ECB Sees Risks to Financial Stability amid Low Rates
Bank profitability prospects in the Euro Area have weakened against the backdrop of the deteriorating growth outlook and the low interest rate environment, especially for banks also facing structural cost and income challenges, the November Financial Stability Review showed. Banks’ non-performing loans ratios have improved slightly since the previous FSR, driven by both solid loan growth and continued, albeit slowing, reductions in NPL. Going forward, weaker economic activity and the related increase in new default inflows may make further reductions in NPL ratios more challenging.
11/20/2019 9:34:21 AM
Excerpts from the ECB Financial Stability Review, November 2019:
Bank profitability concerns remain prominent. Bank profitability prospects have weakened against the backdrop of the deteriorating growth outlook and the low interest rate environment, especially for banks also facing structural cost and income challenges. Reflecting these concerns, euro area banks’ market valuations remain depressed with an average price-to-book ratio of around 0.6. Alongside structural factors, such as legacy non-performing loan (NPL) problems and cost-efficiency, banks’ funding structure appears to have also played a role in shaping market perceptions of banks. Moreover, misconduct costs continue to be an additional factor weighing on bank equity valuations, while inconsistent disclosures may be making it difficult for markets to price banks’ climate-related risks.
The ECB’s introduction of a two-tier system for remunerating excess reserves aims to help the pass-through of low policy rates to bank lending. Banks continue to benefit from the positive volume effects, higher asset valuations and lower credit risk of low interest rates. However, the negative interest rate policy also entails costs for banks, and these are likely to increase the longer negative rates are in place, and the larger the amount of excess liquidity. Accordingly, the ECB introduced a two-tier system for reserve remuneration that will contribute to offsetting the direct impact of negative interest rates on banks’ profitability and thereby support the pass-through of low policy rates to bank lending.
Banks have made slow progress in addressing structural challenges to profitability. Banks’ NPL ratios have improved slightly further since the previous FSR, driven by both solid loan growth and continued, albeit slowing, reductions in non-performing loans. Going forward, weaker economic activity and the related increase in new default inflows may make further reductions in NPL ratios more challenging. In addition, low cost-efficiency, limited revenue diversification and overcapacity continue to weigh on many banks’ long-term profitability prospects.
Strengthening bank resilience remains key, given a weaker macroeconomic backdrop. Despite recent strong issuance of MREL/TLAC-eligible instruments, further progress is needed in building up bail-inable buffers. Banks remain susceptible to abrupt changes in market conditions which could require them to issue MREL-eligible debt at significantly higher costs. Also, macroprudential instruments could be used to mitigate some of the increase in euro area vulnerabilities, highlighting the importance of a continuation of the efforts to strengthen resilience to adverse shocks.
There remain four key vulnerabilities for euro area financial stability. These are (i) mispricing of some financial assets; (ii) high public and private sector indebtedness in several countries; (iii) hampered bank intermediation capacity in view of banks’ subdued profitability outlook; and (iv) increased risk-taking in the non-bank financial sector. While bank profitability challenges appear to have increased since the previous FSR, the likelihood of the other three vulnerabilities materialising in the near term appears largely unchanged, not least as the low interest rate environment mitigates many of the possible triggers for corrections over the short-to-medium term. Beyond the near-term horizon, however, there is a risk that the identified vulnerabilities could unravel in a disorderly manner. Macroprudential policies can help contain many of these vulnerabilities and should be used more actively in some countries. But further progress is still needed to develop macroprudential tools for non-banks.