ECB: Sov. Debt/Bank Sector Interplay Key Fin Stability Risk

Author: Market News International | Category: News

FRANKFURT (MNI) – The interplay between vulnerable public finances
and the banking sector represent a “key risk” to financial stability in
the Eurozone with potential contagion still “the most pressing concern,”
the European Central Bank said in its Financial Stability Review
published on Wednesday.

“For the euro area, this risk has been manifested in applications
for EU/IMF financial assistance from three countries, albeit countries
with a particularly malign set of vulnerabilities in the form of
intertwined fiscal, macroeconomic and banking sector issues,” the
central bank said.

The ECB also highlighted the growing challenges faced by the Greek
government in implementing its consolidation program, and stressed the
dangers of a debt restructuring for Greece.

“In light of the potentially very dangerous implications of
sovereign debt restructuring for the debtor country, including its
banking system, a determined and unwavering focus on improving
fundamentals through both macroeconomic and structural policy reforms in
vulnerable countries is required and within reach,” the ECB said.

“In fact, programmes of adjustment, negotiated with the European
authorities and the IMF, are now in place and should be rigorously
implemented.”

The ECB also highlighted the risk of a “market-driven” and
unexpected jump in global long-term interest rates, which could have
“possible adverse implications” through “a number of channels.”

“First, financial institutions would be subject to losses on
account of their trading exposures to debt securities, as well as to
other assets that are likely to be revalued once the discount rate for
future cash flows is increased,” the report read.

“Furthermore, banks in jurisdictions under strain might have only
restricted access – or, in some cases, even no access at all – to
derivatives markets and other tools that would contribute to hedging
exposures,” it continued.

“Second, an increase in bond yields could trigger credit losses
originating in virtually all economic sectors, potentially including
self-fulfilling concerns about the sustainability of some euro area
issuers’ sovereign debt.”

The implications for strong capital flows into emerging markets
were also flagged by the ECB. Persistently strong capital flows could
add to “overheating pressures” and contribute to “credit booms and
unsustainable asset price developments,” it said.

“In addition, surging private capital inflows to emerging markets
might lead to an accelerated accumulation of reserves as a result of
exchange rate appreciation pressure, thereby adding to the factors that
would contribute to a re-emergence of global imbalances,” the ECB added.

“A disorderly unwinding of these global imbalances could lead to
excessive exchange rate and asset price volatility, and to potential
funding pressures in large advanced capital-importing economies.”

The central bank stressed the need to closely monitor FX risks and
noted “the exposure” of some Eurozone banks to “developments” outside
the monetary union.

“This concerns, in particular, some reliance of euro area banks on
US dollar funding, as well as the foreign currency lending that has been
prevalent in some central and eastern European economies in the last few
years,” the ECB said.

The report highlighted “the continued normalization of the secured
interbank market”, as well as the pick-up in debt issuance. However,
improvements were not broad based, the ECB noted.

“In contrast to these developments for [the large and complex
banking groups], debt issuance by other euro area banks declined
significantly at the beginning of 2011,” the bank said.

“Moreover, while the rise in the share of covered bond issuance was
apparent for both groups, it was more pronounced for non-LCBGs. This
suggests an increasing reliance of several medium-sized and smaller
banks on this funding source, particularly in the context of a still
subdued market for securitised products,” the central bank added.

Turning to the upcoming stress tests, the ECB said that the results
would “contribute to enhancing the transparency of financial
institutions’ capitalisation needs.”

“Furthermore, the newly established European Systemic Risk Board
(ESRB), which has been meeting since the beginning of the year, will
fill a previously existing gap in the architecture for an effective
prevention and mitigation of systemic risks to EU financial stability,”
the ECB added.

The bank noted that the “wide-ranging breadth and scope” of the two
initiatives did not yet appear to calm tensions in the sovereign debt
markets and “allay concerns about fiscal vulnerabilities in the euro
area.”

“It has to be recognised, though, that European crisis management
was not fully in place initially and its subsequent implementation has
been fraught with some detrimental shortcomings,” the central bank
added.

While the Eurozone’s banking system faces a number of risks,
financial conditions have improved, the ECB said. However, work still
needs to be done.

“Important decisions to introduce concrete policy measures at the
EU level to strengthen backstop mechanisms aimed at mitigating financial
vulnerabilities have not been sufficient to overcome all difficulties,”
the report said.

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