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    ECB Publishes Results of Financial Stability Review in May 2021

    ECB published results of the financial stability review in May 2021. The review assesses financial stability vulnerabilities—particularly in the corporate sector—and their implications for financial market functioning, debt sustainability, bank profitability, and the non-bank financial sector. This edition of the financial stability review covers analysis on the impact of climate change on financial stability in the euro area. The analysis shows that a significant share of bank loan exposures to corporates could be subject to a high level of climate-related physical risks, directly affecting firms’ operations or the physical collateral used to secure loans. Both the assessment of risks and the allocation of financing to support the transition to a greener economy can benefit from enhanced disclosures and data as well as clearer green finance standards.

    Climate-related risks to euro area banks, funds, and insurers could be material, particularly if climate change is not mitigated in an orderly fashion. Banks and non-bank financial institutions alike are faced with the task of managing the implications of climate change over the medium to long term. Both need to manage their exposure to a transition to a low-carbon economy and their exposure to physical risks associated with extreme weather and climate-related events or more insidious changes in climate. ECB analysis suggests that such risks appear to be concentrated in certain sectors, geographical regions, and individual banks, thus exacerbating the associated implications for financial stability. Climate-related financial risks that may emerge from the interplay between banks and insurers need to be recognized, with insurance coverage likely deteriorating as extreme weather and climate-related events become more frequent.

    Policy action may be required to ensure the resilience of the financial system to climate-related risks. Enhanced climate-related disclosure requirements, including in relation to companies’ forward-looking emission targets and deeper, more effective green financing are essential steps in a smooth transition toward a sustainable economy and a general reduction of climate-related vulnerabilities. The analysis shows that data and methodological gaps still need to be addressed to evaluate climate-related risks comprehensively. Possible market failures can stem from data gaps, which would raise the risk of greenwashing. The upcoming ECB climate stress test will analyze trade-offs in a forward-looking manner, thus providing a further basis for future policy discussions. Ultimately, given the systemic dimension, considerations about how to mitigate climate-related risks in the financial system require a macro-prudential perspective to be effective and to ensure cross-sector consistency.

    The review highlights that the aggregate non-performing loan (NPL) ratio of euro area banks fell further to 2.7% in the fourth quarter of 2020, mainly reflecting the disposal of legacy NPL assets. Amid the pandemic, banks in countries more affected by previous crises (Cyprus, Greece, Italy, and Portugal) have managed to continue reducing their NPL ratios by up to 9 percentage points. Nevertheless, the eventual expiration of public measures implies that asset quality of banks is likely to deteriorate further over 2021. However, overall, future asset quality depends on the timing and strength of the economic recovery and the exposure of banks to sectors most affected by the pandemic. The review also mentions that banks’ capitalization levels are well above the regulatory minimum requirements; therefore, banks have capital space to absorb losses. So far, it appears that banks with less capital space above regulatory buffers are reluctant to use these buffers. The EU-wide stress-test exercise, the results of which are expected by the end of July 2021, aims to provide additional insights into the resilience of the banking sector in Europe to a prolonged COVID-19 scenario in a lower-for-longer interest rate environment.

     

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    Keywords: Europe, EU, Banking, Financial Stability Review, COVID-19, Macro-Prudential Policy, Systemic Risk, Credit Risk, Climate Change Risk, NPL, ESG, Regulatory Capital, Stress Testing, ECB

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