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The European financial system continues to face a daunting range of interrelated risks, necessitating a concerted response by policy makers both at the political level and from the European System of Financial Supervision, including the European Supervisory Authorities (ESAs), in order to restore the confidence and trust that has been eroded during recent years’ financial crisis.
Compared with the September 2012 report, near-term risks to the EU financial system from the euro area debt crisis (especially bank funding) have generally abated with improving market confidence. However, financial institutions, in particular banks, remain vulnerable to a sudden switch in sentiment. There have also been delays to some of the key policy responses (e.g. Solvency II, CRD IV) which may exacerbate some of the longer term risks highlighted in this report.
Many of the risks arise from the still weak EU macro-economic outlook, which affects the financial positions of governments and private sector borrowers and the outlook for property markets, and which may lead to further deterioration in the profitability and asset quality of banks, insurers and other financial market participants. Policy announcements by European leaders – especially on Outright Monetary Transactions (OMT) and the Single Supervisory Mechanism (SSM) – have significantly reduced market perceptions of tail risks and led to a narrowing of bank and sovereign credit spreads. But to truly break the bank-sovereign link and create foundations for sustainable macro-economic growth will require continued progress on implementation of announced policies. Financial regulations (including Solvency II and CRR/CRD-IV) must remain economically and actuarially sound to promote a stable financial system that can sustainably provide financial services to the real economy and view risks consistently across balance sheets.
Low interest rates are an essential macro-financial policy response, but can over a longer period of time have various negative side-effects: solvency pressures on insurers and defined-benefit pension funds from higher present value of long-term liabilities and depressed reinvestment returns, incentives for search for yield behaviour by institutional investors, profitability pressures on bank net interest margins and risk of hidden forbearance, with build-up of latent credit risk and inefficient market allocation of credit resources. Financial regulation and supervision need to ensure that, consistently across the EU, financial institutions fully recognise and manage these risks to ensure resilience against the risks both of a prolonged period of low interest rates and of any sharp adjustment to interest rates. The continued delay of Solvency II represents a particular challenge for achieving this in the insurance sector.
Risks of further fragmentation of the EU Single Market have been evident through increased home bias and reduced cross-border financial activity of financial institutions. This trend has been driven mainly by financial institutions’ revised business strategies (e.g. focus on core businesses), changes in risk appetite, higher funding costs and the challenging macro environment. But it has also been exacerbated by uncoordinated national policy measures, including ring-fencing of local bank capital and liquidity, which hinders the free movement of capital, increases funding costs, signals supervisory divergence and risks further safeguard measures. Market clustering is also evident in securities markets, with diverging equity returns and credit spreads increasingly correlated within countries or country groups rather than across the EU. For the insurance sector, progress on supervisory convergence and the Single Market remains stalled due to fragmented national solvency standards and delays to Solvency II. To halt fragmentation and strengthen the Single Market, the ESAs need to foster supervisory convergence, amongst others, through a strong role in supervisory colleges and through the development of both the EU-wide Single Rulebook and Supervisory Handbooks. At the political level, EU leaders need to press ahead with the establishment of Banking Union, including SSM, and bank resolution schemes.
The financial crisis has increased financial institutions’ attention to counterparty credit risk, and loss of trust in implicit guarantees and credit ratings have led to increased reliance on collateral. This increasing demand for collateral has been reinforced by regulatory initiatives, including mandatory central clearing of some derivatives (EMIR) and bank capital rules (e.g. CVA charges), as well as the need for banks to hold high-quality liquidity buffers and use of securities for access to central bank funding. Collateral safety and liquidity is increasingly being priced, incentivising more efficient use of collateral through collateral transformation (e.g. liquidity swaps) and reuse, leading to increased financial sector interconnectedness and cross-sectoral contagion risks, encumbrance and risks of pro-cyclical effects in response to shocks to market prices or ratings of either market participants or collateral. The ESAs need to ensure that prudential rules keep up with the evolution of market practices and encourage practices which are both macro- and micro-prudentially sound, and contribute to efficient, fair and stable markets.
Financial market participants remain concerned about the balance sheet valuation and risk disclosures of financial institutions, and value the equity of many EU financial institutions at a significant discount to their book values. Financial institutions should value all their assets and liabilities properly, in full accordance with applicable accounting standards and regulations, to ensure valuation consistency within the EU, and should also analyse and understand the sources of valuation uncertainty. This uncertainty affects both banking book and trading book assets, and ultimately the valuation of capital. Supervisors are strongly encouraged to monitor and review the quality of banks’ assets and the practises of banks to measure the quality of their assets. A particular problem for the insurance sector (due to delays to IASB convergence work and Solvency II) is the continued absence of EU-harmonised accounting standards and regulatory valuation rules. Valuation and risk measurement (especially of complex instruments and longer term risks) is generally based on quantitative models. For assets and risks where firms use similar or identical models, they are consequently exposed to risks of valuation shocks arising from model failures and recalibrations. Additionally, much of the valuation uncertainty relates to financial institutions exposures to the aforementioned common risk factors of macro-economic outlook, interest rates and collateral values. Supervisors are encouraged to set appropriate incentives to correct for potential distortions to valuation and to contribute by these means to the ultimate goal of the protection of consumers and investors.
Confidence in financial market benchmarks suffered in 2012, as previous misconduct in banks’ submission of benchmark interest rates came to light. ESMA and EBA have acted, in coordination with the EU Commission, IOSCO and national authorities, to address the flaws in benchmark rate setting for Euribor and other key benchmarks. While more work needs to be done in designing sustainable resilient solutions for setting of financial benchmarks, continuity of existing benchmarks (which are referenced by an enormous number and value of financial contracts) also needs to be maintained, e.g. by mitigating the risk of disruptive withdrawals from existing rate-setting panels.