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July 19, 2018

IMF issued reports presenting findings from the surveillance of financial sector policies in the Euro area. The published documents include the staff report and the selected issues report under the 2018 Article IV consultation, the financial system stability assessment (FSSA) report, and several technical notes under the Financial Sector Assessment Program (FSAP). The technical notes are on detailed assessment of observance (DAO) of Basel Core Principles for Effective Banking Supervision (BCPs); stress testing the banking sector; bank resolution and crisis management; systemic liquidity management; systemic risk analysis; insurance, investment firm, and macro-prudential oversight; and supervision and oversight of central counterparties (CCPs) and central securities depositories (CSDs).

The FSSA reveals that the resilience of large euro area banks has improved, but important vulnerabilities remain. Capital buffers are, in aggregate, sizable relative to the immediate threats, but some banks are especially vulnerable to credit risk and others to market risks. The banking system has ample liquidity, against a backdrop of ECB support. Risks to financial stability relate mainly to tighter financial conditions, weaker growth, and policy and geopolitical uncertainties. The withdrawal of the United Kingdom from the EU (Brexit) could potentially disrupt financial market and services and thus the wider economy. Also, policy reversals could hurt debt sustainability and test the cohesion of policy making in EU. Overall, banking supervision in the euro area has improved significantly following the creation of the Single Supervisory Mechanism (SSM). A detailed assessment against BCPs finds that SSM has established its operational independence and effectiveness, intensifying supervision while harmonizing at a high level. SSM has also implemented sophisticated risk analysis in the process of setting capital targets for individual institutions.

Nonetheless, banking supervision continues to face important challenges, mostly related to resources, liquidity risk, credit risk, and the fragmentation of national laws. Supervision would be more effective in case of more assured continuity in the assignment of suitable resources provided by national competent authorities. Gauging in real time the evolving capacity of a weak bank to cope with potential liquidity strains is essential. Addressing the persistence of nonperforming loans (NPLs) in some member countries must remain a supervisory priority. Beyond that, common definitions of NPL, minimum standards for insolvency and creditor rights, and rules for valuation of collateral would accelerate resolution of NPLs. Gaps and fragmentation in areas such as fit and proper criteria, major acquisitions, related party transactions, country risk, and sanctions need to be addressed while minimizing divergence at the national level. Divergences from international standards should also be eliminated. In addition, further efforts are needed to ensure effective coordination of prudential supervision with the oversight of anti-money laundering structures.

The assessment highlights that financial oversight of the nonbank financial sector is likewise being strengthened. More centralized oversight of financial market infrastructure by ESMA and ECB is warranted, given the systemic nature of the entities involved. Macro-prudential policy will have to become more adept at addressing risks related to cross-border flows and nonbank sources of financing as the financial system evolves. Bank crisis preparedness and management have been substantially upgraded, but here too the regime remains fragmented. The adoption of the Bank Recovery and Resolution Directive (BRRD) and Single Resolution Mechanism Regulation (SRMR), along with the creation of the SSM and the Single Resolution Mechanism, provide a foundation for dealing with problem banks. The bank crisis preparedness and management framework faces significant transitional and structural challenges. A critical transitional challenge is the buildup of bail-in-able financing (known as MREL), which should be expedited, prioritizing large banks. Effective resolution will depend in part on the ready availability of adequate financial resources; thus, it is essential to make fully operational the Single Resolution Fund, to designate the European Stability Mechanism as its backstop, and establish a European Deposit Insurance Scheme (EDIS).

 

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Keywords: Europe, EU, Banking, Insurance, Securities, PMI, FSSA, Article IV, Technical Notes, FSAP, IMF

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