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Special features & boxes

25 November 2020
Developments in the sovereign-bank nexus in the euro area: the role of direct sovereign exposures

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

Abstract

The increase in sovereign debt in the wake of the pandemic has renewed concerns about the developments in the euro area sovereign-bank nexus. While these interlinkages may arise through various channels, this box assesses these developments focusing on the direct exposures of euro area banks to sovereign debt securities. In 2020 to date, euro area banks increased their exposures to domestic sovereign debt securities by almost 19% in nominal amount, with some differences across countries. This increase reflects both higher issuance of government debt and some bank-specific factors, including the decision to invest the increased amount of deposits in low-risk assets. In future months, euro area banks could further increase their domestic sovereign bond exposures, also in relation to the forthcoming trajectory of government debt

Financial Stability Review Issue 2, 2020
25 November 2020
A macroprudential perspective on replenishing capital buffers

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

E17 : Macroeconomics and Monetary Economics→General Aggregative Models→Forecasting and Simulation: Models and Applications

E51 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Money Supply, Credit, Money Multipliers

C68 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computable General Equilibrium Models

Abstract

This box explores the potential macroeconomic impact of different capital buffer replenishment paths. Model simulations show that replenishing capital buffers too early or too aggressively could be counterproductive and prolong the economic downturn. While the costs of restoring capital buffers to pre-crisis levels are not excessive if the economy moves along the central projection scenario, a weaker economic environment would increase bank losses and result in a more extensive use of capital buffers. In such a scenario, a later and more gradual restoration of capital buffers would be warranted.

Financial Stability Review Issue 2, 2020
25 November 2020
Interconnectedness of derivatives markets and money market funds through insurance corporations and pension funds

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G22 : Financial Economics→Financial Institutions and Services→Insurance, Insurance Companies, Actuarial Studies

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

G15 : Financial Economics→General Financial Markets→International Financial Markets

Abstract

In the most turbulent week during the coronavirus-related market turmoil in March 2020, euro-denominated money market funds experienced very high outflows. But which investors withdrew from these funds and why did they do so? This box suggests that the increase in variation margin on derivatives contracts held by euro area insurance corporations and pension funds was one of the key drivers behind these outflows.

Financial Stability Review Issue 2, 2020
25 November 2020
Selecting adverse economic scenarios for the quantitative assessment of euro area banking system resilience

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G17 : Financial Economics→General Financial Markets→Financial Forecasting and Simulation

E17 : Macroeconomics and Monetary Economics→General Aggregative Models→Forecasting and Simulation: Models and Applications

Abstract

This box introduces the adverse scenario simulation and selection procedure used to assess the banking system resilience quantitatively. The adverse scenario paths are derived directly from the output of the ECB macro-micro model by generating a large number of alternative paths for economic and bank-level variables. The simulation technique uses combinations of macro-financial shocks sourced from their historical distributions. Given the simulated distribution of possible future economic conditions, the selected scenarios are then sorted out among adverse paths where the evolution of variables mirrors a particular narrative commonly linked to prevalent financial stability concerns.

Financial Stability Review Issue 2, 2020
25 November 2020
Causes and implications of variation in euro area banks’ recent loan loss provisioning

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

Euro area banks’ loan loss provisions increased markedly in the first half of 2020 amid the sharp contraction in economic activity, while provisioning levels were widely dispersed across both countries and banks within the same countries. This box aims at identifying drivers of the variation in banks’ provisioning and its possible implications. The wide dispersion of provisioning levels may partly reflect the pronounced economic uncertainty, the heterogeneous sectoral impacts of the COVID-19 crisis as well as the diversity of the impact of public support measures for borrowers. However, it is possible that some of the variation in provisions across banks reflects inadequate provisioning by some banks, in part due to profitability constraints and optimistic assumptions about the economic recovery in estimating credit losses under new, more forward-looking IFRS 9 accounting standard. From a financial stability perspective, it is helpful that euro area banks have generally avoided excessive procyclicality in provisioning, but those with less conservative policies may still need to raise provisioning (and coverage) levels so as to ensure investor trust in asset valuations and transparency in financial statements.

Financial Stability Review Issue 2, 2020
25 November 2020
Some way to go in the transition to the €STR

Abstract

JEL Classification

G10 : Financial Economics→General Financial Markets→General

G12, G13 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

Abstract

Market participants have been slow in transitioning to the euro short-term rate (€STR) as the new reference rate in the overnight index swap (OIS) market. The OIS market segment is a potential source of alternative risk-free interest rates to serve as a fall-back for the euro interbank offered rate (EURIBOR), the benchmark term rate underlying loan and debt security pricing for euro area households and corporates. The euro overnight index average (EONIA) rate is due to cease in January 2022. But trading activity in €STR-referencing OISs, although constantly growing, has remained at very low levels compared with EONIA-referencing OISs. Moreover, EONIA OIS trades that mature after the transition deadline have continued to rise. Market participants are encouraged are encouraged to redouble their efforts to ensure sufficient technical preparedness to trade, price and account for €STR-based products and manage risk related to usage of the €STR.

Financial Stability Review Issue 2, 2020
25 November 2020
Prospects for euro area bank lending margins in an extended low-for-longer interest rate environment

Abstract

JEL Classification

G2 : Financial Economics→Financial Institutions and Services

E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects

Abstract

We examine some aspects of how the low-for-even-longer interest rate environment may affect bank lending margins and overall financial stability. We find evidence that margins fall more in response to declines in nominal short-term rates when these are low to begin with. The compression of margins reflects the sluggish response to further policy rate cuts of deposit rates as these approach the zero lower bound. Moreover, the analysis indicates that bank margins and overall profitability are influenced by both the level of real rates and, more materially, the level of inflation expectations embedded in nominal rates, which reflects the fact that bank profits are partly akin to seigniorage.

Financial Stability Review Issue 2, 2020
24 November 2020
Financial stability considerations arising from the interaction of coronavirus-related policy measures

Abstract

JEL Classification

C68 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computable General Equilibrium Models

E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

E62 : Macroeconomics and Monetary Economics→Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook→Fiscal Policy

E63 : Macroeconomics and Monetary Economics→Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook→Comparative or Joint Analysis of Fiscal and Monetary Policy, Stabilization, Treasury Policy

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

H81 : Public Economics→Miscellaneous Issues→Governmental Loans, Loan Guarantees, Credits, Grants, Bailouts

Abstract

Fiscal, prudential and monetary authorities have responded to the coronavirus (COVID-19) pandemic by providing unprecedented support to the real economy. Importantly, the combination of policy actions has done more to limit the materialisation of risks to households and firms than each policy individually. Exploiting complementarities and ensuring the most effective combination of policies will, however, be equally important when authorities start to phase out the various related relief measures. The fact that in particular the enacted fiscal and labour market measures, as well as their phase-out schedules, differ substantially across the largest euro area economies further complicates the challenge of obtaining the most effective policy combination. Along with the reduction in support to the real economy, the phasing-out of policy measures could adversely affect banks’ balance sheets and capitalisation. Resulting cliff effects in policy support are relevant for prudential authorities in the context of their future decisions on the replenishment of capital buffers. The results of the analysis suggest there are substantial risks associated with the early withdrawal of policy support, although the analysis does not account for the medium-term risks of protracted policy support.

Financial Stability Review Issue 2, 2020
24 November 2020
The performance and resilience of green finance instruments: ESG funds and green bonds

Abstract

JEL Classification

G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Q56 : Agricultural and Natural Resource Economics, Environmental and Ecological Economics→Environmental Economics→Environment and Development, Environment and Trade, Sustainability, Environmental Accounts and Accounting, Environmental Equity, Population Growth

Abstract

Green financial markets are growing rapidly. Funds with an environmental, social and corporate governance mandate have grown by 170% since 2015 and 57% of them are domiciled in the euro area. The outstanding amount of green bonds issued by euro area residents has grown ten-fold over the same period. The large flows into ESG funds and green assets are expected to be sustained over time by increasing concerns around climate change, a gradual generational transfer of wealth towards millennials, and better disclosure and understanding of ESG risks. Given the financial stability risks from climate change, this box aims to understand the performance of such products and their potential for greening the economy. It focuses on the resilience of ESG funds and the absence of a consistent “greenium” – a lower yield for green bonds compared with conventional bonds of similar risk profile – reflecting the fact that green projects do not enjoy benefit from cheaper financing.

Financial Stability Review Issue 2, 2020
23 November 2020
Understanding what happens when “angels fall”

Abstract

JEL Classification

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G24 : Financial Economics→Financial Institutions and Services→Investment Banking, Venture Capital, Brokerage, Ratings and Ratings Agencies

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

Abstract

Credit rating downgrades - especially downgrades from investment grade to high yield (“fallen angels”) - can adversely affect the price and ease of a firm’s debt issuance. Such a downgrade can force (institutional) investors to sell securities, as investment mandates may restrict the securities that they are allowed to hold. We find that market repricing does not typically happen instantaneously after a downgrade, but instead over an extended period which preceding the actual downgrade. The impact of sales by institutional investors is softened by differences in the definition of “investment grade” and flexibility in investment funds’ mandates. Fallen angels since February 2020 follow this pattern, but with a swifter and stronger increase in the credit premium before the first downgrade. Securities of pandemic-related fallen angels show some post-event illiquidity which may be explained by the relatively sudden change in the broader economic outlook and wider market stress. Downgrades to below investment grade are typically also associated with lower bond issuance volumes. If a larger cohort of firms were to face funding pressures, this increases their vulnerability to shocks in the near term and, in the long term, could weigh on investment, creating wider macroeconomic costs.

Financial Stability Review Issue 2, 2020
23 November 2020
Assessing corporate vulnerabilities in the euro area

Abstract

JEL Classification

E6 : Macroeconomics and Monetary Economics→Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

G3 : Financial Economics→Corporate Finance and Governance

Abstract

The coronavirus pandemic has threatened the existence of many euro area firms. While liquidity shortages were seen as the major threat to corporate health at the beginning of the pandemic, more recently firms’ solvency has become the primary concern. Against this backdrop, this box assesses euro area corporate vulnerabilities and the underlying factors. It develops a new composite indicator that allows analysis of the time-varying impact and the relative importance of the factors driving corporate financial soundness and risk. Using aggregate sectoral accounts data, this measure combines indicators along five dimensions: debt service capacity, leverage/indebtedness, financing/rollover, profitability and activity. According to the composite indicator, corporate vulnerabilities have increased to levels last observed at the peak of the euro area sovereign debt crisis and are largely driven by a drop in sales, lower actual and expected profitability, and an increase in leverage and indebtedness. However, extensive monetary, fiscal and prudential policy measures have limited the increase in corporate vulnerability, primarily by ensuring favourable funding conditions. So far, government loan guarantees and bankruptcy moratoria have also prevented a large wave of corporate defaults, but a sizeable number of firms could be forced to file for bankruptcy if these measures are lifted too early or bank lending conditions tighten.

Financial Stability Review Issue 2, 2020
26 May 2020
Macroeconomic impact of financial policy measures and synergies with other policy responses

Abstract

Abstract

As authorities have sought to soften the impact of the coronavirus pandemic, a key concern has been the potential for the banking sector to ration credit and amplify the economic cost. Euro area real GDP could decrease substantially in 2020. For example, it could be 9 percentage points lower than expected before the pandemic shock, with a rebound in 2021 as confinement policies are reversed (see Chart A).

Financial Stability Review Issue 1, 2020
26 May 2020
The role of bank and non-bank interconnections in amplifying recent financial contagion

Abstract

Abstract

Recent events have shown that stress in non-banks can affect other parts of the financial system, for example through forced asset sales and reduced short-term funding. This box examines the interconnections between banks and non-banks through direct exposures, overlapping portfolios and ownership links, and considers how these can increase the risk of systemic contagion.

Financial Stability Review Issue 1, 2020
26 May 2020
Potential impact of government loan guarantee schemes on bank losses

Abstract

Abstract

Many euro area countries have made loan guarantee schemes a central element of their support packages in response to the coronavirus shock (see Chapter 1). In the face of acute revenue and income losses, these temporary schemes can support the flow of credit to the real economy and thereby help stabilise the banking system. This box sets out an illustrative assessment of how the announced schemes are intended to operate, and how they might affect the scale of losses that banks may face in the quarters ahead.

Financial Stability Review Issue 1, 2020
26 May 2020
Euro area banks’ sensitivity to corporate decarbonisation

Abstract

Abstract

As awareness of the environmental, social and economic risks from disorderly climate change has grown, so has awareness of the need for businesses to accelerate their decarbonisation. Banks need to be prepared for changes in loan performance should financial losses result from abrupt shifts in policies, technologies or consumer sentiment in response to the risks posed by climate change. While credit ratings could in principle capture such risks, in practice rating agencies have only just begun incorporating risks arising from an abrupt transition to a low-carbon economy.

Financial Stability Review Issue 1, 2020
26 May 2020
Financial stability implications of private equity

Abstract

Abstract

Private equity (PE) funding, and buyout funds in particular, have grown rapidly as a form of corporate financing in recent years, as the search for yield intensified. The outstanding amount of PE managed by global funds amounted to close to USD 8 trillion in December 2019, of which buyout funds accounted for around a third. Buyout funds have grown faster than any other PE strategy over recent years, even as their managers have diversified their activities. Institutional investors’ demand for access to PE buyout funds has been reflected in increasing rates of oversubscription of buyout funds in the primary market (see Chart A, left panel). This box provides an overview of the main developments in the PE buyout market and assesses potential financial stability risks to both investors in PE funds and the overall financial system.

Financial Stability Review Issue 1, 2020
26 May 2020
Derivatives-related liquidity risk facing investment funds

Abstract

Abstract

Stricter margining requirements for derivative positions have increased the demand for collateral by market participants in recent years. At the same time, euro area investment funds which use derivatives extensively have been reducing their liquid asset holdings. Using transaction-by-transaction derivatives data, this special feature assesses whether the current levels of funds’ holdings of cash and other highly liquid assets would be adequate to meet funds’ liquidity needs to cover variation margin calls on derivatives during stressed market periods, once the derivative portfolios become fully collateralised. The evidence so far indicates that euro area funds were able to meet the fivefold increase in variation margin during the height of the coronavirus-related market stress. But some of them were likely to have done so by engaging in repo transactions, selling assets and drawing on credit lines, thus amplifying the recent market dynamics.

Financial Stability Review Issue 1, 2020
26 May 2020
Trends in residential real estate lending standards and implications for financial stability

Abstract

Abstract

It is often maintained that the recent real estate booms in many euro area countries have been accompanied by a loosening in lending standards. However, data for a thorough cross-country assessment of lending standards have been missing. This special feature uses a novel euro area dataset from a dedicated data collection covering significant institutions supervised by ECB Banking Supervision to analyse trends in real estate lending standards and derive implications for financial stability. First, lending standards for residential real estate loans in the euro area, in particular loan-to-income ratios, eased between 2016 and 2018. Given the significant deterioration in the euro area economic outlook since the coronavirus outbreak, this vulnerability seems of particular relevance. Second, lending standards appear to be looser in countries that saw stronger real estate expansions, suggesting that real estate vulnerabilities may have been growing in some euro area countries. Third, lending standards deteriorated less in countries with borrower-based macroprudential policies in place, highlighting the importance of early macroprudential policy action to help prevent the build-up of real estate vulnerabilities.

Financial Stability Review Issue 1, 2020
25 May 2020
Dividend payouts and share buybacks of global banks

Abstract

Abstract

On 27 March, ECB Banking Supervision recommended that banks refrain from paying out dividends and buying back shares until 1 October 2020, following earlier announcements of temporary capital and operational relief measures. All national authorities in the euro area had made similar requests to banks under their direct supervision. In recent years, euro area banks have increased dividend payouts and share buybacks. Had this continued under the current circumstances, it may have weakened the ability of banks to use retained earnings to absorb losses and support lending to the real economy. This box reviews patterns in global banks’ payouts to shareholders and the contribution that lower payouts may make towards improving bank resilience.

Financial Stability Review Issue 1, 2020
25 May 2020
Recent stress in money market funds has exposed potential risks for the wider financial system

Abstract

JEL Classification

G10 : Financial Economics→General Financial Markets→General

G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

Euro area money market funds (MMFs) provide short-term credit to banks and non-financial corporations (NFCs) through purchases of commercial paper (CP). MMFs also play an important role in non-banks’ cash and liquidity management, given that the funds offer stable value and the possibility to redeem at short notice. As the coronavirus crisis deepened, euro area MMFs experienced large outflows and a number of them had difficulties in raising sufficient cash from maturing assets and liquid positions. Stress in MMFs can impair the financial system’s and the real economy’s access to short-term funding and liquidity during crises. Monetary policy action helped to improve financial market conditions more broadly, thereby also alleviating liquidity strains in the MMF sector.

Financial Stability Review Issue 1, 2020
25 May 2020
Volatility-targeting strategies and the market sell-off

Abstract

Abstract

Low financial market volatility in the years prior to the coronavirus outbreak increased the popularity of investment strategies based on targeting volatility. Low volatility across major asset classes and regions had been a key feature of global asset price developments until recently. Investments following strategies which are reliant on low market volatility have grown over recent years, with varying estimates. Globally, there may be funds with assets under management worth up to USD 2 trillion invested in some form of volatility strategies , with USD 300 billion invested in some 300 risk parity funds, a well-known hedge fund strategy for multi-asset funds. Additional leverage deployed in these funds raises their market-moving capacity.

Financial Stability Review Issue 1, 2020
20 November 2019
Macroprudential policy and powers within the Eurosystem

Abstract

Abstract

The Single Supervisory Mechanism (SSM) Regulation assigns macroprudential responsibilities to both national authorities and the ECB. According to Article 5 of the Regulation, whenever appropriate or deemed required, national authorities shall implement macroprudential measures and the ECB has the power to set higher requirements than those implemented by national authorities for the instruments covered by the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR).

Financial Stability Review Issue 2, 2019
20 November 2019
Portfolio rebalancing by euro area investment funds following outflows

Abstract

Abstract

When investment funds face outflows, fund managers may have to liquidate parts of their portfolio, potentially changing its composition and riskiness as a result. If fund managers

respond to outflows by selling securities proportionally to the initial asset allocation, i.e. selling a vertical slice of the portfolio, the liquidity and risk profile of the fund remains unchanged. But asset managers might have incentives to reduce the portfolio non-proportionally. For example, in trying to avoid incurring losses on illiquid assets, managers might choose to sell the most liquid securities first. And in the hope of increasing returns and attracting future inflows, they might choose to take on more risk in their portfolio. Other managers, worried about future outflows, might hoard liquid securities and de-risk their portfolios. However, large sales of illiquid securities may affect their market price at times of relatively low market liquidity, with possible spillovers to other financial institutions holding the same assets.

Financial Stability Review Issue 2, 2019
20 November 2019
Investment funds and the transmission of the global financial cycle to the euro area

Abstract

Abstract

As the role of investment funds in financing the global economy has grown, so has their role in cross-border capital flows and the global financial cycle. Movements of asset prices have

become more synchronised across countries since the early 1990s, indicating that a global financial cycle has emerged. US monetary policy is often considered as one of the main drivers of this cycle. Up to the mid-2000s, banks’ cross-border flows played a key role in the global synchronisation of financial conditions. Since then, portfolio flows of investment funds actively searching for yield in financial markets worldwide have increased.

Financial Stability Review Issue 2, 2019
20 November 2019
The ECB’s new euro area banking sector macro-micro model

Abstract

Abstract

The new macro-micro model was created for the purpose of macroprudential stress testing of the banking sector. It is a large-scale, multi-bank and multi-country, semi-structural model. The dynamics of each euro area economy are modelled separately, although they are interconnected via trade linkages.

Financial Stability Review Issue 2, 2019
20 November 2019
Climate risk-related disclosures of banks and insurers and their market impact

Abstract

Abstract

Scarce and inconsistent information on the climate-related risk embedded in assets makes the pricing of climate risk difficult for investors and authorities.Recent studies have found that environmental disclosures can affect the market valuation of non-financial businesses operating in sectors that are sensitive to the risks related to the transition to a low-carbon economy. But the impact is less clear for financial institutions. This box investigates climate-related disclosures of large euro area banks and insurers and their impact on stock market valuations.

Financial Stability Review Issue 2, 2019
20 November 2019
Valuations in corporate bond and equity markets

Abstract

Abstract

Global equity and corporate bond prices have increased steadily since the end of the euro area sovereign debt crisis. Equity prices relative to earnings expectations are at the upper end of

their historical distribution and corporate bond yields in the euro area are on aggregate at a historical low. During this time, euro area equity and corporate bond prices have been supported by the large decline in benchmark interest rates, which – in turn – reflects a decline in nominal economic growth rates, as well as accommodative monetary policies, including measures that brought down the short and the long end of the yield curve

Financial Stability Review Issue 2, 2019
20 November 2019
Explaining cross-border transactions in euro area commercial real estate markets

Abstract

Abstract

The upswing in euro area commercial real estate (CRE) markets in recent years has reflected, in part, a strong appetite from international investors, including US investment funds. Since

2013 transactions in euro area CRE markets have more than doubled, alongside a 20% increase in prices (15% in real terms) and a decline in average yields from 5.2% to 3.5%. In parallel, the share of transactions by foreign investors increased to 54% in 2018, from an average of 49% in 2013 when a particularly strong pick-up in transaction volumes started. Furthermore, the role of investment funds in foreign transactions increased to 63% in 2018 from 48% in 2013, with around 40% of these on average originating from the United States.

Financial Stability Review Issue 2, 2019
20 November 2019
Assessing the systemic footprint of euro area banks

Abstract

Abstract

This special feature discusses several ways in which the measurement of banks’ systemic footprint can be complemented with new indicators. The international approach is largely mechanical, but is intended to be complemented by expert judgement. The proposed additional systemic footprint measures may help macroprudential authorities in exercising that judgement. Using loan-level data matched with individual corporate balance sheet information allows macroprudential authorities to gain a better understanding of how a bank’s failure may affect employment and economic activity. Similar data, used in a model of network contagion, help assess the impact of a bank’s failure on the rest of the system. While the measures proposed in this special feature are not embedded in O-SII or G-SII scores, some evidence suggests that the concepts discussed have informed decisions of macroprudential authorities.

Financial Stability Review Issue 2, 2019
18 November 2019
Euro area bank profitability: where can consolidation help?

Abstract

JEL Classification

Add JEL codes separated by semi-colon. : General Economics and Teaching

Abstract

Low aggregate bank profitability in the euro area, which weakens the resilience of the euro area banking sector, is partly explained by the persistent underperformance of a sub-set of banks. These banks all stand out in terms of elevated cost-to-income ratios. But there also appear to be three distinct groups: (i) banks struggling with legacy asset problems; (ii) banks with weak income-generation capacity; and (iii) banks suffering from a combination of cost and revenue-side problems. The common cost inefficiency problem seems most pronounced for the largest and smallest banks. Three strategies, all of which should reduce overcapacity, could address the root causes, while avoiding increasing market power or the systemic footprint of institutions which are already systemically important. For some banks, the focus should be on targeting continued high stocks of NPLs. But in systems with many weak-performing small banks, consolidation within their domestic system could improve performance. Finally, a combination of bank-level restructuring and cross-border M&A activity could help reduce the costs and diversify the revenues of large banks that are performing poorly.

Financial Stability Review Issue 2, 2019
18 November 2019
Implications of bank misconduct costs for bank equity returns and valuations

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G38 : Financial Economics→Corporate Finance and Governance→Government Policy and Regulation

K42 : Law and Economics→Legal Procedure, the Legal System, and Illegal Behavior→Illegal Behavior and the Enforcement of Law

Abstract

Over the past decade, banks have been called to account for their past misconduct. The redress for misconduct has reduced the net income of euro area banks by one-third since the global financial crisis. Analysis further suggests that misconduct costs have had a negative impact on major euro area banks’ one-year buy-and-hold stock returns, after controlling for other bank-specific variables as well as bank and time fixed effects. This relationship appears to be strongest in the immediate aftermath of the global financial crisis, which might indicate greater investor concern about misconduct costs during times of stress.

Financial Stability Review Issue 2, 2019
29 May 2019
Insurers’ investment in alternative assets

Abstract

Abstract

In the current low interest rate environment, euro area insurers have been venturing into

alternative asset classes such as alternative, infrastructure and private equity funds, loans

and real estate holdings. This move helps insurers diversify their portfolios. It may also boost their investment returns and limit the duration mismatch in their balance sheets. More broadly, it

contributes to the diversification of the financing sources of the real economy (see Chart 4.1). But the

portfolio shift towards alternative investments also raises financial stability concerns, which is the

focus of this box. In particular, the shift may increase insurers’ credit and liquidity risks and contribute

to wider financial sector exuberance in some parts of the real economy as well as amplify market

shocks in the event of (abrupt) price corrections.

Financial Stability Review Issue 1, 2019
29 May 2019
The Eurosystem’s asset purchase programme, risk-taking and portfolio rebalancing

Abstract

Abstract

The Eurosystem’s asset purchase programme (APP) has contributed to a portfolio rebalancing of securities holdings within the euro area. The ECB’s asset purchases, with their largest component initiated in March 2015, have compressed the yields of securities across a wide range of asset classes. In line with the portfolio rebalancing transmission channel of monetary

policy, many investors responded to these lower yields by shifting their holdings towards riskier securities with higher expected returns. Non-banks, in particular, have moved increasingly into less-liquid and lower-rated bonds as well as longer-term securities in a search for yield. To the extent that a slowdown in growth or other market or policy developments lead to an increase in term or risk premia, investors may rebalance back towards safer assets.

Financial Stability Review Issue 1, 2019
29 May 2019
Gauging systemic risks from hard-to-value assets in euro area banks’ balance sheets

Abstract

Abstract

Uncertainty associated with hard-to-value securities on bank balance sheets can affect market perceptions of banks, especially during periods of stress. Fair value assets on bank balance sheets are classified into three categories: (i) those which are easy to value and based on quoted market prices (level 1 (L1) assets); (ii) those that are harder to value and only partially derive from quoted market prices (level 2 (L2) assets); and (iii) those that are particularly complex and the valuation of which is based on models instead of observed prices (level 3 (L3) assets). While the accounting standards provide the principles for the allocation of assets to the L2/L3 categories, they also leave some room for interpretation, which can result in different choices across banks. Valuation uncertainties can be problematic in times of stress should they lead investors to mistrust the value of banks’ assets, and in turn trigger liquidity or deleveraging pressures – not least if valuations behave in a correlated manner across banks or are concentrated in systemic banks. Worsening market liquidity conditions that would possibly also lead to reclassifications of assets into the L3 category could further amplify the effect. Against this background, this box first looks at the magnitude and distribution of L2/L3 assets in euro area banks’ balance sheets, and second at their impact on market perceptions of banks through the lens of price-to-book (P/B) ratios during normal and stressed times.

Financial Stability Review Issue 1, 2019
29 May 2019
Recent developments in and the outlook for global bank ratings

Abstract

Abstract

Despite criticism in the aftermath of the global financial crisis, the ratings assigned by the major credit rating agencies continue to play a key role for fixed income investors. Credit ratings can be considered as an overall assessment of the creditworthiness of non-financial and financial corporates. As acquiring information can be costly, they are particularly relevant for the

investment decisions of fixed income investors. The classification of issuers and securities into investment grade and high yield strongly affects institutional demand and might amplify the cyclicality of banks’ asset prices and funding costs during a downturn. Against this background, this box examines trends in credit ratings of listed banks across major advanced economies with a special focus on the euro area and discusses potential financial stability implications.

Financial Stability Review Issue 1, 2019
29 May 2019
Recent developments in banks’ price-to-book ratios and their determinants

Abstract

Abstract

The market valuations of euro area banks have remained low since the global financial crisis, lagging behind those of many international peers. Price-to-book (P/B) ratios offer a yardstick of

bank franchise value, where a P/B ratio greater than one suggests that a bank can generate market value commensurate to the value of its tangible assets. In this way, a P/B ratio lower than unity suggests investor concern about shareholder value, and manifests itself in a higher cost of capital should the bank opt to issue additional equity. This box investigates the determinants of P/B ratios, assessing to what extent bank and country-specific factors have contributed to hampering their recovery.

Financial Stability Review Issue 1, 2019
29 May 2019
CLOs: a financial stability perspective

Abstract

Abstract

Collateralised loan obligations (CLOs) – structured finance vehicles which repackage the credit risk of assets – hold around a third of the outstanding leveraged loans in Europe and the US. In parallel to the growth of leveraged loans, CLOs have almost doubled in size in the last five years. Most of the CLO tranches outstanding have been issued since 2016, when the underlying credit quality had already deteriorated through increased leverage and lower investor protection. In addition, CLO exposures tend to be relatively more concentrated in lower-rated leveraged loans. Amid recent developments in leveraged loan markets, this box focuses on financial stability risks deriving from CLOs.

Financial Stability Review Issue 1, 2019
29 May 2019
Do corporate fundamentals explain differences in sectoral NPLs?

Abstract

Abstract

Weak corporate asset quality is a concern from a financial stability perspective. Distressed corporate debt has been the centrepiece of the high stock of non-performing loans (NPLs) of euro

area banks. NPL stocks are a symptom of balance sheet difficulties faced by a large proportion of firms, which in turn may depress investment and employment, deprive banks of profitable lending opportunities, and therefore weigh on economic growth and the health of the banking sector itself.

Financial Stability Review Issue 1, 2019
29 May 2019
Policy uncertainty and the risk of market repricing

Abstract

Abstract

Financial Stability Review, May Policy uncertainty has remained elevated in recent years for the euro area and the broader global economy, at a time when the political landscape has become more fragmented. Political uncertainty has increased considerably since the global financial crisis in advanced economies. While political uncertainty is hard to capture in any single measure, heightened political fragmentation may complicate decision-making in national parliaments and could in certain instances potentially lead to policy instability. On this basis, a secular increase in the number of political parties during the past decades and a gradual decline in the voting share of the winning party suggests less cohesive political processes across constituencies. Independent of the attribution of political uncertainty to an underlying cause, swings in policy uncertainty have grown in recent years, with trade policy uncertainty gaining prominence due to growing trade protectionism.

Financial Stability Review Issue 1, 2019
29 May 2019
Assessing the risks to the euro area financial sector from a no-deal Brexit – update following the extension of the UK’s membership of the EU

Abstract

Abstract

The extension of the UK’s membership of the EU agreed by the European Council on 10 April avoided a no-deal Brexit scenario over the FSR review period. But the risk of a no-deal scenario

occurring at the end of the extension period cannot be excluded. The additional time should be used by both financial and non-financial sectors to continue to prepare for all possible contingencies, including a disorderly Brexit. Furthermore, banks should use the period in which the UK remains in the EU to make progress towards their target operating models within the timelines previously agreed with their supervisors.

Financial Stability Review Issue 1, 2019
29 May 2019
Macroprudential space and current policy trade-offs in the euro area

Abstract

JEL Classification

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

G28. : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

The countercyclical capital buffer (CCyB) is one of the centrepieces of the post-crisis reforms that introduced macroprudential policy instruments and aims to protect the resilience of the financial system. As only a few euro area countries have activated the CCyB, macroprudential authorities currently have limited policy space to release buffer requirements in adverse circumstances. This special feature provides insights into the relevant macroprudential policy response under different macroeconomic conditions and a gradual build-up of cyclically adjustable buffers could be considered to help create the necessary macroprudential space and to reduce the procyclicality of the financial system in an economic and financial downturn.

Financial Stability Review Issue 1, 2019
29 May 2019
Economic shocks and contagion in the euro area banking sector: a new micro-structural approach

Abstract

Abstract

The financial system can become more vulnerable to systemic banking crises as the potential for contagion across financial institutions increases. This contagion risk could arise because of shifts in the interlinkages between financial institutions, including the volume and complexity of contracts between them, and because of shifts in the economic risks to which they are commonly exposed. Analysis of the euro area banking system’s interlinkages, using the newly available large exposure data, suggests that the system could be more vulnerable to financial contagion through long-term interbank exposures than noted in other studies. That said, common exposures to the real economy – a standard contagion channel in the literature – represent a potential source of individual bank distress and non-systemic events. This analysis also provides an insight into the changes in contagion risk in the system over time, helping us to interpret changes in market indicators of systemic risk, such as aggregated credit default swap (CDS) prices.

Financial Stability Review Issue 1, 2019
29 May 2019
Climate change and financial stability

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

G20 : Financial Economics→Financial Institutions and Services→General

Q54 : Agricultural and Natural Resource Economics, Environmental and Ecological Economics→Environmental Economics→Climate, Natural Disasters, Global Warming

Abstract

This special feature discusses the channels through which climate change can affect financial stability and illustrates the exposure of euro area financial institutions to risks from climate change with the help of granular data. Notwithstanding currently limited data availability, the analysis shows that climate change-related risks have the potential to become systemic for the euro area, in particular if markets are not pricing the risks correctly. A deeper understanding of the relevance of climate change-related risks for the euro area financial system at large is therefore needed. Better data availability and comparability and the development of a forward-looking framework for risk assessments are important aspects of this work going forward.

Financial Stability Review Issue 1, 2019
29 November 2018
Counterparty and liquidity risks in exchange-traded funds

Abstract

Abstract

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

Financial Stability Review Issue 2, 2018
29 November 2018
How can euro area banks reach sustainable profitability in the future?

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G24 : Financial Economics→Financial Institutions and Services→Investment Banking, Venture Capital, Brokerage, Ratings and Ratings Agencies

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

Abstract

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

Financial Stability Review Issue 2, 2018
29 November 2018
Bond funding of euro area banks: progress in the issuance of loss-absorbing instruments

Abstract

Abstract

Global and European regulation is progressively introducing the requirement for banks to have sufficient loss-absorption and recapitalisation capacity, extending beyond equity

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

Financial Stability Review Issue 2, 2018
29 November 2018
Assessing the risks to the euro area financial sector from a disruptive hard Brexit

Abstract

Abstract

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

Financial Stability Review Issue 2, 2018
29 November 2018
ESTER – the new overnight rate for the euro money markets

Abstract

Abstract

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

Financial Stability Review Issue 2, 2018
29 November 2018
Recent trends in credit terms and conditions in euro-denominated securities financing and over-the-counter derivatives markets based on information from the SESFOD survey

Abstract

Abstract

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

Financial Stability Review Issue 2, 2018
29 November 2018
Liquidity conditions in the Italian sovereign bond market since May

Abstract

Abstract

Liquidity in the Italian sovereign bond market deteriorated sharply at the end of May. Heightened political uncertainty led to a rise in Italian sovereign bond yields and triggered a

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

Financial Stability Review Issue 2, 2018
29 November 2018
Assessing global asset price developments through the lens of a structural BVAR model

Abstract

Abstract

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

Financial Stability Review Issue 2, 2018
29 November 2018
Explaining the slowdown in portfolio flows to EMEs

Abstract

Abstract

Portfolio flows to EMEs have declined significantly in the course of 2018, largely as a result of increased investor sensitivity towards EME asset markets and rising protectionist pressures.

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

Financial Stability Review Issue 2, 2018
27 November 2018
The resurgence of protectionism: potential implications for global financial stability

Abstract

JEL Classification

E37 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Forecasting and Simulation: Models and Applications

F13 : International Economics→Trade→Trade Policy, International Trade Organizations

F18 : International Economics→Trade→Trade and Environment

F47 : International Economics→Macroeconomic Aspects of International Trade and Finance→Forecasting and Simulation: Models and Applications

Abstract

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

Financial Stability Review Issue 2, 2018
24 May 2018
A new financial stability risk index to predict the near-term risk of recession

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The real economy repercussions of financial crises are the ultimate focus of financial stability monitoring and policymakers. By extending a standard set of financial stability indicators with indicators capturing spillover and contagion risks, this special feature proposes a financial stability risk index (FSRI) that has predictive power for the near-term risk of deep recessions. It is shown that the empirical performance of the index benefits from combining a large set of macro-financial indicators and, notably, that the information content of the spillover and contagion risk indicators is important.

Financial Stability Review Issue 1, 2018
24 May 2018
Predicting the likelihood and severity of financial crises over the medium term with a cyclical systemic risk indicator

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature presents a tractable, transparent and broad-based cyclical systemic risk indicator (CSRI) that captures risks stemming from domestic credit, real estate markets, asset prices, external imbalances and cross-country spillovers. The CSRI increases on average several years before the onset of systemic financial crises and its level is highly correlated with measures of crisis severity. Model estimates suggest that high values of the CSRI contain information about large declines in real GDP growth three to four years down the road, as it precedes shifts in the entire distribution of future real GDP growth and especially of its left tail. Given its timely signals, the CSRI is a useful analytical tool for macroprudential policymakers to complement other existing analytical tools.

Financial Stability Review Issue 1, 2018
24 May 2018
Assessing the financial stability risks of a possible repricing in the market for subordinated bank bonds

Abstract

Abstract

The cost of subordinated bank debt in the euro area is low and may be susceptible to repricing. Euro area bank bond yields and spreads have narrowed significantly since mid-2016,

reaching levels last observed prior to the global financial crisis. The reductions have been particularly noticeable in the markets for subordinated bonds.57 Against this background, this box

first evaluates whether there are indications that the prices of these bonds may be vulnerable to a correction. It then assesses the potential financial implications stemming from a spread reversal in euro area subordinated bank bonds. The box focuses in particular on the holders of these instruments and examines the sectors that may be particularly vulnerable to a turnaround in this market.

Financial Stability Review Issue 1, 2018
24 May 2018
Recent developments in pricing of non-performing loan portfolio sales

Abstract

Abstract

The market for NPLs in Europe has become more active in recent years. The total amount and volume of transactions has continuously increased in the last three years, although part of the increase in volumes can be attributed to just a few large transactions. Italy and Spain account for the majority of the market turnover. However, the geographical scope of NPL markets in the euro area has also widened, with transactions starting in Greece in 2017 and in Cyprus in 2018. At the same time, market activity in more mature NPL markets, such as Ireland, has weakened against the backdrop of a diminishing supply of NPLs.

Financial Stability Review Issue 1, 2018
24 May 2018
Cost efficiency of euro area banks

Abstract

Abstract

Improving operating efficiency is key if euro area banks are to raise their profitability to

sustainable levels. The FSR has been consistently reporting on the basis of accounting indicators,

such as the cost-to-income ratio (CIR) and the cost-to-assets ratio, that, on aggregate, euro area

banks’ cost efficiency has deteriorated somewhat since 2010. While the improving cyclical

environment is supporting bank profitability, raising it to levels that can ensure banks are able to

provide financing to the real economy in a sustainable manner would benefit from improving their

cost efficiency.

Financial Stability Review Issue 1, 2018
24 May 2018
Leveraged loans: a fast-growing high-yield market

Abstract

Abstract

The market for leveraged loans is significant and recent developments may be generating financial stability risks.25 In both Europe and the United States, the markets for leveraged loans

issued by non-financial corporates are about five times larger than high-yield bond markets. In 2017 US leveraged loan issuance rose well above its pre-crisis levels, with gross issuance, depending on methodology and data source, estimated at between €500 billion and €1 trillion, while EU issuance, estimated at between €120 billion and €320 billion, is around the previous highs recorded in 2007 and 2014.

Financial Stability Review Issue 1, 2018
24 May 2018
Financial stability implications of crypto-assets

Abstract

Abstract

This box assesses potential financial stability concerns related to the rapidly growing market for crypto-assets. Crypto-assets (e.g. bitcoin, ether and ripple) are a new, innovative and high-risk digital asset class.21 Recent price developments and market interest in crypto-assets have given rise to concerns about potential financial stability implications. This box presents key facts on crypto-assets, concluding that they do not currently pose a material risk to financial stability in the euro area, but warrant careful monitoring.

Financial Stability Review Issue 1, 2018
24 May 2018
Regime shifts in stock market volatility: a historical perspective on the US market

Abstract

Abstract

After a period of about two years with fairly steady price increases and persistently low volatility, global stock markets experienced a notable price and volatility correction in early February 2018. Before this correction, policy authorities had become concerned about the benign volatility conditions, since low volatility may lead market participants to take on excessive risk and

thereby create risks to financial stability (the “volatility paradox”). Against this background, a return to conditions of higher volatility could, on the one hand, be regarded as a welcome normalisation. On the other hand, a “disorderly” stock market correction with sharp price declines and large price fluctuations might itself pose risks to financial and economic stability.

Financial Stability Review Issue 1, 2018
24 May 2018
Listed commercial real estate companies and real estate investment trusts: trends and implications for financial stability

Abstract

Abstract

Assessing the dynamics of the euro area commercial real estate (CRE) sector during the current cyclical upturn remains important for identifying potential financial stability risks. The downturn in CRE markets played a significant role in the last financial crisis in many countries and contributed to the increase in the non-performing exposures of the banking sector. As part of this assessment, this box analyses the growing importance of listed CRE companies, and a sub-set thereof known as real estate investment trusts (REITs), in the euro area.

Financial Stability Review Issue 1, 2018
24 May 2018
The growing systemic footprint of Chinese banks

Abstract

Abstract

Emerging market economies have experienced accelerated financial deepening since the onset of the financial crisis. Consequently, financial stability risks emanating from emerging

markets may spill over more widely to the global financial system. A key focus in this regard has been China, not least given the sheer size of its banking sector and the country’s growing role in international finance. Against this background, this box investigates the risks related to the growing size and systemic importance of Chinese banks and their possible implications for euro area financial stability.

Financial Stability Review Issue 1, 2018
24 May 2018
The distribution of interest rate risk in the euro area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature analyses the distribution of interest rate risk in the euro area economy using balance sheet data and information on derivatives positions from significant credit institutions. On aggregate, banks’ interest rate risk exposure is small relative to their loss absorption capacity, but exposure varies across institutions. This variation is driven by loan rate fixation practices at country level. Banks use derivatives for hedging, but retain residual interest rate risk exposures. In fixed-rate countries the main vulnerability to rising interest rates lies with the banks that have the greatest interest rate risk, while households would be directly affected in countries with predominantly variable-rate loans. In the latter case, increased loan servicing costs due to rising interest rates could affect banks through lower asset quality.

Financial Stability Review Issue 1, 2018
29 November 2017
Can commodity trading firms create systemic risk via derivatives markets?

Abstract

Abstract

Commodity traders are relevant from a financial stability perspective as they are active players in derivatives markets. Commodity dealers buy or sell a commodity and transform it, for

example, by transporting or storing it, and may hedge the resulting commodity position with a derivative transaction. The derivative contract will hedge, for example, against commodity price risk, which is considered the largest risk for most trading firms, or against changes in foreign exchange rates. Thus, hedging is inherent to the business of commodity dealers and derivatives are central to commodity traders’ risk management frameworks. At the same time, there are concerns about the speculative use of derivative contracts. For example, in the US the Commodity Futures Trading Commission (CFTC) intends to establish position limits for physical commodity derivatives, with the aim to prevent excessive speculation from distorting commodity prices.

Financial Stability Review Issue 2, 2017
29 November 2017
How would a repricing in bond markets impact euro area investment funds?

Abstract

Abstract

An abrupt repricing of risk premia in bond markets has the potential to expose vulnerabilities in the rapidly growing investment fund sector. A shock to bond prices would give rise to first-round mark-to-market losses for open-end investment funds, particularly those with large exposures to debt securities. From a systemic risk perspective, these losses could propagate through the financial system if negative returns trigger investor outflows, eventually resulting in forced sales of fund portfolios. Such sales have the potential to amplify the original shock to bond prices, with wider financial stability implications in the form of impaired market liquidity and possible spillovers to the real economy, via negative wealth and confidence effects. This box sheds some light on this channel, dubbed the “flow-performance nexus”, by quantifying the impact of an interest rate shock on the net asset values of euro area-domiciled investment funds (everything else held equal). More specifically, the first part of the analysis examines the impact of an increase in yields on the net asset value of the main euro area investment fund categories (equity, bond, mixed, real estate, money market, hedge and other funds), while the second part particularly focuses on euro area bond funds.

Financial Stability Review Issue 2, 2017
29 November 2017
Investment strategies of euro area insurers and pension funds: procyclical or countercyclical?

Abstract

Abstract

Traditionally, the investment behaviour of insurance corporations and pension funds (ICPFs) has been viewed as having a stabilising effect on financial markets in that they act

countercyclically by buying assets, the prices of which fall. Since ICPFs aim to match their long-term liabilities with their long-term assets, they are natural long-term investors and, as such,

they typically hold assets until maturity and are less sensitive to short-term price movements. However, recent studies challenge this view by providing empirical evidence of procyclical

Financial Stability Review November 2017 – Euro area financial institutions investment behaviour, whereby ICPFs sell assets after a drop in price, especially in periods of severe market stress.

Financial Stability Review Issue 2, 2017
29 November 2017
Market perceptions of bank risk in connection with cuts in the deposit facility rate to below zero

Abstract

Abstract

To stimulate post-crisis economies characterised by low growth and low inflation, some central banks, including the ECB, have adopted negative policy rates. The rationale for negative rates is that they provide additional monetary stimulus, giving banks an incentive to lend to the real sector and thereby supporting growth and a return to target inflation.

Financial Stability Review Issue 2, 2017
29 November 2017
Bond market liquidity indicators – an overview

Abstract

Abstract

An accurate assessment of bond market liquidity conditions is a crucial input for financial stability risk analysis. As commonly defined, “liquidity” measures how much trading volume a

financial market can absorb for a given change in price or what the price impact of a given trade volume will be. More elusively, liquidity may indicate how well market prices revert to their

fundamental values. Lower bond market liquidity could amplify market price swings, impair the conversion into cash, and thus create financial stability risks.

Financial Stability Review Issue 2, 2017
29 November 2017
Update on reference rate reforms in the euro area

Abstract

Abstract

Sound benchmarks are necessary for the efficient functioning of the financial system. Benchmark rates are important because of their anchoring role for contracts in financial markets. In

addition, benchmark rates play a pivotal role in the operationalisation and monitoring of the transmission of the ECB’s monetary policy.17 Benchmark rates have been undergoing in-depth

reforms over the last few years. These reforms have been largely guided by a set of principles issued by the International Organization of Securities Commissions (IOSCO) in 2013 as a response to the scandals related to the manipulation of LIBOR. As a result of those reforms, market practices and contracts might need to be adapted to a new environment in the years to come.

Financial Stability Review Issue 2, 2017
29 November 2017
The prevalence of vulnerable firms in the euro area

Abstract

Abstract

The pre-crisis period was characterised by a debt-financed investment boom that ultimately proved unsustainable. Excessive borrowing coupled with overinvestment in some euro area

economies in the run-up to the global financial crisis has rendered parts of the euro area nonfinancial corporate sector vulnerable to shocks. As the financial crisis unfolded and macroeconomic conditions deteriorated, vulnerabilities that were looming in corporate balance sheets became increasingly apparent, with many firms no longer able to service their financial obligations.

Financial Stability Review Issue 2, 2017
29 November 2017
Overcoming Non-Performing Loan Market Failures with Transaction Platforms

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

When banks judge that more value can be extracted by offering non-performing loans (NPLs) for sale rather than working them out themselves, potential investors cannot be sure that the credit quality of the assets is as good as the banks portray it to be. Such information asymmetries in the NPL market drive a wedge between the prices that investors are prepared to pay for NPLs and the prices that banks are prepared to sell them for. While information asymmetries can be overcome through investor due diligence, this requires specialist expertise and the costs of valuing NPL portfolios can be very high. As few investors have the resources to absorb such costs, barriers to entering the market are compounded. This appears to explain why the euro area NPL markets display the features of an oligopsony, a situation where there is a concentration of market power among a limited number of investors, which pushes traded prices even lower. At the same time, potential NPL investors can face coordination challenges when debtors have multiple loans with different banks. In such situations, investors must face the prospect of competing with other creditors for the debtor’s resources. While coordination between banks for common exposures may alleviate this problem, this too can be costly, weighing further on market prices. By offering the prospect of greater transparency in NPL markets, fostering wider investor participation and addressing coordination issues, NPL transaction platforms could help in overcoming all three of these market failures. The attendant improvement in market liquidity would allow banks to achieve better prices for NPL sales, preserve their capital and mitigate financial stability risks. This special feature outlines the desirable features of NPL transaction platforms and discusses their operational implementation.

Financial Stability Review Issue 2, 2017
29 November 2017
Cross-Border Banking in the Euro Area since the Crisis: What is Driving the Great Retrenchment?

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature examines the potential drivers of the post-crisis retrenchment in cross-border banking in the euro area, which stands out in international comparison. Examining a wide range of possible determinants of this phenomenon, it establishes a significant link between deteriorating asset quality and the retrenchment in cross-border banking. Conversely, tighter prudential policies and the introduction of bank levies do not contribute to explaining the reduction in cross-border banking activity. Therefore, tackling the persistent asset quality problems, along with the completion of the banking union, would seem to be pivotal to reaping the potential benefits of cross-border banking within the euro area in terms of risk diversification and risk-sharing.

Financial Stability Review Issue 2, 2017
29 November 2017
Recent Developments in Euro Area Repo Markets, Regulatory Reforms and their Impact on Repo Market Functioning

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Effectively functioning repo markets are of key importance for both financial stability and monetary policy, but the excessive use of repos may also be a source of systemic risk as witnessed during the recent financial crisis. Regulatory reforms introduced since the start of the crisis have aimed to contain systemic risk related to the excessive build-up of leverage and unstable funding, but recently some concerns have been raised about their potential effects on the functioning of the repo market. This special feature presents new evidence on the drivers of banks’ activity in the repo market with respect to regulatory reforms. In addition, it takes a closer look at the repo market structure and pricing dynamics, in particular around banks’ balance sheet reporting dates. While the observed volatility around reporting dates suggests that the calculation methodology for some regulatory metrics should be reviewed, overall, the findings indicate that unintended consequences of regulatory reforms on the provision of repo services by euro area banks have not been material.

Financial Stability Review Issue 2, 2017
29 November 2017
Higher Future Financial Market Volatility: Potential Triggers and Amplifiers

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The reduction in asset price volatility in recent years has taken place in tandem with investors lowering the premia required for lower-rated assets. The current favourable market sentiment could however change abruptly if, for instance, investors were to reassess the outlook for growth or monetary policy. Potential surges in asset price volatility could be amplified by: (i) investors selling off assets perceived as overvalued; (ii) the high levels of corporate leverage; and/or (iii) a rapid unwinding of market positions that benefit from low volatility. Low volatility in financial markets is therefore being closely monitored by financial stability authorities, as it may mask an underpricing of risks and a build-up of financial imbalances.

Financial Stability Review Issue 2, 2017
24 May 2017
Who would pay more for a European deposit insurance scheme: small, medium or large banks?

Abstract

Abstract

On 24 November 2015, the European Commission published a proposal for a European Deposit Insurance Scheme (EDIS). The proposal concerned the creation of a European system of

deposit insurance supported by a European fund and managed by the Single Resolution Board (SRB). One issue frequently raised in connection with this concerns how much various different banks should contribute to such an EDIS. In particular, one of the questions asked is whether, in order to reduce the reporting burden, smaller banks should make a lump-sum, rather than a riskbased, contribution. Another question is whether large banks, which are more likely to go into resolution than insolvency, should be charged a lower percentage of their covered deposits in contributions to the deposit insurance fund, given that these banks already contribute more to the Single Resolution Fund (SRF) and are less likely to need assistance from the EDIS.

Financial Stability Review Issue 1, 2017
24 May 2017
Exchange-traded funds in the euro area – recent trends and vulnerabilities

Abstract

Abstract

Concerns about exchange-traded funds (ETFs) amplifying potential stress in financial markets have resurfaced recently in view of the rapid growth of the industry. Over the past decade, the market for exchangetraded funds has grown to more than €3 trillion of assets under management globally, of which almost €550 billion is accounted for by ETFs domiciled in the euro area. The growth of the sector has been accompanied by a more general increase in the role of passive investment strategies. This box reviews the main features of the ETF market in the euro area and discusses some potential financial stability risks associated with an expanded role for this asset class in the euro area financial landscape.

Financial Stability Review Issue 1, 2017
24 May 2017
The growing role of non-bank lending to households – a case study on the Netherlands

Abstract

Abstract

Non-bank lending to households is increasing. In the euro area, the share of non-banks in longterm lending to households grew from 4.2% in 2010 to 5.4% in 2016. Behind this overall increase are large differences between countries, both in terms of the share of non-bank lending and in terms of its growth since 2010. In most countries, the provision of long-term loans to households is still dominated by banks. In the Netherlands, where insurance companies have long since played a role in mortgage lending, non-banks provide a relatively large share of these loans. Based on joint analysis with De Nederlandsche Bank (DNB), this box describes the shift towards non-bank lending in the Dutch mortgage market and discusses the implications for financial stability and macroprudential policy.

Financial Stability Review Issue 1, 2017
24 May 2017
A comparison of market-based indicators of banking system stress

Abstract

Abstract

One standard market-based indicator of systemic risk regularly presented in the Financial Stability Review is the probability of default of two or more banking groups in the euro

area.50 Recently, a number of alternative methodologies have become available which measure similar market-based banking stress probabilities. The main aim of this box is to cross-check the information content of these alternative measures with the ECB’s core indicator.

Financial Stability Review Issue 1, 2017
24 May 2017
Assessing the accuracy of euro area bank analysts’ earnings forecasts

Abstract

Abstract

For some time, the prospect of continuing low profitability of euro area banks has been highlighted in the FSR as a key risk for financial stability. This risk remains a cause for

concern, as both cyclical and structural factors continue to weigh on banks’ ability to generate sustainable profits. In monitoring this risk, the ECB and other institutions make regular use of bank analysts’ earnings forecasts. Looking at data for euro area banks, this box evaluates the accuracy of those forecasts.

Financial Stability Review Issue 1, 2017
24 May 2017
Interpretations of the recent increases in TARGET2 balances

Abstract

Abstract

This box analyses the factors underlying the renewed increases in TARGET2 balances and concludes that they do not reflect capital flight from certain euro area countries in a context

of generalised mistrust of the respective banking sectors. The increase in TARGET2 balances since March 2015 largely mirrors the cross-border payments resulting from the injection of

liquidity via the APP. Owing to the integrated financial structure in the euro area, securities purchased under the APP are often purchased from counterparties located outside of the jurisdiction of the purchasing central bank. When payments for the securities purchased are made across borders, TARGET2 balances are affected. A significant number of large APP counterparties are domiciled in financial centres located in a few countries. Moreover, non-euro area counterparties, from which around half of purchases by volume have been made, access the TARGET2 payment system mainly via Germany and therefore receive payment for the securities sold to the APP in that jurisdiction. The outcome is that payments for securities purchased under the APP result in sizeable increases in TARGET2 balances.

Financial Stability Review Issue 1, 2017
24 May 2017
Residential real estate prices in capital cities: a review of trends

Abstract

Abstract

Heterogeneous regional developments in housing markets may be a cause for concern from a financial stability perspective. Although diverging developments at the regional level could be

justified by fundamentals, such as differences in regional income, employment, population dynamics and amenities, they could also signal excessive exuberance of house prices in certain

areas, for example due to the strong presence of foreign buyers. In this case, regional developments may spill over to adjacent locations or the entire country via “ripple effects”, with regional price developments potentially ending up leading the housing cycle at the country level. Thus, a close monitoring of regional residential real estate price trends seems warranted, as they may provide an early indication of a potential build-up of vulnerabilities in housing markets at the national level. Moreover, exuberant house price developments in certain regions could, in principle, threaten the stability of financial institutions with mortgage exposures concentrated in those regions. This is especially the case in the context of a low interest rate environment spurring a potential search for yield.

Financial Stability Review Issue 1, 2017
24 May 2017
Financial vulnerability of euro area households

Abstract

Abstract

Monitoring households’ debt servicing capability is vital from a financial stability perspective, not least given the relative importance of household lending in banks’ loan portfolios and the potential associated impact on the profitability and solvency of banks. However, assessing the financial vulnerability of households is challenging, owing to the need for granular data on

household assets, income and liabilities. A key source of consistent information based on households’ self-reported assessments is the Household Finance and Consumption Survey (HFCS). The rich data on the liabilities side of the household balance sheet available in the HFCS makes it a valuable resource for monitoring household financial fragility.

Financial Stability Review Issue 1, 2017
24 May 2017
Preparing for Brexit to secure the smooth provision of financial services to the euro area economy

Abstract

Abstract

The decision of the United Kingdom to withdraw from the European Union (EU) contributes to prevailing political uncertainties, but should not have significant financial stability implications, especially if adequate preparations are made. On 29 March 2017 the United Kingdom notified the European Council, in accordance with Article 50(2) of the Treaty on European Union, of the United Kingdom’s intention to withdraw from the EU. While it adds to the prevailing political uncertainty, the Brexit process itself is currently not one of the main concerns for euro area financial stability. At the same time, depending on the nature of the agreement on withdrawal, the new relationship and any possible transitional arrangements, Brexit will affect how financial services are provided to euro area customers.

Financial Stability Review Issue 1, 2017
24 May 2017
Assessing the Decoupling of Economic Policy Uncertainty and Financial Conditions

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature analyses the recent decoupling between measures of financial conditions and economic policy uncertainty. In 2016, several risky asset prices surged and financial market volatility hovered at low levels while measures of economic policy uncertainty increased sharply, the latter partly triggered by the outcomes of the UK referendum on EU membership and the US presidential election. This special feature attempts to explain these diverging trends. It starts out by reviewing the existing academic literature on uncertainty and its implications for financial conditions. In the empirical part that follows, it provides model-based estimates of the drivers underlying the benign financial conditions prevailing in UK and US financial markets. The results suggest that the adverse impact of economic policy uncertainty on financial conditions in the United States was more than offset by a positive demand shock. In the case of the United Kingdom, however, it was the resolute accommodative monetary policy actions by the Bank of England that supported financial conditions after the referendum. Turning to the euro area, policy uncertainty increased in several countries in the first months of 2017. Looking ahead, further shocks stemming from the political sphere may, in the absence of offsetting factors, tighten domestic financial conditions, increase risk premia and potentially raise debt sustainability concerns.

Financial Stability Review Issue 1, 2017
24 May 2017
Measuring Credit Gaps for Macroprudential Policy

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Excessive credit growth and leverage have been key drivers of past financial crises, notably the recent global financial crisis. For the appropriate setting of countercyclical macroprudential policy instruments, it is therefore important to identify periods of excessive credit developments at an early stage. This special feature discusses the standard statistical method for computing credit gaps and compares it with an alternative approach to measuring credit excesses based on fundamental economic factors. Theory-based credit gaps could provide a useful complement to statistical measures of cyclical systemic risk.

Financial Stability Review Issue 1, 2017
24 May 2017
Resolving Non-Performing Loans: A Role for Securitisation and Other Financial Structures?

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Large stocks of non-performing loans (NPLs) on euro area bank balance sheets continue to present risks to financial stability. Significant legal and administrative reforms have been undertaken over recent years in countries with high levels of NPLs to streamline insolvency proceedings and maximise NPL recovery values. Yet, the market continues to provide low NPL valuations that result in wide bid-ask spreads, thus impeding large-scale NPL sales. This special feature highlights the potential role and benefits of co-investment strategies (between the private sector and the state) for addressing NPLs. These co-investment strategies may reduce information asymmetries between buyers and sellers, thereby enabling transactions that might otherwise not occur, or facilitate sales at higher prices. Moreover, the proposed schemes are priced at market levels and may, therefore, be free of state aid.

Financial Stability Review Issue 1, 2017
24 November 2016
The evolution of sectoral holdings of bail-inable bank debt

Abstract

Abstract

The sectoral distribution of holdings of bank debt has a clear bearing on contagion and – by extension – on financial stability in the event of bank distress. Indeed, under the new bail-in

regime in the EU, eventual write-downs (and/or conversion into equity) upon bank bail-in need to be distributed among shareholders and creditors according to a predefined creditor hierarchy, while avoiding contagion effects on the broader financial system. On the one hand, if a bank were to struggle, high financial sector concentration of its bail-inable debt could lead to concerns over spillover effects. On the other hand, if the bail-inable instruments were held mainly by the household sector, the use of bail-in tools in a bank resolution process may have negative effects on the economy resulting from effects on spending and potential political tensions.

Financial Stability Review Issue 2, 2016
24 November 2016
Assessing the spillover potential between banks, shadow banks and insurance companies in Europe

Abstract

Abstract

Financial distress in the non-bank financial sector can be transmitted to the banking sector through a number of direct and indirect transmission channels. First, the banking sector may be directly exposed to non-bank financial institutions through equity investment or credit claims. Credit claims often arise in connection with prime brokerage services through which non-bank financial firms increase their leverage. In addition, the liquidity credit lines that provide non-financial firms with a backstop against an outflow of their short-term liabilities could also give rise to a significant exposure. Second, non-bank financial institutions play an important role in the funding of the banking sector by investing in bank debt securities and providing liquidity through secured money markets, as well as through the provision of collateral. Third, banks and non-bank financial institutions are also indirectly interconnected through common exposures to assets. Distress in one of these sectors may give rise to asset fire sales, which would depress the prices of assets held by the other sector and, through mark-to-market accounting, adversely impact the profits and capital of that sector.

Financial Stability Review Issue 2, 2016
24 November 2016
The potential for spillovers from emerging markets to euro area banks

Abstract

Abstract

Many emerging market economies (EMEs) are facing a difficult combination of slow growth, weak commodity prices, and further tightening credit conditions. These challenging aggregate

conditions point to the potential for negative spillovers to the euro area. Direct exposures of euro area banks to emerging market assets remain limited (see Box 1 of the May 2016 FSR). At the same time, potential shocks could be transmitted through indirect channels to euro area banks via EMEs’ trade links with euro area countries and a broader financial market confidence channel stemming from uncertainty about growth prospects in EMEs. Such indirect channels are complex. One way of gauging them is by measuring the market perception of the potential for spillovers of financial risk from emerging markets to euro area banks.

Financial Stability Review Issue 2, 2016
24 November 2016
The ECB’s monetary policy and bank profitability

Abstract

Abstract

Banks’ ability to generate adequate profits is relevant for the sustainability of the banking system and, as such, for its ability to provide adequate funding to the economy. Profitable

banks are able to attract capital from market investors and to generate capital through retained earnings. Since the financial crisis, euro area banks’ profitability has been low. This has reflected many factors, including the recognition of losses in the wake of the crisis, restructuring efforts with the aim of improving resilience, as well as an environment of low economic growth and low interest rates. The ECB has mitigated risks to euro area price stability stemming from the crisis by lowering policy rates and adopting a wide range of non-conventional monetary policy measures, in particular the negative deposit facility rate, the expanded asset purchase programme and the targeted longerterm refinancing operations (TLTROs). Since the transmission of these measures hinges on the banking system, they have the potential to affect bank profitability.

Financial Stability Review Issue 2, 2016
24 November 2016
Have global uncertainty shocks become less persistent?

Abstract

Abstract

Global financial markets have been marked by a number of short-lived episodes of elevated volatility in recent years. Strong corrections in asset markets can have adverse financial stability

implications for the financial system owing to the losses that have to be absorbed, thereby reducing available buffers. A prolonged period of volatile and falling asset prices may also weaken the real economy via wealth effects and confidence channels. While large or persistent shocks to asset price volatility can cause clear harm to financial stability, so too might seemingly more insidious short-lived corrections. Indeed, amid surges in market volatility that are short-lived and quick to fade, investors are more likely to take undue risks.

Financial Stability Review Issue 2, 2016
24 November 2016
Monitoring euro area residential real estate markets from a macroprudential perspective

Abstract

Abstract

No other macroeconomic segment has been more closely linked to financial stability than residential real estate. Historical evidence shows that financial crises involving housing market

imbalances have had severe negative repercussions on the overall financial system and economic growth. Accordingly, policies to contain risks stemming from residential property markets have assumed a key role in the macroprudential toolkit. Judiciously informing their use is, however, challenging given the multitude of factors behind real estate developments. This calls for an encompassing view that goes beyond traditional standardised price and valuation metrics.

Financial Stability Review Issue 2, 2016
24 November 2016
Is euro area financial stress becoming more global?

Abstract

Abstract

Financial stress indices have become a common tool to measure the current state of (in)stability in an economy’s financial system as a whole or major parts of it. Recent developments in a particular variant of such an index for the euro area, namely the composite indicator of systemic stress (CISS), reveal three distinct features: First, since mid-2013, the volatility of the CISS has gradually increased, with several large spikes in the last years. This presumably relates to major local and global stress events and may imply heightened risks to financial stability going forward. Second, the euro area CISS has displayed a gradual upward trend over this same period. More recently, the immediate stress following the UK referendum outcome lifted the indicator temporarily to levels last observed at the height of the euro area sovereign debt crisis. Third, the euro area index’s more pronounced swings since 2013 have been correlated with similar movements in other major economic regions – in either the US or Chinese CISS, or both. This may suggest that euro area financial stability conditions have become more intertwined with the international environment.

Financial Stability Review Issue 2, 2016
24 November 2016
Towards a Framework for Calibrating Macroprudential Leverage Limits for Alternative Investment Funds

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Alternative investment funds (AIFs) in Europe operate without regulatory leverage limits. Competent authorities within the EU have the legal power to impose macroprudential leverage limits on AIFs, but no authority has implemented this tool so far. This joint European Central Bank-De Nederlandsche Bank (DNB) special feature (i) presents a macroprudential case for limiting the use of leverage by investment funds, (ii) develops a framework to inform the design and calibration of macroprudential leverage limits to contain the build-up of leverage-related systemic risks by AIFs, and (iii) discusses different design and calibration options. By way of example, it uses supervisory information on AIFs managed by asset managers based in the Netherlands. The article concludes by recommending a way forward to develop an EU-level framework for a harmonised implementation of macroprudential leverage limits for AIFs, which forms a key part of the agenda of the European Systemic Risk Board (ESRB) to develop macroprudential policy beyond banking.

Financial Stability Review Issue 2, 2016
24 November 2016
Addressing Market Failures in the Resolution of Non-Performing Loans in the Euro Area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The high stock of non-performing loans (NPLs) on the balance sheets of euro area banks continues to be an important cause for concern for policymakers. Efforts to resolve this problem have increased significantly in the course of 2016, by supervisors and macroprudential policymakers alike. To relieve capital constraints, these efforts, however, must be complemented with structural reforms to recover the value of NPLs in some countries. Against this background, this special feature focuses on impediments to the functioning of a market for NPL sales. It highlights sources of informational asymmetry and structural inefficiencies. Among indicators of market failure, it distinguishes between supply and demand factors that impede market functioning. In light of the identified externalities, public policy responses are warranted to reduce the cost and duration of debt recovery while also addressing information asymmetries between better-informed banks and potential investors. In certain circumstances the establishment of asset management companies (AMCs) may help to accelerate the value recovery process for banks, while avoiding adverse macroeconomic side effects. Constraints on and limitations of AMCs are also reviewed in this special feature.

Financial Stability Review Issue 2, 2016
24 November 2016
Adapting Bank Business Models: Financial Stability Implications of Greater Reliance on Fee and Commission Income

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The euro area banking sector is faced with cyclical and structural challenges, which are hampering many banks’ ability to generate sustainable profits. In particular, the prolonged period of low nominal growth and low yields compresses net interest income, which traditionally has been (and still is) euro area banks’ main source of income. One way for banks to compensate for compressed net interest margins could be to adapt their business models, moving towards more fee and commission-generating activities. This article discusses the challenges involved in boosting fee and commission income and highlights some of the potential financial stability implications related to a greater reliance on these income sources.

Financial Stability Review Issue 2, 2016
24 May 2016
Latest indicators of euro area bank asset quality

Abstract

Abstract

Euro area banks’ asset quality has remained in the focus of both supervisors and market participants as banks’ balance sheets in some countries are still burdened with a high level of non-performing exposures (NPEs). Large public disclosures, including those associated with the ECB’s comprehensive assessment and the European Banking Authority (EBA) 2015 transparency exercise, have helped to clarify the nature and extent of these NPEs. While euro area banks’ solvency positions have improved significantly over the past few years, the NPE overhang remains a drag on banks’ profitability and weighs on their ability to extend new loans. Against this background, this box presents an updated overview of the scale of the NPE problem in the euro area based on the latest supervisory data on NPEs, provisioning and collateral, and it also discusses some structural features that affect the speed of NPE resolution.

Financial Stability Review Issue 1, 2016
24 May 2016
Financial stability vulnerabilities stemming from cyber risks within financial market infrastructures

Abstract

Abstract

A convergence of globalisation and digitalisation has created a financial ecosystem and operational network which is increasingly interconnected and interdependent. In this context,

computing and digitalisation are becoming increasingly pervasive. Notwithstanding the many benefits this has brought, this convergence has also increased the susceptibility to cyber attacks. There is a trend towards more frequent and severe cyber attacks, and the composition of the attacks is changing amid growing digitalisation, both of which have financial stability implications. In particular, material financial stability risks might stem from individual systemically important firms or from any prospect of excessive financial market volatility.

Financial Stability Review Issue 1, 2016
24 May 2016
Financial stability implications of structural changes in market microstructures – algorithmic and high-frequency trading

Abstract

Abstract

The use of algorithms to execute trades in financial markets has grown considerably in the last decades, amid technological advancements in computing power and the speed of

processing information. Among the wide range of algorithmic trading strategies, high-frequency trading (HFT) has received perhaps the most attention given its potential for major market

disruptions such as the “flash crashes” that have occurred in recent years. Gauging the financial stability implications of HFT strategies is complex given that different strategies may create very heterogeneous externalities (both positive and negative) for other market participants unable to process such high-frequency information. Such externalities give rise to financial stability risks encompassing liquidity, procyclicality, confidence in the face of prospective opacity, and market resilience.

Financial Stability Review Issue 1, 2016
24 May 2016
Euro area corporate default probabilities by sector of activity and firm size

Abstract

Abstract

Weak economic growth coupled with a high aggregate level of indebtedness has implied challenges for euro area non-financial corporations (NFCs) in recent years. Accounting for more than one-third of banks’ total non-bank loan portfolio, the health of NFCs, in particular that of small and medium-sized enterprises (SMEs) which form the backbone of the euro area nonfinancial corporate sector, is crucial for the soundness of the euro area banking sector. The riskiness of underlying non-financial corporate loan portfolios is not uniform though, as expected default frequencies4 (EDFs) strongly depend on the sector of activity and firm size.

Financial Stability Review Issue 1, 2016
24 May 2016
Private credit overhang in emerging economies and risks to euro area financial stability

Abstract

Abstract

Many emerging market economies (EMEs) have seen a rapid expansion of credit to the private sector since the onset of the global financial crisis. Strong credit growth was often driven by abundant capital inflows on the back of both positive growth differentials and the global search for yield by investors amid accommodative macroeconomic policies in advanced economies. As a result, several EMEs appear to be facing a large credit overhang, with a potential for disorderly unwinding amid deteriorating economic growth prospects. The prospective implications of any such correction could reverberate beyond the affected EMEs given their growing economic and financial linkages with the rest of the world in recent years.

Financial Stability Review Issue 1, 2016
24 May 2016
A Case for Macroprudential Margins and Haircuts

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Financial institutions can build up leverage via the use of derivatives and securities financing transactions (SFTs). In order to limit the build-up of excessive leverage and the associated liquidity risks, as well as the pro-cyclical effects of margin and haircut setting practices, the macro-prudential toolkit needs to be extended. This special feature presents the general case for setting macro-prudential margins and haircuts using theoretical and empirical evidence on the effectiveness of various design options. Furthermore, it addresses implementation and governance issues that warrant attention when developing a macro-prudential framework for margins and haircuts. It concludes by recommending a way forward that is intended to inform the ongoing policy discussions at the European and international levels.

Financial Stability Review Issue 1, 2016
24 May 2016
Systemic Implications of the European Bail-In Tool: a Multi-Layered Network Analysis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The new bail-in tool in the EU bank resolution toolkit is an important step forward to safeguard financial stability in Europe, notably in relation to mitigating moral hazard and other problems inherent in a strong reliance on bailouts. At the same time, it is important to understand the potential contagion channels in the financial system following a bail-in and prior to resolution in order to assess potential systemic implications of the use of the bail-in tool. This special feature outlines salient features of the new requirements and then presents a multi-layered network model of banks’ bail-inable securities that could help in gauging potential contagion risk and, prior to a resolution, identifying mitigating measures to avoid systemic implications.

Financial Stability Review Issue 1, 2016
24 May 2016
Recent Trends in Euro Area Banks' Business Models and Implications for Banking Sector Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature reviews recent trends in business model characteristics, discusses their relationship with bank stability and performance, and looks at how this relationship has changed over time, comparing the period before the crisis with the crisis years and the current situation.

Financial Stability Review Issue 1, 2016
25 November 2015
Debt securities holdings of the financial sector in the current low-yield environment

Abstract

Abstract

The protracted low-yield environment in the wake of the global financial crisis and the dearth of assets perceived as risk-free have challenged financial institutions’ investment strategies. As

risk/return strategies adapt to this environment, increased risk-taking is likely. From a financial stability standpoint, such risk-taking is meaningful to the extent that an agglomeration of exposures within key sectors could leave the financial system more vulnerable to an abrupt reversal of risk premia. Debt securities markets, including traditionally conservative segments, are one area where it is possible that investors have substantially increased their exposure to credit and interest rate risk in an effort to achieve higher returns.

Financial Stability Review Issue 2, 2015
25 November 2015
The information in systemic risk rankings

Abstract

Abstract

One of the legacies of the 2008-09 global financial crisis has been a proliferation of approaches to quantifying and ranking the contributions of firms in the financial sector to “systemic risk”. Risk rankings can be based on a variety of well-known systemic risk measures, such as “SRISK” or “Delta CoVaR”, or, alternatively, on balance sheet items (such as a firm’s leverage ratio). However, these systemic risk ranking approaches have seen limited use by policy institutions such as central banks and supervisory authorities. Possible reasons for this include limited theoretical foundations and the reliance of some measures on volatile financial market data.

Financial Stability Review Issue 7, 2015
25 November 2015
Euro area banks’ net interest margins and the low interest rate environment

Abstract

Abstract

In recent years interest rates have fallen to historical lows across the maturity spectrum, which has been accompanied by a substantial flattening of the yield curve. Concerns have arisen that, should such a constellation continue for a protracted period of time, this may hamper euro area banks’ ability to generate net interest income – further dampening profitability that is already depressed by low economic growth and lingering legacy asset quality issues.

Financial Stability Review Issue 2, 2015
25 November 2015
Dark pools and market liquidity

Abstract

Abstract

Concerns about potential market liquidity shortfalls have grown in recent years, amid changing roles of participants in financial markets and related trading patterns. As these structural changes have taken hold, one of the factors touted as harbouring the potential to disrupt market liquidity is a change in market microstructure. A particularly opaque element of this structural development has been the growth in little understood trading venues with no regulatory pre-trade transparency requirements – so-called “dark pools”. These types of venue emerged as the initial transparency regime for equities was implemented in the Markets in Financial Instruments Directive (MiFID). New regulation (MiFID II) aims to limit the size of less transparent trading activities and to bring more trades into light pool (or lit) venues where the order book is made public for all participants. Given the current debate on the impact of expanding the transparency regime to fixed income trading under MiFID II, assessing the development of dark pools within equity markets may provide some insights into the potential effect of the new requirements on bond market structure and liquidity.

Financial Stability Review Issue 2, 2015
25 November 2015
A model-based valuation metric for residential property markets

Abstract

Abstract

Reliable valuation metrics are key for monitoring residential property market developments from a financial stability perspective. Due to the heterogeneity and complexity of housing markets, no single metric of housing valuation at the macro level is sufficient to capture all relevant factors. Statistical indicators for measuring residential property price valuations offer intuitive appeal and ease of construction, but may fail to capture important fundamental factors. By contrast, modelbased approaches offer the advantage that they can explore a wider set of fundamental factors in a multivariate regression framework, but still can only go so far in capturing the symbiotic relationship between housing, rental and mortgage markets.

Financial Stability Review Issue 2, 2015
25 November 2015
The relationship between business and financial cycles

Abstract

Abstract

Boom-bust cycles in financial variables such as credit volumes and residential property prices play an important role in the build-up of financial instability and subsequent financial crises. Against this background, one of the key goals of macroprudential policy is to attenuate such boom-bust cycles, often termed the financial cycle. To inform such policies, various recent studies have presented estimates of cyclical fluctuations in financial indicators for major advanced economies.

Financial Stability Review Issue 2, 2015
25 November 2015
Understanding the links between China and the euro area

Abstract

Abstract

A reassessment of global economic growth prospects has been under way since late 2014, as economic activity in emerging markets has receded from the strong growth seen over the

last years. A key focus in this regard has been China, not only given its sheer size and growing role in international trade and finance, but also given the uncertainties related to the country’s ongoing rebalancing from an investment and export-driven to a consumption-led growth model. The correction in Chinese stock markets in the third quarter of this year sparked a pronounced rise in uncertainty which was pervasive enough to have significant global effects, including on euro area financial markets. Indeed, developments in China could affect the euro area in multiple ways from a financial stability perspective, including via trade, commodity and financial channels, which may work either directly or indirectly.

Financial Stability Review Issue 2, 2015
25 November 2015
The Impact of the Basel III Leverage Ratio on Risk-Taking and Bank Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The Basel III leverage ratio aims to constrain the build-up of excessive leverage in the banking system and to enhance bank stability. Concern has been raised, however, that the non-risk-based nature of the leverage ratio could incentivise banks to increase their risk-taking. This special feature presents theoretical considerations and empirical evidence for EU banks that a leverage ratio requirement should only lead to limited additional risk-taking relative to the induced benefits of increasing loss-absorbing capacity, thus resulting in more stable banks.

Financial Stability Review Issue 2, 2015
25 November 2015
Euro area insurers and the low interest rate environment

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The current environment of protracted low interest rates poses major challenges to euro area insurance companies. This special feature discusses how a prolonged low-yield period might affect the profitability and the solvency of euro area insurers. In the article, it is argued that if interest rates were to stay low for a long time, this could have material implications for the profitability and the solvency of many insurers. However, it is also shown that the impact of low interest rates is likely to differ markedly across insurance companies depending on their business model and balance sheet structure. In particular, the impact is expected to be highest for small and medium-sized life insurers with large government bond portfolios and high guarantees to policyholders that reside in countries where these guarantees are rigid and where contracts embed a long time to maturity.

Financial Stability Review Issue 2, 2015
25 November 2015
Systemic Risk, Contagion and Financial Networks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature proposes a methodology to measure systemic risk as the percentage of banks defaulting simultaneously over a given time horizon for a given confidence level. The framework presented here is applied to euro area banks. It is observed that since the announcement of the comprehensive assessment in October 2013 banks have significantly reshuffled their security portfolios. This has resulted in a decline in the probability of systemic events occurring.

Financial Stability Review Issue 2, 2015
25 November 2015
Quantifying the Policy Mix in a Monetary Union with National Macroprudential Policies

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

In a monetary union, targeted national macroprudential policies can be necessary to address asymmetric financial developments that are outside the scope of the single monetary policy. This special feature discusses and, using a two-country structural model, provides some model-based illustrations of the strategic interactions between a single monetary policy and jurisdiction-specific macro-prudential policies. Counter-cyclical macro-prudential interventions are found to be supportive to monetary policy conduct through the cycle. This complementarity is significantly reinforced when there are asymmetric financial cycles across the monetary union.

Financial Stability Review Issue 2, 2015
28 May 2015
Measuring the propagation of macro-financial shocks at the level of individual euro area financial institutions

Abstract

Abstract

The global financial crisis has highlighted that impaired financial institutions can significantly propagate aggregate or institution-specific stress to the overall economy. With financial contagion a key conduit of these impacts, data at the individual firm level are crucial to account for both crossfirm and macro-financial linkages. While traditional stress-testing methods offer considerable insights into these interdependencies, their findings can be complemented by the use of reducedform models that exploit past empirical regularities. One such framework, drawing on the infinitedimensional vector autoregressive (IVAR) framework of Chudik and Pesaran, includes both firmlevel risk indicators and a global set of macroeconomic variables. This approach offers a means of linking firm-level default probabilities to aggregate international macro-financial variables.

Financial Stability Review Issue 1, 2015
28 May 2015
Synthetic leverage in the investment fund sector

Abstract

Abstract

Excessive leverage is a key contributor to systemic stress. At the same time, measuring leverage has become more complex as financial innovation has given rise to contingent commitments not being captured ex ante by traditional leverage ratios. Such “synthetic leverage” can stem from derivative instruments or securities financing transactions that create exposures contingent on the future value of an underlying asset, which becomes evident, for instance, when a derivative position’s value moves strongly, potentially creating a profit or loss.

Financial Stability Review Issue 1, 2015
28 May 2015
Evaluating the drivers of forbearance and underprovisioning

Abstract

Abstract

Forbearance (or the renegotiation of a loan contract in the event that a borrower fails, or is likely to fail, to fulfil its obligations) is not captured on balance sheets and is therefore not straightforward to measure. It is closely related to underprovisioning, which – alongside forbearance – also includes insufficient provisioning for declared non-performing exposures (NPEs) as a main element.

Financial Stability Review Issue 1, 2015
28 May 2015
Measuring the cost of bank equity in the euro area

Abstract

Abstract

Adequately capturing the cost of bank equity is key for regulators, supervisors and banks given the fundamental role of equity in banks’ capital structures. At the same time, the cost of equity cannot be directly observed and must be inferred from a combination of market prices and expectations of future cash flows. Indeed, measuring the rate of return investors expect from an investment in bank equity is not straightforward given difficulties in estimating future cash flows and assumptions about the retention of earnings; a high degree of uncertainty is therefore intrinsic to any estimate of the cost of equity, irrespective of the methodology employed.

Financial Stability Review Issue 1, 2015
28 May 2015
Commonality of bid-ask spreads in euro area bond markets

Abstract

Abstract

Low secondary market liquidity and the potential for it to evaporate across market segments during periods of stress represent sources of systemic risk. In an environment of low liquidity, market shocks are amplified and propagated at a faster rate. While many measures indicate that global market liquidity is abundant on aggregate, its distribution within the financial system is not uniform. Broad liquidity measures for secondary fixed income markets indicate a deterioration in conditions. This development, alongside reports from large banks of reduced confidence in their ability to act as market-makers during stressed periods, raises concerns regarding the potential for liquidity to evaporate precisely at the moment when it is needed most.10 One means of measuring the propensity for systemic liquidity stress is to separate bond market liquidity into elements common across all market segments (such as investors’ risk perception and appetite for risk or general financial conditions) and elements that are largely idiosyncratic. This box analyses common factors of bid-ask spreads in euro area bond markets, thereby focusing on one particular aspect of liquidity, notably the “tightness” dimension.

Financial Stability Review Issue 1, 2015
28 May 2015
Statistical valuation metrics for residential property markets

Abstract

Abstract

Misaligned asset prices are among the key root causes of financial instability. This pertains particularly to residential property assets upon which the bulk of bank lending is secured. However, measures of the degree of house price misalignments from fundamentals are surrounded by a high degree of uncertainty. This reflects the challenge of adequately capturing the complex interaction of housing, rental and mortgage markets, as well as data constraints and measurement issues. In a cross-country setting, the challenge of identifying misalignments is made all the more difficult by the substantial heterogeneity in structural market characteristics across countries. Commonly used metrics are two statistical-based indicators, the house price-to-rent and house price-to-income indicators. This box assesses the usefulness of these statistical indicators when applied across euro area countries.

Financial Stability Review Issue 1, 2015
28 May 2015
Lower oil prices and their implications for financial stability in the euro area

Abstract

Abstract

The oil market has seen an upheaval since mid-2014, exhibiting a more than 50% peak-to-trough drop in prices. Despite a relatively benign global volatility environment and some recovery since early 2015, going forward, prices are likely to remain below the highs observed after the 2009 recovery, in particular given the supply and price elasticity of North American unconventional oil. The net impact on the global economy, including the euro area, is expected to be beneficial on average given positive growth effects, but its distribution will be clearly asymmetric between oil-exporting and oil-importing economies. Oil-exporting emerging economies seem particularly vulnerable given less diversified economic structures and high oil dependency, notwithstanding varying levels of fiscal space and reserves to cope with related challenges. In this environment, the direct linkages of euro area banks require monitoring from a financial stability perspective. Such linkages comprise the exposure, investment and ownership channels, including petrodollar flows in the form of debt and/or equity funding.

Financial Stability Review Issue 1, 2015
28 May 2015
Accommodative monetary policy and euro area financial stability

Abstract

Abstract

Amid concerns that inflation would remain too low for a prolonged period, implying risks to medium-term price stability, the ECB’s Governing Council has implemented a number of monetary policy measures since June 2014 to provide further monetary policy accommodation to the euro area economy. Most recently, in March 2015 the expanded asset purchase programme (APP) was launched encompassing a set of eurodenominated investment-grade public sector securities. In addition, the expanded APP integrates the existing purchase programmes for asset-backed securities (ABSPP) and covered bonds (CBPP3) that were launched in autumn 2014. Under this expanded programme, which is intended to be carried out at least until the end of September 2016, the combined monthly purchases will amount to €60 billion per month or €1,140 billion in total. As there had been market expectations for some time of a purchase programme and because its size exceeded expectations, it has already produced a substantial easing of broad financial conditions, which is expected to support price stability and foster financial stability in the euro area. At the same time, unintended side effects on financial stability cannot be ruled out as very accommodative monetary conditions stimulate not only economic risk-taking – as intended – but may also lead to excessive financial risk-taking

Financial Stability Review Issue 1, 2015
28 May 2015
A Framework for Analysing and Assessing Cross-Border Spillovers from Macroprudential Policies

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Macro-prudential measures implemented in individual Member States may have cross-border or cross-sectoral repercussions. This special feature discusses cross-border spillover channels. To limit negative spillover effects, macro-prudential instruments should be applied consistently across countries, and reciprocity agreements must be applied transparently.

Financial Stability Review Issue 1, 2015
28 May 2015
Bank Profitability Challenges in Euro Area Banks: the Role of Cyclical and Structural Factors

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Weak profitability among euro area banks is one key risk to financial stability. This special feature examines the main drivers influencing banks’ profitability, including bank-specific, macroeconomic and structural factors. The empirical part of the special feature finds that challenges appear to be mainly of a cyclical nature, although there may also be material structural impediments to reigniting bank profitability.

Financial Stability Review Issue 1, 2015
28 May 2015
Resolving the Legacy of Non-Performing Exposures in Euro Area Banks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The weight of non-performing exposures (NPEs) on the balance sheets of European banks is a cause for concern for policy-makers; yet resolving the issue presents a number of challenges. This special feature presents an overview of the scale of the NPE problem, highlights several operational aspects that are critical for effectively resolving the problem, and outlines the merits of various resolution strategies.

Financial Stability Review Issue 1, 2015
27 November 2014
Regulatory initiatives to enhance overall loss-absorption capacity

Abstract

Abstract

One of the key objectives of the resolution frameworks introduced in response to the recent crisis, such as the Bank Recovery and Resolution Directive (BRRD) in the EU, is the shifting of

the cost of bank failures from the taxpayer to, first and foremost, the shareholders and creditors of the failing bank. This is important for many reasons, not least that of solving the too-big-to-fail problem of large banks, which – unless there is a credible resolution option – often have to be bailed out by the public at huge cost. These banks have often been perceived by markets as having an implicit state guarantee, which creates not only a moral hazard problem, but also an uneven playing field among banks, in that large banks in fiscally strong countries can fund themselves far more cheaply than smaller banks or banks in countries with weaker public finances. Thus, the introduction of a credible resolution framework contributes to weakening the link between banks and their sovereigns, which proved to be both costly and destabilising in the recent crisis.

Financial Stability Review Issue 2, 2014
27 November 2014
Do contingent convertible capital instruments affect the risk perceptions of senior debt holders?

Abstract

Abstract

Contingent convertible capital instruments or bonds (CoCos) are hybrid instruments that are automatically transformed into equity or are written off in the event of a capital shortfall. CoCos thus contain built-in mechanisms for absorbing losses when trigger points are reached. CoCos are flexible instruments that are able to boost regulatory CET1 capital ratios when necessary, while preserving the respective debt status if the pre-specified trigger level is not reached. They have grown in popularity in recent years, not least on account of their state-contingent nature, their distinct accounting treatment and the fact that they combine elements of debt and equity.

Financial Stability Review Issue 2, 2014
27 November 2014
the ECB’s comprehensive assessment exercise

Abstract

Abstract

The results of the ECB’s comprehensive assessment, a thorough and unprecedented examination of 130 euro area banks, were published on 26 October 2014. This box presents the scope, main findings and conclusions of the comprehensive assessment exercise.

Financial Stability Review Issue 1, 2014
27 November 2014
Financial market volatility and banking sector leverage

Abstract

Abstract

Global asset market volatility remained persistently at historical lows across financial asset classes and economic regions from the third quarter of 2013 up until early October 2014. Low financial market volatility may in many ways reflect fundamentals, including low uncertainty regarding policies, limited surprises in economic releases and the stabilising influence of more stringent post-crisis regulation of the financial sector. At the same time, financial stability risks may arise from investor complacency especially during periods of weak returns on financial

assets when investors hunt for yield. Such periods have the potential to embed systemic risk, if they lead to an excessive build-up in leverage or maturity extension.

Financial Stability Review Issue 2, 2014
27 November 2014
Structural and systemic risk features of euro area investment funds

Abstract

Abstract

In addition to remarkable growth in the euro area shadow banking sector over the last years, its structure has also been evolving. By mid-2014, investment funds domiciled in the euro

area had grown to a large size – with money market funds (MMFs) and non-MMF investment funds (IFs) representing almost half of the €19.6 trillion euro area shadow banking sector.

Clearly, these structural changes require an adaptation of financial stability monitoring, to understand the role of the investment fund sector and its prospective role in originating or

transmitting systemic risk. To this end, this box uses granular data for a sub-sample of all euro area investment funds to further characterise the euro area investment fund universe (including MMFs and IFs but excluding hedge funds). This sample excludes hedge funds and covers roughly half of the euro area investment fund population. Within the aggregated assets

under management (AuM) of the analysed sample, equity funds represent the largest share of this total (33.1%) followed by bond (29.8%), money market (17.6%) and mixed (14.7%) funds.

Financial Stability Review Issue 2, 2014
27 November 2014
Does the growing importance of emerging market banks pose a systemic risk?

Abstract

Abstract

One side effect of the global financial crisis has been strong growth in the weight of emerging market banks in the global financial system. Indeed, financial deepening in emerging markets has accelerated in recent years as the financial crisis has triggered both increased capital flows to these economies, as well as deleveraging of banks in advanced economies. By the end of 2013, 28 of the 100 largest banks globally were headquartered in emerging markets, compared with 17 only five years earlier. As the resulting geographical structure of the global financial

system has evolved, the monitoring of risks clearly also needs to be adapted.

Financial Stability Review Issue 2, 2014
27 November 2014
Fire-Sale Externalities in the Euro Area Banking Sector

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature studies the effects of fire-sale externalities in the euro area banking sector. Using individual bank balance sheet data and a framework developed by Greenwood et al. (forthcoming), an indicator is constructed to quantify the effects of fire-sale spillovers in terms of losses in equity capital in the banking system. For some countries, loans to monetary financial institutions are the most systemic assets, while for others loans to households can pose systemic risks. Thanks to the fine granularity of the background data and monthly updates, the index can be used as an early warning indicator and a measure of systemic risk.

Financial Stability Review Issue 2, 2014
27 November 2014
Capturing the Financial Cycle in Euro Area Countries

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature discusses ways of measuring financial cycles for macro-prudential policymaking. It presents some estimates and empirical characteristics of financial cycles. Existing studies on financial cycle measurement remain quite nascent in comparison with the voluminous literature on business cycles. In this context, two approaches – turning point and spectral analysis – are used to capture financial and business cycles at the country level. The results of the empirical analysis suggest that financial cycles tend to be more volatile than business cycles in the euro area, albeit with strong cross-country heterogeneity. Both aspects underscore the relevance of robust financial cycle estimates for macro-prudential policy design in euro area countries.

Financial Stability Review Issue 2, 2014
27 November 2014
Initial Considerations regarding a Macro-Prudential Instrument based on the Net Stable Funding Ratio

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis led to a broad consensus among policy-makers and regulators that macro-prudential frameworks, in addition to micro-prudential policy, must be part of the solution to ensure the resilience of the financial system. The counter-cyclical capital buffer represents the first step in this direction taken by the Basel Committee on Banking Supervision. Regarding liquidity issues, two micro-prudential standards have been designed. The delegated act implementing the liquidity coverage ratio (LCR) at the European level has recently been adopted by the European Commission and the net stable funding ratio (NSFR) standard has just been finalised by the Basel Committee on Banking Supervision and was published on 31 October. After implementing these new standards, it will be necessary to monitor their impact on banks’ behaviour, market liquidity, monetary policy and financial stability before considering introducing any additional instruments. At this stage, the need for a liquidity-based macro-prudential tool is in the early stages of identification and discussion. Therefore, this special feature aims to provide some initial technical considerations regarding the macro-prudential use of the NSFR. The discussion considers two broad perspectives. The first is the need for a counter-cyclical NSFR to complement the counter-cyclical capital buffer. While capital and liquidity standards pursue different objectives, the two can also be used in conjunction depending on the specific risk to financial stability being targeted. The second perspective regards the use of the NSFR as a stand-alone macro-prudential tool, together with its potential trigger mechanism and its use in the current low yield environment.

Financial Stability Review Issue 2, 2014
28 May 2014
Revival of “qualifying” securitisation, main hurdles and regulatory framework

Abstract

Abstract

The securitisation market seized up with the onset of the financial crisis and has remained severely impaired since then. Many factors are deemed to be causing this stagnation, including

poor investor sentiment, unfavourable transaction economics, a poor macroeconomic environment and regulatory concerns.

Financial Stability Review Issue 1, 2014
28 May 2014
Forthcoming implementation of the Bail-in tool

Abstract

Abstract

The forthcoming Bank Recovery and Resolution Directive (BRRD) will introduce a bail-in tool in all Member States by 1 January 2016 at the latest. The bail-in tool will enable resolution

authorities to write down or convert into equity the claims of a broad range of creditors in resolution. This tool will be essential to achieve orderly resolution without exposing taxpayers to losses, while ensuring continuity of critical functions to avoid a serious disturbance in the financial system and the economy as a whole.

Financial Stability Review Issue 1, 2014
28 May 2014
Developments in markets for contingent capital instruments

Abstract

Abstract

As part of the phase-in of Basel III risk-weighted capital and leverage requirements, there is a potential for growth in the use of hybrid debt instruments. The quantitative risk-weighted capital requirements for the Tier 1 (T1) and total capital ratios are significant – implying a 1.5 percentage point capital ratio requirement using additional Tier 1 (AT1) capital (or hybrid debt), as well as a 2.5 percentage point requirement for Tier 2 (T2) capital instruments. At the same time, the leverage ratio needs to be met using Tier 1 capital with no restrictions on AT1 instruments. Under the European transposition of Basel requirements (CRD IV), all AT1 instruments are required to have specific write-down or conversion features, as demonstrated by contingent convertible bonds (CoCos). It is therefore not surprising that there has been a significant recent pick-up in CoCo issuance by euro area banks.

Financial Stability Review Issue 1, 2014
28 May 2014
To what extent has banks’ reduction in assets been a de-risking of balance sheets?

Abstract

Abstract

Deleveraging by euro area banks has been significant over the last years. A fall in euro area MFI balance sheets (euro area-domiciled assets only) by €4.3 trillion since May 2012 underscores euro area domestic balance sheet reduction; taking a broader view of consolidated balance sheets suggests an even larger figure. Indeed, significant banking groups in the euro area have reduced the size of their consolidated balance sheets (that is, including assets outside the euro area) by over €5 trillion – a 20% decline – since their respective peak values (which on aggregate was in the first half of 2012, though differing across banks). The extent of asset reductions has, however, varied greatly across banks with some banks reporting stable or even growing total assets, whereas banks most affected by the global financial crisis – some of which are undergoing orderly restructuring or a winding-down of operations – have cut more than two-thirds of their balance sheets. This raises the question to what extent the reduction in total assets has actually reduced banks’ risk exposures.

Financial Stability Review Issue 1, 2014
28 May 2014
Recent balance sheet strengthening by euro area banks

Abstract

Abstract

Since the third quarter of 2013, when discussions about the ECB’s comprehensive assessment intensified, significant banking groups in the euro area have bolstered their balance sheets by

over €95 billion through equity issuance, one-off provisions, contingent convertible (CoCo) bond issuance and capital gains from asset disposals. This has been in addition to other forms

of capital generation, including for example retained earnings and changes in deferred tax asset treatments, and de-risking (shifts from riskier to safer assets).

Financial Stability Review Issue 1, 2014
28 May 2014
Provisioning and expected loss at European banks

Abstract

Abstract

Mounting credit losses affected European banks greatly during the financial crisis. In many cases, the corresponding adjustment in loan loss provisions occurred rather precipitously, likely

influenced by a combination of market pressure and supervisory action. While for IRB banks the calculation of expected credit loss is tightly regulated in the Basel II Accord and the Capital

Requirements Directive, banks retain considerable discretion in determining the amount of loan loss provisions. As a general rule, banks may create specific provisions only when there has

been a credit event. This restriction implies that provisions typically lag the deterioration in loan quality and do not consider expected loss that is based on forward-looking default probabilities. This divergence in loss recognition results in a provisioning gap that in the course of the crisis needed to be closed, occasionally with the intervention of the competent authorities.

Financial Stability Review Issue 1, 2014
28 May 2014
Distinguishing risk aversion from uncertainty

Abstract

Abstract

The financial crisis has seen an unprecedented increase in financial market volatility and in risk premia for a wide range of assets. Such increases can be driven both by changes in the level of uncertainty (or risk) in the system and by changes in the way investors “tolerate” (or dislike) uncertainty (investors’ risk aversion). An ability to distinguish between these two underlying

drivers can help considerably in financial stability monitoring, as there are structural links between risk aversion and uncertainty on one hand and macro-financial developments on the

other hand. However, the distinction between the two in empirical work is often blurred when some common volatility indicators are used as their proxies.

Financial Stability Review Issue 1, 2014
28 May 2014
Co-movements in euro area bond market indices

Abstract

Abstract

The improvement experienced in financial conditions in euro area bond markets since mid-2012 has led to significant declines in sovereign and corporate bond yields, particularly in vulnerable countries. The lower financial stress since mid-2012 likely stems from a normalisation of conditions as unjustified fears of tail risks in the euro area dissipated. Such a co-movement, however, may also conceal an excessive search for yield, which – from a financial stability perspective – could make bond markets highly vulnerable to a repricing of risk stemming from the still fragile economic recovery and a normalisation of US monetary policy. To assess the potential relevance of those risks, this box puts those high correlations into historical perspective, comparing them with previous crisis and recovery periods and with developments in euro area high-rated bonds.

Financial Stability Review Issue 1, 2014
28 May 2014
Financial stability implications of the crisis in Ukraine

Abstract

Abstract

Geopolitical tensions related to developments in Ukraine have been on the rise in recent months. The potential for such tensions to spill over into a larger conflict has given rise to short-lived bouts of financial market jitters against a backdrop of considerable political uncertainty. While the human and social costs of the crisis in Ukraine are clear, financial stability risks are harder to assess, given the still-evolving situation. Nonetheless, an analysis of direct euro area exposures can be illustrative in gauging the prospective economic and financial impact.

Financial Stability Review Issue 1, 2014
28 May 2014
Global corporate bond issuance and quantitative easing

Abstract

Abstract

Global non-financial corporate bond issuance has surged over the last four years. This increase has been particularly pronounced in emerging market economies (EMEs), where gross issuance has reached unprecedented levels, while issuance in advanced economies has also reached elevated levels by historical standards.

Financial Stability Review Issue 1, 2014
28 May 2014
Financial stability challenges posed by very low rates of consumer price inflation

Abstract

Abstract

Over recent months, HICP inflation in the euro area has fallen to low levels. The ECB’s Governing Council expects inflation to remain low for a prolonged period, followed by a gradual

upward movement in HICP inflation rates. However, some analysts have voiced concerns about the potential for deflation. Associated financial stability concerns relate primarily to debt

sustainability challenges posed by low (or even negative) inflation outturns at the national level.

Financial Stability Review Issue 1, 2014
28 May 2014
Recent Experience of European Countries with Macro-Prudential Policy

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The global financial crisis revealed a need for macro-prudential policy tools to mitigate the build-up of systemic risk in the financial system and to enhance the resilience of financial institutions against such risks once they have materialised. In the EU, macro-prudential policy is an area that is in an early stage of development. This is also true as regards the use of instruments to address systemic risk for which there is so far only limited experience to draw on. Hence, there is general uncertainty about the effectiveness of such instruments in practice. Nevertheless, country-level experience can serve as a useful yardstick for formulating macro-prudential policy in the EU. This special feature considers the experience of European countries with macro-prudential policy implementation. Overall, the evidence surveyed here indicates that macro-prudential policies can be effective in targeting excessive credit growth and rapidly rising asset prices, although other policies can be a useful complement to reduce the build-up of imbalances. At the same time, the appropriate timing of macro-prudential policy measures remains a challenging task.

Financial Stability Review Issue 1, 2014
28 May 2014
Identifying Excessive Credit Growth and Leverage

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Excessive credit growth has often been associated with the build-up of systemic risks to financial stability. With the entry into force of a new macro-prudential policy framework in the EU on 1 January 2014, a set of policy instruments has been made available to regulators to address such risks by curbing excessive leverage and/or imposing capital buffers which increase the resilience of the system against potential future losses. This special feature presents an early warning system designed to support macro-prudential policy decisions. Drawing on the historical experience of EU countries, the model aims to assess whether observed leverage dynamics might justify the activation of macro-prudential tools such as the counter-cyclical capital buffer proposed by the Basel Committee on Banking Supervision. The early warning indicators are based on aggregate credit-related, macroeconomic, market and real-estate variables, while the early warning thresholds are derived by considering conditional relationships between individual indicators in a unitary framework.

Financial Stability Review Issue 1, 2014
28 May 2014
Micro- versus Macro-Prudential Supervision: Potential Differences, Tensions and Complementarities

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature discusses the potential differences, tensions and complementarities between micro- and macro-prudential policies. It argues (i) that in spite of the frictions that may arise between them, micro- and macro-prudential policies overall complement each other, and (ii) that the two policy domains play an equally important role in ensuring financial stability. To benefit most from their complementarities, it is essential that there is constructive cooperation and information sharing between micro- and macro-supervision.

Financial Stability Review Issue 1, 2014
28 May 2014
Risks from Euro Area Banks’ Emerging Market Exposures

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

In light of the recent emerging market tensions, this special feature takes stock of euro areabanks’ emerging market exposures by identifying the major sources and types of related risks and highlighting some of the potential financial channels of contagion. Euro area banks’ emerging market exposures are analysed in time and cross-sectional dimensions, at the country and individual bank level, as well as in absolute terms and relative to some bank balance sheet metrics. Within a panel regression framework, the special feature also seeks to identify those emerging economies that – based on their credit metrics and fundamentals – are the most exposed to financial stability risks, which, if they materialise, may have negative repercussions for euro area banks with sizeable exposures to those economies.

Financial Stability Review Issue 1, 2014
27 November 2013
Recent evidence on taxing financial transactions

Abstract

Abstract

With the financial crisis, there has been renewed political interest in financial transaction taxes (FTTs) – a notion with origins dating back to a proposal by James Tobin some 35 years ago. Indeed, within the European Union, 11 countries have expressed a commitment to introducing such a tax in some form. Notwithstanding any prospective benefits, notably for government

revenues, the imposition of such taxes also entails costs. In particular, FTTs might have implications for the activity and functioning of affected financial market segments. Whilst in principle the existing literature could shed some light on the potential costs and benefits of such taxes, in practice most empirical evidence is more than a decade old, or relates to rather illiquid emerging markets, thereby limiting its applicability to the current European setting.

Financial Stability Review Issue 2, 2013
27 November 2013
Macro-prudential aspects of the SSM regulation

Abstract

Abstract

Macro-prudential policy is a relatively new and evolving concept, with the Financial Stability Board (FSB), the International Monetary Fund (IMF) and the European Systemic Risk Board

(ESRB) playing a key role in developing its organising framework, defining its main objectives and policy tools at the international and European levels, respectively.

Financial Stability Review Issue 2, 2013
27 November 2013
Euro area banks and leverage ratio requirements

Abstract

Abstract

As disillusionment has grown with heterogeneous and opaque risk weighting calculations of banks, the use of simple leverage (i.e. leverage that is not adjusted for risk) has been gaining

prominence among analysts, investors and regulators alike to serve as a backstop for risk-based requirements. While Basel III reforms already foresaw the use of such a leverage ratio, there have been some calls for a more rapid and stringent implementation than currently envisaged. This box evaluates euro area banks’ capitalisation by comparing their leverage ratios with their risk-weighted capital ratios and investigates the relationship between these ratios and marketbased indicators. Finally, it attempts to compare euro area LCBGs’ leverage ratios to those of their global peers.

Financial Stability Review Issue 2, 2013
27 November 2013
The dynamics of fee and commission income in euro area banks

Abstract

Abstract

The financial crisis has tested the resilience of banks across advanced economies – in terms of not only the composition of their balance sheets, but also the robustness of their business models in generating profits even in times of acute distress. While fee and commission income has been a key and relatively stable mainstay of profitability in euro area banks, it is more closely linked to macro-financial conditions than is often assumed. Indeed, this source of income tends to be loosely modelled in forward-looking analyses such as stress tests.

Financial Stability Review Issue 2, 2013
27 November 2013
A new bank sample for the ECB’s financial stability review

Abstract

Abstract

The financial crisis illustrated that the size of banks, along with other factors such as complexity or interconnectedness, can lend a systemic dimension to financial instability. This has led to a global effort to improve the regulation and supervision of the financial sector. Stress specific to mainly the euro area involved a vicious circle between banks and sovereigns, thereby underscoring the need for a better governed and deeper economic and monetary union to support the single currency. A key pillar of these efforts was the European Council’s decision of December 2012 to embark on the creation of a banking union in the European Union.

Financial Stability Review Issue 2, 2013
27 November 2013
Changing expectations of us monetary policy and global asset prices: what can we learn from the 1994 episode?

Abstract

Abstract

The global asset market volatility that accompanied changing expectations regarding a tapering-off of the Federal Reserve’s asset purchases since May resembled previous episodes when the withdrawal of accommodative US monetary policy was associated with significant global market sell-offs. From a financial stability perspective, one past episode stands out, namely that

of developments in 1993-94. During this period, an abrupt change in US monetary policy caught financial markets by surprise, resulting in sharp adjustments to expectations regarding the US monetary policy stance that led to considerable bond market turbulence. Although much has changed since 1994 – central bank communication has improved significantly and monetary policy tools have become more complex – an examination of the mechanics of the 1993-94 episode, and a comparison with recent events, can provide some useful insights into potential vulnerabilities associated with changing expectations regarding the US monetary policy stance.

Financial Stability Review Issue 2, 2013
27 November 2013
House price cycles across Europe

Abstract

Abstract

Housing markets are prone to boom and bust cycles. Within the euro area, striking recent cases include the Irish and Spanish housing markets, where a prolonged strong rise in house prices with origins over 15 years ago was followed by a marked downturn which is still affecting these economies. These two country cases illustrate an implicit asymmetry in housing market dynamics: booms tend to build up gradually, but busts occur swiftly. Given the tight link between housing market developments and lending activity, the early detection of costly booms is key to avoid house price bust episodes with financial stability consequences in the form of increasing mortgage default risk.

Financial Stability Review Issue 2, 2013
27 November 2013
Financial fragility of euro area households

Abstract

Abstract

The severity of the global financial crisis has entailed significant consequences for the real economy. Households, which account for the largest component of economic activity, have experienced the effects of this crisis in different ways, also translating into growing financial strains. Monitoring households’ debt servicing capability is therefore vital from a financial stability perspective, not least given the associated impact on the profitability and solvency of banks.

Financial Stability Review Issue 2, 2013
27 November 2013
Gauging the macroeconomic impacts of changing financial conditions in emerging market economies

Abstract

Abstract

As macroeconomic conditions in advanced economies have started to improve, financial markets have priced in a normalisation of accommodative macroeconomic policies that have underpinned the recovery from the financial crisis. A corollary of this has been a capital flow reversal – sharp at times – in several emerging market economies, which intensified in early May after the US Federal Reserve signalled its intention to taper its bond-buying programme in late 2013. As the latest investment fund asset allocation data show a tendency to further rebalance portfolios away from emerging markets, this box assesses the growth implications of this activity and discusses potential repercussions for the euro area.

Financial Stability Review Issue 2, 2013
27 November 2013
Preparatory Work for Banking Supervision at the ECB

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature briefly outlines the work currently being undertaken at the European Central Bank, in close cooperation with the national competent authorities of the participating Member States, for the assumption of supervisory responsibilities in November 2014. Following a short introduction, which summarises some of the features of the single supervisory mechanism, the preparatory developments are outlined, around five main themes, which reflect the organisation of the preparatory structures.

Financial Stability Review Issue 2, 2013
27 November 2013
Predicting Financial Vulnerabilities to Guide the Set-Up of Counter-Cyclical Capital Buffers

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The systemic dimension of the financial crisis has underscored the need for an expanded set of policies to contain systemic risk throughout the financial cycle. Counter-cyclical capital buffers (CCBs) form an integral part of the expanded European macro-prudential toolkit in this respect, with a “time series” focus in that they increase the resilience of the banking sector to shocks arising from financial and economic stress over the cycle and thereby provide a means to attenuate pro-cyclicality inherent in the financial system. To guide the setting of CCBs, the Basel Committee on Banking Supervision (BCBS) has proposed a focus on, inter alia, the deviation of the domestic credit-to-GDP ratio fromits backward-looking trend (also known as the domestic credit-to-GDP gap), given its track record of signalling financial stress well in advance. The Capital Requirements Directive (CRD) IV specifies that other variables should also be taken into consideration in addition to the credit gap. This special feature assesses the usefulness of private sector credit and other macro-financial and banking sector indicators in guiding the setting of CCBs in a multivariate early warning model framework. The analysis shows that in addition to credit variables, other domestic and global financial factors such as equity and house prices, as well as aggregate banking sector balance sheet indicators, help to predict historical periods of financial vulnerabilities in EU Member States. Consequently, policy-makers deciding on CCB measures could benefit from considering a wide range of indicators.

Financial Stability Review Issue 2, 2013
27 November 2013
Gauging the Effectiveness of Cross-Sectional Macro-Prudential Tools through the Lens of Interbank Networks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature examines various macro-prudential tools through the lens of recent advances in the study of interbank contagion. The specific set of tools analysed are those designed to contain the “cross-sectional” dimension of systemic risk – that is, those designed to limit the systemic risk stemming from factors such as correlations and common exposures across financial institutions. These include tools such as large exposure limits and other regulatory requirements designed to limit the spread of systemic risk between banks. The analysis rests on the basic notion that interbank network structures, and hence the risk of contagion across the banking system in response to shocks, are influenced by banks’ optimising behaviour subject to regulatory (and other) constraints. Changes in macro-prudential policy parameters, such as large exposure limits, capital charges on counterparty exposures and capital and liquidity requirements more generally, will affect the contagion risk because of their impact on banks’ asset allocation and interbank funding decisions. This in turn implies that well-tailored macro-prudential policy can help reduce interbank contagion risk by making network structures more resilient. The analysis shows that to capture the full extent of potential interbank contagion, all of the different layers of bank interaction should be taken into account. Hence, if the regulator only focuses on one segment of interbank relationships (e.g. direct bilateral exposures), the true contagion risks are likely to be grossly underestimated. This finding has clear policy implications and flags the importance of micro- and macro-prudential regulators having access to sufficiently detailed data so as to be able to map the many interactions between banks.

Financial Stability Review Issue 2, 2013
29 May 2013
Modelling the joint dynamics of banking, sovereign, macro and corporate risk

Abstract

Abstract

While the global financial crisis has seen many phases, a main feature has been the interplay of risks across various economic and financial sectors, even culminating in outright risk

transfer in some cases. Prominent examples have included the spillover of fragilities from the financial sector to the broader economy and from the banking sector to the sovereign sector.

In monitoring the propensity for such phenomena to occur and in evaluating their impact, direct (i.e. accounting) linkages tend to understate risks. Earlier and more robust signals of the

possibility for cross-sectoral linkages to cause systemic stress can be obtained via contingent claims analysis (CCA), which augments cross-sectoral linkages on the basis of the main tenets of financial option pricing.

Financial Stability Review Issue 1, 2013
29 May 2013
Financial stability and bancassurance groups – lessons from the euro area experience during the financial crisis

Abstract

Abstract

A popular financial services model in Europe is a melding of banking and insurance activities together under one roof – or so-called bancassurance groups. These arrangements can yield many benefits, including economies of size and scope, and sectoral diversification can reduce income and balance sheet volatility. The financial crisis, however, also highlighted the fragilities of this model, with recourse to state aid by several financial groups with significant banking and insurance activities. First, the complexity and the inherent opacity of the structure pose challenges in terms of risk management, market discipline and supervisory control. Second, the multiple use of regulatory capital may overstate the capacity of a group to absorb losses – either across the various regulated entities within the group (double or multiple gearing) or through the use of debt issued at the holding company level to acquire equity stakes in subsidiaries (double leverage). Third, intra-group transactions may lead to risk transfers and contagion channels within the group. Finally, the various units of a group may individually build up risk positions, which may lead to an uncontrolled concentration of risk at the group level. In the European Union, bancassurance groups are subject to supplementary supervision concentrating on these risks, provided that they match the criteria stipulated in the Financial Conglomerates Directive (FiCoD).

Financial Stability Review Issue 1, 2013
29 May 2013
Measuring systemic risk contributions of European banks

Abstract

Abstract

A clear lesson of the global financial crisis has been the propensity for company-specific risk to spill over to other firms. In fact, it is not just a company’s size and idiosyncratic risk but also its interconnectedness with other firms which determine its systemic relevance. This realisation has underpinned not only a growing set of tools to capture such systemic risk, but also numerous regulatory initiatives to limit and mitigate it.

Financial Stability Review Issue 1, 2013
29 May 2013
Deleveraging by euro area banks

Abstract

Abstract

Euro area banks have been reducing their leverage since the outbreak of the financial crisis. This ongoing process is an important component of adapting banks’ balance sheets and

business models to a post-crisis environment and, if undertaken in a smooth manner, should result in positive externalities. Clearly, both its scale and pace require close monitoring, not

least given its potential impact on the supply of credit to the real economy. In this vein, several estimates have been published by international organisations and market analysts alike,

suggesting large aggregate deleveraging needs and limited adjustment by euro area banks to date. This box describes deleveraging efforts made by euro area banks over the crisis period

and highlights the considerable uncertainty surrounding deleveraging projections.

Financial Stability Review Issue 1, 2013
29 May 2013
Evaluating differences in banks’ credit risk weights

Abstract

Abstract

A growing chorus of analysts, investors and regulators have expressed concern about the murkiness of banks’ internal models, including the complexity and opacity of risk-weighting

formulas. This has led to some loss of confidence in disclosures of banks’ risk-weighted assets (RWAs). This box discusses how changes in risk weights affect key reporting such as solvency

ratios and illustrates variations in risk weights across euro area LCBGs by utilising publicly available Pillar 3 disclosures.

Financial Stability Review Issue 1, 2013
29 May 2013
The network structure of the credit default swap market and its determinants

Abstract

Abstract

Despite considerable growth in the credit default swap (CDS) market over the last decade, it remains opaque in many respects. In particular, the over-the-counter (OTC) nature of the trades

implies a high potential for counterparty risk, which may embed externalities that reverberate well beyond a bilateral structure of exposures. A more detailed understanding of the network

structure is thus essential to identify potential sources of financial stability risks that may emanate from this financial market segment. Indeed, while such questions have already been at the centre of attention in the context of interbank markets for some time now, derivative markets have been analysed less deeply to date, mainly on account of an unavailability of data.

Financial Stability Review Issue 1, 2013
29 May 2013
Financial stability implications of reference rates and key requirements for the next generation of benchmarks

Abstract

Abstract

Reference interest rates serve as a key orientation or benchmark of the prevailing price of liquidity for financial market participants and help in standardising financial contracts for both

wholesale and retail clients (e.g. loans for house purchase). A commonly agreed reference rate is superior to multiple customised interest rates from an efficiency perspective as it lowers the cost of information and, hence, transaction costs and – ultimately – leads to higher market liquidity. In this way, such rates have a clear social function, making them a public good. Financial stability risks may arise, however, with market failures associated with this public good if, for instance, trust in the reliability and robustness of the reference rates is compromised stability risks may, however, also arise if the widespread use of particular reference rates leads to unsuitable applications – for example, in the pricing of credit instruments, the implementation and calibration of hedging strategies and the valuation of a wide range of financial instruments for risk management and asset-liability or performance measurement purposes that create basis risk.

Financial Stability Review Issue 1, 2013
29 May 2013
Developments in Cyprus and their impact on financial stability in the euro area

Abstract

Abstract

The financial sector in Cyprus harboured many vulnerabilities, predominantly in the two largest domestic banks which held total assets with a value equalling almost four times the

country’s GDP. In particular, the financial sector was characterised by high exposures to Greek sovereign bonds (and the associated private sector involvement) and the private sector in Greece. Together with a significant deterioration of the quality of domestic bank assets, this eroded the banks’ capital. Ultimately, the capital needs of major Cypriot banks rose to almost €9 billion, equivalent to 50% of Cypriot GDP. These vulnerabilities had been highlighted by the European Commission and the IMF in their regular country monitoring reports, and in the EU Capital Exercise undertaken by the European Banking Authority.

Financial Stability Review Issue 1, 2013
29 May 2013
Exploring the Nexus between Macro-Prudential Policies and Monetary Policy Measures

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis highlighted the importance of systemic risks and of policies that can be employed to prevent and mitigate them. Several recent initiatives aim at establishing institutional frameworks for macro-prudential policy. As this process advances further, substantial uncertainties remain regarding the transmission channels of macro-prudential instruments as well as the interactions with other policy functions, and monetary policy in particular. This special feature provides an overview and some illustrative model simulations of the macroeconomic interdependence between macro-prudential instruments and monetary policy.

Financial Stability Review Issue 1, 2013
29 May 2013
Asset Support Schemes in the Euro Area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Asset management companies (AMCs) have been established in a number of euro area countries to resolve large stocks of impaired bank assets following the financial crisis. This special feature describes some of the fundamental characteristics of such entities from a financial stability perspective. In particular, it reviews some of the lessons learned from the AMCs’ establishment and early operations, notably regarding the eligibility of banks and assets, which has implications for the size and capital structure of an AMC, as well as the valuation of assets to be transferred, strategies for their management and disposal and other operational issues.

Financial Stability Review Issue 1, 2013
29 May 2013
New ECB Survey on Credit Terms and Conditions in Euro-denominated Securities Financing and Over-the-Counter Derivatives Markets (SESFOD)

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

In the run-up to the global financial crisis that began in mid-2007, leverage and risk-taking in the financial system increased substantially, in particular in the shadow banking system. This increase was facilitated by an erosion of credit terms in securities financing and over-the-counter (OTC) derivatives markets, which served as important conduits for leverage in the financial system. Recognising the lack of information on such developments, a number of major central banks, including the ECB, have started to conduct regular qualitative surveys on changes in credit terms and conditions in these wholesale credit markets. This special feature presents the key features and some of the first results of the recently launched quarterly ECB survey on credit terms and conditions in euro-denominated securities financing and OTC derivatives markets (SESFOD). It also discusses how the survey could be used for macro-prudential monitoring purposes.

Financial Stability Review Issue 1, 2013
14 December 2012
Central clearing for derivatives

Abstract

Abstract

Financial derivatives play an important role in the financial system. They allow financial and industrial corporations to hedge their risk exposures in a customised way – thereby facilitating

risk-taking that is integral to economic growth. They also, however, present specific risk management challenges insofar as this market is inherently complex, given the heterogeneous nature of derivatives, their inherent degree of leverage, more limited liquidity and the significant role of non-linear risks.

Financial Stability Review Issue 2, 2012
14 December 2012
Gauging the potential for sovereign and banking sector spillovers in the euro area

Abstract

Abstract

One salient feature of the euro area sovereign debt crisis has been the increase in financial links and interdependencies between banks and sovereigns. In this environment, the incidence of shocks affecting the assessment of creditworthiness both on the sovereign and on the bank side has implied time-varying spillovers – across sovereigns, across banking sectors and between the two. One methodology that captures how such interdependencies can vary over time is the construction of an index that captures the potential impact of shocks to sovereign and bank credit default swap (CDS) spreads. This box links these two sets of data in a vector autoregression framework, augmented by several common regional and global factors as controls, for 11 sovereigns and nine country-specific groups of banks in the euro area. The index is based on an 80-day rolling window of derived generalised impulse responses from the dynamic relationships between the credit risk of banks and sovereigns.

Financial Stability Review Issue 2, 2012
14 December 2012
Developments in the price-to-book ratios of large and complex banking groups

Abstract

Abstract

The financial crisis and its consequences, including the deterioration of economic activity, have had a strong impact on the market valuation of financial institutions across the globe –

particularly on that of large and internationally active banks. One manifestation thereof has been a considerable drop in the current market price-to-book value ratios of large and complex

banking groups (LCBGs), to levels below one for all but two institutions. This occurred despite significant efforts by banks to ease investor concerns by strengthening their balance sheets and improving their capital ratios.

Financial Stability Review Issue 2, 2012
14 December 2012
Main findings of the euro money market survey 2012

Abstract

Abstract

On 28 September 2012 the ECB published the results of the Euro Money Market Survey 2012, which were based on data collected from banks in 28 European countries (the EU Member

States plus Switzerland) and covered developments in various segments of the euro money market in the second quarter of 2012. This box reports the survey’s main findings. Overall, the survey results suggest a strong impact of the euro area sovereign debt crisis as well as of the Eurosystem’s extraordinary policy measures that aim at restoring market functioning and the proper transmission of monetary policy in an environment where the euro money market remains fragmented.

Financial Stability Review Issue 2, 2012
14 December 2012
The financial crisis and external financing of euro area non-financial corporations

Abstract

Abstract

As bank-related strains have been a key feature of the financial crisis, access to other financing sources has provided important support for non-financial corporations (NFCs) in the euro area. This has included a broad range of external financing instruments, such as equity, debt securities and, in particular, also inter-company loans and trade credit. This box explores this issue first on the basis of changes in the balance sheet structure, then by examining patterns across euro area countries.

Financial Stability Review Issue 2, 2012
14 December 2012
Recent trends in global portfolio flows amid sovereign tensions in the euro area

Abstract

Abstract

The rise of global tensions on account of the intensification of the sovereign debt crisis in the euro area since mid-2011 has led to distortions in capital flows and to a rebalancing of portfolio investment – both across asset classes and across borders. One aspect of these disrupted flows has been a hunt for safe and liquid assets in the context of heightened (and protracted) uncertainty. Indeed, an analysis of balance of payments data, complemented by high-frequency data on mutual fund portfolio decisions, suggests significant safe-haven flows.

Financial Stability Review Issue 2, 2012
14 December 2012
Predicting Bank Distress and Identifying Interdependencies among European Banks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Financial institutions have played a central role in the ongoing financial crisis. The bank bailout costs associated with the current global financial crisis and the large output losses experienced in several countries clearly motivate the attempts to develop early warning models for predicting banking crises and individual bank failures. This special feature presents an early warning model based on publicly available bank-specific and country-level indicators for predicting vulnerable European banks that could potentially experience distress given suitable triggers. A novel model extension incorporates an estimated tail dependence network of European banks to the early warning model in order to take into account vulnerabilities arising from estimated interdependencies.

Financial Stability Review Issue 2, 2012
14 December 2012
The Impact of Bank Funding Market Fragmentation on Credit Intermediation during the Sovereign Debt Crisis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The persistent feedback loop between tensions in the sovereign debt market and the banking sector has increased the fragmentation within the euro area bank funding market, with banks in distressed countries facing much greater funding difficulties than banks operating in other countries.This special feature analyses how, against the background of the sovereign debt crisis, funding market fragmentation has affected the capacity of banks to provide credit to the economy. A quantitative assessment based on macroeconomic models provides estimates on the effect that the market fragmentation could exert on economic activity. Overall, while the impact on the euro area as a whole is assessed to be limited, some regions have been affected disproportionately.

Financial Stability Review Issue 2, 2012
14 December 2012
Towards a Banking Union

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The establishment of a banking union is a major component of the framework required for a genuine Economic and Monetary Union (EMU). The legislative proposals published by the European Commission on 12 September 2012 regarding the establishment of a Single Supervisory Mechanism (SSM) as part of a “Roadmap towards a Banking Union” represent a major step in this direction. The proposals follow up on the euro area summit statement of 29 June, and are in line with the European Council’s call for an integrated financial framework. This special feature argues that while the building of a banking union is an arduous and complex process, it is nevertheless essential to support an effective EMU. The financial crisis has illustrated the fundamental inconsistency of banking supervision being carried out at the national level in a currency area with a single monetary policy. Under the current setting, fragility in national banking systems can be quickly transmitted to the national fiscal side and vice versa, triggering an adverse feedback loop between fiscal and banking problems. This is damaging from a financial stability perspective and hampers the smooth transmission of monetary policy. In the short term, the SSM should contribute to weakening significantly the link between banks and sovereigns persisting in a number of euro area countries. In the long term, the stronger institutional framework of the SSM should exert a beneficial influence on the euro area and the global economy. From this perspective, this special feature highlights the importance of moving towards a common supervisory system and implementing a common resolution regime. In particular, an independent European resolution authority is urgently required to meet the challenges posed by the resolution of banking institutions, also at a cross-border level. Such an authority is also necessary in order to align the incentives of the SSM and the resolution function.

Financial Stability Review Issue 2, 2012
12 June 2012
Systemic risk measure – A portfolio probabilistic perspective on measuring default risk

Abstract

Abstract

The risk of banking institutions defaulting – and in particular those with a systemic dimension – is at the heart of financial stability analysis. One approach to modelling such default risk which has gained considerable prominence in recent years concerns the probability of simultaneous failures of multiple financial institutions. While such extreme events are highly unlikely to actually materialise in practice, such methodologies provide a succinct means of conceptually viewing the financial system as a joint distribution of its constituent financial institutions. Moreover, such a methodology can take publicly available data to assess the likelihood of such an extreme systemic event. This box presents a methodology based on clear, flexible and reproducible estimation methods to measure such joint default risk, applied to euro area large and complex banking groups (LCBGs) – and compares it with results from selected existing methodologies.

Financial Stability Review Issue 1, 2012
12 June 2012
Asset encumbrance at euro area large and complex banking groups

Abstract

Abstract

Asset encumbrance, or a declining pool of unpledged assets for unsecured creditors, has become quite topical in the context of a shift towards secured borrowing in bank funding patterns. While asset encumbrance as a result of an increased use of secured funding is frequently cited as a concern by analysts, its measurement at an aggregate level is not straightforward and must be inferred. This box attempts to shed more light on the magnitude of balance sheet encumbrance at euro area LCBGs, using data that are publicly available in the form of banks’ annual reports.

Financial Stability Review Issue 1, 2012
12 June 2012
What does stock lending data tell us about investors’ sentiment towards euro area large and complex banking groups?

Abstract

Abstract

The prices and trading data of securities and derivative instruments are a timely means of extracting quantitative market-based assessments relating to particular issuers. This has led to

their common use, both as a monitoring tool and as an input into investment decisions. In this respect, securities lending data offer additional insights into investors’ perceptions regarding

specific issuers, also in the absence of significant fluctuations in the price of individual securities. This box examines some securities lending market-specific indicators that can be used to analyse and monitor changes in investor sentiment using such data. It focuses on the lending and borrowing of selected stocks of large and complex banking groups (LCBGs) in the euro area with a view to gauging changes in investors’ sentiment towards these banks.

Financial Stability Review Issue 1, 2012
12 June 2012
The impact of the longer-term refinancing operations on money market options

Abstract

Abstract

The Eurosystem’s December 2011 and February 2012 three-year longer-term refinancing operations (LTROs) targeted deficiencies in bank term funding markets, and were instrumental

in preventing a credit crunch that could have compromised the maintenance of price stability in the euro area. Notwithstanding the clear and targeted objective of this policy action, it appears to have reverberated well beyond the banking system and into the broad financial system. This, in turn, appears to have stemmed from its inherent boost to market confidence, and more specifically its effect of removing the distributional “tail risk” of an extreme event occurring in the economic and financial environment.

Financial Stability Review Issue 1, 2012
12 June 2012
Assessing stress in interbank money markets and the role of unconventional monetary policy measures

Abstract

Abstract

Interbank money markets have exhibited intermittent stress since the onset of the financial turmoil in mid-2007 – tensions at times extreme, reflecting both counterparty and liquidity risk.

Central bank policy measures, and in particular extraordinary non-standard ones, have made a strong contribution to stemming liquidity-related pressures in interbank markets. This box

presents a means of measuring the intensity of such pressures, and thus the unwillingness of banks to grant unsecured loans. It then focuses on conditions over recent months in the euro

money market and in particular the impact of the Eurosystem’s three-year LTROs announced in December 2011, or more specifically an estimate of how stress may have evolved in the absence of this policy measure.

Financial Stability Review Issue 1, 2012
12 June 2012
Is disintermediation by euro area corpo rates with respect to their external financing possible if banks reduce the supply of loans?

Abstract

Abstract

Non-financial corporations rely on two main sources of external financing: borrowing from banks and direct issuance of securities (such as shares and bonds) on the capital market. A traditionally higher reliance on bank financing in the euro area contrasts with a generally more important role for capital market-based funding in the United States. This has implied a particularly acute vulnerability of euro area non-financial corporations to reductions in the supply of bank loans. At the same time, the ongoing structural deleveraging that is taking place in the banking sector as a general process of adapting bank business models to a post-crisis operating environment has implied scope for a disintermediation of banks and – by extension – growing room for euro area non-financial corporations to increasingly seek access to direct market funding. This box examines corporate financing developments during 2009-10 in order to assess the extent to which euro area corporates have already engaged in such financial disintermediation.

Financial Stability Review Issue 1, 2012
12 June 2012
Extracting fiscal risk signals from sovereign credit default swap spreads

Abstract

Abstract

Sharp increases in sovereign credit default swap (CDS) spreads have attracted considerable attention during the financial crisis, especially the high CDS spreads of euro area sovereigns under stress. Reflecting the broad-based fiscal deterioration in conjunction with the recent crisis, rising CDS spreads have been observed in advanced economies not only inside but also outside the euro area. Notwithstanding the recent tightening, between October 2010 and January 2012, five-year sovereign CDS spreads nearly tripled in Japan, almost doubled in the United Kingdom and rose marginally in the United States (see Chart A). In contrast to the experience of some countries in the euro area, however, the rise of sovereign CDS spreads in Japan, the United Kingdom and the United States was not accompanied by a simultaneous increase in government bond yields. In these countries, the latter broadly declined, which raises the question of the extent to which rising CDS spreads signal changes in market perceptions regarding country-specific credit risk.

Financial Stability Review Issue 1, 2012
12 June 2012
Measuring international financial spillovers

Abstract

Abstract

International real and financial linkages, while an integral part of an efficient and wellfunctioning economic and financial system, also embed an inherent fragility in the form of an international propagation of adverse (in addition to benign) country-specific developments. Given the complexity of financial markets, financial spillovers may take on many forms. Equity

markets are an asset class in which financial linkages and prospects for spillovers are strong. Indeed, through highly mobile international capital in this asset class, equity prices are naturally endowed with a high degree of internationalisation. This box uses equity prices to construct a global spillover index for major markets, which is decomposed to show the contribution of each region to global financial market stress.

Financial Stability Review Issue 1, 2012
12 June 2012
EU Bank Deleveraging – Driving Forces and Strategies

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Deleveraging by EU banks over the medium term is to be expected owing to funding and capital-related pressures of both a cyclical and especially a structural nature. Major EU banks have already reduced their leverage ratios since the outbreak of the financial crisis, mainly via improving nominal capital levels. Going forward, the deleveraging process is, however, likely to focus primarily on the asset side, given the current difficult conditions in capital markets and the subdued growth outlook. The externalities associated with this process need not necessarily be negative. Deleveraging can reflect a more efficient allocation of financial resources, a correction of over-inflated asset prices or a reduction of debt overhangs, all of which would bring the economy onto a more sustainable growth path. This notwithstanding, authorities need to monitor the process closely to ensure that it occurs in an orderly fashion and thus avoid negative repercussions on the real economy and the financial system more broadly.

Financial Stability Review Issue 1, 2012
12 June 2012
Liquidity Regulation as a Prudential Tool: A Research Perspective

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

In response to the flaws in banks’ liquidity risk management revealed by the global financial crisis, the Basel Committee on Banking Supervision has proposed a new set of liquidity requirements to complement its revised capital requirements framework. This special feature reviews, from a research perspective, the role of liquidity requirements in mitigating not only liquidity risks, but also solvency risks in banking. It highlights how liquidity requirements differ from capital requirements and discusses how selected features of the Basel III liquidity rules can help to reap the benefits of liquidity outlined by research theories.

Financial Stability Review Issue 1, 2012
12 June 2012
Evaluating Interconnectedness in the Financial System on the Basis of Actual and Simulated Networks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Multiple levels of analysis are required to assess banks’ fragility in a complex banking system. On the one hand, network analysis using existing data for the euro area shows a banking structure which is well integrated across euro area countries, with some banks playing an important role at the euro area level while others have a more domestic focus. On the other hand, a dynamic network modelling approach can illustrate important aspects and fragilities of interbank activity in a simulated network in the absence of real micro data. This special feature first describes a static approach to financial network analysis and then gives a specific illustration of a dynamic network in a stress-testing context. Both provide important insights for financial stability analysis. The static analysis of existing financial networks and the use of a simulated network for stress testing exploit information on the microstructure of banking activities to characterise the robustness of the banking sector to operating shocks. This is a unique application of conceptual and analytical techniques that have only recently been introduced in financial analysis.

Financial Stability Review Issue 1, 2012
19 December 2011
Beyond the stress testing of individual banks: how shock propagation throughout the economy may multiply initial losses

Abstract

Abstract

Stress tests aim at identifying weak points in financial systems by estimating the potential losses in individual financial institutions under various adverse but plausible scenarios. The majority of present methodologies are designed to capture the effect of stress on the capital buffers of the particular institution under examination. However, the assessment in many cases stops there, without considering potential knock-on effects on other institutions that might be interconnected with the institution under investigation. Such second-round effects might act as important amplifiers of stress in the financial system because in a modern economy bilateral financial interlinkages across various sectors are tight. As a result, financial stress in some sectors could cause a chain reaction in which the balance sheets of other financial and non-financial sectors might also be adversely affected.

Financial Stability Review Issue 2, 2011
19 December 2011
Credit risk protection by insurance companies

Abstract

Abstract

Traditional insurance activities are rarely thought of as harbouring significant systemic risk, not least given stringent risk management and the rather illiquid nature of claims inherent

in the business models of insurance providers. The financial crisis has illustrated, however, that other non-core activities, which typically bear more similarities to banking activities than

to traditional insurance contracts, may embed more potential to disrupt financial stability.

Financial Stability Review Issue 2, 2011
19 December 2011
A reflection on recent developments in the operational risk management frameworks in the banking industry

Abstract

Abstract

Trading losses at UBS in September 2011 (estimated at around €2 billion) – with similarities to another loss at Société Générale in 2008 (€4.9 billion) – recall the events that led to the

bankruptcy of Barings Bank more than fifteen years ago, after the fraudulent activities of one of its employees had resulted in a USD 1.3 billion loss. These recent events show that despite

tighter regulation of the banking industry, the failures in operational risk management continue to represent a recurring problem. All three cases are classic large operational risk events that arose as a consequence of numerous control and governance failures. The distinguishing common feature in all these cases is a single rogue trader who manages to circumvent a series of internal controls and take advantage of weak governance to implement elaborate trading strategies resulting in losses, further exacerbated by adverse market movements.

Financial Stability Review Issue 2, 2011
19 December 2011
How do bank risk and sovereign risk interact? A CDS market-based analysis

Abstract

Abstract

The sovereign crisis afflicting parts of the euro area has unfortunately provided a vibrant illustration of the vulnerability of a banking sector when combined with high sovereign risk.

Many metrics, of course, exist to gauge the strength of the close relationship between the risks in the sovereign bond markets and the banking sector. One approach is to use credit default

swap (CDS) markets to analyse the multitude of transmission channels which may exist. First, the direct exposure of the banking sector to sovereign bonds implies a transfer of risk from the sovereign CDS to the banking CDS. Second, the “fiscal cost” of banking crisis resolution implies a risk transfer from the bank CDS market to the sovereign CDS. Third, the cross-border links between financial institutions can be qualified as the banking channel of sovereign risk. Even if the analysis of market prices is not a panacea for a complete assessment of these transmission channels, it allows for a daily monitoring of market participants’ expectations concerning the potential risk spillovers between banking risk and sovereign risk.

Financial Stability Review Issue 2, 2011
19 December 2011
The euro area government debt securities lending market

Abstract

Abstract

Owing to the lack of publicly available quantitative information, relatively little is known about the euro area government debt securities lending market. The same holds true, albeit to a much lesser extent, for securities lending in general. This is more relevant and cause for concern in view of the fact that securities lending represents an important part of the global shadow banking system. Against this background, the purpose of this box is to introduce securities lending activity and to provide some information on the euro area government debt securities lending market, with an additional focus on three euro area countries covered by EU/IMF financial support programmes.

Financial Stability Review Issue 2, 2011
19 December 2011
A credit default swap-based measure of government bond market impairments in the euro area

Abstract

Abstract

Since the first half of 2010, the government bond markets of some euro area countries have faced illiquid market conditions and other impairments. To address these problems and contribute to restoring an appropriate monetary policy transmission mechanism, the ECB has conducted interventions in dysfunctional euro area market segments since 10 May 2010, using the Securities Markets Programme (SMP). The impact of the SMP cannot be assessed merely on the basis of declines in government bond yields, nor on that of any particular narrowing of spreads, as neither gives an exact picture of market impairments or a robust indication of the effect of the ECB’s interventions. Indeed, government bond yields and spreads are affected by a multitude of factors beyond the ECB’s interventions, in particular by investors’ risk aversion and by market perceptions about the sustainability of public debt, as well as by other European measures such as the actions and prospects of the European Financial Stability Facility (EFSF).

Financial Stability Review Issue 2, 2011
19 December 2011
The EUR/USD basis swap as an indicator of stress in money markets

Abstract

Abstract

The US dollar funding needs of European and other non-US banks has attracted a great deal of attention since the Lehman Brothers bankruptcy in 2008, not least given the fragility of this

source of wholesale market funding. This box reviews the basic aspects of this market, and compares the situation in the foreign exchange (FX) swap market prevailing in the aftermath of

the Lehman Brothers episode to the current situation by discussing the so-called basis swap as an indicator of stress in US dollar funding conditions.

Financial Stability Review Issue 2, 2011
19 December 2011
Public debt sustainability: expanding the toolbox

Abstract

Abstract

Assessing sovereign debt sustainability has become a key issue for several advanced economies – both inside and outside the euro area – at this stage of the financial crisis. The methodologies used to make such assessments have tended to vary in their assumptions and rigour – perhaps not surprisingly given the difficulty of accurately modelling the complex interplay between fiscal fundamentals, macro-financial conditions and financial sector strength. A commonly used approach is based on a stock-fl ow identity for public debt accumulation, treating macro-financial conditions as exogenous.

Financial Stability Review Issue 2, 2011
19 December 2011
Indicators for detecting possible value misalignments in commercial property markets

Abstract

Abstract

Commercial property loans represent a considerable proportion of most banks’ assets and, given their tendency to exhibit strong pro-cyclical volatility, embed financial stability risks that tend to crystallise in property value downturns. At the level of individual commercial properties, well-accepted metrics exist for assessing valuations – which, typically, involve discounting the future income stream the properties are expected to generate. At the aggregate level, however, widely accepted valuation metrics are more scarce – not least given a lack of suitable data (particularly acute in the case of euro area countries). One alternative approach to detecting possible value misalignments in commercial property markets, which is explored in this box, can therefore be to compare property values with some macroeconomic variables – since commercial property values tend to follow economic developments rather closely – and some aggregate commercial property data that can give indications of the demand and supply factors in commercial property markets.

Financial Stability Review Issue 2, 2011
19 December 2011
Firms’ liquidity management during periods of financial stress

Abstract

Abstract

It has long been argued that banks’ liquidity problems can have a pernicious influence on the credit conditions of non-financial firms. Banks’ inability to access market financing can

contribute to the tightening of lending standards for firms – a situation clearly observed in the bank lending surveys conducted by the ECB in the wake of the financial crisis in 2007 and

2008. Such a development can contribute to the transformation of non-financial firms’ initial liquidity problems into solvency problems for the firms whose bank credit lines are cut, thereby increasing the likelihood of loan defaults and capital losses for banks.

Financial Stability Review Issue 2, 2011
19 December 2011
Financialisation of commodities

Abstract

Abstract

Surging and volatile commodity prices have been a concern for policy-makers over the last few years from many different angles. One such angle has been the “financialisation of commodity markets”, whereby commodity markets would be increasingly influenced by agents with limited interest in hedging physical exposures, but rather an interest in commodities as an asset class. One particular financial stability risk stems from the potential for concentrated exposures and unexpected spillovers among markets that create pockets of instability that may affect individual financial institutions and could have repercussions on the wider financial system. This box outlines the main aspects of this debate, first describing the basic premise, followed by an assessment of the literature, and the reporting of some illustrative results of an empirical model designed to capture time-varying correlations of selected commodities with financial market developments.

Financial Stability Review Issue 2, 2011
19 December 2011
Assessing equity and property prices in selected large emerging market economies

Abstract

Abstract

Over the past decade, emerging markets have been growing as a share of world output. The so-called BRIC economies (Brazil, Russia, India and China), in particular, have outperformed

advanced economies in terms of economic growth. The strong economic performance has, however, partly been fuelled by strong credit growth, coupled with booming asset and property

prices. These developments have raised concerns that the economies could overheat, thereby presenting numerous financial stability risks associated with an unwinding of imbalances, with resulting potential for aggregate global shocks and contagion. Most relevant for the euro area could be those risks transmitted through trade, financial and – more generally – confidence channels. Making use of two selected early-warning indicators on equity and residential property markets, this box takes an aggregate view of the BRIC economies and analyses the potential for the group as a whole to be subject to costly asset price busts.

Financial Stability Review Issue 2, 2011
19 December 2011
What are the consequences of the downgrade of the united states’ sovereign debt?

Abstract

Abstract

On Friday 5 August, the United States’ longterm sovereign debt was downgraded from AAA to AA+ (with a negative outlook) by Standard & Poor’s (S&P), one of the three global rating agencies, without a clear reaction of the bond market following this announcement: the Treasury yields did not increase and market liquidity did not dry up. To some extent the decision by S&P was expected, as the conditions under which a downgrade would take place had been communicated on several occasions by S&P.

Financial Stability Review Issue 2, 2011
19 December 2011
Downside risks to real activity in the united states: the role of disagreement in expectations in determining macroeconomic vulnerability

Abstract

Abstract

One critique of the build-up phase prior to the onset of the recession in 2008-09 was that “groupthink” amongst macroeconomic forecasters prevailed, whereby a lack of heterogeneity in

beliefs led to myopia about the potential for such an event. This reflects a general phenomenon whereby an economy can become more vulnerable if people largely agree about the future course of the economy, and can become more resilient if they hold differing beliefs. One explanation for this phenomenon is that the acquisition of insurance coincides largely with beliefs about economic developments. If expectations are very homogenous, this can lead to higher aggregate risk because of overly homogenous insurance schemes. On the one hand, the risks of a severe downturn may be underplayed and sow the seeds for unhedged losses. On the other hand, risks of recession may be overplayed, thereby leading to overly precautionary behaviour contributing to self-fulfilling outcomes. In either setting, when risk aversion is more homogenous, aggregate losses may be amplified. This box examines financial stability risks from disagreement in macroeconomic expectations, on the basis of a model using a disagreement metric for measuring and assessing financial stability.

Financial Stability Review Issue 1, 2011
19 December 2011
Common Equity Capital, Banks' Riskiness and Required Return on Equity

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

In the ongoing reform of the financial system, a key regulatory objective is to increase the soundness and resilience of banks. In line with this objective, regulators have placed emphasis on higher common equity capital requirements. The industry has been critical of a higher reliance on equity. Since equity is the most expensive source of capital, it is often asserted that higher equity ratios may materially increase banks’ funding costs, with adverse consequences for credit availability. Based on a sample of large international banks, this special feature provides an assessment of the relationship between banks’ equity capital, riskiness and required return on equity. Following a methodology employed in recent papers, an attempt is made to measure these relationships in the light of the hypothesis of Modigliani and Miller on the irrelevance of the capital structure for the value of the firm. The empirical evidence discussed in this special feature supports the notion that higher capital requirements tend to be associated with a decrease in the riskiness of equity returns and thus of the required risk premium, in line with the theoretical argument. This conclusion counters the industry’s concern about a material increase in funding costs and further supports the regulators’ focus on higher equity requirements.

Financial Stability Review Issue 2, 2011
19 December 2011
Empirical Determinants of Non-Performing Loans

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature reviews trends in the credit quality of banks’ loan books over the past decade, measured by non-performing loans, based on an econometric analysis for a panel of 80 countries. The assessment of overall asset quality and credit risk in the financial sector is an important element of macro-prudential surveillance. A thorough understanding of the main drivers thus facilitates the identification of key vulnerabilities in the financial sector.Results suggest that – not surprisingly – real GDP growth has been the main driver of non-performing loans during the past decade. Exchange rate depreciations are also linked to an increase in non-performing loans in countries with a high degree of lending in foreign currencies to unhedged borrowers. In addition to these two factors, equity prices also have an impact on non-performing loans, in particular in countries with large stock markets relative to the size of the economy. Finally, interest rates also tend to affect loan quality. While these findings are found to be robust in the heterogeneous panel dataset, such results should only be applied with great caution to individual countries where additional country and sector-specific factors might have an impact on non-performing loans.

Financial Stability Review Issue 2, 2011
19 December 2011
Global Liquidity: Measurement and Financial Stability Implications

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Global liquidity, both in times of abundance and shortage, has a range of implications for financial stability. Surges in global liquidity may be associated with strong asset price increases, rapidly rising credit growth and – in extreme cases – excessive risk-taking among investors. Shortages of global liquidity may lead to disruptions in the functioning of financial markets and – in extreme cases – depressed investor risk appetite, leading to malfunctioning markets. This special feature takes a broad perspective and starts by defining and identifying the key drivers behind the multifaceted concept of global liquidity, all of which are related to more accommodative global financing conditions. Thereafter, a conceptual framework is proposed for how policy-makers can monitor global liquidity. This involves looking in depth at a broad set of indicators such as: (i) short-term interest rates in advanced and emerging economies; (ii) asset price valuation indicators; (iii) uncertainty, risk appetite and financial liquidity indicators; and (iv) capital flows, international reserves and cross-border credit growth. Building on this framework, the special feature also discusses policy responses to global liquidity developments from a financial stability viewpoint.

Financial Stability Review Issue 2, 2011
19 December 2011
Mapping the State of Financial Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The ongoing global financial crisis has demonstrated the importance of understanding the sources of systemic risk and vulnerabilities that may lead to systemic financial crises. An early identification of sources of vulnerabilities is essential as it makes it possible to take preventive, targeted policy actions. This special feature presents the Self-Organising Financial Stability Map (SOFSM), which is a novel methodology based upon data and dimensionality reduction for mapping the state of financial stability, visualising the sources of systemic risks and predicting systemic financial crises.

Financial Stability Review Issue 2, 2011
19 December 2011
The Impact of Different Bank Characteristics on Risk and Performance

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature outlines the evidence on the relationship between different bank characteristics and risk before and during the recent financial crisis. A significant amount of bank risk materialised during the crisis. It is argued that two major structural developments in the banking sector (namely deregulation and financial innovation) probably had a large effect on banks’ business models and capital levels. This, among other factors, affected banks’ incentives to take on new risks in the decade leading up to the crisis. The empirical evidence from a number of studies suggests that banks with higher levels of capital, more stable funding and stronger risk controls performed better during the recent crisis. It also suggests that greater regulation of banks experiencing large increases in stock market valuation is warranted. The main empirical findings are in line with the Basel III recommendations.

Financial Stability Review Issue 2, 2011
15 June 2011
Lending by insurers

Abstract

Abstract

In recent months several euro area insurers have announced plans to increase their lending activities – in particular for commercial property investment – to fill the void left by banks that,

in some cases, have scaled back their commercial property lending. This box presents some data on insurers’ lending activities and highlights some financial stability implications.

Financial Stability Review Issue 1, 2011
15 June 2011
US dollar funding needs of euro area banks and the role of US money market funds

Abstract

Abstract

Euro area banks have built up sizeable positions in US dollars over the last ten years. According to data from the Bank for International Settlements (BIS), the US dollar assets of euro area banks at the end of the fourth quarter of 2010 totalled approximately USD 3.2 trillion. These positions were accumulated progressively over the last ten years and reached a temporary high between the third quarter of 2007 and the first quarter of 2008. They are largely the result of search-for-yield types of investment in USD-denominated assets, but also include business expansions into the United States, as well as customer-driven US dollar financing requirements for corporate or project financing. This box looks at the funding consequences linked to these sizeable positions.

Financial Stability Review Issue 1, 2011
15 June 2011
Bank capital ratios and the cost of market funding

Abstract

Abstract

An important policy issue is whether higher bank capital facilitates access to private funding markets. If the risk profile of banks’ assets is similar, higher risk-weighted capital ratios should

imply that banks are able to fund themselves at lower credit spreads.

Financial Stability Review Issue 1, 2011
15 June 2011
The impact of the financial crisis on banks’ deposit margins

Abstract

Abstract

Bank funding risk has been one of the most important sources of banking sector vulnerability throughout the financial crisis. Indeed, one of the notable implications of the ongoing sovereign debt crisis was the intensification of this risk. Especially in some euro area countries where access to market funding has been particularly constrained in recent years, banks have tried to compensate for this by turning to more stable funding sources, such as retail deposits. In order to attract depositors, many banks have increased deposit rates, which has, in turn, resulted in decreasing, and lately even negative, deposit margins having adverse consequences for bank profitability. Using a panel econometric approach and exploiting confidential information from the Eurosystem’s bank lending survey (BLS), this box illustrates how impaired access to wholesale funding during the recent financial crisis has influenced the cost of euro area banks’ deposit funding.

Financial Stability Review Issue 1, 2011
15 June 2011
Exchange-traded funds

Abstract

Abstract

Exchange-traded funds (ETFs) are (mostly) passive index-tracking investment products granting investors cost-effective and liquid exposure to a wide range of asset classes and geographical areas. These products have experienced impressive growth since 2000, and they weathered the crisis relatively unscathed. The growth of these products, the pace of the related financial innovation and (linked to the latter) their increasing degree of complexity have attracted supervisory bodies’ attention at the international level. This box summarises the key characteristics of ETFs, describes the evolution of ETFs in terms of the number of funds and assets under management (AuM) (also providing where possible relevant euro area or EU data) and finally sketches in broad terms the issues that may require closer scrutiny in the near future by the international financial stability, supervisory and regulatory communities.

Financial Stability Review Issue 1, 2011
15 June 2011
Tracking bond and stock market uncertainty using option prices

Abstract

Abstract

Financial option prices – through the estimation of risk-neutral densities (RNDs) – offer the possibility to gauge the uncertainty attached by market participants to future asset prices and to track its changes over time. This box discusses the uncertainty surrounding the short-term (three-month) outlook for the ten-year German government bond (“Bund”) price – gauged using the prices of options on Bund futures – and relates it to that for the Dow Jones EURO STOXX 50 index during the financial turbulence of the last few years.

Financial Stability Review Issue 1, 2011
15 June 2011
Common trends in euro area sovereign credit default swap premia

Abstract

Abstract

The tensions in euro area sovereign debt markets are currently considered one of the major risk factors for financial stability. Looking back at the developments in euro area sovereign credit spreads since 2008, one may distinguish two different types of driving forces. First, there are “common factors”, such as investors’ risk aversion that tends to lift all credit spreads for a given perceived “amount” of credit risk. In a similar fashion, a worsening global macroeconomic outlook would tend to increase all spreads – albeit likely to a varying extent – via the expected adverse impact on a country’s public expenditures and tax base. Second, there are country-specific influences such as political developments or the sudden requirement to support certain financial institutions. Such country-specific developments have the potential to change investors’ outlook concerning the success of fiscal consolidation and thereby affect the respective country’s sovereign credit spreads. If country-specific influences are more (less) important than common factors, the correlation between different countries’ sovereign credit spreads would tend to be low (high). This box attempts to quantify these aspects: it measures the tightness of co-movement across euro area sovereign credit spreads and sets out to gauge the relevance of common driving forces versus idiosyncratic influences.

Financial Stability Review Issue 1, 2011
15 June 2011
Government financial assets and net government debt in the euro area

Abstract

Abstract

In assessing sovereign debt sustainability, government holdings of financial assets, and not only gross government liabilities, should also be taken into account. An indicator of net government debt provides useful complementary information to gross government debt levels, in particular when an increase in government liabilities is accompanied by a simultaneous increase in government financial assets.

Financial Stability Review Issue 1, 2011
15 June 2011
Tools for detecting a possible misalignment of residential property prices from fundamentals

Abstract

Abstract

Euro area residential property prices have exhibited pronounced volatility over the last decade, not dissimilar to the dynamic in other advanced economies. A legacy of the substantial

appreciation in house prices in most euro area countries over the decade leading up to 2005, as well as the strong expansion of economic activity related to housing, has been an accumulation of imbalances in this sector that continue to affect the economic and financial outlook. This box reviews the recent evolution of some measures for detecting residential property price misalignments from fundamentals in selected euro area countries for which relatively long time series for house prices and the ancillary fundamental variables are available from national and international sources.

Financial Stability Review Issue 1, 2011
15 June 2011
What do option risk-neutral density estimates tell us about the euro/dollar exchange rate?

Abstract

Abstract

Risk-neutral densities (RNDs) provide an estimate of the probability that market participants attach to future price developments. They are derived from the option prices of a given asset,

and under certain assumptions can provide a distribution of outcomes on the basis of which a quantitative risk assessment can be made. In the case of exchange rates, they are an important tool in assessing the likelihood of sharp movements – a key risk for financial stability – and the evolution of this likelihood over time. This box introduces RND estimates for the euro/dollar exchange rate, briefly describes how they are constructed, explains how they can be interpreted and discusses the information they provide at the current juncture.

Financial Stability Review Issue 1, 2011
15 June 2011
Is the narrowing of global imbalances since the financial crisis cyclical or permanent?

Abstract

Abstract

Global current account and financial imbalances have narrowed markedly during the financial crisis. From a policy perspective, it is important to determine to what extent this narrowing

constitutes a structural feature of the global economy, and to what extent it is cyclical, which would imply a renewed widening of imbalances, thereby putting the global recovery at risk.

As well as macroeconomic risks associated with global growth, the re-emergence of widening global imbalances may have negative effects on euro area financial stability through increased

market and liquidity risks. In particular, should investor concerns focus on the sustainability of public debt, countries with large deficits may experience funding pressures owing to

heightened risk aversion and a concomitant rise in bond yields. This may also have an impact on the term structure of international interest rates and lead to volatility in foreign exchange

markets, which could spill over to other market segments. Moreover, if global imbalances were to widen and concerns relating to the condition of countries with large external deficits

or surpluses were to arise, the risk of disorderly exchange rate adjustments may emerge. Aside from financial stability considerations, this question is also central to international

policy discussions, particularly in the context of the G20 Framework for Strong, Sustainable and Balanced Growth, which aims to ensure a durable reduction in global imbalances, together

with a sustained global recovery.

Financial Stability Review Issue 1, 2011
15 June 2011
Portfolio Flows to Emerging Market Economies: Determinants and Domestic Impact

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature describes the recent wave of private capital flows to emerging market economies (EMEs), analyses the drivers of the flows and discusses the impact of portfolio flows on domestic macro-financial conditions. Currently, private capital flows to emerging markets are characterised by a surge in portfolio inflows which have reached similar levels to those prevailing prior to the onset of the financial crisis in 2007. The prospect of sudden stops and reversals sometimes associated with strong portfolio inflows can complicate the management of domestic macro-financial conditions in EMEs with potential negative financial stability implications. One of the key risks over the medium term linked to such flows is a boom/bust cycle in one or more systemically important emerging economies, along with the unwinding of imbalances and possible contagion. A bust could create severe disruptions in global financial markets and affect the euro area through a rise in global risk aversion, as well as through direct real economy and financial market linkages.

Financial Stability Review Issue 1, 2011
15 June 2011
Financing Obstacles Faced by Euro Area Small and Medium-sized Enterprises During the Financial Crisis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

During the recent financial crisis, euro area firms, and especially small and medium-sized enterprises (SMEs), reported severe problems gaining access to finance. Using new survey data for a sample of more than 5,000 firms in the euro area, this special feature presents the results as a means of tracking the financing obstacles faced by non-financial corporations, as well as a structural analysis of this issue during the recent crisis. After disentangling the impact of various factors, it is shown that firm age and size are key determinants of whether a company experiences problems accessing financing. As SMEs are often unable to switch from bank credit to other sources of finance, experiencing major financing obstacles can be a considerable challenge and can endanger economic growth. Looking forward, expanding access to finance while ensuring financial sector stability through responsible practices and an appropriate evaluation of risks appears essential for a sustained economic recovery.

Financial Stability Review Issue 1, 2011
15 June 2011
Systemic Risk Methodologies

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has illustrated the importance of timely and effective measures of systemic risk. The ECB and other policy-making institutions are currently devoting much time and effort to developing tools and models which can be used to monitor, identify and assess potential threats to the stability of the financial system. This special feature presents three such models recently developed at the ECB, each focusing on a different aspect of systemic risk. The first model uses a framework of multivariate regression quantiles to assess the contribution of individual financial institutions to systemic risk. The secondmodel aims to capture financial institutions’ shared exposure to common observed and unobserved drivers of financial distress using macro and credit risk data, and combines the estimated risk factors into coincident and early warning indicators. The third model relies on standard portfolio theory to aggregate individual financial stress measures into a coincident indicator of systemic stress.

Financial Stability Review Issue 1, 2011
15 June 2011
Financial Resolution Arrangements to Strengthen Financial Stability: Bank Levies, Resolution Funds and Deposit Guarantee Schemes

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Fundamental reforms of regulation and supervision are currently under way – both at international and European level – to address the deficiencies exposed by the financial crisis. In this context, a range of policy approaches have been developed, aimed at mitigating the burden on taxpayers and minimising future reliance on public funds to bail out financial institutions. This special feature examines the recent initiatives undertaken by several EU Member States to implement bank levies and resolution funds, in some cases exploiting synergies with deposit guarantee schemes (DGSs). These financing mechanisms are fully supported by the European Commission in the context of the proposed EU framework for bank recovery and resolution.

Financial Stability Review Issue 1, 2011
9 December 2010
Using data on MFIS’ statistical revaluations to gauge information on changes in banks’ trading-book valuations

Abstract

Abstract

Valuation losses in the trading books constituted the first wave of losses suffered by euro area LCBGs in the current crisis, triggered by the collapse of the US sub-prime market. More recently, estimating potential losses from banks’ government bond portfolios formed an important part of the EU-wide stress-testing exercise carried out in July 2010. The important role played by trading-book holdings for the profit and loss accounts of many LCBGs has intensified the need for monitoring, stress testing and possibly also forecasting the valuations of banks’ trading books for financial stability purposes. An important impediment to this work is the limited availability of data from public sources which consist mainly of quarterly or annual observations from banks’ published financial reports. This box focuses on the statistical revaluations data collected under Regulation (EC) No 25/2009 of the ECB of 19 December 2008 concerning the balance sheet of the monetary financial institutions sector (recast) (ECB/2008/32) and discusses its usefulness in providing information for the analysis of changes in trading and banking-book valuations at the aggregate banking sector level.

Financial Stability Review Issue 2, 2010
9 December 2010
Evolution of euro area banks’ customer funding gap

Abstract

Abstract

The customer funding gap is an indicator that is defined as net loans (i.e. gross lending to the nonfinancial sector minus provisions for non-performing loans) minus customer deposits. It shows whether banks have enough deposits to cover the expansion of their lending activities or whether they have to tap the money and capital markets to finance these activities. A customer funding gap can lead to funding risks in case liquidity unexpectedly ceases to be available, conditions experienced in autumn 2008 as well as the first half of 2010. This box looks at the development of the aggregated liabilities and at the evolution of the funding gap of the set of euro area banks that participated in the EU-wide stress-test exercise. The customer funding gap for this sample has increased in both absolute and relative (i.e. as a percentage of total assets) terms since 2005, although it declined in 2009.

Financial Stability Review Issue 2, 2010
9 December 2010
Assessment of the risks of EU banks’ exposures to sovereign debt as revealed in the exercise undertaken by the Committee of European Banking Supervisors (CEBS)

Abstract

Abstract

The EU-wide stress-testing exercise that was carried out in July 2010 involved, among other features, the disclosure of the exposures of all 91 participating banks to 30 European sovereigns. The reason for this extensive disclosure was to provide a harmonised source of information to market participants and, thereby, to help them in assessing the scope of potential losses

by individual institutions that would arise from fluctuations in the value of sovereign debt. The exercise provided evidence that the EU banks’ trading-book holdings of foreign sovereign

debt securities are unlikely to be large enough to create a direct channel for the propagation of systemic risk, which is somewhat contrary to the views held by some market participants prior to the disclosure.

Financial Stability Review Issue 2, 2010
9 December 2010
Sensitivity of euro area banks’ interest income to changes in short-term market rates

Abstract

Abstract

Net interest income generated by retail customer activities, such as, in particular, the collection of deposits and the granting of loans, is one of the main sources of income for euro area banks. At the current juncture, with short-term interest rates hovering at historical lows and many banks experiencing protracted difficulties in accessing both retail and wholesale funding, banks’ deposit margins have been squeezed significantly. Similarly, in euro area countries where the majority of loans carry a rate of interest that is either floating or has a short period of fixation, lending margins have also come under pressure in light of the sharp decline of short-term market rates over the past two years. By contrast, banks in euro area countries where a significant part of loans are granted at rates that are fixed for a long term have tended to benefit from the relatively steep yield curve observed in 2009 and 2010 (see the chart above). Against this background, this box examines the possible implications of an increase in short-term market rates, as currently expected by market participants, on euro area banks’ retail customer-related net interest income.

Financial Stability Review Issue 2, 2010
9 December 2010
Main findings of the euro money market survey 2010

Abstract

Abstract

On 23 September 2010, the ECB published the results of the Euro Money Market Survey 2010, which were based on data collected from banks in 27 European countries and covered

developments in various segments of the euro money market in the second quarter of 2010. This box reports on the survey’s main findings.

Financial Stability Review Issue 2, 2010
9 December 2010
Comparison of the US, UK and EU macro-prudential frameworks

Abstract

Abstract

In the EU, the United Kingdom and the United States, new macro-prudential frameworks have been established, including the creation of new official bodies to improve systemic oversight

and coordinate macro-prudential interventions. This box briefly describes the structure and responsibilities of these bodies and outlines the main differences.

Financial Stability Review Issue 2, 2010
9 December 2010
Government measures to safeguard financial stability in the euro area

Abstract

Abstract

From early 2010 fiscal imbalances in certain euro area countries have been causing tensions in sovereign debt markets. Euro area countries responded by affirming their willingness to take determined and coordinated action, if necessary, to safeguard financial stability in the euro area as a whole. In this context, on 2 May 2010 euro area countries agreed to activate, together with the IMF, a three-year financial support programme for Greece. On 6-7 May 2010, tensions escalated abruptly in financial markets. In line with their earlier commitment, European governments took urgent and unprecedented action to safeguard financial stability. On 9 May 2010, the Member States agreed to establish a comprehensive package of measures, consisting of three elements.

Financial Stability Review Issue 2, 2010
9 December 2010
Have euro area banks been more discriminating against smaller firms in recent years?

Abstract

Abstract

The combination of a general economic slowdown and the intensification of the financial crisis in late 2008 resulted in a marked reduction in lending to non-financial corporations in the euro area. Survey-based evidence suggests that the slowdown in credit to the euro area corporate sector reflects both lower borrower demand and more restrictive loan supply by banks faced with pressures on their balance sheets. However, the economic impact on and hence potential feedback loops to the financial sector crucially hinge on the extent to which the borrowers facing a less abundant supply of bank credit are able to replace it with other sources of finance. Against this background, this box sheds some light on whether lending to smaller companies, which are typically more bank-dependent, has declined by more than credit to larger firms.

Financial Stability Review Issue 2, 2010
9 December 2010
Capital flows to emerging markets

Abstract

Abstract

Private capital inflows into emerging economies have rebounded well from the trough experienced in 2009. The International Institute of Finance (IIF) estimates that the net private capital flows to emerging economies will total USD 825 billion in 2010 and USD 834 billion in 2011, significantly higher than the USD 581 billion recorded in 2009. The most significant changes are expected in private creditors’ (commercial banks and non-bank financial institutions) net inflows into emerging markets. Moreover, net portfolio investments in emerging markets are expected to continue to be sizeable in the medium term, totalling USD 187 billion in 2010 and USD 143 billion in 2011. In fact, using high-frequency data from a survey among fund managers (Emerging Portfolio Fund Research – EPFR) shows that portfolio inflows into emerging market assets, particularly into emerging market debt securities, started to rebound as early as the second quarter of 2009. In cumulative terms, inflows into emerging market equity markets exceeded the outflows recorded during the crisis by mid-2009, while bond markets have registered net inflows in cumulative terms since the second quarter of 2010.

Financial Stability Review Issue 2, 2010
9 December 2010
US government-sponsored enterprises: outlook and risks

Abstract

Abstract

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which have been major providers of credit to US mortgage borrowers, have become increasingly relevant to financial stability, in particular in the recent crisis. First, in September 2008, due to the systemic risks attached to these entities, Fannie Mae and Freddie Mac were placed under temporary government control to avoid insolvency. Second, the Treasury entered into a Senior Preferred Stock Purchase Agreement providing limited guaranteed capital injections, which in December 2009 were extended to allow unlimited capital infusions over the next three years. Against this background, this box examines the current role of the GSEs in the US housing market, their fiscal costs and the possible downside risks to the housing market and to financial stability more generally once the support is scaled back.

Financial Stability Review Issue 2, 2010
9 December 2010
Stress-Testing Banks in a Crisis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature describes the key characteristics of macro stress tests for banks specifically in relation to their use during financial crises. The analysis draws on recent experiences in the United States in 2009 and in the EU in 2010, where macro stress tests for banks were used in one of the most severe financial crises in decades.

Financial Stability Review Issue 2, 2010
9 December 2010
Basel III

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has revealed a number of shortcomings in the existing framework of prudential regulation. This special feature outlines the main elements of the Basel Committee on Banking Supervision’s proposals to strengthen global capital and liquidity regulations, commonly referred to as Basel III.

Financial Stability Review Issue 2, 2010
9 December 2010
Comparing Macro-Prudential Policy Stances Across Countries

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Macro-prudential policy aims to secure the stability of the financial system. The global financial crisis has shown how linkages between countries play a significant role in transmitting financial shocks. It is therefore of interest to examine macro-prudential policy for a group of countries as a whole. The macro-prudential policy stance based on an analysis of a group of countries may differ from the policies resulting from an analysis of each country in isolation. This special feature examines how similar stand-alone macro-prudential policies would have been for a selected group of countries and compares the desired stand-alone policies to a policy derived from a portfolio analysis. The desired macro-prudential policy stances (tight, neutral or accommodating) are derived from a set of historical indicators intended to measure systemic risk, but which clearly need further refinement. The degree of similarity between the countries’ policy stances varies over time. During some time periods it is quite high. Furthermore, the analysis shows that the desired macro-prudential policy stance derived from individual country data at times broadly corresponds to the policy stance derived from aggregated data for the portfolio. In Europe the increased focus on macro-prudential policy has led to the establishment of the European Systemic Risk Board (ESRB). The ESRB will have responsibility for EU-wide macro-prudential oversight and policy recommendation.

Financial Stability Review Issue 2, 2010
9 December 2010
Towards Macro-financial Models with Realistic Characterisations of Financial Instability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The global financial crisis has revealed important deficiencies of the standard macroeconomic models in capturing financial instabilities. Realistic characterisations of such instabilities include bank defaults, financial market illiquidity, extreme events, and related non-linearities. None of these feature in the macroeconomic models regularly used for forecasting and monetary policy analysis and only recently has more emphasis been given to better developing the role of financial sectors in these models. This gap is of particular concern given the ongoing efforts to establish serious macro-prudential oversight and regulation to counter systemic risks. The aim of this special feature is to provide an overview of the recent upsurge in research papers trying to integrate more developed financial sectors in standard macroeconomic models and to compare this work with what is needed for the support of macro-prudential policies. One conclusion is that very significant further research efforts are needed, including attempts using modelling approaches that deviate from the currently dominating macroeconomic paradigm. It is of great importance that the academic and policy-oriented research communities join forces in working towards this objective.

Financial Stability Review Issue 2, 2010
9 December 2010
New Quantitative Measures of Systemic Risk

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

A host of new quantitative measures of systemic risk have recently been proposed in the academic and central banking literature. The stated purpose of these tools is to support macro-prudential oversight and inform policy decisions. This special feature surveys these measures, focusing primarily on the most recent developments that have not yet been covered in the ECB’s Financial Stability Review, and explains what can be learned from them. The strengths and weaknesses of approaches when applied in a macro-prudential context are discussed. Significant research in this area has addressed how to measure the systemic importance of specific financial intermediaries, for example by estimating the externalities they may exert on the financial system. With the rising number of different analytical measures and models it becomes increasingly important to prioritise between them and to construct a system of measures that, overall, covers all dimensions of systemic risk and how they relate to each other.

Financial Stability Review Issue 2, 2010
31 May 2010
Are low risk-free interest rates good or bad for insurance companies?

Abstract

Abstract

Large and increasing investment exposures to government bonds have left insurers more vulnerable to changes in long-term risk-free interest rates and their levels. However, changes in risk-free interest rates affect both the asset and the liability side of insurers’ balance sheets. This box discusses the various ways in which interest rate levels and changes impact insurers, with the aim of shedding some light on whether low-risk free interest rates are good or bad for insurers.

Financial Stability Review Issue 1, 2010
31 May 2010
Using provisional ECB statistics for insurers and pension funds to analyse their investment risks and linkages

Abstract

Abstract

Investment risks are one of the most prominent risks that insurers and pensions funds are confronted with, and the analysis of insurers’ and pension funds’ financial asset positions is therefore an important element in financial stability analysis. From a broader financial stability perspective, it is also important to analyse the investment of insurers and pension funds, since portfolio reallocation of insurers, or the unwinding of positions, has the potential to affect

financial stability by destabilising asset prices. In addition, the investment of insurers and pension funds create important financial links to, in particular, governments and banks.

Financial Stability Review Issue 1, 2010
31 May 2010
Separating banking and securities business: glass-Gteagall revisited

Abstract

Abstract

On 21 January, 2010, the US Administration proposed a new set of broad regulatory initiatives for the banking sector. Among these, there was support for the proposal put forward by Paul Volcker, the former Chairman of the Federal Reserve Board, which, in practice, recommends restrictions on banks’ business models. The so-called “Volcker rule” aims to prevent banks that have access to central bank and deposit insurance facilities from trading on their own account, as well as from owning and investing in hedge funds and private equity. In a way, the initiative brings back to the regulatory landscape a modified version of the Glass-Steagall restrictions on banks’ securities business. This box takes a mainly academic view and is limited to offering an overview of the main arguments and analytical results – including its limitations – surrounding the original Glass-Steagall Act in the light of the recent crisis from a European perspective.

Financial Stability Review Issue 1, 2010
31 May 2010
Measuring the contribution of individual sectors to systematic risk during the recent financial crisis

Abstract

Abstract

With a focus on the recent financial crisis, this box proposes an indicator that measures the degree of interlinkage between different economic sectors in the euro area. In particular, the box studies the extent to which the overall risk of banks, non-financial firms, households or other economic sectors is driven by systematic risk factors that are common to the entire economy, as is, for instance, the interest rate environment, and what is the relative contribution of an individual sector to the overall systematic risk in the economy.

Financial Stability Review Issue 1, 2010
31 May 2010
Government measures to support banking systems in the euro area

Abstract

Abstract

In response to the intensification of the financial crisis in autumn 2008, euro area governments implemented coordinated measures in support of financial sectors. These measures consisted mainly of guarantees for bank liabilities, capital injections and asset support schemes. These measures, together with the sizeable macroeconomic policy stimuli and the extensive liquidity support provided by the ECB, were successful in restoring confidence in the euro area financial system and in improving its resilience. This box describes the state of the government support measures and the progress that has been made in exiting from these measures. It should be added that the progressive intensification of market concerns about sovereign credit risks within the euro area in April and early May 2010 also put pressure on the operating environment of banks. In some countries, these developments led to an increase in government support rather than to its withdrawal.

Financial Stability Review Issue 1, 2010
31 May 2010
Estimate of potential future write-downs on securities and loans facing the euro area banking sector

Abstract

Abstract

This box provides an update of the estimate of potential write-downs for the euro area banking system, applying the same methodology that was used in past issues of the FSR. After the finalisation of the December 2009 FSR, securities prices continued to rise and CDS spreads on structured credit securities continued to tighten, contributing to a lowering of the marked-to-market loss rates implied by the prices and spreads of these securities. Against this background, compared with the figures presented in the December 2009 FSR, the estimate of total potential write-downs on securities for the period from 2007 to 2010 has been reduced by €43 billion to €155 billion. Furthermore, since the write-downs on securities that had been reported by euro area banks at the time of writing exceeded the write-downs implied by prevailing market prices, it cannot be excluded that some write-backs on securities classified as “available-for-sale” or “held-for-trading” may be recorded by some banks in the period ahead. These potential write-backs could be as high as €32 billion and this would be reflected in higher profits on securities classified as “held-for-trading”, or in lower reserves for securities held in the “available-for-sale” category. In both cases, it could generate capital relief for the banks who benefit.

Financial Stability Review Issue 1, 2010
31 May 2010
Are conditions in the market for euro credit portfolio risk back to normal?

Abstract

Abstract

The credit market has been at the epicentre of the global financial crisis since its outbreak in summer 2007. Of great importance for euro area banks is the market for European portfolio credit risk, as it provides instruments for hedging corporate loan exposures. In this market, indicators based on market prices of standardised contracts can illustrate arbitrage opportunities, which should typically be very small if markets function normally. This box summarises how price-based indicators derived from two commonly used arbitrage strategies can provide insights into market conditions for the trading of credit portfolio risk.

Financial Stability Review Issue 1, 2010
31 May 2010
Public debt, sovereign risk and corporate financing costs: possible spillover channels

Abstract

Abstract

Concerns about the adverse consequences of the deterioration of public finances in euro area countries have driven euro area credit markets since the publication of the December 2009 FSR. This box describes potential channels for a possible spillover of sovereign credit risk to corporate financing costs.

Financial Stability Review Issue 1, 2010
31 May 2010
Fiscal policies and financial stability: analytical framework

Abstract

Abstract

This box aims to provide an overview of economic and financial linkages between the government and financial sectors. Acknowledging that financial market stability may influence public finances, the box focuses on potential channels through which fiscal policies may support or represent a risk for financial stability. These linkages are wide-ranging and rather heterogeneous in nature; therefore, it may be useful to distinguish between several types of relationships.

Financial Stability Review Issue 1, 2010
31 May 2010
Households’ financial distress and unemployment

Abstract

Abstract

The capacity of households to repay their debts has been hampered by the economic downturn that took place in the course of 2008 and the first half of 2009. Indeed, with some lag with respect to the economic cycle, delinquency rates are still increasing markedly in some euro area countries, forcing banks to provision funds to cover for possible losses and, in some cases, leading to write-offs on loans on their balance sheets.

Financial Stability Review Issue 1, 2010
31 May 2010
Financial stability implications of the increase in property sale and leaseback activity

Abstract

Abstract

Over the past decade, an increasing number of companies have engaged in the “sale and leaseback” of their property, such as office buildings or retail space. Under a sale and leaseback agreement, a company sells a property to a professional property investor and leases it back, with the aim of raising capital. In the past, companies often saw ownership of their own property as a sign of strength. However, in the last decade, the stigma attached to selling off “the family silver” lessened, and sale and leaseback activity became increasingly popular. The market was also fuelled by some prominent examples of sale and leaseback activity in Europe in recent years.

Financial Stability Review Issue 1, 2010
31 May 2010
Macroeconomic and financial system uncertainty during the latest recession

Abstract

Abstract

During the recent crisis, the sharp rise in uncertainty following the exceptional events in the financial sector seems to have been an important feature shaping developments in the real economy. Uncertainty influences financial institutions’ willingness to lend and finance economic needs, can put pressure on balance sheets or wealth, and curtails the ability of households and businesses to finance their investment plans. It is also relevant for the real economy because

it can push households and firms to postpone expenditure and increase precautionary savings. Finally, it can impair the ability of financial institutions to intermediate credit or provide liquidity. This box looks at measures of uncertainty for financial markets and the macroeconomic outlook and discusses how the continued heightened uncertainty may be affecting the prospects for the real economy, possibly feeding back to financial stability.

Financial Stability Review Issue 1, 2010
31 May 2010
Asset sales by hedge funds and conventional open-end investment funds at the height of the crisis

Abstract

Abstract

There is a fairly widespread consensus that the trading activities of hedge funds were not one of the direct causes of the recent financial crisis. Nonetheless, it is difficult to argue that these investors were innocent bystanders, not least because both forced and voluntary deleveraging of their portfolios contributed to, and amplified, the adverse asset price dynamics witnessed in many financial markets during the financial market turmoil. Thus, it can be argued that hedge funds were not simply “caught” by the crisis, but that they had also contributed to it. To shed more light on this contribution, this box provides estimates of net asset sales by hedge funds at the nadir of the crisis, and it compares these sales with the forced sales of conventional open-end investment funds.

Financial Stability Review Issue 1, 2010
31 May 2010
Risks stemming from the us commercial property sector

Abstract

Abstract

The risks to financial stability stemming from US property markets have been well documented in previous issues of the Financial Stability Review (FSR) and elsewhere. While risks from the residential property sector have abated somewhat amid signs of a stabilisation in the market, conditions in the commercial property sector have continued to deteriorate. Rising delinquencies on commercial property loans and related securities may result in substantial further losses for US, and possibly, European banks in the near term. This box highlights the exposure of mediumsized US banks to the commercial property sector, and describes the channels through which a downturn in the sector may drag on the US economic recovery and spill over to the euro area.

Financial Stability Review Issue 1, 2010
31 May 2010
Asset price booms, credit bubbles and future financial stress – assessing systemic risks in emerging markets

Abstract

Abstract

To many observers, the recent increases in equity, bond and property prices in emerging markets appear to be unjustifiably strong, particularly when coupled with credit booms in certain economies such as China. This box explores whether vulnerabilities that could lead to a systemic event – an event involving a high level of financial instability and thus potentially negative real economic consequences – in key emerging economies are currently building up. From a policy

perspective, this is important as a systemic event in a key emerging economy could potentially spill over to global financial markets and undermine the recovery of the global economy.

Financial Stability Review Issue 1, 2010
31 May 2010
Interest rate risk and the federal reserve’s tightening cycle: comparison with the events of 1994

Abstract

Abstract

Concerns about interest rate risk – the potential for increases in interest rate volatility and subsequent reductions in earnings or the economic value of portfolios – have intensified recently, on account of the significant accumulation of bonds by commercial banks. Current concerns have a historical precedent: in 1994 bond-yield volatility rose significantly as US long-term bond yields increased sharply and global investors liquidated their government bond holdings. Concerns quickly spread to global fixed income markets, resulting in significant capital losses worldwide. This box compares current developments with those in 1994 and explores the risks to financial stability.

Financial Stability Review Issue 1, 2010
31 May 2010
Macro-prudential Policy Objectives and Tools

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The need for a framework for macro-prudential policy has been widely recognised in the aftermath of the financial crisis. This special feature discusses, in a tentative way, core elements of this framework: namely its objectives and the policy tools that could be used to achieve them. The bulk of the policy tools, for which concrete proposals have been put forward at the global level, tend to aim at enhancing the resilience of the financial system. A different set of tools, aimed at addressing financial imbalances directly, could also be of importance in mitigating system-wide risks. Central banks’ involvement in macro-prudential policy advice could relate to this latter set of tools more prominently, supported by their systemic risk surveillance and assessment tasks.

Financial Stability Review Issue 1, 2010
31 May 2010
Analytical Models and Tools for the Identification and Assessment of Systemic Risks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The identification and assessment of systemic risks is a core function of macro-prudential supervision. There are four broad approaches for analytical models and tools that can support this function. The first three each aim to detect early one of the three main forms of systemic risk, namely the endogenous build-up and unravelling of widespread imbalances, exogenous aggregate shocks and contagion. First, early-warning models and indicators use information in current data in order to signal the presence of emerging imbalances and risks without adding exogenous shocks that are not priced in by the market. Second, macro-stress-testing models are used to assess the resilience of the financial system against extreme but plausible scenarios of widespread exogenous shocks, irrespective of whether current market data give a particular weight to them. Third, contagion and spillover models assess the transmission of instability among financial intermediaries and among financial markets to the extent that the sources are not common. Financial stability indicators, the fourth approach, display the current state of systemic instability in order to, for example, identify the presence of crises. The specific tools underpinning these approaches are broadly available, although further research efforts are also necessary.

Financial Stability Review Issue 1, 2010
31 May 2010
Recent Regulatory Initiatives to Address the Role of Systemically Important Financial Institutions

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has demonstrated the critical role played by some large and complex financial institutions in undermining financial stability. Particular attention is currently being paid by policy-makers to the question as to how systemically important financial institutions (SIFIs) should be regulated and how failures, if they occur, should be resolved.This special feature provides an overview of the ongoing initiatives at the European and international level to deal with these institutions in the broader context of measures aimed at curbing moral hazard and institutions’ contributions to systemic risk.

Financial Stability Review Issue 1, 2010
31 May 2010
Financial Networks and Financial Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The recent global financial crisis has illustrated the role of financial linkages as a channel for the propagation of shocks. It also brought to the fore the concept that institutions may be “too interconnected to fail”, in addition to the traditional concept of being “too big to fail”. This special feature introduces recent research on networks in disciplines other than economics, reviews its application to financial networks and discusses how network analysis can be used to gain a better understanding of the financial system and enhance its stability.

Financial Stability Review Issue 1, 2010
31 May 2010
Addressing risks associated with foreign currency lending in EU member states

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

As the impact of the recent financial crisis began to spread beyond mature economy financial systems, attention was increasingly drawn to the potential systemic risks associated with the prevalence of foreign currency lending in some EU Member States. Although the direct exchange rate risk for banks in most of these countries is controlled by regulatory limits on open foreign exchange positions, banks are still exposed to the indirect exchange rate risk that can arise from currency mismatches on their clients’ balance sheets. This special feature summarises the measures that have been taken by several EU countries to address the financial stability risks related to rapidly expanding foreign currency lending to the non-financial private sector. The experience gained so far indicates that the effectiveness of these measures has been rather limited. Although a variety of factors appear to explain this, what has been particularly important is the persistence of wide differentials in the interest rates paid on loans in domestic currency over those paid in foreign currency, as well as the intensity of bank competition. Moreover, countries’ experiences have revealed that when the presence of foreign-owned banks in local markets is significant, as is the case in non-euro area EU countries in central and eastern Europe, the impact of implementing these measures has been materially curtailed.

Financial Stability Review Issue 1, 2010
18 December 2009
ESCB-CESR recommendations for securities settlement systems and central counterparties in the European Union

Abstract

Abstract

On 23 June 2009 the ESCB and CESR published “Recommendations for securities settlement stems and recommendations for central counterparties in the European Union”. The main aim of the ESCB-CESR recommendations is to promote efficient, safe and sound pan-European post-trading arrangements in order to facilitate greater confidence in securities markets, ensure better investor protection, contain systemic risk and foster financial stability. Furthermore, the

recommendations seek to improve the efficiency of the market infrastructure, which should in turn promote and sustain wider financial market integration and efficiency in Europe.

Financial Stability Review Issue 2, 2009
18 December 2009
Assessing insurers’ investment risks

Abstract

Abstract

Investment risks are usually one of the most important types of risk an insurance company is confronted with. To mitigate investment risks, insurers often invest in various markets to spread their exposures. It is, therefore, important to analyse the conditions in the markets in which insurers invest and to combine this information with that on insurers’ investment exposures to assess insurers’ investment risks. This box proposes some measures of investment uncertainty,

from an insurer’s perspective, for the key markets in which insurers invest. It combines these measures with investment exposure data for a sample of large euro area insurers to assess their overall level of investment risk.

Financial Stability Review Issue 2, 2009
18 December 2009
Credit default swaps and counterparty risks for eu banks

Abstract

Abstract

The financial turmoil has highlighted the importance of counterparty risk management for banks. An issue of particular relevance in this context has been counterparty risk that may crystallise through the over-the-counter (OTC) derivatives markets, as shown by the acute difficulties experienced by market participants in the aftermath of the default or near default of Bear Stearns, Lehman Brothers and AIG. These cases have highlighted the typically opaque linkages within the OTC markets, which led to a situation in which some market participants may have become too big or interconnected to fail. In view of these developments, the ESCB’s Banking Supervision Committee (BSC) carried out a study aimed at assessing the counterparty risk and the main related risks faced by European market participants that are active in, and exposed to, the credit default swap (CDS) market. The report was based on survey data collected from a sample of 31 EU banks, as well as from a number of public and private data sources, and has benefited from market intelligence. This box summarises some of the main findings and policy measures outlined in the report

Financial Stability Review Issue 2, 2009
18 December 2009
Public measures to support banking systems in the euro area

Abstract

Abstract

In response to the intensified financial market stresses in the autumn of 2008, euro area governments implemented coordinated support measures to alleviate strains on their banking systems. These measures complemented the extensive liquidity support that has simultaneously been provided by the ECB. This box summarises the public measures that have been taken and discusses their implications for euro area governments’ fiscal balances. It also reviews some

issues related to the eventual exit from such measures.

Financial Stability Review Issue 2, 2009
18 December 2009
Estimate of potential future write-downs on securities and loans facing the euro area banking sector

Abstract

Abstract

An estimate of potential write-downs for the period from the beginning of 2007 until end-2010 related to the financial market turmoil for euro area banks was published in the June 2009 FSR, along with the methodology that was used to make the calculations. Using the same methodology and with the benefit of more granular data on loan and securities exposures of euro area banks, this box presents an update of the estimate and assesses, based on new macroeconomic forecasts, the magnitude of potential future write-downs that may be suffered by the euro area banking sector by the end of 2010.

Financial Stability Review Issue 2, 2009
18 December 2009
Developments in the euro area covered bond market

Abstract

Abstract

Before the eruption of the crisis, euro area financial institutions had been relying heavily on covered bonds to fund an important part of the increase in residential mortgage and public sector lending. This box describes the main developments in the euro area covered bond market during the crisis and reports on some of the effects of the covered bond purchase programme (CBPP) that was announced on 7 May 2009 and that constitutes an integral part of the enhanced credit support measures initiated and implemented by the Eurosystem.

Financial Stability Review Issue 2, 2009
18 December 2009
Main findings of the euro money market survey 2009

Abstract

Abstract

On 24 September 2009, the ECB published the results of the Euro Money Market Survey 2009, which were based on data collected from banks in 27 European countries and covered developments in various segments of the euro money market in the second quarter of 2009. This box reports on the survey’s main findings.

Financial Stability Review Issue 2, 2009
18 December 2009
Measuring credit risk in the euro area household sector

Abstract

Abstract

To provide an approximation of changing patterns in the credit risk faced by the euro area household sector, this box applies a standard corporate finance model based on financial option pricing techniques. In the calculations, data from the euro area household sector’s financial accounts (measured at market prices) and information on financial market volatility are used.

Financial Stability Review Issue 2, 2009
18 December 2009
Property companies in the euro area

Abstract

Abstract

The business activities of property companies span a variety of areas related to real estate, and the definition of a property company is therefore a rather broad concept. This box briefly describes the structure of the property company sector in the euro area.

Financial Stability Review Issue 2, 2009
18 December 2009
Access to finance for non-financial corporations in the euro area

Abstract

Abstract

Since profitability and thus the ability of firms to generate internal funding have remained very low, or even deteriorated, non-financial corporations may become heavily dependent on external financing. In this context, constraints in firms’ access to external finance could increase firms’ solvency and liquidity risks, triggering an increase in corporate defaults and putting additional pressure on the profitability of the banking system. Against this background, this box examines how the availability of financing resources for non-financial corporations has developed since the previous issue of the FSR. It finds that, for larger companies, access to external finance has improved slightly, but that, for both large and small firms, conditions remain tight.

Financial Stability Review Issue 2, 2009
18 December 2009
Deleveraging via a decline in international bank lending during the global turmoil

Abstract

Abstract

Financial globalisation has been an important feature of the world economy over the past decade. International financial claims showed a strong upward trend, rising from approximately USD 10 trillion in the first quarter of 1999 to USD 35 trillion in the second quarter of 2008. As the recent financial turmoil took hold of the world economy, financial institutions responded to capital shortages by cutting their lending and selling other assets to reduce the size of their balance sheet, a process known as deleveraging. Equally important was a home-bias effect in an environment of high uncertainty regarding the credit quality of banks on a global scale.

Financial Stability Review Issue 2, 2009
18 December 2009
Stress tests conducted in EU member states in central and Eastern Europe

Abstract

Abstract

Many non-euro area EU Member States in central and eastern Europe have experienced a significant worsening of macroeconomic conditions since the start of the current financial turmoil. From a financial stability perspective, it is crucial to assess whether the financial systems in these countries would be capable of weathering plausible but severe shocks, over and above the central scenario of macroeconomic correction. There is a broad consensus that macro stress tests

are a useful tool for making such assessments and, accordingly, the authorities in almost all euro area and non-euro area EU Member States in central and eastern Europe have carried out such exercises in the course of 2009. The nature of the stress tests conducted differed across countries, reflecting variations in business cycle developments, as well as differences in specific sources of risk and vulnerability. Nevertheless, the exercises in many countries assessed the sensitivity of non-performing loan rates and capital adequacy ratios to a worsening of economic conditions that was more severe than projected. This box, which draws upon findings published by the national central banks of the EU Member States in this region, summarises the key conclusions of these exercises.

Financial Stability Review Issue 2, 2009
18 December 2009
Housing price cycles in the United States

Abstract

Abstract

Strains in the residential mortgage market in the United States are generally perceived as one of the main triggers of the ongoing financial and economic crisis. Empirical evidence suggests that an expansion in the supply of mortgages, in particular sub-prime mortgages, during the period when US house prices were rising was largely driven by borrowers and lenders extrapolating the most recently observed house price increases into the future. On the borrowers’ side, expectations of future house price appreciation rendered housing both a more attractive and an affordable asset. On the lenders’ side, default risk was perceived to be lower, as the loan-to-value ratio was expected to fall with future house price increases. Such myopic behaviour by market participants may have been encouraged by the fact that house prices tend to follow persistent cycles, which might induce market participants to become overly optimistic (or pessimistic) about the outlook for house valuations in each respective state of the cycle. This box introduces an empirical model that tries to capture this peculiar price dynamic and assesses the vulnerability of the US housing market.

Financial Stability Review Issue 2, 2009
18 December 2009
A global index of financial turbulence

Abstract

Abstract

In order to understand the impact and assess the severity of episodes of financial turmoil, including the current financial crisis, it is useful to highlight the key features of stress in global financial markets and to put them into a historical perspective. This box presents the key features of a global index of financial turbulence (GIFT) that identifies a number of dimensions of financial stress that have been emphasised in the literature. This index shows that, although stresses in global financial markets remain at historical highs, financial market turbulences continued to abate after the finalisation of the June 2009 FSR.

Financial Stability Review Issue 2, 2009
18 December 2009
Towards the European Systemic Risk Board

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has raised questions about the effectiveness of the current supervisory architecture. As a result, policy recommendations for regulatory reform have emerged at the European and global level which aim at enhancing the tools and structures devoted to macro-prudential oversight, as well as at ensuring an effective interplay with the monitoring of individual financial institutions. The overall objective of these policy actions is to strengthen the resilience and robustness of the financial system and thus enhance financial stability. Against this background, this special feature describes the framework being proposed for macro-prudential oversight in the EU and is structured as follows: first, it describes the decisions and actions taken at the international and EU level to strengthen macro-prudential supervision. Second, it elaborates on the envisaged framework for contributing to the safeguarding of financial stability at the EU level. Finally, the processes of the proposed macro-prudential supervisory framework, as well as the challenges for the proposed framework to work effectively, are analysed.

Financial Stability Review Issue 2, 2009
18 December 2009
The Concept of Systemic Risk

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Research, in conjunction with market intelligence and current policy analysis, can make an important contribution to the understanding of systemic risk. It is one element in learning the lessons from the financial crisis and in supporting ongoing efforts to further develop the macro-prudential dimension of financial supervision. This special feature briefly discusses the concept of systemic risk and surveys the existing research literature. Research in the last two decades has made significant progress in analysing systemic risk, in particular contagion risks. It has also documented the relevance of macroeconomic shocks and started to analyse endogenously pro-cyclical behaviour from the perspective of systemic risk. Some of the analyses described important features of the present crisis. Substantial further research efforts, however, need to be made, inter alia, to develop aggregate modelling frameworks that capture realistic features of financial instability, to better understand the endogenous build-up and unravelling of widespread imbalances and to assess the systemic importance of non-bank financial intermediaries.

Financial Stability Review Issue 2, 2009
18 December 2009
Is Basel II Pro-cyclical? A Selected Review of the Literature

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The purpose of this special feature is to review the ongoing academic debate on the potential pro-cyclical effects of bank capital regulation under Basel II, as well as the initiatives undertaken and new proposals put forward to reduce such potential effects. The main conclusions that seem to emerge are fourfold. First, based on simulation exercises, Basel II may increase the volatility of bank capital requirements over the business cycle. Second, available empirical micro-economic evidence on the relationship between bank capital and the credit supply suggests that bank lending may become more cyclical with Basel II, but mostly as far as undercapitalised and illiquid banks are concerned. Hence, at the aggregate level, the extent to which Basel II may amplify the business cycle depends on the degree of undercapitalisation and access to liquidity of the banking sector as a whole. Third, given the data limitation and identification problems, it is still too early to precisely assess whether or not Basel II has affected the business cycle in the countries where it is already implemented. Fourth, while there seems to be a view among academics that Basel II, as it currently exists, may not be adequately designed to cope with all sources of risks in the financial system, financial regulatory authorities have recently been discussing a comprehensive set of measures to enhance the Basel II framework with the aim to contain leverage and promote the build-up of counter-cyclical capital buffers in the banking sector.

Financial Stability Review Issue 2, 2009
18 December 2009
Tools to Detect Asset Price Misalignments

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Asset markets seem to have been playing an increasingly important role in many economies, and policy-makers have become far more aware that the sizeable changes and, sometimes,significant corrections of asset prices may lead to financial and, ultimately, macroeconomic instability. Not least against the background of the recent financial turmoil, many international institutions and academics have focussed on the development of early warning indicator models for asset price misalignments. After providing a short review of the literature and the methodologies used in this context, this special feature presents some empirical results related to defining and predicting asset price misalignments. An asset price composite indicator is constructed which incorporates developments in both the stock price and house price markets, and a method for identifying asset price busts is presented. An empirical analysis carried out on the basis of a panel probit-type approach finds that credit aggregates, nominal long-term interest rates and the investment-to-GDP ratio, together with developments in either house or stock prices, are the best indicators that help to predict busts up to eight quarters ahead.

Financial Stability Review Issue 2, 2009
18 December 2009
The Importance of Insurance Companies for Financial Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Insurance companies can be important for the stability of financial systems mainly because they are large investors in financial markets, because there are growing links between insurers and banks and because insurers are safeguarding the financial stability of households and firms by insuring their risks. This special feature discusses the main reasons why insurance companies can be important for the stability of the financial system. It also highlights the special role of reinsurers in the insurance sector and discusses some of the key differences between insurers and banks from a financial stability point of view.

Financial Stability Review Issue 2, 2009
15 June 2009
Assessing the liquidity risks of insurers

Abstract

Abstract

Liquidity risk has caused problems and even insolvencies in the financial services industry in the past and it remains a key risk for financial institutions to manage in the future. Liquidity risk can be defined as the risk that cash resources are insufficient to meet cash needs either under current conditions or in stress scenarios. This box describes some of the key liquidity risks that can confront insurers and presents some liquid asset measures.

Financial Stability Review Issue 1, 2009
15 June 2009
Assessing the resilience of euro area banks to an adverse macroeconomic scenario in the new eu member states and emerging markets

Abstract

Abstract

Recent macro-financial developments in central and eastern Europe and emerging markets indicate that virtually all of them are being affected by the significant deterioration in global financial and economic conditions. Impacts on these countries have been heterogeneous, albeit severe in some cases, reflecting significant differences in their domestic and external imbalances and therefore their vulnerability. The challenging macro-financial environment has meant that

the banking sectors of new EU Member States and emerging market countries have come under increasing strain, predominantly as a result of a combination of two shocks. First, external funding, on which many banking systems in these regions are reliant, became more scarce and expensive in 2008 and 2009; and second, the risk that non-performing loans will rise materially has increased on account of the economic slowdown and its repercussions for the debt servicing capacities of the corporate and household sectors. In some cases, this has already stretched balance sheets, not least owing to the balance-sheet effect of exchange rate depreciations. Against this background, this box analyses potential losses facing euro area banks should downside risks for the macroeconomic outlook of some new EU Member States and emerging market economies materialise.

Financial Stability Review Issue 1, 2009
15 June 2009
Estimating potential write-downs confronting the euro area banking sector as a result of the financial market turmoil

Abstract

Abstract

As the global financial turmoil has unfolded, several estimates have been made, both by public and private sector institutions, of the potential losses to be absorbed by financial systems. In order to assess the magnitude of probable losses the euro area banking sector faces, this box presents an estimate of total potential write-downs until the end of 2010. Combining these estimates with what is already known about banks’ write-downs on credit-linked securities and losses on loans since the eruption of the market turmoil in August 2007, an estimate of total (past and expected) write-downs is also made.

Financial Stability Review Issue 1, 2009
15 June 2009
Elasticity of banks’ interest income vis-à-vis recent changes in short-term market rates

Abstract

Abstract

In the context of the current severe pressure on banks’ earnings and solvency, a direct and immediate channel through which bank profitability may be strengthened is via the effect of recent changes in short-term money market rates on banks’ net interest income. This box provides some estimates of the impact of recent declines in short-term money market interest rates (in part triggered by the monetary policy easing by the ECB) on banks’ net interest income from loans and deposits.

Financial Stability Review Issue 1, 2009
15 June 2009
The composition and quality of bank capital

Abstract

Abstract

Following the intensification of the financial crisis in late 2008, euro area banks have come under increased pressure to improve the size and quality of their capital buffers. This box examines the capital positions for a sub-sample of 15 euro area LCBGs that had reported in enough detail to provide figures for both 2007 and 2008.

Financial Stability Review Issue 1, 2009
15 June 2009
Government measures to support banking systems in the euro area

Abstract

Abstract

This box summarises the measures taken by euro area governments to support the banking sector and discusses their implementation and effectiveness.

Financial Stability Review Issue 1, 2009
15 June 2009
The impact of short-selling restrictions on equity markets

Abstract

Abstract

“Short-selling” refers to the practice of selling shares without owning them, hoping to buy them at a lower price at a later point in time, thus making a profit. If the shares are borrowed, the practice is called “covered” short-selling. “Naked” short-selling is the practice of selling stock without having a lending party, hoping to find one later. Until the current global financial crisis, authorities and academic literature tended to hold the view that short-selling plays a positive role in financial markets in the long run. Short-selling is seen to result in more efficient pricing, to decrease volatility and increase liquidity, and to improve possibilities for hedging and risk management.

Financial Stability Review Issue 1, 2009
15 June 2009
The bond-CDS basis and the functioning of the corporate bond market

Abstract

Abstract

Over the few months following the default of Lehman Brothers, conditions in the European corporate bond market deteriorated significantly. This box, after discussing the concept and the main drivers of the bond-CDS basis, examines why this measure may be a good indicator of overall conditions in the corporate bond market. In view of the persistence of the negative basis in the investment-grade segment of the market, the box also discusses the main reasons for the failure of arbitrage and its consequences for the investors that used basis-related investment strategies.

Financial Stability Review Issue 1, 2009
15 June 2009
Indicators of liquidity in the euro money market

Abstract

Abstract

Since August 2007 the euro money market has experienced severe disruptions as a result of contagion from shocks in other market segments, an increased preference for liquidity and heightened counterparty credit risk concerns. However, changes in liquidity conditions have not been homogeneous across the various segments of the euro money market. This box presents a simple “barometer” which can help in the monitoring of market conditions across those segments.

Financial Stability Review Issue 1, 2009
15 June 2009
Money market intermediation and liquidity insurance

Abstract

Abstract

Following the change to a fixed rate tender procedure with full allotment as of the maintenance period beginning on 8 October 2008, aggregate liquidity provision in Eurosystem refinancing operations increased significantly, exceeding the strict needs resulting from autonomous factors and reserve requirements. The aggregate excess liquidity has been reflected in an elevated recourse to the deposit facility of the Eurosystem. This box discusses some factors that may help to explain the demand for excess liquidity by focusing on the financial stability dimension of the operational framework for monetary policy implementation in times of financial market stress. In fact, the empirical evidence suggests that, in addition to partially taking over the intermediation of liquidity shocks from the market, the Eurosystem has offered banks insurance against liquidity uncertainty and has therefore contributed actively to operational and financial stability.

Financial Stability Review Issue 1, 2008
15 June 2009
Debt servicing ratio and household characteristics in the euro area

Abstract

Abstract

Available macroeconomic data from sectoral accounts indicate that the debt servicing ratio of euro area households remained at a relatively stable level of around 9-10% between 1991 and 2005, before increasing slightly to 11% in 2007. Aggregated information is of limited value when trying to qualify the risk to financial stability stemming from household income. For example, risks would be rather high should the bulk of mortgages be concentrated on the lowest income or unemployed borrowers. As such, whenever possible, it is important to complement the aggregate developments with micro-level information, to assess how broadly or narrowly the debt servicing ratio is distributed across the population according to different characteristics, in particular income.

Financial Stability Review Issue 1, 2009
15 June 2009
Corporate defaults: a likely source of further financial system stress

Abstract

Abstract

Throughout the ongoing financial turmoil, much emphasis has been placed on the size and significance of write-downs by financial institutions on their asset-backed securities and derivatives holdings. Increasingly, however, attention is focusing on corporate debt and the likely loan losses that may materialise as the turmoil continues and the real economy endures a significant slowdown. This box explores this issue in the context of speculative-grade corporate debt and finds evidence of a sharp increase in losses on corporate bond holdings since the end of 2008. These have arisen from an increase in corporate default rates, combined with a decline in the remaining value of defaulting firms. This may have an impact on the ability and willingness of the financial system to provide further financing to the non-financial sector.

Financial Stability Review Issue 1, 2008
15 June 2009
The current macroeconomic cycle: a comparison with previous banking crises

Abstract

Abstract

As the global financial crisis intensified and spread over the past year, the macroeconomic outlook in the euro area worsened significantly. One way of better understanding the possible impact of the financial turmoil on the real economy is to compare the amplitude and time profile of macroeconomic cycles (and patterns in macro-variables) with those observed during past episodes of banking crises. With the inevitable caveats – including that no two financial crises or

recessions are entirely alike – a comparison with earlier episodes provides some insight into the “common” or “average” path followed by economies facing significant financial dislocation.

Financial Stability Review Issue 1, 2008
15 June 2009
Counterparty credit risk in the credit default swap market

Abstract

Abstract

The failure of Lehman Brothers revealed that counterparty credit risk – the risk of default by a major credit protection issuer or dealer in the credit default swap (CDS) market – is non-negligible. This risk comprises the potential replacement costs of CDS contracts if troubled CDS market primary dealers were to default. From a financial stability perspective, such a default would not pose a systemic risk for the financial system if the resulting losses were low or widely distributed

across dealers. If the default of one dealer, however, caused another to default or precipitated a cascade of defaults owing to a disorderly unwinding and settlement of CDS contracts, this would generate severe systemic consequences, not only for the CDS market, but also for the financial system as a whole. Against this background, this box introduces an indicator of counterparty credit risk in the CDS market and discusses some specific issues related to that risk.

Financial Stability Review Issue 1, 2009
15 June 2009
Securitisation and the conditions for its restoration

Abstract

Abstract

There has been a dramatic reduction in securitisation activity since 2007. Although significant amounts of highly-rated securities have been issued by some banks, these have been retained for use as collateral for accessing central bank liquidity. This mechanism has played a crucial role in providing banks with necessary liquidity and has stabilised the securitisation market. As the securitisation process can be regarded as an innovation which, if properly managed, contributes to welfare, its restoration is important for the functioning of the fi nancial system. This box explains why the securitisation market has frozen and explores the conditions that would be required to restore it, which may, in turn, contribute to an easing of credit market conditions.

Financial Stability Review Issue 1, 2009
15 June 2009
Links between governments’ and banks’ CDS spreads in the euro area in the periods before and after the failure of Lehman brothers

Abstract

Abstract

In the period following the collapse of Lehman Brothers, two notable differences arose in euro area sovereign CDS spreads: first, euro area governments’ CDS spreads rose above their long-run averages and began to co-move closely with the CDS spreads of investment-grade euro area banks; second, divergences across euro area governments’ CDS spreads grew, possibly reflecting differences in the financial cost implications of individual government support measures for local banking sectors across euro area countries as well as disparities in exposures towards emerging markets as well as central and eastern European countries. This box examines the links between the CDS spreads of governments and banks, and explores the determinants of sovereign spreads in the euro area.

Financial Stability Review Issue 1, 2009
15 June 2009
Determinants of Bank Lending Standards and the Impact of the Finance Turmoil

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Banks are key providers of funds to firms and households in the euro area. The analysis of bank lending standards – banks’ internal guidelines or criteria governing their loan policy – is therefore important for understanding the provision of credit in the euro area. This special feature first analyses the determinants of bank lending standards in the euro area and how changes in lending standards impact on banks’ risk taking. Second, it shows that, generally, the risk built up by banks in good times may – via its impact on capital – imply future restrictions on the supply of loans and that bank balance sheet constraints may have a detrimental impact on the loan supply in the current crisis.

Financial Stability Review Issue 1, 2009
15 June 2009
Liquidity Hoarding and Interbank Market Spreads

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Interbank markets play a key role in banks’ liquidity management and the transmission of monetary policy. With the onset of the financial crisis, liquidity has been reduced in some segments of the interbank market. Moreover, since late September 2008, banks have hoarded liquidity instead of lending excess funds in the interbank market. The malfunctioning of interbank markets endangers the stability of the banking system. This special feature argues that asymmetric information about credit risk is an important factor contributing to these patterns.

Financial Stability Review Issue 1, 2009
15 June 2009
Balance Sheet Contagion and the Transmission of Risk in the Euro Area Financial System

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The identification of vulnerabilities, trigger events and channels of transmission is a fundamental element of financial stability analysis. Using data for the euro area, this article combines measures of leverage and volatility with interlinked balance sheets to show how local financial shocks can spread through the financial system and affect balance sheets and risk exposures in other parts of the system. Analysis of this network of interlinked assets and liabilities leads to the conclusion that the cross-sector balance sheet exposures in the euro area financial system constitute important channels through which shocks can be transmitted across sectors. High financial leverage and elevated asset volatility are key factors in increasing a sector’s vulnerability to shocks and contagion.

Financial Stability Review Issue 1, 2009
15 June 2009
Estimating Probabilities of Hedge Fund Liquidation

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

A failure of an individual hedge fund or a group of hedge funds can have adverse implications for financial stability, mainly through an impact on asset prices and market liquidity and through potential losses for the hedge funds’ creditors. Therefore, it is important to understand the underlying reasons behind hedge fund failures and to create indicators that would allow strains in the hedge fund sector to be monitored. To this end, this special feature focuses on cases of hedge fund liquidation and estimates the main factors that could point to a higher liquidation risk, using a panel logit analysis. On the basis of the estimation results, a composite indicator is proposed, which shows that the probabilities of hedge fund liquidation increased substantially in 2008 and remained elevated at the beginning of 2009.

Financial Stability Review Issue 1, 2009
15 June 2009
Some Lessons from the Financial Market Turmoil for the Use of Market Indicators in Financial Stability Analysis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature discusses some of the market-based indicators that are used regularly in the Financial Stability Review (FSR), focusing in particular on indicators whose information content was distorted by the financial crisis owing to factors such as extreme risk aversion, impaired market liquidity and high uncertainty about the intrinsic values of assets traded on some markets. The analysis shows that, particularly during times of crisis, great analytical efforts are required for an appropriate interpretation of developments in these indicators. This is due to the fact that credit default swap (CDS) spreads, interest rates and equity prices all include a range of risk premia, so that it is important to be aware how much and in what ways these premia are driving asset prices. If these factors are properly taken into account, market-based indicators still provide a very rich source of up-to-date information for financial stability analysis.

Financial Stability Review Issue 1, 2009
15 December 2008
T2S – Europe’s integrated securities settlement platform, and its contribution to financial stability

Abstract

Abstract

On 17 July 2008, the Governing Council decided, after two years of intense cooperation with users and providers of settlement services, to build a new settlement platform, TARGET2-Securities (T2S). The Deutsche Bundesbank, the Banco de España, the Banque de France and the Banca d’Italia will build and operate T2S; an ECB team will continue to manage the overall programme, and its relationship with all stakeholders inside and outside the Eurosystem. T2S is expected to become operational in 2013.

Financial Stability Review Issue 2, 2008
15 December 2008
The insurance underwriting cycle in the euro area

Abstract

Abstract

The amount of insurance premiums written and insurance premium rates typically move in cycles that have in the past lasted between six and ten years. Insurance underwriting cycles can be divided into “hard market” periods, in which insurance rates are at levels that correspond to a return on capital that equals or exceeds the cost of capital, and “soft market” periods, in which underwriting returns are low or even negative. This box examines how the insurance underwriting cycle can shape the financial performance of insurers, and thus financial stability.

Financial Stability Review Issue 2, 2008
15 December 2008
Measuring the time-varying risk to banking sector stability

Abstract

Abstract

To further expand the market-based framework for monitoring systemic risk in the Financial Stability Review, this box introduces a new method for estimating joint probabilities of default (PoDs) for euro area and global LCBGs.

Financial Stability Review Issue 2, 2008
15 December 2008
Price of default risk as a measure of aversion to credit risk

Abstract

Abstract

Since the financial turmoil erupted, the CDS spreads of LCBGs have widened significantly, suggesting that banks’ default risk has increased. This may be explained by investors’ increased aversion regarding credit risk, which followed the repricing in this risk category in the aftermath of the sub-prime problems. This box decomposes the CDS spreads of LCBGs into an expected loss component and a default risk premium. The latter reflects the compensation required by

investors for accepting exposure to default risk, and can also be used as an indicator of aversion to credit risk.

Financial Stability Review Issue 2, 2008
15 December 2008
Measures taken by governments and central banks to preserve the stability of banking systems

Abstract

Abstract

Against the background of the intensification of the financial market stresses in October 2008, a number of governments and central banks across the globe took extraordinary measures to preserve the stability of banking systems. These actions, which should be distinguished from the prudential measures that had been initiated earlier and are discussed in detail in Special Feature A of this FSR, range from offers of government guarantees for bank debt issuance and retail deposits to the provision of additional capital resources to distressed banks. This box briefly discusses the measures taken in different jurisdictions, both in the euro area and in other major economic areas.

Financial Stability Review Issue 2, 2008
15 December 2008
Restoring the balance sheets of large and complex banking groups in the euro area: dividend cuts and asset disposal

Abstract

Abstract

The losses suffered by euro area LCBGs as a result of the financial turmoil have forced many of them to contain risks by reducing the leverage on their balance sheets. When doing so, banks can follow three different options (or any combination thereof). They can raise new capital, they can reduce their dividend pay-out ratios, or they can shed assets. This box focuses on the latter two channels of deleveraging, i.e. on dividend policies and asset disposals. In so doing it provides

some estimates of the potential impact on leverage should euro area LCBGs choose one of these options, rather than raising new equity capital, to restore their balance sheets.

Financial Stability Review Issue 2, 2008
15 December 2008
Transparency in securitisation markets

Abstract

Abstract

Since the outbreak of the ongoing financial market turbulence, liquidity in both the primary and the secondary securitisation markets has virtually vanished. Often cited reasons for this development in the securitisation markets are the lack of reliable valuation frameworks and the inadequate transparency of complex structured finance products, such as different types of asset-backed securities (ABSs). As a consequence of this post-outbreak analysis, many proposals aimed at restoring market liquidity, put forward by market participants and policy-making bodies alike, have focused on the need for firms to enhance the transparency of, and disclosure in, the securitisation markets. This box discusses the causes of the turbulence in terms of transparency and highlights what is currently going on to restore market confidence.

Financial Stability Review Issue 2, 2008
15 December 2008
Funding liquidity, funding liquidity risk and its interaction with market liquidity

Abstract

Abstract

The developments in the various segments of the euro money market since August 2007 are typical of a liquidity crisis and suggest the existence of a link between market liquidity and funding liquidity risks. Nevertheless, empirical evidence of this link is difficult to find, mainly due to the problem of measuring funding liquidity risk. This box discusses the notions of funding liquidity and funding liquidity risk, proposes a simple indicator for measuring funding liquidity risk and presents an empirical link between market and funding liquidity, based on evidence from recent data.

Financial Stability Review Issue 2, 2008
15 December 2008
Structural trends in the euro money market

Abstract

Abstract

On 26 September 2008, the ECB published the preliminary results of the Euro Money Market Survey 2008. Similar to earlier surveys, the 2008 survey was based on data collected from banks, and it covered the second quarters of 2007 and 2008. This box reports on some of the main findings of this survey.

Financial Stability Review Issue 2, 2008
15 December 2008
Gauging risks to euro area house prices on the basis of a dynamic dividend-discount model

Abstract

Abstract

When housing is viewed as an asset, understanding the evolution of house prices is not unlike understanding the development of financial assets, in that changes in their valuation derives from news on fundamental determinants, or dividends, and expected returns. One methodology that is based on this notion and widely applied in understanding movements in financial asset prices (such as equities or bonds) is the dynamic dividend-discount model pioneered by Campbell and Shiller. In its basic form, this model equates the excess return of a given asset over an alternative riskless asset to the discounted fl ow of dividends it provides along with changes in expected returns.

Financial Stability Review Issue 2, 2008
15 December 2008
A return of traditional emerging market risk?

Abstract

Abstract

Before the onset of the financial market turmoil in the summer of 2007, risk premia for emerging market assets displayed a notable decline. In part, this decline was justified by a strengthening of the debt-repayment capacities of many emerging markets and by their large current account surpluses. To some extent, however, it also reflected a disregard for traditional measures of emerging-market risk amid a global hunt for yield and abundant liquidity. Some pockets of vulnerability have persisted, for example, in countries neighbouring the EU and in some new EU Member States that run considerable current account deficits. In addition, sizeable capital inflows to emerging markets may cease or contribute to macroeconomic overheating.

Financial Stability Review Issue 2, 2008
15 December 2008
Transmission of us dollar and pound sterling money market tensions to the euro money market

Abstract

Abstract

This box quantitatively evaluates the interaction between the tensions in three important money markets (the US dollar, pound sterling and euro money markets) by testing the hypothesis that tensions in the euro money markets can be attributed to tensions in the other two markets and the long-term no-arbitrage condition among them. The analysis attempts to determine the direction of the transmission of money market tensions, and it assesses the possible reasons for the directions detected.

Financial Stability Review Issue 2, 2008
15 December 2008
Risks to financial stability from new EU member states

Abstract

Abstract

Following a period of buoyant economic activity, which was also associated with the buildup of some financial imbalances, macroeconomic conditions in many new EU Member States deteriorated in the first half of 2008, albeit with marked differences across individual countries. Furthermore, in October 2008 financial markets in some central and eastern European (CEE) countries also suffered from heightened risk aversion as concerns about the negative macroeconomic impact of the financial turmoil spread to emerging markets. In view of the strong financial links between different parts of the EU, this also served as a reminder of the importance of channels for potential contagion between banking sectors in the euro area and those in the new Member States. Against this background, this box explores the extent to which the remote possibility of severe and prolonged macroeconomic stress in the new EU Member States could give rise to risks to euro area financial stability. The findings presented here are that the risks for euro area financial stability from adverse developments in new EU Member States are unlikely to cause systemic stress in the euro area banking sector. However, some euro area banks with sizeable exposures to new EU Member States could face a significant slowdown of their earnings growth in the event of a sharper-than-expected downturn in host countries.

Financial Stability Review Issue 2, 2008
15 December 2008
The US house price outlook

Abstract

Abstract

In the United States, house prices peaked in mid-2006. According to the price indices cited most often, namely the national Case-Shiller index (C-S National) and OFHEO purchases only index (OFHEO), prices in the third quarter of 2008 were 21% and 6.5% respectively below their peaks. Market expectations in late November 2008 – as measured by the Case-Shiller 10 (C-S 10) futures price index for 10 major US cities – indicate that house prices will bottom out in 2010. This is about six months later than had been expected at the beginning of 2008 and by November prices were expected to fall to more than 15 percentage points below the expectations formed in the early part of the year. In terms of the C-S 10, this implies that house prices will be more than 30% below the peak recorded in mid-2006 before they start to stabilise. If the historical relationships between these indices hold, the C-S National and OFHEO could experience further price declines of around 10% and 5% respectively. It should be noted, however, that these futures price-based projections are surrounded

by high uncertainty because the longer-horizon C-S 10 futures markets are highly illiquid.

Financial Stability Review Issue 2, 2008
15 December 2008
Recent Policy Initiatives to Strengthen the Resilience of the Financial System

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature summarises the main policy initiatives that are aimed at strengthening the resilience of the financial system, both at the international and at the European level. Because events in financial markets are continuing to unfold, triggering prompt responses by governments and supervisors, this special feature can, at this stage, only provide an interim overview of the major initiatives taken thus far.

Financial Stability Review Issue 2, 2008
15 December 2008
Risk Management Lessons of the Financial Turmoil

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature presents some observations on what were good risk management practices at large financial institutions, as well as the main lessons that could be learnt from the recent period of financial market distress and the recommendations that could be made from a risk management perspective.

Financial Stability Review Issue 2, 2008
15 December 2008
Deleveraging and Resilience among Large and Complex Banking Groups in the Euro Area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature attempts to evaluate the resilience of lending by euro area large and complex banking groups to the financial turmoil, using recent quarterly balance sheet data. The analysis suggests that loans to customers will decline in the coming quarters. While a further drop in the value of assets in the financial sector would accentuate and prolong this process of deleveraging until the end of 2009, efforts to raise bank capital would help mitigate the expected decline in customer loan growth.

Financial Stability Review Issue 2, 2008
15 December 2008
Liquidity Risk Premia in Money Market Spreads

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Unsecured interbank money market rates such as the EURIBOR increased strongly with the start of the financial market turbulences in August 2007. There is clear evidence that these rates reached levels that cannot be explained solely by higher credit risk premia charged by lenders in interbank transactions. This special feature presents this evidence and provides an explanation which draws on the funding liquidity risk of lenders in unsecured money markets.

Financial Stability Review Issue 2, 2008
15 December 2008
Securitisation in the Euro Area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Securitisation has become an increasingly important element of structured finance and has seen rapid development in recent years. In light of the tumultuous events in financial markets since August 2007, however, the securitisation process has come under increasing scrutiny. This special feature explores the securitisation process from a supply-side perspective, highlighting the benefits and drawbacks of this approach. An overview of developments in the market, in the context of the recent turbulence, is also provided. A new source of data on securitisation is then introduced and results on emerging trends in the market are highlighted.

Financial Stability Review Issue 2, 2008
9 June 2008
What are euro area reinsurers insuring and where?

Abstract

Abstract

Reinsurers are important for the stability of the financial system mainly because they are of systemic importance to the primary insurance market. This is because they facilitate risk-spreading, mainly of extreme losses, from primary insurers. The systemic importance of reinsurers is, however, also due to the fact that the global reinsurance sector is dominated by a limited number of large companies (some of which are domiciled in the euro area) and the failure of one reinsurer would therefore have a significant impact on its many counterparties. In addition, reinsurers have the potential to affect asset prices since they are large investors in financial markets. To diversify risk concentrations, most reinsurers are active globally and in a multitude of insurance segments. This allows

reinsurers to reduce the volatility of claims payments and thereby lower the sum of total risk capital required. To accurately identify potential losses facing euro area reinsurers it is therefore of importance to have information on reinsurers’ underwriting risk exposures. This box presents information from reinsurers’ annual reports on what reinsurers are insuring and where.

Financial Stability Review Issue 1, 2008
9 June 2008
Stress testing: a fundamental tool for financial risk measurement

Abstract

Abstract

Stress testing is a risk management tool used to gauge the potential impact on a portfolio of hypothetical events and/or movements in a set of financial variables. There has been a tendency in the past to see stress testing as a secondary risk management tool compared to other methods of risk measurement such as value at risk (VaR). However, stress testing has become very common and sophisticated and it is being applied regularly by financial institutions to measure the likely impact of market shocks, as well as credit and liquidity events. This box explains what stress testing is, its benefits and drawbacks, and its relationship with other more established risk measures.

Financial Stability Review Issue 1, 2008
9 June 2008
Analysing the topology of the EU cross-border banking flows network

Abstract

Abstract

In an integrated financial system, cross-border banking flows are an important source of funding for financial institutions as well as for private sector borrowers. From the viewpoint of financial institutions, wider access to wholesale financing reduces the dependency of individual institutions on local deposit bases and it allows for a more efficient day-to-day management of their funding liquidity needs. In addition, by allowing for the matching of institutions with

surplus and deficit funds in the cross-border interbank markets, it provides obvious welfare gains from trade. For retail clients, an integrated cross-border banking market allows for equal treatment of borrowers across different parts of the financial system by exposing local lenders to foreign competition. At the same time, however, in times of financial stress a network of crossborder banking flows could provide a channel through which problems in one institution may

propagate wider throughout the financial system. This box illustrates some stylised facts about the network of EU cross-border banking flows (and its interlinkage with the United States which is included as a proxy for the “rest of the world”), using country-level data collected by the Bank for International Settlements (BIS). At the European level, an EU rather than a euro area geographical scope to the analysis is more meaningful due to the fact that some non-euro area EU countries, such as the United Kingdom and Sweden, are important financial counterparties for several euro area countries.

Financial Stability Review Issue 1, 2008
9 June 2008
Leveraged loan exposures and mark-to-market write-down risks of euro area large and complex banking groups

Abstract

Abstract

Between 2004 and 2007 the issuance of leveraged loans (loans extended to below investmentgrade-rated companies) almost tripled in the euro area, reaching around €240 billion. A number of mutually reinforcing factors contributed to the substantial pick-up in this type of lending by euro area banks. In particular, a boom in global leveraged buyout (LBO) activity increased the supply of these loans which were readily absorbed by investors due to the rapid expansion of a secondary market for such loans and the growing popularity of collateralised loan obligations (CLOs) which also took leveraged loans into their underlying collateral pools. The growth in the leveraged loan market also coincided with a shift by many large banks from a “buy and hold” business model towards an “originate and distribute” one. However, distribution of collateralised debt securities into the markets became very diffi ult from the second half of 2007 onwards as a result of the market turbulence. This meant that many banks were forced to “warehouse” leveraged loans that they had originally been planning to securitise. This left them exposed to credit and market risks on these loans. Against a background in which only a relatively small share of leveraged loan exposures had been written down by euro area LCBGs by early May 2008, this box makes an attempt to estimate the magnitude of total mark-to-market write-downs on banks’ leveraged loan

exposures.

Financial Stability Review Issue 1, 2008
9 June 2008
Initiatives and measures that are being taken in order to restore confidence and strengthen financial system resilience

Abstract

Abstract

The turmoil in mature economy financial markets has revealed a number of weaknesses in the existing regulatory and supervisory framework worldwide. In response, competent authorities, international organisations as well as market participants themselves have launched several initiatives to identify the major causes of the turmoil and to develop responses aimed at restoring confidence and at strengthening the resilience of the financial system. In this connection, this box provides an overview of three streams of work that deserve special attention: the roadmap of the ECOFIN Council; the recommendations of the Financial Stability Forum (FSF); and initiatives that are being taken by the private sector.

Financial Stability Review Issue 1, 2008
9 June 2008
Mark-to-market accounting and the loss figures produced by large and complex banking groups

Abstract

Abstract

This box outlines the accounting and valuation concepts behind the recent figures disclosed by euro area LCBGs. Contrary to certain media reports the majority of these figures reflect valuation changes on securities held rather than impairments reflecting outright credit losses. In any event, there are inherent difficulties in comparisons across institutions due to differences in the methods and assumptions used to value these exposures.

Financial Stability Review Issue 1, 2008
9 June 2008
Financial stability implications of the drying-up of securitised commercial mortgage markets

Abstract

Abstract

Amid the turbulence in credit markets, and in particular structured credit markets, after the summer of 2007 the issuance of commercial mortgage-backed securities (CMBS) came to a halt in Europe, eventually resuming at more modest issuance volumes. With lowered investor appetite for these securities, opportunities for banks to spread commercial property loan exposures were reduced. This, in turn, reduced their willingness to lend for commercial property development and ownership. In addition, it led to revenue decline and exposures to “hung loans” for investment banks that originated commercial property loans with the aim of distributing them as structured credit products. These negative developments came at a time when commercial property markets in the euro area – at least in some countries – started to show signs of deterioration. Thus, the structured commercial mortgage market and the direct commercial property ownership and development market have the potential to negatively affect each other. This box provides a brief overview of the CMBS market in Europe and it identifies the main risk propagation channels from this market from a euro area financial stability viewpoint.

Financial Stability Review Issue 1, 2008
9 June 2008
Evidence on liquidity and credit risk from deposit-OIS spreads

Abstract

Abstract

One of the most important features of the recent financial turmoil has been wide money market spreads. A commonly used measure of the risk premium in interbank markets is the spread between unsecured deposit and EONIA swap rates (the deposit-OIS spread). In the euro area, deposit rates are indicated by EURIBOR fixings, based on a trimmed average of unsecured deposit quotes provided by a panel of up to 43 banks, while overnight-indexed swaps (OIS) serve as a proxy for overnight rate expectations. These spreads, which before the inception of the financial turmoil hovered below ten basis points for maturities of up to twelve months and below five basis points for shorter maturities, reached record levels in recent months. This box outlines the evolution of these spreads and examines the information they may contain regarding credit and liquidity concerns.

Financial Stability Review Issue 1, 2008
9 June 2008
Eurosystem standing facilities and financial stability

Abstract

Abstract

Standing facilities are designed to provide and absorb overnight liquidity and are aimed at bounding overnight market rates. Two standing facilities are available to eligible Eurosystem counterparties on their own initiative, subject to their fulfilment of certain operational access conditions. Counterparties can use the marginal lending facility to obtain overnight liquidity from the national central banks (NCBs) against eligible assets and can use the deposit facility to make overnight deposits with the NCBs. The interest rate on the marginal lending facility normally provides a ceiling and the interest rate on the deposit facility a floor for the overnight interest rate. Under normal circumstances, there are no restrictions on the access of counterparties to these facilities, apart from the requirement to present sufficient underlying assets when using the marginal lending facility. Counterparties must fulfil certain eligibility criteria defined with a view to giving a broad range of institutions access to the standing facilities, whilst ensuring that certain operational and prudential requirements are taken into account: institutions must be subject to the Eurosystem minimum reserve system; they must be financially sound (subject to supervision by national authorities); and they must satisfy operational criteria defined by the respective NCB.

Financial Stability Review Issue 1, 2008
9 June 2008
Year-end and quarter-end effects on money markets

Abstract

Abstract

The end of the calendar year typically takes on a particular significance for financial institutions and it is also often associated with changes in the economic behaviour of other market participants. Events in the second half of 2007 created an environment of great uncertainty as the year-end approached and, as a consequence, tensions in money markets were much more acute than is usually the case at this time. This box offers a brief overview of typical year-end and quarter-end considerations.

Financial Stability Review Issue 1, 2008
9 June 2008
Is the corporate bank lending cycle turning?

Abstract

Abstract

Non-financial corporate lending in the euro area has expanded strongly since 2002, and reached a nominal annual growth rate of 15% in March 2008. In spite of the tensions in global credit markets, bank lending to euro area non-financial corporations has thus remained strong, suggesting that firms, so far, have weathered the turbulence well. The resilience in loan growth observed up to early 2008 is unusual as financial institutions’ lending criteria tend to tighten in

periods of financial stress, resulting in lower credit growth and a slowdown in economic activity. Looking ahead, ECB bank lending survey data show that the trend towards euro area banks tightening their credit standards on loans to enterprises that began in late 2007 continued in early 2008. This may, in due course, indicate a turn in the corporate credit cycle, as it becomes more costly and difficult for non-financial corporations to gain access to bank financing. This box evaluates the state of the current corporate credit cycle by comparing observed loan growth with implied credit growth suggested by a simple model.

Financial Stability Review Issue 1, 2008
9 June 2008
How vulnerable are euro area and us firms to further tensions in credit markets?

Abstract

Abstract

In assessing the potential impact that the strains in financial markets may have on euro area and US non-financial companies, firms’ leverage and the cost of finance play a key role. To this end this box first examines some of the differences between euro area and US firms with regard to their reliance on bank and market-based sources of financing. It then goes on to assess how these differences together with higher financing costs may impact on the balance sheets of the enterprises.

Financial Stability Review Issue 1, 2008
9 June 2008
The macroeconomic environment and financial stability: evidence from past banking crisis

Abstract

Abstract

The macroeconomic environment can be an important factor underlying the stability of the financial system, affecting the creditworthiness of firms and households, the buoyancy of financial markets, and the profitability and stability of financial institutions. As a corollary, the macroeconomic environment can also be an important exogenous source of risk for financial stability: an adverse shock – or constellation of shocks – can directly impair households’ and firms’ ability to honour their financial obligations. It may also be an indirect source of imbalances that build up endogenously over time. Although the form of such vulnerabilities varies – including excessive investment, debt accumulation, rapidly rising asset prices, or widening current account deficits – the mechanism tends to be similar. It is usually associated with a misperception of future returns or risk that leads to an inter-temporal misallocation of resources and a build-up of imbalances that weakens the resilience of the system to future adverse disturbances.

Financial Stability Review Issue 1, 2008
9 June 2008
“Monoline” financial guarantors: the business model and linkages with financial institutions and capital markets

Abstract

Abstract

One of the sectors worst affected by the turbulent credit market environment after the summer of 2007 is the financial guarantor sector (also referred to as “bond insurers” or “monolines”). Large credit spread increases, coupled with rating downgrades on structured credit products against the default of which the financial guarantors had sold protection, caused large mark-to-market losses for most financial guarantors, which weakened their capital positions. The capital shortfalls led to a questioning of the ratings of the financial guarantors (often AAA-rated), and guarantors that were not able to raise new capital were downgraded by rating agencies. The rating downgrades of some financial guarantors led to rating downgrades and value losses for the securities that they had insured. These developments rippled through parts of the financial system and capital markets through both direct and indirect channels. This box describes the financial guarantor business model and how the problems in the sector spread to other parts of the financial system and to capital markets.

Financial Stability Review Issue 1, 2008
9 June 2008
Recent developments in Chinese equity markets

Abstract

Abstract

The marked increase in valuations in Chinese equity markets between early 2006 and the autumn of 2007 and the correction that occurred after the finalisation of the last FSR have given rise to financial stability concerns about the potential consequences of a bubble burst. While implications for euro area financial stability should not be overstated, this box reviews recent developments in Chinese equity markets, as they have attracted significant attention since the

publication of the last FSR.

Financial Stability Review Issue 1, 2008
9 June 2008
The role of structured markets in propagating the initial sub-prime shock

Abstract

Abstract

Notwithstanding the positive contribution they can make in facilitating portfolio diversification and the distribution of risk across a wide range of investors – thus enhancing credit risk management possibilities – structured finance markets played a central role in propagating the initial sub-prime mortgage market shock across broader credit markets (see Figure A). This box examines some of the factors which contributed to such propagation.

Financial Stability Review Issue 1, 2008
9 June 2008
US mortgage markets, mortgage resets scheduled in 2008, and the recent fed interest rate cuts

Abstract

Abstract

Delinquency and foreclosure rates on US mortgages started to increase in mid-2006, especially for adjustable-rate sub-prime mortgages (see Chart A). Compared to the previous economic downturn in 2001-2002, delinquency rates have not been exceptionally high. However, a new structural feature of the market is the substantial share of sub-prime mortgages, which increased from just over 10% of the total stock of mortgage loans in 2000 to over 20% in 2006. This category of mortgage loan exhibited a much higher incidence of delinquency, with sub-prime adjustable-rate mortgages (ARMs) registering a delinquency rate of 20% in the

fourth quarter of 2007, up from 6.6% in the first quarter of 2006. In this sub-category, the US Treasury estimates that approximately 1.8 million adjustable-rate sub-prime mortgages – with an estimated value of between USD 300 and USD 400 billion – will reset in 2008 and 2009.The bulk of these resets are expected to take place during the first three quarters of 2008 and should decline rapidly thereafter. As the fragility of sub-prime ARM mortgages is pivotal to the financial stability outlook at the current juncture, this box explores how the interest rate burden implied by these resets varies with the interest rate.

Financial Stability Review Issue 1, 2008
9 June 2008
Securitisation, Bank Risk-Taking and Loan Supply in the Euro Area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature examines whether securitisation activity and banks’ risk-taking have had any impact on euro area banks’ lending behaviour. It finds this to be the case. In particular, based on a sample covering around 3,000 intermediaries over the first seven years of EMU, it is found that the favourable financial condition of banks together with strong securitisation activity seem to have diminished the importance of the bank lending channel and strengthened the ability of banks to supply loans. However, it is also found that this capacity depends upon business cycle conditions and, notably, upon banks’ risk positions. In other words, deterioration in either could have an adverse affect on bank loan supply.

Financial Stability Review Issue 1, 2008
9 June 2008
What Equity, Credit and Credit Default Swap Markets Tell Us About the Risk Profile of Banks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Information from equity and credit market based indicators of banks is commonly used for financial stability assessment. In this practice, it is often assumed that equity market-based indicators provide information on the markets’ assessment of the outlook for, and the risks surrounding, future banking profitability. At the same time, for the credit-based indicators the prior assumption is that these provide information on the credit risk outlook for banks or the likelihood of bank failure. However, such indicators are likely to exhibit some co-movement owing to common drivers, such as the business cycle or interest rate changes. This special feature confirms that this is the case even for bank-specific (or idiosyncratic) equity and credit measures. In order to pin down the nature of the interaction between credit and equity markets and key macroeconomic drivers, a dynamic model is estimated, revealing a large role for a risk aversion driver, and a weaker one for changes in interest rates and oil prices. The analysis also finds that risk measures based on equity lead those stemming from the credit default swap (CDS) market.

Financial Stability Review Issue 1, 2008
9 June 2008
How Has CDO Market Pricing Changed During The Turmoil? Evidence from CDS Index Tranches

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The general repricing of credit risk which started in summer 2007 has highlighted significant problems in the valuation of collateralised debt obligations (CDOs). This special feature analyses the determinants of movements in CDS index tranche premia. The main finding is that the repricing of credit risk led to a heightened impact of risk aversion and liquidity measures on market prices. Overall, the results imply that even in the most liquid segment of the CDO market, market prices still contain a sizeable liquidity premium.

Financial Stability Review Issue 1, 2008
12 December 2007
More than thirty years after the “Herstatt” case, foreign exchange settlement risk is still an issue

Abstract

Abstract

On 26 June 1974, the German banking supervisory authority decided to close a German bank, Bankhaus Herstatt, because of heavy losses it had endured as a result of speculative foreign exchange positions it had taken. Its foreign exchange dealers had sold a sizeable amount of US dollars against the Deutsche mark, but the market moved against them. The bank was closed in the middle of the German business day, before the opening of US markets. By this time, it had already received – via the German payment system – the marks it had bought two days earlier. However, because of the time zone difference, Bankhaus Herstatt had not yet delivered the dollars it had sold. As a result, several financial institutions were adversely affected and the US-based CHIPS system had to close for 24 hours.

Financial Stability Review Issue 2, 2007
12 December 2007
Terrorism insurance: who insures and who is insured

Abstract

Abstract

Terrorism insurance is designed to cover potential losses and liabilities that might occur as a result of terrorist activities. Before the events of 11 September 2001 in the US, terror risks were often covered by private insurers – or at least not specifically excluded – in property insurance. After these events there were many changes in the global terrorism insurance market with a trend among global insurers towards excluding terror coverage from their contracts. Many governments have, however, become more involved in mitigating the risk exposure of insurers by developing explicit schemes or terror pools to address terror risks. These developments raise questions about who could face losses caused by terrorism activity. This box describes who provides terrorism insurance and who is insured in the euro area.

Financial Stability Review Issue 2, 2007
12 December 2007
Euro area insurers’ direct exposures to the structured us sub-prime mortgage market

Abstract

Abstract

The recent market turbulence created by negative developments in the US sub-prime residential mortgage market and the related uncertainty surrounding structured credit products have raised concerns about the extent and nature of euro area insurers’ exposures to these kinds of investments.

Financial Stability Review Issue 2, 2007
12 December 2007
A market-based indicator of the probability of adverse systemic events involving large and complex banking groups

Abstract

Abstract

One of the defining features of the recent market turmoil was the extent to which cash credit and related derivative markets were affected. Credit default swap (CDS) spreads widened significantly for banks and other financial institutions and in August/September and again in early November they reached levels not seen since the beginning of 2003. The recent market turmoil can be distinguished from the turbulent episodes observed during May 2005, May-June 2006, and February-March 2007 by its more protracted nature and because it may imply more serious consequences for the banking sector. Using the CDS spreads and equity returns of large and complex banking groups (LCBGs), this box provides an empirical evaluation of the probabilities of simultaneous defaults among LCBGs. More specifically, it outlines a new financial stability indicator – the market perception of the probability of an adverse systemic event occurring among euro area LCBGs as well as among global LCBGs, whose financial condition is likely to have an important bearing on systemic stability in the euro area – and it assesses how this indicator was affected by recent market turmoil

Financial Stability Review Issue 2, 2007
12 December 2007
Market liquidity risk measurement

Abstract

Abstract

Market participants need to be aware of the implications of trading in markets that are not liquid at all times, that is, markets in which they cannot liquidate positions at going market prices. For example, the recent market turmoil was characterised by a drying up of liquidity in some key financial segments. Credit risk instruments in particular were badly hit by this sudden increase in market liquidity risk. The fall in market liquidity had repercussions in terms of funding liquidity, with some financial institutions becoming unable to fund their illiquid collateral positions. Market participants therefore need to be able to estimate liquidity risk and manage it, especially in situations of market turbulence.

Financial Stability Review Issue 2, 2007
12 December 2007
Model risk: an overview of the issues

Abstract

Abstract

“Model risk” is the risk of error due to inadequacies in financial risk measurement and valuation models. Insufficient attention to model risk can lead to financial losses. In an ever complex financial world in which esoteric pricing and risk measurement models are continually being introduced, the consequences of model risk are an apparent and increasing source of risk to financial stability.

Financial Stability Review Issue 2, 2007
12 December 2007
The “originate and distribute” banking business model and recent credit market turmoil: some tentative lessons

Abstract

Abstract

Since the issuance of the first mortgage-backed securities in the 1980s, banks have been moving towards greater segmentation of their financial intermediation activities. Rather than retaining loans they originated, banks gradually began to distribute loans to the secondary market, either directly or by repackaging them into various financial instruments which fall under the general category of asset-backed securities (ABSs). This activity has the advantages of diversifying banks’ funding sources, reducing concentrations of credit risk, minimising overall funding costs and, under certain conditions, reducing regulatory capital. Furthermore, the process frees up capital for new lending, provides income from the sale of the loans, and generates fees from continuing servicing of the underlying loans (collecting interest and principal repayments and passing them on to the holders of the securities). In the last couple of years, in the US in particular, non-bank institutions, such as mortgage brokers, have also became important participants in the origination of loans that could be sold on to banks which specialise in structuring various financial instruments. This box recaps some of the lessons that have been learnt for the originate and distribute model as a result of recent market turmoil.

Financial Stability Review Issue 2, 2007
12 December 2007
Assessing credit risk in the loan portfolios of euro area large and complex banking groups

Abstract

Abstract

Recent fi nancial market developments have demonstrated the importance of understanding the underlying risks in the credit portfolios of banks. This box seeks to address the issue of gauging the credit risk facing euro area large and complex banking groups (LCBGs) under different stress scenarios by making use of a measure of portfolio credit risk which draws upon publicly available data and extending the approach to these issues introduced in the June 2007 FSR. A modelling framework that uses publicly available data is particularly useful for central banks without supervisory responsibilities such as the ECB which have no access to supervisory data but which do have mandates to contribute to financial system stability.

Financial Stability Review Issue 2, 2007
12 December 2007
Assessing the impact of recent market turmoil on euro area large and complex banking groups: a stress test of potential balance sheet expansion

Abstract

Abstract

The credit market turmoil that erupted in late July and early August 2007 is likely to have negative implications for the funding requirements, earnings and even capital ratios of several euro area LCBGs. The turbulence, which had its origins in a loss of confidence in assets that are backed by mortgage loans extended to US sub-prime borrowers, triggered contingent credit lines to be drawn on some LCBGs to fund off-balance sheet vehicles, after these vehicles were no longer able to roll over their short-term funding in the asset-backed commercial paper (ABCP) market. The loss of confidence also contributed to market liquidity problems across a wide range of related securitisation activities. As a consequence, several LCBGs endured a crystallisation of warehousing risks on household and corporate loans – some of which are extended to finance leveraged buy-out (LBO) transactions – which they were not intending to hold on their balance sheets.

Financial Stability Review Issue 2, 2007
12 December 2007
Identifying large and complex banking groups for financial system stability

Abstract

Abstract

The financial performances of large and complex banking groups (LCBGs) are regularly monitored and analysed for the financial system stability assessment in the ECB’s FSR. As noted in the December 2006 FSR, updates of the identification of LCBGs are periodically needed to take into account the effects of structural change such as mergers, acquisitions and organic growth in the banking sector. It was also noted that the analysis could benefit from expanding the set of variables used to identify LCBGs to make the analysis more robust and complete. This box presents the results of the first update of the analysis used to identify LCBGs

Financial Stability Review Issue 2, 2007
12 December 2007
Recent issues in the euro area money market: causes, consequences and proposed mitigating measures

Abstract

Abstract

In early August 2007 two interrelated factors seemed to simultaneously cause an evaporation of liquidity in the euro area money market. First, those banks which knew that they were exposed to US sub-prime related assets – either directly or indirectly via contingent liquidity lines – started to build up precautionary balances in anticipation of likely future liquidity needs. Second, liquidity providing banks in the interbank market became wary of lending funds to other banks as a result of uncertainty about counterparty asset quality. The result of this hoarding of liquidity was that interbank money market rates at long-term maturities increased sharply and remained elevated until the cut-off date of this FSR. The ECB and other major central banks met the increased liquidity needs in a series of operations, some of which were also extended to longer term maturities. While the operations were successful in bringing down and stabilising overnight interest rates close to the key policy rates, banks’ willingness to lend funds in the interbank market remained affected by the disturbances. Against this background, the need to find a solution to the root cause of banks’ unwillingness to extend credit in the interbank market has been accelerated by the risk that the volatility in the term money market could have implications on banks' ability to fund themselves which, in a negative scenario, could in turn hamper the intermediation of credit to the non-financial sectors of the economy. This box discusses the sources of the problems in the interbank money markets and presents some private sector initiatives to mitigate market tension.

Financial Stability Review Issue 2, 2007
12 December 2007
Understanding asset backed commercial paper structures

Abstract

Abstract

The functioning of the asset-backed commercial paper (ABCP) market was severely disrupted during the recent market turmoil. This market lies at the crossroads between the cash money market and the structured credit markets. From a bank’s perspective, ABCP programmes create a means of removing assets, which have a risk-weighted capital requirement, from their balance sheet while retaining some economic interest through income generation from the management

of the special purpose vehicle (SPV) which issues the securities. ABCP programmes typically involve the setting up of a funding structure to issue the commercial paper (CP). This box provides an overview of some of the ABCP structures which exist, and it outlines some of the vulnerabilities that became more evident with the various types of structure during the recent disturbances.

Financial Stability Review Issue 1, 2007
12 December 2007
A "barometer'' for financial market turmoil

Abstract

Abstract

The recent turmoil in fi nancial markets is a good example of how tensions can develop in one market and gradually spread to other market segments. This box presents a simple cross-market “barometer” which can help in the monitoring of this contagion effect. The barometer consists of 20 relevant market indicators covering different market segments (foreign exchange, equities, bonds, money markets, credit derivatives, and emerging markets). The barometer compares the

level of each indicator on a certain day with its pre-turmoil level (calibrated as zero on the scale) and with its level at the “peak” of the turmoil (calibrated as 100). While the pre-turmoil level is taken on the same day for all indicators, the day corresponding to the turmoil “peak” level is different for each indicator. Charts A to C show this barometer at three different stages in the recent market turmoil.

Financial Stability Review Issue 2, 2007
12 December 2007
An overview of developments in euro area housing and mortgage markets

Abstract

Abstract

In spite of increasing economic integration within the EU, the performances of national housing markets and the characteristics of mortgage markets have remained rather heterogeneous. This has meant that the balance sheet conditions of households and the nature and extent of exposures of banks to household sectors differ significantly across countries within the euro area. Therefore, in order to identify financial stability risks and vulnerabilities, it is important to look behind euro area average or aggregate figures and examine developments at the national level as well. With this in mind, this box draws upon indicators that are available at the national level to analyse country-specific housing market developments that are relevant from a financial stability perspective.

Financial Stability Review Issue 2, 2007
12 December 2007
Potential implications of recent credit market stress on the euro area credit cycle

Abstract

Abstract

The global re-pricing of risk in the credit market which commenced in July and August 2007 was more severe and longer-lasting than the episodes of market turbulence in May 2005 and in February-March 2006. Some market observers have suggested that the episode, which involved substantial de-leveraging by investors in securitized credit markets and which resulted in sizeable income and investment losses for banks, could – if it results in tighter credit availability – have increased the risk of a downturn in the global credit cycle. This box describes some of the important channels through which de-leveraging by the financial sector can interact with the underlying phase of the credit cycle.

Financial Stability Review Issue 2, 2007
12 December 2007
Hedge fund investor redemption restrictions and the risk of runs by investors

Abstract

Abstract

In contrast to traditional open-end investment funds, which provide daily liquidity for investors, hedge funds are well known for having complicated redemption restrictions. Moreover, various combinations of these restrictions further mask the true vulnerability of hedge funds to investor withdrawals. Against this background, this box provides an overview of various investor redemption restrictions used by hedge funds and assesses the amount of time that would be needed before investors could withdraw all of their capital from the hedge fund sector.

Financial Stability Review Issue 2, 2007
12 December 2007
Measuring the crowding of hedge fund trades

Abstract

Abstract

In the June 2005 FSR, two indicators were proposed as possible measures of the crowding of hedge fund trades: the dispersion of monthly hedge funds’ returns and the median pairwise correlation coefficient of monthly hedge funds’ returns within a strategy. In the June 2006 FSR, a weighted average correlation coefficient across hedge fund strategies was used to complement the analysis of the similarity of hedge funds’ investment positions. This box provides an update and reassessment of various measurement approaches and presents some results on new alternative measures.

Financial Stability Review Issue 2, 2007
12 December 2007
Causes and consequences of the recent market turmoil

Abstract

Abstract

The recent turmoil in financial markets had its origins in a sharp re-pricing of credit risk following growing creditworthiness problems in the US sub-prime mortgage market. This led to concerns about the nature and extent of financial institutions’ exposures to sub-prime mortgages both direct and indirect via structured credit products. Notwithstanding the fact that financial market participants judged most of the affected institutions as having an ability to cope with

the potential losses, the uncertainty surrounding the dispersion of these losses and the lack of transparency as to the magnitude of the risks faced by financial institutions triggered a loss of risk appetite. Higher risk aversion spread to several other asset markets and it led to disruptions in some money market segments. The fact that markets were unprepared and had underpriced the risks of these events was reflected in very tight credit spreads and low implied volatilities across a range of markets. This box recalls some of the major triggering events behind the market turmoil and it assesses the consequences.

Financial Stability Review Issue 2, 2007
12 December 2007
Sovereign wealth funds - a new class of investors

Abstract

Abstract

Several sovereign wealth funds (SWFs), which are special agencies that manage part of the (mostly foreign) assets of sovereign governments, have emerged as major global market participants over the last few years. Based on individual market and official sources, such funds may have accumulated more than USD 2.2 trillion – slightly more than the total assets under the management of the global hedge fund industry which is currently estimated at around USD 2 trillion. SWFs have complemented, or even replaced, the “traditional” accumulation and management of foreign reserves, as these institutions aim at better diversifying risk and generating higher returns than traditional reserves, which are typically invested in low-yielding government securities. With some market observers estimating that the overall size of SWF assets could exceed that of global foreign reserves within a few years, it is important to better understand the possible impact the activities of such funds could have on asset prices, risktaking and, ultimately, financial stability which is presently hindered by a lack of data. This box discusses some of the ways in which the activities of SWFs could exert influence on asset prices.

Financial Stability Review Issue 2, 2007
12 December 2007
Bank Capital In Europe and the US

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This Special Feature presents evidence on the level and cross-sectional dispersion of large publicly-traded banks’ capital ratios, both regulatory and economic, in Europe and the US. It reveals that banks’ holdings of capital are well in excess of the regulatory minimum and that there is a surprisingly large dispersion of banks’ capital ratios, warranting further investigation. It then goes on to show that standard cross-sectional determinants of firm leverage also explain the capital structure of most large banks in the US and Europe. An important finding is that most banks seem to be optimising their capital structure in much the same way as firms.

Financial Stability Review Issue 2, 2007
12 December 2007
The Impact of Short-Term Interest Rates on Bank Credit Risk-Taking

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This Special Feature discusses the effect of short-term interest rates on bank credit risk-taking. In addition, it examines the dynamic impact of monetary policy on the credit risk of loans. It presents evidence that low short-term interest rates encourage bank risk-taking and reduce the credit risk of outstanding loans. However, credit risk becomes high at times when interest rates return to or rise above their average level after having been very low for a long period.

Financial Stability Review Issue 2, 2007
12 December 2007
Commercial Property Investment and Financial Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Commercial property markets are important for financial system stability mainly because commercial property constitute large holdings of different kinds of investors and because of the considerable amounts of bank lending that such holdings entail. Volatility in commercial property prices has proved to be a source of financial system instability in the past. Hence, from a financial stability viewpoint, it is important to monitor the nature and scale of exposures to commercial property within the financial system.

Financial Stability Review Issue 2, 2007
12 December 2007
Measuring Financial Market Liquidity and Risk Aversion Interdependence

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The relationship between risk aversion and financial market liquidity is usually found to be negative – i.e. higher risk aversion is typically associated with lower market liquidity. However, this is not the case all of the time. Indeed, there have been rather lengthy periods when higher financial market liquidity has been associated with increasing risk aversion. This Special Feature examines the co-movement of these series for the euro area from the beginning of 1999 until late 2007. The analysis suggests that close monitoring of financial market risks is needed when financial market liquidity is rising but risk aversion is increasing. Even though such states can persist for a considerable period, they seem to be followed by periods of higher risk aversion and reduced market liquidity as has been the case from July 2007 onwards.

Financial Stability Review Issue 2, 2007
12 December 2007
Net Asset Value Triggers as Early Warning Indicators of the Hedge Fund Liquidation

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Hedge funds are flexible and relatively unconstrained institutional investors, which may also use leverage to boost their returns.This investment freedom and their ability to leverage can pose risks for their creditors and trading counter-parties, who need to safeguard their credit exposures. Triggers based on the cumulative decline in the total net asset value of a fund are frequently used by banks to protect themselves against credit losses stemming from hedge fund failures. An empirical examination of the indicator properties of such triggers as early warning signals of impending hedge fund liquidation finds that they are not very precise in detecting future problems. Nonetheless, they still provide opportunities for banks to review the risk profiles of the hedge funds they are exposed to, thereby allowing them to take necessary protective action against risks.

Financial Stability Review Issue 2, 2007
15 June 2007
CPSS Report on "New developments in clearing and settlement arrangements for OTC derivatives"

Abstract

Abstract

This box refers to a CPSS report based on interviews with 35 major dealers worldwide. This report concludes inter alia that any post-trading infrastructure for OTC derivatives should ensure that other service providers, clearing houses, payment and settlement systems have open and fair access to its services and should aim to achieve interoperability with other types of infrastructure.

Financial Stability Review Issue 1, 2007
15 June 2007
The effects of global climate change on the euro area insurance sector

Abstract

Abstract

Recent reports suggest that the earth’s climate is becoming more volatile as a result of both human activity and natural variability. Indeed, the occurrence of extreme weather events such as drought or flooding has increased in recent years, as have heatwaves and windstorm activity. As a result, financial losses and insured financial losses owing to global weather disasters have increased significantly, especially over the past two decades. Insurance underwriters and reinsurers offering protection for weather-related damage are increasingly faced with new challenges given the higher occurrence of extreme events. This Box reviews some of the potential risks and challenges that more volatile climate conditions pose for euro area insurers.

Financial Stability Review Issue 1, 2007
15 June 2007
Bank rating and support analysis

Abstract

Abstract

The banking system is a low-default sector in that banks default very infrequently, especially when compared with other corporate sectors. Different reasons could explain this low realised default rate. A significant one is that the banking sector is subject to supervision. Another reason, recently put forward by rating agencies, is the existence of external support which could prevent a bank in difficulties from entering into a state in which it could default. Support mechanisms can come in a variety of different forms. An important one is the potential support that a government could offer to a failed bank. Alternatively, external support could also come in the form of a parent or shareholder group injecting new funds into the troubled bank.

Financial Stability Review Issue 1, 2007
15 June 2007
Decomposition of the risks faced by the banking and the insurance sectors using a factor model

Abstract

Abstract

From a financial stability perspective, it is useful to decompose the risks faced by the financial sector into systematic, sector-specific and idiosyncratic components. The aim of this Box is to apply a latent factor model framework to achieve such a decomposition for both the banking and insurance sectors.

Financial Stability Review Issue 1, 2007
15 June 2007
Market risk measurement, beyond value at risk

Abstract

Abstract

Financial risk management has evolved dramatically over the last few decades. One of the most widespread tools used by financial institutions to measure market risk is value at risk (VaR), which enables firms to obtain a firm-wide view of their overall risks and to allocate capital more efficiently across various business lines. This box places the VaR approach into a broader risk measurement context and compares the metric with alternatives.

Financial Stability Review Issue 1, 2007
15 June 2007
Loan loss impairments: what is behind the numbers?

Abstract

Abstract

Credit risk is the most important risk that banks must face. This means that for assessing the effect of credit risk on banks profitability and solvency, adequate disclosures of potential and realised credit risk are important. Furthermore, information about how this risk is quantified and managed is important for effective market discipline. One key piece of information that is needed for the assessment of credit risk is the loan loss impairment figures that are contained in banks’ financial statements. Both 2005 and 2006 were transitional years in the euro area banking sector since the full implementation of the new IFRS accounting standards by euro area LCBGs. This Box explains what loan impairments are; describes the figures that euro area LCBGs provided under IFRS in their 2006 results; as well as the information provided to interpret and compare these figures.

Financial Stability Review Issue 1, 2007
15 June 2007
Variance swaps

Abstract

Abstract

In a financial market context, volatility is a measure of the extent of asset price fluctuations. It is a necessary input for various models used for pricing options and other financial instruments, and can be measured in many different ways. While so-called realised volatility measures the extent of past price variation, the volatility implied in options prices is used to gauge the market view of expected future price fluctuations. As the structures of financial instruments have become increasingly complex, market participants need instruments which allow them to trade volatility in order to hedge structured transactions or to take purely directional views on volatility. While “plain vanilla” options contracts on underlying assets provide exposure to the volatility of the underlying asset, they are impure for hedging or taking positions on volatility because they simultaneously provide exposure to the direction of the underlying asset. Although hedging options according to the BlackScholes prescription can remove the exposure to the underlying asset, so-called delta hedging is at best inaccurate because many of the Black-Scholes assumptions are violated in practice. For instance, volatility cannot be accurately estimated, financial assets cannot be traded continuously, transaction costs cannot be ignored, markets sometimes move discontinuously, and liquidity is often a problem.

Financial Stability Review Issue 1, 2007
15 June 2007
Constant proportion debt obligations

Abstract

Abstract

A feature of credit derivatives markets over recent years has been constant product innovation. Several recent products have evolved out of a risk management technique pioneered in the 1960s known as CPPI, a strategy designed to leverage investments while providing a measure of downside protection. CPDOs represent one of the most recent additions in this regard, and were introduced for the first time in summer 2006. A CPDO is a fully funded credit structure that combines high leverage in the CDS market with a mechanism to place a part of an excess yield in a reserve in order to secure future payments and absorb losses. This Box describes the basics of the CPDO structure, as well as the possible impacts on credit markets and the risks associated with the structure.

Financial Stability Review Issue 1, 2007
15 June 2007
Understanding financial market liquidity

Abstract

Abstract

Market intelligence indicates that financial market participants have rarely seen liquidity in global financial market as abundant as since 2003 and that an almost insatiable appetite has existed among investors for some time for privately issued assets, especially risky credit products. The term “liquidity” is, however, frequently used loosely and it is often difficult to disentangle precisely what concept is meant in this respect. It is useful to recall that economic theory offers at least two different concepts of liquidity. One of them can be called monetary liquidity and it pertains to the quantity of liquid assets in the economy, which is in turn related to the level of interest rates. A second concept is market liquidity, which is generally seen as a measure of the ability of market participants to undertake securities transactions without triggering large changes in their prices. These two concepts are quite distinct from one another and although there can be relationships between them they are rather complex and by no means direct. From a financial stability perspective, it is important to identify the sources of financial market liquidity because if there are risks associated with the durability of the factors driving it, this could leave asset prices vulnerable to abrupt changes in market liquidity. Focusing on the second concept, this box introduces an indicator designed to gauge patterns in euro area market liquidity, it assesses some of the explanations commonly offered for perceptions of abundant market liquidity and it draws some financial stability conclusions.

Financial Stability Review Issue 1, 2007
15 June 2007
Term spreads and floating rate lending to households and non-financial corporations in the euro area

Abstract

Abstract

The degree of interest rate variability or the length of the initial period of interest rate fixation on bank loans determines whether the interest risks associated with them are predominantly borne by borrowers or by lenders. When loans are extended at variable interest rates, the bulk of the interest rate risk is carried by the borrowers. By contrast, when lending rates are fixed, borrowers are shielded from interest rate risk, yet banks can be left exposed to the risk of divergence between the cost of funding the loan and the interest earned on it, unless they hedge with appropriate market instruments. Hence, information on the distribution of new lending according to the degree of interest rate flexibility in the contracts can shed light on how interest rate risks are spread between borrowers and lenders. Moreover, the degree of interest rate risk borne by borrowers can have implications for banks’ exposure to credit risk. When most loans are contracted at variable rates, the proportion of borrowers who could find themselves in difficulty when seeking to service their loans will tend to be larger in the event of an interest rate increase. Against this background, this Box assesses the extent to which changes in bank lending rates for loans with different periods of initial rate fixation affect the relative share of these loans in total new monetary financial institution (MFI) loans in the euro area.

Financial Stability Review Issue 1, 2007
15 June 2007
Comparing the leverage of listed and unlisted corporations

Abstract

Abstract

Aggregate financial accounts data show that after 2004, corporate sector leverage in the euro area, which was already high, began to rise again. Using aggregate data for the surveillance of vulnerabilities building up in the non-financial corporate sector may, however, conceal differences between specific groups of firms. For instance, there have been indications that private equity-sponsored LBO activity in the euro area has been significantly raising the leverage, perhaps excessively so, of the affected firms. If that is the case, this would be seen

in the leverage ratios of unlisted firms, as private equity deals either involve unlisted firms or consist of taking publicly listed firms private so that they no longer have a stock exchange listing. From a financial stability viewpoint, if leverage becomes excessive among private equity-backed firms, then the likelihood of a large default or of a cluster of smaller defaults becomes increasingly probable if the credit cycle were to deteriorate. As noted by the UK’s Financial Services Authority, “this has negative implications for lenders (particularly before distribution), purchasers of the debt (particularly where these positions are concentrated or leveraged), orderly markets and conceivably, in extreme circumstances, financial stability”. Once firms are taken private, it becomes increasingly difficult to monitor the condition of their balance sheets. Nevertheless, this Box attempts to infer their condition by comparing leverage patterns for the non-financial corporate sector as a whole with leverage patterns of listed firms which do periodically issue financial statements.

Financial Stability Review Issue 1, 2007
15 June 2007
Hedge fund liquidations

Abstract

Abstract

Hedge funds are often considered to be a rather risky alternative investment, although the historical risk-adjusted performance of non-investable hedge fund indices of some investment strategies might suggest the opposite. Because the failure of a large hedge fund or a cluster of smaller hedge funds could cause financial instability by impairing banks’ soundness and the smooth functioning of affected financial markets, this Box investigates hedge fund failures in greater detail.

Financial Stability Review Issue 1, 2007
15 June 2007
Volatility and risk aversion in major currency markets

Abstract

Abstract

The volatility implied in options prices across both major asset classes and economic regions fell significantly after mid-2003, converging in major bond markets from values ranging between 10% and 6% annualised to around 4% in 2006, while falling in major equity markets from values ranging between 50% and 30% annualised in mid-2002 to about 10% by the end of 2006, despite a temporary rise between May and July that year. Implied volatility also fell in major foreign exchange markets after mid-2003, reaching historical lows in 2006. Several factors have been cited as being potential drivers of these patterns. First, as discussed in earlier editions of the FSR, very low risk-free interest rates and an abundance of liquidity in financial markets seemed to set in motion a search for higher yield. Second, the existence of ample market liquidity may have raised the risk appetite of investors, inducing them to take on greater risk. Furthermore, with greater market liquidity, financial transactions tend to have less of an impact on market prices, and some investors may have lowered their expectations of future volatility on account of this. The fall in implied volatility in recent years has often been seen as a manifestation of increasing risk appetite. Although the two quantities are intrinsically linked, financial theory does not however predict that movements in expected volatility, as gauged by implied volatility, are fundamentally proportional to changes in risk appetite or risk aversion. This is because implied volatility is composed of both a premium for volatility risk and expectations of future volatility. What is needed, therefore, to uncover the volatility risk premium – a yardstick of investor risk appetite – is a pure measure of expected volatility. This Box illustrates one way of doing this, and shows why movements in implied volatility should be interpreted with caution.

Financial Stability Review Issue 1, 2007
15 June 2007
Carry trades in foreign exchange markets

Abstract

Abstract

After nearly two years of broad stability, the Japanese yen began to depreciate vis-à-vis the euro in January 2005, and by May 2007 it had fallen in value by close to 15% compared with the end of 2004, and by around 45% compared with October 2000. By the same token, since

around May 2006 the Swiss franc has depreciated almost continuously vis-à-vis the euro, reaching an all-time low in May 2007. Taking a long-term perspective and employing Consumer Price Index (CPI)-deflated bilateral exchange rates, both the Japanese yen and the Swiss franc are currently trading higher than their averages since 1992. In view of the prolonged phase of expansion experienced by the Japanese economy and the economic upswing recorded by Switzerland in 2006, the recent weakening of the two currencies is somewhat difficult to explain in terms of economic fundamentals. One factor often offered by market participants in explanation for the persistent weakening of the two currencies has been foreign exchange carry trades, driven by a significant widening of short-term interest rate differentials vis-a-vis the euro and especially the US dollar through 2005 and 2006. Carry trades are simple leveraged investment strategies consisting of borrowing in a low-yielding currency and investing in a higher-yielding one. The investment horizon for a carry trade is typically rather short in order to minimise the exposure to currency risk, thus requiring a systematic rollover to exploit gaps in interest rate differentials. From a finance theory perspective, the gains from carry trading are puzzling, as higher interest rate differentials should logically be offset by depreciation of the higher-yielding currency. However, in practice high-yielding currencies tend to appreciate on average, thereby increasing the returns and popularity of carry trades. When expected foreign exchange volatility is low – as was the case through 2005 and 2006 – further impetus can be given to investors to enter into carry trades since foreign exchange risk is perceived to be unable to affect the gains achieved from the interest rate side.

Financial Stability Review Issue 1, 2007
15 June 2007
The impact of emerging market shocks on global equity markets

Abstract

Abstract

Recent events in emerging market economies (EMEs) – such as the introduction of capital controls in Thailand, the unveiling of nationalisation plans in Venezuela, the Russia/Belarus conflict over oil exports to western Europe, and concerns about the risk of a possible default in Ecuador – contributed to inducing substantial corrections in emerging equity markets. A relevant issue for global financial stability is to assess the extent to which such events or shocks – originating in EMEs – affect global equity markets more broadly, including those in the euro area. The debate on the relevance of EMEs for global financial markets has traditionally focused in particular on transmission and contagion during financial crises in EMEs. Yet emerging market assets have become an increasingly important global asset class over the past decade, meaning that their potential to influence pricing in other markets – also during normal times – may be increasing. This makes it important to understand whether, and to what extent, EMEs have systemic importance for global financial markets, above and beyond their influence during crises episodes. This Box aims at shedding light on the transmission of EME equity market shocks to global equity returns as well as to 15 individual mature economies’ markets.

Financial Stability Review Issue 1, 2007
15 June 2007
US sub-prime mortgage spillover to credit risk transfer markets

Abstract

Abstract

The share of adjustable rate mortgages (ARMs) in new mortgage credit extended in the US has risen significantly since 2002. Whereas at the end of 2002 the share of ARMs was about 20% in dollar volume terms and just over 10% by number of new mortgages granted, their respective shares peaked at around 50% and 35% in mid-2005, after which they declined somewhat. Of these mortgages, a substantial number were “sub-prime” – i.e. mortgages granted to individuals with poor credit histories. This Box explains why delinquencies on these loans rose significantly after mid-2005, and shows how this ultimately led to spillovers into certain portions of the CRT markets in early 2007.

Financial Stability Review Issue 1, 2007
15 June 2007
Saving behaviour and global imbalances: the role of emerging economies

Abstract

Abstract

Although global private savings have, at an aggregate level, represented a relatively stable share of world GDP at around 20% over the past quarter of a century or so, there has been considerable variation in savings patterns across countries and regions. In particular, the private savings of developed economies, as a proportion of GDP, have trended slightly downwards from the early 1980s onwards. By contrast, private savings have risen more or less continuously in emerging Asia, with the exception of the years in the immediate aftermath of the financial crisis of 1997-98, while they have been relatively volatile in Latin America. Understanding the drivers of these regional divergences is important in order to ascertain whether the so-called global savings glut could possibly explain the significant widening of global current account imbalances over the past five years. It is also relevant in terms of assessing the extent to which ample savings in emerging economies have possibly contributed to a significant lowering of global long-term real interest rates in recent years. In view of these considerations, this Box examines the empirical drivers of private savings within a large panel of emerging and developed economies over the past quarter of a century.

Financial Stability Review Issue 1, 2007
15 June 2007
Bank Income Diversity and Systemic Risk

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Since the enaction of the Second Banking Directive of 1989, European banks have been permitted to engage in any degree of functional diversification that they consider optimal in terms of risk and return. From a financial stability assessment perspective, it is useful to ask how functional diversification affects risk in the banking system. This Special Feature uses statistical techniques to generate a market-based risk measure, and examines how developments in banks’ income components affect this risk measure during times of extreme equity market movements. The main findings are that size and trading income have a positive effect on the systemic risk measure used, while income from traditional intermediation activities is negatively related to the risk measure used.

Financial Stability Review Issue 1, 2007
15 June 2007
Global Macro-Financial Developments and Expected Corporate Sector Default Frequencies in the Euro Area

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Identifying the macro-financial factors that drive the default probability of banks’ borrowers and thus the default risk in banks’ loan books is important in order to obtain a better understanding of conjunctural sources of risk in the financial system. This Special Feature presents an original approach for modelling the links between a global macroeconomic model already used at the ECB for modelling international economic and financial linkages and corporate sector expected default frequencies (EDFs) in the euro area. The results show that euro area default probabilities are strongly affected by shocks to GDP, stock prices, exchange rates and oil prices. Furthermore, the model is capable of providing robust estimations under a wide range of shocks. It could thus be particularly useful for generating scenarios in order to stress test the resilience of individual banks along with the entire banking system.

Financial Stability Review Issue 1, 2007
15 June 2007
Assessing Portfolio Credit Risk in a Sample of EU Large and Complex Banking Groups

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

In terms of economic capital, credit risk is the most significant risk faced by banks. This Special Feature implements a credit risk model – based on publicly available information – with the aim of developing a tool to monitor credit risk in a sample of large and complex banking groups (LCBGs) in the EU. The results indicate varying credit risk profiles across these LCBGs and over time. Notwithstanding some caveats, these results demonstrate the potential value of this approach for monitoring financial stability.

Financial Stability Review Issue 1, 2007
15 June 2007
Measuring Investors' Risk Appetite

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The willingness of investors to bear financial risk, commonly referred to as investors’ risk appetite, has been a subject of growing interest among market participants and observers alike not least on account of the buoyancy of financial markets over the past three to four years. Many different indicators of risk appetite have been developed but patterns in them are not always the same even though they are supposed to capture the same phenomenon. This Special Feature aims at unearthing a common component between several commonly followed indicators and it develops a composite measure of risk appetite. The resulting composite measure appears to capture well several periods when markets underwent episodes of stress.

Financial Stability Review Issue 1, 2007
15 June 2007
Accounting for Rising Leveraged Buyout Activity

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The value of global corporate leveraged buyout (LBO) transactions has expanded substantially over the past couple of years. Many of the deals have been characterised by high debt-to-equity ratios, which have reached levels comparable to those seen in the US LBO boom of the 1980s. Putting recent developments into historical perspective, this Special Feature recalls the implications of theories of optimal capital structure for recent developments and it explains how recent LBO activity has been facilitated by recently developed techniques for credit risk transfer. From a financial stability perspective, there are some concerns as it cannot be excluded that intense competition to win new deals in the pursuit of fee income, together with the strength of the bargaining power of private equity firms in negotiating terms for LBO transactions, may have led to an inadequate pricing of risks by investors invarious forms of LBO debt. To mitigate these risks, banks will need to ensure the adequacy of stress-testing of their direct exposures and exercise vigilance in the monitoring of counterparty risks.

Financial Stability Review Issue 1, 2007
11 December 2006
Key elements of business continuity management

Abstract

Abstract

The “Business Continuity Oversight Expectations for Systemically Important Payment Systems (SIPS)” identify four elements as key to business continuity management. However, each SIPS remains responsible for its own business continuity management and, in particular, should endeavour to achieve high resilience objectives for the system, its critical participants and its third-party providers of critical functions and/or services.

Financial Stability Review Issue 2, 2006
11 December 2006
Overview of the financial market infrastructure

Abstract

Abstract

The European financial market infrastructure – which is composed of payment systems, securities clearing and settlement systems and payment instruments – is in the middle of a development process. The pace of the creation of an internal market for financial services in the various financial market infrastructure components has been uneven, and the provision of services to an ever-larger number of international market participants and markets poses increasing challenges. Over the longer term, the efficiency of the EU-wide infrastructure must be enhanced, and the efficiency of EU financial markets must be promoted in many ways. Improving the efficiency and integration of payment systems and financial systems more generally are important objectives of the ECB. When the infrastructure operates reliably, it fosters financial stability as well. This Box provides an overview of the most important infrastructural developments.

Financial Stability Review Issue 2, 2006
11 December 2006
Hedging longevity risk

Abstract

Abstract

Providers of annuities, such as life insurance companies and pension funds, face the risk that the duration of their assets can become mismatched from that of their liabilities, and that the mortality rates of policyholders could fall at a faster rate than anticipated in their pricing and reserving calculations. As profit margins in the provision of annuities tend to be low, reflecting competition, the profit margin of annuity providers will be squeezed if the mortality assumptions built into the prices of annuities turn out to be overestimated. Indeed, some life insurance companies have been claiming that their annuity businesses have been producing losses because annuitants have been living longer than expected. Some companies have sought to cover themselves against this longevity risk by only quoting prices for annuities on uncompetitive terms. This Box discusses the challenges posed by longevity risk, and examines ways in which life insurers can manage their exposure to this risk.

Financial Stability Review Issue 2, 2006
11 December 2006
Banks' hybrid capital instruments: financial stability implications

Abstract

Abstract

The purpose of banks’ core capital is to absorb unexpected losses in order to safeguard the solvency of the institution and to enable it to continue operating as a business. Regulatory core capital consists of an unlimited amount of equity and a limited amount of other instruments that may include certain types of financial instruments known as hybrids. Generally speaking, hybrid instruments have both equity and debt characteristics. For example, one type of hybrid may pay a regular dividend based on a par value (just like a bond coupon), but may be treated in a similar way to equity for regulatory purposes in that it can also be used for absorbing unexpected losses. For euro area banks, a significant amount of these instruments are now included in Tier 1 capital and are increasingly being used as non-core capital funding for further lending or financing acquisitions. This reflects the development of this market globally as well as increased issuance by non-financial firms. This Box concentrates on the increasing use of this type of capital instrument by banks, and the possible financial stability implications.

Financial Stability Review Issue 2, 2006
11 December 2006
Credit portfolio management practices and their implications

Abstract

Abstract

Financial institutions are increasingly measuring and managing the risk from their credit exposures at the portfolio level, in addition to the transaction level. A greater focus on so-called credit portfolio management (CPM) has occurred for a number of reasons. The first is a greater recognition of the fact that individual credit exposures can be highly correlated, leaving banks open to the possibility of facing multiple adverse credit events. CPM can help in lowering such undesirable credit risk concentrations. Additional driving factors have been greater emphasis on improving the risk/return profiles of credit portfolios, and making better use of regulatory capital. Furthermore, opportunities for managing credit exposures proactively, after they have been originated, have been facilitated by improved liquidity in the secondary loan market, the increased importance of syndicated lending, the availability of credit derivatives, and an increasing availability of sophisticated models for evaluating credit risk, as well as improved data, and information technologies that facilitate the management of credit risk on a portfolio basis. One implication of CPM is that banks are increasingly moving away from traditional buy-and-hold loan exposure management to an originate-and-distribute business model. This Box discusses recent advances in CPM practices and their implications.

Financial Stability Review Issue 2, 2006
11 December 2006
Combining information on bank performance

Abstract

Abstract

A common way of assessing the performance of an individual bank is to compare its accounting data or its share price with similar indicators computed for a peer group. For example, the set of indicators concerning banks’ profitability that is regularly monitored in the ECB Financial Stability Review comprises a mix of both accounting-based and market-based indicators that are aggregated to form peer group averages and various measures of dispersion. The headline or main accounting ratios that are frequently used include return on equity (ROE) and return on risk-weighted assets (RORWA), as well as various other measures such as loan impairment charges, cost-to-income ratios and capital ratios. These indicators attempt to gauge various aspects of banking sector performance – including overall profitability, asset quality, efficiency and regulatory capital. To arrive at a more comprehensive assessment, this information is complemented with information extracted from market indicators such as banks’ stock prices, price-earnings ratios as well as derived measures such as risk-neutral density functions and distance-to-default indicators. The main difference between the two sets of indicators is that accounting data are based on realised or actual outcomes, whereas market data are based on investors’ expectations of future bank performance. These expectations are formed by summarising all available information on the outlook for banks. This Box compares the

information that can be gauged from these two sources, and it provides an example where they may be fruitfully combined. The main finding is that pooling information from both sources may provide useful insights for financial stability analysis.

Financial Stability Review Issue 2, 2006
11 December 2006
Recovery swaps

Abstract

Abstract

Product innovation seems to be a natural feature of the credit derivatives markets, resulting in new instruments being introduced and new risks and exposures being traded. While the life span of some of these innovations has been rather ephemeral, others have proven their value to market participants, becoming standard and sometimes overtaking their underlying cash markets in importance and liquidity. Prime examples of such innovations have been CDSs and CDOs, whose trading volumes and use in investment strategies have undergone exponential growth in recent years. This Box aims at describing one of the relatively new markets which has not been very extensively used but, depending on the development of the credit environment, has the potential to become more widely used in the future – the recovery rate swap.

Financial Stability Review Issue 2, 2006
11 December 2006
Implications for credit market liquidity of credit risk transfer instruments

Abstract

Abstract

Measuring and understanding market liquidity is extremely challenging for all market participants. It is not just the level of liquidity that matters, but also its variability and how it evolves as a consequence of market-driven or regulatory-driven developments. Over the last few years, the creation of CRT instruments has been the main market-driven innovation in European credit markets. These instruments have had a major effect on the management of credit risk by banks and other financial institutions, and are playing an increasingly important role in the functioning of credit markets both in quiet and distressed market conditions. This Box considers the impact that CRT instruments may have on liquidity, especially under conditions of market stress.

Financial Stability Review Issue 2, 2006
11 December 2006
Gauging the extent of credit risk transfer through credit derivatives

Abstract

Abstract

In September 2006, Fitch Ratings published its fourth annual global credit derivatives survey.This survey captures the main market developments between end-2004 and end-2005. It covers 75 financial institutions (including banks and broker/dealers, insurance companies and reinsurers, and financial guarantors). The institutions covered in the survey are believed to represent the major players in the credit derivatives market. It contains attempts at quantifying the scale of the transfer of credit risk outside the traditional banking and insurance arena. This Box discusses some of the most relevant findings of the survey from a financial stability perspective.

Financial Stability Review Issue 2, 2006
11 December 2006
Bank write-offs/write-downs of private sector loans in the euro area

Abstract

Abstract

Bank write-offs/write-downs of loans (henceforth just write-offs) provide information about the creditworthiness of debtors and of losses incurred by banks in their lending. So long as the information is sufficiently timely, it can help in assessing the quality of banks’ assets, and

therefore constitutes an additional yardstick of the soundness of the euro area banking sector. This Box reviews the nature of euro area bank write-offs vis-à-vis the private sector (households and non-financial corporations), and describes developments in recent years.

Financial Stability Review Issue 2, 2006
11 December 2006
Vulnerabilities in open-end real state mutual funds

Abstract

Abstract

In several euro area countries, a number of open-end real estate funds have experienced severe liquidity shortages in recent years, including most recently in Germany. These crises not only often resulted in the closure of individual funds, but also led to the disappearance of this type of investment in some countries. Open-end real estate funds may come under pressure when real estate prices move downwards. Some recent policy initiatives (especially in Germany) have been taken to deal with this fragility. Open-end real estate funds may be susceptible to financial fragility for two main reasons: liquidity transformation, and revaluation policies.

Financial Stability Review Issue 2, 2006
11 December 2006
Hedge fund risk transparency

Abstract

Abstract

Three important issues are frequently raised in public policy discussions concerning hedge funds: risks to financial stability, regulation, and transparency. There is an ongoing debate as to whether the solution to financial stability concerns lies in regulating these institutions or in

enhancing their transparency. The general view is that direct regulation of hedge funds may be neither desirable nor feasible, and that so-called indirect regulation – through the regulation of counterparties and creditors of hedge funds as well as by raising investor awareness – may be the best way to manage hedge fund-related risks. The indirect approach places great emphasis on regulated entities (e.g. prime broker banks) applying prudent risk management and market discipline in their dealings with hedge fund clients. As such, for the approach to work, the information disclosed to regulated counterparties by a hedge fund must be sufficient to allow them to monitor their risks effectively. A key concern in applying this approach is that banks are often not informed in a sufficiently detailed and timely fashion on the entire portfolio held by individual hedge funds (hereafter “the portfolio problem”), and are therefore unable to detect crowded (concentrated) trades across their hedge fund clients. The portfolio problem carries with it the risk of building up excessive leverage, whereas crowded (concentrated) trades may threaten liquidity available in major financial markets. Both of these aspects were important during the near-collapse of LTCM, a large hedge fund, in September 1998. The purpose of this Box is to provide an overview and assessment of various proposals that have been made to enhance the transparency of hedge fund activities, and to shed some light on some potential market-based solutions to the portfolio problem.

Financial Stability Review Issue 2, 2006
11 December 2006
Financial market volatility - what caused the recent spike?

Abstract

Abstract

In early May 2006, a month-long correction in the financial markets took place. Most equity and commodity markets experienced price falls, and emerging countries’ assets and currencies were adversely affected by significant outflows. At the same time, highly liquid and secure G7 government bond markets experienced strong inflows due to safe-haven buying. The sudden change in investors’ positions can be broadly traced to three underlying factors: the immediately preceding sharp rise in most equity indices and commodities; an unexpected reappraisal of risks, particularly in emerging markets and concerns about the US economic outlook. Whereas the net impact on prices was in the end limited, these events could signal risks of volatility surges in the period to come, at least for some asset markets.

Financial Stability Review Issue 2, 2006
11 December 2006
Are the external positions of the new eu member states excessive?

Abstract

Abstract

From a financial system stability perspective, among a broad set of economic and political indicators to be taken into account when assessing a country’s vulnerability to a currency crisis, it is crucial to assess the evolution of the external imbalances of countries. By late 2006, with the major exception of the US, collectively the central and eastern European countries (CEEC) were the only region in the world recording sizeable and persistent current account deficits. By

contrast, Asian and Latin American countries recorded either moderate deficit or surplus positions. Although the CEEC are economically relatively small, financial distress in these countries could entail more widespread financial stability risks. For instance, the Asian crisis in 1997-1998 demonstrated that financial distress in one country can affect a much larger economic area if investors simultaneously withdraw their funds from countries with similar characteristics. From a euro area perspective, the CEEC are particularly relevant given their geographic proximity and the participation of some of these countries in the Exchange Rate Mechanism (ERM) II.

Financial Stability Review Issue 2, 2006
11 December 2006
Potential regional housing market corrections in the United States: what role for state-level spillovers?

Abstract

Abstract

In recent years, US house prices have risen rapidly: by the end of 2005, aggregate nominal and real house prices were about 70% and 53% respectively above their early-2000 levels. These large overall changes at the national level, however, mask considerable heterogeneity in house price dynamics across cities, states and regions during this period. To a large extent, these differences can be attributed to the importance of local conditions in determining housing market conditions. For instance, from 2000 onwards property price inflation in areas with lower elasticity of land supply – such as coastal areas – was more pronounced than in other regions of the country. Reflecting this heterogeneity, the distribution of house price changes across 387 US metropolitan statistical areas has been wider since 2000 than it was during the 1990s, and considerably more positively skewed. This geographical heterogeneity in house price changes can be contrasted with generally declining income dispersion across states over recent decades, prompting the question whether house prices, especially in some regions of the US, have become decoupled from their underlying fundamental determinants. While there is much debate as to the degree to which house prices are on aggregate misaligned with the underlying fundamentals for the US as a whole – in particular given the possibility of structural changes affecting house price relationships with the fundamentals or historical norms – it would appear that house prices may well be overvalued in some US cities. If so, this would mean that some local markets could be vulnerable to house price correction. In this regard, this Box analyses a key issue for financial stability, namely the extent to which any prospective local housing market correction would spill over to other areas of the country.

Financial Stability Review Issue 2, 2006
11 December 2006
Recent developments regarding china and global imbalances

Abstract

Abstract

The single largest vulnerability to a disorderly correction of global current account configurations arising from EMEs continues to stem from a number of downside risks to the Chinese economy. Though still notable, the risks in this context since the completion of the June 2006 FSR appear to be on an incipient downward trend in spite of the upturn in domestic economic activity over the same period. Five developments underlie this assessment.

Financial Stability Review Issue 2, 2006
11 December 2006
Identifying Large and Complex Banking Groups for Financial System Stability Assessment

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

For the purposes of financial system stability assessment, it is important to identify and monitor the activities of banking groups whose size andnature of business is such that their failure and inability to operate would most likely have adverse implications for financial intermediation, the smooth functioning of financial markets or other financial institutions operating within the system. A simple and common approach for identifying such institutions – often grouped under the heading large and complex banking groups (LCBGs) – is to rank them by the size of their balance sheets. However, asset size alone may fail to shed much light on the importance and complexities of the interconnections that a banking group may have within a financial system, especially given the growing importance of banks’ off-balance sheet activities. Knowledge about such interconnections is important because it can help in mapping how, or if, strains in a large banking group could spread to otherinstitutions or markets. Based on a multiple indicator approach, this Special Feature takes a first step towards statistically identifying banking institutions that meet certain “largeness” characteristics that go beyond balance sheet size.

Financial Stability Review Issue 2, 2006
11 December 2006
The Information Content of CDS Index Tranches for Financial Stability Analysis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Information extracted from credit default swap (CDS) index tranches can provide an important contribution to a forward-looking assessment of banking system risk. The market prices of CDS index tranches provide the basis forconstructing an indicator of the level of systematic risk in the credit market. Inparticular, this indicator describes traders’ views on the future relative development of systematic and idiosyncratic portfolio credit risk. Thus, it shows whether traders are more concerned about economy-wide credit risk or about firm-specific credit risk such as the default of a particular firm. This Special Feature constructs an estimate of the implied correlation for the euro credit market and describes its use in financial stability analysis. The three main results of this analysis are as follows. First, after January 2006, there was evidence that the focus of credit traders had moved from firm specific credit risk towards systematic credit risk. This finding can be linked to a number of fundamental determinants of credit market valuation, all of which point in the same direction. Second, the implied correlation provides detailed information about how the credit markets functioned during the May 2005 market turbulence. Third, most of the variation in the implied correlation is not linked to other financial market indicators.

Financial Stability Review Issue 2, 2006
11 December 2006
Explaining Episodes of Dynamic Credit Growth in Central and Eastern Europe

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Credit growth has accelerated in recent years in some central and (south-) eastern European countries (CEECs).While low starting levels of financial intermediation help explain the speed of credit growth, its fast pace could raiseconcerns from a financial and macroeconomic stability perspective. This Special Feature suggests a methodology for analysing these episodes that explicitly accounts for both macroeconomic developments and the catching upprocess associated with the transition from planned to market economies that countries in the region have been undergoing. However, even if both factors are taken into account evidence is still found in some countries of higher credit growth than the empirical model would suggest. In these cases the dynamics ofcredit growth are nevertheless not markedly different for foreign or domestic currency lending, or for lending to households and corporations. Given the limited available data, however, these results must be interpreted with caution, and further research is called for to address issues such as the mechanisms through which the exchange rate regime, the presence of foreign banks and the range of lending products on offer may impact credit developments in the region.

Financial Stability Review Issue 2, 2006
11 December 2006
Assessing Systemic Risk in the European Insurance Sector

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

If very large changes in the stock prices of individual insurance undertakings tend to occur simultaneously, it can be said that extreme-value dependence is present. If such dependence is found to be present, it can indicate that these firms are exposed to common sources of risk. With a focus on gaining insight into systemic risk within the insurance sector, this Special Feature examines the incidence of extreme-value dependence across different types of insurance undertakings and it goes on to examine the main drivers of such co-movement, to the extent that it is present. A key finding is that extreme-value dependence is evident among larger composite insurers. In addition, two important drivers of extreme-value dependence between insurance companies are found: exposure to extreme financial market events, and to non-life underwriting.

Financial Stability Review Issue 2, 2006
11 December 2006
The EU Arrangements for Financial Crisis Management

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Since the introduction of the euro, the progress made in the integration of financial markets and market infrastructures in the EU, the growing number of internationally active institutions and the diversification of financial activities have increased the liquidity and efficiency of the relevant markets. At the same time, however, such developments have also increased the likelihood that systemic disturbances could affect more than one Member State, and possibly increase the scope for cross-border contagion. In this context, the specific arrangements for handling crises at the EU level between the authorities responsible for safeguarding financial stability have been considerably enhanced since the introduction of the euro. The enhancements include legislative initiatives in the framework of the Financial Services Action Plan (FSAP), the implementation of the Lamfalussy framework for regulation and supervision in all financial sectors, the adoption of agreements on voluntary cooperation between responsible authorities, and the development of practical arrangements, such as the organisation of financial crisis simulation exercises. This Special Feature provides a structured overview of the progress made in the specific arrangements for financial crisis management between central banks, banking supervisors and finance ministries. Arrangements involving other authorities, such as other sectoral financial supervisors or deposit-insurance schemes, are not dealt with in this Special Feature.

Financial Stability Review Issue 2, 2006
1 June 2006
The global search for yield and funding liquidity risks for hedge funds

Abstract

Abstract

In the three years prior to the end of 2005, net inflows into the hedge fund sector were particularly strong, averaging USD 20 billion per quarter. However, net outflows in the last quarter of 2005 warned many hedge fund managers of the possibility of higher withdrawals in the future. This also raised questions about the factors that drive money flows into the hedge fund industry. It has frequently been suggested that the main drivers of inflows were the global search for yield, against a background of persistently low interest rates globally, coupled with high risk appetite among investors. This Box tests this hypothesis by discussing the funding liquidity risks faced by hedge fund managers and by analysing the determinants of aggregate money flows into single-manager hedge funds.

Financial Stability Review Issue 1, 2006
1 June 2006
Asymmetry and fat tails of the density of the euro area insurance and banking stock indices

Abstract

Abstract

The risk-neutral density (RND) extracted from financial options prices facilitates direct insights into the entire distribution of market expectations regarding the future price of an underlying asset at a given point in time. In the monitoring of the euro area insurance and banking sector, high-frequency indicators can be useful as part of the ongoing assessment of perceived risks. This Box aims at analysing two indicators that can be extracted from options market prices and which provide information on the degree of asymmetry and the fatness of the tails of the RND. These indicators are commonly known as risk-reversals and strangles respectively in foreign exchange markets.

Financial Stability Review Issue 1, 2006
1 June 2006
Rating triggers in the reinsurance sector

Abstract

Abstract

The reinsurance sector contributes positively to financial stability by providing a safety net for the primary insurance industry. Reinsurance companies typically absorb the most volatile part of the risk corresponding to peak exposures (i.e. the risk of substantial losses arising from events occurring with a low probability) which primary insurers are not willing to keep in their balance sheets. By pooling insurance risk, reinsurance firms can achieve superior risk diversification, both in term of business lines and geographically and after a catastrophe event, they tend to be able to endure losses transferred by the primary sector. As a result, risks and capital in the insurance industry tend to be better managed, making the primary insurance sector more resilient when it takes out reinsurance. Furthermore, despite their central role in the worldwide insurance markets as “insurers of last resort” and their very high business concentration, reinsurance undertakings are often not perceived as being a source of systemic risk. The low potential of financial market disruption and the limited counterparty risks for banks on the credit derivatives markets support the view that reinsurance undertakings are not systemic core institutions. This Box aims at questioning this view by analysing some of the ways in which the reinsurance sector may constitute a vulnerability or weak-spot for the stability of the financial system. In particular, it examines how the likely widespread inclusion of rating triggers in reinsurance contracts in the run-up to implementation of Solvency II may increase the vulnerability of reinsurers to liquidity risk in the same way as runs can take place on banks.

Financial Stability Review Issue 1, 2006
1 June 2006
Subordinated debt issues by euro area banks

Abstract

Abstract

The size and complexity of several euro area financial institutions make it difficult for supervisors and analysts to make an accurate assessment of individual institution risk. At the macro-prudential level, this presents a challenge in determining forward-looking risks to financial stability that originate from the banking sector. Public accounting information can be used for these purposes, but its value tends to be limited by reporting lags and the backwardlooking nature of the data. The third pillar of the Basel II accord clearly recognises the positive role that market discipline can play in reducing the risks to financial stability. Against this background, the prices of securities when issued on the primary market may also influence bank management. There are also advantages in using secondary market information in addition to accounting information, due to the ability of markets to process a large amount of information rapidly and to reflect this information in securities prices under normal market conditions. Subordinated debt holders might exercise more discipline than depositors or equity holders because depositors may be covered by deposit insurance, whereas equity investors may benefit from the bank taking on more risk under certain conditions. Monitoring the subordinated debt market segment therefore adds to the set of indicators on banking system stability that are capable of conveying information on future systemic risks. This is because wide spreads may indicate concerns of increasing risk. This Box provides a brief overview of the structure of the euro area bank subordinated debt market, comparing the euro area banking sector to other major economies, and it briefly analyses some data on individual issues by euro area banks.

Financial Stability Review Issue 1, 2006
1 June 2006
Downside risk in euro area bank stocks

Abstract

Abstract

One way of gauging information about the robustness of the financial system on a continuous basis is to analyse developments in bank stock prices. From a financial stability viewpoint, knowledge of how the market behaves under extreme conditions is central. As such, it is important to take into account the well-established fact that stock returns often exhibit both excess kurtosis and skewness, which also tend to depend on actual market conditions. The degree of non-normality in stock returns may also be related to firm size. By using data on individual bank stocks included in the Dow Jones EURO STOXX banking sector index, this Box investigates the downside risks associated with euro area banks from an institution-size perspective.

Financial Stability Review Issue 1, 2006
1 June 2006
Survey on EU banks' large exposures to single-name corporates

Abstract

Abstract

In the aftermath of the default of Parmalat, a relatively large Italian corporation, those EU banks with large exposures to the firm remained resilient, thereby mitigating the potential stresses on the financial system that could have arisen from such a large corporate failure. However, the episode raised the question of whether such resilience was actually an isolated event or a more general feature of the EU banking system. To address this issue, the BSC undertook a survey in SYSTEM August and September 2005 to assess whether the idiosyncratic risk of large exposures to singlename corporates could be of concern from the perspective of the stability of EU banks, and to shed some light on prevailing risk management practices with respect to these exposures. This Box summarises the main findings of the survey. In view of the caveats in the survey’s data and its limited and uneven sample, the survey findings can however only be considered as indicative, and any conclusions drawn are of necessity relatively provisional.

Financial Stability Review Issue 1, 2006
1 June 2006
Survey on EU banks'perception of the future EU banking landscape

Abstract

Abstract

The assessment of the EU banking landscape over the next five to ten years critically depends on expected changes in banks’ operating environment. This Box describes the results from a survey of major EU banks concerning the factors that EU banks considered to be of higher importance in shaping their business environment over this time period, and then outlines the main challenges that they identified.

Financial Stability Review Issue 1, 2006
1 June 2006
Assessing the financial stability implications of recent findings from the ECB bank lending survey

Abstract

Abstract

The ECB’s Bank Lending Survey (BLS) provides timely qualitative information about the credit standards being applied by euro area banks on loans to enterprises and households. In addition, the BLS provides early evidence on the contributing factors behind changes in credit standards as well as the conditions and terms applied to banks’ lending activity. This may help in detecting turning points in the credit cycle, and thus contributes to a comprehensive financial stability assessment. With this perspective in mind, this Box examines the results of the BLS since the finalisation of the December 2005 FSR.

Financial Stability Review Issue 1, 2006
1 June 2006
How risk-tolerant are investors?

Abstract

Abstract

The possibility of a reappraisal of the pricing of a wide array of financial securities prices has over the past couple of years been considered to be one of the major risks to global financial stability. Since this assessment has been largely based on questions about whether investors have perceived risks as being very low and/or whether they have been prepared to accept less compensation for holding risky assets, the degree of risk appetite in global and euro area financial markets needs to be assessed in order to shed some light on this question. From a financial stability viewpoint, excessively high risk appetite may push asset prices beyond their intrinsic value and, if it persists, could sow the seeds of financial market stress if it leads to a misallocation of capital in the economy and disorderly conditions in financial markets. This Box assesses recent patterns in two risk appetite indicators.

Financial Stability Review Issue 1, 2006
1 June 2006
Developing market solutions to improve the functioning of credit derivatives

Abstract

Abstract

Some large corporate bankruptcies in 2005 had the potential to create adverse disturbances in credit risk transfer (CRT) markets, as some of the affected corporations had been used as reference entities in numerous credit derivatives transactions. The credit events following on from these defaults resulted in early settlement or renegotiation of a large number of credit derivatives contracts across many segments of the CRT markets. The fact that the eventual impact of these credit events was not as severe as might have been expected can, to an extent, be attributed to some recent innovations that have taken place in the credit derivatives market. Some of the most important of these innovations are described in this Box, which also draws some implications for market functioning.

Financial Stability Review Issue 1, 2006
1 June 2006
The widening of the collateral pool for secured lending in the euro area

Abstract

Abstract

Trading in the euro area secured money market has been growing significantly in recent years. According to the ECB’s Euro Money Market Survey, by 2002 the secured market had already become the largest segment in the euro area money market. In addition, according to the International Capital Markets Association (ICMA) European repo market survey, outstanding repo transactions in the European market saw annual growth of around 16% between December 2004 and December 2005, mirroring growth rates seen in surveys in previous years. As the recourse to secured borrowing has been increasing, so too has market participants’ need for more collateral. While a shift from unsecured to secured borrowing should be positive from a financial stability viewpoint, there have been some concerns that the quality of the collateral used in these transactions has been deteriorating. This Box describes some of the more important developments in the collateral pool for secured lending in the euro area and it assesses their implications for financial stability.

Financial Stability Review Issue ,
1 June 2006
Structural trends in the euro money market

Abstract

Abstract

On 20 January 2006, the ECB published its sixth study of the structure and functioning of the euro money market. A new feature of the study is that it also covered the 10 Member States which joined the EU on 1 May 2004. Similar to earlier studies, the 2005 study was based on data collected from banks, and it covered the second quarters of 2004 and 2005. To keep the results comparable with earlier studies, the study was split into two parts, the first analysing data from banks residing in countries, which were EU Member States prior to 1 May 2004 and the second focusing on data from banks located in the other EU Member States. This Box reports on some of the main findings of the first part of the study. Overall, four main developments can be identified.

Financial Stability Review Issue 1, 2006
1 June 2006
Global and euro area corporate default rates

Abstract

Abstract

The overall credit quality of the corporate sector improved considerably over recent years. An important reflection of this was a significant decline in corporate sector default rates in the euro area as well as around the world. The global speculative-grade default rate of issuers rated by Moody’s, fell for the fourth consecutive year to 1.7% in March 2006, reaching the lowest level observed since 1997. In the euro area the default situation was even more benign: the default

rate was 0% from June 2004 onwards. However, against the background of some evidence suggesting that corporate creditworthiness in the euro area could turn in the period ahead, this Box examines recent patterns in speculative-grade default rates, both in a global and a euro area context. Furthermore, the short-term outlook for euro area default rates is briefly discussed in light of the 12-month global speculative-grade forecast provided by Moody’s.

Financial Stability Review Issue 1, 2006
1 June 2006
Assessing the quality of corporate earnings in the euro area

Abstract

Abstract

The balance sheets of euro area non-financial corporations improved greatly from 2003 onwards, partly owing to a significant improvement in aggregate profitability during this time, and corporate earnings are expected to remain robust throughout 2006. For a comprehensive credit risk assessment, it is important to analyse thoroughly the quality of earnings reported by firms. This Box attempts to shed some light on the quality of earnings reported by euro area firms listed on stock markets over recent years and it assesses the implications.

Financial Stability Review Issue 1,
1 June 2006
Is corporate credit quality in the euro area nearing a turning point?

Abstract

Abstract

The overall credit quality of the non-financial corporate sector in the euro area has been very benign for the last couple of years, following substantial efforts on the part of firms to restructure their balance sheets. This, in parallel with a notable strengthening of profits, helped improve corporate sector balance sheets. Against this background, the frequency of corporate sector defaults declined, and an overall improvement in credit quality was acknowledged through declining credit spreads and improving credit ratings. As corporate credit quality tends to be cyclical and determined by factors such as leverage and the strength of profitability of firms, the most recent cycle of improvement can eventually be expected to come to an end. With this consideration in mind, this Box examines whether corporate sector creditworthiness in the euro area is nearing a turning point.

Financial Stability Review Issue 1, 2006
1 June 2006
The spillover of the search for yield to non-traditional emerging market assets

Abstract

Abstract

As investors came to believe that the upside potential of traditional emerging market debt – broadly defined as foreign currency-denominated debt issued by EME sovereigns with an established credit record – became more limited after substantial spread compression, they began to shift their attention to securities that promised higher returns within the EME universe. These included external debt issued by less established EME issuers, EME local currency bonds and EME equities. This Box describes recent trends in the structure and breadth of EME markets and assesses their implications for market stability.

Financial Stability Review Issue 1, 2006
1 June 2006
Explaining the US income balance

Abstract

Abstract

In 1980, the US was a net creditor towards the rest of the world to the tune of USD 360 billion. However, by the end of 2004 the US owed foreigners USD 2.5 trillion, or around 22% of US GDP. Despite this marked deterioration of the US international investment position (i.i.p.) over the past quarter century, the US income balance has consistently recorded surpluses ranging between 0.1 and 0.5% of GDP, although in 2005 this surplus dramatically shrank to an estimated USD 1 billion because of rising debt service obligations. One way of interpreting this is that the US has been earning a negative rate of return on its net foreign liabilities. This Box discusses some of the reasons why the US income balance has been in surplus despite the fact that the US has a net foreign liability position vis-à-vis the rest of the world, and it additionally examines the implications this may have for global financial stability.

Financial Stability Review Issue 1, 2006
1 June 2006
Country-Level Macro Stress-Testing Practices

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Just as banks are increasingly using stress testing to assess risk at the institution level, macro stress tests are becoming an increasingly important tool for financial stability analysis by central banks. These tools can be used by central banks to assess the capability of the financial system, especially the banking system, to weather extreme but plausible shocks to its operating environment. Given the importance of credit risk for banks, this Special Feature discusses various conceptual aspects of designing macro stress-tests for the banking system, with a special emphasis on credit risk.

Financial Stability Review Issue 1, 2006
1 June 2006
Assessing Banking System Risk with Extreme Value Analysis

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The literature has proposed a number of approaches how to assess the stability of banking systems. In this Feature a novel approach is described that is based on extreme value theory (EVT). EVT is particularly suitable for the analysis of financial instabilities, as it is designed to deal with the occurrence of extremely rare events (“tail risk”). For example, it has been used to examine the severity of stock market crashes, the pricing of catastrophic loss risk in reinsurance or the extent of operational risk in banks. The present application to systemic risk in banking derives a parameter from market returns that can capture the exposure of an arbitrary large number of banks to each other and to aggregate risk. The 25 systemically most important banks are analysed for the euro area and the United States, respectively, between 1992 and 2004. The results suggest that multi-variate spill-over risk among banks may be more pronounced in the United States than in the euro area. One explanation for this finding seems to be that cross-border linkages are still weaker in Europe. Exposure to extreme systematic risk, however, is rather similar in the two banking systems. On both sides of the Atlantic the two forms of banking system risk increase during the second half of the 1990s. Increases in spill-over risk in Europe are, however, very gradual. The findings raise interesting policy questions about the relationship between financial integration as well as financial consolidation and the stability of banking systems.

Financial Stability Review Issue 1, 2006
1 June 2006
What Drives EU Banks' Stock Returns? An Analysis Based on the Return Decomposition Technique

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Information about the factors that drive bank level stock return variability can provide useful input to financial stability analysis. In this Special Feature, the dynamic dividend-discount model is combined with an accounting-based VAR framework that decomposes EU banks’ stock returns into cash flow and expected return components. The main findings are that while the bulk of the variability of EU banks’ stock returns is due to cash flow shocks, the expected return shocks are relatively more important for large than for small banks. This suggests that large banks could be more prone to market-wide events that, in the literature, are associated with the expected return news component as opposed to the bank-specific news component, typically assumed to be incorporated in the cash flow component.

Financial Stability Review Issue 1, 2006
8 December 2005
The Cpss-Iosco Recommendations For Central Counterparties

Abstract

Abstract

In November 2004, the CPSS of the central banks of the G10 countries and the Technical Committee of IOSCO published a report entitled “Recommendations for Central Counterparties”, which contains 15 recommendations for CCP clearing houses. Most of the recommendations aim at reducing risks that CCPs may be exposed to. As CCPs are systemically important institutions for the financial markets that they serve, these recommendations also contribute to strengthening financial stability. This Box briefly describes some of the aspects addressed by the recommendations with respect to the most important risks faced by CCPs that

are particularly relevant from a financial stability perspective.

Financial Stability Review Issue 2, 2005
8 December 2005
The Oversight Of Retail Payment Systems

Abstract

Abstract

The Eurosystem’s task of promoting the smooth operation of payment systems consists of

ensuring the safety and efficiency of payment systems and the security of payment instruments.

In pursuing this objective, to start off with, the Eurosystem concentrated on large-value

payment systems, as these systems were regarded as the most relevant for financial stability in

the euro area. However, turnover data for euro retail payment systems suggested that some of

these systems had likewise reached a size, and thus relevance, where disruptions could trigger

systemic risks.

Financial Stability Review Issue 2, 2005
8 December 2005
The oversight of swift: objectives, scope and structure

Abstract

Abstract

The oversight of SWIFT focuses on the security, operational reliability, business continuity and resilience of the SWIFT infrastructure. The oversight activities performed by central banks aim at ensuring that SWIFT has in place appropriate governance arrangements, structures, processes, risk management procedures and controls that enable it to manage effectively the risks it may pose for financial stability and the soundness of financial infrastructures. This oversight does not grant SWIFT any certification, approval or authorisation, and SWIFT continues to bear responsibility for the security and reliability of its systems, products and services.

Financial Stability Review Issue 2, 2005
8 December 2005
Low interest rates and balance sheet vulnerabilities of life insurance companies and pension funds

Abstract

Abstract

Owing to population ageing, the size of pension funds and insurance companies’ balance sheets has been growing rapidly. In the euro area, the total assets-to-GDP ratio of these institutional investors reached 58.5% in 2004, up from 51.3% in 2002.The decline in longterm interest rates since the 1990s and their persistently low levels have weakened the balance sheets of these institutions. The important share of bond holdings in their investment portfolios has weighed significantly on profitability over recent years, which has remained subdued. However, the main negative impact of low yields has been on the assessment of liabilities and therefore on companies’ net debt. In those countries where bond yields influence the choice of the discount rate used for reserves funding calculations, the lower the market rates, the higher the present value of liabilities. Hence, any fall in long-term interest rates may lead to a significant funding gap in balance sheets, given the typically longer average duration of liabilities than of assets. This Box discusses some of the financial stability issues raised by the impact of the low level of long-term interest rates on life insurers’ and pension funds’ balance sheets.

Financial Stability Review Issue 2, 2005
8 December 2005
Ageing population and longevity risk

Abstract

Abstract

As the so-called baby boom generations – i.e. those born between the mid-1940s and the mid1960s – approach retirement, policymakers in many developed countries have become increasingly concerned about retirement funding and retirement income security. With ongoing pension reforms reducing the generosity of funding from public sources, more emphasis is being placed on private saving. However, the inherent uncertainty about the length of human life complicates any decision regarding saving for retirement. In particular, there is a risk that individuals may outlive their resources and could be forced to reduce their living

standards quite substantially when they reach a more advanced age, or even risk falling into a poverty trap. Longevity risk, which materialises when expectations regarding lifespan are not met, has two components. Individual longevity risk is the risk that a person will die either prior to or after the average lifespan of his/her cohort. It can theoretically be diversified away by pooling risks in private annuity markets, where those who live longer than the average may benefit from the contributions of those who die earlier. Collective longevity risk concerns the risk of underestimating the average expected longevity. This risk poses more challenges than individual longevity risk because it cannot be shared within members of the same cohort by writing a large number of life policies. This Box discusses some of the challenges raised by collective longevity risk, for which no simple hedge may be found.

Financial Stability Review Issue 2, 2005
8 December 2005
A decomposition of euro area bank stock volatility

Abstract

Abstract

Since the recovery of the euro area stock markets started in March 2003, the Dow Jones EURO STOXX banking sector index has performed strongly, increasing by roughly 80% up to November 2005. Moreover, the upturn in euro area bank’s stock prices has been accompanied by a declining trend in various measures of stock market uncertainty. In this respect, both realised volatility and forward-looking measures such as implied volatility on options of the bank index have declined in tandem to relatively low levels by historical standards. This development of lowered uncertainty would imply that the risks facing the European banking sector are currently assessed as rather benign. By using data on individual bank stocks, this Box decomposes the decline in overall bank index volatility into two separate parts: the first measuring the contribution from single stock variances; and the second reflecting the covariation between stocks making up the index. Given that the degree of covariation among individual banks’ stock returns is important for assessing the risk of common vulnerability to similar shocks, and that this covariation from time to time may be dominated by some subset of banks (possibly changing over time), this decomposition may also provide some tentative hints about changes in the “systemic risk” embedded in financial market prices.

Financial Stability Review Issue 2, 2005
8 December 2005
Large EU banks' esposure to hedge funds

Abstract

Abstract

Over the last couple of years, the hedge fund industry has expanded rapidly. Because of the important role that hedge funds play as participants in financial markets and as counterparties to financial institutions, especially banks, it has become increasingly important to monitor their activities and to assess the implications for financial stability. Against this backdrop, the ESCB Banking Supervision Committee decided to investigate the links between EU banks and hedge funds. This Box reports on the main findings of this survey.

Financial Stability Review Issue 2, 2005
8 December 2005
The syndicated loan market in the euro area matures into a distinct asset class

Abstract

Abstract

The global syndicated loan market has grown significantly over the last decade, with the total amount of gross issuance more than tripling between 1994 and 2004. The share of euro area borrowing rose from close to negligible levels just a few years earlier to reach 25% of global lending in 2005 (from January to October).

Financial Stability Review Issue 2, 2005
8 December 2005
Survey on major EU banks'perception of risks in the year ahead

Abstract

Abstract

This Box summarises the answers from a survey of banks’ perceptions of main risks for the year ahead. The survey was undertaken by the Banking Supervision Committee, with the assistance of the Working Group on Developments in Banking (WGBD), in February and March 2005, covering all EU Member States. It was similar to the one held in 2004 (see ECB (2004), Report on EU Banking Structures, November). It was completed by 99 banks, 43 of which were from euro area Member States, and 56 from non-euro area Member States. A maximum of five banks per country participated in the survey. The respondent banks were asked to state what they perceived as major risks and to distinguish between macroeconomic, financial market, sectoral, strategic and regulatory risks. They were then asked to assign different scores to these five broad categories on a scale from 1 (very low) to 5 (most important), and to elaborate in more detail what they felt constituted those risks.

Financial Stability Review Issue 2, 2005
8 December 2005
Assessing financial stability implications of recent findings from the ECB bank landing survey

Abstract

Abstract

The ECB’s Bank Lending Survey (BLS) provides timely qualitative evidence of the lending policies of the euro area banking sector, and should be a useful tool for detecting turning points in the credit cycle and potential credit crunches facing euro area households and firms. This Box examines recent developments in banks’ credit standards – and the underlying determinants – on the approval of loans to households and loans since early 2005, as reported in the October 2005 BLS.

Financial Stability Review Issue 2, 2005
8 December 2005
Financial conditions of large euro area banks

Abstract

Abstract

Problems in individual large euro area financial institutions could potentially spill over to other parts of the euro area financial system. For this reason, it is particularly important to monitor closely developments in these institutions. This Box complements the analysis in the main text by reviewing the recent financial results of a sample of large euro area banks. Because of the varying dates of implementation of IFRS by European banks, some of the set of euro area banks used in previous editions of this Review have begun to compile their financial statements under IFRS, whereas others have continued reporting under local or US GAAP (Generally Accepted Accounting Principles). During the implementation period, this complicates to some extent the analysis of financial statements from a financial stability perspective, given that IFRS and nonIFRS accounts are not directly comparable. Consequently, in order to ensure a consistent analysis, the large banks are analysed in two sub-groups depending on whether they reported their 2005 accounts under IFRS or non-IFRS.

Financial Stability Review Issue 2, 2005
8 December 2005
Developments in the european credit derivatives markets

Abstract

Abstract

European credit derivatives markets have, like their US counterparts, experienced rapid growth in the past few years. If history is a guide, such rapid growth is often accompanied by an increased potential for instability should conditions take a turn for the worse. This Box discusses the financial stability implications of recent events in these markets.

Financial Stability Review Issue 2, 2005
8 December 2005
Structural trends in the euro money market

Abstract

Abstract

The fifth study on the structure and functioning of the euro money market was conducted in early 2005 by the ECB together with the 15 national central banks (NCBs) that were members of the European System of Central Banks (ESCB) before 1 May 2004. The study was based on turnover data collected from banks covering the second quarters of 2003 and 2004. This Box reports on some of the main findings of this study, and draws attention to the following three main findings. First, although changes in the aggregate turnover of the euro money market were limited between the second quarters of 2003 and 2004, there were some notable compositional changes, especially in terms of growing activity in secured relative to unsecured market. Second, overall activity in the euro money market became less concentrated, although large differences have remained across market segments. Third, the growing use of electronic platforms to make transactions in many market segments produced a further narrowing of bidoffer spreads.

Financial Stability Review Issue 2, 2005
8 December 2005
The influence of mortage product innovations on risks to household debt sustainability

Abstract

Abstract

In an environment of strong competition, banks in the euro area have been offering new mortgage products targeted at a larger number of borrowers. With these new products, two previous obstacles to borrowing have been removed. First, it is now possible in some countries for households to borrow higher amounts with little or no down payment, through higher loanto-value ratios. Second, in a number of countries, other products have become available, allowing middle and lower-income borrowers to alter repayments relative to their financial resources, while borrowing larger amounts than might have been possible in the past. This has mainly been achieved by extending the average loan maturity (up to 30-35 years in some countries). This Box reviews the specific features of these mortgage products and their implications for the sustainability of household debt.

Financial Stability Review Issue 2, 2005
8 December 2005
Corporate earnings and sectoral exposure at risk in the euro area

Abstract

Abstract

An important determinant of corporate sector creditworthiness is the (expected) profitability of firms. When firms’ profitability begins to improve, the availability of internal sources of finance also rises, and often this is associated with, and even anticipated by, narrowing corporate bond spreads. In early 2005 there were some signs of a deceleration in the rate of profit growth of stock exchange-listed firms. Since aggregate figures may hide differences at the sectoral level, and because banks may have different exposures to different corporate sectors, this Box examines corporate earnings at a sector level, making links to the sectoral exposure at risk of euro area banks

Financial Stability Review Issue 2, 2005
8 December 2005
Sectoral profit and leverage developments of euro area listed non-financial corporations: evidence based on micro data

Abstract

Abstract

Following the slump in aggregate euro area corporate sector profitability in 2001 and 2002, there was a significant turnaround. At the same time, the accumulation of debt slowed down as companies sought to restructure their balance sheets. Since aggregate figures may hide differences at the sectoral level, and because banks may have different exposures to different corporate sectors, it is of interest to analyse measures of corporate financial performance at a sectoral level. This Box examines recent developments in profit and leverage indicators for the non-financial corporate sectors in the euro area based on firm-level data.

Financial Stability Review Issue 2, 2005
8 December 2005
The reform of the renminbi exchange rate regime

Abstract

Abstract

Against a background of large and growing global financial imbalances and concerns about the associated risks for global financial stability, international pressure mounted on the Chinese authorities to adopt a more flexible exchange rate regime in order to help curb growing global current account imbalances and to alleviate upward pressure on more flexible international currencies. Many analysts also expected that any revaluation of the Chinese currency would trigger greater exchange rate flexibility in other Asian countries. On 21 July 2005, the renminbi was revalued by 2% against the US dollar, from 8.2765 to 8.11, and the Chinese authorities announced that they had moved to a “managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies”. However, since the reforms, the renminbi has continued to be tightly managed against the US dollar, so that little impact on the scale of global imbalances can be expected in the short term.

Financial Stability Review Issue 2, 2005
8 December 2005
Credit deveolpments in the new non-euro area EU member states

Abstract

Abstract

Macroeconomic stabilisation and banking sector restructuring are two of the factors that have fostered financial sector development in several of the new EU Member States. Regulatory reforms, leading to increased competition and supply of new products have, together with improvements in domestic legal systems, also supported dynamic credit activity in these countries. In addition, favourable financing conditions, supported by low-inflation policies and higher incomes and income expectations, have encouraged strong credit demand, up from relatively low levels. This Box discusses some of the financial stability implications that could arise from the strength of credit growth in these countries.

Financial Stability Review Issue 2, 2005
8 December 2005
Falling savings and risk debt in the household sector: a financial stability risk?

Abstract

Abstract

The personal savings rate in the United States has declined steadily over recent decades and fell to a negative value in the third quarter of 2005. At the same time, household sector indebtedness has risen to historically unprecedented heights. Somewhat similar patterns have also been observed in other mature economies, such as Australia and Canada. These developments have occurred against a background of rising household sector net worth, an important part of which has been due to valuation gains on wealth holdings. This Box discusses some of the financial stability risks that could arise from an increased dependence on asset valuation along with any associated increase in leverage of household balance sheets.

Financial Stability Review Issue 2, 2005
8 December 2005
The recent surge in US share buybacks: causes and possible financial stability implications

Abstract

Abstract

From the second half of 2004 onwards, US corporations retired an extraordinary volume of equity from the market. Throughout 2004 and the first half of 2005, equity retirements in the US non-financial corporate sector exceeded gross equity issuance by USD 1,149 billion. In the first half of 2005, share repurchases by public companies listed in the S&P500 index reached a historical record. This Box discusses some of the causes behind the surge in equity repurchases by US firms, and highlights some of the possible financial stability implications of this.

Financial Stability Review Issue 2, 2005
8 December 2005
Measurement Challenges in Assessing Financial Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Financial stability assessment as currently practised by central banks and international organisations probably compares with the way monetary policy assessment was practised by central banks three or four decades ago – before there was a widely accepted, rigorous framework. The measurement challenges that lie ahead for financial stability assessment are formidable. However, it is important to acknowledge that significant progress has been made in recent years. Even though there is no obvious framework for summarising developments in financial stability in a single quantitative measure, a growing number of central banks around the world are making financial stability assessments and publishing financial stability reports, many of them based on a broad and forward-looking conception of financial stability.

Financial Stability Review Issue 2, 2005
8 December 2005
Financial Market Contagion

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Recent research has greatly improved the understanding of financial contagion. There are two main channels though which contagion may emerge among financial markets: physical exposure and asymmetric information. Contagion can be empirically identified through the propagation of extreme negative returns, the increase in interdependence compared to normal times, and the distinction from common shocks. The evidence on international financial market contagion suggests that it is a relevant phenomenon that has indeed occurred in various crises, but in severe form, it is rather rare. In most instances the breadth of contagion seems to be limited to specific countries or geographical regions. In addition, it is less frequent across different asset classes than within the same asset class. Finally, simple measures for market comovements, such as standard correlation coefficients, do not usually perform well as indicators of contagion.

Financial Stability Review Issue 2, 2005
8 December 2005
Assessing the Financial Vulnerability of Mortgage-Indebted Euro Area Households Using Micro-Level Data

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

From a financial stability viewpoint, the condition of household sector balance sheets can have an important bearing on the credit risks that banks face. As in other mature economies, increasing household sector indebtedness in the euro area over recent years has raised some concerns about sustainability and, as a corollary, creditworthiness. Drawing upon survey information contained in the European Community Household Panel (ECHP) database, this Special Feature highlights some of the characteristics of indebted households in the euro area, and analyses the degree of vulnerability of mortgage-indebted households.The picture that emerges from an analysis of micro data covering euro area households over the period 1994-2001 suggests an overall improvement in resilience. In particular, mortgage debt appeared to be held mostly by high-income households, which tend to have good prospects for servicing debt. Nevertheless, considering the substantial increase in house prices and the significant accumulation of mortgage debt in some Member States after theperiod covered by the data examined in this Special Feature, continued monitoring of household sector indebtedness is called for.

Financial Stability Review Issue 2, 2005
8 December 2005
What Determines Euro Area Bank Profitability?

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Banks are key components of the euro area financial system. Understanding the interplay between banks and their operating environment assists in identifying sources of risk and vulnerability within the system. This Special Feature attempts to examine the empirical importance of bank-specific, market structure and macro-financial factors on euro area banks’ financial performance over the last decade or so.

Financial Stability Review Issue 2, 2005
8 December 2005
Main Effects from the New Accounting Framework on Banks

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

The EU Regulation requiring all listed companies, including banks, to prepare consolidated financial statements in accordance with International Financial Reporting Standards (IFRS) has been a positive development that will increase the transparency and comparability of financial statements in the EU. However, the first-time application of these new rules will have a significant impact on financial statements which should be taken into account when analysing the accounting figures. The aim of this Special Feature is to provide a brief overview of the main ways in which IFRS will affect banks’ primary financial statements.

Financial Stability Review Issue 2, 2005
8 December 2005
Central Counterparty Clearing Houses and Financial Stability

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Central counterparty clearing houses (CCPs) play an important role in efficiently reallocating counterparty credit risks and liquidity risks in financial markets. However, as systemically important players, they must manage their risks in an adequate way in order to avoid creating new risks for financial stability.

Financial Stability Review Issue 2, 2005
31 May 2005
ESCB-CESR standards for securities settlemet systems

Abstract

Abstract

In October 2004, the Governing Council of the ECB and CESR approved a report entitled “Standards for Securities Clearing and Settlement in the European Union”. The report, prepared by a joint ESCB-CESR working group, contains 19 standards for securities settlement systems, in particular central securities depositories (CSDs), including international CSDs, and custodian banks in the EU. This Box briefly describes some of the most important aspects addressed by the 19 standards. A major aim of the standards is “to limit and manage systemic risk”. Five types of risks in the securities settlement process are explicitly addressed.

Financial Stability Review Issue 1, 2005
31 May 2005
Clearing of over-the-counter (OTC) derivatives transactions

Abstract

Abstract

In March 2005, the Bank for International Settlements (BIS) published its regular Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. The survey compiles statistics gathered by 52 central banks and monetary authorities around the world. The turnover part of the survey is based on data for April 2004. It covers both foreign exchange and OTC derivatives markets, while the part on positions in derivatives contracts reflects the situation as it was in June 2004 and purely covers OTC derivatives. This Box highlights some of the key findings of the survey and reviews some initiatives that have taken place in the development of infrastructures for post-trade processing in OTC derivatives markets.

Financial Stability Review Issue 1, 2005
31 May 2005
The core principles for systemically important payment systems

Abstract

Abstract

Safe and efficient financial infrastructures support the effectiveness of financial markets and can help in containing systemic risk. As payment systems are a core component of the financial system infrastructure, and as the volumes and values of transactions being transferred through payment systems around the world continue to grow, robust and efficient payment systems are indispensable. In order to contribute to preventing a potential malfunctioning of a payment system from triggering wider disruptions in the financial system and to maintain and promote robust financial systems, their design and operation should be based on internationally recognised and widely accepted standards. In January 2001, the G10 Governors endorsed a report entitled “Core Principles for Systemically Important Payment Systems” (also known as the Core Principles report). The Core Principles report extends the Lamfalussy Standards, which were designed for a very specific category of systems. It applies more broadly to systemically important payment systems of all types, not just to schemes that involve crossborder and multi-currency netting, and to all countries in the world. The Core Principles complement the six Lamfalussy Standards, the primary concern of which was the management of (non-)financial risk, with four further principles.

Financial Stability Review Issue 1, 2005
31 May 2005
The reinsurance market and catastrophe bonds

Abstract

Abstract

The balance sheets and creditworthiness of reinsurance companies are highly sensitive to catastrophic events such as natural disasters or terrorist attacks. In particular, the events of 11 September 2001 in the US were followed by substantial credit rating downgrades of all euro area reinsurance companies and, by May 2005, these assessments had not yet been fully reversed (see Chart B15.1) These reactions suggest that reinsurance might not be the most efficient way to handle losses from extremely large and infrequent events. After a major catastrophic event, capacity constraints in the reinsurance market tend to exert upward pressure on reinsurance premia.

Financial Stability Review Issue 1, 2005
31 May 2005
Distance to default as a measure of banking sector fragility

Abstract

Abstract

In making financial stability assessments, market indicators can complement traditional analysis of balance sheet indicators. As market indicators are based on securities prices which themselves contain the collective expectations of numerous market participants regarding the underlying fundamentals governing valuations, they are a potentially rich and comprehensive source of information, and have the important advantage of being forward-looking. If market participants take sufficient account of risks and vulnerabilities, such indicators can shed light on perceptions of the robustness of the financial system. Furthermore, their availability at very high frequencies facilitates continuous assessment. Nevertheless, it is important to bear in mind that the potential for securities prices to depart from the underlying fundamentals calls for caution: analysis of market-based indicators should not be a substitute for formal balance

sheet analysis. This Box examines the indicator properties of the so-called distance to default, a market-based indicator which provides a quantitative measure that can provide early indications of financial distress and fragility.

Financial Stability Review Issue 1, 2005
31 May 2005
Option-based indicators of future risks in euro area banks stock prices

Abstract

Abstract

In assessing financial stability, central banks use a wide range of tools to monitor the risks of financial institutions. Timely indicators – such as expected default frequencies (EDFs) and distances to default (DDs) – can be extracted from the prices of financial assets. Bank stock prices in particular reflect market participants’ views on the future earnings prospects of banks by discounting future dividends. EDFs and DDs in turn provide an assessment of the probability of banks experiencing financial distress (see Box 14). Compared to these indicators, option prices convey complementary information about the uncertainty perceived by market participants. By incorporating the market’s assessment of the expected future volatility of the asset price over the lifetime of the option, the observed prices of options provide additional information that goes beyond the expected average value contained in the stock price. This Box describes how information on uncertainty about future banking sector performance can be gauged from option prices.

Financial Stability Review Issue 1, 2005
31 May 2005
Measuring the interest rate risk of euro area banks using an asset pricing model

Abstract

Abstract

Banks are exposed to interest rate risk through a number of channels, some of which are offsetting. For instance, an increase in interest rates can have a direct and positive effect on banks’ expected net interest income whereas it can adversely affect the value of their fixed income holdings. In addition, by influencing the broad economic environment, changes in interest rates can also have indirect effects on banks. On one hand, higher interest rates can have a negative impact on banks’ credit quality and non-interest income. On the other hand, higher rates can also signal expectations of an economic upswing with positive future implications for the banking sector. This Box assesses changes in the interest rate risk of a selection of euro area banks by means of a method which makes use of the fact that banks’ equity prices contain information about their long-term outlook for profitability.

Financial Stability Review Issue 1, 2005
31 May 2005
Financial stability implications of the new international financial reporting standards

Abstract

Abstract

The International Financial Reporting Standards (IFRS) are the accounting rules issued by the International Accounting Standards Board (IASB). The policy discussion surrounding the IFRS has centred around the potential impacts on financial stability that could be both temporary and more permanent. This discussion has been particularly prominent in the EU given the adoption of Regulation (EC) No 1606/2002, which requires all listed European companies, including banks, to publish their consolidated financial statements in accordance with the IFRS from 1 January 2005 onwards. However, to ensure appropriate oversight, these standards need to be formally endorsed before they become legally binding in Europe. The EU endorsement process for accounting standards involves three stages.

Financial Stability Review Issue 1, 2005
31 May 2005
Assessing financing conditions with the ECB bank lending survey

Abstract

Abstract

The ECB’s Bank Lending Survey provides important qualitative information on a timely and regular basis about banks’ credit policies. By providing early indications of turning points in the credit cycle and potential credit crunches facing euro area households and firms, the survey constitutes a useful complementary source of information for assessing sources of risk and vulnerability to financial stability. With this perspective in mind, this Box examines recent

developments – including the underlying driving factors – in banks’ credit standards on the approval of loans to households and firms since late 2004, based on findings from the Bank Lending Survey.

Financial Stability Review Issue 1, 2005
31 May 2005
Corporate bond spreads and default expectations in the euro area

Abstract

Abstract

In theory, corporate bond spreads, defined as the difference between yields on corporate and government bonds with similar maturities, should be pricing in default expectations over the entire maturity of the bond. If the pattern in corporate bond spreads begins to suggest that market participants are not taking account of other forms of forward-looking information on default rates, this could be seen as a sign of myopia, and might suggest a risk of misaligned prices in the corporate bond market. This Box addresses the issue of whether prices in the euro area non-financial corporate bond market have become misaligned by examining the relationship between non-financial corporate bond spreads and two other forward-looking indicators for the short-term probability of default, i.e. over the next 12 months.

Financial Stability Review Issue 1, 2005
31 May 2005
The extension of the euro yield curve to ultra-long maturities

Abstract

Abstract

By expanding the range of securities available to agents for facilitating investment and the hedging of financial risks, financial innovation can – through better tailoring of risk-return trade-offs to individual wants and needs – contribute to enhancing the stability of the financial system. At the end of February 2005, the French Treasury issued the first euro-denominated 50-year government bond. The 4% Obligations Assimilables du Trésor (OAT) bond maturing in 2055 is the longest-maturity bond on the euro yield curve. Investor demand has been very high: while the issuance amount was EUR 6 billion, the order book reached a total volume of EUR 19.5 billion and the yield at issuance was 4.21%, just 3 basis points above the comparable 30-year bond at that time. Moreover, demand was widespread among different investor groups and by geographical distribution (see Charts B8.1 and B8.2). This Box examines some of the factors that motivated the launch of, and high demand for, this new OAT bond, an innovation which marks the creation of a new segment on the euro yield curve and represents a further step in the development of the euro fixed income market.

Financial Stability Review Issue 1, 2005
31 May 2005
The narrowing of bid-offer spreads in money market instruments

Abstract

Abstract

A notable pattern in the euro area money market – which comprises short-term deposits, FX swaps, repos and EONIA swaps – has been the continued narrowing of bid-offer spreads, especially in 2004. Bid-offer spreads can provide a yardstick of liquidity in the market; the increased volume and liquidity in the EONIA swap market has sometimes compressed spreads to less than a basis point, making it less attractive for banks to act as market makers. This Box reviews some of the factors that lie behind this compression of bid-offer spreads and assesses some of the possible implications.

Financial Stability Review Issue 1, 2005
31 May 2005
Household debt rations in the euro area from an international perspective

Abstract

Abstract

Household borrowing has increased considerably in a number of regions of the world over the past decade, bringing debt ratios to unprecedented heights. This has not only raised some questions about sustainability, but has also highlighted differences in the level and the evolution of debt ratios across countries. This Box examines the level of household debt ratios within the euro area and in comparison with a selection of mature economies

Financial Stability Review Issue 1, 2005
31 May 2005
The external financing conditions of small and medium-sized enterprises in the euro area

Abstract

Abstract

In raising external funding, small and medium-sized enterprises (SMEs) frequently face financing conditions that differ to those confronting larger enterprises. This is often due to the fact that enterprises of a different size tend to be exposed to different sources of economic risk. SMEs normally rely on just one or a few business lines, and are thus less diversified in their activities, and they are typically less well diversified geographically than larger firms. This means that SMEs are often more exposed to domestic demand developments. Moreover, without access to the capital markets, SMEs typically face more constraints in accessing external finance, as they are often limited to bank credit.

Financial Stability Review Issue 1, 2005
31 May 2005
Interest rate sensitivity of debt raised by non-financial corporations in the euro area

Abstract

Abstract

Low short-term interest rates, together with the progressive steepening of the euro area market yield curve observed in recent years, appear to have encouraged non-financial corporations (NFCs) to make increasing recourse to short-term and/or floating rate-based debt financing. To the extent that this has made corporate sector balance sheets more sensitive to rising short-term interest rates, this could have implications for the credit quality of banks. Against this background, this Box examines the short-term interest rate sensitivity of the outstanding bank debt and debt securities issued by firms.

Financial Stability Review Issue 1, 2005
31 May 2005
US Governement-Sponsored enterprises and systemic risk

Abstract

Abstract

In recent months, reputational and accounting problems at two US government-sponsored enterprises (GSEs), the Federal National Mortgage Association (FNMA, or “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”) have lent renewed impetus to the ongoing debate concerning the status of US GSEs and the risks that they pose. The two GSEs are privately owned corporations chartered by the federal government to achieve a public financial purpose. They have a line of credit to the Treasury; they are exempt from state and local taxes, which increases their profit margins; and no Securities and Exchange Commission (SEC) registration of their debt or mortgage-backed-securities (MBS) is required.

Financial Stability Review Issue 1, 2005
31 May 2005
Hedge funds and the crowding of trades

Abstract

Abstract

From an efficiency perspective, hedge funds can have a positive effect on the financial system: they contribute to market liquidity, play an important role in the price discovery process, contribute to the elimination of market inefficiencies, and can enhance investment diversification. However, the proliferation of hedge funds in recent years and their growing importance as participants in global financial markets has raised questions about the possible implications for financial market dynamics and, more generally, stability. As an increasing number of funds attempt to exploit profitable opportunities from similar strategies, concerns have been expressed that the positioning of individual hedge funds is becoming more similar or “crowded”. Moreover, the growth of the industry could also be leading to diminishing returns and could as a result push funds into greater risk-taking, through leverage, in order to satisfy the expectations of demanding investors. This Box examines the issue of the risk that crowded trades will result in adverse market dynamics by analysing recent hedge fund return performances from a historical perspective.

Financial Stability Review Issue 1, 2005
31 May 2005
US Current Account: interaction with the international investment position and adjustment channels

Abstract

Abstract

Large and growing global current account imbalances may be an increasing source of tension in the world financial system as they pose risks for financial and exchange rate market volatility, ultimately affecting the optimal allocation of world savings. These risks are well recognised in both academic and policy quarters, and there is a broadening consensus that the current composition of global current accounts could prove unsustainable from a long-term perspective, with the evolution of the US current account being seen as a key factor. This Box highlights specific trends that could undermine the sustainability of the US current account relative to its international investment position (IIP). It also discusses the possible channels through which an adjustment of global imbalances may take place.

Financial Stability Review Issue 1, 2005
31 May 2005
Assessing Financial Stability: Conceptual Boundaries and Challenges

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Central banks have a strong and natural interest in safeguarding financial stability. This special feature discusses some key ingredients that are needed for a systematic approach to financial stability monitoring and assessment. A good understanding of what is meant by financial stability and what is meant by financial instability, taken together, can serve to define the boundaries of the scope of the analysis. A balancing of financial efficiency and stability objectives may require an understanding of the safeguarding of financial stability less as a zero tolerance of bank failures or of an avoidance of market volatility, than as avoiding financial disruptions that have adverse consequences for the real economy.

Financial Stability Review Issue 1, 2005
31 May 2005
Indicators of Financial Distress in Mature Economies

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature analyses the indicator properties of macroeconomic variables and aggregated financial statements from the banking sector in providing early signals of distress in the banking sector. Identifying leading indicators of financial distress is important when assessing systemic risk within a broader financial stability analysis. An empirical model is estimated using data for 15 mature countries over the period 1980-2001. The analysis suggests that low economic activity, high domestic credit growth, rapid growth in property prices, as well as low profitability and low liquidity in the banking sector, have good properties as leading indicators of financial distress.

Financial Stability Review Issue 1, 2005
31 May 2005
Assessing the Determinants of Financial Distress in French, Italian and Spanish Firms

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

Knowledge of the determinants of financial distress in the corporate sector can provide a useful foundation for analysing the degree of credit risk facing banks, and represents a key input for assessing risks and vulnerabilities to financial stability. This special feature examines the determinants of corporate failure in Italian, Spanish and French SMEs in order to shed light on whether the predictors of financial distress in these countries are the same or not. This is done by estimating models for each of these countries and a common model for the three. This allows an assessment of the differences in the determinants of financial distress and in the predictive ability of the two model set-ups.

Financial Stability Review Issue 1, 2005
31 May 2005
Has the European Collateralised Debt Obligations Market Matured?

Abstract

JEL Classification

G00 : Financial Economics→General→General

Abstract

A market for collateralised debt obligations (CDOs) has evolved rapidly in Europe in recent years. Synthetically created CDOs based on credit default swaps have become a popular vehicle for transferring corporate related credit risk from the banking sector to other parts of the financial system. As with other new markets, CDOs contribute to financial efficiency, but also present new risks that central banks need to understand. From a financial stability viewpoint, concerns have been expressed about mispricing and inadequacies in risk management, even by the most sophisticated market players, as well as excessive reliance on rating agencies. Furthermore, public authorities face challenges in tracking credit risk around the financial system. Innovation and improvements in market functioning have helped to mitigate some of these concerns. In particular, the evolution of credit indices has fostered standardisation and secondary market activity. However, challenges for financial stability remain, requiring an ongoing monitoring of market developments by central banks.

Financial Stability Review Issue 1, 2005
15 December 2004
CPSS-IOSCO Recommendations for securities settlement systems

Abstract

Abstract

In November 2001, recommendations were published for the design and operation of securities settlement systems, drafted by a joint task force of the Committee on Payment and Settlement Systems (CPSS) of the central banks of the Group of Ten countries and the International Organisation of Securities Commissions (IOSCO). These 19 CPSS-IOSCO recommendations set out minimum standards tha