Financial Stability Review, May 2020

Foreword

• It has caused one of the largest and sharpest economic contractions in recent history.
• Against this backdrop, the May 2020 Financial Stability Review assesses how the financial system has operated so far during the pandemic.
• It also sets out policy considerations for both the near term and the medium term.
• It does so to promote awareness of systemic risks among policymakers, the nancial industry and the public at large, with the ultimate goal of promoting financial stability.
• By providing a financial system-wide assessment of risks and vulnerabilities, the Review also provides key input to the ECBs macroprudential policy stance.

Overview

The coronavirus pandemic prompted extreme financial market sell-offs and stress

• The spread of the coronavirus (COVID-19) triggered abrupt shifts in asset prices and led toan increase in financial system stress (see Chart 1, left panel).
• After several years of low volatility with only short-lived spikes, financial market volatility quickly surged to levels last seen at the time of the global financial crisis.
• Chart 1 Euro area systemic stress indicators rose sharply as a result of the spread of the coronavirus and the enforcement of public containment measures
• The coronavirus pandemic has affected virtually all aspects of economic activity, at times interacting with pre-existing financial vulnerabilities (see Figure 1).
• While the presence of these vulnerabilities amplified some of the response to the coronavirus shock, the financial system nonetheless proved broadly resilient, partly reflecting the regulatory reforms of the past decade.
• Some asset prices could be susceptible to corrections, if GDP and earnings growth outturns are worse than markets appear to expect.
• Figure 1 The coronavirus pandemic affected the real economy and the financial system, with sector-specific vulnerabilities being reinforced by strong interlinkages
• Large parts of the global and euro area economies came to a near standstill in early 2020.
• The initial tightening of market conditions was sudden, broad-based and, at times, disorderly.
• Sectors more affected by the pandemic, such as travel services, automobiles, and energy which faced additional pressure from the sharp fall in oil prices saw significant declines.
• Since the end of March, there has been a notable recovery in equity prices and key bond spreads, although conditions remain significantly tighter than before the pandemic.
• Chart 2 The deterioration of global economic growth prospects triggered a spike in volatility and an abrupt correction in global stock markets
• Market liquidity came under pressure, with investment funds experiencing outflows and amplifying market dynamics.
• As the market sell-off intensified, investment funds experienced outflows resembling those seen during the global financial crisis.
• Liquidity stress among investment funds may reappear, given their low level of liquid assets prior to the turmoil and the currently low levels of market liquidity.
• During the recent stress, overall market liquidity improved following central bank policy interventions.
• Chart 3 In addition to stress in riskier bond market segments, liquidity pressures triggered large-scale investment fund outflows from safer assets as well
• These measures range from standard monetary policy action to non-standard measures, including asset purchases, lending facilities, liquidity support and currency swap lines.
• The main euro area central clearing counterparties (CCPs) were able to avoid operational disruption during the turmoil.
• Despite high volatility in financial markets prompting large variation margin calls in both cleared and non-cleared derivatives markets (see Special FeatureB), calls were in general met by market participants.
• The robustness of central clearing, a key area of financial sector reform after 2008, also helped avoid wider dysfunction in derivatives markets.
• However, the reformed financial system (including central clearing) has not yet been tested for a widespread deterioration in creditworthiness.
• That said, in general, the impact on claims is expected to be less significant, as epidemics are usually excluded from (non-life) insurance cover.

Corporates and households face lower income and rising debt burdens

• Non-financial firms, many already highly indebted and facing profitability challenges prior to the pandemic, now face cash-flow strains and higher financing costs.
• This weakens corporate debt sustainability over the medium term.
• In particular, riskier firms, which have levered up in recent years amid low funding costs, are likely to face downgrade risk (see Chart 4, right panel).
• This could imply higher funding costs and possible rollover risks going forward, primarily for the very large lower-rated investment-grade segment.
• Chart 4 Corporate liquidity pressures are increasingly evident, while higher downgrade risk may challenge non-financial firms
• The pandemic and subsequent containment measures are affecting euro area households, primarily through higher unemployment and weaker income.
• At the same time, private consumption has declined as consumer confidence has fallen and households have deferred non-essential purchases.
• Higher unemployment and income risks are compounded by the already high level of household indebtedness in several euro area economies.
• But policy action, including loan moratoria and income support measures in a number of countries, could mitigate the related risks.
• Chart 5 Households challenged in countries with high pre-pandemic unemployment and low liquidity buffers amid growing risks of real estate market corrections

Fiscal measures provide essential support, but add to public debt burdens

• All euro area countries have announced fiscal measures to cushion the economic impact of the pandemic.
• These measures aim to support health services, to replace lost incomes, and to protect the corporate sector.
• The measures include tax breaks, public investments and fiscal backstops, such as public guarantees or credit lines (see Chart6, left panel).
• The fiscal measures help mitigate the economic fallout, and to the extent that they help economic growth to recover more quickly, they can be supportive of medium-term debt sustainability.
• Chart 6 Fiscal relief measures reduce the near-term impact of the pandemic, but may reinforce medium-term public debt sustainability concerns

Euro area banks are supported by capital and liquidity buffers, but face even weaker profitability

• Bank valuations fell to record lows and bank funding costs increased, despite the enhanced resilience since the global financial crisis.
• Importantly, euro area banks entered this stress episode with stronger capital levels, better liquidity positions and more stable funding structures than they had at the time of the global financial crisis a decade ago (see Chart 7, left panel).
• Chart 7 Despite increased resilience since the global financial crisis, bank valuations plunged
• Mirroring changes in corporate earnings expectations, bank analysts have also revised down their 2020 return on equity (ROE) forecasts for euro area banks (see Chart 8, left panel).
• Euro area banks prospects are further hindered by continuing structural problems.
• Low cost-efficiency, limited revenue diversification and overcapacity continue to weigh on many banks profitability prospects.
• Furthermore, banks continue to face the challenges of operating in business continuity mode, including the associated increase in cyber risk.
• Prudential authorities across the euro area acted to maintain the flow of credit to the economy, complementing monetary and fiscal measures.
• Chart 8 Euro area banks profitability outlook has deteriorated further amid gloomy corporate earnings prospects, low interest rates and looming asset quality problems

Policy measures alleviate near-term risks to financial stability, but medium-term vulnerabilities have risen

• The euro area financial system has weathered much of the recent stress with the help of policy measures, but the lost economic output and higher debt burdens increase the medium-term risks to euro area financial stability.
• The potential of these vulnerabilities to materialise simultaneously further increases the risks to financial stability.

1 Macro-financial and credit environment

1.1 Sharp deterioration of near-term economic outlook

• The global and euro area economies have faced one of the largest and fastest contractions on record, with an uncertain recovery ahead.
• In the first quarter of the year, euro area real GDP declined by 3.8% quarter on quarter according to preliminary flash estimates.
• Economic projections for all euro area countries for 2020, which are surrounded by a high degree of uncertainty, suggest substantial declines in output, with annual rates of decline ranging between -6% and -9.2% (see Chart 1.1, left panel).
• Preliminary scenario analysis by ECB staff suggests a decrease in euro area GDP of between 5% and 12% this year.
• Chart 1.1 Expected contraction in 2020 well beyond what could have been foreseen in February
• Governments have launched a range of fiscal relief measures to support companies and employment, in addition to automatic fiscal stabilisers.
• Beyond supporting health systems, national governments and the European Commission have also sought to mitigate the economic impact on households and companies.
• In addition, a European recovery fund to increase the EU budget temporarily by 500 billion was proposed by the French and German Heads of State.
• In addition, sovereign bond spreads could narrow as a higher share of aggregate sovereign debt would benefit from higher ratings (see Chapter2).
• National governments have implemented or expanded schemes to support continued employment, such as wage subsidies or special temporary unemployment schemes.
• Micro- and macroprudential authorities have also acted to support continued bank lending with capital measures amounting to around 140billion (see Chapter 5).
• While the central expectation is for the pandemics economic fallout to be temporary, there are downside risks to the recovery despite the large-scale policy support.
• Based on growth-at-risk predictions, the 5th quantile of GDP growth one year ahead has dropped from -1% to around -11% (see Chart 1.2, left panel).
• Across euro area countries, dispersion is very wide, reflecting that countries have been impacted differently by the virus and the associated containment measures (see Chart 1.2, right panel).
• Several forces are behind the downside risks: first, not only countries but also economic sectors have been affected to different extents by the lockdown measures.
• These sectors account for about half of total gross value added in the euro area (see Chart 1.3, left panel).
• Chart 1.3 Sensitive sectors account for almost half of total gross value added and unemployment may rise substantially
• Weak global growth and protracted disruption of supply chains may also delay the recovery in the euro area.
• Emerging market economies (EMEs) have experienced sharp capital outflows since end-January (see Chart 1.4, left panel).
• Capital outflows and the depreciation of EME currencies against the US dollar are likely to depress economic activity in EMEs, and raise concerns about debt sustainability in a number of countries.
• The International Monetary Fund (IMF) projects global activity (excluding the euro area) to contract by 2.3% in 2020.
• Chart 1.4 The global recovery is also uncertain, as EMEs experienced sharp capital outflows and world trade is expected to shrink

1.2 Substantial fiscal response to pandemic implies a large increase in sovereign debt

• The fiscal policy response to the economic fallout of the coronavirus has softened the impact, and is expected to support economic recovery.
• These include direct spending measures and loan guarantees for the non-financial private sector (see Chart 1.5, left panel).
• The first category includes, for example, expenditure to expand medical capacity in response to the pandemic, as well as schemes aimed at supporting continued employment, such as wage subsidies or special temporary unemployment schemes.
• These measures include guarantees for export credit and for other liquidity assistance and credit lines via national development banks (see Box4).
• Chart 1.5 Euro area governments have taken strong action to support the economy affecting budget deficits this year
• These higher financing needs result from both the standard functioning of automatic fiscal stabilisers and the fiscal stimulus packages.
• The proportion of corporate sector guarantees called will depend on the depth and length of the recession and such calls will increase government financing needs.
• As a result, budget deficits and government debt levels are expected to increase, supporting activity in the near term.
• Moreover, a number of countries are facing substantial debt repayment needs over the next two years (see Chart 1.6, right panel).
• While the large fiscal policy response mitigates the economic cost of the downturn, thereby providing a first line of defence against fiscal debt sustainability concerns, a more severe and protracted economic downturn could give rise to debt sustainability risks in the medium term.

1.3 Income declines and rising unemployment will test resilience of household balance sheets

• Survey-based indicators point to a strong deceleration in employment across all business sectors led by the services and retail sectors (see Chart 1.7, left panel).
• Mirroring the bleaker employment expectations and generally elevated uncertainty, households assessed their financial situation as being much weaker and accordingly consumer confidence declined strongly.
• On aggregate, euro area households entered the pandemic period with strong balance sheets.
• Household real disposable income had continued its expansion in 2019, underpinned by employment gains and robust wage growth (see Chart 1.7, right panel).
• However, the recent substantial decline in equity markets could weigh on households financial asset holdings and housing wealth might also decline.
• Chart 1.7 Households expect a significant deterioration in their economic situation although past income growth and savings can provide some buffer
• Bank lending standards for households have tightened and total lending to households declined in March.
• Before the coronavirus shock hit, aggregate bank loan growth had continued rising gradually, but with variation across euro area countries, reflecting different economic conditions and real estate cycles.
• By contrast, growth of consumer credit had been gradually decelerating already, in line with slower economic growth and the associated lower spending on durable goods.
• This may partly reflect capacity constraints of banks which were busy providing loans to NFCs, but was also due to lower loan demand.
• Households facing wage declines owing to a more precarious work situation and sole proprietors facing financing strains might have drawn on credit lines.
• Risks to household debt sustainability could arise as a result of the economic contraction and if the recovery is slow.
• This should also depend on the fraction of households that experience income declines, for example in the context of job losses or self-employed people who face substantial revenue losses.
• In addition, the continued favourable financing conditions should mitigate some of the vulnerability.
• Chart 1.9 Debt and debt service burdens had declined in most euro area countries prior to the pandemic

1.4 Widespread cash-flow challenges put the corporate sector under stress

• Vulnerabilities have increased considerably in the corporate sector due to the pandemic and related containment measures.
• Corporate profits on aggregate are expected to follow the large drop in economic activity (see Chart 1.10).
• Flash PMI data for May provide first indications of some rebound in economic activity.
• Chart 1.10 Downside risks to corporate earnings could unearth debt vulnerabilities
• Expected default frequencies and distance-to-default measures deteriorated sharply in March and April (see Chart 1.11, left panel).
• Credit risk measures have surpassed their average values since 2014, but remained below the levels that had been observed during the financial and sovereign debt crises.
• In addition, rating agencies have increased the number of downgrades, notably in the high-yield segment (see Chart 1.11, right panel).
• The corporate sector had already seen a rising number of downgrades over the past two years, reflecting the pronounced increase in leverage over that period (see Chart 1.12, left panel and Box 1).
• Chart 1.11 Rapid increase in credit risk and in the number of corporate rating downgrades


Chart 1.12 The risk posed by leverage of high-yield firms materialised

• Many corporates have experienced liquidity shortages and have drawn down credit lines, increasing their leverage.
• At the same time, in relation to the size and pace of the economic shock these liquidity buffers have proven insufficient in many cases.
• Notably SMEs and businesses that depend heavily on current cash flows, such as travel and tourism, quickly experienced liquidity shortages and funding constraints.
• In response, many firms drew on credit lines (see Chart 1.13, left panel) and loan provision in March increased by around 120 billion to the highest monthly level on record.
• Chart 1.13 Credit lines and government support schemes are the first source of external finance to address liquidity needs
• Over the next two years, corporates in sensitive sectors face significant debt refinancing needs.
• Gross issuance of corporate bonds was robust in early 2020, before stalling in mid-February and then resuming after 24March, supported by the implemented policy measures and in particular by the PEPP, which along with the other measures improved risk sentiment (see Chapter2).
• For some firms, challenges in refinancing debt could result in solvency problems, in particular in the event of a slow economic recovery and continued impediments to business models.
• Chart 1.14 Sectors sensitive to the pandemic measures have substantial refinancing needs Corporate refinancing needs in sensitive sectors over the next five years (percentages, billions)
• The outstanding amount of PE managed by global funds amounted to close to USD8 trillion in December 2019, of which buyout funds accounted for around a third.
• Buyout funds have grown faster than any other PE strategy over recent years, even as their managers have diversified their activities.
• Institutional investors demand for access to PE buyout funds has been reflected in increasing rates of oversubscription of buyout funds in the primary market (see Chart A, left panel).

1.5 Signs of slowing in real estate markets

• Residential real estate (RRE) prices were continuing to rise towards the end of 2019, but are now expected to moderate.
• However, valuation measures still suggest that RRE prices are higher than would be justified by fundamental data.
• While house prices had continued to rise in almost all euro area countries towards the end of 2019, growth rates displayed a wide dispersion across countries, reflecting the heterogeneity of euro area property markets.
• A number of countries face structural vulnerabilities in their property markets.
• Accordingly, larger house price corrections would be more probable in countries where house prices show the strongest signs of overvaluation.
• The impact of the coronavirus shock on RRE markets depends on its persistence and its effects on employment and household income.
• Commercial real estate (CRE) markets entered the pandemic at the peak of a cycle, with tentative signs of moderation already showing.
• Annual CRE price growth picked up again in 2019 and has been fluctuating around 5% since 2016.
• Prices in the office segment grew at 8.8% annually, while the retail segment faced declining prices in real terms.
• Transaction values increased slightly at the end of 2019 driven by price increases, as transaction numbers declined further.
• Commercial real estate tends to be sensitive to economic activity and to react strongly to a slowdown (see Chart 1.15, left panel), as lower profitability of NFCs likely results in a decreased demand for commercial leasable space.
• Chart 1.16 Prime CRE price dynamics were moderating in line with the signs of a maturing cycle, while the stock market reaction to the pandemic in the CRE sector was strong
• Risks to financial stability stemming from real estate markets have increased.
• The risk of house and CRE price corrections is increasing, especially in countries where prices are stretched.
• Furthermore, the demand for housing might slow down, leading to a further decline in the real estate cycle as a result of the drop in economic activity and employment.

2 Financial markets

2.1 Coronavirus spread sparks extreme market volatility

• Riskier asset markets sold off rapidly in February and March as the coronavirus spread globally.
• But far-reaching public and economic lockdowns in many parts of the world to contain the spread of the virus triggered large and sudden price declines in global financial markets in February and March.
• Riskier asset classes, including equities and lower-rated debt, came under high selling pressure amid extreme levels of volatility (see Chart 2.1, first, second, third and fifth panels).
• Equity and bonds issued by the energy sector recorded some of the largest markdowns as extreme volatility extended to commodity prices (see Chart 2.1, sixth panel).
• In its initial phase, the market sell-off extended to several high-quality asset markets, including gold and top-rated government bonds (see Chart 2.1, fourth panel), as investors fled into liquidity.
• The extreme levels of market stress eased in late March when central banks and fiscal authorities across the world took extraordinary measures.
• Central banks engaged in asset purchases in primary and secondary securities markets and expanded collateral eligibility in the face of deteriorating market liquidity, which had undermined financial markets capacity to intermediate between the financial and non-financial sectors and, with it, the monetary policy transmission mechanism.
• Moreover, the Governing Councils decision to maintain collateral eligibility of bonds that had recently lost or would at some point lose investment-grade status helped to halt the widening of lower investment-grade sovereign spreads.
• Chart 2.2 Market volatility peaked across asset classes and regions Realised volatility heat map
• Measures of market volatility, systemic stress and financial conditions reached historical highs.
• In March, the VIX index, gauging option-implied volatility in the US equity market, reached its highest level on record.
• Market volatility was also widespread across different regions and asset classes, resembling the pattern observed during the global financial crisis (see Chart 2.2).
• Financial conditions tightened on account of both rising credit risk, as the macroeconomic and earnings outlook deteriorated, as well as higher risk premia (see Section 2.3).
• This may in part reflect that, unlike in 2008, the financial sector was not at the core of the market turmoil.

2.2 Central banks acted to restore liquidity in core market segments

• Market stress in March was amplified by scarce liquidity across several asset classes.
• Market analysts reported that investors were seeking to liquidate positions across numerous asset classes in the first two weeks of March, partly resulting from investment fund share redemptions (see Chapter 4).
• It might however also have reflected difficulties experienced by authorised participants in the ETF market in taking arbitrage opportunities (see Chapter4).
• Portfolio strategies based on volatility targets or risk parity may also have reinforced the market sell-off.
• Targeting a medium level of volatility, such strategies can afford a high degree of leverage during spells of low volatility.
• Chart 2.4 Typical market relationships broke down at the height of the market turmoil, resulting in a liquidity squeeze
• Central counterparties (CCPs) proved to be resilient to recent market stress.
• Volumes in some markets temporarily increased, as investors augmented their demand for hedging instruments in volatile markets.
• But rapid price movements and volatility in markets triggered considerable margin calls in March (see Chart 2.5, left panel, and Special Feature B).
• A lack of liquidity may have also prompted some investors to close highly leveraged positions, thereby also putting pressure on underlying asset prices.
• Market participants with deteriorating creditworthiness may face stricter trading or position limits as well as requests for dedicated margin add-ons by CCPs, possibly limiting the availability of market liquidity.
• Money market funds (MMFs) came under severe liquidation pressure as financial and non-financial investors redeemed large amounts of shares.
• Central banks across the globe intervened swiftly to ensure liquidity in financial markets.
• Even securities deemed as highly liquid, such as commercial paper, were shed by MMFs to meet rising redemption pressure.
• Most prominently, the Eurosystem contributed to easing scarcity in market liquidity by significantly expanding corporate and sovereign bond purchases under the asset purchase programme (APP) and the PEPP (see Chart 2.6, left panel).
• [3] In addition, the additional flexibility with respect to sovereign issuer limits under the PEPP contributed to restoring market liquidity.
• [4] Chart 2.6 Eurosystem provided liquidity in securities and US dollar markets
• Volatility-targeting strategies and the market sell-off Prepared by Danilo Vassallo, Lieven Hermans and Thomas Kostka Low financial market volatility in the years prior to the coronavirus outbreak increased the popularity of investment strategies based on targeting volatility.
• Low volatility across major asset classes and regions had been a key feature of global asset price developments until recently.
• [5] Investments following strategies which are reliant on low market volatility have grown over recent years, with varying estimates.

2.3 Markets governed by increasing macro and credit risk

• Notwithstanding the various amplifying effects from scarce market liquidity, price declines in equity and credit markets first and foremost reflect lower expected earnings and elevated corporate default risk.
• Near-term earnings expectations for listed corporates have fallen sharply as they have drawn down on credit lines as cash flows evaporated which, in turn, raised corporate leverage ratios (see Chapter 1).
• Higher credit risk is mirrored in an acute increase in credit spreads of corporate as well as sovereign bonds with lower investment-grade and sub-investment-grade ratings.
• Sovereign credit spreads have been sensitive to policies at the European level.
• Higher sovereign spreads might, in turn, cascade to other market segments through banks sovereign exposures and through public guarantees on non-financial corporate debt.
• Chart 2.7 Increasing corporate and credit risk
• High uncertainty about future economic outcomes added to the widening of financial asset risk premia.
• Beyond the adverse economic shock itself, the high uncertainty surrounding the outlook for growth, corporate earnings and defaults has also weighed on asset prices.
• Investors are requiring higher risk premia to compensate for the increased downside risks to earnings and creditworthiness.
• The current extreme levels of macroeconomic uncertainty would even be consistent with a more pronounced widening of risk premia in equity markets (see Chart 2.8, left panel).
• Chart 2.8 Rising macroeconomic and market uncertainty contributed to widening risk premia
• High asset valuations prior to the shock probably exacerbated the market correction and there remains a risk of further asset price declines.
• Financial asset price inflation prior to the shock might have intensified the sell-off.
• This positive investor sentiment might evaporate rapidly should the earnings recession in 2021 turn out more severe than currently anticipated.
• Corporate bond markets also appeared richly valued before the market crash, with credit spreads of both investment-grade and high-yield NFC bonds ranging below their post-financial crisis averages (see Chart 2.9, right panel).
• In particular, bonds at the lower end of the credit spectrum are at risk of renewed markdowns, for instance in the event of significant downgrades and defaults in this segment.
• Corporate bond prices signal a considerable risk of imminent downgrades from investment grade to high yield, with some sectors more exposed than others.
• Increased levels of credit risk can translate into jumps in spreads of downgraded bonds.
• Previous issues of the FSR warned of the particular risk from large-scale downgrades of borrowers in the BBB segment in this context, as their downgrades are associated with a loss of investment-grade status.
• Chart 2.10 Differences in BBB-rated bond spreads across borrowers signal downgrade risk for sectors most exposed to the coronavirus shock
• While bond markets were fast to react to deteriorating corporate fundamentals, actual rating downgrades may occur more gradually as rating agencies assess companies ability to withstand a severe recession.
• One year after the collapse of Lehman Brothers, the largest credit rating agency had downgraded one in six NFCs that were rated BBB prior to the pandemic to high-yield status.
• But an increasing share of corporates in the BBB bucket put on negative rating outlooks and watchlists signals a likely rise in downgrades over the coming quarters (see Chart 2.11, middle panel).
• Downgrades might significantly increase the supply of high-yield corporate bonds, with likely price effects.
• As downgrades materialise, investment-grade investors such as insurance companies, pension funds, investment funds and some ETFs might sell the downgraded assets in their portfolios.
• Chart 2.11 Downgrades are expected to rise significantly, especially for BBB-rated debt
• Historical comparisons have their shortcomings, however, as the nature of an economic shock can expose different sets of sectors to heightened default risk.
• The speed and extent of downgrades also remain hard to predict.
• Downgrades and defaults among high-yield issuers and leveraged loans are projected to increase (see Chart 2.12, left panel).
• Projected downgrades aggravate adverse longer-term trends in credit quality within the high-yield sector, with a declining share of the highest rating bucket (BB) (see Chart 2.12, middle panel).
• Chart 2.12 Deteriorating credit quality in high-yield bond market
• High corporate bond spreads and downgrades may hamper corporates ability to roll over their maturing bonds.
• Bond issuance by euro area corporate borrowers froze in March, arguably reflecting higher spreads and overall funding costs in corporate bond markets alongside elevated uncertainty (see Chart 2.13, left panel).
• As investor uncertainty, reflected in at times prohibitively high financing costs, persists, current and prospective high-yield borrowers face pressing rollover risks.
• Chart 2.13 Rollover risk is higher in adverse financial conditions, but mitigated by a favourable maturity structure

3 Euro area banking sector

3.1 Lower valuations and tighter market funding conditions

• Euro area bank valuations saw outsized declines as global equity market prices fell in March.
• In many countries, bank equity indices saw larger corrections than the broad market, in anticipation of the economic fallout from the coronavirus pandemic on banks balance sheets.
• Since mid-March, banks have recuperated some of the losses but less than the broader market suggesting lingering concerns specific to the outlook for banks.
• The stock price declines translated into lower market valuations of banks (see Chart 3.1, right panel).
• Chart 3.1 Euro area bank stock prices and valuations fell more than the broader equity market as the coronavirus spread
• Bond funding costs for euro area banks rose, particularly for riskier instruments.
• Spreads on all wholesale market debt widened, but the impact was more pronounced for riskier instruments (see Chart 3.2, left panel).
• For the euro area on aggregate, from mid-February to mid-March, the spreads of the most risky instruments (i.e.
• Since mid-March, bond spreads have declined by around 1,000 basis points for AT1 bonds and 20 basis points for senior unsecured bonds, while spreads of covered bonds remained unchanged.
• Chart 3.2 Banks wholesale debt funding costs increased substantially, in particular for riskier instruments
• Short-term funding remained ample in euro area banks, which entered the stress episode with larger buffers than during the 2008 crisis.
• Since 2014, banks have built up substantial buffers of high-quality liquid assets (HQLA), which are mainly in the form of central bank reserves and government bond holdings (see Chart 3.3, left panel).
• There are notable differences across countries.
• The Single Supervisory Mechanism (SSM) has allowed banks to operate temporarily below the LCR requirement, with the aim of banks using liquidity buffers to support the real economy.
• Chart 3.3 Euro area banks have built substantial liquidity buffers over the past decade, but some banks are more reliant on sovereign debt Sources: ECB, ECB supervisory statistics and ECB calculations.
• Household and corporate deposits also continue to provide euro area banks with a stable source of funding at low costs.
• Deposits account for the majority of the funding of euro area banks on aggregate, with households being the largest providers of funds, and corporates accounting for one-sixth of the total.
• If market funding conditions remain tight, a heavier reliance on wholesale funding might cause bank profitability to face stronger headwinds in the future.
• Banks continue to benefit from low deposit funding costs (see Chart 3.4, left panel), even if negative rates have seen limited pass-through.
• Chart 3.4 Euro area banks continue to benefit from stable low-cost deposit funding, with an increase in corporate deposits in March resulting from firms short-term borrowing
• Reflecting the tightening in market conditions, the gross issuance of bank bonds dropped close to zero at the end of February.
• However, even if banks refinance the total volume of maturing bonds at currently observed secondary market yields, they would still not see an increase in average bond funding costs in the near future.
• However, if funding conditions were to remain tight, the difference between average bond funding costs of banks in countries more and less affected by past crises would widen (see Chart 3.5, right panel).
• To provide funding and thereby alleviate potential liquidity strains of banks, the ECB conducted additional Eurosystem operations of around 480 billion since mid-March.
• Chart 3.5 Tightening market funding conditions increase refinancing costs for banks bond funding compared with those seen at the beginning of 2020
• Credit rating downgrades of banks might increase their market funding costs, limit their ability to achieve MREL targets and weigh on future profitability.
• Amid concerns about future earnings and asset quality, rating agencies have placed several banking sectors on negative outlook.
• The non-linear relationship between a banks rating and its funding costs might lead to substantially higher funding costs and lower issuance volumes (see Chart 3.6, left panel).
• Sizeable sovereign-bank links in some euro area countries create risks of negative feedback loops arising from sovereign or bank rating downgrades.
• Chart 3.6 The potential for rating downgrades could generate feedback loops between sovereigns and banks in some countries

3.2 Asset quality set to decline in the wake of the pandemic, but capital buffers have increased during the past decade

• The improvement in euro area banks asset quality continued in 2019, but at a slower pace than previously.
• The aggregate non-performing loan (NPL) ratio of euro area banks declined to 3.3% in the fourth quarter of 2019, with risk reductions taking place in both high and low-NPL countries.
• Since end-2018, the reduction in NPL ratios has halved on the back of weaker cyclical conditions that have led to smaller declines in the NPL stock, while total loans have increased moderately (see Chart 3.7, left panel).
• Chart 3.7 NPL ratios declined further, but reductions slowed on the back of lower sales and write-offs, while new NPL inflows increased only slightly up to end-2019
• Banks asset quality is expected to deteriorate as a consequence of the pandemic, although government measures should provide a significant offset.
• This is, in turn, expected to lead to missed payments, eventually resulting in an increase in non-performing loans.
• Furthermore, a large share of industries in euro area countries are operating with low liquidity buffers, which lower their debt servicing capacity (see Chart 3.8, left panel).
• The larger estimated impact on Italian and Spanish banks reflects a relatively high weight of corporate exposures and weaker corporate liquidity buffers.
• Chart 3.8 Liquidity shortages of NFCs are likely to lead to higher loan losses for banks, although government schemes will reduce some of the impact
• More structurally, banks asset quality will also be affected by the need to continue managing the implications of the transition to a greener economy.
• The average emission intensity of euro area banks exposures towards large corporates has improved in recent years.
• Chart 3.9 Despite the commitment of some corporates to adjust their business models to comply with the Paris Agreement, there is still a wide dispersion of emission intensities Dispersion of emission intensities both within and across economic sectors (tons of CO2 equivalent emissions per million euro of sales)
• Banks need to be prepared for changes in loan performance should financial losses result from abrupt shifts in policies, technologies or consumer sentiment in response to the risks posed by climate change.
• While credit ratings could in principle capture such risks, in practice rating agencies have only just begun incorporating risks arising from an abrupt transition to a low-carbon economy.
• Substantially higher regulatory capital ratios since the global financial crisis increase banks capacity to absorb potential losses.
• The Common Equity Tier 1 (CET1) capital ratio, which was introduced in the context of Basel III, increased from 12.7% in 2014 to 14.5% in the third quarter of 2019.
• There is some heterogeneity at the country level, with capital increases and asset reductions being the main drivers in countries less affected by past crises, whereas risk-weight reductions played a more important role in countries more affected by past crises.
• During 2019, euro area significant institutions CET1 ratios strengthened further to 14.8% in the fourth quarter of 2019, mainly on the back of retained earnings.
• Overall, at the end of 2019, management buffers above current minimum capital requirements appear to provide banks with a good starting point for absorbing potential future losses related to the repercussions from the coronavirus (see Chart 3.10, right panel).
• Chart 3.10 Banks have increased their solvency positions substantially since the global financial crisis and are hence now much better positioned to absorb potential losses
• On aggregate at the start of 2020, banks had capital to withstand a significant increase in loss rates on corporate loans.
• In a mechanical simulation, available capital buffers can be compared with hypothetical losses on exposures to economic sectors that appear most sensitive to the consequences of the coronavirus outbreak.
• At current provision coverage levels, such losses imply that, on average, about 23% of exposures to the sensitive sectors become non-performing.
• Further loss-absorption capacity is available, as banks may operate below the capital level implied by Pillar 2 guidance and may use combined buffer requirements.
• Chart 3.11 Capital buffers are sufficient to absorb a sizeable increase in loan losses on average, but dispersion of individual banks resilience is wide
• The European Banking Authority has decided to postpone the EU-wide stress-test exercise to 2021 so that banks can focus on their core operations.
• However, the SSM is currently conducting a desktop vulnerability analysis of the euro area banking sector.
• [16] A large drawdown of credit lines by corporates might erode banks capital ratios, although prudential measures enhance banks lending capacity.
• Given increased liquidity pressures, a number of NFCs have drawn down credit lines from their banks (see Chapter 1).
• At country level, the estimated CET1 ratio impacts fall in the range of 0.9-3.0 percentage points (see Chart 3.12, right panel).
• [17] Chart 3.12 A large-scale drawdown of corporate credit lines could result in a material increase in banks RWAs and lead to some erosion of their capital ratios
• Government subsidy and loan guarantee schemes are expected to cushion some of the impact on banks.
• As discussed in Chapter 1, nearly all euro area governments have stepped in to provide financial assistance to households and companies facing cash-flow difficulties in the wake of the pandemic.
• This has included direct support and support via guarantees to banks on loans.
• Internal estimates suggest that State guarantees for corporate loans could help to reduce losses significantly, and transfer some of the remaining risk to governments.
• In addition, a range of measures make it easier for euro area banks to use capital buffers to absorb losses and avoid deleveraging.
• The combination of microprudential and macroprudential measures implemented by authorities is expected to provide euro area banks with capital relief of around 140 billion (see Chapter 5).
• Banks have also faced the additional challenge of operational risk stemming from more prominent cyber vulnerabilities.
• Higher digitalisation may offer significant cost-saving and therefore profit-improving opportunities for banks, at least in the medium-to-long term.
• This box reviews patterns in global banks payouts to shareholders and the contribution that lower payouts may make towards improving bank resilience.

3.3 Banks’ ability to support the recovery might be hampered by weak profitability

• The profitability of euro area banks weakened in 2019 and market analysts have further revised down their 2020 and 2021 return on equity (ROE) projections.
• The aggregate ROE of euro area significant institutions declined in 2019 to less than 5.5% and the weakness in bank profitability intensified, with more than 80% of SIs reporting an ROE below 8%, compared with 75% in the third quarter (see Chart 3.13, left panel).
• As the pandemic shifted economic expectations, market analysts also reduced their forecasts for ROE of listed euro area banks to 2.4% in 2020 and 3.5% in 2021 (see Chart 3.13, right panel).
• While the euro area banking sector appears better positioned for the coronavirus-related risks with respect to solvency and liquidity compared with a decade ago, the weak profitability, especially in comparison with international peers, might limit banks intermediation capacity going forward as banks are less capable of dealing with loan losses.
• Chart 3.13 The outlook for bank profitability, which was already weak and declining, has deteriorated substantially
• While lower profitability in 2019 mainly reflected one-off factors and increased capital, higher impairments are the main expected drag on profits in 2020.
• Despite increasing core revenues during 2019, weak non-interest income was still weighing on revenues.
• The first earnings releases by euro area banks for the first quarter of 2020 show that higher provisioning has contributed substantially to lower bank profitability.
• Chart 3.14 While one-off factors accounted for most of the ROE decline in 2019, rising impairments represent substantial headwinds for profitability going forward
• Higher loan growth supported banks core revenues in 2019, but the adverse impact of the coronavirus looks set to reduce lending.
• The rise in euro area banks net interest income (NII) since the second half of 2018 was mainly driven by a pick-up in loan volumes, in particular for lending to households for house purchase.
• That said, the drawdowns of NFC credit lines and the granting of new loans with public guarantees did lead to higher NFC loan growth in March, but the margins of State-guaranteed loans might be low.
• Chart 3.15 Core revenues were recently supported by higher lending volumes in particular for mortgage loans, but coronavirus uncertainty may reduce loan demand
• As interest margins have compressed, euro area banks have increasingly passed negative rates on to depositors and tried to diversify their revenue sources.
• If lending volumes are unable to support net interest income in 2020, the pressure on banks to pass negative rates on to their depositors will remain.
• While net interest income remains 60% of total operating income (the core revenue of euro area banks), the importance of net fee and commission income (NFCI) has increased over the last years.
• Substitution towards asset management activity by banks with low NII could increase interconnectedness between asset management and banking sectors (see Box 6).
• Overall, while euro area banks started 2020 with increased resilience, the pandemic is now set to weigh on banks balance sheets and future profitability.
• Core revenues have benefited from higher loan volume recently, but increased uncertainty about the economic outlook and declining consumer and business confidence could reduce lending volumes.
• Policy measures to ease regulatory requirements and discourage banks from deleveraging should prevent even worse feedback loops arising from a credit crunch.

4 Non-bank financial sector

4.1 Forced asset sales by non-banks amplified market dynamics

• The sharp decrease in risky asset prices globally led to significant valuation losses for non-banks, especially investment funds.
• The valuation losses in the securities portfolios of euro area non-bank financial sectors between February and March are estimated to range from about 6% for insurance companies to over 11% for investment funds (see Chart 4.1, left panel).
• In part, this is due to increased holdings of risky securities by this sector over recent years.
• Chart 4.1 Non-banks suffered large asset valuation losses from the market response to the coronavirus pandemic
• To cushion the losses and reduce liquidity risk, some non-banks rebalanced their portfolios towards cash and safe assets, which amplified market tensions.
• Liquidity strains were evident across non-banks as funds investing in illiquid assets experienced outflows in excess of liquidity buffers (see Section 4.2), with redemptions also from institutional investors.
• Comprehensive holdings data for this period are not yet available, but market intelligence and past evidence suggest that asset managers rebalanced their portfolios significantly following the outflows.
• [19] As the flight to cash intensified, outflows from money market funds (MMFs) also put strains on the short-term funding of banks and non-financial corporations (NFCs) (see Box 7).
• Selling pressures were further aggravated by cash needs related to derivative exposures, as financial institutions needed to cover margin calls (see Special FeatureB).
• Investment mandates, internal rating targets and higher capital charges could prompt non-banks to sell these assets following any downgrade to high-yield status.
• Further rebalancing of non-bank portfolios towards safer assets could increase the cost of financing for risky borrowers and impair their access to capital market financing.
• If liquidity concerns, market malfunctioning and changes in risk perception were to prompt non-banks to sell assets, a wider restriction of credit in capital markets could ensue.
• As a result, the issuance of high-yield corporate bonds could keep decreasing (see Section 2.3).
• Stress in funds could also affect short-term funding markets, if funds need to raise cash to meet outflows or margin calls.
• Vulnerabilities in the bank and non-bank financial sectors can contribute to contagion across the financial system due to the high degree of interconnectedness.

4.2 Large outflows from investment funds tested the sector’s resilience

• The investment fund sector experienced exceptionally large outflows between 20February and 20March (see Chart3, right panel, in the Overview).
• Among euro area funds, high-yield corporate bond funds were hit the hardest, seeing cumulative outflows of more than 10% of assets under management (AuM) over this period.
• The week of 12-18March saw the largest outflows from high-yield funds since 2007 (see Chart 4.3, left panel).
• High-yield funds investing in European corporates experienced even larger outflows over this period (i.e.
• From 12March, euro area money market and sovereign funds also began experiencing rapid outflows, driven by rising cash demand from end-investors.
• Chart 4.3 High-yield and money market funds experienced extreme outflows resembling those seen during the peak of the global financial crisis
• Cash holdings of bond and equity funds have declined consistently over previous years.
• [23] Outflows from euro area corporate bond funds between 20February and 20March exceeded funds median holdings of liquid assets and cash for both high-yield and investment-grade funds (see Chart 4.4, left panel).
• In some cases, funds needed to implement strategies in response to extreme liquidity pressure, including charging investors redemption fees.
• Funds also struggled to price assets as market liquidity dried up and, in some cases, imposed redemption gates (see Chapter5).
• For example, investing in illiquid assets is a central purpose of many fund types, but such funds also need substantial precautionary cash holdings.
• Chart 4.4 Increased liquidity risk-taking by funds has reduced their ability to manage outflows
• [25] In particular, low market liquidity for the underlying assets increases the cost of executing the arbitrage mechanism which usually closes these spreads.
• [27] Euro area investment funds hold 180 billion in ETF shares, households exposure comes to almost 120 billion and insurance corporations and pension funds (ICPFs) hold 70 billion (see Chart 4.5, right panel).
• Focusing on investment-grade and high-yield corporate bond ETFs, investment funds are estimated to hold 17 billion, households 9 billion and ICPFs 7 billion.
• The recent reduction in liquidity for these instruments may have impaired the capacity of these sectors to raise cash, aggravating existing liquidity shortages.
• Chart 4.5 ETF market frictions can have spillover effects on a range of other sectors
• Looking ahead, open-ended real estate investment funds may face pressures as the commercial real estate cycle begins to turn (see Section1.5).
• The role of the investment fund sector in financing real estate varies across the euro area, with a particularly large real estate fund presence in the Netherlands and Germany (see Chart 4.6, left panel).
• [28] While open-ended real estate funds have higher cash buffers now than in 2008 (see Chart 4.6, right panel), there are sometimes large mismatches between the liquidity of these funds assets and liabilities.
• [29] Funds capacity to provide redemptions may also be hampered by the difficulty in pricing real estate assets during market volatility.
• Chart 4.6 Real estate funds play a prominent role in some countries, but cash holdings are relatively high
• Most securities are denominated in euro (51%), followed by US dollars (27%) and British pounds (21%).
• MMFs are particularly important for the short-term funding market, holding 251 billion and 40 billion in short-term securities issued by euro area banks and firms, respectively, including commercial paper (see Chart A, right panel).
• Although commercial paper is a minor source of bank funding, covering less than 3% of total funding needs, it provides a meaningful source of wholesale unsecured short-term funding, especially in US dollars, for internationally active banks.

4.3 Euro area insurers face a double hit from the fall in asset prices and low interest rates amid potential liquidity risks

• Similar to banks, insurers were affected more severely by the coronavirus shock than the broad market indices (see Chart 4.7, left panel).
• Euro area life insurers valuations saw the largest declines, in line with their high exposure to the asset price declines after the coronavirus shock.
• In the United States, life insurer valuations fell by 38% compared with 28% for the insurance broad index (see Chart 4.7, right panel).
• Chart 4.7 Insurers stock valuations declined by more than broad market indices
• Insurers solvency could be significantly weakened by a double hit from asset price declines and lower-for-longer interest rates.
• In general, insurers were well capitalised at the onset of the pandemic (see Chart 4.8, left panel).
• That said, increased risk-taking by some insurers over recent years had made the sector more vulnerable to the repricing of financial assets.
• This is because lower risk-free rates typically increase the present value of insurers liabilities more than that of their assets, especially for life insurers.
• [31] If concerns about public debt sustainability arise again, solvency ratios could also be adversely affected by the high concentration of sovereign debt in insurers portfolios.
• Chart 4.8 Insurers were generally well capitalised before the pandemic, but solvency is adversely affected by asset price valuation losses and potential further drops in risk-free rates
• [32] Such potential losses on inflows could also pose liquidity risks to the insurance sector.
• In addition, solvency could be affected if corporates default on debt securities held by insurers or in the event of corporate debt downgrades.
• The latter would result in asset valuation losses and require higher capital charges, thus decreasing solvency capital ratios.
• As a consequence of the pandemic, some insurers could face significant liquidity strains.
• Moreover, the recent strains in the MMF sector (see Box7) point to a potential risk of contagion to insurers given the important role of MMFs in insurers liquidity management.
• The vast majority of insurance technical reserves to cover potential future claims by policyholders relate to life insurance products (see Chart 4.9, left panel).
• As such, this type of business is expected to be rather resilient to additional payment claims.
• The non-life insurance segment is relatively small and covers several different types of insurance (see Chart 4.9, right panel).
• However, in some countries governments have negotiated with the insurance industry so that the latter partially pays business interruption claims despite the exemptions.
• Some further business lines, like motor insurance, can even be expected to see lower claims due to reduced traffic.
• [34] Looking further ahead, an extension of the low interest rate environment in light of the economic downturn may also weigh on insurers profitability and future solvency.
• These estimates capture an average trend for the euro area and therefore can mask more severe mismatches between return income and guaranteed rates in some insurance companies.
• Chart 4.10 The spread between investment income and guaranteed rates is expected to narrow further, but to stay positive until 2030

5 Macroprudential policy issues

5.1 Authorities acted to help banks draw on capital buffers and continue lending

• Mindful of the lessons of earlier crises, prudential authorities also acted to facilitate the continued provision of bank credit.
• The impact of this would be worse if banks were to deleverage rather than draw down on the existing regulatory capital buffers.
• Common Equity Tier 1 (CET1) capital ratios of euro area banks increased from 10.4% at the end of 2010 to 14.8% by the end of 2019.
• Some of this capital was being held by banks to meet buffer requirements, while some constituted management buffers over and above regulatory capital requirements.
• These buffers were accumulated so that banks could, in the event of stress, absorb losses and continue to provide credit.
• Chart 5.1 Macro- and microprudential measures, worth over 140 billion, make it easier for banks to use capital to absorb losses and support lending CET1 capital stack and remaining macroprudential capital buffers in the euro area (Q4 2019, billions)
• The temporary release of P2G and the adjustments to P2R amount to 120 billion of bank capital.
• Banks might also want to avoid facing limits on distributions, including on AT1 instruments, which might apply when using residual buffers.
• [37] Macroprudential authorities released or reduced more than 20 billion of capital buffer requirements, including through the release of countercyclical capital buffers (CCyBs).
• [38] Authorities have also released or reduced buffer requirements for structural risks or delayed the implementation of new requirements.
• [40] To ensure that the capital relief provided by prudential authorities is used to support lending, banks were asked to limit payouts to shareholders.
• It should also reduce any stigma associated with restrictions on dividend distributions that might normally follow banks drawing down on their capital buffers.
• Taken together, these measures should help the euro area banking system to sustain lending to households and companies, while weathering losses.
• The policies could provide particular support to lending to non-financial corporations (NFCs), with banks providing almost 2.5 p.p.
• Overall, current developments highlight the value of the macroprudential framework and, in particular, of releasable capital buffers.
• The coronavirus has been the first test for the macroprudential framework since it was set up post-2008.
• The enacted prudential measures will provide relief to banks as long as they are needed, and until the economic recovery is well established.
• The recent events also demonstrate that, beyond the overall level of bank capital, releasable buffers are important to offer policy space in situations of economic distress, as we have seen this year.

5.2 Using flexibility in the bank regulatory framework

• Implementation of the Basel III standards, including those for market risk and Pillar 3 disclosures, has been deferred by one year to 1January 2023.
• Although the revised timeline does not affect banks current capital positions, it may mitigate potential procyclical increases in capital requirements in a stress situation.
• Looking ahead, full and consistent implementation of all Basel III standards based on the revised timeline remains necessary.
• The Basel Committee on Banking Supervision (BCBS) and supervisory authorities also acted to mitigate unintended consequences of the accounting framework for banks capital position.
• Notably, where banks judge there to be a significant increase in credit risk they must now account for lifetime expected losses.
• Supervisors and standard-setters have supported the full use of the flexibility of the IFRS9 framework and the prudential framework.
• This flexibility is currently foreseen to be applied on a case-by-case basis under the scrutiny of the supervisors expert judgement.
• The post-2008 crisis establishment of a macroprudential policy framework in the euro area has helped the banking sector respond to the shock.
• More broadly, while the euro area has made good progress in tackling legacy NPLs, the pandemic may lead to a deterioration of bank asset quality.

5.3 Mitigating risks from the non-bank financial sector

• Investment funds, particularly high-yield corporate bond funds, experienced exceptionally large outflows between 20February and 20March (see Chapter 4).
• Other funds used price-based measures, such as swing pricing[47] and redemption fees, to ensure trading costs were borne by redeeming investors.
• Monetary policy action, including the PEPP, helped improve financial market conditions, thereby also alleviating liquidity strains in the money market fund (MMF) sector.
• [48] Following the announcement of these measures, liquidity conditions in financial markets improved, and outflows from MMFs and other investment funds abated (see Chart 5.3).
• The European Securities and Markets Authority (ESMA) and national competent authorities (NCAs) continue to monitor flows of investment funds and the impact of the pandemic on financial markets.
• [49] These aim to enhance business continuity planning, reporting and disclosure of coronavirus-related risks, and risk management.
• But securities markets supervisors have few legal instruments at their disposal to tackle systemic risks.
• Authorities should have a range of policy tools available to effectively mitigate the build-up of risks in funds during periods of exuberance.
• Lessons from the recent stress in the MMF sector should be drawn, including for regulation.
• These funds are allowed to offer a constant share price as long as the funds NAV at amortised cost does not deviate from the corresponding market value.
• Otherwise, the fund will trade at a variable price, which can result in mark-to-market losses for investors.
• [52] A number of funds were close to breaching the regulatory limits on NAV and on weekly maturing assets during the recent period of volatility.
• The market response to the pandemic underlines the need to strengthen the Solvency II framework for insurance companies.
• The communication of the European Insurance and Occupational Pensions Authority (EIOPA) regarding mitigating action and the temporary suspension of dividend distributions and share buybacks helped to dampen the impact of the shock on the sector.

Special features

Trends in residential real estate lending standards and implications for financial stability

• This special feature uses a novel euro area dataset from a dedicated data collection covering significant institutions supervised by ECB Banking Supervision to analyse trends in real estate lending standards and derive implications for financial stability.
• First, lending standards for residential real estate loans in the euro area, in particular loan-to-income ratios, eased between 2016 and 2018.
• Second, lending standards appear to be looser in countries that saw stronger real estate expansions, suggesting that real estate vulnerabilities may have been growing in some euro area countries.
• Third, lending standards deteriorated less in countries with borrower-based macroprudential policies in place, highlighting the importance of early macroprudential policy action to help prevent the build-up of real estate vulnerabilities.

Derivatives-related liquidity risk facing investment funds

Prepared by Linda Fache Rousová, Marios Gravanis, Audrius Jukonis and Elisa Letizia[58]