Vítor Constâncio

ECB Financial Stability Review May 2015

28 May 2015

Press briefing presentation

Rubric Recent developments



Measures of financial market, banking sector and sovereign stress in the euro area (Jan. 2011 – May 2015)

Euro area financial system stress, as extracted from market indicators, has remained overall low over the past six months, despite shorter periods of higher financial market volatility

probability of default of two or more LCBGs (percentage probability; left-hand scale) composite indicator of systemic stress in financial markets (right-hand scale) composite indicator of systemic stress in sovereign bond markets (right-hand scale)

28

0.7

November FSR

 Indicators of stress among euro area banks and sovereigns remain at low levels  Systemic stress across the broader financial system also contained

24

0.6

20

0.5

16

0.4

12

0.3

8

0.2

4

0.1

0 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15

0.0

Sources: Bloomberg and ECB calculations. Notes: (i) “Probability of default of two or more LCBGs” refers to the probability of simultaneous defaults in sample of 15 large and complex banking groups (LCBGs) over a one-year horizon. (ii) For further details on the CISS methodology, see Hollo, D., Kremer, M. and Lo Duca, M., “CISS – a composite indicator of systemic stress in the financial system”, Working Paper Series, No 1426, ECB, March 2012. 2

Rubric Recent developments



Euro area financial and economic indicators signal a stark dichotomy in risk-taking

High financial risk-taking, low sovereign yields, subdued credit growth coupled with subdued economic risktaking (Jan. 2008 to Mar. 2015, index: Jan. 2008 = 100) bank credit to corporates

 High financial risk-taking. The prices of financial assets in most segments have continued to rise …

real fixed investment EURO STOXX index euro area corporate bond yields (right-hand scale) 130

9 November FSR

120

 … but, the recent increases in asset prices have not been accompanied by growing leverage in the banking sector nor by rapid private sector credit expansion.  Economic risk-taking in the euro area is clearly lagging.

8

110

7

100

6

90

5

80

4

70

3

60

2

50

1

40 2008

0 2009

2010

2011

2012

2013

Sources: Thomson Reuters Datastream and ECB. Note: The Iboxx euro corporate bond all maturity index is employed.

3

2014

2015

Main Rubric risks for the euro area financial system

1. Abrupt reversal of compressed global risk premia amplified by low secondary market liquidity 2. Weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets 3. Rise of debt sustainability concerns in the sovereign and corporate sectors amid low nominal growth 4. Prospective stress and contagion effects in a rapidly growing shadow banking sector

4

Rubric Main risks and vulnerabilities Risk 1 - Abrupt reversal of compressed global risk premia amplified by low secondary market liquidity Stock prices broadly in line with fundamentals in the euro area, valuations somewhat stretched for US stock prices (Jan. 1983 - May 2015, yellow shaded area represents the 25-75 percentiles)

Valuation estimates for euro area residential and prime commercial property above their long-term average (Q1 2009 - Q3 2014; average of price changes in Austria, France, Germany, Ireland, the Netherlands and Spain) 35 Residential property 30 25 20 15 10 5 0 -5 -10 -15 -20 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 35 Commercial property 30 25 20 15 10 5 0 -5 -10 -15 -20 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

euro area CAPE, 25th -75th percentile US CAPE

60

50

40

30

20

10

0 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Sources: Jones Lang Lasalle, ECB and ECB calculations.

Sources: Thomson Reuters Datastream, Robert Shiller's homepage (http://www.econ.yale.edu/~shiller/data.htm) and ECB calculations. Notes: Cyclically adjusted price/earnings (CAPE) ratios for the euro area and the United States. The cyclically adjusted price/earnings ratios for the euro area are imputed from Datastream's stock market indices. The US CAPE is taken from Robert Shiller's homepage. .

5

Note: Valuation estimates for residential property prices are based on four different valuation methods: price-to-rent ratio, price-to-income ratio and two model-based methods. For details of the methodology, see Box 3 in ECB, Financial Stability Review, June 2011. For further details on valuation estimates for prime commercial property, see Box 6 in ECB, Financial Stability Review, December 2011. .

Rubric Main risks and vulnerabilities Risk 2 - Weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets …while the cyclical downturn in certain areas has contributed to a high outstanding stock of nonperforming assets (2006 – 2014; annual percentage changes (GDP); median NPLs as a share of total loans, median ROE, vulnerable countries)

Non-performing loans broadly stable in the majority of euro area countries … (2006 – 2014; annual percentage changes (GDP); median NPLs as a share of total loans, median ROE, non-vulnerable countries) NPLs (left-hand scale)

NPLs (left-hand scale)

ROE (left-hand scale)

ROE (left-hand scale)

GDP (right-hand scale)

GDP (right-hand scale)

20

6

15

20

6

15

4

4

10

10 2

5 0

2

5 0

0

0

-5

-5

-2

-2 -10

-10 -4

-15 -20 2007

2008

2009

2010

2011

2012

2013

-6

-20

-6 2006

-4

-15

2006

2014

2007

2008

2009

2010

2011

2012

2013

2014

Sources: SNL Financial, Eurostat and ECB calculations.

Sources: SNL Financial, Eurostat and ECB calculations.

Note: Return on equity (ROE), non-performing loans (NPLs) and GDP growth in non-vulnerable countries. Euro area countries excluding Spain, Italy, Portugal, Greece, Cyprus and Slovenia.

Note: Return on equity (ROE), non-performing loans (NPLs) and GDP growth in vulnerable countries. Vulnerable countries: Spain, Italy, Portugal, Greece, Cyprus and Slovenia.

.

6

.

Rubric Main risks and vulnerabilities Risk 2 - Weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets Currently, EU bank profitability is mainly being suppressed by weak cyclical factors …

The importance of cyclical developments for EU bank profitability is confirmed when comparing it with that of their US peers (end-2013; ratios and percentages)

(1994 – 2013; ratios and percentages) sample average

CR5 (+)

Herfindahl index (+)

EU banks 2013

size (-) 200

2013 average

US banks 2013 CR5 (+)

equity ratio (+) 150

250

equity ratio (+)

200 150

100 LLP over total loans (-)

50

credit over GDP (+)

100

LLP over total loans (-)

50 0

0

-50

-50

-100

loan growth (+)

credit over GDP (+)

real GDP growth (+) real GDP growth (+)

loan growth (+)

inefficiency (-) diversification (-)

diversification (-)

retail ratio (+)

inefficiency (-)

retail ratio (+) Sources: Bloomberg, Eurostat, SNL Financial and ECB calculations.

Sources: Bloomberg, Eurostat, SNL Financial and ECB calculations. Notes: Current state of EU banks’ profitability determinants against historical benchmarks (sample average). The historical averages have been normalised to 100. Current values of the indicators are measured in terms of deviations from historical averages. .

size (-) 300

7

Notes: Current state of EU banks’ profitability determinants against their US peers (US measures normalised to 100). The US-based indicators have been normalised to 100. Current values of the EU-based indicators are measured in terms of deviations from the US indicators. 24 large US banks are considered.

Rubric Main risks and vulnerabilities Risk 2 - Weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets Slightly higher valuations of euro area banks in 2015, but they still trade at a discount vis-à-vis their US peers (Jan. 2007– May 2015, grey shaded area represents the difference between United States and the euro area)

Still substantial gap between euro area banks’ cost of equity and the return on equity (Q1 1999 - Q4 2014)

Inter-quartile range ROE

Inter-quartile range COE

median COE

median ROE

euro area United States

3.0

25 20

2.5

15 2.0

10 5

1.5

0 1.0

-5 -10

0.5

-15 -20

0.0 -0.5 2007

Sources: Bloomberg, Thomson Reuters, Consensus and ECB calculations.

2008

2009

2010

2011

2012

2013

Source: Thomson Reuters Datastream. Note: Price-to-book ratio for euro area and US banks

Note: Cost of equity (COE) and return on equity (ROE) for a large sample of listed euro area banks. Based on the sample of 33 euro area banks included in the Euro STOXX index. 8

2014

2015

Rubric Main risks and vulnerabilities Risk 2 - Weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets Despite the challenging environment, market-based indicators suggest a stable outlook for euro area insurers (Q1 2002 – 2016)

Insurance companies’ investment portfolios still dominated by fixed income securities (2011 – 2014; percentage of total investments; weighted averages)

2011

2012

2013

2014

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

Sources: JPMorgan Cazenove, individual institutions’ financial reports and ECB calculations. Note: Based on available data for 15 large euro area insurers and reinsurers.

Sources: Thomson Reuters, Datastream, ECB and ECB calculations.

9

Rubric Main risks and vulnerabilities Risk 3 - Rise of debt sustainability concerns in the sovereign and corporate sectors amid low nominal growth Euro area debt remains elevated also in the private sector (2000 – 2014; Debt as a percentage of GDP)

2015 financing needs are substantial for several euro area countries (2015; percentage of GDP; percentages)

households non-financial corporations government

25 Gross financing needs

120 IT

20 ES FR

15

100 PT

80

BE

EA NL

10 SK LT 5 LV

FI DE

60

SI

GR

AT

40

MT IE

20

LU

0 0

50

100 150 Gross general government debt

200

Sources: European Commission and Bloomberg. Note: The size of the bubble reflects the 2015 year-to-date average tenyear government bond yield.

0 2000

2002

2004

2006

2008

2010

2012

2014

Sources: Eurostat and ECB. Notes: Based on ESA 2010 standards, except for general government debt from Q1 2000 to Q4 2005, for which the ESA 1995 has been used. Nonfinancial corporate debt is unconsolidated, comprising loans (incl. intrasectoral loans), debt securities and pension reserves. For the household 10sector, the series ends in Q3 2014; for the remaining series, the last data points are for Q4 2014.

Rubric Main risks and vulnerabilities Risk 4 - Prospective stress and contagion effects in a rapidly growing shadow banking sector Steady increase in the euro shadow banking sector suggests that vulnerabilities are likely to have been growing more in this segment (Q4 2008 – Q4 2014; index: Q4 2008 = 100)

Bond and real estate funds most likely to amplify shocks and impose externalities on the system (Data as of Q4-2014), x-axis: Leverage (total assets / shares and units issued), y-axis: Liquidity mismatch (shares and units issued / liquid assets)

shadow banks: hedge funds

5.0

shadow banks: investment funds (excl. money market funds) shadow banks: overall

4.5

banks

Bond funds €3.0 trillion

4.0 Shares issued to liquid assets

260 220 180 140 100 60 20 2008

Real estate funds €0.4 trillion

3.5 3.0

MMFs €0.9 trillion

2.5 2.0

2010

2011

2012

2013

1.0

0.0 1.00

2014

Mixed funds €2.1 trillion

1.5

0.5

2009

Hedge funds €0.2 trillion

Equity funds €2.3 trillion

Other funds €0.5 trillion

1.10

1.20

1.30

Leverage

Sources: ECB and ECB calculations.

Sources: ECB and ECB calculations.

Note: Assets of selected euro area financial sectors

Note: Liquidity mismatch and leverage among euro area money market and investment funds. Bubble size: total assets in EUR trillions 11

Rubric Conclusions  Euro area systemic stress contained but with vulnerabilities  Downside risks to economic growth have receded …  … and asset prices have increased over the past six months but still without generalised overvaluations…  … while lower-than-average turnover ratios and deal sizes imply high price sensitivity to market shocks  Market-intermediated credit rather abundant and available on rather generous terms  Several policy challenges  The need for a strict focus of the ECB's monetary policy on its price stability mandate, together with country and sector challenges, suggests a strong role for macroprudential policy in dealing with any systemic risk related to potential asset price imbalances  Further initiatives needed to monitor and assess vulnerabilities in the growing shadow banking sector  Banks’ balance sheets strengthened further but combination of cyclical and structural challenges to profitability needs to be tackled  Public and private debt ratios still high and in need of correction with potential sustainability challenges if higher nominal growth not sustained 12