measures and instruments for insurance”, ESRB, November 2018.
58. See, for example, “Report on systemic risks in the EU insurance sector”, European Systemic Risk Board, December 2015.
59. For more details, see McDonald, R. and Paulson, A., “AIG in Hindsight”, Journal of Economic Perspectives, Vol. 29, No 2, 2015, pp. 81-106.
60. EIOPA’s June 2018 “Financial Stability Report” provides the first insights into the use of derivatives by EU insurers based on Solvency II reporting.
61. EMIR data are highly complex and require extensive processing (see ESRB Occasional Paper No 11). The results presented in this box are based on a cleaned sub-sample of the data for euro area insurers, using the reference date of 28 September 2018. In particular, the data (initially reported by both counterparties to a trade) are paired and de-duplicated, and outliers are removed. Despite this processing, the final data are still subject to some data quality limitations (missing values, some transactions remain unpaired, possible under-reporting, etc.). The final data also do not capture insurers’ exposures at group level because they do not include exposures of non-insurance entities belonging to insurance groups (unless these have a derivative contract with an insurance company).
62. Gross market value is defined as the sum of (the absolute value of) negative and positive market values. The value of €55 billion is somewhat smaller than the corresponding aggregate from ECB balance sheet data (€63 billion in June 2018; obtained as the sum of derivative assets and liabilities).
63. Only 434 out of the 2,328 euro area insurers included in the list of insurers published by EIOPA are found to be active in the derivatives market according to EMIR data.
64. For an analysis of the impact of hedging on interest rate risk borne by euro area banks, see e.g. Hoffmann, P., Klaus, B. and Langfield, S., “The distribution of interest rate risk in the euro area”, Special Feature C in Financial Stability Review, ECB, May 2018.
65. See Article 132 of the Solvency II Directive. This requirement may in particular limit the selling of CDS (i.e. the type of activity that increases exposure to credit risk and which was widely used by AIG).
66. European Commission Delegated Regulation (EU) 2015/2205.
67. The definitions of the risk types correspond to the published EBA aggregates. In this regard, credit risk losses are defined as impairments or reversal of impairments on financial assets not measured at fair value through profit or loss, while market risk losses include gains/losses in 2018 originating from net trading income, other comprehensive income and P&L items that are mandatory or optional at fair value through profit or loss.
68. Although net interest income increases in the adverse scenario, it is lower compared with the baseline scenario, contributing 122 basis points to the difference in the fully loaded CET1 ratio between the adverse and the baseline scenarios.
69. In the EBA stress test, interest income is split between interest income earned on reference interest rates (which correspond to the underlying risk-free rates) and interest income earned on margins. In this regard, margin is defined as the premium charged by banks over the portfolio’s reference rate.
70. In the EBA stress test, methodological constraints restrict the evolution of interest rates applied to assets and in particular liabilities.
71. In the case of the 2018 EBA EU-wide stress test, the scenarios were published on 31 January 2018, while the final stress-test results were published on 2 November 2018 (i.e. a lag of more than eight months).
72. The overall impact is estimated simply as the sum of the individual impacts under the assumption that the risks considered in the sensitivity analyses are uncorrelated.
73. See Opinion of the European Central Bank of 2 March 2018 on a proposal for a regulation of the European Parliament and of the Council amending Regulation (EU) No 1092/2010 on European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board (CON/2018/12) and Opinion of the European Central Bank of 11 April 2018 on a proposal for a regulation of the European Parliament and of the Council amending Regulation (EU) No 1093/2010 establishing a European Supervisory Authority (European Banking Authority) and related legal acts (CON/2018/19).
74. See Statement of the Euro Summit meeting, 29 June 2018.
75. See Carmassi, J., Dobkowitz, S., Evrard, J., Parisi, L., Silva, A. and Wedow, M., “Completing the Banking Union with a European Deposit Insurance Scheme: who is afraid of cross-subsidisation?”, Occasional Paper Series, No 208, ECB, April 2018.
76. See Opinion of the European Central Bank of 8 November 2017 on amendments to the Union framework for capital requirements of credit institutions and investment firms (CON/2017/46).
77. In this regard, the European Commission has initiated the legal process by launching a public consultation in March 2018.
78. See “Macroprudential regulatory issues – Key ECB messages on the European Commission’s banking reform package from a macroprudential perspective”, Macroprudential Bulletin, Issue 4, ECB, December 2017.
79. See “Targeted review of the macroprudential framework”, Macroprudential Bulletin, Issue 5, ECB, April 2018.
80. See Opinion of the European Central Bank of 8 November 2017 on revisions to the Union crisis management framework (CON/2017/47).
81. See “Targeted review of the macroprudential framework”, Macroprudential Bulletin, Issue 5, ECB, April 2018.
82. See “Commission measures to address the risks related to NPLs”, European Commission, March 2018.
83. For example, one proposed deviation is that the stable funding requirement should not apply to the most liquid assets. The proposed deviation also suggests that a lower stable funding requirement for banks’ short-term lending to other financial counterparties, including secured lending, should be applied until a review of the treatment of secured transactions included in the NSFR has been completed.
84. See Opinion of the European Central Bank of 8 November 2017 on amendments to the Union framework for capital requirements of credit institutions and investment firms (CON/2017/46).
85. See Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds and Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation.
86. See Regulation (EU) 2015/2365 of the European Parliament and of the Council of 25 November 2015 on transparency of securities financing transactions and of reuse and Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.
87. See “Macroprudential liquidity tools for investment funds – A preliminary discussion”, Macroprudential Bulletin, Issue 6, ECB, October 2018.
88. See Opinion of the European Central Bank of 22 August 2018 on the review of prudential treatment of investment firms (CON/2018/36).
89. See Opinion of the European Banking Authority in response to the European Commission’s Call for Advice on Investment Firms, 29 September 2017. Recommendation 60 of that Opinion states that the new prudential regime for investment firms should include a macroprudential perspective. In this regard, the importance of mitigating the build-up and the materialisation of systemic risks should be emphasised, with a view to determining whether appropriate macroprudential tools to address those risks should be developed. Recommendation 61 states that a detailed analysis assessing the potential systemic impact of the three classes of investment firms is needed. In this respect, it should be considered whether the macroprudential perspective ought to be tailored to the specificities of investment firms’ business models. See also “Designing a new prudential regime for investment firms”, Discussion Paper EBA/DP/2016/02, European Banking Authority, 4 November 2016.
90. See “FinTech action plan: For a more competitive and innovative European financial sector”, European Commission, March 2018.
91. Also based on contributions from Martin Bijsterbosch, Andrea Deghi, Maciej Grodzicki, Lieven Hermans, Ivan Huljak, Nadya Jahn, Marco Lo Duca, Thomas Kostka, Katri Mikkonen, Diego Moccero, Philippe Molitor and Cristian Perales. Comments from Glenn Schepens are also acknowledged.