Financial Stability Review - December 2009 issue

Presented at the press briefing by Vice-President Lucas Papademos, Frankfurt 18 December 2009

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

The extraordinary remedial actions taken by central banks and governments since late last year have been successful in restoring confidence in, and improving the resilience of, financial systems around the world. Financial system support measures have been addressing the funding challenges of key financial institutions and have bolstered their capital positions. These measures, together with sizeable macroeconomic policy stimuli, set in motion a mutually reinforcing process between financial system conditions and real economic performance, fostering improving business cycle prospects, as well as a fading of systemic risk.

An important reason for lowered systemic risk was an abatement of tail risk, thanks primarily to the downside protection by governments of financial institutions’ balance sheets. A recovery of risk appetite, underpinned by lowered systemic risk, contributed to the remarkable turnaround in financial markets since March 2009 and supported the trading income of large and complex banking groups (LCBGs). Many of these institutions also benefited from a considerable boost to net interest income on account of very steep yield curves. These better financial conditions strengthened the profitability of many LCBGs to such an extent that they were able to absorb considerable write-downs on securities and loans while still, on average, reporting material improvements in profitability over three consecutive quarters. Some were even able to return the capital they had received from governments, thus exiting from financial support.

Despite the recovery in financial markets and improved financial performance of euro area LCBGs, there are several grounds for caution in assessing the outlook for financial stability in the euro area. In particular, the main risks identified outside the euro area financial system include the possibility of:

  • vulnerabilities being revealed in non-financial corporations’ balance sheets, because of high leverage, low profitability and tight financing conditions;
  • greater-than-expected household sector credit losses if unemployment rises by more than expected;
  • the surge of government indebtedness raising concerns about the sustainability of the public finances, as well as the crowding out of private investment; and
  • an adverse feedback between the financial sector and public finances as a result of financial system support measures, fiscal stimuli and weak economic activity.

Within the euro area financial system, important risks include the possibility of:

  • renewed financial strains and that the recent recovery of bank profitability will not prove durable;
  • vulnerabilities of financial institutions associated with concentrations of lending exposures to commercial property markets and to central and eastern European countries being unearthed; and
  • a setback for the recent recovery of financial markets, if macroeconomic outcomes fail to live up to optimistic expectations.

All in all, the challenges facing the euro area banking sector in the period ahead call for caution in avoiding timing errors in disengaging from public support. In particular, exit decisions by governments will need to carefully balance the risks of exiting too early against those of exiting too late. Exiting before the underlying strength of key financial institutions is sufficiently well established runs the risk of leaving some of them vulnerable to adverse disturbances, possibly even triggering renewed financial system stresses. Late exits, on the other hand, can entail the risk of distorting competition, creating moral hazard risks that come with downside protection – including the possibility of excessive risk-taking – as well as exacerbating risks for public finances.

To cushion the risks that lie ahead, banks will need to be especially mindful in ensuring that they have adequate capital and liquidity buffers in place. If the circumstances require it, some banks may need to raise new and high-quality capital. In addition, some banks, especially those which have received state support, may need fundamental restructuring in order to confirm their long-term viability when such support is no longer available. This could involve the shrinking of balance sheets through the shedding of unviable businesses with a view to enhancing their profit-generating capacities. At the same time, banks should take full advantage of the recent recovery in their profitability to strengthen their capital positions, so that the necessary restructuring of businesses and the enhancement of shock-absorbing capacities do not impinge materially on the provision of credit to the economy.


Chart 1

The outlook for US residential property prices has improved over the past six months, although the stock of vacant homes remains large …

… while the decline in commercial property prices has been very sharp and the outlook remains negative.

Chart 2

After the slump in late 2008 and in early 2009 the profits of US non-financial corporations have improved …

… however, the main driver of the increase in profits has been cost-cutting, while revenues have been sluggish.

Chart 3

The global financial markets rebounded after the first quarter of 2009, reflecting positive developments in investors’ confidence …

… and the global hedge fund sector has been one of the beneficiaries, with almost all of the broadly defined hedge fund investment strategies having recouped much of the losses they had suffered in 2008.



Chart 4

The decline in euro area economic activity was sharp, but quarterly real GDP growth rates recently turned positive …

… and the latest Eurosystem staff macroeconomic projections show a gradual recovery in 2010, although the recovery process is likely to be uneven.

Chart 5

The expected default rates of euro area nonfinancial corporations have moderated somewhat from the peaks reached in early 2009 …

… but expected default rates remain elevated, reflecting high corporate sector leverage which is adding to the credit risks faced by euro area banks.

Chart 6

Conditions in the euro area commercial property markets have continued to deteriorate over the past six months …

… and they are expected to remain challenging until economic conditions improve and investors’ appetite for commercial property assets returns.

Chart 7

The slowdown in residential property price inflation in most of the euro area countries continued in the first half of 2009, with prices falling in almost half of the countries …

… and this was accompanied by a fall in the growth rate of loans extended by banks for house purchase.


Chart 8

Partly as a consequence of past reductions in policy interest rates, the slope of the euro area yield curve is steeper than it has ever been since the launch of the euro in 1999 …

… and this has supported the earnings of those euro area large and complex banking groups (LCBGs) that are engaged in maturity transformation activities (i.e. borrowing short-term and lending long-term).

Chart 9

The recovery in euro area equity prices has contributed to easier corporate financing conditions and to a strengthening of the trading revenues of LCBGs …

… while long term (cyclically adjusted) valuation measures suggest that equity prices are not particularly high by historical standards.

Chart 10

Euro area LCBGs’ earnings improved after the dismal performances of 2008, but some institutions still reported net losses …

… the main contributors to the recovery in earnings were trading income, owing to the buoyant market conditions, and net interest income, owing to the steep yield curve and wider lending margins.

Chart 11

Capital raised on financial markets, a reduction in risk-weighted assets and government support contributed to a broad-based improvement in the capital ratios of LCBGs …

… but the loan-loss provisions of euro area LCBGs have increased, with some institutions having to cope with particularly large provisions.

Chart 12

Better wholesale market funding conditions have contributed to a stabilisation in the take-up rates of funds committed by governments to support banking systems …

… while measures of concentration show that, for each support category for the euro area as whole, the share of the three largest recipient institutions represents around half of all funds tapped by euro area banks.


The latest estimate of the potential cumulative write-downs for the euro area banking sector is €553 billion for the period from 2007 to 2010, which is higher than the estimate published in the June 2009 FSR because of increasing write-downs on exposures to commercial property and the inclusion of write-downs on securities issued by central and eastern European countries …

… the latest ECB estimates put the potential further write-downs on assets for the euro area banking sector up to the end of 2010 at €187 billion.

Chart 13

The financial performance of large euro area insurers remained rather subdued in the second and third quarters of 2009, although investment income improved …

… and insurers further increased their investment exposures to corporate and government bonds.

Chart 14

Weak economic activity has continued to weigh adversely on the underwriting performances of euro area insurers …

… and the uncertainty in financial markets remains a challenge for the stability of insurers’ investment income.



  1. Towards the European Systemic Risk Board
  2. The concept of systemic risk
  3. Is Basel II pro-cyclical? A selected review of the literature
  4. Tools to detect asset price misalignments
  5. The importance of insurance companies for financial stability