ECB Financial Stability Review June 2006

Let me now briefly turn to the euro area stock and corporate bond markets, both of which continued to develop dynamically until very recently. The Review points out that despite the favourable economic outlook, a risk of a slowdown in market dynamics cannot be excluded if risk-free interest rates continue to edge upwards and credit ratings and/or earnings growth surprise to the downside. On the positive side, structural developments in euro money markets, described in Box 6 of the Review, and the increased use of collateral in borrowing and lending transactions, discussed in Box 7, suggest an overall strengthening of the financial system’s resilience to a systemic shock.

The price-earnings ratio of the euro area stock market (shown on the left of slide 8) indicates that despite the rather elevated level, this valuation measure remains well below its peaks reached in 2000. However, should corporate earnings growth unexpectedly slow down, the consequent rise in price-earnings ratios could make stocks look relatively expensive to other assets.

The chart on the right plots the implied volatility of euro area stock prices and corporate bond spreads which both gradually declined throughout the first five months of the current year, despite rising long-term bond yields. The rather sharp jump in these indicators during the last two weeks, suggests that there was room for adjustment to a higher pricing of risk in the context of changing views regarding the future macro-financial environment.

Before discussing the developments in euro area financial institutions, let me first highlight an important dimension of the market-based intermediation process: the rapid development of structured finance products. Although the risk-transfer that this market has facilitated has very likely led to efficiency gains and a better management of risks within the financial systems, there are several concerns which mostly arise from the fact that relatively little is known about how this market has effectively spread risk and how it would function in a situation of extreme stress.

Since June 2002, the size of the global credit default swaps market has increased nearly exponentially (see chart on the right on slide 9). While the use of credit derivatives has substantially contributed to enhanced risk-sharing and is expected to have improved the resilience of the financial system, questions can be asked about the sustainability of the pace of growth in these markets as well as about their implications for the emergence of other forms of risk.

Two issues in particular have surfaced in the course of the past year. First, the sheer complexity of many of the structured products introduced in the credit derivatives markets implies that there are potentially large risks for end-users who might not fully understand the time-varying risk profiles of such instruments. Indeed, as illustrated in several episodes of recent large corporate downgrades, the pricing of structured credit products might not adequately account for unanticipated changes in correlation structures among the assets incorporated in the underlying pools. Second, the rapid increase in trading volumes has stretched banks’ and dealers’ settlement systems and caused backlogs that could contribute to liquidity problems in a situation of increased trading activity. These problems could be particularly relevant for the European market, given the larger discrepancy in size between the cash bond market and the derivatives market than in the US. There are signs that, in accordance with the recommendations of the Counterparty Risk Management Group II report, many global banks have successfully worked towards solutions to these problems. However, it is rather widely acknowledged that pockets of vulnerability remain in these markets. Box 8 of the Review discusses recent market initiatives for improving the functioning of the credit derivatives market.

As shown by the chart on the right, the structure of market participants on the two sides of the credit derivatives market has changed over the past three years. Among the buyers of credit protection, the share of banks has declined in favour of hedge funds and other investors, such as private equity firms. Among the sellers of protection, insurance companies have increased their share at the expense of banks. It is worth noting, however, that hedge funds have been active also on the issuing side of the credit derivatives markets which is a business typically characterised by lucrative fees.

With regard to the financial situation of large euro area banks, the financial results, overall, paint a picture of a very profitable banking sector with rather comfortable solvency ratios. In most euro area countries, bank profits were driven by continuing cost control and volume growth in mortgage lending that more than compensated for the narrowing of interest rate margins. Moreover, banks have also benefited from a recovery in lending to the non-financial corporate sector, as well as from the buoyant growth in fees and commissions. It should also be kept in mind, however, that the introduction of new international accounting standards might have had an impact on banks’ profitability.

The frequency distribution of the return on equity of large euro area banks (see chart on the left on slide 10) shows that the degree of dispersion among banks narrowed considerably in 2005. The banks with the lowest returns on equity managed to improve their performance, shifting the overall distribution to the right. Banks’ profits were also supported by the fact that the frequency distribution of loan impairment charges of large euro area banks, previously referred to as provisioning, shifted substantially to lower levels between 2004 and 2005 (as shown on the right-hand side of slide 10). Although this is an indication of an overall improvement in the quality of large euro area banks’ loan books, questions can be asked about the sufficiency of banks’ charges for expected loan losses should the credit environment deteriorate from the current very benign conditions. Regarding banks’ buffers for unexpected losses, on the other hand, the capital ratios for the same (large euro area) banks show that, in general, a greater proportion of banks exhibited higher capital ratios in 2005 relative to the previous year.

The generally positive assessment of large euro area banks is complemented by a thorough analysis of risks related to interlinkages between banks. Special features B and C look at two different aspects of the relationships between banks: those running through extreme contagion channels and through earnings expectations. On both accounts, lessons learned suggest the need for continued and careful monitoring of banks with large and cross-border operations, as these appear to account for a disproportionate share of the systemic risk in the sector. With this in mind, Special Feature A takes stock of various conceptual aspects of designing macro-stress tests for the banking sector, with a focus on credit risk.

Judging from market-based forward-looking indicators, the central outlook for the banking sector remains positive. Market participants’ perceptions of banks’ risks have continued to diminish, also recognising banks’ greater ability to manage and shed risks in their balance sheets. However, the increasing reliance of large euro area banks on non-interest income, and in trading income in particular, could imply increased risks in the future. As a reappraisal of market risk could take place in connection with an abrupt unwinding of the search for yield, banks could be exposed to greater market risks directly or indirectly through their exposure to counterparties.

Box 13 in the Review analyses the downside risks in euro area banks’ stock prices. The chart on the left on slide 11 shows that the tail risk of portfolios consisting of stocks of banks from three different size categories (large, medium-sized and small listed banks) behave rather differently under different market conditions. Indeed, while the risks of investing in different types of banks do not differ substantially under low volatility conditions, such as the one that prevailed until recently, the risks from investing in large euro area banks increase considerably when market volatility goes up.

Overall, however, forward-looking market indicators provide a positive assessment of the outlook for the euro area banking sector, although the uncertainty surrounding this assessment has increased since the publication of the December 2005 Review. The chart on the right on slide 11 depicts the broadly based contraction of a standard measure of credit risk – the expected default frequency – across banks with different levels of risk. Notable in this regard is the substantial improvement in this indicator for the most risky banks.

Allow me now to turn to non-bank financial institutions, focusing on insurance companies and hedge funds, two sectors that have been at the centre of attention during the past year. Despite significant losses incurred by the reinsurance sector following the damage caused by natural catastrophes, the financial performance of the euro area insurance sector as a whole improved in 2005, owing to stronger investment income, improving underwriting income and rising equity prices. Market-based indicators suggest that the outlook for the sector remains favourable in the immediate future. However, there are a number of risks facing the industry in the period ahead. These include the possibility of premium competition in the non-life sector, longevity risk in the life sector, and the possibility, albeit diminishing, of an influenza pandemic.

The chart on the left on slide 12 portrays the performance of the insurance sub-sectors relative to the Dow Jones EURO STOXX. Whilst the impact on the reinsurance sub-sector of the damage caused by natural catastrophes is evident, other sub-sectors appear more resilient. The chart on the right on slide 12 shows the median expected default frequency and average subordinated debt spread for euro area insurance companies. Both measures of risk in the sector have reached new lows since 2001, indicating that market participants see an improving resilience in the sector.

The current Review contains for the first time a specific section dedicated to assessing developments in the global hedge funds sector. The pace of growth of the capital under management of global hedge funds, which had moderated in the course of 2005, fluctuated rather sharply in the first months of 2006, partly due to the mixed performance of most strategies in the last quarter of 2005 and improved results in the first quarter of 2006. After several quarters of reduced inflows into the hedge fund sector, and an outflow in the last quarter of 2005, inflows re-bounded in the first quarter of 2006 as shown by the chart on the left on slide 13. Looking forward, however, the possibility of tighter global liquidity conditions has raised investor redemption risk for hedge fund managers, particularly as the share of less liquid assets has reportedly been increasing.

At the same time, correlations of returns within some hedge fund investment strategies and among strategies remained high or even increased, raising the risk of disorderly synchronous exists from similar trades in an environment of unexpected market turbulence. This is illustrated in the chart on the right on slide 13.