ECB published results of the financial stability review in May 2020. Among other issues, the financial stability review assesses operations of the financial system so far during the COVID-19 pandemic. Overall, the review concludes that the pandemic greatly amplified existing vulnerabilities of the financial sector, corporates, and sovereigns. Euro area banks, although now better capitalized, are likely to face significant losses and further pressure on profitability. The review also highlights that the policy responses to the pandemic are essential to preserve financial stability.
The review considers the financial stability implications of the potential economic after-effects of the pandemic while also taking account of the financial vulnerabilities identified before the pandemic, including those related to financial market functioning, debt sustainability, bank profitability, and the non-bank financial sector. The review also sets out policy considerations for the near and the medium term. This issue of the review contains two special features: one feature analyzes trends in real estate lending standards and derives implications for financial stability while the other feature discusses derivatives-related liquidity risk facing investment funds.
The results of the review highlight that, despite the immense social and economic disruption in the wake of the COVID-19 pandemic, decisive policy responses have helped to prevent a seizing-up of the financial system. Banks should benefit from the action of prudential authorities across the euro area to ease capital requirements and grant more operational flexibility to maintain the flow of credit to the economy. In addition, ECB Banking Supervision recommended that banks temporarily refrain from paying dividends or buying back shares, strengthening their capacity to absorb losses and avoid deleveraging. These capital measures are expected to remain in place until the economic recovery is well established. Short-term funding remained ample in euro area banks, which entered the stress episode with larger buffers than during the 2008 crisis. The Single Supervisory Mechanism has allowed banks to operate temporarily below the liquidity coverage ratio requirement, with the aim of banks using liquidity buffers to support the real economy.
However, the impact of COVID-19 on the economy and markets has increased existing vulnerabilities for euro area financial stability. Bank valuations fell to record lows and bank funding costs increased, despite the enhanced resilience since the global financial crisis. An expected increase in credit risk in the wake of the pandemic weakened the outlook for bank profitability, although in the near-term government schemes may offset some losses. Banks continue to face the challenges of operating in business continuity mode, including the associated increase in cyber risk. Banks also need to continue managing the implications of the transition to a greener economy. The main euro area central clearing counterparties were able to avoid operational disruption during the turmoil. Despite the high volatility in financial markets prompting large variation margin calls in both cleared and non-cleared derivatives markets, calls were in general met by market participants. The risk of corrections in euro area residential and commercial real estate markets has increased in the wake of the pandemic.
The assessment shows that credit rating downgrades of banks might increase their market funding costs, limit their ability to achieve minimum requirement for own funds and eligible liabilities, or MREL, targets, and weigh on future profitability. There remains a risk that credit rating agencies could downgrade sovereigns and/or banks on the back of rising credit risks. Such a development could reactivate the negative feedback loops of the sovereign-bank nexus, especially for Italy and Portugal, as well as for Spain, where bank ratings are closest to non-investment grade. The reforms to bank resolution and bail-in should reduce the strength of the nexus compared with past crises. However, the benefits of these reforms could be weaker if banks are unable to reach their targets in terms of issuing bail-in-able debt.
Keywords: Europe, EU, Banking, Insurance, Securities, Financial Stability Review, COVID-19, Macro-prudential Policy, Systemic Risk, Operational Risk, Credit Risk, Liquidity Risk, MREL, Basel, Credit Rating Agencies, ECB
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