Financial crises

Foreword

• It does so to promote awareness of these 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 provides key input to the ECBs macroprudential policy analysis.

Overview

• Volatility in financial markets around the turn of the year illustrated risks that could arise from global and euro area growth surprises.
• Persistent downside risks to growth reinforce the need to strengthen the balance sheets of highly indebted firms and governments, as well as a euro area banking sector beset by weak profitability.

Risks to economic growth remain tilted to the downside

• Euro area economic growth prospects have softened somewhat, in tandem with a weakening of growth prospects around the globe.
• ECB projections confirm a weakening in economic growth prospects in the first half of the year, consistent with downward revisions by analysts, with a growing cross-country dispersion of growth prospects this year (see Chart1, left and middle panels).

A materialisation of downside risks to the growth outlook would intensify public debt sustainability challenges

• Should downside risks to growth materialise, financing costs for vulnerable sovereigns are likely to increase and may unearth debt sustainability concerns.
• A sound medium-term approach to public finances, as expected under the Stability and Growth Pact, is key to containing public financing costs, which would support debt sustainability.
• Upward pressure on sovereign spreads stemming from the weakening growth outlook has been counterbalanced by the continued accommodative monetary policy of the ECB.
• The composite indicator of systemic stress in euro area sovereign bond markets (SovCISS) suggests that financial markets see no imminent debt sustainability concerns for the euro area as a whole (see Chart2, left panel).

Signs of vulnerability in corporate credit markets

• Generally, low corporate interest payment burdens, high liquidity buffers and a relatively diversified financing structure alleviate near-term financial stability risks for the euro area corporate sector.
• But the favourable financing conditions in most advanced economies have also allowed firms with weaker balance sheets to increase their leverage.
• Risk-taking is particularly pronounced in higher risk segments, such as the leveraged loan markets.
• Weak underwriting standards have become commonplace in the US and European leveraged loan markets (see Chapter2).

Search for yield, liquidity risk and leverage in the non-bank financial sector could amplify the wider financial cycle

• Furthermore, euro area asset managers and investment funds are among the main holders of low-rated collateralised loan obligations (see Box4).
• Second, non-banks may amplify the cyclical underpricing of risk as they search for yield, potentially also taking on more leverage and liquidity transformation.

Potential for asset price corrections and an unwinding of the considerable investment fund inflows over the last decade

• In December last year, global stock markets and the riskier parts of the corporate bond markets sold off sharply after a prolonged period of rising asset prices.
• While the December turmoil was orderly and without immediate widespread consequences, the episode illustrated that investor sentiment can prove unpredictable.
• Overall, the investment fund sector seems to have coped well with outflows during the high volatility episode in December 2018.
• Such sales have the potential to amplify the original shock to asset prices in less liquid markets.

Property prices could correct if downside risks to growth were to materialise

• House prices in the euro area grew by 4.2% in 2018, contributing to signs of mild overvaluation for the euro area as a whole.
• The high share of non-euro area transaction inflows contributes to the vulnerability of commercial real estate markets.

Structural profitability challenges for the euro area banking sector

• The prospect of weaker economic growth has weighed further on structurally weak profitability expectations for euro area banks.
• Profitability continues to fall short of the returns required by investors for the majority of euro area banks.
• GDP growth in the euro area has been lagging behind that in other major economies in recent years (see Chart7).
• In order to return to sustainable profitability, euro area banks need to tackle a number of structural challenges (see Chart7).
• Market-based funding costs for euro area banks have remained volatile over the past six months.
• This suggests that the euro area banking sector as a whole should be resilient to a range of downside risks.

Policy responses to ensure resilience

Macroprudential policy action

• Over the last year a number of euro area countries have implemented macroprudential policy measures to address the build-up of systemic risk.
• Despite the economic headwinds, further increasing macroprudential policy space in some countries appears desirable to build bank resilience and insure against the materialisation of tail events.
• While macroprudential policies targeting residential real estate appear sufficient in most of the euro area countries, in some, the policy stance may need to be adjusted and further policy actions should be considered by national authorities.

Strengthening the regulatory framework

• Regulatory initiatives at the international and EU levels are vital in establishing a sound and robust framework for financial institutions, markets and infrastructures.
• The CRR/CRDIV review also introduces major changes in the macroprudential regulatory and policy framework by: (i)clearly delineating the responsibilities of micro- and macroprudential authorities; (ii)enhancing the flexibility of the toolkit; and (iii)streamlining the activation and coordination mechanisms.
• Strengthening the regulatory framework for non-bank financial intermediation is crucial in order to limit regulatory arbitrage and enhance the resilience of the broader financial system.

1 Macro-financial and credit environment

1.1 Weaker near-term euro area growth outlook coupled with persistent downside risks

• Notwithstanding a rebound of GDP growth at the start of 2019, survey indicators continue to point to a subdued economic expansion in the near term.
• Chart 1.1 Moderation in euro area cyclical momentum and lower inflation outturns reflect expected temporary slowdown in nominal growth Real GDP growth, Economic Sentiment Indicator and composite output PMI for the euro area (left panel), as well as HICP inflation, HICP inflation excluding energy and food and inflation expectations in the euro area (right panel) (left panel: Jan. 2011-Apr.
• This nominal growth path in the euro area contrasts with more favourable economic prospects in the United States, despite a deterioration of the 2019 growth and inflation outlook for both jurisdictions (see Chart 1.2).
• Chart 1.2 Real GDP growth and inflation have been revised down for both the euro area and the United States amid increasing downside risks Distribution of the 2019 HICP/CPI and real GDP growth forecasts for the euro area and the United States (probability density)
• Persistent downside risks cloud the global and euro area growth outlook.
• Alongside waning fiscal and structural reform efforts in some euro area countries, downside risks to euro area growth mainly relate to global factors.
• The US economy is currently in its second longest expansion on record, buttressed by fiscal stimuli in the late phase of the business cycle.
• While near-term recession risks in the United States appear to be limited, the equity market corrections at the turn of the year, the ongoing US-China trade dispute, vulnerabilities associated with elevated corporate leverage (see Chapter2) and weaker global growth prospects have led to continued market concerns regarding the downside risks to US economic growth.
• The materialisation of downside risks to growth could challenge euro area financial stability.
• A no-deal Brexit poses manageable risks to overall euro area financial stability and authorities have prepared for this scenario.
• Nevertheless, there remain tail macro-financial risks whereby a no-deal Brexit interacts with other global shocks, in an environment where risks to the euro area growth outlook are tilted to the downside.

1.2 Fragile public debt sustainability

• Stress remained subdued in euro area sovereign debt markets, but uncertainties at the country level prevail.
• Despite the signs of slower economic growth, the composite indicator of systemic stress in euro area sovereign bond markets (SovCISS) has declined somewhat since the turn of 2018-19.
• The aggregate euro area fiscal deficit declined from 1.0% of GDP in 2017 to 0.5% of GDP in 2018 (see Chart 1.5, right panel).
• This improvement was chiefly driven by favourable cyclical conditions and lower interest payments.
• Heightened political and policy uncertainty could also add to public debt sustainability concerns.
• Looking ahead, beyond slower growth, several other factors may challenge the sustainability of public finances.
• Debt servicing needs remain high for several in particular the most highly indebted euro area countries.
• In fact, public finances remain fragile in a number of countries.
• The materialisation of any of these risks may reignite concerns regarding public debt sustainability in the more vulnerable euro area countries.
• First, fiscal fundamentals are key in determining vulnerability to sovereign debt sustainability concerns most notably the stock of public debt relative to GDP.
• Chart B Policy uncertainty can trigger sovereign debt sustainability concerns Interlinkages between policy uncertainty and sovereign debt sustainability concerns
• This finding may reflect market concerns about the incompleteness of the institutional framework of the monetary union in combination with the sustainability of public debt in some euro area economies.
• Such concerns were particularly evident at the height of the euro area sovereign debt crisis in 2010-12, when sovereign CDS markets put an additional premium on political uncertainty, as well as public debt, for euro area economies compared with other advanced economies.

1.3 Euro area households resilient, but some country-level vulnerabilities prevail

• Euro area households income position has so far been fairly resilient to the slowdown in economic activity.
• Chart 1.8 Income risks for euro area households have remained contained so far, while household confidence and sentiment started to recover in early 2019 Gross disposable income growth (left panel), change in the net worth of euro area households (middle panel), as well as consumer confidence and euro area households expectations about their financial situation and unemployment prospects (right panel) (left panel: Q1 2010-Q4 2018, annual percentage changes; middle panel: Q1 2010-Q4 2018, four-quarter moving sums, percentage of gross disposable income; right panel: Jan. 2010-Apr.
• Household indebtedness has stabilised for the euro area as a whole, while remaining a cause for concern in some countries.
• On aggregate, the indebtedness of euro area households has stabilised at slightly below 58% of GDP in 2018 a level that was last observed in early 2006 and is slightly below the estimated threshold associated with debt overhang based on the macroeconomic imbalance procedure.
• A relatively resilient income position and improved net worth coupled with record low interest burdens bolster euro area households debt servicing capacity for the time being (see Chart 1.9, middle panel).
• Lending flows to households stabilised at moderate levels, but underlying dynamics vary across countries and according to the purpose of lending.
• So far, euro area households have been resilient to the slowdown in economic activity, but stock imbalances remain high in some countries.
• Relatively solid income and net worth growth coupled with continued favourable financing conditions support households debt servicing capacity.

1.4 Legacy imbalances leave firms vulnerable to weaker growth

• Mirroring the weaker economic growth prospects, corporate sentiment deteriorated further in the euro area at the turn of 2018-19.
• While remaining well above long-term averages, corporate order books have become thinner, gradually translating into poorer capacity utilisation in manufacturing and lower corporate profits (see Chart 1.11, left panel).
• The consolidated NFC debt-to-GDP ratio stabilised at around 77.5% for the euro area as a whole in 2018.
• In fact, differences in the financial health of firms across sectors of economic activity may have important implications for banks asset quality (see Box3).
• Corporate interest payments have touched record lows in both gross and net terms (see Chart 1.13, left panel), thereby bolstering the debt servicing capabilities of euro area NFCs.
• NFCs now also tend to finance their expansion to a larger extent with internally generated funds than in the past.
• Firms external financing flows moderated in line with the economic slowdown, but overall financing conditions remain benign for euro area NFCs.
• 2019, annual percentage changes, diffusion index: 50+ = expansion; middle panel: Q1 2011-Q2 2019, weighted net percentages, three-month expectations; right panel: Jan. 2011-Mar.
• The operating environment has become more challenging for euro area NFCs, with the slowdown in economic momentum weighing on firms profit-generation capacity.
• At the same time, legacy stock imbalances continue to linger in a number of countries and sectors.
• Nearly 15% of euro area corporate and SME loans were non-performing in the first quarter of 2015.
• The quality of corporate loans varies across countries and economic sectors (see ChartA).
• Industry data reveal marked differences in both the strength and duration of the pass-through from corporate financial health to NPLs.
• Changes in gross value added and employment provide advance information about prospective changes in NPL ratios at the industry level.

1.5 Sustained momentum in euro area property markets

• Euro area residential property markets maintained strong momentum in 2018.
• Chart 1.15 Expansion in euro area residential property markets has continued amid signs of slight overvaluation and continued heterogeneity at the country level Euro area real GDP growth and house price changes in euro area capital cities and at the euro area aggregate level (left panel), euro area residential property price deviations from estimated fair value (middle panel), as well as house price growth and valuation estimates of residential property prices across euro area countries (right panel) (left panel: Q1 2006-Q4 2018, annual percentage changes, nominal; middle panel: Q1 2006-Q4 2018, percentages, average valuation estimate, minimum-maximum range across valuation estimates; right panel: annual percentage changes, nominal, percentages)
• Price dynamics and transaction volumes reflect continued strong activity in euro area commercial property markets.
• This marked compression of prime commercial property yields across the euro area might be indicative of possible overvaluation in commercial property markets (see Chart 1.16, middle panel).
• All in all, the ongoing momentum of residential and commercial property markets in some countries and market segments warrants monitoring.
• There are limited signs that the ongoing recovery of euro area residential property markets might translate into broad-based rapid housing loan growth in the euro area.

2 Financial markets

2.1 Financial markets proved sensitive to concerns about global economic growth

• Signs of a deteriorating global economic outlook and related shifts in expectations about monetary policy triggered a period of heightened market volatility.
• Towards the end of 2018 global equity indices declined, risk premia rose materially and major economy sovereign bonds benefited from flight-to-safety flows (see also Chapter4).
• The indicator started to decline in January, when tensions in global financial markets subsided.
• Global equity markets exhibited high volatility, mainly reflecting downward revisions to the growth outlook and trade tensions.
• A model-based decomposition of euro area corporate bond spreads confirms the relevance of the role of spillovers from the United States and other global factors (see Chart2.3, right panel).
• Chart 2.3 Corporate bond spreads have increased mainly due to external factors Spreads between non-investment-grade and investment-grade corporate bond yields (left panel) and decomposition of euro area corporate spreads (right panel) (left panel: 2Oct.
• In the US, prices were also affected by outflows from, and associated sales by, mutual funds and exchange-traded funds (see Chapter4).
• Since the start of the year spreads for both leveraged loans and high-yield bonds have partially retrenched (see Chart2.4, middle panel).
• Indicators of systemic stress in sovereign bond markets remained fairly stable at low levels over the review period (see Chapter1).
• Italian sovereign bond yields were more volatile and remained at a higher level than in early 2018, despite declining during the review period.

2.2 A weaker economic outlook could trigger further corrections in asset prices

• But even with a more positive growth outlook, changes in monetary policy accommodation could trigger large adjustments in financial markets.
• In particular, market contacts highlight a perception of current heightened sensitivity of asset prices to policy accommodation and central bank communication.
• Lower corporate profitability, higher funding costs and higher default rates could amplify the magnitude of any downturn.
• Corporate leverage also contributed to the higher correlation of corporate bond spreads with equity prices observed in recent months.
• While the risk of tighter financial conditions has fallen in recent months, rating downgrades typically translate into higher corporate bond spreads (see Chart2.7, left panel).
• In the euro area, corporate issuance in the lowest part of the investment-grade spectrum has increased over the last years (see Chart2.7, right panel).
• CLO issuance in US dollars and, to a lesser extent, in euro has increased sharply over the past two years (see Chart2.8, left panel).
• In Europe, the share of covenant-lite loans rose to 70% in the course of 2018 (see Chart2.8, right panel).
• In parallel to the growth of leveraged loans, CLOs have almost doubled in size in the last five years (see ChartA, panel2).
• [19] In addition, CLO exposures tend to be relatively more concentrated in lower-rated leveraged loans (see ChartA, panel3).
• While most CLO tranches outstanding have a high credit rating, CLO collateral quality and structural protections have weakened recently.
• CLO tranches outstanding are generally also better protected than before the crisis: AAA European CLO tranches now have collateral backing of around 40% compared with less than 30% pre-crisis.
• Scenario analysis suggests that more junior CLO tranches are most vulnerable to credit losses, while holders of higher-rated tranches are highly exposed to downgrade risk.
• [23] But loss given default (LGD) ratios are likely to be higher in this credit cycle than in the past, given weaker underlying credit quality and a higher proportion of covenant-lite loans.
• Banks typically purchase AAA senior and upper mezzanine tranches, while insurance companies buy upper mezzanine tranches, and hedge funds purchase the riskiest tranches, including equity (see ChartB, panel3, for the European CLO buyers).
• While AAA and high-rated upper mezzanine tranches are unlikely to incur losses even in severe stress, they are subject to significant downgrade risks.
• While an economic contraction remains a key risk for euro area financial markets, volatility can also arise from other sources.
• Chart 2.9 Days with high volatility have become less frequent in the euro area Stock market volatility (percentage of trading days with high volatility)
• Threats to the multilateral system of global trade still weigh on the global growth outlook and could adversely affect equity and corporate bond markets.
• Trade negotiations between the US administration and China have continued and risks associated with trade disputes and a resumption of protectionist pressures remain substantial.

3 Euro area banking sector

3.1 Prospects of banks addressing weak profitability may be diminished by a worsening cyclical outlook

Banks’ profitability in 2018 was supported by lower impairments, but operating performance remains subdued

• Euro area banks profitability remained low in 2018, as a continued fall in the cost of risk was offset by still subdued operating performance.
• At the same time, banks pre-impairment operating profits, at less than 0.75% of total assets, remain well below pre-crisis levels.
• In 2018, within a balanced sample of 100 SIs, around half of the banks recorded an ROE below 6% (see Chart 3.1, right panel).
• After two years of declines, the contribution of net interest income (NII) growth to overall revenues turned slightly positive in 2018.
• Significant banks cost-to-income ratio reached nearly 66% in 2018, a 3 percentage point increase over the last three years.
• By contrast, banks with the largest deterioration in cost-efficiency tended to show both weak revenue performance and above-average growth in operating expenses (see Chart 3.3, right panel).
• Persistently low profitability can limit banks ability to generate capital, thus restraining the build-up of buffers against unexpected shocks as well as their capacity to fund loan growth.
• Mirroring weak current and expected profitability, a number of banks continue to display depressed market valuations (see Box5).
• Cost-cutting measures by banks, such asthe streamlining of branch networks, as well as consolidation via mergers and acquisitions (M&As) could be possible avenues for reducing overcapacity in the system and enhancing profitability.
• Similarly, market concentration varies widely across euro area countries, with operating profitability (as measured by cost-to-income ratios) typically higher in more concentrated banking sectors (see Chart 3.5, right panel).
• From a profitability perspective, increased digitalisation may offer significant cost-saving opportunities for banks (e.g.
• P/B ratios of euro area banks have remained below one for over eight years now.
• During the 2008-09 crisis, however, both US and euro area banks P/B ratios fell to much lower levels, although those of US banks dropped below one for a shorter period of time.
• The sample used is composed of 70 globally active banks, equally divided into euro area and US institutions.
• Stronger expected economic growth and higher profitability ratios are associated with higher P/B ratios, while higher bank capital is associated with lower ratios.
• The post-crisis weakness in euro area banks P/B ratios has evolved, initially associated with weak growth and later with faltering bank profitability.
• During the sovereign debt crisis, however, weak bank profitability played a more decisive role in depressing P/B ratios (yellow bar).

The improvement in asset quality continues, but further efforts are needed to reduce NPLs

• Euro area banks asset quality continued to improve in 2018, with non-performing loan (NPL) reductions becoming more broad-based.
• Significant institutions aggregate NPL ratio has declined at a steady pace, to below 4% at end-2018 from 6.2% in 2016.
• However, the average deal size dropped in 2018, and the gross volume of NPL sales fell by more than 30% (see Chart 3.7, right panel).
• This is likely to be because the largest and easier-to-execute portfolio transactions have mostly been completed by now.
• The provisioning coverage of remaining NPLs also improved year on year, although trends diverged somewhat across countries.
• This suggests that some of the additional provisions that had been made in early 2018 were consumed by NPL reductions during the year.

Improvements in banks’ capital ratios paused in 2018, mainly reflecting the one-off impact of IFRS 9 adoption

• Improvements in euro area banks regulatory capital ratios paused in 2018, mainly due to the introduction of IFRS9 at the beginning of the year.
• Banks Common Equity Tier1 (CET1) ratios experienced a one-off decline in the first quarter of 2018, mainly reflecting the impact of IFRS9 first-time adoption, but remained broadly stable thereafter (see Chart 3.9, left panel).
• Breakdowns of capital requirements and buffers by size also reveal substantial heterogeneity, with buffers generally positively correlated with (past) profitability.
• An analysis of the different size groups shows that, on average, the largest banks hold the lowest capital buffers relative to minimum requirements (see Chart 3.10, left panel).
• Similar to risk-weighted ratios, the improvement in euro area banks leverage ratios also paused in 2018.
• Chart 3.11 The improvement in banks leverage ratios also paused in 2018, while euro area G-SIBs continue to lag behind their international peers Significant institutions leverage ratios (left panel) and euro area G-SIBs leverage ratios in international comparison (right panel) (left panel: Q4 2014-Q4 2018, percentages; right panel: 2015-18, percentages)
• Looking ahead, the final BaselIII revisions will require further adjustments in banks capital in the future.
• [32] According to the EBAs impact assessment, the output floor and operational risk frameworks are the two main drivers of higher capital requirements under the final BaselIII framework, followed by credit risk and credit valuation adjustments (CVAs), with the relative importance of these factors varying across different groups of banks.

Benign cyclical conditions supported banks’ credit quality in 2018, but market-based measures signal increasing credit risk albeit from low levels

• Credit risk measures reported by banks remained subdued in a maturing business cycle, but expectations of a slowdown in economic growth point to higher risks in the future.
• Credit risk measures, such as reported probabilities of default and expected loss ratios, did not signal an increase in the riskiness of banks credit portfolios, with the exception of a small uptick in risk measures for small and medium-sized enterprise (SME) loans in the latter part of 2018 (see Chart 3.12).
• Market-based measures and loan loss provisioning forecasts point to some worsening in the credit risk outlook for 2019-20.
• [33] In some segments, banks with stronger lending growth report somewhat higher credit risk measures.

Funding market conditions improved, but the need to build up bail-inable buffers may pose challenges for some banks

• The funding mix of euro area banks remained broadly unchanged in 2018, while their aggregate liquidity coverage ratio (LCR) slightly increased year-on-year (see Chart 3.14).
• Banks aggregate net stable funding ratio (NSFR) remained above 100%, but NSFRs continued to vary widely across banks, with some banks still having shortfalls.
• Following a marked deterioration in late 2018, market funding conditions eased in the first half of 2019.
• Bank bond spreads have tightened since early 2019 across all seniorities and bond types, reversing much of the funding cost increases observed in late 2018 and reducing cross-country differences (see Chart 3.15).
• Benefiting from improved funding conditions, euro area banks stepped up their debt issuance activity in the first few months of 2019.
• An increase was seen in most instrument classes, from covered bonds through non-preferred senior debt to additional Tier 1 (AT1) instruments (see Chart 3.16, left panel).
• Notwithstanding these improvements, banks need to issue more TLAC/MREL-eligible bonds may pose challenges for some banks over the next years.
• A possible increase in funding costs might complicate these banks efforts to build up the necessary loss-absorption capacity and could weigh on their profitability.
• Credit ratings can be considered as an overall assessment of the creditworthiness of non-financial and financial corporates.
• As acquiring information can be costly, they are particularly relevant for the investment decisions of fixed income investors.
• Euro area banks creditworthiness lags behind that of their main global competitors and euro area non-financial corporates.
• Fourth, while euro area banks had a better rating than their non-financial corporate counterparts until the euro area sovereign debt crisis, the situation reversed afterwards.
• Over the past few years the bulk of euro area banks have traded at P/B ratios below one (see ChartA, middle panel).
• Applied to US and euro area banks, such an exercise reveals that, for most banks, the ratings inferred from market pricing are below actual ratings.

Late-cycle market volatility has the potential to negatively affect banks’ capital ratios, in particular through the revaluation of sovereign bond portfolios

• Banks exposures to domestic sovereign debt were broadly stable on aggregate, but some banks remain vulnerable to a possible aggravation of sovereign risk concerns.
• Banks holdings of domestic sovereign debt remain elevated or have even increased since early 2018 in some euro area countries, including Italy and Portugal (see Chart 3.18, left panel).
• More broadly, possible increases in financial market volatility have the potential to negatively affect banks capital ratios through their impact on risk-weighted assets.
• Heightened equity and debt market volatility in the fourth quarter of 2018 contributed to an increase in banks market risk exposures as measured by value at risk (see Chart 3.19, left and middle panels).
• While the accounting standards provide the principles for the allocation of assets to the L2/L3 categories, they also leave some room for interpretation, which can result in different choices across banks.
• Worsening market liquidity conditions that would possibly also lead to reclassifications of assets into the L3 category could further amplify the effect.
• On aggregate, L2 assets constituted 13% and L3 assets 0.9% of total assets.
• The distribution of L2/L3 assets and the type of assets within categories closely reflect the business models of the banks.
• Importantly, from a systemic point of view, the impact remains small even for euro area G-SIBs with large L3 asset portfolios.
• Interacting L3 asset holdings with market volatility shows that the relationship becomes stronger when the VIX increases.

Recent developments and open issues regarding the review of the European System of Financial Supervision and the EU banking reform package

• Key developments in this regard include the review of the European System of Financial Supervision (ESFS) and of the Capital Requirements Regulation and Directive (CRR/CRD).
• The political agreement reached by the EU co-legislators on the ESFS review in March 2019 is generally welcome.
• The EU co-legislators also reached a political agreement on the EU banking reform package in February 2019.

3.2 Evaluating the resilience of the euro area banking sector through scenario analysis

• This section provides a quantitative assessment of the resilience and profitability of euro area financial institutions under both a baseline and an adverse scenario.
• [41] The analysis covers about 100 large and medium-sized banking groups directly supervised by the ECB.

Evaluation of banks’ resilience and profitability under the baseline scenario

• Real GDP growth in the baseline scenario has been revised down by 0.6percentage points in 2019 (see Table 3.1).
• Table 3.1 Main changes in the macroeconomic projections and related assumptions for the euro area between December 2018 and March 2019
• Weaker growth in the baseline scenario points to a potential decline of 0.7percentage points in banks ROE by 2021.
• This would nevertheless be some 0.7percentage points below the level projected based on the December 2018 macroeconomic projections.
• The aggregate CET1 capital ratio is projected to increase by about 1.8percentage points to 15.7% by the end of 2021 (see Chart 3.21).
• [46] Chart 3.21 Under the baseline scenario, banks solvency position would improve Drivers of the CET1 ratio change under the baseline scenario (percentages, percentage point contributions)

Evaluation of banks’ resilience under the adverse scenario

• The adverse scenario is a tail event, designed with the ECB models also used for the EBA stress-test scenarios.
• The adverse scenario results in a maximum year-on-year decline of euro area real GDP of about 2.7percentage points (see Table 3.2).
• [48] The aggregate risk-weighted CET1 ratio falls from 13.9% to 10.5% by 2021 in the adverse scenario.
• Only a few small banks would face severe solvency difficulties under the adverse scenario, falling below a 6% CET1 ratio.

4 Non-bank financial sector

4.1 Non-bank financial institutions continued increasing their financing of the euro area economy

• Euro area non-bank financial institutions have increased their share of credit provided to the real economy over the last six months.
• Chart 4.1 The euro area non-bank financial sector continues to grow and provide financing to the real economy Growth of non-banks financial assets (left panel) and financing flows to the real economy (right panel) (Q1 1999-Q4 2018; left panel: trillions; right panel: average annual flow in billions)
• The low interest rate environment has led to low investment returns on relatively safe assets.
• Procyclical risk-taking by non-bank financial institutions may contribute to wider financial sector exuberance and renders them more vulnerable to potential shocks in global financial markets.
• While the share of high-yield corporate bonds held by non-banks slightly decreased over the last six months, levels remain elevated.
• Euro area asset managers and funds are also among the main holders of low-rated collateralised loan obligations (see Box4).
• Euro area insurance corporations and pension funds and to a lesser extent investment funds play an important role in the financing of euro area sovereigns.
• ICPFs play a particularly important role in providing long-term financing to (higher-rated) euro area sovereigns (see Chart 4.4, middle and right panels).
• Non-banks, in particular, have moved increasingly into less-liquid and lower-rated bonds as well as longer-term securities in a search for yield.
• To quantify this, individual data on securities holdings of euro area financial sectors (banks, insurance corporations and investment funds) available since 2013 are exploited.
• Despite the higher sensitivity of portfolio allocation to changes in yields and a more flighty investor base, model estimates indicate a smooth rebalancing of bond portfolios under a baseline projection for term premia.
• For example, investors would reduce their holdings of high-yield corporate bonds by 1% on average over the next three years, equivalent to a 17 billion reduction of holdings across all sectors (see ChartA, panel a).
• This is particularly relevant for holdings of euro area sovereign bonds issued by countries more affected by the sovereign debt crisis.
• Larger price corrections for risky asset classes could also trigger a larger rebalancing of financial sectors holdings and have potential implications for financial stability.
• Looking at the corporate structure of euro area financial institutions, banks and insurance corporations tend to be controlled by institutions within the same sector.
• Ownership links may be beneficial for the holder company in periods of market distress and represent a source of income diversification.
• First, euro area MMFs, IFs and OFIs represent an important source of funding for the banking sector and also for the real economy notably through debt and equity financing.
• This can drive procyclical risk-taking in the banking sector and contribute to wider financial sector exuberance in some parts of the real economy.
• Overall, the share of non-bank financial intermediation has been growing in the euro area, with potential implications for financial stability and the financing of the real economy more broadly.

4.2 Increased volatility of fund flows highlights the risks that investment funds could pose to liquidity in financial markets

• Global corporate bond funds including high-yield and investment-grade funds experienced significant outflows over the last year, while government bond and money market funds continued receiving large inflows (see Chart 4.6, left panel).
• In particular, high-yield global bond funds have experienced outflows every month from November 2017 to December 2018, with a cumulated outflow of over USD130 billion.
• Global equity funds continued to experience net outflows throughout most of the reporting period, despite rising stock prices during the first four months of this year.
• Large outflows were triggered in December last year by a sharp drop in US equity prices, while outflows from euro area equity funds continued their negative trend since mid-2018 (see Chart 4.7).
• Around 60% of active hedge funds in a sample based on data provided by Preqin delivered negative net returns last year.
• Overall, the investment fund sector seems to have coped well with outflows during the high volatility episode.
• Recent volatility in fund flows highlights that investment funds can be subject to the procyclical behaviour of investors and asset managers.
• In addition, the sensitivity of fund managers to changes in yields has increased in the low-rate environment (see Box8).
• Mutual funds are governed by the UCITS Directive and the Alternative Investment Fund Managers Directive,[62] providing EU-wide standards for transparency, concentration risk, leverage and liquidity.
• It introduced three distinct fund categories subject to specific requirements: constant net asset value (CNAV), variable net asset value (VNAV) and low-volatility NAV (LVNAV) funds.
• In particular, CNAV funds became subject to new requirements regarding redemption gates and fees as well as liquidity requirements.

4.3 Insurers’ investment income is expected to deteriorate further in the low-yield and low-growth environment

• The gains were particularly pronounced in the non-life and reinsurance segments (see Chart 4.10, right panel).
• The limited impact on insurers equity valuations suggests that the results were broadly in line with market expectations (see Chart 4.10, left panel).
• Despite strong underwriting revenues, insurers median return on equity dropped modestly to below 8% in the last quarter of 2018 (see Chart 4.11, middle panel).
• This may be attributed to above-average natural catastrophe losses and very weak investment income in that quarter.
• Going forward, insurers investment income may deteriorate further, as (older) high-yielding bonds in portfolios mature and are replaced by (newly issued) lower-yielding bonds.
• But, if the low-yield environment prevails beyond this horizon, the yield to maturity at issuance of almost all bonds in insurers portfolios would drop below 3%, further eroding insurers investment income.
• Some insurers are searching for yield, and income, through greater exposure to credit, liquidity and term risks.
• Over the last five years euro area insurers increased their exposures to BBB-rated and high-yield bonds from around 35% to 41% of their bond portfolios (see Chart 4.13, left panel).
• This is particularly important as insurers investment behaviour currently tends to contribute to the wider financial sector exuberance and may turn procyclical in distress periods, potentially amplifying price corrections.
• Beyond the decrease in high-quality liquid assets in insurers portfolios, insurers may also face elevated liquidity risks on the liability side.
• [76] In this context, further efforts to enhance thinking on the macroprudential toolkit for insurers are important.
• The largest exposures are currently in the Netherlands (25%), followed by Belgium (14%) and Finland (13%).
• While starting from low levels, infrastructure and alternative funds have been the fastest-growing among the alternative asset classes in insurers portfolios.
• Such exposures accounted for around 7.7% of insurers investment portfolios at the end of 2018 and included exposures to both residential and commercial real estate markets (see ChartB, left panel).
• There are several reasons why investment in alternative assets could also help insurers address the profitability challenges they face in the prevailing low-yield environment.

Special features

A Climate change and financial stability

• Prepared by Margherita Giuzio, Dejan Krusec, Anouk Levels, Ana Sofia Melo, Katri Mikkonen and Petya Radulova[83] This special feature discusses the channels through which climate change can affect financial stability and illustrates the exposure of euro area financial institutions to risks from climate change with the help of granular data.
• A deeper understanding of the relevance of climate change-related risks for the euro area financial system at large is therefore needed.

B Economic shocks and contagion in the euro area banking sector: a new micro-structural approach

• This contagion risk could arise because of shifts in the interlinkages between financial institutions, including the volume and complexity of contracts between them, and because of shifts in the economic risks to which they are commonly exposed.
• Analysis of the euro area banking systems interlinkages, using the newly available large exposure data, suggests that the system could be more vulnerable to financial contagion through long-term interbank exposures than noted in other studies.

C Macroprudential space and current policy trade-offs in the euro area

Prepared by Matthieu Darracq Pariès, Stephan Fahr and Christoffer Kok

• This legislation brings long-overdue relief to consumers who are trying to pay off their debts and achieve financial stability.
• "HB88 is an important step towards closing that divide by helping families get out of debt and build financial security."
• "With debt judgments collecting 9% interest for up to 26 years, debt is plaguing families across this state," said lead bill sponsor Representative Will Guzzardi.
• Taken together, these reforms will make debt more manageable and help families more quickly balance their budget and build financial security.

• Reported operating earnings for the 2019 first quarter of $363 million were up 8 percent versus $335million in the 2018 first quarter.
• Reported operating margin of 13.0 percent increased 90 basis points in the first quarter of 2019 versus the prior year quarter.
• For the 2019 first quarter, the company's effective tax rate was 25.4percent versus 21.6 percent in the 2018 first quarter.
• Operating cash flow was $127 million in the 2019 first quarter compared to $147 million in the 2018 first quarter.

• The change in government debt between two years equals the interest paid on the stock of debt, the primary deficit (excess of expenditure, excluding interest payments, over revenue), and other factors (deficit-debt adjustments).
• Theoretical models do not provide clear cut conclusions with respect to the sign and size of the interest rate-growth differential on government debt.
• [4] Empirically, the relevant interest rate-growth differential for public debt dynamics, as defined above, has been positive for advanced mature economies over longer periods.