FRANKFURT (MNI) – The withdrawal of public support measures for the
Eurozone’s banking system must be handled with “caution and care” in
order to avoid a setback to the recovery of the financial system and the
real economy, the European Central Bank said in its Financial Stability
Review, published Thursday.
In particular, the central bank warned of “acute concerns” about
the situation of banks still addicted to central bank funding once the
ECB resumes the phasing out of its non-standard liquidity support.
The euro area’s financial system still faces risks that could cause
problems of systemic dimensions, the document said. However, should
those risk not materialize, “then we can conclude that the financial
sector will continue to recover both in terms of resilience and
profitability,” ECB Vice President Vitor Constancio said in a press
conference at which he presented the Review.
The report warned that, “the importance of getting the timing of
the exit from public support measures to the financial sector right
should not be underestimated.” Divergent financial market developments
across the region make it exceptionally challenging to get the timing
right, it added.
The central bank called for “swift and decisive steps” in those
Eurozone member states where imbalances have been accumulating,
especially since conditions in euro area banks’ funding markets —
though better — “remain far from normal.”
“In particular, the continuing dependence of a limited number of
financial institutions on public support in some countries means that
action is needed by the responsible authorities in the form of
restructuring, de-risking and, where necessary, downsizing of the
balance sheets of such firms,” the ECB said.
It warned especially that “concerns about the challenges that these
[dependent] banks may face when the ECB will proceed further with the
phasing-out of the enhanced credit support measures remain acute.”
On the other hand, “in those parts of the euro area where long-term
interest rates have declined to very low levels … risks associated
with a renewed search for yield could be developing,” the ECB said. In
those cases, authorities must be “particularly vigilant to prevent new
imbalances from developing and further complicating the delicate balance
that is facing policymakers in the period ahead,” the report said.
The analysis reflects the growing challenge for the ECB as it
attempts to set a sound policy for the Eurozone as a whole. Tensions in
peripheral countries have forced the central bank to delay its exit from
non-standard measures even as the overall situation in money markets has
improved significantly. Meanwhile, a rising number of Governing Council
members warn against keeping non-standard measures in place for too
long.
The central bank said that under its baseline scenario, the euro
area financial sector should further strengthen its resilience and
profitability in the period ahead but warned that significant risks
remain.
The main risk to this outlook “stems from the interplay between
sovereign debt problems and vulnerabilities in segments of the euro area
banking sector,” the central bank warned.
“Given the potential for continued adverse feedback between weak
public finances and financial sector vulnerabilities in many parts of
the euro area, there is no room for complacency,” it said.
The ECB also noted that the risk of a negative feedback loop
between the sovereign debt crisis and the real economy could spread more
widely within the Eurozone, though it called this a “low probability
event.”
“Strong commitments by governments to rein in public sector
imbalances and to implement measures that support the competitiveness of
and confidence in the euro area economy are necessary to ensure
financial sector soundness in the future,” the ECB stressed.
“At the same time, banks should use opportunities available to
bolster their capital buffers, including the transitional period to the
Basel III rules, to further improve their resilience towards possible
shocks in the period ahead,” it added.
Recapitalization efforts are particularly important since banks
continue to face significant risks, “including the possibility of a
renewal of strains, because of heightened funding vulnerabilities and
dampened profitability prospects.”
“Sizeable refinancing needs over the next few years” will be a key
challenge as “banks will continue to compete for funds with the public
sector,” likely leading to higher cost. At the same time, fiscal
consolidation efforts may dampen short-term earnings prospects for
banks, the report said.
Persistently high leverage of non-financial corporations, together
with difficult financing conditions and weak profitability in some
segments and potential further losses as a result commercial property
lending exposure, pose some downside risks to the real economy, the
report said. However, ECB Constancio noted that “the risk stemming from
companies, the real estate sector and private households have decreased
since our last report.”
The report also warned that there is “the possibility of heightened
financial market volatility, particularly in the euro area government
bond and stock markets, if the relatively favorable macroeconomic
outcomes recently seen in the euro area as a whole were to turn out not
to have heralded a more robust economic recovery.”
And yet another risk stems from a possible widening of global
financial imbalances and a potentially disorderly unwinding of those
imbalances, which might result in “significant exchange rate volatility”
that could add to the fiscal and financial sectors’ difficulties in some
euro area countries,” the report said.
“Imbalances are forecast to continue to increase over the next few
years. The G20 has not found a solution to address this yet,” Constancio
noted. “It continues to be a source of concern in the international
monetary system.”
The report cautioned that vulnerabilities of the interplay between
sovereign problems and weakness in segments of the euro area banking
system, combined with the re-emergence of global financial imbalances,
“have the potential to generate negative surprises of potentially
systemic importance.”
–Frankfurt newsroom +49 69 72 01 42; e-mail: jtreeck@marketnews.com
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