Publication of the December 2006 ECB Financial Stability Review

The European Central Bank (ECB) today publishes its December 2006 Financial Stability Review.

The Review, which has been published semi-annually since December 2004, assesses the stability of the euro area financial system with regard to both the role it plays in facilitating economic processes and its ability to absorb adverse disturbances and prevent them from having an inordinately disruptive impact.

The analysis contained in the Review has been prepared with the close involvement of the Banking Supervision Committee, which is a forum for cooperation between the ECB and the national central banks and supervisory authorities of the EU.

The purpose of the Review is to promote awareness in the financial industry and among the public of issues relevant to safeguarding the stability of the euro area financial system. By providing an overview of sources of risk and vulnerability with regard to financial stability, the Review also seeks to play a role in preventing financial crises.

As has been stressed in the past, calling attention to such sources of risk and vulnerability does not mean seeking to identify the most probable outcome. Rather, it merely entails highlighting potential and plausible sources of downside risk, even if the probability of their realisation is relatively low.

The main points of the overall assessment of the stability of the euro area financial system contained in the Review can be summarised as follows:

The strength and resilience of the euro area financial system has been confirmed in the six months to 3 November 2006, the cut-off date of the Review. The system has so far proven resilient to adverse disturbances. Although there was a bout of volatility across a broad range of financial markets during May and June 2006, markets comfortably absorbed disturbances and no major financial institution was significantly impacted. Earlier concerns that an idiosyncratic collapse of a large hedge fund could trigger adverse asset price dynamics were mitigated by the fact that the plunge into financial distress in September 2006 of Amaranth Advisors had little discernible impact on markets. In the euro area, conditions for raising funds in the credit and equity markets remained favourable, there was further broad-based improvement in the profitability of banks, and the balance sheets of insurance companies were strengthened further. Key financial infrastructures, including payment systems such as TARGET, and securities clearing and settlement systems, remained robust and continued to operate smoothly.

However, over the same period of time, several potential sources of risk and vulnerability for euro area financial system stability have remained, others have grown in importance, and some new ones have begun to emerge. In the global and euro area financial systems, to the extent that long-term interest rates and risk premia have been driven too low in some financial markets, asset valuations could prove vulnerable to several potential adverse disturbances, which could leave banks exposed to greater than normal risks, especially if market events were to challenge the loss-absorption capacities of their counterparties. There has also been growing unease about the extent of credit risk transfer outside the banking system. As regards sources of risk and vulnerability outside the euro area, large global financial imbalances remain a global source of medium-term risk for the stability of financial systems, despite some rebalancing of global growth patterns and recent declines in oil prices. In the euro area, rapid re-leveraging in some parts of the corporate sector – partly induced by a surge in leveraged buyout activity facilitated by private equity funds – and growing household sector financial imbalances will require close monitoring in the period ahead.

Looking ahead, the durability of euro area banking sector profitability could, despite its current strength, be tested in the period ahead. In recent years large banks in the euro area have managed to improve their profitability in a challenging operating environment characterised by a flattening market yield curve, margin erosion and intense competition. At the same time, the solvency positions of these banks have remained comfortable. There is, however, some concern that intense competition could have encouraged banks to loosen credit standards, which could have left them with greater exposures to the risk of adverse credit events. While the direct market risks faced by large euro area banks are likely to prove manageable, banks may still face risks in other market-related business activities as well as counterparty risks from both non-financial and non-bank financial firms where risk management practices may be less advanced.

All in all, the central scenario for euro area financial stability remains broadly favourable but there is no room for complacency as several sources of risk and vulnerability can be identified. On the positive side, the resilience of the system was confirmed by its ability to comfortably absorb adverse disturbances over the past six months. In addition, global economic activity is becoming more evenly balanced, the gradual shift to less accommodating monetary policies is proceeding smoothly, the credit quality of the key counterparties of banks – households and firms – generally remains high and large euro area banks are very profitable, their solvency ratios are comfortable and risk management continues to improve. However, a global source of medium-term risk for the stability of the financial system continues to be the large global financial imbalances. In global and euro area financial markets long-term yields and credit spreads remain very low, and thus vulnerable to a reappraisal of risk. At the same time, important risks may be developing – although they are extremely difficult to quantify – related to credit risk transfer markets in which hedge funds have become increasingly present. In addition, there has been rapid re-leveraging in some parts of the corporate sector, induced in part by a surge in leveraged buy-out (LBO) activity, and household sector financial imbalances continue to grow and are especially sizeable in a number of countries.

Further information

The Review can be downloaded from the “Publications” section of the ECB’s website (http://www.ecb.europa.eu/pub). Printed copies are also available free of charge from the ECB’s Press and Information Division at the address given below.