system also remained contained (see Chart 25).
The financial stability risks faced by the euro area during 2014 can be divided into two broad categories.
First, “legacy” issues from the global financial crisis, while receding throughout the year, remained a concern. For the euro area, these mainly related to insufficient progress in addressing weaknesses on the part of both the banking sector and governments.
The second broad set of risks were “emerging” risks, which mainly stemmed from a continued global search for yield. This left the financial system more vulnerable to an abrupt reversal of risk premia.
Underlying all of the key risks to financial system stability was the uncertainty owing to the weak, fragile and uneven economic recovery. The very low rate of inflation also has the potential to aggravate existing vulnerabilities, should it remain at current levels for longer than expected or decline further.
Continued progress in resolving legacy issues from the global financial crisis
Both banks and governments continued to take action in 2014 to address legacy risks from the crisis. Euro area bank balance sheets were strengthened further in the course of the year, with a clear shift towards capital increases – related to the comprehensive assessment carried out by the ECB – from deleveraging and de-risking in previous years. At the same time, progress by euro area governments in implementing fiscal consolidation and structural reforms continued, although the pace was uneven across countries. The improved sentiment resulted in significantly declining yields on lower-rated euro area government bonds, which in some cases reached levels last seen before the eruption of the euro area-centred second wave of the global financial crisis in 2010.
Despite this progress by both banks and governments, financial stability challenges persist. While the comprehensive assessment ensured that significant banks in the euro area have sufficient capital levels, the banking system needs to address remaining fragilities and uncertainties. The main challenge facing the euro area Chart 25
Measures of financial market, banking sector and sovereign stress in the euro area
(January 2011 – February 2015)
0.0
Jan. July Jan. July Jan. July Jan. July
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)
2011 2012 2013 2014
Sources: Bloomberg and ECB calculations.
Notes: “Probability of default of two or more LCBGs” refers to the probability of simultaneous defaults in the sample of 15 large and complex banking groups over a one-year horizon. For more information on composite indicators of systemic stress, see Hollo, D., Kremer, M. and Lo Duca, M., “CISS – a composite indicator of systemic stress in the fi nancial system”, Working Paper Series, No 1426, ECB, March 2012.
banking sector during 2014 was continued low profitability levels in large parts of the sector, which stemmed mainly from the weak economic environment. Persistently weak bank profitability could become a systemic concern if it limits banks’ ability to improve their shock-absorbing capacity via retained earnings and provisioning.
This could prevent banks from engaging in new profitable lending activities and lead to more structural business model-related concerns in a low growth environment.
In such circumstances, banks might be tempted to take on more risk to improve profitability, which in turn could make them more vulnerable to future shocks.
Banks’ return on equity during 2014 stood well below their cost of equity (shareholders’
expected rate of return), which also points to a structural need for further balance sheet adjustment in parts of the banking system. Sluggish bank profitability was, however, a challenge that affected not only euro area banks during 2014. Their aggregate financial performance closely resembled that of non-euro area European banks and – once loan loss provisioning is corrected for – also that of their US peers (see Chart 26).
Sovereign debt-related stress remained contained in the euro area during 2014.
Supported by the improved sovereign debt market conditions following the announcement of Outright Monetary Transactions in 2012 and the ECB’s policy action during 2014, market sentiment remained relatively favourable. The gradual strengthening of cyclical economic conditions and the ongoing fiscal consolidation underpinned this development.
Sentiment was also supported by continued progress in weakening the links between sovereigns and banks. The establishment of the SSM and regulatory initiatives – such as new bail-in rules – were crucial in this respect. However, the continued significant correlation between the borrowing costs of euro area banks and sovereigns highlights the need for continued progress.
Chart 26
Pre- and post-provision return on equity of euro area and global large and complex banking groups
(percentages; medians; two-period moving average)
a) Pre-provision return on equity b) return on equity
0
2007 2008 2009 2010 2011 2012 2013
euro area LCBGs
non-euro area European LCBGs US LCBGs
2007 2008 2009 2010 2011 2012 2013
euro area LCBGs
non-euro area European LCBGs US LCBGs
Sources: SNL Financial and ECB calculations.
Notes: “Non-euro area European LCBGs” includes banks from the United Kingdom, Switzerland, Sweden and Denmark. Data are for the period from the fi rst half of 2007 to the fi rst half of 2014.
Public debt sustainability challenges persisted in 2014 owing to continued high debt levels in many countries, heightened downside risks to the economic outlook and a very low inflation environment.
Uncertainties relating to the sustainability of sovereign debt are likely to remain a key issue. This highlights the need for further adjustment of the fiscal and economic fundamentals that are relevant for debt sustainability.
Supported by the progress made by banks and sovereigns in tackling legacy problems from the global financial crisis, the increase in euro area financial market integration witnessed since 2012 continued throughout 2014, reaching levels last seen before the onset of the euro area sovereign debt crisis (see Chart 27).26 Improvements in the state of financial market integration were registered to varying degrees in all key market segments – money, bond, equity and banking markets.
In the money market, integration continued to increase at a gradual pace amid sustained action by banks to reduce balance sheet uncertainties and improve funding positions. This improvement was reflected in declining levels of excess liquidity – the amount of cash held by banks above usual requirements.
Fragmentation also receded further in euro area bond markets during 2014.
The improvement in bond market integration was the result of several factors.
First, the disparity in economic sentiment across euro area countries declined further.
Second, the ECB’s decisions on further monetary policy measures underpinned confidence throughout the year. Third, the monetary policy stance across other major currency areas remained accommodative overall, which contributed to a search for higher-yielding assets. This drove down the spreads of riskier assets and contributed to lower fragmentation in euro area bond markets. These factors also supported stock markets, where the degree of cross-country heterogeneity declined somewhat further in 2014 in the euro area.
The integration of euro area banking markets improved somewhat during 2014 with regard to lending activity and the gathering of deposits. Cross-border banking activity increased moderately, although the level of integration in banking markets remained lower than before the onset of the financial crisis. This was illustrated, for example, by the persistent gap between the borrowing costs paid by non-financial corporations – particularly small and medium-sized enterprises – across euro area countries, which has not yet closed.
While the Eurosystem considers financial market integration to be first and foremost a market-driven process, the legislative and regulatory framework for the financial system clearly plays an important facilitating role. Numerous important achievements
26 For a more detailed analysis of financial market integration developments during 2014, see Financial integration in Europe, ECB, 2015, forthcoming.
Chart 27
Price-based Financial Integration Composite (FINTEC) for the euro area
(January 1999 – December 2014)
0.00 0.25 0.50 0.75 1.00
1999 2001 2003 2005 2007 2009 2011 2013
Sources: ECB and ECB calculations.
Notes: The “price-based FINTEC” (Financial INTEgration Composite) aggregates the information from a selection of existing price-dispersion indicators that cover the four financial market segments of interest. The FINTEC is bounded between zero (full fragmentation) and one (full integration). Increases in the FINTEC signal higher financial integration. For further details, see Financial integration in Europe, ECB, 2015, forthcoming.
in the regulatory realm during 2014 supported financial market integration (see also Sections 3.3 and 3.4 of this chapter). The ECB assumed responsibility for banking supervision on 4 November 2014. The Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) are essential pillars of a more robust and resilient framework to help prevent future financial crises as well as to ensure effective intervention and, ultimately, the resolution of banks if needed. This will contribute significantly to the integration of European financial markets.