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# Foreword

This is the third issue of the Financial Stability Review (FSR) prepared in the context of the coronavirus COVID-19 pandemic, with many euro area countries having faced a third wave of infections. As a result, a vast number of firms – particularly those in the services, leisure and travel sectors – still cannot operate normally, and the economy is still reliant upon policy support to prevent widespread unemployment, corporate insolvencies and economic contraction. The human and economic costs of the pandemic continue to accrue.

That said, vaccination programmes are progressing and offering a route out of the pandemic. Financial markets have been driven by expectations of an upswing, exemplified by a striking rally in global equity markets. We are optimistic that financial and economic conditions will bounce back. There is, however, a reality that the pandemic will leave a legacy of higher debt and weaker balance sheets, which – if unaddressed – could prompt sharp market corrections and financial stress or lead to a prolonged period of weak economic recovery.

The May 2021 FSR assesses financial stability vulnerabilities – particularly in the corporate sector – and their implications for financial market functioning, debt sustainability, bank profitability and the non-bank financial sector. Risks to financial stability remain elevated and have become more unevenly distributed. The pandemic has imposed higher costs on some vulnerable countries with larger services sectors, which in turn implies a greater need for continued policy support and growing interconnections between their government, corporates and banks. More broadly, the euro area banking sector also continues to face headwinds, with its profitability subject to uncertainty about the balance of loan losses to come and provisions already booked.

This issue of the FSR also looks beyond the pandemic at the other great challenge of our time – climate change – and the risks that this poses to euro area financial stability. A special feature brings together the further enhancements that we have made to our framework for monitoring and assessing climate-related risks to financial markets, banks and non-banks.

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. The FSR exists to promote awareness of systemic risks among policymakers, the ﬁnancial industry and the public at large, with the ultimate goal of promoting financial stability.

Luis de Guindos
Vice-President of the European Central Bank

# Overview

## Euro area recovery has been delayed, with the impact of the pandemic increasingly concentrated in some sectors

A third wave of coronavirus infections in the euro area has weighed on the near-term economic outlook. More targeted lockdown and social distancing measures and economic adaptation have helped euro area economies to cope better with the pandemic. Nonetheless, many euro area countries faced a third wave of infections in the first months of 2021 that – together with the slow start of the vaccine roll-out – has delayed the economic recovery (see Chart 1, left and middle panels). Looking ahead, progress with vaccinations and the gradual easing of containment measures should support a rebound in economic activity in the course of 2021.

The impact of the pandemic has been increasingly concentrated in some sectors and countries with pre-existing vulnerabilities. The euro area services sector continues to be more adversely affected by the restrictions on social interaction and mobility than manufacturing. The weakest performing sectors, such as trade, transport and accommodation, as well as arts and entertainment, have seen continued declines in gross value added of 2-4 times the aggregate. By contrast, the industrial sector has been recovering faster, supported by improved foreign demand. This sectoral divergence, combined with differing trajectories of the pandemic, has led to a wide divergence in 2021 economic forecasts at the euro area country level (see Chart 1, middle panel).

Improved economic prospects for the United States led to a notable increase in US long-term nominal interest rates, with global effects. A faster roll-out of vaccinations and agreement on a sizeable fiscal stimulus programme have led to a marked improvement in the US economic growth and inflation outlook (see Chart 1, left and middle panels). The ensuing 60 basis point rise in US ten-year government bond yields since the start of 2021 (see Chart 1, right panel), first driven by higher inflation expectations and later by rising real rates, led to some modest spillovers to the euro area (see Chapter 2). These spillovers were partially offset as the ECB’s Governing Council reinforced its accommodative policy stance by significantly stepping up its asset purchases. Beyond the euro area, rising US yields coupled with an appreciation of the US dollar could generate larger shifts in global capital flows and, as indicated by past crises, may represent a source of risk for emerging market economies with external financing needs (see Box 1 and Chart 2.8, right panel).

## Financial markets exhibited remarkable exuberance as US yields rose

As US interest rates rose and global bond markets sold off, equity markets saw a renewed rally. The rise in US benchmark bond yields led to a global sell-off in bond markets (see Chart 2, left panel). At the same time, equity markets remained buoyant, supported by a recovery in expected earnings and robust risk sentiment (see Chapter 2). The recent rise in composite stock indices has been coupled with a somewhat stronger advance by financial stocks. These had previously underperformed technology stocks, which were among the best performers in 2020 (see Chart 2, right panel).

The buoyancy of financial markets has stood in contrast to weaker economic fundamentals, while recent bouts of volatility highlight the risk of repricing. Despite the recent stock price declines in some sectors, stock market valuations remain elevated. In the United States, valuations stand well above pre-pandemic levels, whereas they are at more moderate levels in the euro area. Spreads on euro area non-financial corporate (NFC) bonds remain at risk of an abrupt repricing, in particular for the high-yield segment, where they have fallen below pre-pandemic levels despite growing vulnerabilities. Overall, risk assets remain sensitive to changes in the benchmark yield curve and a reassessment of valuations could ensue if investor expectations regarding the likelihood and pace of monetary policy tightening were to change without an accompanying improvement in growth prospects (see Chapter 2).

Many euro area investment funds, insurers and pension funds are exposed to a further rise in yields or a correction in credit markets. Investment fund flows have also rebalanced from debt to equity given rising yields (see Chart 3, left panel). Still, in their search for yield over recent years, non-banks have increased the duration risk of their debt securities portfolios to multi-year highs. This increases the sensitivity of their assets to higher rates, though for insurers and pension funds asset valuation losses could be compensated for by a fall in the value of their liabilities given the sector’s negative duration gap. Non-banks also have large exposures to firms with weak fundamentals, with more than a quarter of the sector’s NFC debt holdings subject to a negative credit outlook or credit watch by rating agencies (see Chart 3, right panel). Roughly half are also BBB-rated, only one notch above high-yield status.

In parallel, since last November, investment funds have further reduced their liquidity buffers. Cash buffers and liquid asset holdings are now below pre-pandemic levels and are approaching new lows, leaving the sector highly vulnerable to fire sales of assets in the event of large-scale redemptions. Investment funds’ liquidity risk has increased amid a search for yield (see Box 6) over recent years. This underscores the importance of strengthening the resilience of the non-bank financial sector, including from a macroprudential perspective (see Chapter 5).

## Corporate solvency challenges could weigh on sovereigns, households and creditors

Reliance on debt has increased among vulnerable firms, amid higher rollover risks. Debt-to-equity ratios have increased considerably among the most leveraged firms, with the 90th percentile increasing from 220% at end-2019 to over 270% in the final quarter of 2020 (see Chart 4, left panel). Corporate earnings expectations for the euro area have remained below pre-pandemic levels, while corporate funding conditions remained around the tightest levels since the pandemic started, especially for small and medium-sized enterprises (SMEs), highlighting elevated refinancing risks. Higher (risk-free) rates would increase debt servicing costs from historical lows and could raise medium-term risks in countries with elevated debt levels. The substantial increase in liquidity buffers among euro area firms may cushion corporate rollover risks, even though this appears to be particularly relevant for large listed firms.

Solvency risks in the corporate sector are set to rise as public support measures fade. Extensive policy support has kept corporate insolvencies unusually low in a period of extreme economic weakness, unlike during previous crisis episodes (see Chart 4, right panel). The impact of the pandemic on corporates is increasingly concentrated in the services sectors and among SMEs. This implies that a sudden tightening of financing conditions or a further delayed economic recovery could have more severe implications for financial stability than the aggregate picture suggests, in particular in countries heavily reliant on pandemic-sensitive sectors. Therefore, even as the economy recovers, corporate insolvencies are expected to increase from the very low levels observed in 2020, partly driven by a backlog of insolvency cases. As a result, governments face a delicate balance between prematurely adjusting support measures, which may contribute to triggering a wave of corporate insolvencies, and maintaining support measures for too long and thus keeping unviable corporates alive (see Special Feature A).

An increase in corporate insolvencies may impact households via employment prospects, so far prevented by policy support measures. On aggregate, household balance sheets have been cushioned so far, thanks to government income support schemes, record high saving rates, continued robust developments in euro area residential real estate markets and the recovery in stock markets. However, high dependence on government support schemes makes households vulnerable, and their financial and employment situation could worsen in the event of prolonged economic weakness, which may translate into job losses linked to a growing number of corporate insolvencies (see Chart 5, left panel).

At the same time, continued strength in residential real estate markets and mortgage lending has increased household indebtedness and vulnerabilities. The risk of a correction in residential real estate markets has increased amid signs of overvaluation for the euro area as a whole. In contrast to the resilience of residential real estate markets, commercial real estate markets are already facing a substantial market correction (see Chart 5, right panel). A further decline in commercial real estate prices could feed through to the financial system via increased credit risk, decreased collateral values and losses on direct holdings, as well as to lower investment and economic activity by non-financial corporations.

The continued need for policy support may add to medium-term sovereign debt sustainability concerns in more vulnerable countries. The aggregate euro area sovereign debt-to-GDP ratio rose to 100% in 2020, up from 86% of GDP in 2019, as governments have financed extensive economic support to cushion households and firms. Fiscal policy support has been particularly large in some countries with a larger share of economic sectors most impacted by the pandemic and lockdowns (see Chart 6, right panel). As a result, vulnerabilities from the outstanding stock of debt appear higher than in the aftermath of the global financial crisis and the euro area sovereign debt crisis, although debt servicing and rollover risks appear more benign given continued favourable sovereign financing conditions in terms of both pricing and duration (see Chart 6, left panel). Contingent liabilities could increase sovereign debt levels further if the economic situation turns out to be weaker than expected and pandemic-related corporate loan guarantees are called on a broader scale (see Box 2). The associated increase in public debt levels, further delays in the implementation of the EU recovery fund or the emergence of an adverse sovereign-bank-corporate nexus (see Box 4) could trigger a reassessment of sovereign risk by market participants and reignite market pressures on more vulnerable sovereigns. This may render the exit from policy measures more challenging in vulnerable countries with a higher reliance on fiscal support measures.

## Improved market sentiment towards euro area banks, but profitability and asset quality concerns remain

Euro area bank stock prices have recovered markedly from the low levels of October 2020. Bank equity prices have rallied in two waves on positive news about vaccines and reflation expectations. Banks outperformed the overall market, mirroring a wider recovery in previously underperforming stocks. While investors appear to anticipate that a steepening of the yield curve could support bank profitability, analysts’ return on equity (ROE) expectations for 2022 have remained unchanged since last summer (see Chart 7, left panel). Nonetheless, euro area bank valuations remain depressed by both international and historical standards. Improved market sentiment towards banks, coupled with market expectations of an extension of the pandemic emergency purchase programme, have also translated into tighter spreads on bank bonds, further improving market funding conditions for euro area banks.

Nevertheless, the outlook for bank profitability remains weak and the prospects for loan demand are uncertain. Euro area banks’ ROE fell from 5.3% in 2019 to 1.3% in 2020 owing to pandemic-related loan loss provisions and ongoing margin compression in a low interest rate environment (see Chapter 3). Heterogeneity across countries was high, with banking sectors in some countries recording sizeable losses (see Chart 3.4). Despite recently improving market sentiment towards euro area banks, market analysts still expect profitability to recover only gradually, projecting an ROE of 3% and 5% for 2021 and 2022 respectively, given higher provisioning needs and lower expected operating income. The outlook for lending could be challenging as a result of both tighter credit standards and lower corporate credit demand. The former is related to banks’ heightened risk perceptions, while the latter is associated with the adjustment of state guarantee programmes and the need to improve balance sheets.

Early signs of a rise in loan impairments are becoming increasingly visible. Cushioned by large-scale fiscal, monetary and prudential support, bank asset quality has been preserved despite the sharp recession. In fact, the aggregate non-performing loan (NPL) ratio for the euro area reached its lowest level on record at 2.7% in 2020, as banks reduced legacy portfolios. Loan loss provision flows returned to pre-pandemic levels in the second half of 2020. But the normalisation may prove temporary, as early indicators of deteriorating asset quality are becoming increasingly visible, including a rise in forbearance. This is particularly the case in countries where lengthy and costly insolvency procedures inhibit claim enforcement (see Chart 7, right panel). A weaker than expected economic recovery and growing vulnerabilities in the corporate sector may entail higher loan loss provisioning going forward. In addition, as moratoria and public guarantees are gradually adjusted (see Chapter 1 and Box 2), credit risk may reappear with a lag, also implying increased loan loss provisions.

## Climate change may pose material risks to financial stability

Climate-related risks to euro area banks, funds and insurers could be material, particularly if climate change is not mitigated in an orderly fashion. Banks and non-bank financial institutions alike are faced with the task of managing the implications of climate change over the medium to long term (see Special Feature B). Both need to manage their exposure to a transition to a low-carbon economy and their exposure to physical risks associated with extreme weather and climate-related events or more insidious changes in climate (see Chart 8). ECB analysis suggests that such risks appear to be particularly concentrated in certain sectors, geographical regions and individual banks, exacerbating the related implications for financial stability. At the same time, data and methodological gaps still need to be addressed to evaluate climate-related risks comprehensively. In addition, climate-related financial risks that may emerge from the interplay between banks and insurers need to be recognised, with insurance coverage likely deteriorating as extreme weather and climate-related events become more frequent.

Policy action may be required to ensure the resilience of the financial system to climate-related risks. Enhanced climate-related disclosure requirements, including in relation to companies’ forward-looking emission targets, and deeper, more effective green financing are essential steps in a smooth transition towards a sustainable economy and a general reduction of climate-related vulnerabilities. At the same time, possible market failures can stem from data gaps, which would raise the risk of greenwashing. The upcoming ECB climate stress test will also analyse trade-offs in a forward-looking manner, thereby providing a further basis for future policy discussions. Ultimately, given the systemic dimension, considerations about how to mitigate climate-related risks in the financial system require a macroprudential perspective to be effective and to ensure cross-sector consistency.

## Policies should continue to support the recovery, while targeting the build-up of vulnerabilities in selected areas

Extended policy measures have remained key in mitigating the economic costs of the pandemic, but vulnerabilities continue to build up in some areas. With many euro area countries facing renewed surges in infections, lockdown measures have been reinstated and economic support measures maintained. Divergence across countries and sectors has continued to increase, ultimately leading to a concentration of risk that often coincides with pre-existing vulnerabilities in both the real economy and the financial sector. Looking ahead, medium-term vulnerabilities for euro area financial stability remain elevated and relate to: (i) a mispricing of some asset classes, raising the risk of corrections in markets; (ii) growing balance sheet challenges in the public and non-financial private sectors; (iii) weaker bank profitability amid high credit risk exposure; and (iv) further increases in duration, liquidity and credit risks of non-banks. The financial stability implications could be amplified by the emergence of an adverse feedback loop across various sectors of the economy.

Policies should remain broadly accommodative but could be more targeted to support a robust economic recovery amid remaining uncertainty and the potential for credit risk to materialise. Conditional on the economic impact of the pandemic, the extensive policy support, in particular for corporates, could continue to move gradually from being broad based to more targeted. In this context, fast and effective use of the €750 billion Next Generation EU (NGEU) recovery funds would complement national support measures and mitigate cross-country divergences in the coming years. Specifically for banks, capital relief measures should continue to prevent excessive deleveraging, while proper and timely recognition of credit risk would maintain confidence in balance sheets. In this context, it is worth noting the preliminary evidence which suggests that some banks may be reluctant to use available capital buffers, which could in turn affect credit conditions, especially for corporate lending. In the medium term, a higher share of releasable capital buffers could be considered, as it can enhance banks’ ability to absorb losses and maintain the provision of key financial services in a crisis. In addition, concerns related to the expected asset quality deterioration in the banking sector reinforce the need for effective NPL solutions. Given the low interest rate environment and profitability challenges, efforts to address structural issues across banks should be stepped up. Finally, from a broader regulatory perspective, strengthening the banking union and the timely, full and consistent application of Basel III remain key policy priorities for the banking sector going forward.

Further progress towards developing a macroprudential framework for non-banks is expected and would be highly welcome. In particular, the Financial Stability Board is developing recommendations targeting structural vulnerabilities associated with money market funds, open-ended investment funds and margining practices in order to enhance the resilience of the non-bank financial sector. Once issued, they should be swiftly implemented in the European Union as appropriate.

# 1 Macro-financial and credit environment

## 1.1 Increasing concentration of risk in more vulnerable sectors and countries

Economic activity fell amid renewed lockdown measures, but activity has proved more resilient than during the first lockdown. The resurgence of coronavirus cases last autumn caused euro area governments to reinstate tight containment measures, which weighed on economic activity in the euro area in the fourth quarter of 2020 and the first quarter of 2021. At the same time, the economic impact of the second lockdown remained more contained than that of the first lockdown for two reasons. First, containment measures were on average less stringent than in the second quarter of 2020. Second, economic activity has become less sensitive to the stringency of lockdown measures, including across countries with different stringency levels, as firms and households have adapted to the new environment (see Chart 1.1, left panel). This higher resilience is not only visible on average, but also when comparing countries with different levels of stringency.

Slack in labour markets and subdued investment could point to a sluggish recovery. Although economic activity recovered to some extent in the second half of 2020, the number of employees and total hours worked remain substantially below pre-pandemic levels (see Chart 1.1, right panel). While hours worked are likely to rebound once employees on short-time work return to full-time work, the high share of laid-off workers who left the labour force altogether could herald a more persistent disruption to labour markets. Non-employed workers, especially from sectors that face a more permanent drop in demand, could face difficulties in re-entering the labour market after the pandemic, which would weigh on economic growth. Similarly, investment remains subdued, reflecting firms’ uncertainty about the timing of the pandemic and their own growth prospects after the pandemic subsides (see Chart 1.1, right panel). Looking back at the global financial crisis as a precedent, a slow recovery of investment may also be a harbinger of a more sluggish recovery from the pandemic than the swift rebound in consumption suggests.

While the availability of vaccines has improved the medium-term economic outlook, uncertainties remain in the near term. The approval of multiple vaccines in late 2020 and early 2021 improved the economic outlook for the euro area and reduced the uncertainty about the length of the pandemic. While this has boosted the growth prospects for 2022, the ongoing containment measures weigh on the near-term outlook (see Chart 1.2, left panel). In addition, the slow start to the vaccine roll-out in the euro area makes it unclear when the euro area will reach herd immunity and return to normal economic activity. Moreover, the virus continuing to evolve poses considerable tail risks as vaccine-resistant mutations may yet emerge, necessitating a prolonged period of constrained social and economic activity.

The slow start to the vaccination campaign and a more moderate fiscal stance may leave the euro area lagging its advanced economy peers. The euro area was initially much slower than other advanced economies to ramp up vaccination (see Chart 1.2, right panel). As the pace of vaccination in the euro area picks up, however, this gap is narrowing. Nonetheless, the euro area may take longer than the United States or the United Kingdom to reach herd immunity depending on the further vaccination progress, which would allow for a return to normal. In addition, euro area governments have adopted a more moderate fiscal stance relative to GDP and compared with the respective output gap than the US administration in 2021. Although the “Biden package” of USD 1.9 trillion is expected to generate positive spillovers of up to 0.3% of real GDP for the euro area, the more accommodative fiscal stance in the United States could further increase the divergence between the two economic areas. Such a disparity in growth prospects could create upward pressure on real interest rates in the euro area and tighten overall financing conditions to the detriment of euro area corporates, households and sovereigns.

Global risks remain contained, and emerging markets proved resilient as policy uncertainty in the United Kingdom and the United States fell. Despite the economic challenges and the slow global vaccination roll-out, financial conditions and capital flows in emerging markets have remained fairly resilient so far. These dynamics are, however, highly dependent on global risk appetite and monetary policy accommodation in advanced economies (see Box 1). The agreement of a trade deal between the United Kingdom and the European Union at the end of 2020 and the transition to a new administration in the United States have reduced policy uncertainty in both the United Kingdom and the United States. At the same time, the tensions relating to export controls on vaccines highlight the importance of trade in overcoming the pandemic, but also its fragility.

The divergence across sectors widened as containment measures became more targeted. The gradual reopening and the more targeted containment measures during the second lockdown allowed less badly affected sectors to widely resume normal activity, whereas services such as tourism, entertainment and travel to a large extent remained shut (see Chart 1.3, left panel). Consequently, the most affected sectors were not only hit most in the first half of 2020, but also rebounded less relative to the initial drop in the second half of 2020, increasing the divergence across sectors (see Chart 1.3, right panel). This divergence may widen further if the slow roll-out of vaccines necessitates continued containment measures over the summer tourism season, especially in southern European countries.

Continued cross-sectoral divergence could trigger a costly reallocation of resources. The widening sectoral divergence poses risks to financial stability for two reasons. First, the most affected sectors face more severe liquidity and solvency risks than aggregate economic indicators suggest, and the materialisation of these risks could trigger an unravelling of macro-financial imbalances with adverse spillovers to other sectors. Second, the continued divergence will at some stage lead to a reallocation of resources from the most affected sectors to sectors with better growth prospects. The costs associated with such a cross-sectoral reallocation of resources, for example due to retraining of workers, could further weigh on the strength and pace of the economic recovery in the short to medium term.

## Box 1 Emerging markets’ vulnerability to a reassessment of risk

Prepared by Irina Balteanu and Livia Chiṭu[1]

Financial conditions in emerging market economies (EMEs) have weathered the COVID-19 crisis well so far, despite an intense but short-lived stress episode at the onset of the pandemic. Financial conditions in EMEs have rebounded strongly since March 2020; they currently stand at levels similar to before the pandemic thanks to lower bond spreads and higher equity prices. Capital flows have also recovered, with market segments typically judged to be riskier by foreign investors, such as equity and local currency debt, recording strong inflows in the second half of last year. This rebound helped to relieve pressures on financial systems and support activity in EMEs. Nevertheless, recent concerns about rising bond yields and higher than expected inflation in advanced economies have translated in a tightening of financial conditions and slowdown of capital flows to EMEs. In this context, this box assesses potential vulnerabilities facing large EMEs and the risks posed to euro area financial stability.

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## 1.2 Benign financing conditions limit debt sustainability risks

The pandemic continues to weigh on fiscal budgets in 2021 as governments extend support measures. When governments reinstated strict containment measures at the end of last year, they also extended existing support measures to cushion the economic impact on firms and households. As a consequence, fiscal deficits in 2021 will be higher than projected last autumn and are expected to exceed the deficit in 2020 for the euro area as a whole (see Chart 1.4, left panel). In addition to existing liquidity support measures, governments started shifting more towards solvency support, for example by replacing government-guaranteed loans with grants or by injecting capital into larger, often state-associated companies. While the shift towards solvency support may be more effective in supporting weaker corporates which increasingly face solvency rather than liquidity problems, it also weighs on fiscal budgets more directly than indirect support measures that constitute contingent liabilities (see Box 2).

Extending the general escape clause of the Stability and Growth Pact until the end of 2022 could pre-empt a premature fiscal tightening. Current projections indicate that, due to the economic fallout from the pandemic, governments will continue to run up considerable fiscal deficits in 2022. As the deficits in more than half of the euro area countries are projected to exceed the 3% criterion in 2022, deactivating the escape clause at the end of 2021 might trigger a premature fiscal tightening in 2022. Extending the use of the clause this year already gives governments greater certainty about fiscal space going forward, which reduces the risk of an expectations-driven adverse spiral of reduced fiscal support, tighter corporate financing conditions and a further contraction in economic activity (see Box 4). At the same time, a strong rebound in economic activity would alleviate the need for additional fiscal support and thereby cushion the impact of already reinstating the Stability and Growth Pact rules in 2022.In addition, some stabilisation measures may be phased out as the economy recovers without a major contractionary impact.

Even so, the recent increase in sovereign debt will have less of an impact on fiscal budgets than would have been the case in previous crises. The steady decline in government bond yields has reduced the average gross interest payments of euro area sovereigns despite higher debt-to-GDP ratios than in 2009 (see Chart 1.4, right panel). Aside from this effect, lower interest rates also imply that gross interest payments are less sensitive to changes in debt-to-GDP ratios over time. In 2009, a country with a debt-to-GDP ratio that was 10 percentage points higher on average faced gross interest payments that were 0.4 percentage points higher. That elasticity has shrunk by half since 2009, to 0.2 percentage points. As a consequence, increases in sovereign debt levels due to unexpected events such as the pandemic impose a smaller burden on fiscal budgets, which implies that sovereign balance sheets are more resilient to exogenous shocks than at the time of the global financial crisis. Nevertheless, a sustained rise in sovereign bond yields could raise refinancing costs for governments, which would have a negative effect on sovereign debt sustainability in the medium to long run.

Governments locked in low interest rates in the second half of 2020 and early 2021 by issuing longer maturity debt, thus reducing rollover risk. Between December 2019 and March 2021, average sovereign bond yields declined by 43 basis points in the euro area, supported by accommodative monetary policy. Following an initial surge in short-term debt issuance last spring, governments locked in these favourable financing conditions by shifting their net issuance towards longer-term debt, in particular bonds with maturities of more than five years (see Chart 1.5, left panel and Chapter 2). This has not been affected so far by the recent rise in sovereign bond yields. Accordingly, the average residual maturity of sovereign debt increased by four months between May 2020 and March 2021.

Low interest rates coupled with longer maturities partially offset the adverse impact of higher debt levels on debt service ratios. The large increase in sovereign debt-to-GDP ratios in 2020 increased the debt service ratio[2] relative to GDP for all euro area countries (see Chart 1.5, right panel). At the same time, longer maturities and to a lesser extent lower rates alleviated the increase in debt service ratios for sovereigns, especially in countries where debt-to-GDP ratios have increased significantly. In addition, approximately 35% of the increase in the euro area debt-to-GDP ratio is driven by the drop in GDP. As the economy recovers, this denominator effect will subside, further easing the debt service ratio and the rollover risk of sovereign debt. In addition, governments continue to hold sizeable deposits with the Eurosystem, which further cushions short-term debt servicing needs.

The effectiveness of the EU recovery package is constrained by countries’ absorption capacity and depends on the productive use of the funds. The €750 billion Next Generation EU (NGEU) package can complement national fiscal support measures in the coming years and help sustain the recovery without national budgets being directly negatively affected.[3] However, historical absorption rates of structural EU funds show that Member States would need to absorb the NGEU funds at an unprecedented pace to make full use of the package (see Chart 1.6, left panel).[4] Based on the absorption rates of year 6 in the 2007-13 multiannual financial framework (MFF), up to 55% of the more than €300 billion in grants contained in the NGEU Recovery and Resilience Facility (RRF) may remain unused (see Chart 1.6, right panel).[5] The lack of absorption capacity in the worst affected countries in particular may impede the disbursement of the NGEU funds, which could further exacerbate the cross-country divergence following the pandemic and potentially spur refragmentation pressures in sovereign bond markets. In addition, the need to absorb NGEU funds quickly may compromise the efficient and productive use of those funds.

While favourable financing conditions mitigate short-term risks in the public sector, the continued need for fiscal support poses medium-term risks. Although financing conditions have limited the impact of increased sovereign debt levels on fiscal budgets and debt service costs, the pandemic continues to take a substantial toll on fiscal budgets. The need to extend existing support measures and retain automatic stabilisers will keep fiscal budgets tightly linked to the evolution of the pandemic. In addition, the adverse impact of continued containment measures on corporate balance sheets increases the risk that contingent liabilities will materialise and further strain public budgets (see Box 2). Finally, a sudden rise in interest rates could raise concerns about the sustainability of sovereign debt over the medium term, although the impact on sovereigns’ debt service needs would be alleviated by the extended average maturity of sovereign debt portfolios.

## Box 2 Contingent liabilities: past materialisations and present risks

Prepared by Sándor Gardó, Benjamin Hartung, Mariusz Jarmuzek and Algirdas Prapiestis

Fiscal policy support has mitigated financial stability risks during the pandemic, but the vulnerabilities arising from contingent liabilities have increased for euro area sovereigns. National policy responses to support households and firms during the pandemic directly increased the aggregate euro area general government debt-to-GDP level by around 14 percentage points to around 100% of GDP in 2020. Additionally, public guarantee schemes that were introduced in 2020 constitute sizeable contingent liabilities for governments in most euro area countries, adding to the stock of both existing government guarantees and other implicit contingent liabilities, which reinforces concerns about the emergence of an adverse sovereign-bank-corporate nexus. Against this backdrop, this box presents historical evidence from contingent liability materialisations, investigates their commonalities and differences with the situation under the current pandemic-induced shock and assesses the ensuing risk for sovereigns.

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## 1.3 Aggregate household resilience masks uneven impact of the pandemic

Households’ economic sentiment has improved on hopes of a swift economic recovery, although uncertainty about employment lingers. Survey-based measures of economic confidence started to improve at the end of 2020 when the vaccine roll-out began (see Chart 1.7, left panel). Despite the overall improvement in sentiment, forward-looking measures of unemployment continue to signal a deterioration in employment prospects. The euro area aggregate sentiment masks considerable differences between euro area countries, reflecting the uneven impact of the pandemic on households across the euro area. Households that report the largest deterioration in their financial situation over the last year also show the highest unemployment expectations for the coming 12 months, leaving them in a vulnerable position when support measures are scaled back (see Chart 1.7, right panel).

Cushioned household income, excess savings and record high net worth have increased the overall financial resilience of households. Despite recovering from the initial shock of the pandemic, disposable income remains reliant on government support in the form of higher net social transfers (see Chart 1.8, left panel). Moreover, households saved a significant amount of their income as containment measures limited spending on durable goods.[6] Cumulative excess savings compared to the pre-pandemic savings rate stood at around 4% of GDP in the fourth quarter of 2020. Whether pent-up demand will translate into higher future consumption remains uncertain, despite a large share of the excess savings ending up in deposit accounts (see Chart 1.8, middle panel). Excess savings are likely held by higher-income households, which have a lower marginal propensity to consume. Finally, robust house price growth and recovering stock prices continued to support net wealth, causing this metric to surge to 754% of disposable income in 2020 (see Section 1.5).

The increase in aggregate household financial wealth masks considerable differences across countries and income groups. Low-income individuals and countries that already exhibited slow economic growth before the pandemic are affected disproportionately. For this group of households, dependence on policy support measures remains high (see Chart 1.8, right panel). Moreover, there are indications of tighter access to credit combined with cliff effects on their expenditure stemming from the phasing out of moratoria and other economic support policies. Strains on this group of households are likely to intensify if support is dialled back prematurely, resulting in lower consumption and a lower debt service capacity.

Household borrowing varies significantly across different types of credit (see Chart 1.9, left panel). Growth in aggregate bank lending to households stabilised at 3% from the start of 2020, mainly on account of a 5% increase in lending for house purchase. Consumer credit declined by 2%, reflecting the ongoing impact of the tighter COVID-19 restrictions on consumer confidence and demand for durable goods. Going forward, a further moderation in banks’ risk perceptions towards households might support looser credit standards and boost consumption when lockdown measures are scaled back and the economy fully reopens (see Chart 1.9, middle panel).

Government schemes and record low debt servicing costs have helped to make household debt more sustainable. So far, the pandemic has had a relatively modest impact on household debt ratios, as disposable income increased while spending opportunities were limited during lockdowns. As a result, nominal household debt increased at a slower pace in the first half of 2020 compared to the pre-pandemic path (see Chart 1.9, right panel), while the debt-to-liquid assets ratio declined to 76% in the fourth of 2020. In addition, very low interest rates have driven debt servicing costs down to all-time lows, with interest payments as a share of disposable income falling to 2.2%. Households increasingly favoured fixed rate mortgages in new annual credit flows over variable rate alternatives, further contributing to lower overall vulnerability. As a result, the share of fixed rate mortgages had increased to 59% in March 2021 compared to just 47% in March 2016.

Overall, financial stability risks stemming from the household sector have been less pronounced than previously anticipated. With stronger balance sheets, robust net wealth and record low debt servicing costs, households have built up some capacity to weather economic headwinds. However, lower-income workers have not generally benefited from mitigating factors in the form of higher financial wealth, leaving them in a potentially vulnerable position when policy support is scaled back. In addition, household resilience remains highly contingent on the extent to which corporate insolvencies rise, as this could translate into significantly higher unemployment. Whether these risks materialise will depend on the ability of governments to keep supporting the households that have been hardest hit by the pandemic, especially in those countries where the take-up of policy support is substantial, residential properties are overvalued and debt levels are elevated.

## 1.4 Corporate solvency risks on the rise

Weak revenues and low profit margins continue to weigh on corporate profits, gradually raising the pressure on corporate solvency. Similar to previous recessions, gross corporate profits declined more than gross value added in 2020, as squeezed profit margins added to the fall in corporate revenues (see Chart 1.10, left panel). Although both profits and revenues were more resilient in the second wave than during the initial phase of the pandemic, their continued decline added to the total shortfall compared with 2019 levels. In total, corporate profits in 2020 were 8.1% below gross profits in 2019. Consequently, retained earnings (measured by gross savings) dropped substantially, unlike in the global financial crisis when they recovered during the first year of the recession. This sharp and persistent drop in corporate savings limits the scope for new investment going forward, although firms may use available cash buffers to support capital accumulation.

Aggregate liquidity and capital buffers conceal a divergence across corporates, as risks rise for cash-strapped and overindebted firms. On aggregate, the considerable increase in gross debt has so far largely been offset by a similar rise in corporate holdings of liquid assets. Granular data for listed firms confirm that corporates took on more debt to build up precautionary liquidity buffers as the correlation between changes in gross debt and changes in cash buffers across firms increased (see Chart 1.10, middle panel). However, this effect is particularly prominent for large listed corporates whereas SMEs, which were more heavily affected by the pandemic and are less likely to have access to market-based funding, face more severe liquidity challenges. The concentration of liquidity risk among the most vulnerable corporates implies that a sudden tightening of financing conditions or a protracted economic recovery could have more severe consequences for financial stability than the aggregate picture suggests. In addition, liquidity problems increasingly morph into solvency issues – while the first wave of the pandemic was characterised by bond issuance and bank borrowing to meet liquidity needs, firms have recently issued more equity (see Chart 1.10, right panel). Among listed firms, however, equity issuance has been concentrated in a few firms, especially in the technology sector, which tend to have benefited from the pandemic.

More recently, corporate credit growth has slowed, reflecting both corporates deferring investment and banks tightening lending conditions. In the second half of 2020, demand for bank loans slowed abruptly as bank lending conditions tightened and the need to bridge working capital needs subsided (see Chart 1.11, left panel), especially in the worst affected sector, services. Besides the drop in demand for liquidity and the more cautious risk perceptions of banks, the slowdown in bank lending to corporates also reflects the reduced willingness of firms to invest in fixed capital while uncertainty remains about the timing and pace of the economic recovery. However, the subdued investment activity could also indicate a more structural pessimism about the viability of certain business models or the limited scope for new investments amid elevated debt levels. That in turn would have a more lasting impact on the economic recovery and corporate balance sheets. Moreover, building up liquidity buffers in the early stages of the pandemic has shielded some firms from revenue shortfalls and reduced the subsequent need for additional external financing.

Government-guaranteed loans may have become less effective in supporting corporate financing conditions. Following the large take-up of guaranteed loans in the second quarter of 2020, the demand for such loans has dropped sharply in tandem with the slowdown in new bank loans to corporates in the second half of 2020 (see Chart 1.11, middle panel). Looking ahead, the take-up of government-guaranteed loans is likely to fall further, as guarantees appear to have become less effective in supporting corporate financing conditions. Throughout 2020, credit standards eased considerably for guaranteed loans while tightening for non-guaranteed loans (see Chart 1.11, right panel). However, this gap in credit standards between guaranteed and non-guaranteed loans is projected to narrow in the first half of 2021. Also, overindebted corporates may be unwilling to take on additional debt, given the uncertain outlook.

Smaller firms benefited most from government guarantees but are particularly affected by a recent tightening of bank lending conditions. SMEs have been more likely to resort to government-guaranteed loans than larger firms, given their reliance on bank lending and the disproportionate impact of the pandemic on smaller enterprises. They have also been more likely to benefit from the benign effect of guarantees on credit standards, as they faced a sharper tightening of credit conditions for non-guaranteed loans (see Chart 1.11, right panel). The projected tightening of credit standards on guaranteed loans therefore disproportionately affects SMEs.

An abrupt increase in bankruptcies could challenge insolvency frameworks and impede the efficient reallocation of resources. Despite the unprecedented fall in corporate revenues and profits, bankruptcies in the euro area decreased by approximately 20% in 2020 relative to 2019 levels as public authorities provided policy support and in some cases suspended mandatory insolvency filings. Dealing with such a backlog of delayed bankruptcies would prove a challenge for judicial systems even in normal times. Although corporate solvency is likely to be more resilient than historical comparisons suggest, given the relatively swift recovery and the sizeable policy support, the number of insolvencies-in-waiting could still be higher than the current expected default frequency suggests (see Chart 1.12, left panel). Once support measures end, bankruptcy courts could therefore see an abrupt increase in insolvency filings, which could lead to the legal system becoming congested and insolvent firms taking longer to be resolved. That in turn could result in an inefficient and delayed reallocation of resources to more viable businesses, with adverse macroeconomic consequences in the medium term. Public authorities should therefore ensure that insolvency frameworks are sufficiently resourced to deal with a higher number of corporate insolvencies (see Chart 1.12, right panel).

Given the uncertain outlook for the viability of business models, targeting policy support towards viable firms remains challenging. Ideally, the broad-based liquidity support measures that shaped the early phase of the pandemic would be superseded by more targeted measures that help viable firms remain solvent. However, assessing corporate viability remains challenging in the light of the uncertain economic outlook and the post-pandemic prospects of different business models. While broad-based measures may lead to some misallocation of resources to non-viable firms (see Special Feature A), the alternative of withdrawing support to viable firms too early may have even more adverse consequences.

## 1.5 Euro area property market cycles diverge further

Euro area residential real estate (RRE) prices continued rising throughout the fourth quarter of 2020. At the euro area level, nominal house prices increased by 5.8% in the last quarter of 2020 (see Chart 1.13, left panel). While on aggregate prices continued to trend upwards in the euro area, growth rates varied widely across countries (see Chart 1.13, middle panel). The overall resilience observed in housing markets reflects several factors. First, household income has largely recovered as a result of the continued policy support and a rebound in economic activity. Second, the low interest rate environment and elevated macro uncertainty continue to put a floor under demand, as housing is perceived as a safe investment. Third, subdued construction activity in the second half of 2020 weighed on housing supply, adding upward pressure on prices, especially in markets with already tight housing supply.

A combination of buoyant house price growth and the uncertain macro backdrop kept measures of overvaluation elevated. Moreover, house price growth during the pandemic has generally been higher for those countries that were already experiencing pronounced estimated overvaluation prior to the pandemic (see Chart 1.13, middle panel). While providing a consistent set of benchmarks across countries, measures for overvaluation are surrounded by significant uncertainty and may be sensitive to country-level specificities, such as tax treatment or structural property market characteristics. In addition to elevated valuation measures, risks related to household indebtedness remain high for some countries, as credit for house purchase has continued to increase (see Section 1.3). This adds to the already elevated vulnerabilities that had accumulated in some euro area countries before the pandemic started.

Estimates of downside risk to house prices signal an expected slowdown of price growth in the coming year (see Chart 1.13, right panel). Despite high measures of overvaluation in some euro area countries, house price growth is expected to moderate, but prices are not expected to decline in the coming year. This expectation mainly reflects the improved economic outlook and overall more robust household balance sheets. Moreover, results from the bank lending survey also indicate credit standards for loans to households for house purchase eased slightly in net terms in the first quarter of 2021, possibly further supporting demand. However, future RRE price developments remain highly dependent on the recovery path and the ability of policymakers to prevent cliff edges by not abruptly ending support measures, especially given much of the resilience observed in household balance sheets is a direct result of policy support measures (see Section 1.3).

In contrast to the residential market, the pandemic sparked a price correction in the commercial real estate (CRE) market. Prices for prime CRE declined in the fourth quarter of 2020, albeit with large difference between those sectors hit hardest by the pandemic (retail) and those less affected (office) (see Overview chapter). Moreover, market intelligence suggests that prices in prime locations might also have been impacted less, as high-quality assets are typically easier to adapt to changing demand. Survey data indicate that the CRE market entered a downturn in the second quarter of 2020. Moreover, rising overvaluation in recent years has left room for a substantial price correction, as a majority of investors indicate that valuations have not bottomed out yet (see Chart 1.14, left panel). Also, activity remained at levels around half of the long-run average, potentially masking a further decline in property prices.

A sharper CRE market correction could have implications for bank balance sheets and introduce negative economic feedback loops. A further decline in CRE prices could feed through to the financial system via increased credit risk, decreased collateral values and losses on direct holdings. Bank lending to the CRE segment accounts for 7% of exposure to the non-financial private sector in the euro area, although levels vary substantially across countries. A significant drop in CRE prices could result in lower investment and economic activity by non-financial corporates, as CRE is often used as collateral to obtain finance. Survey data show that over half of survey participants have seen financing conditions deteriorate each quarter since the outbreak of the pandemic (see Chart 1.14, right panel). In addition, a further price correction may also spark procyclical behaviour within the financial system when risk exposure is reduced, loan loss provisions fall, and lending standards tighten. Moreover, a combination of low market liquidity and high redemption pressure on CRE investment funds could amplify the price decline and lead to fire sales, further increasing negative feedback loops.

Risks to financial stability stemming from real estate markets remain elevated. A sharper than expected decline in CRE valuations might set off negative economic feedback loops, while the RRE market might prove vulnerable to a withdrawal of policy support measures. Against this background, the financial sector may be exposed to the risk of corrections in the real estate market, especially in those countries where debt levels are elevated and policy support measures contribute significantly to household income.

# 2 Financial markets

## 2.1 Partial spillover of risks from rising US rates

A rise in US government bond yields led global sovereign bond yields higher, with euro area yield curves also steepening mildly. Rising US yields in recent months reflected the combination of a substantial fiscal stimulus package and optimism around vaccine roll-outs. The bond market sell-off also spilled over to some degree to other advanced economies, resulting in a mild steepening of the euro area GDP-weighted yield curve (see Chart 2.1, left panel). 2021 has seen the largest upward move in the ten-year US Treasury yield since the “taper tantrum” in 2013. However, the drivers of the yield change in 2021 appear more benign than in 2013, as a much smaller share relates to uncertainty on the outlook for US monetary policy (see Chart 2.1, middle panel). Foreign spillovers also explain a structurally increasing share of the euro area term premium (see Chart 2.1 right panel). Excessive increases in yields not motivated by domestic fundamentals threaten to unduly tighten financial conditions, if a rise in US yields has a large spillover effect on the euro area.

Euro area risk-free rates have risen only mildly, partly reflecting continued emphasis on accommodative monetary policy. Ten-year euro area risk-free rates moved back to pre-pandemic levels as the inflation component of risk-free rates increased to its highest level since the end of 2018 (see Chart 2.2, left panel). This reflects an improved economic outlook and a reassessment by investors of the balance of risks around the inflation outlook. In December 2020, alongside other monetary policy measures the Governing Council decided to recalibrate TLTRO III conditions and also to expand the pandemic emergency purchase programme envelope, where bond purchases were to be significantly stepped up in the second quarter of 2021.[7] The monetary policy measures help preserve favourable financing conditions, which are vital as countries take steps to re-open their economies.

The strong rise in US yields compared with euro area yields may affect global capital flows in the medium term. In recent years, FX hedged yields on ten-year US Treasuries have been relatively unattractive. However, the rise in US Treasury yields, which in February was reinforced by the largest foreign outflows since April 2020, has made this asset class more appealing. For Japanese investors, US Treasuries currently offer a higher FX hedged yield and a better credit rating than some of the largest euro area sovereign bond markets (see Chart 2.2, right panel).[8] This change could generate wider shifts in investor and capital flows and may lessen overseas demand for euro area sovereign bonds.

A sustained rise in interest rates would expose investors to valuation losses on their bond holdings. The aggregate amount of duration risk in the bond market has risen steadily in recent years on the back of increasing amounts of outstanding bonds, longer maturities and declining interest rates (see Chart 2.3, left panel). Sustained rises in interest rates would have a larger negative impact on the value of investors’ debt holdings, with major implications for institutional investors (see Chapter 4).

Current sovereign CDS spreads across a range of advanced and emerging market economies may indicate some complacency relative to credit ratings. The current long-term credit rating mapping with five-year CDS spreads is somewhat flatter than in the period after the global financial crisis, suggesting more benign pricing of sovereign risk (see Chart 2.3, right panel). This reflects a longer-term global trend which has seen the credit quality of many sovereigns decline, but their CDS spreads compress further at the same time. Further downgrades cannot be ruled out in an adverse scenario, with possible non-linear effects on credit risk pricing. At the same time, the current benign financing conditions have eased debt sustainability risks for many sovereigns in the short term, and the EU recovery package may further mitigate such risks for euro area countries (see Chapter 1).

## 2.2 Robust risk sentiment with pockets of market exuberance

Risk sentiment remained robust as the global growth outlook improved. Risk sentiment indices continued to recover in 2021 on the back of higher expected growth rates and optimism surrounding vaccine roll-outs (see Chapter 1), especially in the United States. While both the United States and the euro area are benefiting from continued accommodative monetary policy, risk sentiment in the United States has moved further ahead, boosted by the sizeable fiscal stimulus programmes (see Chart 2.4, left panel). Recent corporate earnings data appear to partly validate this optimism. However, some degree of uncertainty lingers, for example around the corporate earnings outlook and the pace of re-opening of some economies. This may leave room for disappointment.

The rise in interest rates weighed on some more exuberant equity market segments, while broad-based equity indices continued to advance. Indices tracking newly listed entities (IPOs), special purpose acquisition companies (SPAC) and non-profitable technology firms saw large price gains during the market recovery. A shared trait of these companies is that their profit expectations are more uncertain, and/or concentrated more in the future, than for the average firm. Their share prices have benefited from historically low interest rates, as this increases the net present value of their cash flows and pushes investors to riskier segments in their search for yield. However, as the rise in US Treasury yields accelerated in February, these equity indices declined. By contrast, equity indices covering more established companies – including the S&P 500 and EURO STOXX – continued advancing overall, less impacted by the rise in risk-free discount rates with bank stocks outperforming technology stocks (see Chart 2.4, right panel). This distinction highlights the disparate impact from rising rates across the stock market universe.

Some pockets of speculative activity emerged amid the robust risk sentiment, prompting extraordinary price volatility in specific sections of US equity markets. At the end of January 2021, groups of retail investors bought several US small cap stocks where leveraged investors had large short exposures. Their actions, coordinated on social media, pushed those stock prices to high levels, thereby imposing substantial losses on short sellers such as hedge funds that were forced to buy the underlying shares to close their positions. Equity call options, the volumes of which have increased noticeably in the United States since 2019, possibly further contributed to the price surges, as sellers typically hedge by buying the underlying stocks as well. While the price volatility was extraordinary in individual stocks, likely amplified in some cases by the unwinding of option hedges and resulting in restrained trading activities on some retail brokerage platforms, it had limited spillover effects to broader market volatility (see Chart 2.5, left panel). Separately, Archegos Capital Management (ACM) had built up large positions in several US and Chinese stocks through equity derivatives with built-in leverage. In March ACM defaulted on margin calls following a failed stock offering and associated equity price fall. Several of ACM’s prime brokers were forced to liquidate stocks, with a few non-US banks suffering large losses. These episodes serve as a reminder that intense speculation, especially if leveraged, can cause financial institutions to suffer concentrated losses.

The significant price volatility raises questions about the transparency and degree of leverage in financial markets. The overall leverage used by some non-bank market participants sometimes falls outside the regulatory perimeter. While data limitations make it impossible to gain a full picture of stock market leverage, available data suggest it has been increasing. In the United States, the debit balances in customers’ securities margin accounts reported to the Financial Industry Regulatory Authority (FINRA) increased by 72% over the last year to a record USD 823 billion in March 2021. However, margin debt as a proportion of stock market capitalisation remains well below previous peaks. EMIR data reported by euro area counterparties show an increase in the notional value of equity swaps and contracts for differences to nearly €15 trillion (see Chart 2.5, right panel). Survey-based evidence also suggests that hedge funds are increasingly using previously unutilised leverage capacity in euro-denominated securities financing and over-the-counter derivatives markets.[9]

Signs of exuberance have also been observed in the renewed interest in crypto-assets, although financial stability risks appear limited. The surge in bitcoin prices has eclipsed previous financial bubbles like the “tulip mania” and the South Sea Bubble in the 1600s and 1700s.[10] While this has largely been driven by retail investors, some institutional investors and non-financial corporations are also demonstrating a growing interest. Its price volatility makes bitcoin risky and speculative,[11] while its exorbitant carbon footprint and potential use for illicit purposes are grounds for concern. Crypto-assets are still not used widely for payments, and euro area institutions have little exposure to crypto-linked financial instruments, so financial stability risks appear limited at present.

## 2.3 Sharp increases in interest rates may reveal vulnerabilities in risk assets

A sharp rise in interest rates could prompt an adjustment in risk asset valuations, with possible adverse implications for financial stability. Standard price/earnings (P/E) ratios are more stretched in the United States than the euro area. This partly reflects sectoral compositions, as US equity indices have a larger share of technology companies with higher P/E ratios, for example. There is also a marked skewness in the distribution of forward P/E ratios across firms in both the United States and the euro area, with a larger share of firms exhibiting stretched valuations than in the past (see Chart 2.6, left panel). When the opportunity cost of holding risk-free assets is taken into account, valuations look less stretched. They remain near long-term averages, as investors do not yet appear to have reduced their risk-compensation preferences substantially (see Chart 2.6, right panel). Real risk-free rates have declined to historically low levels over the last two decades and current valuations may rely in part on expectations that risk-free rates will remain very low for a protracted period. That said, the rise in yields this year has produced some headwinds for equities. Risk asset valuations may become vulnerable in a scenario where risk-free rates increase sharply and sustainably as a result of investors reassessing the likelihood and pace of monetary policy tightening without an accompanying improvement in real growth (see Box 3).

## Box 3 Risk of spillovers from US equity market corrections to euro area markets and financial conditions

Prepared by Magdalena Grothe, Tobias Helmersson, Dominic Quint and Danilo Vassallo

US equity market prices have surged over the last year, prompting concerns about stretched valuations and the potential risk of market corrections. Cyclically adjusted price/earnings (P/E) ratios for the United States have reached historically high levels over the last year (see Chart A, left panel). In the past, periods of elevated valuations relative to earnings have tended to be followed by substantial market downturns. In view of these developments, this box examines the implications of a possible correction in US stock prices for euro area financial conditions and financial stability.

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Easy credit market pricing may also be vulnerable to price corrections. Median euro area corporate CDS spreads are near multi-year lows, while corporate leverage has increased to cyclical highs (see Chart 2.7, left panel). Large listed corporates took on more debt and built cash buffers, which may be a sign of financial strength to weather the pandemic. If corporate leverage remains elevated, however, market pricing may become vulnerable in the event of a renewed economic downturn. Moreover, bond spreads across euro-denominated bond instruments per unit of duration remain at the low end of the historical range after the global financial crisis, providing investors with low compensation for the degree of risk they assume (see Chart 2.7, middle panel) (see also Chapter 4). Furthermore, the range of corporate bond spreads around the median has also narrowed to near the tightest levels seen since 2009, indicating a continuation of the search for yield that has characterised financial markets in recent years (see Chart 2.7, right panel). European leveraged loan markets show a similar picture, with tight secondary market spreads close to pre-pandemic lows and low spreads per turn of leverage (see Chart A.4, left panel in Special Feature A). The average leverage ratio of newly originated loans remains near its highest level since the global financial crisis, with the share of loans with high leverage (>6x) increasing further. Default rates peaked in the third quarter of 2020 but remained benign and well below levels seen in previous crises. However, they may rise as fiscal support is withdrawn.

Corporate bond spreads have been supported by an improvement in the economic outlook together with supportive monetary policy. A number of forward-looking credit risk metrics have improved since the last Financial Stability Review, on the back of the improved macroeconomic outlook. For example, the share of non-financial corporations on the brink of a downgrade to non-investment grade has fallen back from the peak in the last quarter of 2020, and expected default frequencies have declined as well. The flexibility of purchases under the ECB’s pandemic emergency purchase programme (PEPP) is helping to support the smooth transmission of monetary policy. Furthermore, corporate bond spreads proved resilient to somewhat higher volatility in interest rate markets at the beginning of 2021 (see Chart 2.8, left panel). In addition, the favourable terms and large take-up of TLTRO III are supporting bank lending to non-financial corporations which, together with precautionary bond market funding, has helped to reduce funding rollover risk. At the same time, sentiment may be vulnerable to a deterioration in the economic outlook, as the solvency concerns for many companies may only fully surface once fiscal support measures are phased out (see Chapter 1).

Emerging market capital flows have so far been relatively resilient to the rise in yields. Many emerging market economies (EMEs) entered the coronavirus crisis with stronger fundamentals and a better cyclical position than before the global financial crisis. EME financial conditions have also improved markedly since the pandemic shock, and the recovery in capital flows since March 2020 has primarily been driven by the turnaround in global risk appetite. So far, capital flows have been relatively resilient to the rise in yields this year, particularly in contrast with the taper tantrum episode in 2013 (see Chart 2.8, right panel). This appears to confirm the observation that even though the yield moves have been similar in size, the composition of drivers this time paint a more benign economic picture (see Chart 2.1, middle panel). In addition, most EMEs are less dependent on external financing than in 2013, which mitigates the impact of a potential capital flow reversal.[12] However, push factors such as monetary policy in advanced economies, as well as contagion from market turbulence in neighbouring countries, are typical triggers of sudden stops in EME capital flows. This means that major challenges related to a tightening in financial conditions and associated capital flow volatility cannot be ruled out for countries with large external financing needs and elevated debt levels, should advanced economy monetary policies tighten faster than expected (see Box 1).

# 3 Euro area banking sector

## 3.1 Increasing signs of asset quality deterioration

The aggregate non-performing loan (NPL) ratio of euro area banks fell further to 2.7% in the fourth quarter of 2020, mainly reflecting the disposal of legacy NPL assets. In the midst of the pandemic, banks in countries more affected by previous crises (Cyprus, Greece, Italy and Portugal) have managed to continue reducing their NPL ratios by up to 9 percentage points. NPL ratios are the highest for loans to small and medium-sized enterprises (SMEs) (6.7%) and the lowest for mortgage lending (2.7%).

Forward-looking metrics, however, indicate a significant weakening of asset quality, although actual loan losses remain modest. The share of performing loans with forbearance measures increased and the fraction of loans classified as unlikely to pay bottomed out in the course of 2020 (see Chart 3.1, left panel). While still small relative to total loans, loans regarded as showing significantly increased credit risk (so-called Stage 2 assets) increased steadily over 2020, with net inflows into Stage 2 assets being six times higher than before the pandemic by the end of the year. Flows into actual credit-impaired (i.e. Stage 3) assets increased more modestly, rising by 1.3 times (see Chart 3.1, right panel). Due to the large scale of government support measures in the form of statutory moratoria and public guarantees, the time between the contraction in economic activity and NPL formation might be longer than seen in past recessions. Moreover, banks’ practices with respect to the identification of the significant increase in credit risk and forbearance vary, which raises the risk of a delayed recognition of asset quality issues by some banks.[13] Sizeable provisions were set aside in 2020 to cover higher expected loan losses, although there remain downside risks to provisioning as policy support expires. According to results from first quarter earnings releases of listed euro area banks a smaller amount of loan loss provisions was booked in the first quarter compared to the levels seen in 2020.

The increase in credit risk is most visible in sectors more affected by the pandemic. Loan-level credit register data (AnaCredit data) indicate that the share of loans which migrated from Stage 1 to Stage 2 increased more substantially over 2020 in pandemic-sensitive sectors. This was most pronounced in the accommodation sector where the risk migration increased fivefold from 5% to 25% (see Chart 3.2, left panel). The deterioration has also been somewhat greater in sectors which already had a higher share of non-performing loans (see Chart 3.2, right panel). Assuming that the transitions between IFRS stages by sector observed during 2020 also apply in 2021, the stock of Stage 2 assets would increase from 13% in the fourth quarter of 2020 to 17% at the end of 2021 for euro area banks on aggregate.

The eventual expiry of public measures implies that bank asset quality is likely to deteriorate further over 2021. Fiscal, monetary and prudential measures have supported bank asset quality during the pandemic, but the effect of these measures is expected to recede over time. With the expiry of public support measures, credit risk dependencies of sovereigns, financials and corporates in the euro area are expected to decline (see Box 4). Government-guaranteed loans offered vulnerable corporates access to finance, but may expose firms to medium-term rollover risks, in particular where guarantee schemes have a short residual maturity and bank lending standards have tightened (see Chapter 1). Statutory moratoria have provided relief to firms and households affected by the containment measures, but they have likely masked some asset quality risks. For the euro area on aggregate, three-quarters of the moratoria had expired by January 2021, but in some countries active moratoria still represent a sizeable share of total loans (see Chart 3.3, left panel). Loans emerging from moratoria have performed only slightly worse than the rest of the loan book thus far. However, loans remaining under moratoria are likely to be particularly vulnerable to asset quality deterioration, as they tend to be concentrated in the pandemic-sensitive sectors of the economy and already show a higher NPL ratio than loans which have emerged from the moratoria.

## Box 4 Credit risk transmission during the pandemic: the sovereign-bank-corporate nexus

Prepared by Christian Gross and Cosimo Pancaro

It has been argued that the coronavirus pandemic has strengthened what is known as the sovereign-bank-corporate nexus, also intensifying the transmission of credit risk shocks across sectors.[14],[15] An increase in interdependencies among sovereigns, banks and corporates may mean that if vulnerabilities arise in one sector, they become more likely to spill over to other sectors. This box sheds light on how the structure of cross-sectoral credit risk transmission has evolved since the start of the pandemic. It does so by using high-frequency, firm-level data on expected default frequencies (EDFs) to estimate the direction and intensity of credit risk spillovers between the sovereign, bank, non-bank financial and corporate sectors.[16]

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But, overall, future asset quality depends on the timing and strength of the economic recovery, and the exposure of banks to sectors most affected by the pandemic. Since the previous FSR, forecasts for euro area real GDP growth in 2021 have been revised downwards from 4.7% to 4.2% as the vaccination roll-out had a slow start and several countries prolonged lockdowns to contain a third wave of infections. Therefore, bank asset quality is likely to deteriorate further, especially where there is greater exposure to sectors most heavily affected by the pandemic. Within the category of coronavirus-sensitive sectors, some countries’ banks are more exposed to the accommodation sector, where loan performance may be particularly affected by prolongations of travel restrictions (see Chart 3.3, right panel).

## 3.2 Profitability of euro area banks set for a slow recovery

The profitability of euro area banks sank in 2020 on the back of pandemic-related loan loss provisions and lower revenues. The aggregate return on equity (ROE) of euro area significant institutions declined from 5.3% at the end of 2019 to 1.3% in the fourth quarter of 2020[17], with large differences between the first and second half of the year as well as across countries (see Chart 3.4, left panel). The first half of 2020 was characterised by substantial loan loss provisions to cover the fallout from the pandemic, while the second half saw a pronounced decline in income, partly due to weaker corporate loan demand. The ROE drop was larger in countries more affected by past crises as both core revenues and other profit and loss (P&L) components declined strongly in the first half of the year, while they rose in other countries. The return on equity reported by banks for 2020 was positive, with the exception of Cyprus, Greece, Ireland, Italy, Portugal and Spain where the losses were driven largely by loan loss provisions and other P&L items.[18] Based on listed banks’ first quarter earnings releases, the profitability of euro area banks improved significantly reflecting gains from cost-cutting and stronger trading income, but their trailing return on equity remained below pre-pandemic levels on aggregate.

Euro area bank profitability is anticipated to recover slowly, with models based on market expectations projecting aggregate ROE of 3% at the end of 2021 and 6% in 2022 (see Chart 3.4, right panel). These forecasts depend crucially on the path of the overall economic recovery and ultimately on the progress in rolling out vaccines across euro area countries. While the time span until interest rates are expected to return to positive territory has shortened recently from 2030 to 2026, this implies that rates will still remain low for a substantial period, thereby putting pressure on banks’ interest income.

Operating profits weakened mainly on the back of lower net interest income, especially towards the end of the year. As the economic fallout from the pandemic intensified, banks’ operating profits faced a decline in both net interest income (NII) and net fee and commission income (NFCI). While the negative contributions from these two components were offset by cost-cutting and non-core operating profit items in the second and third quarters, the decline in net interest income increased in the fourth quarter and resulted in a lower operating profit for the full year (see Chart 3.5, left panel). Going forward, operating profits are expected to recover only slowly and to be supported by additional cost-cutting and higher NFCI. NII declined in 2020 by 12% and thereby continued the downward trend that started in 2018. While the volume of interest-earning assets was about 6% larger than in 2019, the margin decline became more pronounced in the second half of 2020 (see Chart 3.5, right panel). The pressure on NII is expected to decline only in 2022.

Trading income supported the profitability of euro area banks with a stronger investment banking focus. Higher trading activity in volatile markets especially during the second and fourth quarters helped some euro area banks with a stronger focus on capital market activities to beat analysts’ earnings expectations due to higher revenues in equity and fixed income trading. Since capital market activity during 2020 was at levels not seen since 2009, the positive impulse from trading activities might be smaller going forward. While some non-euro area investment banks incurred substantial losses on margin calls due to the default of Archegos Capital Management (see Chapter 2), euro area banks were only marginally affected. The incident, however, highlights the risks related to the prime brokerage business.

Looking ahead, some of the pressures weighing on interest margins in 2020 are expected to ease, notably if yield curves steepen. A flattening of the yield curve in early 2020, followed by a reduced pass-through of negative rates to corporate depositors in the second half of 2020, contributed to lower interest margins of euro area banks. The larger NII decline for the loan book relative to fixed income securities can be mainly attributed to smaller risk premia on state-guaranteed non-financial corporate (NFC) loans and weaker demand for consumer lending (see Chart 3.6, left panel). Looking ahead, forward rates suggest that the yield curve slope has bottomed out and is expected to rise until 2023. Against the backdrop of rising inflation and growth expectations since February, the ten-year swap rate expected at the end of 2023 increased by 40 basis points. As net interest margins co-move with the slope of the yield curve, the opportunities for banks to generate higher margins from maturity transformation on new lending should hence improve over the next years (see Chart 3.6, right panel). But as the existing stock of loans is only repricing gradually, the margin recovery of the entire loan book will take time.

A recovery in lending income relies on the economic rebound improving corporate and consumer confidence, as well as easier lending standards. In the second half of 2020 banks tightened lending standards, in particular for corporate loans, as risk perceptions rose and the take-up of guaranteed loans moderated (see Chart 3.7, left panel). The tightening was more pronounced for loans to SMEs and for loans with longer maturities. Reflecting the ongoing uncertainties surrounding the development of the pandemic and the speed of the roll-out of vaccines in the euro area, banks expect an additional tightening of credit standards in the first half of 2021. As a consequence of reduced corporate loan demand since September 2020 and despite tighter housing credit standards, lending volume was mainly driven by mortgage lending on the back of low interest rates (see Chart 3.7, right panel). So far in 2021, average monthly lending flows to the non-financial private sector have exceeded pre-pandemic levels due to higher corporate lending in March. This was largely driven by borrowing in Germany which could be related to a robust manufacturing sector and the financing of working capital. While industrial confidence has recovered, an improvement in consumer confidence is required for high-margin consumer lending to pick up and thereby support bank profitability going forward.

Business disruptions at euro area banks have increased during the pandemic, but losses have remained limited compared with other operational risk events. The higher usage of online banking and the increase in remote work during the pandemic have led to losses as a consequence of business disruptions and system failures, but these losses have remained limited relative to other operational risk events. A closer look at the affected business lines reveals that the bulk of losses related to business disruptions were attributed to the entire institution, retail banking or trading and sales (see Chart 3.8, left panel).

While cyber incidents reported by euro area banks have increased during the pandemic, institutions have not been severely impacted so far. Cyber incidents reported to the ECB by significant institutions in 2020 have increased compared with the previous year, mainly driven by incidents with a malicious intent. Distributed denial of service (DDoS) attacks in particular are trending upwards, including ransom DDoS by large threat actors (see Chart 3.8, right panel).

Fortunately, these attacks have caused only very limited interruptions mostly due to the unavailability of smaller third parties. An upward trend can be observed in the incidents related to third parties due to an increasing reliance of the industry on third-party services. No major incidents related to cyber attacks on euro area financial market infrastructures have been reported yet. But persistent deficiencies in basic ICT (information and communication technology) hygiene, complex ICT architecture and a growing amount of end-of-life ICT systems in many banks still need to be addressed. Some large-scale ICT projects to address these vulnerabilities could be delayed due to the pandemic, but banks may also put off addressing these weaknesses because of the economic outlook and likely lower profitability.

## 3.3 Banks’ bond spreads tightened and capital ratios rose

After declining markedly towards the end of 2020, bond spreads of euro area banks tightened further but at a slower pace. For the euro area on aggregate, bank bond spreads declined significantly during November and December, mirroring the equity price rally. The increase in the spreads of bank bonds observed in March 2021 (see Chart 3.9, left panel) can be attributed to the increase in government bond yields and was more pronounced for senior bonds such as covered bonds (+10 basis points) and non-preferred senior and holding company debt instruments (+6 basis points). As around half of the outstanding bank bonds mature by 2025 and the yields for refinancing these bonds are expected to still remain below those yields agreed at issuance, banks are likely to continue benefiting from favourable market funding costs over the next years (see Chart 3.9, right panel). The ECB’s longer-term refinancing operations provide additional funding support for euro area banks.

As private issuance has fallen substantially in recent years, banks need to prepare for an eventual return to market funding in the medium term. Due to the pandemic, the ECB has provided substantial longer-term funding to banks which led to a significant increase in liquidity buffers during 2020. The combined amount of excess reserves and deposit facility holdings has increased since end-2019 by €1.9 trillion (see Chart 3.10, left panel). The latest targeted longer-term refinancing operation (TLTRO) auction in March 2021 saw one of the largest take-ups due to its more favourable terms. As a consequence, the central bank funding reliance of euro area banks on aggregate has increased strongly and bond issuance volumes of non-G-SIBs have fallen to historical lows, amid some heterogeneity across euro area countries. Normalised by banks’ total assets, central bank funding reliance was the highest in Italy and Spain and banks in these two countries out of the four largest euro area economies are also closer to the non-investment-grade rating space (see Chart 3.10, right panel). Among other aspects, size also seems to play a role as mid-sized banks, i.e. banks with total assets between €20 billion and €200 billion, exhibit the highest central bank funding reliance. To avoid that banks face challenges in a few years when trying to return to market funding, it is essential that they work on resolving some of their balance sheet weaknesses and structural issues, for example by improving cost-efficiency; this is especially the case for some smaller banks, which might face limited market access and might therefore have to progressively rebuild an investor base.

Common Equity Tier 1 (CET1) ratios of euro area banks on aggregate improved in 2020 by around 60 basis points to 15.4%. The rise in capital ratios was largely driven by declining average risk weights, which compensated for balance sheet expansion, while the contribution from retained earnings shrank at the end of 2020 (see Chart 3.11, left panel). Regulatory changes (i.e. the Capital Requirements Regulation “quick fix”) and prudence on dividends also contributed to higher capital ratios. Looking in more detail at the changes in risk-weighted assets during 2020 reveals that market risk increased in the second quarter and to a lesser extent in the fourth quarter on the back of higher trading activity in volatile markets. There was a marked decline in corporate credit risk-weighted assets in the third and fourth quarters (see Chart 3.11, right panel), which appears at least partly related to NFC loans granted with state guarantees and to the adjustment of the SME supporting factor. The increase in excess liquidity, which is assigned a zero risk weight, also played a major role in the decrease of average risk weights. At the country level, CET1 ratios increased in all countries except Estonia, Finland, Greece, Ireland, Luxembourg and Slovenia where balance sheet expansion outweighed the other factors.[19]

As asset quality indicators suggest that a materialisation of pandemic-related credit risk has started, this is likely to have implications for banks’ capital ratios going forward. Banks’ capitalisation levels are well above regulatory minimum requirements and therefore banks have capital space to absorb losses. So far, however, it appears that in particular banks with less capital space above regulatory buffers are reluctant to actually use these buffers (see Chapter 5). The EU-wide stress-test exercise, the results of which are expected by end-July, aims to provide additional insights into the resilience of the European banking sector to a prolonged COVID-19 scenario in a lower-for-longer interest rate environment.

Euro area bank equity prices have benefited from a broader market rally since November. The approval of vaccines against the coronavirus in late 2020 boosted hopes for a stronger global economic recovery and triggered a rotation out of growth stocks into value stocks (see Chapter 2). Against this backdrop and despite unchanged bank profitability projections for 2021 and 2022, bank stock prices rose by 40% in November alone. In February, the announcement of US fiscal stimulus and a pick-up in US inflation expectations spilled over to the euro area and lifted bank shares by another 25% (see Chart 3.12, left panel).

But considered over a longer horizon, euro area bank stock prices have strongly underperformed the euro area broader market and banks in the United States. While there were rallies of euro area bank stock prices also in 2012 and 2017, the longer-term relative unattractiveness of the sector is rooted in structural issues, such as cost inefficiencies, which are in turn reflected in lower profitability. In the fourth quarter of 2020, 7% of euro area listed banks reported an ROE above 10%, compared with 49% of banks in the United States (see Chart 3.12, right panel). Addressing these structural challenges, for example through mergers and acquisitions, is crucial for a turnaround that is longer lasting.

# 4 Non-bank financial sector

## 4.1 Non-bank financial sector vulnerabilities could manifest in the high-yield corporate bond market

Market-based financing of the real economy has remained robust since mid-2020, with conditions continuing to be supported by accommodative policies. By December 2020, market based credit to non-financial corporations (NFCs)  – i.e. intermediated via markets as opposed to loans typically originated by banks – had recovered from the initial pandemic turmoil, to stand at roughly 20% of total external credit (see Chart 4.1, left panel).[20] While euro area non-bank financial institutions were the dominant net buyers of debt overall, net purchases by the Eurosystem were around the same size as those by investment funds (IFs), insurance corporations and pension funds (ICPFs) and other financial institutions combined in the second and third quarter, highlighting the robust indirect support from the official sector.

While fiscal and financial policy measures have indirectly supported non-banks’ asset quality so far, credit risk could trigger valuation losses over the coming months. The share of bonds with negative credit watch or outlook held by ICPFs and IFs rose sharply in early 2020, but declined slightly towards the end of the year, partly reflecting policy support to NFCs (see Chart 4.1, right panel). Potential rating downgrades could materialise either as policy support is withdrawn abruptly or if higher global interest rates spill over into euro area credit markets, jeopardising the ability of companies to roll over their debt and support the recovery.[21] This in turn would expose non-banks to significant credit losses.

A rise in yields would also trigger bond valuation losses, to which ICPFs and IFs are more exposed than in the past. These sectors have increased the duration in their bond portfolios over recent years in order to boost returns in the challenging environment of ultra-low interest rates. But this increases the sensitivity of their assets to rising interest rates (see Chart 4.2, left panel). Asset valuation losses from rising bond yields could trigger outflows which, when coupled with low liquidity buffers, could force bond funds to liquidate assets to meet investor redemptions (see Chart 4.5).[22] In the short term, ICPFs would face asset valuation losses as well, although these could be more than offset by the drop in liabilities valuation, given the negative duration gap (see Section 4.3). The net effect would be an improvement in the equity position and the overall balance sheet capacity of ICPFs. Depending on other concurrent macroeconomic developments, ICPFs could then increase asset purchases in some segments at a time when bond funds could be forced to sell.

High-yield corporate bond segments, where investment funds are dominant players, are particularly exposed to an increase in credit spreads. Investment funds have typically had a much stronger preference for holding high-yield bonds issued by financial and non-financial corporations, unlike banks and ICPFs, which generally prefer less risky fixed income assets (see Chart 4.2, right panel). But high-yield bonds are also the most vulnerable to an increase in credit spreads, which tend to widen when global rates increase. In the euro area, though, this segment is small compared with investment grade corporate and sovereign bond segments. That said, should higher global yields trigger fund outflows and asset liquidation, it is unlikely that banks and ICPFs – which historically largely underweight high-yield bonds – would substantially step up their presence in these segments, thereby increasing the risk of price dislocation and a credit crunch for more vulnerable corporates.

Non-banks’ pro-cyclical behaviour and liquidity risks, together with their reliance on public support as seen last March, demonstrate the need to enhance resilience across the sector (see Chapter 5). For instance, liquidity risks in some types of investment funds could be limited by lengthening redemption frequencies and setting minimum liquidity buffers. Furthermore, the recent event involving Archegos Capital (see Chapter 2), a highly leveraged non-bank entity heavily interconnected with large banks, again raises the issue of contagion due to margin calls, default cascades and fire sales.[23]

## 4.2 Investment funds may be vulnerable to a global increase in interest rates

Overall, since November 2020 investors’ flows have shifted from bond funds to equity funds amid a robust increase in risk appetite. While investors mainly preferred bond and money market funds until mid-2020, equity funds started to receive record-high inflows following the COVID-19 vaccine announcements in November 2020 (see Chart 4.3, left panel). The significant fiscal stimulus in the United States and the agreement of the Brexit deal between the EU and the United Kingdom also contributed to the surge in risk appetite and equity fund inflows.

Inflows concentrated on euro area investment funds that focus on global, US and emerging markets, with equity funds receiving the lion’s share. By contrast, flows into funds investing in western European markets remained generally stable. The rise in aggregate equity fund flows masks rotation from growth to value funds, benefiting European equity funds over US funds (see Chart 4.3, right panel). Flows into western European equity funds investing in the energy and financial sectors have recovered particularly strongly.

These developments have been broadly reflected in recent transactions by euro area investment funds. In the fourth quarter of 2020, euro area equity funds purchased about €135 billion of US and other developed economy equities, while bond funds purchased about €45 billion of EME and other developed country sovereign bonds (see Chart 4.4, left panel). Investment funds also purchased corporate debt securities across the globe, but at a slower pace than earlier in 2020, due in part to lower issuance activity.

The credit risk of euro area investment funds remains elevated, while duration risk stands at a multi-year high. As a result of continued subdued economic activity, up to a third of investment funds’ NFC debt holdings are subject to a negative credit outlook or credit watch from rating agencies (see Chart 4.1, right panel). Coupled with the fact that more than 60% of corporate debt securities purchased in 2020 are either high yield or rated BBB, this highlights the increasing credit risk faced by investment funds. In addition, the continued search for yield in a low interest rate environment has pushed investment funds to increase the maturity[24] and, therefore, the duration of their debt securities portfolios (see Chart 4.2, left panel), exposing them to greater interest rate risk from rising yields.

Significant and abrupt increases in global interest rates may lead to material valuation losses on euro area investment funds’ debt portfolios. To date, repricing has been more pronounced for US debt securities than for their euro area equivalents due to the different increases in yields in the two economic areas (see Chart 2.1, left panel). Nevertheless, euro area investment funds are heavily exposed to US interest rate risks. In particular, their holdings of US-based and USD-denominated debt securities are close to record levels (see Chart 4.4, right panel) and the duration of their US bond portfolios is high, exceeding that in their overall debt securities portfolios.

Over recent years, investment funds’ liquidity risk has increased amid a search for yield (see also Box 5). Since last November, funds’ cash positions have continued to fall as a proportion of their total assets. Cash buffers have declined below pre-pandemic levels to reach new lows (see Chart 4.5, left panel). Liquid asset holdings also stand at relatively low levels, falling below pre-pandemic volumes for funds investing in corporate bonds (see Chart 4.5, right panel). This is a concern, as rising credit risks and elevated asset valuations in some financial market segments leave the fund sector vulnerable to shocks. Furthermore, an increase, particularly abrupt, in global yields may trigger relatively large redemptions, especially for funds investing in debt securities. Given the persistent liquidity risk in investment funds, such shocks may lead to funds selling assets, with the potential to exacerbate adverse market dynamics and propagate spillovers to other financial intermediaries.[25] This underscores the importance of strengthening the resilience of the investment fund sector from a macroprudential perspective (see Chapter 5).

## Box 5 Investment fund flows, risk-taking and monetary policy

Prepared by Margherita Giuzio, Christoph Kaufmann and Ellen Ryan

This box examines the response of the investment fund sector to monetary policy shocks and the implications of this for financial stability. The investment fund sector has more than doubled in size since the global financial crisis. As the sector grows, so does its importance for the funding of economic activity and the transmission of monetary policy. But excessive risk-taking by funds can also have damaging effects for the wider financial system when it contributes to high levels of corporate leverage or when risky asset holdings need to be unwound quickly in times of market stress, as occurred in March 2020.

More

## 4.3 Insurers engage in further risk-taking, but could benefit from the moderate increase in global interest rates

While the profitability of euro area insurance companies remains subdued, their capitalisation has started to recover. Towards the end of 2020, solvency ratios already regained more than half of the decline that occurred amid the initial coronavirus shock (see Chart 4.6, left panel). By contrast, insurers’ profitability still lies significantly below multi-year averages (see Chart 4.6, right panel).

Despite the signs of improvement in the economic outlook, the insurance sector remains under pressure from low interest rates and weak demand. The economic fallout from the pandemic led to a further fall in interest rates over 2020 together with higher financial market volatility. These developments weighed on the sector’s investment income. In addition, the recession and the ongoing uncertainty surrounding the pandemic meant that sales of life and savings products remained subdued, despite higher household saving. Non-life insurers also saw their new business contract, although the sector is benefiting from rising policy prices and generally solid underwriting profitability. This has been particularly evident in retail business lines like motor insurance where fewer loss events were registered due to lockdown measures. Going forward, a materialisation of credit risks (see Chapter 1) could further weigh on insurers’ profits.

Even though profitability prospects remain muted, insurers’ stock valuations have recovered from last year’s losses. The stock market valuations of insurance corporations increased over 2020 in tandem with the broader equity market (see Chart 4.7, left panel). Life insurers significantly outperformed most other market segments, primarily because the recent moderate steepening of the yield curve has improved investor sentiment towards the sector. This development contrasts with the trend observed over recent years, when life insurance stocks typically performed worse than the overall market. A decomposition of insurance stock prices shows that the sector’s valuation gains are mainly driven by the positive sentiment on stock markets that started to resurface in November 2020 (see Chart 4.7, middle panel). At the same time, the weak profitability prospects for the sector continue to hold down insurers’ valuations.

Insurers are taking on more risk as they increase their investments in alternative asset classes. Amid decreasing income from debt securities portfolios, insurers have continued gradually increasing their exposures to higher yielding but potentially riskier alternative assets (see Chart 4.7, right panel). Around 70% of these holdings are invested in real estate-related assets. Exposures to commercial real estate in particular could suffer credit and valuation losses if the pandemic-accelerated shift towards more working from home and online shopping persists after lockdown restrictions are lifted (see Chapter 1.5). This could have a sizeable impact on insurers’ solvency. Empirical analysis shows that a 10% decline in the value of commercial real estate holdings could wipe out as much as 4% of aggregate insurance excess of assets over liabilities in the EU.[26]

Although insurers have accumulated record-high exposures to duration risks, higher interest rates would boost the sector’s capitalisation significantly due to negative duration gaps. If interest rates on insurers’ fixed income holdings increased by 1%, asset valuation losses would amount to 8.6% of the bond portfolio (€250 billion) compared to 7.7% (€200 billion) four years ago (see Chart 4.8, left panel). Global interest rates have started rising in 2021, particularly in the United States. This trend has affected euro area rates, which have also increased albeit more mildly (see Chapter 2). Under a scenario of moderately higher interest rates abroad in 2021, euro area insurers’ bond portfolios could lose around €20 billion in value, which could translate into capital losses of the same size (see Chart 4.8, middle panel).[27] However, the largest share of insurers’ fixed income portfolios (78%) is invested in euro area assets while only about 7% is invested in US assets. Moreover, the sector has a negative duration gap on its balance sheets, with a weighted average duration of assets and liabilities of 7.3 and 13.3 years respectively at the end of 2019. As a result, even a small rise in interest rates in the euro area would lead to sizeable reductions in insurers’ liabilities by an estimated €250 billion. This decrease would more than offset all asset valuation losses and could lead to net capital gains of more than €150 billion (2%).[28]

Moderately higher interest rates would only partially dampen the deterioration of insurers’ investment income over the next few years. Under the interest rate changes assumed, the average portfolio return would fall to 2% five years ahead compared to 1.8% in a scenario in which interest rates do not increase (see Chart 4.8, right panel). A more significant improvement in investment income prospects would require much larger changes in interest rates. Consequently, the revenue outlook for the insurance sector remains muted.

# 5 Macroprudential policy issues

## 5.1 Supporting economic recovery and the resilience of the banking sector amid pandemic-related vulnerabilities

Since the November 2020 FSR, policy measures have continued to support financial stability by limiting corporate insolvencies and containing rising unemployment. With many euro area countries facing renewed surges in infections, lockdown measures have been reinstated and economic support policies maintained or extended, increasingly in a more targeted and selective manner.[29] Taken together, the extension of economic, monetary, prudential and other support measures has underpinned the functioning of the financial system, prevented widespread bank deleveraging and maintained generally accommodative credit conditions.[30]

As pandemic and economic conditions allow, extensive policy support, particularly for corporates, could gradually move from being broad based to more targeted.[31] As long as significant lockdown measures remain in place to control the pandemic in euro area countries, economic policy support that prevents viable companies from failing and unemployment from rising considerably will also protect near-term financial stability. As parts of the economy become better adapted to lockdown measures, increasingly targeted extensions of policy support across euro area countries are already contributing towards limiting the medium-term financial stability side effects and should be continued. These adverse effects arise from the growth in sovereign and corporate indebtedness and the allocation of resources to potentially non-viable, “zombie” companies (see Special Feature A), which increase balance sheet vulnerabilities of sovereigns, corporates and banks. Adjusting support schemes to strengthen mechanisms for assessing the future viability of beneficiaries or promote debt/equity restructuring for highly leveraged but viable firms could be a particularly useful way of managing financial stability side effects (for example, through existing initiatives such as quasi-equity instruments and the partial conversion of guaranteed loans into direct grants).[32] Moreover, fast and effective use of the €750 billion Next Generation EU (NGEU) recovery funds should complement national support measures to mitigate cross-country divergences in the coming years.[33]

For banks specifically, capital relief measures should continue to prevent excessive deleveraging, which could negatively impact the economic recovery. Credit risk and losses for banks are expected to materialise as some businesses suffer permanent damage from the pandemic and become unviable. Therefore, as highlighted in previous issues of the FSR, it is crucial that bank capital buffers are usable to absorb losses and to avoid procyclical financial amplification effects due to, for example, bank deleveraging. At the same time, managing non-performing loans (NPLs) effectively will also be key to reducing the drag on bank balance sheets and supporting lending. In this context, the prudent approach to capital distributions has been extended and adapted from the initial guidance asking financial institutions to refrain from making any distributions to shareholders. Following the updated guidance, banks can proceed with capital distributions up to a conservative threshold set by the competent authorities.[34] Banks are expected to exercise extreme prudence and engage in discussion with the competent authorities before taking any action on dividend distributions or share buybacks.[35]

Banks will retain investor confidence by ensuring the proper and timely identification of credit risk, supporting this by using capital buffers in case of need.[36] Given the potential for losses to materialise, the ability to distinguish between viable and non-viable borrowers becomes increasingly essential to supporting a robust recovery. The policy guidance issued since the November 2020 FSR has continued to emphasise the need to set aside adequate provisions based on assumptions appropriate for the current risk environment and, more generally, to identify credit risk in a timely manner.[37]

However, preliminary evidence points to banks’ reluctance so far to use available capital space. In particular, initial evidence suggests that banks with less capital headroom above regulatory buffers appear reluctant to use these buffers by letting capital ratios decrease,[38], despite supervisors communicating that they expect these buffers to be used.[39] In recent quarters, lending to corporates by banks with a smaller capital headroom on top of the combined buffer requirement (CBR) has decreased significantly (see Chart 5.1). The preliminary evidence points to a more pronounced weakening of credit provision to non-financial corporations, a stronger reduction in risk weights and a tightening in lending conditions by banks closer to the CBR relative to other banks.[40] For the moment, these procyclical adjustments may have only limited implications for aggregate credit supply due to the limited number of banks close to the CBR threshold. Nevertheless, if credit risk materialises and more banks approach the threshold, there is the risk that procyclical adjustments could become more systemic.

In the medium term, a higher share of releasable capital buffers could be considered, as this can enhance banks’ ability to absorb losses and continue providing key financial services in a crisis. An enhanced role for releasable capital buffers could strengthen authorities’ ability to act countercyclically. It would also reflect the increasingly important role that macroprudential policy needs to play as the first line of defence in preserving financial stability in the face of a severe, system-wide shock. Any change to the buffer framework should ensure continued compliance with the applicable international standards set by the Basel Committee on Banking Supervision.

Concerns regarding the expected deterioration in asset quality in the banking sector reinforce the need for effective NPL solutions. Among several initiatives under way, the European Commission’s action plan on tackling non-performing loans emphasises two key objectives: (i) the continued development of secondary markets for distressed assets; and (ii) reform of insolvency and debt recovery frameworks.[41] The first objective has already played a key role in NPL reductions in some Member States (e.g. Greece and Italy) in recent years. This requires an appropriate balance to be struck between strengthening common standards and market transparency, on the one hand, and avoiding excessive administrative barriers to entry to the NPL market, on the other hand. The second objective aims to reduce costs and delays, which would translate into higher recoveries for banks and investors, together with higher NPL valuations in the market. Moreover, further initiatives may be necessary if NPLs increase beyond current expectations. A common EU blueprint for NPL securitisations benefiting from government guarantees might also be useful. EU policymakers should also consider options to restructure and recapitalise distressed but viable companies. A more flexible application of the Commission’s framework for public support that would make it easier to set up asset management companies could complement policy efforts to manage potential systemic NPL problems.

Given the low interest rate environment and profitability challenges, efforts to address structural issues across banks should intensify. The euro area banking sector is hampered by low cost-efficiency, limited revenue diversification and overcapacity. Banks have increased cost-cutting efforts in response to the pandemic by further reducing the number of staff and branches, but low profitability may limit the required digital transformation. Consolidation via mergers and acquisitions could be one potential avenue for reducing overcapacity in the sector. This process should be market-driven but can also be supported by completing the banking union and removing barriers to consolidation, such as differences in national insolvency and taxation regimes and restrictions on the free flow of capital and liquidity within banking groups.

The timely, full and consistent application of the Basel III framework remains essential with a view to strengthening banks’ resilience to withstand future shocks. Deferring the implementation timeline by one year freed up operational capacity for banks and supervisors to respond to the immediate priorities related to the pandemic without affecting the substance of the reforms. These reforms, which reflect important lessons learned from the global financial crisis, are necessary to further strengthen the regulatory framework for banks. The ECB’s updated macroeconomic impact assessment shows that the economic costs of implementing the reforms are modest and temporary, and outweighed by their permanent benefits in terms of strengthening the resilience of the economy to adverse shocks.[42] It also finds that potential deviations from the globally agreed Basel III reforms – for example, with regard to the output floor – would dilute the benefits to the real economy.

Where ongoing developments point to increasing vulnerabilities, such as in the residential real estate (RRE) sector, policies should prudently balance procyclical considerations against the need to stem the build-up of risk. Capital already built up to target RRE risks should only be released to facilitate loss absorption if losses start to materialise. At the same time, heightened vulnerabilities require careful monitoring. Going forward, it could be worth considering gradually activating or tightening borrower-based measures, but not before economic conditions stabilise and the impact of the pandemic on RRE markets is clearer. Nonetheless, such considerations should carefully consider the stage of the RRE cycle and any potential procyclical effects on demand, especially from income-based limits.

## 5.2 Further steps towards developing macroprudential policies for non-banks

The market turmoil in March 2020 exposed structural fault lines in the non-bank financial sector – in particular liquidity mismatches in investment funds. Many money market funds (MMFs) and open-ended investment funds faced acute liquidity stress last spring owing to significant outflows and difficulties in selling assets in markets with little or no secondary trading. These funds responded to this liquidity pressure by acting procyclically through asset sales (see Chart 5.2 and Box 6). Over 200 European investment funds also suspended redemptions.[43] This behaviour added to pressure on asset valuations and market liquidity, contributing to the tightening of funding conditions in the real economy. This tightening ultimately only eased when central banks took extraordinary policy action. Furthermore, renewed risk-taking and growing liquidity mismatches in funds in recent months continue to pose increasing risks (see Chapter 4).

A comprehensive macroprudential approach for non-banks remains a key missing element in the overall policy framework. Many investment funds, insurance corporations and pension funds are subject to relatively weak liquidity requirements. They are typically designed from a microprudential perspective. A comprehensive macroprudential approach instead would address structural vulnerabilities and emerging risks in the non-bank financial sector. This would lower the need for extraordinary central bank intervention to tackle significant market stress. Furthermore, it would also complement monetary policy in good times, thereby further aligning the financial stability and monetary policy mandates of central banks.

The Financial Stability Board (FSB) is expected to issue recommendations aimed at strengthening the resilience of the non-bank financial sector. Once issued, they should be swiftly implemented in the EU as appropriate. These recommendations will stem from the ongoing FSB work on MMFs, open-ended investment funds and margining practices. The vulnerabilities in MMFs must be addressed, in particular by reducing their liquidity mismatch. This could be achieved by limiting investments in relatively illiquid assets or increasing liquidity buffers, which should be made more usable given the evidence that MMFs have been reluctant to draw down on their buffers in the past. These are among the measures being examined by the FSB in relation to the MMF sector.[44] Given the interdependencies of money markets across jurisdictions and currencies, this work is of particular importance for ensuring a globally consistent approach to policy reforms. Any FSB recommendations on MMFs should feed into the review of the EU Money Market Fund Regulation planned for 2022. For open-ended investment funds, minimum liquidity requirements could be considered to increase their asset liquidity profile, while requirements on redemption frequencies and notice periods would help to bolster their resilience, thereby reducing their reliance on crisis liquidity management tools.[45] Finally, it is important to assess whether tools to reduce excessive procyclicality in initial margins for derivatives – a topic relevant for both bank and non-bank financial institutions – need to be recalibrated and/or revised.[46] There is also scope for increasing the transparency and predictability of margining practices.

The ongoing review of the EU Solvency II framework could also strengthen the macroprudential approach to insurance companies. The proposal put forward by the European Insurance and Occupational Pensions Authority in its Opinion suggests introducing measures of a macroprudential nature that would usefully equip national supervisory authorities with additional powers to tackle systemic risk in insurance companies.[47] These include powers to introduce a capital surcharge for systemic risk, require the development of systemic risk and liquidity risk management plans, and temporarily freeze redemption rights. The Solvency II review could also consider other macroprudential aspects proposed by the European Systemic Risk Board such as new Pillar 2 liquidity provisioning requirements for insurers with a vulnerable liquidity profile and making the volatility adjustment symmetric to build capital buffers during good times.[48]

## Box 6 Investment funds’ procyclical selling and cash hoarding: a case for strengthening regulation from a macroprudential perspective

Prepared by Katharina Cera, Linda Fache Rousová, Angelica Ghiselli, Christoph Kaufmann and Sean O’Sullivan

During the March 2020 market turmoil, investment funds shed assets on a large scale – but was this selling commensurate with the outflows they faced or was it much larger? This box finds evidence of the latter, highlighting that the less regulated non-UCITS funds tended to engage in more procyclical selling and cash hoarding than UCITS funds.[49] While it can be rational for fund managers individually to sell assets in excess of current outflows when uncertainty about future redemptions is high, such cash hoarding may be detrimental to the stability of financial markets from a macroprudential perspective.[50]

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# Special features

## Corporate zombification: post-pandemic risks in the euro area

Tobias Helmersson, Luca Mingarelli, Benjamin Mosk, Allegra Pietsch, Beatrice Ravanetti, Tamarah Shakir and Jonas Wendelborn[51]

Policy measures aimed at supporting corporates and the economy through the coronavirus pandemic may have supported not just otherwise viable firms, but also unprofitable but still operating firms – often referred to as “zombies”. This has in turn raised questions about an increased risk of zombification in the euro area economy, which could constrain the post-pandemic recovery. Firm-level, loan-level and supervisory data for euro area companies suggest that zombie firms may have temporarily benefited from loan schemes and accommodative credit conditions – but likely only to a modest degree. These firms may face tighter eligibility criteria for schemes and more recognition of credit risk in debt and loan pricing in the future. Tackling the risk of zombification more fundamentally requires the consideration of suggested reforms to insolvency frameworks, and better infrastructure for banks to manage non-performing loans.

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## Climate-related risks to financial stability

Prepared by Spyros Alogoskoufis, Sante Carbone, Wouter Coussens, Stephan Fahr, Margherita Giuzio, Friderike Kuik, Laura Parisi, Dilyara Salakhova and Martina Spaggiari

The ECB has been intensifying its quantitative work aimed at capturing climate-related risks to financial stability. This includes estimating financial system exposures to climate-related risks, upgrading banking sector scenario analysis and monitoring developments in the financing of the green transition. Considerable progress has been made on capturing banking sector exposures to firms that are subject to physical risks from climate change. While data and methodological challenges are still a focus of ongoing debates, our analyses suggest (i) somewhat concentrated bank exposures to physical and transition risk drivers, (ii) a prevalence of exposures amongst more vulnerable banks and in specific regions, (iii) risk-mitigating potential for interactions across financial institutions, and (iv) strong inter-temporal dependency conditioning the interaction of transition and physical risks. At the same time, investor interest in “green finance” continues to grow – but so-called greenwashing concerns need to be addressed to foster efficient market mechanisms. Both the assessment of risks and the allocation of finance to support the orderly transition to a more sustainable economy can benefit from enhanced disclosures, including of firms’ forward-looking emission targets, better data and strengthened risk assessment methodologies, among other things.

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# Acknowledgements

The Financial Stability Review assesses the sources of risks to and vulnerabilities in the euro area financial system based on regular surveillance activities, analysis and findings from discussions with market participants and academic researchers.

The preparation of the FSR was coordinated by the Directorate General Macroprudential Policy and Financial Stability. The Review has benefited from input, comments and suggestions from other business areas across the ECB. Comments from members of the ESCB Financial Stability Committee are gratefully acknowledged.

The Review was endorsed by the Governing Council on 12 May 2021.

Its contents were prepared by Katharina Cera, Nander de Vette, Giovanni di Iasio, Linda Fache Rousová, John Fell, Sándor Gardó Benjamin Hartung, Tobias Helmersson, Christoph Kaufmann, Benjamin Klaus, Marco Lo Duca, Dilyara Salakhova, Tamarah Shakir, Seán O’Sullivan, Eugen Tereanu and Jonas Wendelborn.

With additional contributions from Lorenzo Cappiello, Sante Carbone, Michal Dvořák, Isabel Figueiras, Angelica Ghiselli, Michael Grill, Maciej Grodzicki, Lieven Hermans, Paul Hiebert, Sujit Kapadia, Dejan Krusec, Laura Lebastard, Allegra Pietsch, Mara Pirovano, Beatrice Ravanetti, Moreno Roma, Marek Rusnák, Ellen Ryan, Sebastiano Michele Zema, Martina Spaggiari, Mika Tujula, Christophe Van Nieuwenhuyze, Danilo Vassallo and Stefan Wredenborg.

Editorial, multimedia and production assistance was provided by Eszter Miltényi-Torstensson, Mike Moss, Peter Nicholson, Katie Ranger and Sophia Suh.

© European Central Bank, 2021

Postal address 60640 Frankfurt am Main, Germany
Telephone +49 69 1344 0

Website www.ecb.europa.eu

All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

For specific terminology please refer to the ECB glossary (available in English only).

PDF ISSN 1830-2025, QB-XU-21-001-EN-N
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1. With contributions from Pablo Andrés Anaya Longaric, Sungyup Chung, Johannes Gräb and Elena Vollmer.
2. The debt service ratio captures the impact of debt, average interest rates and maturities by assuming that current debt is repaid in equal instalments over the average residual maturity of outstanding debt. It is defined as $D S R = D Y * i 1 - 1 + i - s$ where D/Y denotes debt-to-GDP, i denotes the interest rate and s the average residual maturity of sovereign debt. See Drehmann, M., Ilnes, A., Juselius, M. and Santos, M., “How much income is used for debt payments? A new database for debt service ratios”, BIS Quarterly Review, Bank for International Settlements, September 2015.
3. Ultimately, the EU debt will be refinanced by European taxpayers as it is backed by Member States’ contributions to the EU budget and EU own resources.
4. For more details, see the box entitled “Towards an effective implementation of the EU’s recovery package”, Economic Bulletin, Issue 2, ECB, 2021.
5. The MFF and RRF funds differ in terms of structural composition and the conditions associated with the usage of the funds. The absorption rates may therefore differ for the RRF funds compared to historical MFF absorption rates.
6. See also the box entitled COVID-19 and the increase in household savings: precautionary or forced?”, Economic Bulletin, Issue 6, ECB, 2020.
7. See ECB press release dated 11 March 2021 and press release dated 10 December 2020.
8. Japanese investors form an important part of the global investor community and represented almost 18% of foreign holdings of US Treasury securities in February 2021 according to the Treasury International Capital reporting system.
9. See ECB press release dated 14 April 2021 for the March 2021 “Survey on credit terms and conditions in euro-denominated securities financing and OTC derivatives markets”.
10. See the box entitled “Financial stability implications of crypto-assets” Financial Stability Review, ECB, May 2018.
11. The European Securities and Markets Authority (ESMA) recently renewed its warning to investors about the risks of investing in crypto-assets.
12. OECD Economic Outlook, Interim Report
13. For additional details, see the communication to the banking industry dated 4 December 2020 regarding the identification and measurement of credit risk during the pandemic.
14. See the speech entitled “The sovereign-bank-corporate nexus – virtuous or vicious?” by Isabel Schnabel at the LSE conference on “Financial Cycles, Risk, Macroeconomic Causes and Consequences”, Frankfurt, 28 January 2021.
15. The term sovereign-bank-corporate nexus refers to the tight interdependencies between these sectors which are linked by multiple interacting channels. See, for example, Dell’Ariccia, G., Ferreira, C., Jenkinson, N., Laeven, L., Martin, A., Minoiu, C. and Popov, A., “Managing the sovereign-bank nexus”, Working Paper Series, No 2177, ECB, September 2018.
16. This analysis relies on the methodology developed by Diebold and Yilmaz (2014) and Gross and Siklos (2020) and uses Moody’s EDFs at daily frequency for up to 16 euro area countries for four sectors (sovereigns, banks, non-bank financials and non-financial firms). The methodology enables the derivation of estimates of directional connectedness based on variance decompositions in large-scale vector autoregressions (VARs) that trace the impact of individual shocks on all variables considered in the system of equations. Results are visualised by means of graphical network representations which portray the empirical estimates in an informative manner. See Diebold, F.X. and Yilmaz, K., “On the network topology of variance decompositions: Measuring the connectedness of financial firms”, Journal of Econometrics, Vol. 182, Issue 1, 2014, pp. 119-134, and Gross, C. and Siklos, P., “Analyzing credit risk transmission to the nonfinancial sector in Europe: A network approach”, Journal of Applied Econometrics, Vol. 35, Issue 1, 2020, pp. 61-81.
17. With bank profitability declining strongly in 2020, the ROE figure for the fourth quarter of 2020 depends on the way net income is annualised. In the FSR, the four-quarter average of total equity is used in the denominator, while net income is annualised using four-quarter trailing sums. ECB Banking Supervision annualises quarterly data by multiplying them by four, resulting in a different headline profitability number.
18. In some countries, the number of significant institutions included in the sample is smaller than the total number of banks operating in the country which might affect the results. The negative ROE reported by Spanish banks was driven by one institution, which recorded goodwill impairments.
19. In some countries, the number of significant institutions included in the sample is small relative to the total number of banks operating in the country which might affect the results.
20. See Section 4.1, Financial Stability Review, ECB, November 2020.
21. See Section 2.3, Financial Stability Review, ECB, November 2020.
22. In stress episodes, funds tend to sell even more than explained by investor redemptions; see Box 6.
23. See Box 6 entitled “The role of bank and non-bank interconnections in amplifying recent financial contagion”, Financial Stability Review, ECB, May 2020.
24. See Chapter 4 on Non-banks in Financial Stability Review, ECB, May 2020.
25. See Chapter 4 on Non-banks in Financial Stability Review, ECB, May 2020.
26. See the analysis in the chapter entitled “Developments in commercial real estate”, Financial Stability Report, European Insurance and Occupational Pensions Authority (EIOPA), December 2020.
27. As euro area insurers’ liabilities are predominantly denominated in euro, their value would not react to higher interest rates abroad.
28. The estimated effects on the capitalisation would be less benign to the extent that the rising interest rates depress stock and corporate bond valuations in insurers’ portfolios.
29. Economic support measures have been largely extended into 2021, but in several cases in a more targeted manner (see also the discussion in Chapters 1 and 3 on the role of guarantees and moratoria).
30. For example, while a decision to extend the leverage ratio exemption of central bank reserves has not yet been taken, a continued exemption would help support the implementation and transmission of policies such as the pandemic emergency purchase programme (PEPP) and the targeted longer-term refinancing operations (TLTROs). Note that the banking system as a whole cannot avoid holding (in the form of central bank reserves) the excess liquidity created by monetary policy decisions.
31. See also “COVID-19 support measures – Extending, amending and ending”, Financial Stability Board, April 2021.
32. These initiatives benefit from the European Commission’s prolonged and expanded State Aid Temporary Framework, including the increase in aid ceilings and the possibility to convert repayable instruments such as guaranteed loans into direct grants.
33. See Section 1.2 for a more in-depth discussion of the NGEU package.
34. On 15 December 2020, the European Systemic Risk Board extended the recommendation on restrictions of distributions during the COVID-19 pandemic until September 2021 and introduced certain amendments. National authorities complied with the recommendation. On the same day, the ECB also extended its recommendation on dividend distributions accordingly until 30 September 2021.
35. Additional analysis indicates that restrictions on distributions increase the resilience of banks by ensuring that capital is used to support the real economy and absorb losses. At the same time, however, they may negatively affect bank valuations due to the uncertainty over future distributions (see also the forthcoming issue of the ECB Macroprudential Bulletin).
36. For a broader overview of policy actions taken since the beginning of the pandemic, see Chapter 5 of the May and November 2020 issues of the FSR.
37. See the discussion in Chapter 3, as well as the December 2020 ECB Banking Supervision guidance on the identification and measurement of credit risk in the context of the coronavirus (COVID-19) pandemic, and the April 2021 press release on the targeted review of internal models, which emphasises the importance of accurate modelling of credit risk parameters. In addition, the EBA guidelines on legislative and non-legislative moratoria on loan repayments applied in the light of the COVID-19 crisis (originally extended until end-March 2021) have not been renewed.
38. Banks’ willingness to accept a decline in capital ratios can be undermined by a number of factors, including market, supervisory, macroprudential and regulatory factors (see Behn, M., Rancoita, E. and Rodriguez d’Acri, C., “Macroprudential capital buffers – objectives and usability”, Macroprudential Bulletin, Issue 11, ECB, October 2020).
39. See, for example, “ECB Banking Supervision provides temporary capital and operational relief in reaction to coronavirus”, press release, 12 March 2020; “Basel Committee meets; discusses impact of Covid-19; reiterates guidance on buffers”, press release, Bank for International Settlements, 17 June 2020; and “FSB Chair’s letter to G20 Finance Ministers and Central Bank Governors: July 2020”, Financial Stability Board, 15 July 2020.
40. These preliminary findings are also confirmed by multivariate analyses that make it possible to control for bank-level characteristics, the macro-financial environment and credit demand. Moreover, the combination of simple chart-based evidence measured in terms of exposures at default and original exposures makes it possible to identify bank reactions which are driven by capital-related and fiscal policy-related incentives. More specifically, exposure at default developments are useful for monitoring the exposures that must be covered by capital, while original exposure developments, which are not subject to credit risk mitigation, provide information on credit that is originated by banks and reaches the real economy.
41. Action plan: Tackling non-performing loans (NPLs) in the aftermath of the COVID-19 pandemic”, European Commission, 16 December 2020.
42. See “The macroeconomic impact assessment of Basel III finalisation in Europe”, ECB, forthcoming.
43. Grill, M., Molestina Vivar, L. and Wedow, M., “The suspensions of redemptions during the COVID‑19 crisis – a case for pre-emptive liquidity measures?”, Macroprudential Bulletin, Issue 12, ECB, April 2021.
44. Grill, M., O’Sullivan, S., Wedow, M. and Weistroffer, C., “Liquidity transformation by investment funds: structural fault line or desirable financial transformation? A systemic perspective”, Macroprudential Bulletin, Issue 12, ECB, April 2021; and Capotă, L., Grill, M., Molestina Vivar, L., Schmitz, N. and Weistroffer, C., “How effective is the EU Money Market Fund Regulation? Lessons from the COVID‑19 turmoil”, Macroprudential Bulletin, Issue 12, ECB, April 2021.
45. Giuzio, M., Grill, M., Kryczka, D. and Weistroffer, C., “A theoretical model analysing investment funds’ liquidity management and policy measures”, Macroprudential Bulletin, Issue 12, ECB, April 2021.
46. See, for example, Cominetta, M., Grill, M. and Jukonis, A., “Investigating initial margin procyclicality and corrective tools using EMIR data”, Macroprudential Bulletin, Issue 9, ECB, October 2019.
47. See Opinion on the 2020 Review of Solvency II, European Insurance and Occupational Pensions Authority, EIOPA-BoS-20/794, 17 December 2020.
48. See “Response letter to a consultation of the European Commission on the review of Solvency II”, European Systemic Risk Board, 16 October 2020.
49. The classification of funds as UCITS and non-UCITS depends on whether they fall under the EU Directive on undertakings for collective investment in transferable securities (UCITS). UCITS funds are mutual funds that can be sold to retail investors and are perceived as non-speculative, diversified and well-regulated investments.
50. Morris, S., Shim, I. and Shin, H.S., “Redemption risk and cash hoarding by asset managers”, Journal of Monetary Economics, Vol. 89, April 2017, pp. 71-87, show that cash hoarding behaviour is pervasive among fund managers when they face redemptions. For more recent evidence, see also Schrimpf, A., Shim I. and Shin, H.S., “Liquidity management and asset sales by bond funds in the face of investor redemptions in March 2020”, BIS Bulletin, No 29, Bank for International Settlements, March 2021.
51. The authors are grateful to Benjamin Hartung, Paloma Lopez-Garcia, Giulio Nicoletti, Marek Rusnák, Ralph Setzer, Mika Tujula and Peter Welz for useful comments and discussions.
Annexes
19 May 2021