ecb financial stability review -- 9-dec-2010

8/8/2019 ECB Financial Stability Review -- 9-DEC-2010

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F I N A N C I A L S t A b I L I t y R e v I e w

D e C e m b e R 2 0 1 0


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FINANCIAL STABILITY REVIEDECEMBER 2010

In 2010 all ECB publications

feature a motif taken from the

500 banknote.


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European Central Bank, 2010

AddressKaiserstrasse 2960311 Frankfurt am MainGermany

Postal addressPostfach 16 03 1960066 Frankfurt am MainGermany

Telephone+49 69 1344 0

Websitehttp://www.ecb.europa.eu

Fax+49 69 1344 6000

All rights reserved. Reproduction for educational and non-commercial purposesis permitted provided that the source isacknowledged.

Unless otherwise stated, this document usesdata available as at 19 November 2010.

ISSN 1830-2017 (print)ISSN 1830-2025 (online)


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PREFACE 7

I OVERVIEW 9

II THE MACRO-FINANCIAL ENVIRONMENT 17

1 THE EXTERNAL ENVIRONMENT 17

1.1 Risks and nancial imbalancesin the external environment 17

1.2 Key developments ininternational nancial markets 28

1.3 Conditions of global nancialinstitutions 36

2 THE EURO AREA ENVIRONMENT 42

2.1 Economic outlook and risks 422.2 Balance sheet condition of

non- nancial corporations 432.3 Commercial property markets 482.4 Balance sheet condition of the

household sector 50

2.5 Economic situation of thegovernment sector 53

III THE EURO AREA FINANCIAL SYSTEM 63

3 EURO AREA FINANCIAL MARKETS 63

3.1 Key developments in the moneymarket 63

3.2 Key developments in capitalmarkets 67

4 THE EURO AREA BANKING SECTOR 74

4.1 Financial condition of large andcomplex banking groups 74

4.2 Banking sector outlook and risks 774.3 Outlook for the banking sector

on the basis of market indicators 974.4 Overall assessment 100

5 THE EURO AREA INSURANCE SECTOR 10 2

5.1 Financial condition of large primary insurers and reinsurers 102

5.2 Insurance sector outlook and risks 104

5.3 Outlook for the insurance sector on the basis of market indicators 108

5.4 Overall assessment 109

6 STRENGTHENING FINANCIALSYSTEM INFRASTRUCTURES 11 0

6.1 Payment infrastructuresand infrastructure services 110

6.2 Securities clearing and

settlement infrastructures 114IV SPECIAL FEATURES 11 7

A STRESS-TESTING BANKS IN A CRISIS 11 7

B BASEL III 12 5

C COMPARING MACRO-PRUDENTIALPOLICY STANCES ACROSS COUNTRIES 13 3

D TOWARDS MACRO-FINANCIAL MODELS

WITH REALISTIC CHARACTERISATIONSOF FINANCIAL INSTABILITY 13 8

E NEW QUANTITATIVE MEASURESOF SYSTEMIC RISK 14 7

GLOSSARY 155

STATISTICAL ANNEX S1

BOXES

US government-sponsored1 enterprises: outlook and risks 22Capital ows to emerging markets2 34Have euro area banks been more3discriminating against smaller rmsin recent years? 45Government measures to safeguard4 nancial stability in the euro area 55Comparison of the US, UK and5EU macro-prudential frameworks 60Main ndings of the Euro Money6Market Survey 2010 65

CONTENTS


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Sensitivity of euro area banks7interest income to changes inshort-term market rates 77Assessment of the risks of EU banks8exposures to sovereign debt asrevealed in the exercise undertaken

by the Committee of EuropeanBanking Supervisors (CEBS) 84Evolution of euro area banks9customer funding gap 89Using data on MFIs statistical10revaluations to gauge informationon changes in banks trading-book valuations 93

CHARTS

1.1 Current account balances of selected economies 17

1.2 Gross government debt in theG7 countries and EME holdingsof foreign exchange reserves

181.3 US federal debt held by the public and the ten-year Treasury bond yield 19

1.4 US corporate sector pro ts 201.5 Distribution across forecasters

for US real GDP growth in 2011 201.6 US delinquency rates 201.7 US commercial property prices

by property type 211.8 US household net worth

and personal saving rate 21

1.9 US home sales 221.10 Outstanding deposits and loansin the non- nancial privatesector in selected non-euroarea EU countries 26

1.11 Unemployment rates in selectednon-euro area EU countries 26

1.12 General government balancesin non-euro area EU countries 26

1.13 Forecast of GDP growth and budget de cits in 2011 for selected emerging and advanced

economies 271.14 Consolidated cross-border claimsof euro area nancial institutionson emerging economies 27

1.15 Exposure of euro area banksto non-EU and EU emergingEurope 28

1.16 Spreads between the USDLIBOR and the OIS rate 29

1.17 The Federal Reserves balancesheet: liquidity support measuresand asset purchase schemes 29

1.18 Long-term bond yields andnominal growth expectationsin the United States 30

1.19 MOVE index of volatility in theUS government bond market 30

1.20 Issuance of RMBSs by private banks and GSEs, Federal Reserveholdings of RMBSs, and CMBSand CDO issuance 31

1.21 US investment-grade andspeculative-grade corporate

bond yields, as well as Treasury bond yields and spreads 31

1.22 S&P 500 equity index, S&Pequity volatility and risk appetite index 32

1.23 Price/earnings ratios for equitymarkets in emerging economies 33

1.24 Portfolio in ows into emergingeconomies 33

1.25 Net interest income and nettrading income of global largeand complex banking groups 36

1.26 Loan loss provisioning ratiosof global large and complex

banking groups 371.27 Return on shareholders equityand return on assets for globallarge and complex

banking groups 371.28 Tier 1 capital ratios for global

large and complex bankinggroups 38

1.29 Stock prices and CDS spreadsfor a sample of global largeand complex banking groups 38

1.30 Global hedge fund returns 39

1.31 Distribution of single-manager hedge fund drawdownsglobally 40

1.32 Hedge fund leverage 40


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CONTENTS

2.1 Distribution across forecastersfor euro area real GDP growthin 2011 42

2.2 Sales growth, return on assetsand cost/sales ratio of listednon- nancial rms in theeuro area 43

2.3 Total debt and interest burdenof non- nancial corporationsin the euro area 44

2.4 Expected default frequenciesfor selected non- nancial sectorsin the euro area 47

2.5 Changes in the capital valueof prime commercial propertyin euro area countries 48

2.6 Changes in the capital valueof euro area prime commercial

property, commercial propertyrent growth and euro area realGDP growth 49

2.7 Forecast for the capital valueof prime commercial propertyin the euro area 49

2.8 Household sector net worthin the euro area 51

2.9 Unemployment rates and forecastin the euro area countries 52

2.10 Unemployment rates andhousehold indebtednessin the euro area countries 52

2.11 Euro area household sectorsdistance to distress 53

2.12 Euro area bank, sovereignand corporate debt issuance 582.13 Government debt in euro area

countries by holder 592.14 Euro area sovereign debt maturity

pro le 593.1 Financial market liquidity

indicator for the euro areaand its components 63

3.2 EONIA volume and recourseto the ECBs deposit facility 64

3.3 Contemporaneous and forward

spreads between the EURIBOR and EONIA swap rate 64

3.4 Difference between long-termeuro area sovereign bond yieldsand the overnight index swap rate 68

3.5 Implied euro bond marketvolatility at different horizons 68

3.6 Euro area long-term government bond yields and nominal GDPgrowth expectations 69

3.7 Interest rate carry-to-risk ratiosfor the United States and theeuro area 70

3.8 High-yield and investment-grade bond issuance in the euro area 70

3.9 Issuance of asset-backedsecurities by euro area banks 71

3.10 Issuance of covered bonds inselected euro area countries 71

3.11 Spreads over LIBOR of euro areaAAA-rated asset-backed securities 72

3.12 Spreads between covered bondyields and euro interest rateswap rates 72

3.13 Sovereign credit risk andthe performance of nationalstock indices 73

3.14 Price/cash ow ratio and realGDP growth in the euro area 73

4.1 Euro area LCBGs return onequity and aggregated net income 75

4.2 Euro area LCBGs return onassets and leverage 75

4.3 Breakdown of euro area LCBGsincome sources and loan loss

provisions 754.4 Euro area LCBGs Tier 1 ratiosand contribution of components tochanges in the aggregateTier 1 ratio 76

4.5 Changes in credit standards for loans or credit lines to enterprisesand households 80

4.6 Commercial property loansextended by selectedeuro area LCBGs 81

4.7 Cumulative default rates of

commercial property loansincluded in CMBSs in the EU 81


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4.8 Aggregate contribution of pro ts,loan losses and risk-weightedassets to Tier 1 capital ratiosunder the baseline and adversescenarios 83

4.9 Distributions of Tier 1 capitalratios across euro area LCBGsunder the baseline and adversescenarios 83

4.10 Credit exposure of LCBGs tocentral and eastern Europe andemerging markets 87

4.11 Change in euro area banks accessto wholesale funding over the pastthree months 87

4.12 Debt maturities for euro area banks 88

4.13 Euro area banks net debt issuance 884.14 Currency decomposition of debt

issuance by euro area banks 914.15 Spread between short-term

household deposit rates and thethree-month OIS rates for selectedeuro area countries 92

4.16 Euro area yield curvedevelopments (based on euro areaswap rates) 92

4.17 Annual growth rates of MFIsgovernment bond holdings incountries where LCBGs are located 93

4.18 Annual growth rates of shareholdings by MFIs incountries where LCBGs are located 93

4.19 Dispersion of the CDS spreads of selected major European and USdealers in OTC derivatives markets 96

4.20 Estimated proportion of hedgefunds breaching triggers of cumulative total NAV decline 97

4.21 Euro area LCBGs equity pricesand ve-year senior CDS spreads 98

4.22 Systemic risk indicator and joint probability of distress of euro areaLCBGs 98

4.23 Decomposition of one-year senior

CDS spreads of euro area LCBGsand the price of default risk 99

4.24 Dow Jones EURO STOXX bank index and option-impliedrisk-neutral density bands 100

5.1 Distribution of gross-premium-written growth for a sample of large euro area primary insurers 102

5.2 Distribution of investment incomeand return on equity for a sampleof large euro area primary insurers 103

5.3 Distribution of gross-premium-written growth for a sample of large euro area reinsurers 103

5.4 Distribution of investment incomeand return on equity for a sampleof large euro area reinsurers 103

5.5 Distribution of capital positionsfor a sample of large euro areainsurers 104

5.6 Earnings per share (EPS) for asample of large euro area insurers,and euro area real GDP growth 104

5.7 Distribution of bond, structuredcredit, equity and commercial

property investment for a sampleof large euro area insurers 105

5.8 Investment uncertainty map for euro area insurers 105

5.9 Average guaranteed interest rateson life insurance policies, ten-year government bond yields and theten-year EUR swap rate 106

5.10 Atlantic hurricanes and storms 1085.11 CDS spread for a sample of large

euro area insurers and the iTraxxEurope main index 1085.12 Credit rating and market-implied

rating for a sample of euro areainsurers 109

TABLES

2.1 General government budget balance and gross debt 54

2.2 Change in general governmentdebt in the euro area 54


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PREFACEFinancial stability can be de ned as a conditionin which the nancial system which comprises nancial intermediaries, markets and marketinfrastructures is capable of withstanding shocksand the unravelling of nancial imbalances.This mitigates the likelihood of disruptions in the nancial intermediation process that are severeenough to signi cantly impair the allocation of savings to pro table investment opportunities.Understood this way, the safeguarding of nancial stability requires identifying the mainsources of risk and vulnerability. Such sourcesinclude inef ciencies in the allocation of nancialresources from savers to investors and themispricing or mismanagement of nancial risks.The identi cation of risks and vulnerabilities isnecessary because the monitoring of nancialstability must be forward looking: inef cienciesin the allocation of capital or shortcomingsin the pricing and management of risk can,if they lay the foundations for vulnerabilities,compromise future nancial system stabilityand therefore economic stability. This Reviewassesses the stability of the euro area nancialsystem both with regard to the role it plays infacilitating economic processes and with respectto its ability to prevent adverse shocks fromhaving inordinately disruptive impacts.

The purpose of publishing this Review is to promote awareness in the nancial industryand among the public at large of issues that arerelevant for safeguarding the stability of the

euro area

nancial system. By providing anoverview of sources of risk and vulnerability for nancial stability, the Review also seeks to playa role in preventing nancial crises.

The analysis contained in this Review was prepared with the close involvement of, andcontributions from, the Banking SupervisionCommittee (BSC). The BSC is a forum for cooperation among the national central banks andsupervisory authorities of the European Union(EU) and the European Central Bank (ECB).


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I OVERVIEWOVERALL ASSESSMENT OF THE EURO AREAFINANCIAL STABILITY OUTLOOK

The overall economic and nancial situationis still fraught with risks for nancial stability.The main source of concern stems from theinterplay between sovereign debt problemsand vulnerabilities in segments of the euro area

banking sector. Another important source of risk is the re-emergence of global imbalances andthe possibility of their disorderly unwinding.These two vulnerabilities have the potential togenerate negative surprises of potential systemicimportance. This issue of the Financial StabilityReview (FSR) assesses these risks and points tothe appropriate actions to avoid or to mitigatetheir effects.

It is, however, important to underline that, shouldthe current consensus baseline macroeconomicscenario for the euro area, which assumesmoderate growth, materialise, the euro area nancial sector is expected to further strengthenits resilience and pro tability in the period ahead.This assessment is supported by several importantdevelopments: rst, decisive actions taken atthe EU level by Member States includingadditional nancial backstop mechanisms set up

by governments and by central banks to support nancial stability; second, scal consolidationefforts by Member States; and third, increasedtransparency concerning nancial institutionsasset exposures.

The main risks for the euro area nancialsystem continue to include the concerns aboutthe sustainability of public nances, with the

potential for further adverse feedback betweenthe public nances, macroeconomic growthand nancial sector developments. Despite thefact that the interplay between vulnerabilities of economic growth, scal imbalances and bank funding conditions is prevalent in a limitednumber of euro area countries, which representa relatively small share of total euro area GDP,

risks of potential contagion to other euro areacountries remain. However, the establishment of the European Financial Stabilisation Mechanism,

the European Financial Stability Facility andthe ECBs Securities Markets Programmeshould help to reduce the adverse impact onthe euro area nancial system in case suchlow-probability events materialised. Furthermore,also the countries not directly affected by theabove-mentioned interplay may be experiencinggrowing risks of a renewed build-up of nancialimbalances in the context of persistently lowinterest rates.

Other, albeit less material, risks identi edoutside the euro area nancial system include the

possibility of a resurgence of global imbalances,with the risk of their disorderly unwinding. Theimpact of such risks, should they crystallise,would likely be rather heterogenous across thedifferent parts of the euro area nancial system.

Although the risks to euro area household andnon- nancial corporate sectors have declinedsomewhat compared with the assessment inthe June 2010 FSR in terms of their likelihoodof materialising, the volume of relatednon-performing loans could still be signi cant,owing to the important roles of these sectorsas sources and users of funds in the euro area nancial system.

Within the euro area nancial system, importantrisks include the possibility of a renewalof strains, because of heightened fundingvulnerabilities and dampened pro tability

prospects. Furthermore, vulnerabilities of some nancial institutions associated withconcentrations of lending exposures tocommercial property markets still exist.

Finally, there is also the possibility of heightened nancial market volatility, particularly in theeuro area government bond and stock markets,if the relatively favourable macroeconomicoutcomes recently seen in the euro area as awhole were to turn out not to have heralded amore robust economic recovery. This market

risk relates in particular to banks locatedin or exposed to countries with elevatedsovereign risk.


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In a broader sense, re ecting this link betweenmacroeconomic outcomes and nancial marketvolatility, a key concern in the period aheadis that many of the risks and vulnerabilitiesmentioned could be unearthed by a scenarioinvolving weaker than expected economicgrowth.

These main risks for euro area nancial stabilityare presented in the table below.

All in all, signi cant actions taken by euroarea governments in the spring and summer of 2010 to bolster con dence in the nancialsector were important to contain systemic risk in the euro area. This notwithstanding, giventhe potential for continued adverse feedback

between weak public nances and nancialsector vulnerabilities in many parts of theeuro area, there is no room for complacency.Strong commitments by governments to reinin public sector imbalances and to implementmeasures that support the competitiveness of and con dence in the euro area economy arenecessary to ensure nancial sector soundness inthe future. At the same time, banks should useopportunities available to bolster their capital

buffers, including the transitional period to theBasel III rules, to further improve their resiliencytowards possible shocks in the period ahead.

In an environment of divergent nancialmarket developments across the euro area,the timing and phasing of exit from remaining

public sector support measures pose particular challenges. Swift and decisive steps must betaken to address imbalances in those partsof the euro area nancial system where they have

been accumulating. In particular, the continuingdependence of a limited number of nancialinstitutions on public support in some countriesmeans that action is needed by the responsibleauthorities in the form of restructuring,de-risking and, where necessary, downsizing of the balance sheets of such rms. At the sametime, in those parts of the euro area wherelong-term interest rates have declined to verylow levels, partly re ecting safe-haven capitalin ows, risk associated with a renewed searchfor yield could be developing. The relevantauthorities need to remain particularly vigilantto prevent new imbalances from developingand further complicating the delicate balancethat is facing policy-makers in the period ahead.The importance of getting the timing of exit from

public support measures to the nancial sector right should not be underestimated. Withdrawalof public support must proceed with caution andcare, so as not to spark a setback to nancialstability which would ultimately threaten theeconomic recovery.

Main risks for euro area financial stability

Outside the nancial system,the main sources of risk for euro area nancial stabilityinclude the possibility of:

Concerns about the sustainability of public nances, with the potentialfor further adverse feedback between public nances, macroeconomicgrowth and nancial sector developmentsA resurgence of global imbalances and the risk of a disorderly unwindingof those imbalancesPockets of vulnerability being revealed in euro area non- nancialcorporations balance sheets, because of high leverage,low pro tability and dif cult nancing conditionsGreater-than-expected euro area household sector credit losses if unemployment remains high for a prolonged period, or surprises to the upside

Within the euro area nancialsystem, important risks includethe possibility of:

A renewal of strains on nancial systems, because of heightened fundingvulnerabilities and dampened pro tability prospectsVulnerabilities of some nancial institutions associated with concentrationsof lending exposures to commercial property markets being revealedHeightened nancial market volatility if macroeconomic outcomesfail to live up to market expectations


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I OVERVIEW

The next part of this section reviews the mainsources of risk and vulnerability that are

present in the macro- nancial environment.This is followed by an assessment of themain sources of risk and vulnerability thatare speci c to the euro area nancial system.The section concludes with a reference to thelatest regulatory developments.

SOURCES OF RISK AND VULNERABILITY OUTSIDETHE EURO AREA FINANCIAL SYSTEM

The main risk for the euro area nancial systemremains the concern about the sustainability of

public nances in some euro area countries witha potential for further adverse feedback effects

between public nances and the nancial sector.For some countries, the consequence has beenthe creation of conditions for adverse feedback loops to open up between downside risks toeconomic growth, bank funding vulnerabilitiesand scal imbalances. This triangle of vulnerabilities has already led to further strainsin a number of banking sectors, especially infunding markets, since the nalisation of theJune FSR. Various propagation and contagionchannels can be identi ed through whichsuch country-speci c disturbances couldspread wider in the euro area nancial system.As evidenced by the development of sovereign

bond spreads since summer 2010, nancialmarket participants seem to discount andfrequently revise their assessment of such risks

with particular emphasis on three euro areacountries.

Market concerns about sovereign credit risk didease somewhat in the second quarter, due to animproved general macroeconomic outlook andfollowing a number of policy initiatives thatwere put in place from May 2010 onwards including the ECBs Securities MarketsProgramme, the establishment of the EuropeanFinancial Stabilisation Mechanism and theEuropean Financial Stability Facility, as well as

the publication of the EU-wide macro-stress-testresults. Moreover, euro area countries announcedtheir commitment to undertake or accelerate scal consolidation. In the third quarter and also

more recently, however, perceptions of sovereigncredit risk were driven by increasing fears thatcontingent or implicit government liabilitiesassociated with state guarantees for the nancialsector could actually trigger sizeable governmentexpenditures in some countries.

The crisis has clearly demonstrated that limited progress with scal consolidation risks causingnegative nancial market reactions leadingto signi cantly higher nancing costs for sovereigns as the credit risk premium rises.This in turn increases the likelihood of anunsustainable debt spiral. At the same time,higher public sector nancing needs will alsoincrease bank funding costs through elevatedcompetition for bond investors funds.

Looking forward, it should be recognised that the bene cial growth effects of scal consolidationstemming from a decreased net present value of future taxes and a related reduction in uncertaintywith respect to scal sustainability in generalwill be felt mostly in the medium term. As aconsequence, short-term earnings prospects for

banks could suffer. However, these concernsin no way call into question the fundamentalneed for strong and swift scal consolidation inseveral euro area countries.

While the necessary consolidation efforts will be proceeding in the coming years, any successionof signi cant bad news concerning individual

banks, banking sectors or GDP growth in generalcould lead to a simultaneous, mutually reinforcingdeterioration of bank and sovereign nancingcosts. This triangle of vulnerabilities is at work independent of the initial source of the imbalance,which is, with respect to the two euro area countriesmost concerned, the government sector in Greeceand the banking sector in Ireland. In Greece the scal problem of the government sector triggereda reassessment among market participants of thecreditworthiness of the Greek banking sector,seriously restricting Greek banks access to market

funding, which nevertheless has improved recentlywith some banks being able to increase their capital. In Ireland, a more traditional banking crisisdue to impaired assets and excessive exposure to


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property lending has led to a recapitalisation needof the banking system which, simply due to thesize of the banking sector relative to the publicsector, constitutes a challenge for the country.Correspondingly, Ireland applied for an EU/IMF nancial support programme on 21 November, theterms of which were agreed on 28 November.

There are important side effects of the adverse scal- nancial-growth feedback mechanismwhich is at work in the euro area countries withlarge public sector imbalances. In this respect,and with moderate price developments over themedium term in the euro area, and some non-standard monetary policy measures in place,a generally low interest rate level across thewhole spectrum of the yield curve will prevailfor those countries not, or much less, affected

by concerns about domestic scal sustainability,due to safe-haven effects.

A further risk originating outside the euroarea nancial system is related to internationalcapital ows and the risk of overheatingemerging economies and related asset price

bubbles in the short run, and the re-emergenceof pre-crisis-style global imbalances in themedium run.

Net private capital in ows to emerging marketsare expected to increase signi cantly in 2010and 2011 compared with 2009. For euroarea investors, there is a risk of a swift future

correction of asset prices, should an emergingsearch-for-yield type of behaviour soon leadto large and possibly concentrated exposuresto certain emerging markets. The risk of anemerging market asset price boom-bust scenariohas not increased since the nalisation of theJune FSR, however, as some emerging marketeconomies have already enacted policy measuresto contain capital in ows or, as in the case of China, booming housing markets.

What is more likely to become a potential risk in

the medium run is the possibility of a resurgenceof global imbalances, in which in particular emerging Asia nances a US savings de cit,

leading to further growth of the net externalliabilities of the United States. Such a situationentails the risk of signi cant exchange ratevolatility should doubts about the sustainabilityof persistent US current de cits re-emerge.Behind this assessment is the observationthat part of the past reduction of US trade andcurrent account de cits appears to be cyclicaland these de cits have already been wideningagain during 2010, while the mirror image has

been observed in China. In order to support USeconomic growth and employment, the FederalReserve announced on 3 November a new roundof quantitative easing measures in the form of central bank bond purchases.

For the euro area, exchange rate volatilityrelated to an abrupt correction of globalimbalances would affect member countriesdifferently, depending on the geographicalstructure of foreign trade, as non-euro areatrade weights for individual countries varysigni cantly. This could potentially amplifydivergent cyclical developments and add tothe scal and nancial sectors dif culties inspeci c countries.

Although the overall outlook for euro areanon- nancial corporations has been improving,leverage is still relatively high. Some segmentsof the non- nancial corporate sector continue to

be confronted with dif cult nancing conditions,which makes these corporations balance

sheets vulnerable to shocks to their revenuesor nancing costs. But improving pro tstogether with the relatively low prevailing costof nancing, which mitigates rms interestrate burden, should support the ability of rmsto service their debt and thus improve their creditworthiness in the period ahead. Strains

persist however for some small and medium-sized enterprises (SMEs), on account of lower

pro tability levels and tighter credit standards.In addition, although the pro tability of non- nancial corporations should continue to be

supported by the recovery in economic activity,even if this recovery takes place at a moremodest pace, still subdued activity in some euro


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I OVERVIEW

area countries is likely to continue to weigh on pro tability in some markets and sectors of theeuro area. The overall assessment is thus rather one of a general improvement with respect torisks related to the euro area non- nancialsector, but pockets of vulnerability remain. Atthe euro area level, the construction as well aswholesale and retail sectors seem to be the mostvulnerable ones, due to their low pro tabilityand relatively high debt levels.

Turning to commercial property markets,although most euro area countries have witnessedsome improvements, prices are likely to remain

below the highs seen in previous years for some time to come. This poses risks for manyloan- nanced property investors and commercialmortgage-backed securities (CMBSs) withloans due for re nancing in the coming monthsand years. It cannot be excluded, therefore, thatadditional losses could materialise for some banksin the period ahead as a result of their exposure tocommercial property lending and investment.

Euro area household sector balance sheetconditions have broadly developed in linewith what was anticipated in the June 2010FSR. While the macroeconomic environmenthas continued to negatively affect householdsector balance sheets, the overall assessmentremains one of continued sustainability butwith important differences across euro areacountries. Vulnerabilities of household sector

balance sheets stemming from still subduedhousehold income prospects and residential property price developments therefore remain.Household income prospects are depresseddue to unemployment rates predicted to remainelevated and even to further increase in severaleuro area countries. House prices in some euroarea countries seem still to have potential for further downward adjustment.

SOURCES OF RISK AND VULNERABILITY WITHINTHE EURO AREA FINANCIAL SYSTEM

Since the publication of the June 2010 FSR euroarea banks rolled over substantially less funds

in the Eurosystem credit operations than theyhad borrowed in earlier operations. However,this decline in borrowing by banks from theEurosystem did not lead to any disruption in theeuro money market, despite some initial concerns

by market participants. Towards the end of the period under review, the availability of fundsalso beyond the overnight maturity improved for a selected number of stronger banks, whereasthe weaker banks seemed to nd it dif cult toaccess term funding and thus remained relianton liquidity provided by the Eurosystem.

Notwithstanding the reduced recourse toEurosystem operations, a number of indicatorscontinued to point to lingering counterparty creditrisk concerns in the euro money market. First,the difference between euro area unsecured andsecured interbank lending rates remained highand especially so for longer maturities. Amidremaining tensions in the euro money market,on 2 December 2010 the ECB announcedthat it would maintain the current xed ratefull-allotment policy for main re nancingoperations as long as necessary and at least until12 April 2011. The three-month longer-termre nancing operations (LTROs) will likewise beconducted with a xed rate tender procedure withfull allotment up to the end of the rst quarter of 2011. Second, the set of bidders in the Eurosystemoperations remains segmented, with a smallnumber of institutions which are excessivelyreliant on central bank liquidity accounting for

a substantial share of the overall re

nancingvolumes. Concerns about the challenges thatthese banks may face when the ECB will proceedfurther with the phasing-out of the enhanced creditsupport measures remain acute. At the same time,there have been further signs of normalisationin the access to market-based nancing by themajority of banks in the euro area.

In the euro area government bond markets, by the cut-off date for this issue of the FSR,the yields on the highest-rated long-term euro

area government bonds declined further fromthe levels that prevailed in mid-May 2010.The overall decline in yields was characterised


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by signi cant volatility which to a large extentre ected concerns among market participantsabout the outlook for global and euro areamacroeconomic activity as well as renewedworries about the scal situation in some euroarea countries. There were also occasional ight-to-safety ows which helped to depress theyields of high-grade euro area sovereign bondsin some cases to historical lows. At the other end of the rating spectrum, despite a spell of relief in July 2010 following several successfulgovernment bond auctions in peripheral euroarea countries and overall positive EU-wide bank stress-test results, intra-euro area government

bond yield spreads started widening again inlate August 2010 on account of resurfaced scal sustainability concerns. Overall, liquidityin certain euro area government bond marketsremained limited and the ECBs SecuritiesMarkets Programme was crucial in addressingthe malfunctioning of these markets.

The euro area securitisation markets remainimpaired, as re ected by the subdued issuancevolumes in the euro area asset-backed security(ABS) market, which have fallen to the lowestlevel since 2003. Insuf cient transparency aboutthe composition of the asset pools has beenidenti ed as one of the key impediments to asustainable recovery of securitisation markets.To partially address this issue, and since theEurosystem is one of the most important lendersagainst ABSs, the nal preparatory work

initiated in April 2010 on the establishmentof loan-level information requirements for ABSs in the Eurosystem collateral framework has advanced as planned so that the newrequirements should become applicable for newly issued ABSs in due course. These newrequirements will clearly increase transparencyin this market, thereby contributing to moreinformed risk assessments and helping torestore con dence in the ABS markets.

In the euro area equity markets, indices somewhat

recovered from the sharp correction in May 2010, but tended to uctuate within relatively tightranges. This was despite the fact that at the euroarea level, economic news tended to come in

more positive than what had been priced in bymarket analysts prior to the data releases. Rather,

prices seem to have ebbed and owed in line withchanges in market sentiment regarding scalsustainability risk, the soundness of the bankingsector and the macroeconomic outlook. Againstthis background, the performances of euro areanational stock market indices appeared to bestrongly in uenced by changes in the perceivedsovereign credit risk of the country. In thesecircumstances, should the future macroeconomicoutcomes at the euro area level no longer continue to surprise on the upside, volatility inthe equity markets may increase again.

The pro tability of those euro area large andcomplex banking groups (LCBGs) which reportquarterly earnings results continued recoveringin the second and the third quarters of 2010,mainly driven by further buoyant net interestincome, on average lower albeit in many casesstill high loan loss provisions and a steady streamof fee and commission income. Net interestincome (by far the most important revenuesource for this group of banks) continued to besupported by still relatively steep yield curvesand the continuing wide margins applied by

banks on new lending. In addition, since the nalisation of the June 2010 FSR it has becomeincreasingly apparent that growth in volumesof loans extended by banks in the euro area for house purchase could have passed a turning point.This development seems to have been driven

mainly by the low interest rates and improvedaffordability following sharp drops in house pricesin a number of euro area countries. That said, thereare substantial differences in developments acrossindividual Member States with lending for house

purchase remaining anaemic in countries where public nance problems have pushed long-terminterest rates to high levels and which face lessfavourable economic growth and employment

prospects. At the same time, bank lending to non- nancial corporations has recovered far moresluggishly in the euro area as a whole, re ecting

low demand and, in some cases, continuing tightlending standards applied particularly on riskier borrower categories, such as SMEs. In the periodahead, a prospective recovery in volumes of


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I OVERVIEW

corporate lending could provide a further boost to banks net interest income.

In contrast to the on average positivedevelopments in the LCBGs core maturitytransformation business, there was a remarkabledrop in the trading revenues of these institutions.This decline in trading income was a global

phenomenon and seemed to have continuedalso in the third quarter, mainly related to lower trading volumes. All in all, the marked volatilityin the two major income streams of LCBGs over the past years suggests that there is a risk thatthe recent recovery in LCBGs earnings may notturn out to be sustainable.

The only gradual recovery in LCBGs assetgrowth after a period of slowdown or an outrightcontraction in balance sheets in 2008-09 which in some cases was substantial and for some institutions was partly related to requiredmeasures taken in response to governmentsupport received in combination with efforts toraise new capital contributed to an improvementin LCBGs capital ratios across the board.While this improvement seemed to have cometo a halt in the rst half of 2010, it should benoted that the earlier recovery in regulatorycapital ratios among these institutions had beensubstantial, including for banks which hadrecorded the weakest ratios.

The positive developments in LCBGs solvency

ratios were also con

rmed by the results of the stress-test exercise, coordinated by theCommittee of European Banking Supervisors(CEBS) and developed in close cooperation withthe European Central Bank and the EuropeanCommission, which was completed in July2010. Altogether, 91 EU banks were coveredin the exercise, representing around 65% of the assets of the EU banking sector. Apartfrom covering credit and market risks in the

banks portfolios, the exercise also addressedmarket concerns over EU banks exposures to

sovereign risk from EU countries, on accountof which interbank market liquidity had fallenmarkedly in Europe, especially in the euro area,

in early May. The publication of the results on23 July 2010 increased transparency concerningthe holdings of sovereign debt by EU banksand identi ed pockets of vulnerability. In thiscontext, it is important to note that the severe

problems faced by some euro area banks outsidethe set of LCBGs in the months following the

publication of the stress-test results mainlyrelated to acute vulnerabilities in their liquidityand funding positions which were not the focusof the stress-test exercise.

While the EU-wide bank stress tests provideduseful information about the concentrationsof credit risk in the banking system, the extentto which different LCBGs are exposed to interestrate risks is less well-known and more challengingto assess. In particular, the sharp divergence inlong-term bond yields across individual euro areacountries implies that the interest rate risks faced

by banks operating in different parts of the euroarea could be very different in nature. On theone hand, banks operating in countries wherelong-term interest rates have increased sharplymay bene t from improved net interest incomein the short term, whilst they are exposed tomark-to-market losses on their holdings of xedincome securities. Going forward, the persistentlyhigh long-term rates are likely to start havinga more pronounced negative impact on these

banks earnings as volumes of new lending will be affected and the quality of new borrowersis expected to deteriorate. In contrast, LCBGs

which operate predominantly in countries wherelong-term interest rates are at very low levelsface the opposite type of risks, with the prospectof mark-to-market losses on unhedged xedincome exposures increasing as rates eventuallygo up. Against this backdrop, interest rate risk can be considered as the key unknown for theeuro area LCBGs in the period ahead.

Financial performance of euro area insurancecompanies remained stable, on average, in thesecond and third quarters of 2010. This was

in line with the expectations outlined in theJune 2010 FSR, although there was a wide variationin results across institutions. The main risks faced


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by insurers remain associated with the low levelof yields on AAA-rated government bonds andthe moderate recovery in economic activity.This notwithstanding, available informationon the solvency positions of euro area insurerssuggests that, on average, they have a reasonableamount of shock-absorption capacity to weather a materialisation of the risks they currently face.

REGULATORY DEVELOPMENTS

An important structural change that will have animpact on banks regulatory capital requirementsis the proposed revisions to strengthen globalcapital and liquidity regulations with the goalof promoting a more resilient banking sector (the so-called Basel III framework). Amongthe main items in terms of capital requirements,the new rules prescribe an increase in minimumrequirements for common equity and Tier 1capital, to be phased in gradually over a longimplementation period. The new rules also includea non-risk-based Tier 1 leverage ratio that willserve as a backstop to the risk-based measures.As regards the new liquidity regulations, themain element is a 30-day liquidity coverage ratio,underpinned by a long-term structural liquidityratio. The agreement on the new rules is animportant step towards bolstering banks future nancial soundness.

Finally, on 1 January 2011 the new Europeansupervisory framework will come into being,

with the establishment of the EuropeanSystemic Risk Board (ESRB) and the creationof three European Supervisory Authorities(ESAs) covering, respectively, banks, securitiesmarkets, and insurance companies and pensionfunds. This signi es a substantial strengtheningof the European supervisory structure bothat the micro- and for the rst time at themacro-prudential level, as the ESRB will havethe mandate to identify systemic risks for theEU nancial sector as a whole and to make

policy recommendations to contain those risks.


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II THE MACRO-FINANCIAL ENVIRONMENT1 THE EXTERNAL ENVIRONMENT

Due to some deterioration in the global macroeconomic outlook since the nalisationof the June 2010 Financial Stability Review(FSR), several risks originating outside theeuro area remain high or have even increased.

Notwithstanding quantitative monetaryeasing, persistently large scal de cits and corresponding high levels of debt, in part due toeconomic stimulus packages, heightened the risk of an increase in US bond yields, which could,in turn, spill over to global bond yields and lead to increases in the cost of capital and losseson xed income securities for banks around the world. At the same time, the emergence of risks stemming from weaknesses in household balance sheets has resulted in a further rise indelinquency rates and credit-related write-offsin mortgage lending-related sectors. In addition,the broad-based improvement in global money,equity and credit markets remains vulnerable tothe possibility of further reversals in risk appetiteand to negative news from the banking sector.The risks facing global nancial institutionsin relation to above-average write-offs oncommercial property loans, more challenging

funding conditions, and adverse macro- nancial developments also remain high. While theoutlook for emerging economies has improved,many have faced unexpectedly high capital in ows, although the risk of the re-emergenceof asset price bubbles across the region has not

increased further, thanks to the introduction of some macro-prudential measures. Finally, in themedium term, the risk of a re-emergence of

global nancial and current account imbalancesremains, which could eventually lead to abrupt

global capital movements.

1.1 RISKS AND FINANCIAL IMBALANCESIN THE EXTERNAL ENVIRONMENT

GLOBAL FINANCIAL IMBALANCESSince the nalisation of the June 2010 FSR

the adjustment of global nancial and currentaccount imbalances has halted, as a re ection of the cyclical adjustment of global trade and thesevere tensions in nancial markets. As a result,

US external imbalances increased, causing thetrade de cit to widen from 2.9% of GDP in thelast half of 2009 to 3.5% of GDP in the rst half of 2010 and 3.8% of GDP in the third quarter of the year.

There are several factors that could inthe absence of a signi cant cooling of theeconomy contribute to a further worseningof the US current account de cit in the periodahead (see Chart 1.1). A considerable increasein personal savings in the second half of 2009and the rst half of 2010 has been followed by aslight downward trend, on account of improvinghousehold net worth, despite still elevatedunemployment rates. This trend was drivenin part by strengthening private consumption,growing at an annualised quarterly rate of about2.6% during the third quarter of the year.

In emerging Asia, most notably China,current account surpluses rose again after the publication of the last FSR. This mainly

Chart 1.1 Current account balancesof selected economies

(2005 2015; percentage of US GDP)

12

8

4

0

-4

-8

12

8

4

0

-4

-8

other AsiaChinaoil exportersJapanUnited Stateseuro area

2005 2007 2009 2011(p)

2013(p)

2015(p)

Sources: IMF World Economic Outlook and ECB calculations. Note: (p) denotes projection.


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re ected a marked pick-up in exports due tostronger than expected foreign demand, as wellas lower import growth on account of decreasingimport prices and moderating domestic demand.In addition, the fading-out of scal stimulusmeasures and continued limited exchangerate exibility in some surplus economies inemerging Asia could contribute to an increasein current account surpluses in the region.In oil-exporting economies, in contrast, externalsurpluses remained relatively stable on accountof the stabilisation of oil prices over the past sixmonths (see Chart 1.1).

Looking forward, the risks of a resurgenceof global nancial imbalances might recedesomewhat over the short term to the extentthat the global economic recovery is losingmomentum. This re ects the cyclical natureof the adjustment of imbalances. At the sametime, the structural factors behind large global nancial and current account imbalancesremain in place and could together with thegrowing scal burden of advanced economies cause a resurgence of imbalances over themedium term.

In this respect, the main mechanisms behindthe build-up of large and persistent globalimbalances could be exacerbated by twofactors: the continuing symbiotic relationship

between public sector de cits and the growing scal burden in major advanced economies,

as well as public sector surpluses in the formof the excessive accumulation of foreignexchange reserves in major emerging economies(see Chart 1.2). Ultimately, this would underminethe credibility of any efforts to rebalance savingsand investment in a sustainable way, both withinand across the main imbalanced economies.As a consequence, the risk of potential funding

pressures in large de cit economies might risein the period ahead both in advanced economiesand globally, as the focus of investors concernsmay increasingly shift to the sustainability of

debt levels in the face of the uncertain resilienceof the economic recovery.

US SECTOR BALANCES

Public sectorThe ongoing shortfall of federal revenuesrelative to spending, together with theextraordinary policy response to the nancialcrisis, have led to considerable scal imbalancesin the United States. The budget outlook hasdeteriorated to some extent in comparison withthe June 2010 FSR.

According to the November Monthly BudgetReview published by the Congressional BudgetOf ce (CBO), the federal scal de cit stoodat 8.9% of GDP in the scal year 2010, onlyslightly below the de cit of 10.0% in 2009.Although the CBO expects a gradual further reduction of the federal budget de cit, scalimbalances are expected to persist over the nextten years, with the de cit, under current policies,estimated to stay in the range of 2.5% to 3.1%throughout 2013-20. As a result, federal debtheld by the public is expected to increase from

53% of GDP in 2009 to almost 70% by 2020and to rise further thereafter (see Chart 1.3).

Chart 1.2 Gross government debt in theG7 countries and EME holdings of foreignexchange reserves(1991 2015; USD trillions)

60

50

40

30

20

10

0

12

10

8

6

4

2

01991 1995 1999 2003 2007 2011

(p)2015

(p)

gross government debt of G7 economies (left-hand scale)emerging market economies foreign exchange reserves(right-hand scale)

Sources: IMF World Economic Outlook and ECB calculations. Note: (p) denotes projection.


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II THE MACRO-FINANCIAL

ENVIRONMENT

Federal debt would be higher if additional scalmeasures proposed in the 2011 Presidents

budget (such as extensions to income tax cuts)as well as new stimulus proposals made in

early September 2010 were to make it into law.Moreover, data on the federal debt held by the public do not include the debt of government-sponsored enterprises (GSEs) despite thefact that Fannie Mae and Freddie Mac have

been under government conservatorship sinceSeptember 2008 (see also Box 1). While part of this debt is likely to be recovered, it representsa potential additional implicit governmentliability.

According to an alternative scal scenario that

incorporates several changes to current law thatare widely expected to occur, the federal debtratio could rise to as much as 185% of GDP

by 2035 (see Chart 1.3). 1 There is a risk that the

unfavourable long-term budget outlook couldincrease the probability of a US scal crisis. 2 In such a scenario, investors would becomereluctant to nance all US government

borrowing needs unless compensated withsuf ciently high interest rates. Although remote,such a scenario could lead to a sudden and sharprise in interest rates from their currently lowlevel (see Chart 1.3). As a consequence,the CBO estimates that a four percentage pointrise in interest rates could nearly double federalinterest payments by 2015 relative to the

baseline projection. Thus, the scal outlook would worsen further, as maturing long-termdebt would need to be re nanced at higher rates.Aside from crowding out private investment,such a situation would severely constrain theroom for further policy actions if these wererequired. A further concern is that a rise ininterest rates would also reduce the market valueof outstanding government bonds, thus causinglosses for the holders of such bonds. This couldaffect both domestic and foreign investors andspill over into other global nancial markets,thereby causing renewed nancial turbulence.

The US government has a large number of options for improving the scal outlook and eliminating such risks. Proposals for consolidation will be spelled out by the FiscalCommission at the end of 2010 and an earlyagreement on credible consolidation measureswould help to dissipate uncertainty.

Corporate sectorAgainst the background of the ongoing modesteconomic recovery, the situation of the USnon- nancial corporate sector has continued toimprove since the nalisation of the June 2010FSR. On a quarterly basis, corporate pro tgrowth turned positive in early 2009 andremained robust throughout the rst half of 2010, though it slowed in the second quarter.The turnaround in pro ts, which initially had

been supported mainly by pro ts of domestic

Fore more details, see CBO, The long-term budget outlook,1June 2010.See CBO, Federal debt and the risk of a scal crisis,2 Economicand Budget Issues in Brief , 27 July 2010.

Chart 1.3 US federal debt held by the publicand the ten-year Treasury bond yield

(1939 2035; scal years)

200180

160

140

120

100

60

80

20

40

0

2018

16

14

12

10

8

6

4

2

0

19491939 1959 1969 1979 1989 1999 2009 2019 2029

alternative fiscal scenario, June 2010(percentage of nominal GDP; left-hand scale)

ten-year Treasury bond yield(percentage; right-hand scale)

baseline scenario, August 2010(percentage of nominal GDP; left-hand scale)

extended baseline scenario, June 2010(percentage of nominal GDP; left-hand scale)

Source: US Congressional Budget Of ce. Notes: The baseline is based on The budget and economicoutlook An update, August 2010, while the other twoscenarios are taken from Long-term budget outlook, June 2010.The extended baseline scenario adheres closely to current law.The alternative scal scenario incorporates changes to currentlaw that are widely expected to occur or that would modify some

provisions that might be dif cult to sustain over a long period.


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nancial industries, increasingly spread to pro ts of domestic non- nancial companiesand to a lesser extent to the rest of the world(see Chart 1.4).

Re ecting this strong pro tability, external nancing needs of non- nancial corporationsremain limited as capital expenditure is broadlycovered by gross savings. The outlook for corporate sector pro tability is somewhatuncertain, however, as cost-cutting by rmsvia employment reduction has contributedsigni cantly to pro t recovery and thus puts aquestion mark over the future development of aggregate demand. At the same time, a recentreassessment by nancial markets of the strengthand sustainability of the US economic recoverysuggests that there are downside risks to theoutlook for pro ts (see Chart 1.5).

Regarding the asset quality in nancialsector balance sheets, the quality of loans tonon- nancial corporations started to improvesomewhat after the nalisation of the June 2010FSR, despite a still elevated ratio of credit debt

to net worth of non- nancial companies inthe second quarter of 2010. The improvementis re ected in a decline in delinquencies andcharge-offs on commercial and industrial loansin the rst half of 2010 (see Chart 1.6) and inlower speculative-grade corporate default rates(see Chart S3).

Chart 1.4 US corporate sector profits

(Q1 2004 Q3 2010; percentage point contribution to year-on-year growth; seasonally adjusted)

50

40

30

20

10

0

-10

-20

-30

-40

11

10

9

8

7

6

5

4

3

22004 2005 2006 2007 2008 2009 2010

unemployment rate (percentage; right-hand scale)total corporate profits (left-hand scale)domestic non-financial industries (left-hand scale)domestic financial industries (left-hand scale)rest of the world (left-hand scale)

Sources: US Bureau of Economic Analysis and ConsensusEconomics.

Notes: Corporate pro ts include inventory valuation and capitalconsumption adjustments. Corporate pro ts data are onlyavailable up to Q2 2010.

Chart 1.5 Distribution across forecastersfor US real GDP growth in 2011

(Jan. 2010 Nov. 2010; percentage change per annum;maximum, minimum, interquartile distribution and average)

5.0

4.5

3.5

3.0

2.5

1.5

1.0

2.0

4.0

5.0

4.5

3.5

3.0

2.5

1.5

1.0

2.0

4.0

Jan. Feb. Mar. Apr. May June July Aug. Oct.Sep. Nov.2010

Source: Consensus Economics.

Chart 1.6 US delinquency rates

(Q1 1991 Q2 2010; percentages)

1991 1993 1995 1997 1999 2001 2003 2005 2007 20090

2

4

6

8

10

12

14

0

5

10

15

20

25

30

35

residential mortgages (left-hand scale)

commercial and industrial loans (left-hand scale)sub-prime residential mortgages (left-hand scale)

credit card loans (left-hand scale)commercial real estate loans (left-hand scale)

Sources: Federal Reserve Board of Governors and MortgageBankers Association.


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ECB


ENVIRONMENT

Even loan delinquencies in the commercial realestate sector which remains one of the weakestareas of the non- nancial corporate sector appear to have shown signs of stabilisationsince late 2009, in line with the slight increasein commercial property prices from their trough

in the fourth quarter of 2009 (see Chart 1.7).This increase mainly re ects the prices of properties for industrial use, multi-familyrental properties and to a lesser extent of ces.Meanwhile, the prices of retail properties thatare closely related to the residential housingmarket remain particularly weak and couldcontinue falling if downside risks to the USresidential property market materialise (see thehousehold sector section).

Household sector

The balance sheets of US households havecontinued to improve modestly since theJune 2010 FSR. Nevertheless, some nancialstability risks stemming from the US household

sector remain, largely as a result of increaseddownside risks attached to the US housingmarket and the general US economic outlook.

Net wealth as a percentage of disposableincome recovered somewhat from its trough in

early 2009, though this recovery was interruptedin the second quarter of 2010 as a result of a decline in nancial assets (see Chart 1.8).Meanwhile, the ratio of household net worth todisposable income remains below its long-termaverage. Nevertheless, recent upward revisionsto the personal saving rate imply that greater

progress in the repair of household balancesheets has already been made than previouslyexpected, which provides a more positive basisfor the medium-term outlook for consumption.

As a result of lower interest rates and a further decline in the ratio of the stock of household debtto income, there have been further improvementsin debt servicing and nancial obligations ratios,

Chart 1.7 US commercial property pricesby property type

(Q1 2001 Q2 2010; index: Q4 2000 = 100)

200

190

180170

160

150

140

130

120

110

100

90

200

190

180170

160

150

140

130

120

110

100

90

aggregate

apartmentindustrialofficeretail

2001 2003 2005 2007 2009

Sources: Moodys and MIT Center for Real Estate. Notes: The dynamics of the aggregate national price index differ

slightly from those of the main component indices as the indicesare measured at different dates and historical data are not updated(explaining the larger fall from the peak in the aggregate thanin the component indices). This out-of-bounds phenomenonis explained in more detail in Moodys/REAL CommercialProperty Price Indices, May 2010, Moodys Investors Service,special report.

Chart 1.8 US household net worthand personal saving rate

(Q1 1960 Q3 2010)

4.0

4.4

4.8

5.2

5.6

6.0

6.4

6.8

0

2

4

6

8

10

12

14

household net worth to disposable income (ratio;left-hand scale)

personal saving rate (percentage of disposable income;right-hand scale)

1960 1970 1980 1990 2000 2010

Sources: Bureau of Economic Analysis and Federal ReserveBoard.

Note: Net worth is only available up to the second quarter of 2010.


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which have returned closer to their long-termaverages (see Charts S5 and S6). In addition,delinquencies on consumer loans, most notablyon credit cards, have also started to come down(see Chart 1.6).

However, two main risks can be identi ed for the US household sector. First, the improvedsituation of the corporate sector, stemming toa signi cant extent from cost-cutting measures,

had negative repercussions on household sector employment. Indeed, the unemployment ratestood at 9.6% in October 2010, having comedown only slightly from its recession peak of 10.1% last October. Second, the situation inthe US housing market remains fragile and hasdeteriorated again, after the expiry of sometemporary government support measures.

In particular, home sales have declined sharplyfollowing the expiration of the rst-timehomebuyer tax credit extension at the end of April 2010 and only rebounded slightly in morerecent months (see Chart 1.9). This has broughtthe supply of homes on the market relative tothe current sales rate back to rates well abovelong-term averages. Meanwhile, charge-offs,delinquencies (see Chart 1.6) and foreclosureson mortgages continued to rise in the secondquarter of 2010, exerting downward pressureon house prices. According to the S&P/CaseShiller house price futures for the ten largestUS cities, and following a modest recoveryover the past few months, it is assumed thathouse prices will remain broadly at over the next year. Overall, the risks posed to thehousing market by elevated foreclosure rates,the still large imbalance between the supplyof and demand for homes and the waning of

policy stimulus thus remain on the downside(see also Box 1).

Chart 1.9 US home sales

(Q1 2006 Q3 2010; millions at an annualised rate)

1.2

1.1

1.0

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

7.0

6.5

6.0

5.5

5.0

4.5

4.0

3.5

expiration of first-timehomebuyer tax credit

expiration of tax

credit extension

existing home sales (left-hand scale)new home sales (right-hand scale)

2006 2007 2008 2009 2010

Sources: National Association of Realtors and US CensusBureau.

Box 1

US GOVERNMENT-SPONSORED ENTERPRISES: OUTLOOK AND RISKS

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which have been major providers of credit to US mortgage borrowers, have become increasingly relevantto nancial stability, in particular in the recent crisis. 1 First, in September 2008, due to thesystemic 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

1 The Federal Home Loan Bank System (FHLB), the Federal Agricultural Mortgage Corporation (Farmer Mac) and the Farm CreditSystem are also government-sponsored enterprises, but given their size and their role in the mortgage market, this box mainly focuseson Fannie Mae and Freddie Mac.


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ENVIRONMENT

December 2009 were extended to allow unlimited capital infusions over the next three years. 2 Against this background, this box examines the current role of the GSEs in the US housingmarket, their scal costs and the possible downside risks to the housing market and to nancialstability more generally once the support is scaled back.

The governments involvement via the GSEs has become pivotal for the US housing marketduring the crisis. First, as credit from private asset-backed securities issuers dried up, theGSEs became the only source of net positive mortgage nancing (see Chart A). As a result,in March 2010, the GSEs accounted for 53% of the total stock of home mortgages, comparedwith 40% in 2006. Second, the US Treasury and the Federal Reserve have purchased more than

USD 1.4 trillion of mortgage-backed securities (MBSs) issued by GSEs, thereby contributingto historically low mortgage rates and enabling more affordable mortgage repaymentre nancing. Furthermore, although the share of seriously delinquent loans remained elevated,GSEs contributed to a decrease in foreclosure rates and a decrease in excessive housing supply

by foreclosure prevention actions and re nancing activity for current mortgage borrowers(see Chart B). 3

Regarding credit risk, after the emergence of the crisis, GSEs faced signi cant losses on their credit portfolios, especially on mortgages which were originated in 2006 and 2007. As a result,since 2008 65% of their capital losses have been recapitalised by the Treasury to keep themsolvent (see Chart C). Looking ahead, since the GSEs underwriting standards were raisedonly after the government took control, there is a risk that losses from mortgages which were

2 Initially, the GSEs were allowed to draw up to USD 100 billion, which was later increased to USD 200 billion, in capital from the Treasury.3 Two programs were introduced in this respect: the Making Home Affordable Program and the Home Affordable Re nancing Program.

Chart A Net borrowing of US home mortgages

(Q1 1990 Q2 2010; USD billions; four-quarter cumulativeaverage ows)

1990 1993 1996 1999 2002 2005 2008

1,5001,250

1,000

1,5001,250

1,000

750 750

500

250

0

-250

-500

-750

500

250

0

-250

-500

-750

net borrowing of home mortgages

loans from MFIs

other

loans from GSE issuersloans from private ABS issuers

Source: Board of Governors of the Federal Reserve.

Chart B Foreclosure prevention actionsand current and performing loans

(Q1 2008 Q2 2010; thousands of loans (left-hand scale); percentage (right-hand scale))

10090

80

70

60

50

40

30

20

10

0

300

250

200

150

100

50

0

nonforeclosure home forfeiture actionsother home retention actionsforbearance plansrepayment plansloan modifications6 months after modification (right-hand scale)3 months after modification (right-hand scale)

2008 2009 2010

Source: Federal Housing Finance Agency.


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originated in 2008 are yet to materialise in 2010, given the fact that cumulative default rates for

mortgages issued in 2008 are higher than for those issued in 2006 (see Chart C).

As to the scal propagation channels, the GSEs debt obligations have enjoyed an implicitguarantee by the federal government which, together with tax and regulatory exemptions, hasresulted in sizeable federal subsidies. In January 2010 the Congressional Budget Of ce estimatedthat the subsidy costs would amount to 2.7% of 2009 GDP over the scal years 2009 to 2019,with the bulk of outlays occurring in 2009. Meanwhile, private sector estimates suggest evenlarger costs. Moreover, if the debt held by the two GSEs were to be accounted for as governmentdebt (currently not the case), this would signi cantly raise current federal debt levels: the GSEstotal debt was around 10.7% of GDP at the end of 2009. Against the background of the alreadyweak US scal situation, the support to the GSEs thus implies large contingent liabilities for thegovernment, which add to the risks of further growing scal imbalances.

The dependence of the US mortgage market on the GSEs, as well as on other forms of governmentsupport, highlights the risks of a renewed collapse of the US housing market and a real activitydrop in the event of a sudden government exit. 4 These risks could evolve into a negative feedback loop between the housing and nancial sector, leading to a signi cant deterioration of the credit

portfolio quality of small and medium-sized banks in particular. In such a scenario, there would be increased defaults on the part of several non-systemic institutions. At the same time, euro area nancial institutions would also be affected: directly due to a sharp decrease in the value of their MBS holdings and indirectly due to spillover effects to equity and debt markets, tapped by theGSEs for funding purposes.

4 For more details on the impact of US housing support initiatives on recent housing market developments, see for example Box 1, ECB,Monthly Bulletin , September 2010.

Chart C Cumulative default rateby origination year for single-familyconventional loans(2002-2009; basis points)

30

20

25

15

10

5

02002 20042003 20062005 2007 2008 2009

30

20

25

15

10

5

0

after 1 year - Fannie Maeafter 1.5 years - Fannie Mae

after 1.5 years - Freddie Macafter 1 year - Freddie Mac


Chart D Capital position of GSEs withRequested Senior Preferred Draw

(Sep. 2008 June 2010; USD billions)

180

130

80

30

-20

-70

-120

-170

-180

180

130

80

30

-20

-70

-120

-170

-1802008 2009 2010

Requested Senior Preferred DrawGAAP net worthcumulative drawscapital surplus



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ENVIRONMENTMounting scal costs and unsustainable dividend payments required from GSEs under theSenior Preferred Stock Purchase Agreement call for a reform of current GSE status. 5 Severaloptions are being discussed and the likely outcome is that some form of government supportfor these entities will prevail, although the scope may be scaled back. The options include full

privatisation, the transfer of key activities to the government and the re-establishment of theGSEs. From a nancial stability perspective, however, several conditions must be met to avoid arenewed housing decline: the US housing market must stabilise and private mortgage originationmust be revived. To achieve this, current nancial sector reforms need to be implemented insuch a way as to address dysfunctional aspects of securitisation markets: lack of transparency,

complexity and inappropriate incentives in the originate-to-distribute model.

5 The reform is also driven by the need to target subsidies at speci c groups determined by law-makers instead of providing a general subsidy.

REGION-SPECIFIC IMBALANCES

Non-euro area EU countriesMacroeconomic and nancial conditionshave strengthened further in the EU countriesoutside the euro area, but the key vulnerabilitiesremain broadly unchanged. There are, however,signi cant differences across countries in thisregard.

In most non-euro area EU countries, the prospects for economic activity have improvedfurther since the nalisation of the June 2010FSR, although the recovery is likely to bemuted and uneven. In the United Kingdom,the economic recovery has continued to bere ected in stronger than expected GDP growthin the third quarter, although the recovery stillfaces headwinds in the coming quarters. In

many non-euro area EU countries, domesticdrivers of growth remained depressed, whileoutput growth continued to depend on foreigndemand. Narrowing or stable credit defaultswap (CDS) as well as interest rate spreads,rising stock prices and appreciating currenciesvis--vis the euro suggest that nancialconditions have improved somewhat. In somecountries with IMF/EU nancial assistance

programmes, however, nancial conditionsweakened on account of market concernsregarding the continuation of assistance. Credit

growth has remained subdued or negative,re ecting both weak credit demand and tightlending conditions.

Although lending in foreign currency hasvirtually come to a halt, a key vulnerabilityremains the substantial currency mismatchon private sector balance sheets resultingfrom large shares of outstanding foreigncurrency loans. There is an ongoing concernthat potential currency depreciations couldsigni cantly add to the debt burdens of households or companies that are exposed tothis mismatch, in particular in view of somerecent volatility in exchange rates in a number of countries. In addition, the outstanding totalamount of domestic loans signi cantly exceedsthat of deposits in several of these countries(see Chart 1.10). High loan-to-deposit ratiossuggest that banks continue to depend stronglyon foreign funding (mostly in the form of

parent bank lending) and that there is a need tomobilise domestic deposits.

Another challenge facing banks exposed tonon-euro area EU countries stems from thedeterioration in credit quality, particularly inthose countries where output contracted stronglyand leverage was high. Household balancesheets, for example, are being stretched by higher unemployment, although in most countriesunemployment seems to have reached a peak (see Chart 1.11). Nevertheless, history showsthat non-performing loans tend to remain highfor several years following a nancial crisis.

The signi cant deterioration of scal positionsduring the past few years, which has contributed to


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still persistent scal de cits, albeit with signi cantdifferences across countries (see Chart 1.12), alsoconstitutes a risk. These scal imbalances couldundermine investor con dence and pose fundingchallenges for both sovereign issuers and the

banking sector in these countries.

Looking ahead, the economic outlook in thenon-euro area EU countries remains vulnerable toadverse disturbances, although macroeconomic

and nancial conditions have improved. Strainscould reappear quickly if investor risk aversionwere to rise as a result of uncertainties abouteconomic policies or political tensions in somecountries (particularly those with IMF/EU nancial assistance programmes). In addition,risk aversion towards the countries could alsoincrease as a result of spillovers from tensionsin other EU countries or a reassessment of risk in general. Such disturbances could leadto disruptions in key funding markets, whichwould heighten the re nancing challengesfacing banks and sovereigns. These risks areworsened by large currency mismatches in

some countries.

Emerging economiesOverall, economic recovery in emergingeconomies has continued since the nalisationof the June 2010 FSR. This has been particularlythe case in the major economies, such as China,India and Indonesia in emerging Asia, andBrazil in Latin America, where both robustdomestic demand and recovering global tradehave supported economic growth. Despite therecovery in economic activity, in ationary

pressures have remained contained in mostcases. Moreover, the recovery in economicactivity has also improved the scal situation inmost emerging economies (see Chart 1.13).

Chart 1.12 General government balancesin non-euro area EU countries

(percentage of GDP)

6

4

2

0

-2

-4

-6

-8

-10

-12

-14

6

4

2

0

-2

-4

-6

-8

-10

-12

-14

20072010

SE EE BG HU DK CZ PL RO LT LV UK

Source: European Commission.

Chart 1.10 Outstanding deposits and loansin the non-financial private sectorin selected non-euro area EU countries(Q2 2010; percentage of GDP)

local currencyforeign currency

120

80

40

0

40

80

120

120

80

40

0

40

80

120ROPLCZHULTBGEELV

deposits

loans

Sources: National central banks and Eurostat.

Chart 1.11 Unemployment rates in selectednon-euro area EU countries

(Jan. 2008 Sep. 2010; percentage of the labour force)

0

5

10

15

20

25

0

5

10

15

20

25

Czech Republic

Latvia

Hungary

Romania

Bulgaria

Estonia

Lithuania

Poland

2008 2009 2010

Source: Eurostat.


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ENVIRONMENT

Despite signi cant economic recovery, themacroeconomic risks for emerging economieshave increased compared with the June 2010 FSR.This is because, alongside the slowdown in activityin advanced economies, particularly the UnitedStates, economic growth in emerging economiesis expected to moderate in the quarters ahead.

In spite of some progress, without substantialstructural change and moves to rebalance sourcesof growth, emerging economies will remainvulnerable to increased macroeconomic risksstemming from the slowdown of the globaleconomy. Thus, the main macroeconomic risksfor emerging economies are related to the extent of the slowdown in activity in advanced economiesas well as to the robustness of domestic demandas scal and monetary policy support declines,as does the scope to provide such support.

Regarding nancial risks, both domestic andinternational nancing conditions for emergingeconomies have improved since the nalisationof the June 2010 FSR. At the same time,however, there has been an increase in nancialvulnerabilities related to the widening of currentaccount de cits, exposing countries to shifts ininvestor sentiment through their dependencyon shorter-term volatile capital in ows(see Section 1.2).

Regarding the risks related to cross-border lending, cross-border lending to emergingeconomies stabilised in the rst quarter of 2010,as a percentage of total assets, and decreased inthe second quarter of the year (see Chart 1.14),despite signi cant private capital ows into

portfolio investments in emerging markets.Lending patterns diverged signi cantly acrossemerging economies but, most notably, theshare of claims vis--vis emerging Europe and

Asia decreased.

In non-EU emerging Europe, non-performingloans continued to rise during the rst half of 2010 but the resulting losses were able to

be absorbed by large capital and pro t buffersin most countries. In Ukraine, however, bank recapitalisations of around 2.5% of GDP becamenecessary.

While the exposure of euro area banks tocredit risk originating in non-EU emerging

Europe is limited on average (around 5% of total cross-border claims of euro area banks),individual euro area countries hold up to20-30% of their total cross-border claims in

Chart 1.13 Forecast of GDP growthand budget deficits in 2011 for selectedemerging and advanced economies(Oct. 2010; percentages)

0

-2

-4

-6

-8

-10

-12

0

-2

-4

-6

-8

-10

-120 2 4 6 8 10 12

advanced economies

emerging Asia

Latin Americaand emergingEurope

x-axis: real GDP growthy-axis: budget deficit

RussiaTurkey

UkraineMexico

Brazil IndonesiaChina

India

US

UK

Argentina

euro area

Source: IMF World Economic Outlook, October 2010. Note: The largest three emerging markets of each region are shown.

Chart 1.14 Consolidated cross-borderclaims of euro area financial institutionson emerging economies(Q1 2003 Q2 2010; percentage of total assets)

0

1

2

3

4

5

6

7

8

9

0

1

2

3

4

5

6

7

8

9

2003 2004 2005 2006 2007 2008 2009

offshore centres

Latin America and Caribbean

Asia and Pacific

developing Europe

Africa and Middle East

Sources: BIS and ECB calculations.


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non-EU emerging Europe (which representsaround 1% of their total assets), a gurewhich rises to 50-75% (1.5-2% of their totalassets) if new EU Member States are included(see Chart 1.15).

Regional contagion effects could amplifya nancial shock stemming from a suddenunravelling of imbalances in the region.In particular, EU Member States which might

be perceived by investors as still sharing

certain vulnerabilities with non-EU countriesin emerging Europe could be negativelyaffected too. A deterioration of credit qualityin the whole region could have negativerepercussions on euro area banks with largeexposures to the region. The negative spilloverswould be exacerbated by the fact that euro area

banks own local subsidiaries and branches inthe region.

Looking ahead, the main risks to nancialstability for emerging economies relate to the

potential volatility in private capital in owsthat could in extreme cases either lead to suddenstops of capital in ows or contribute to theformation of asset price bubbles. In addition,

there are macroeconomic risks related to theextent of the slowdown in economic activity,whether through the decline in externaldemand or through the weakening of domesticdemand in the light of the withdrawal of monetary and scal policy stimulus measuresat home and abroad. Finally, in some countries,rising in ationary pressures could amplify themacroeconomic risks.

1.2 KEY DEVELOPMENTS IN INTERNATIONALFINANCIAL MARKETS

US FINANCIAL MARKETS

The money marketConditions in the US money market haveimproved since the nalisation of the June 2010FSR. After some tensions in the market inearly May, related to the re-emergence of counterparty risk, and uncertainties relatedmostly to the impact of sovereign risk on

banks sovereign debt holdings, conditionsin the US money market quickly normalised.The re-introduction of the swap lines betweenmajor central banks in May contributedto the stabilisation of and to an eventualdownward trend in spreads between the three-month US dollar London interbank offeredrate (LIBOR) and overnight index swap(OIS) rates. Moreover, three-month forwardspreads, which increased more signi cantly

in June, reverted to their pre-crisis levels(see Chart 1.16).

At the same time, OIS rates declined alongthe curve as expectations for the US economicoutlook were revised further downwards andexpectations of monetary policy tighteningwere signi cantly postponed. While some of the temporary liquidity facilities have alreadyexpired, the Federal Reserve decided to rollover the redemptions of the mortgage-backedsecurities (MBSs) and US Treasuries into new

asset purchases of US Treasuries, in order to maintain the size of its outright holdingsof securities. On 3 November the FederalOpen Market Committee (FOMC) announced

Chart 1.15 Exposure of euro area banksto non-EU and EU emerging Europe

(Q1 2010; percentage of total extra-euro area claims)

80

70

60

50

40

30

20

10

0

80

70

60

50

40

30

20

10

0AT GR IT BE PT euro

area NL DE FR IE ES

emerging Europe (including EU Member States)non-EU emerging Europe

Sources: BIS and ECB calculations. Note: Non-EU emerging Europe includes south-east Europeand the CIS countries.


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ENVIRONMENT

additional purchases of USD 600 billion of longer-term Treasury securities by the end of the second quarter of 2011 (see Chart 1.17).

The US dollar funding situation of European banks continued to be under scrutiny as the perceived counterparty risk for some European banks remained elevated in relation to their

exposure to certain sovereign debt. However,unlike at the peak of the Lehman crisis,US dollar funding seemed to be a questionof price rather than availability. US dollar rates implied by foreign exchange swapshave remained high but contained well below

post-Lehman levels, partly thanks to the swaplines between the Fed and the ECB.

Looking ahead, the majority of market participants expect a further expansion inthe balances of the Federal Reserve. Overall,

however, the likelihood of a faster thanexpected unwinding of the Federal Reserves balance sheet seems relatively remote at present(see section on government bond markets).

In addition to the possibility of a further rise inrisk aversion towards European sovereign debt,US money markets continue to be vulnerableto the risk of disruptions arising from abruptchanges in market regulation, which impliesmore severe restrictions on the maturity pro leof money market funds. Hence, while thesefunds signi cantly reduced the average maturity

of their asset holdings, they were at the sametime increasingly competing for risk-aversedepositors. As a consequence, in an environmentof low short-term interest rates, the pro tabilityof money market funds diminished, whichcould lead to signi cant out ows of funds.In combination with possibly more restrictiveregulation in upcoming banking reforms, theserisks could further increase the funding costsfor banks.

Government bond markets

US long-term government

ecb financial stability review -- 9-dec-2010

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