Opening remarks at the press briefing on the occasion of the publication of the June 2009 ECB Financial Stability Review

Developments in the US economy, particularly in the household sector, continue to be central to the global financial stability outlook. There are two reasons for this: first, the important contribution of US consumer spending to global economic activity; and, second, the continuing high exposure of global financial institutions to securities backed by US mortgages and consumer loans. According to the IMF, these exposures amount to USD 1.3 trillion.

Since the end of 2008, private consumption in the US has recovered somewhat after a significant decline in the second part of 2008. This decline resulted from weak income growth, rising unemployment and a rapid deterioration in the balance sheets of US households. Total net household wealth in the US declined by USD 7.8 trillion (or 13%) in the second half of 2008. The outlook for household wealth in the US depends on many factors, amongst which the future evolution of US house prices is important. Chart 1 shows that, according to the Case-Shiller futures price index for 10 major US cities, prices are expected to fall by a further 14% from their current levels, before bottoming out by mid-2010. Moreover, delinquency rates on mortgages and on all other types of household loans have exceeded the peak rates recorded in the previous downturn in 2002-2003.

The delinquency rates on US commercial and industrial loans also picked up but have remained lower than those on household loans and well below the levels reached during the 2002-2003 recession. This suggests that the US corporate sector has proven relatively resilient to the turmoil thus far. However, the outlook for the US non-financial corporate sector has deteriorated. As shown in Chart 2, US corporate profits fell further in the second half of 2008. Both domestic profits and those from the rest of the world contributed to the decline on a year-on-year basis. The turn in the corporate credit cycle has also been reflected in the rise of speculative-grade corporate default rates since the end of 2007, which over the course of the next 12 months are projected to reach levels far above the peaks in the early 1990s and in 2001. The expected sharp increase in US speculative-grade corporate defaults could cause a widening of credit spreads and exacerbate funding problems. Moreover, it could adversely affect the US labour market and consumer spending.

In emerging market economies, macroeconomic conditions have continued to worsen significantly, reflecting the confluence of weaker external demand, tighter financing constraints and falling commodity prices. In Central and Eastern Europe, economic and financial conditions deteriorated sharply, as a consequence of reduced capital inflows, the collapse of international trade and declining domestic demand. Although the economies of these countries are heterogeneous, many were highly vulnerable to a reduction in capital flows because their economic expansions had been financed to a considerable extent by external borrowing. Reduced external demand has also had a significant impact on several countries in the region. As a result, credit growth to the private sector has decelerated rapidly, and there is an emerging risk of a vicious circle between weakening economic activity and deteriorating asset quality. Against this background, as shown in Chart 3, sovereign credit default swap (CDS) spreads increased sharply in early 2009, especially in those economies with a large fiscal deficit and a wide current account deficit, and where domestic demand has weakened significantly. The CDS spreads have narrowed substantially since March 2009, but they remain at levels well above those in the first half of 2007. The risk to the euro area economy relates both to the close economic links with these countries as well as to the large exposures of a number of euro area banks to the region.

The pace of economic activity has slowed significantly since October 2008. Especially in the first quarter of 2009, we witnessed a substantial and broad-based contraction of euro area activity. Both external and domestic demand are expected to decline further in 2009 and gradually recover in 2010. As shown in Chart 4, private sector forecasters and international institutions have been revising downwards their estimates of real GDP growth for 2009 and 2010.

This assessment is broadly in line with the June 2009 Eurosystem staff macroeconomic projections for the euro area published on 4 June, according to which annual real GDP growth will range between -5.1% and -4.1% in 2009 and between -1.0% and 0.4% in 2010, that revised downwards the ranges of projected GDP growth, particularly for 2009, compared with the March 2009 ECB staff macroeconomic projections. The projected gradual recovery next year, with rates of growth returning to positive levels by mid-2010, reflects the effects of the significant macroeconomic stimulus under way as well as of the measures taken so far to restore the functioning of the financial system both inside and outside the euro area. Box 5 of the Review provides a comparison of the amplitude and time profile of “normal” economic cycles with those observed during past episodes of banking crises. The latter were characterised by a more protracted U-shaped recession, while the former involved a sharp decline in activity followed by a swift recovery.

Nevertheless, in recent weeks, there have been signs – both within and outside the euro area – that the pace of deterioration in activity is moderating and that consumer and business sentiment is improving though still remaining at low levels. In addition, there may be stronger than anticipated effects on activity stemming from the extensive macroeconomic stimulus under way and from other policy measures taken. Confidence may also improve more quickly than currently expected. At the same time, concerns remain about the following potential downside risks: a stronger impact on the real economy from the financial market turmoil, more unfavourable developments in labour markets, the intensification of protectionist pressures and adverse developments in the world economy stemming from a disorderly correction of global imbalances.

Concentrating on the euro area non-financial corporate sector, lower sales volumes and profit margins have caused a substantial weakening of corporate profitability which is expected to persist in 2010. Firms in the euro area entered the economic downturn with a relatively high leverage ratio. Reduced profits hamper firms’ ability to generate internal financing while, at the same time, external financing conditions are likely to remain tight, as long as banks continue to de-leverage and other funding markets remain under stress.

Non-financial corporations’ default rates for both euro area and European firms have started to increase. The European speculative grade-rated corporations’ default rate is expected to jump to almost 20% by the end of 2009, as shown in Chart 5. Furthermore, credit rating agencies began revising downwards their ratings of non-financial corporations in December 2008. Box 6 of the Review takes a closer look at the outlook for corporate defaults. It concludes that given the extraordinary nature of recent developments in the financial markets, current forecasts could prove too pessimistic despite the sharp decline in economic activity. The prospect of global and European speculative-grade corporations’ default rates increasing substantially implies a significant risk to the financial system.

Another source of risk is the commercial property market where conditions continued to deteriorate over the past six months. In the first quarter of 2009, commercial property prices actually fell in all 13 euro area countries for which data are available. The outlook will remain unfavourable until economic and financial conditions improve and investor appetite for commercial property returns. Potential further losses constitute a significant risk for many banks since commercial property loans in the euro area on average account for about 10% of total loans and, in many cases, exposures are even much larger.

Turning to the household sector, euro area house price increases continued to ease in 2008, as shown on Chart 6. In at least six euro area countries house prices have declined on an annual basis. These developments have been associated with a moderation of both housing demand and supply, but the balance of the changes in demand and supply has been putting downward pressure on prices.

The annual rate of growth of loans to the household sector declined sharply in the final quarter of 2008 and in the first quarter of 2009, reflecting the deterioration in housing markets, weakening economic conditions and prospects, and the ongoing tightening in credit standards. According to the results of the April 2009 ECB bank lending survey, a further dampening of households’ demand for housing loans is expected due to worsened housing market prospects and low consumer confidence.

Let me now focus on the euro area financial system. Over the past few months, developments in several financial markets give rise to some optimism. Although market liquidity in the euro area is still tight, it has improved appreciably, especially in the interbank money market.

Since mid-February, conditions in the euro money markets improved. This is reflected in the lower utilisation of the ECB deposit facility and in higher overnight unsecured interbank transaction volumes. More importantly, money market rates have declined substantially and the spreads between Euribor rates and EONIA swap rates have continued to narrow, as shown in Chart 7. In late May 2009, the spread between the 3-month Euribor and the EONIA swap rate had fallen below 50 basis points for the first time since the collapse of Lehman Brothers in September 2008. In shorter maturities, money market spreads have narrowed even further. These positive developments are a consequence of the extensive provision of liquidity and other policy measures taken by the Eurosystem. Forward Euribor-EONIA swap spreads in the three-month maturity indicate that these spreads are expected to continue narrowing in the coming months.

An important development in financial markets was the marked increase in the net issuance of euro area government debt securities at the end of 2008 and early 2009, as shown in Chart 8. New debt issuance has mainly been in the form of short-term debt, partly because the steeper yield curve has made short-term financing relatively cheaper. The national bank support schemes, which were announced in October 2008, were perceived by investors as a credit risk transfer from the private to the public sector. This is reflected in the widening of government bond spreads relative to Germany and the increasing divergence in CDS spreads in the first quarter of 2009, especially in those countries with a weaker public finance position and a relatively large financial sector. Since March 2009, however, a narrowing of bond and CDS spreads indicates some improvement in investors’ confidence in the euro area sovereign bond markets.

In mature economies, stock market valuations have steadily improved since early March of this year and the major equity indices both in the euro area and globally have more than recovered the losses of the first two months of the year, while volatility has also declined. As shown on Chart 9, several equity valuation measures, including the ratio of equity prices to long-term past corporate earnings, indicate that despite the recent recovery in prices, equity market valuations in the euro area are still substantially lower than the peaks reached in October 2007 and in March 2000, and also below the long-term average level.

Turning next to the euro area financial institutions, large and complex banking groups (LCBGs) remained under intense financial stress in the last quarter of 2008. Profits and (the weighted average) return on equity (ROE) declined sharply, as shown in the left panel of Chart 10. This performance reflects partly further write-downs on structured product portfolios and increasingly the deterioration in the macroeconomic environment, which resulted in an increase in loan losses and a decline in non-interest revenue. In the first quarter of 2009, euro area banks’ ROE improved somewhat, albeit at a very low level, thanks to a more favourable trading environment and better non-interest revenues. The asset quality of banks’ loan portfolios will remain a crucial determinant of their performance in the rest of the year.

At the same time, the efforts of euro area LCBGs to bolster their capital buffers have contributed to maintaining their current regulatory capital ratios at levels that conform to the regulatory minimum requirements. Both the median and the weighted average Tier 1 ratios increased in 2008 compared with 2007 (from 7.76% to 8.15%, and from 7.7% to 8.6%, respectively). The total capital ratio followed a broadly similar pattern. However, part of the recovery in regulatory capital is also due to a reduction in risk-weighted assets and to asset shedding at a majority of LCBGs.

Since the turmoil erupted, the total reduction in net income attributable to write-downs of global banks on their assets has amounted to just under USD 1 trillion so far. The left panel on Chart 11 shows that US banks have accounted for the bulk of the income losses – about 60% of the overall figure. A further 20% of the global losses was incurred by UK and Swiss banks and euro area banks’ write-downs also corresponded to 20% of the total. To compensate for the large write-downs, euro area LCBGs successfully raised capital in 2008 – both from private and from public sources. By late-May 2009, euro area banks had received relatively more capital than their US peers in relation to the recorded write-downs, as private and public capital injections were equivalent to 119% of the write-downs in the euro area versus 88.5% in the United States.

Since October 2008, EU governments have implemented support measures to alleviate strains on the European banking system. These measures complement the extensive liquidity support that has been provided by the ECB/Eurosystem and have been implemented in accordance with specific guidance from the ECB and the European Commission. The bank support measures taken, which include equity re-capitalisations, guarantees of new bank debt and asset relief schemes, are summarised in Box 11 and a tentative assessment of their effectiveness is provided. The main conclusion is that the measures have been successful in stabilising the banking system and in bolstering confidence.

The take-up rates of the government committed support to banking systems has varied across countries and across types of measures. Overall, the take-up rates are considered satisfactory taking into account banks’ needs so far. In particular, the use of government guarantees on new bank debt issuance has been indispensable in providing banks with access to medium-term funding when needed, as shown in Chart 12. Looking forward, banks should be encouraged to take advantage of the governments’ commitments for support and strengthen their capital buffers. This is especially important in order to restore the provision of credit to the economy and also because the current ample liquidity provided by the ECB will not remain permanently in place.

A key issue for bank performance and financial system stability is the amount of potential further write-downs that could be faced by global and euro area financial institutions and the additional capital that should be raised by them in order to safeguard their solvency. Box 14 of the FSR presents the ECB staff estimates of potential write-downs on the securities and loans of euro area banks which, for the sake of comparability and transparency, are calculated following the approach used by the IMF in its Global Financial Stability Report published in April 2009. However, the ECB staff calculations have been based on certain parameters that can be estimated on the basis of euro area data. Table 1 on Slide 15 shows the estimated potential write-downs facing the euro area banking sector.

The ECB staff estimates suggest that the total amount of potential write-downs of euro area banks on their securities and loans over the period 2007-2010 could amount to around USD 649 billion. Taking into account the write-downs on banks’ securities reported by late May 2009 and the banks’ loan loss provisions for 2007 and 2008, the potential future losses of euro area banks, largely concentrated on their loan exposures, could be around USD 283 billion until the end of 2010. These potential losses would be cushioned by provisions and retained earnings over the next two years.

I want to stress that estimates of potential future write-downs on banks’ securities and loans depend crucially on the assumptions made and the methodology used and they are subject to a considerable margin of error. Bearing in mind the significant uncertainty surrounding all available estimates, further efforts are needed to obtain as accurate figures as possible because the magnitude of the expected potential write-downs has weighed heavily on investor confidence and has affected already-weakened financial institutions.

Finally, allow me to make a few points with regard to euro area insurance companies. Large euro area insurers suffered a deterioration in their financial conditions in the second half of 2008 and the first quarter of 2009. Most of them reported declines in premium income, as falling equity prices and widening credit spreads lowered the demand for life insurance products. At the same time, non-life insurance business lines were challenged by the deterioration in the economic environment which adversely affected the demand of households and firms for their products. In addition, insurers endured a significant erosion of their investment income because of stresses in many of the financial markets in which they mainly invest, especially corporate bonds and equities.

As can be seen in Chart 14, the biggest investment exposure of euro area insurers relates to corporate and government bonds, on average about 60% of total investment in 2008 for a sample of large insurers, up from 46% in 2007. In addition, many insurers have investment exposures to structured credit products. Continued high yields on corporate bond and structured credit products have led to large unrealised losses in many insurers’ “available for sale” bond portfolios. Insurers may have to sell such securities and realise losses if the ratings of the securities they hold are downgraded or in the event of liquidity shortages. In addition, realised losses for insurers are likely to increase as corporate bond default rates are expected to rise in the period ahead.

The main challenge that the euro area insurer sector is currently confronted with is a synchronised deterioration in both underwriting and investment income. This is illustrated in Chart 14. Insurance underwriting is usually supported by a favourable economic environment and the slowdown in economic activity is weighing on the underwriting performance of euro area insurers. At the same time, the turmoil in the financial markets continues to weigh on insurers in their attempts to generate investment income.