From Fragmentation to Financial Integration in Europe
Chapter

Chapter 6. Risks and Vulnerabilities

Author(s):
Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Author(s)
Jorge Chan-Lau, Luc Everaert, Daniel C. Hardy, Heiko Hesse and Nadege Jassaud 

The incompleteness of European Union (EU)-wide and Economic and Monetary Union (EMU) policy frameworks played an important role in the recent financial turbulence in Europe. It exacerbated the impact of financial innovation, deregulation, and soft touch supervision were key factors that led to the global financial crisis. Europe was also afflicted and was probably hit harder than other parts of the world because of its traditional reliance on bank-based finance and its high bank leverage (Figures 6.1 and 6.2).

Figure 6.1Overview of Financial Structure

(in percent of GDP)

Source: World Bank Financial Structure database (2012).

Note: Data are for 2010, except private credit; and 2008 for Bulgaria, the Czech Republic, Denmark, and Hungary.

Figure 6.2Capital-to-Asset Ratio

(in percent)

Source: IMF, Financial Soundness Indicators.

Note: 2012:Q2, except Bulgaria (2009); Spain; France (2010); Latvia; Slovak Republic (2012:Q1); and the United Kingdom (2011:Q4).

Source of Vulnerabilities

Fragilities stem from four intertwined vulnerabilities:

  • Low growth. Real activity in the euro area and the United Kingdom is projected to decline slightly in 2013 while slowing in most other EU countries. The deep recessions in the southern periphery have spilled over to the rest of the euro area and affected the emerging economies in the EU. Medium-term growth prospects are highly uncertain but modest at best. This implies that banks’ non-performing loans are likely to rise and that their profitability will be under pressure, thus removing an important source of capital growth. For the insurance sector, low growth, and the likely accompanying low returns on assets, will put pressure on solvency. Solvency levels have also been decreasing as a result of the poor investment climate and the stagnant economy, which resulted in higher claims.

  • Fiscal vulnerabilities. Lackluster medium-term growth will hamper efforts to restore fiscal sustainability. Weak confidence in the fiscal sustainability of many euro area members—and fiscal crises in some—has severely undermined financial sector balance sheets of banks, insurance companies, and pension funds, given their large exposures to euro area sovereigns. This is reflected, for example, in the share price and credit default swap spread observed across the insurance industry.

  • Funding pressure. Market funding remains a challenge, especially for periphery banks, though pressures have eased somewhat following the European Central Bank’s (ECB) Outright Monetary Transactions (OMT) announcement. Wholesale funding markets have segmented along national borders, and the Eurosystem has served the role of buffer by intermediating funds between surplus countries and countries experiencing a funding gap—as reflected in the TARGET2 imbalances. Many banks are still heavily reliant on ECB funding, with challenges on asset encumbrance and collateral eligibility due to, for instance, rating downgrades, valuation effects on their collateral, and overall loss of market confidence. The phasing out of unconventional central bank operations will also be challenging for many banks. In the absence of further easing of market funding conditions, banks may be compelled to shed further noncore activities or reduce credit supply.

  • Deleveraging. Since the start of the crisis in 2008, European banks have deleveraged considerably, mainly across borders. Total intra-EU exposure to nonresidents of the country of the bank has declined by €1.5 trillion, among which €950 billion was accounted for by the reduction of exposures to residents in the euro area periphery. Within the euro area, the decline in cross-border claims of euro area monetary financial institutions amounted to almost €500 billion since the onset of the crisis. EU banks have also been running down their activities outside the EU.1 Bank deleveraging can be explained by a combination of structural and cyclical forces (IMF, 2012e, 2012f): adjustment of business models to the new regulatory and economic environment, pressures to build capitalization, reduction in reliance on unstable market funding, and strained financial conditions and weak demand for credit.

These vulnerabilities are prone to fuel adverse feedback loops. In countries where sovereigns ran into trouble, the banking system suffered severely as the value of sovereign backstops fell and funding costs rose. In countries where banking systems had to be supported massively, the sovereign weakened, in turn reducing the value of its support to the banking system. In both cases, the real economy suffered, further fueling the adverse loop. The underlying difficulties often arise from other sectors in the economy. Excessive household leverage often leads to a boom-and-bust cycle in residential real estate. In some countries, a corporate debt overhang threatens the financial system and constitutes a contingent liability for the sovereign through the banking system.

Against this background and despite substantial reform progress, our analysis suggests that the EU banking system remains fragile. Based on a sample of large financial institutions, soundness indicators show resilience in European emerging economies though with concerns about liquidity, comparatively better performance in non-euro area advanced EU economies, and very mixed results in the euro area. Across indicators, capitalization and earnings show improvement, but there remains a great deal of dispersion between stronger and weaker banks (Figure 6.3), while asset quality remains mixed (Figure 6.4).2

Figure 6.3Individual EU Bank Core Tier 1 Ratios

Sources: SNL Financial; and IMF staff calculations.

Note: Based on consolidated data from a sample of about 220 EU banks.

Figure 6.4Individual EU Bank Buffers

Sources: Bank for International Settlements (BIS); the European Banking Authority (EBA); SNL Financial; and IMF staff estimates.

Note: The asset quality indicator is a weighted average of real GDP forecasts for 2012 and 2013, weighted by a bank’s exposure to each economy. The exposures are taken from data published by the EBA and updated using BIS consolidated banking data.

Market pressures on EU banks have eased in recent months, bank bond issuance has picked up, and customer deposit levels have stabilized. Credit default swap spreads have come down from high levels, though they still remain elevated for banks in the euro area periphery (Figure 6.5). The cost of issuance, therefore, still remains too high to economically support lending in these economies. The combination of bank balance sheet pressures—as well as weak demand—has led to a fall in credit growth in many economies in the region (Figure 6.6). Small- and medium-sized enterprises (SMEs) are unable to obtain sufficient credit in some economies in the region (Figure 6.7) and interest rates on SME loans are diverging between the core and noncore euro area (Figure 6.8).

Figure 6.5Five-Year Bank Credit Default Swap Spreads

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: The chart shows asset-weighted averages for each region.

Figure 6.6Bank Lending in Selected EU Countries

Sources: Bank of England; Haver Analytics; and IMF staff calculations.

Note: Adjusted for securitizations.

Figure 6.7Met and Unmet Demand for Bank Credit from Small-and Medium-Sized Enterprises

Source: European Central Bank Survey on the Access to Finance of SMEs; and IMF staff calculations.

Note: Unmet demand is the percentage of respondents that applied for a loan and did not get all or most of the loan.

Figure 6.8Interest Rate on New Loans to Small- and Medium-Sized Enterprises

Source: European Central Bank, monetary and financial statistics.

Note: Chart shows the interest rate on new loans to nonfinancial corporations up to and including €1 million in value.

Findings from National Financial Sector Assessments

The overstatement of asset quality has been one major cause of the banking crisis experienced by some EU countries. Medium-term financial and macroeconomic risks, common across the region, could further impair asset quality and damage banking sector balance sheets. Stress tests, however, suggest that capital buffers appear broadly adequate. Against liquidity shocks, the availability of official facilities help protect the banking system, but central banks in smaller countries may face difficulties shoring up foreign currency shortages, especially in U.S. dollars. Safeguarding against tail risk scenarios requires continuing building up capital and liquidity buffers to meet the Basel III targets. Enhancing financial sector oversight and macroprudential supervision will also help reduce balance sheet risks.

The experience of EU crisis countries underscores the importance of an adequate assessment of asset quality in banks’ balance sheets. In Greece and Portugal, domestic banks suffered substantial losses mainly from their domestic sovereign debt holdings. In Ireland and Spain, losses in the banking system were triggered by the burst of domestic real estate bubbles. Capital buffers and provision regimes, including dynamic provisions, as in the case of Spain, were not designed to withstand the massive losses entailed by the downgrade of risk-free assets to junk status and the large downward price corrections when asset price bubbles burst. Markets concerns about banks’ creditworthiness also led to funding shortages, reducing their ability to continue funding their domestic economies and sovereigns.

Recent Financial Sector Assessment Programs (FSAPs) in EU countries highlight a number of common financial and macroeconomic risks across the region.3 These risks emerged in the aftermath of the global financial crisis and the sovereign debt crisis in the euro area (as demonstrated in the tables in Appendix 6.1). The main financial risks are stresses and dislocations in wholesale funding markets that could lead to adverse liquidity and refinancing conditions; deteriorating or sustained high sovereign risk if the euro area crisis intensifies; and a major further downward correction of asset prices. The main macroeconomic risks are associated with the scenarios of a global double-dip recession and a protracted slow growth in Europe. Uncertainty about the regulatory environment and the burden it may place on banks and financial institutions is also viewed as a source of risk in jurisdictions hosting systemic banking systems and financial institutions. In several EU countries, the high degree of concentration in the banking sector creates too-big-to-fail problems that could amplify the country’s vulnerability were the risks to materialize.

These risks could materialize in further deterioration of asset quality in banks’ balance sheets, a contraction of credit to the real economy, and rising stress in funding markets. Rising sovereign risk could affect banks still holding substantial claims on sovereigns and corporates from countries in recession, raising their funding costs and encouraging further deleveraging that could shrink credit supply in the banks’ home and host jurisdictions. Given the strong trade and financial linkages within the EU, adverse global macroeconomic scenarios characterized by slow and/or negative growth and rising unemployment would lead to higher non-performing loans (NPLs) and declining profits, reducing the scope for bank recapitalization without further deleveraging. Banks in the region that rely heavily on market funding would face liquidity problems in the face of declining capital buffers, increasing impaired assets, and a weak earnings outlook. While official measures adopted by the ECB have helped to restore some normalcy to funding markets, central banks in smaller countries may face difficulties providing liquidity in foreign currency. Finally, the recent FSAPs in EU countries note that these risks contribute to reinforcing the bank—sovereign linkage, with weaknesses in the banking sector contributing to increased sovereign risk, and vice versa.

Notwithstanding these risks, FSAP stress tests suggest that capital buffers in EU countries appear mostly adequate to withstand severe macroeconomic shocks, but there are some caveats. The resilience of the banking sector to macroeconomic shocks follows from efforts to repair balance sheets in the banking system, including the divestment of noncore assets. These efforts contributed to an earnings recovery for some large internationally diversified banks. However, impaired assets from the past remain a problem in many EU countries, and there are concerns in some cases that reported NPLs and provisions could understate losses. Outside the crisis countries, comprehensive asset quality reviews have not been conducted, with the exception of Spain. Absent such reviews, the loss estimates may not reflect the underlying quality of the banks’ balance sheets. Banking, by nature, builds up on leverage, which magnifies asset losses. Even though capital buffers relative to assets will increase under Basel III, assessing asset quality is a must.

FSAP recommendations point toward the need to continue building up buffers and strengthening financial sector oversight and macroprudential supervision. The need for larger and better quality buffers has been highlighted by recent experience, with Basel III providing the roadmap and timelines. FSAP recommendations related to financial sector oversight and macroprudential supervision aimed mainly at improving the legal framework, enhancing the review, supervisory and crisis management processes, and improving the quality of the data used to monitor and measure risks. The proposed banking union could help anchor oversight and supervision within a macroprudential perspective emphasizing the proper assessment of asset quality.

Findings from EU-Wide Stress Tests

The stress test exercises conducted by the European authorities, first by the Committee of European Bank Supervisors (CEBS) and subsequently by the European Banking Authority (EBA), succeeded in prompting banks to increase the quantity and quality of their capitalization, and contributed to a reduction in uncertainty and an increase in the credibility of the process. However, despite banks raising more than €200 billion as a result of the recapitalization exercise, confidence in European banks is not fully restored, in part because the market suspects some banks of having been insufficiently transparent—including as part of the stress testing exercises—about their losses and exposures to problem sectors. Most major banks now seem comparatively well capitalized, but funding remains problematic, for example, because of reliance on official funding and asset encumbrance in some banks. The sector also faces deep structural challenges relating to low profitability and growth and the longer-term impact of regulatory changes.

Stress testing has become an essential and very prominent tool in the analysis of financial sector stability and development of financial sector policy. Starting with the 2010 test led by the CEBS, and reinforced by the 2011 test and the bank recapitalization exercise led by the EBA, the output of EU-wide stress tests has been viewed as essential information on the health of the system. Moreover, the reliability of the results and the efficiency with which they were generated (especially the recapitalization exercise) have greatly influenced the credibility of the European and national authorities involved.

The 2010 CEBS-led stress testing exercise, which can be viewed as the start of EU-wide stress testing and which was initiated near the start of the financial crisis, was relatively poorly received. The stress scenario was regarded as too mild in the circumstances, and there was little assurance that banks had not been able to incorporate an optimistic bias into the results. Limited information disclosure did little to relieve the intense uncertainty prevalent at that time. The sample of banks included some that quickly proved to pose systemic risks in certain countries.

In the 2011 EBA-led exercise, the final estimated capital shortfall was modest. This result was largely the product of many banks—especially those with relatively weak capital buffers—preemptively increasing their capitalization and what with hindsight appears to be unduly optimistic baseline and stress scenarios, including with regard to the treatment of sovereign risk. Three main quality control mechanisms were: the banks’ own controls; those by National Supervisory Authorities (NSAs), for example, supervisory judgment; and the quality assurance process led by EBA. For the latter, EBA formed a Quality Assurance Task Force with members seconded from NSAs, the ECB, and the European Systemic Risk Board, who challenged their peers in other NSAs on the consistency of the banks’ bottom-up assumptions, methodologies and results. Compared to the 2010 stress test, EBA improved its off-site review by checking bank input data for errors, ensuring the correct adoption and application of the stress testing methodologies, and using statistical benchmarks (mainly cross-sectional) for probabilities of default, loss given default, and default rates by counterparties, country and sector.

For the 2011 stress test, EBA’s board of supervisors decided not to include market risk haircuts to the banks’ sovereign exposures in the banking book, but did publish relevant data. Only the banks’ sovereign holdings in the trading book would be subject to mark-to-market. Given the intensification of the euro area sovereign debt crisis, this assumption was debatable and criticized, but the enhanced disclosure and transparency of the banks’ sovereign exposures allowed market analysts to calculate their own sovereign haircuts and eventually the capital shortfall of banks in the sample.

The subsequent recapitalization exercise contained some elements common to stress testing. Importantly, all sovereign securities’ holdings were subject to mark-to-market. Most banks have met the 9 percent core Tier 1 capital requirement; the exceptions are banks in unusual circumstances where action is being taken, especially where governments apply. One important implication of this achievement is that banks already more or less have the capital necessary to meet requirements under Basel III or the EU’s Capital Adequacy Directive IV, even were the requirements to be applied in full or imposed through market discipline.

Appendix 6.1. Risks and Vulnerabilities in eu Countries Identified by Recent Financial Sector Assessment Programs (FSAPS)
TABLE 6A.1Systemic EU Countries: France, Germany, and Luxembourg
France (FSAP Completion Date: July 2012)Germany (FSAP Completion Date: July 2011)Luxembourg (FSAP Completion Date: May 2011)
Main Source of RiskVulnerabilities
Stresses and dislocations in wholesale funding markets; adverse liquidity and refinancing conditions.
  • Likelihood: medium; impact: high.

  • Bank refinancing needs in 2013–14 are significant and heavily reliant on wholesale funding.

  • Domestic interbank market frozen as of end-October 2012.

  • Vulnerable to systemic liquidity shocks owing to cross-border interbank exposures and derivatives positions.

  • Likelihood: medium; impact: medium.

  • Some banks may face distressed U.S. dollar funding conditions.

  • Certain banks rely heavily on market funding including through interbank borrowing, securitization, and covered bond issuance.

  • Landesbanken seem to be more vulnerable than other banks; retail banks exhibit more resilience.

  • Likelihood: medium; impact: medium to high.

  • Liquidity pressures on local bank subsidiaries could materialize if parent bank is under severe stress; the failure of the parent bank would likely lead to the failure of the subsidiary.

  • Deteriorating or sustained high sovereign risk; intensification of the euro area crisis.

  • Likelihood: medium; impact: medium to high.

  • Large exposure of SIFIs to periphery countries in Europe could translate into losses from deteriorating loan quality and sovereign bond values.

  • Bank deleveraging may lower returns and profitability.

  • Downgrade of own sovereign could negatively impact banks’ ratings, funding costs, and ability to support derivatives operations.

  • Likelihood: medium; impact: medium to high.

  • Financial institutions’holdings of foreign sovereign, sovereign-linked, and subnational government claims are substantial.

  • Likelihood: high; impact: high.

  • GUPS exposures amount to half of the aggregate bank capital in the jurisdiction.

  • GllPS-related losses of parent groups could lead to additional losses through indirect exposures arising from solvency and liquidity pressures. These exposures are difficult to quantify though.

Declining or sharp downward correction to asset prices.
  • Likelihood: medium; impact: medium to low.

  • LTV ratios are high but the risks to banks from a downward house price correction appear limited owing to households’ comparatively low debt levels and sound lending standards.

  • A housing price correction could still have an indirect impact on banks through its impact on real GDP.

  • N.A.

  • Likelihood: low to medium; impact: medium (domestically), high (globally).

  • Turbulence in bond and asset markets could lead to large scale fund redemptions, damaging the domestic and European fund industry.

  • Run on funds could depress asset market prices further, forcing fund sponsors, depository and custodian banks to provide liquidity.

  • Linkages to domestic banks appear limited; similarly, the direct impact on European bank funding through fire sale of assets is also limited.

Double-dip recession.
  • Likelihood: medium; impact: high

  • Bank asset quality would be affected; NPLs likely to rise; lower earnings from lower interest margins and higher provisioning needs.

  • Increased financial distress and heightened risk aversion could dampen growth by widening spreads and reduced credit supply.

  • Likelihood: low; impact: medium.

  • Credit quality deterioration.

  • Reduced bank profitability from an inversion of the yield curve.

  • Non-bank financial institutions affected by market losses on securities; losses in pension funds and insurance companies from the impact of low rates on long-term liabilities.

  • A short recession is unlikely to generate systemic risk.

  • Likelihood: medium; impact: medium to high.

  • Strong capital buffers make banks resilience as long as the parent bank does not fail.

Slow growth in Europe; low interest rate environment
  • N.A.

  • Likelihood: medium; impact: high.

  • Reduced profitability and ability to meet higher capital requirements.

  • Losses in pension funds and insurance companies from the impact of low rates on long-term liabilities.

  • N.A.

Regulatory uncertainty and regulatory burden.
  • N.A.

  • Likelihood: high; impact: low.

  • Money market banks and large financial groups will be the most affected, having to increase core capital and decrease leverage.

  • Likelihood: low; impact: high.

Sources: IMF (2011a, 2011c, 2012d).Note: GUPS: Greece, Ireland, Italy, Portugal, and Spain; LTV: loan-to-value; N.A.: not available; NPL: nonperforming loan; SIFI: systemically important financial institutions.
Sources: IMF (2011a, 2011c, 2012d).Note: GUPS: Greece, Ireland, Italy, Portugal, and Spain; LTV: loan-to-value; N.A.: not available; NPL: nonperforming loan; SIFI: systemically important financial institutions.
TABLE 6A.2Systemic EU Countries: The Netherlands, Spain, and Sweden
The Netherlands (FSAP Completion Date: March 2011)Spain (FSAP Completion Date: May 2012)Sweden (FSAP Completion Date: July 2011)
Main Source of RiskVulnerabilities
Stresses and dislocations in wholesale funding markets; adverse liquidity and refinancing conditions.
  • Likelihood: medium; impact: medium.

  • Banks reliant on interbank borrowing, securitization and covered bond issuance would be the most affected.

  • Increased competition for retail deposits could squeeze profitability further; “safe haven” concerns could reduce the returns for banks with funding surpluses.

  • Likelihood: medium to high; impact: high.

  • Substantial bank refinancing needs in 2012–13.

  • Despite comfortable buffers of ECB instruments that could be used as repo collateral, worsening market conditions could impose higher haircuts to banks’ collateral.

  • Refinancing difficulties could prevent an orderly deleveraging in the banking sector.

  • Likelihood: medium; impact: high.

  • Banks could face refinancing risks, including higher funding rates.

  • The central bank has limited ability to offset foreign currency liquidity shortages.

Deteriorating or sustained high sovereign risk; intensification of the euro area crisis.
  • Likelihood: medium; impact: low.

  • Banks appear less exposed to GUPS countries than are some in neighboring countries.

  • Spillovers from the periphery to the core raise concerns.

  • Likelihood: high; impact: high.

  • Limited direct exposure of the banking system to periphery countries, but exposure to domestic sovereign is high, amounting to 150 percent of core Tier 1 capital.

  • Trading book and mark-to-market value of the available for sale book only minimally affected by valuation haircuts.

  • N.A.

Declining or sharp downward correction to asset prices.
  • Likelihood: medium; impact: high.

  • Banks are heavily exposed to the residential housing market; falling prices and lending arrears would have a negative impact on banks’ balance sheets.

  • Likelihood: high; impact: high.

  • Since real estate exposures are large, recapitalization needs will further increase.

  • About one out of four banks in the stress test sample would face severe capital losses.

  • Likelihood: medium; impact: high.

  • Falling housing prices would lead to direct losses in the banking system and indirect losses from weaker economic growth and higher unemployment.

Double-dip recession in advanced economies.
  • Likelihood: medium; impact: medium.

  • Bank solvency affected by high and/or rising unemployment rates; sharp housing price corrections; rising NPLs from firms and households.

  • Difficulties of foreign subsidiaries would impact parent banks negatively.

  • N.A.

  • Likelihood: medium; impact: medium.

  • Bank asset quality would be adversely affected through various transmission channels including increased unemployment, deteriorating corporate earnings, and a sharp correction in real estate prices.

Slow growth in Europe; low interest rate environment.
  • Likelihood: medium; impact: medium to high.

  • Impact similar to second bullet item above but scenario not included in stress test.

  • Scenario not included in stress test.

  • Impact considerations largely in line with the realization of the double-dip recession risk.

  • N.A.

Regulatory uncertainty and regulatory burden.
  • N.A.

  • N.A.

  • Likelihood: medium; impact: high.

  • Banks need to extend their funding maturity to comply with new liquidity regulations, leading to higher lending rates, reduced lending and/or lower bank profitability.

Sources: IMF (2011b, 2011d, 2012c).Note: FSAP: Financial Sector Assessment Program; GUPS: Greece, Ireland, Italy, Portugal, and Spain; N.A.: not available; NPL: nonperforming loan.
Sources: IMF (2011b, 2011d, 2012c).Note: FSAP: Financial Sector Assessment Program; GUPS: Greece, Ireland, Italy, Portugal, and Spain; N.A.: not available; NPL: nonperforming loan.
TABLE 6A.3Systemic (the United Kingdom) and Nonsystemic (the Czech Republic and Slovenia) EU Countries
SystemicNonsystemic
United Kingdom (FSAP Completion Date: May 2011)Czech Republic (FSAP Completion Date: February 2011)Slovenia (FSAP Completion Date: October 2012)
Main Source of RiskVulnerabilities
Stresses and dislocations in wholesale funding markets; adverse liquidity and refinancing conditions.
  • Likelihood: medium and rising; impact: high.

  • Stable funding in the banking sector beyond six months is inadequate.

  • Likelihood: medium; impact: high.

  • Mainly associated with the failure of a foreign parent bank.

  • Upstreaming capital and/or liquidity to parent may limit the operational scope of the subsidiaries.

  • Reputational risk would pressure liquidity and funding costs; and encourage deleveraging.

  • LTROs have contributed to alleviate banks’ funding pressures but the loan-to-deposit ratio for the system is high.

  • Foreign-owned banks are more reliant on wholesale funding than domestic banks.

Deteriorating or sustained high sovereign risk; intensification of the euro area crisis.
  • Likelihood: medium and rising; impact: low.

  • Extreme tail risk losses in the banking sector could amount to about 6 percent of 2010 GDP.

  • Rising sovereign risk could expose banks to funding disruptions.

  • N.A.

  • Impact: low.

  • GUPS exposures are small.

Declining or sharp downward correction to asset prices.
  • Likelihood: medium; impact: medium.

  • Commercial real estate loans account for a substantial share of corporate loans, putting banks at risk if CRE prices decline sharply.

  • Housing loans to low-income households are more sensitive to housing price declines and real interest rate shocks.

  • Lender forbearance practices could be masking increased risks in housing and CRE markets.

  • Two large U.K. banks have very large exposures to Asia, which has experienced rapid asset price increases on the back of strong capital inflows.

  • See fourth bullet item below on housing prices and commercial real estate prices.

  • Housing and commercial real estate prices have remained relatively stable since the price correction experienced in 2008; however, the inventory of foreclosed properties and NPLs in the sector has increased.

  • Further declines in CRE and housing prices are likely to accelerate foreclosures and NPLs in the banking sector, resulting in impairments.

  • Protracted bankruptcy procedures suggest increased foreclosures would affect prices only after a substantial lag of about 2–3 years.

Double-dip recession in advanced economies.
  • Likelihood: medium; impact: medium.

  • Major banks would be able to absorb losses, with extreme tail risk losses amounting to about 2½ percent of 2010 GDP.

  • Likelihood: medium; impact: medium to high.

  • Unfavorable export markets; slower domestic growth; drop in asset prices; reversal of capital flows.

  • Negative effects on banks’ asset quality leading to a substantial drop in capitalization.

  • Heavy concentration of bank loans in commercial real estate and mortgages makes banks especially sensitive to a severe macroeconomic shock.

  • Likelihood: high; impact: high.

  • Negative impact through trade and financial channels.

  • Further recapitalization needs required for the largest domestic bank.

Slow growth in Europe; low interest rate environment.
  • Likelihood: medium; impact: low.

  • The insurance sector exhibits resilience to low interest rates; extreme tail risk losses in the banking system could be as high as 5 percent of 2010 GDP.

  • Likelihood: high; impact: medium.

  • Negative impact on economy through main trading partners, especially Germany; asset quality and income deterioration in the banking sector.

  • Higher funding costs resulting from competition for deposits and the adoption of Basel III to a certain degree.

  • Higher exchange rate volatility could amplify stress conditions.

  • N.A.

Regulatory uncertainty and regulatory burden.
  • Likelihood: medium; impact: medium.

  • Basel III could have a significant impact on banks; core Tier 1 capital reduced by half for six largest banks under new definition; new liquidity requirements will affect short-term wholesale funding practices; SIFIs profitability adversely affected.

  • Solvency II, which becomes effective January 1, 2013, could encourage search for yield among insurers.

  • N.A.

  • N.A.

Sources: IMF (2011e, 2012a, 2012b).Note: CRE: commercial real estate; GIIPS: Greece, Ireland, Italy, Portugal and Spain; LTROs: long-term refinancing operations; N.A.: not applicable; NPL: nonperforming loan; SIFIs: systemically important financial institutions.
Sources: IMF (2011e, 2012a, 2012b).Note: CRE: commercial real estate; GIIPS: Greece, Ireland, Italy, Portugal and Spain; LTROs: long-term refinancing operations; N.A.: not applicable; NPL: nonperforming loan; SIFIs: systemically important financial institutions.

Estimates from the Bank for International Settlements (BIS) suggest that French and German banks, for example, cut their U.S. dollar asset activities (including in trade finance and project financing) by $270 and $100 billion, respectively, in the year up to the second quarter of 2012

Partly because banks outside this large-bank sample have proven a source of trouble, these observations need to be interpreted with care.

The assessment is based on a review of EU countries’ FSAPs conducted in 2011–12, including the Czech Republic, France, Germany, Luxembourg, the Netherlands, Slovenia, Spain, Sweden, and the United Kingdom.

References

    International Monetary Fund2011aLuxembourg: Publication of Financial System Stability AssessmentIMF Country Report No. 11/148 (WashingtonJune) http://www.imf.org/external/pubs/ft/scr/2011/cr11148.pdf.

    International Monetary Fund2011bKingdom of the Netherlands: Publication of Financial System Stability AssessmentIMF Country Report No. 11/144 (WashingtonJune) http://www.imf.org/external/pubs/ft/scr/2011/cr11144.pdf.

    International Monetary Fund2011cGermany: Publication of Financial System Stability AssessmentIMF Country Report No. 11/169 (WashingtonJuly) http://www.imf.org/external/pubs/ft/scr/2011/cr11169.pdf.

    International Monetary Fund2011dSweden: Publication of Financial System Stability AssessmentIMF Country Report No. 11/172 (WashingtonJuly) http://www.imf.org/external/pubs/ft/scr/2011/cr11172.pdf.

    International Monetary Fund2011eUnited Kingdom: Publication of Financial System Stability AssessmentIMF Country Report No. 11/222 (WashingtonJuly2011) http://www.imf.org/external/pubs/ft/scr/2011/cr11222.pdf.

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    International Monetary Fund2012cSpain: Publication of Financial System Stability AssessmentIMF Country Report No. 12/137 (WashingtonJune) http://www.imf.org/external/pubs/ft/scr/2012/cr12137.pdf.

    International Monetary Fund2012dFrance: Publication of Financial System Stability AssessmentIMF Country Report No. 12/341 (WashingtonDecember) http://www.imf.org/external/pubs/ft/scr/2012/cr12341.pdf.

    International Monetary Fund2012eGlobal Financial Stability Report: The Quest for Lasting StabilityWorld Economic and Financial Surveys (WashingtonApril) http://www.imf.org/External/Pubs/FT/GFSR/2012/01/index.htm.

    International Monetary Fund2012fGlobal Financial Stability Report: Restoring Confidence and Progressing on ReformsWorld Economic and Financial Surveys (WashingtonOctober) http://www.imf.org/External/Pubs/FT/GFSR/2012/02/index.htm.

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