ECB review an unsettling read
The European Central Bank released its semi-annual Financial Stability Review last week. While it did not receive much coverage here, it was the trigger for further volatility and investor nervousness in European financial markets in the first half of the week.The ECB observed many large and complex, eurozone, banking groups returned to modest profitability in 2009 and their financial performances strengthened further in the first quarter of 2010. These developments, together with increased capital buffers, to well above pre-crisis levels, suggest that most of these institutions have made important progress on the road to financial recovery. Furthermore, the dependence of the financial system, especially of large institutions, on government support and the enhanced credit support measures of the Eurosystem tended to wane. Nevertheless, ECB estimates of the potential write-downs on loans confronting the eurozone banking system displays a peak in 2010 and it is probable that loan losses will remain considerable in 2011, as well. This prospect, combined with continued market and supervisory authority pressure on banks to keep leverage under tight control, suggests that banking sector profitability is likely to remain moderate in the medium term.At the same time, the ECB said the progressive intensification of market concerns about sovereign credit risk in the early months of 2010 opened up a number of hazardous contagion channels and adverse feedback loops between financial systems and public finances. By early May, adverse market dynamics had taken hold across a range of asset markets in an environment of diminishing market liquidity, ultimately impairing the function of some markets.As a result of this, the main risks for the eurozone financial system include the possibility of concerns about the sustainability of public finances persisting or even increasing with an associated crowding-out of private investment; and adverse feedback between the financial sector and public finances continuing.The measures taken by the ECB to stabilise markets and restore their functioning, as well as the establishment of the European Financial Stabilisation Mechanism, have considerably lowered tail and contagion risks. However, the ECB argues that sizeable fiscal imbalances remain, and the responsibility rests on governments to frontload and accelerate fiscal consolidation, so as to ensure the sustainability of public finances, not least to avoid the risk of a crowding-out of private investment while establishing conditions conducive to durable economic growth. With pressure on governments to consolidate their balance sheets, disengagement from financial sector intervention means that banks will need to be especially mindful of the risks that lie ahead. In particular, they should ensure that they have adequate capital and liquidity buffers in place to cushion the risks, should they materialise. Against this background, the problems of those financial institutions that remain overly reliant on enhanced credit measures and government support will have to be tackled decisively, said the ECB. Fundamental restructuring will be needed when long-term viability is likely to be threatened by taking away state support.