Stock market crashes

• The resurgence of coronavirus cases in autumn dampened the economic recovery as governments reintroduced tighter albeit more targeted restrictions.
• As new cases declined in late spring, authorities began to ease the strict social distancing measures that had aimed to control the initial spread of the virus (see Chart 1.1, left and middle panels).
• Although the resurgence of infections since August has triggered a renewed tightening of restrictions, these have become more targeted (see Chart 1.1, middle panel), thereby limiting their overall economic impact somewhat.
• Nonetheless, there have already been signs of weaker business confidence and economic activity (see Chart 1.1, right panel).
• Chart 1.1 Rebound in business confidence slows down as resurging infections trigger reintroduction of tighter albeit more targeted government restrictions

• The economic impact of the pandemic is highly skewed towards sectors that are directly affected by social distancing measures.
• Together with the more cautious behaviour of consumers, these targeted restrictions have weighed on consumption in general and in particular for those sectors that are most exposed to social distancing measures.
• The output contraction is therefore much more asymmetric across sectors than in previous crises (see Chart 1.2, left panel).
• Governmental support to firms has preserved production capacity so far, but this could be challenged if the economic situation deteriorates further.
• At the same time, these liquidity-providing support measures may become less effective if the economic situation deteriorates further and liquidity constraints morph into solvency issues.
• Chart 1.2 Disproportionate output loss in sectors most affected by social distancing, but unemployment increase remains muted as firms cut hours

• With cases resurging, the outlook for real GDP growth has weakened since the May FSR and remains highly uncertain.
• Notably the upside risk of a sharp rebound in 2021 has receded substantially, pointing towards a more prolonged recession than expected in May.
• Forward-looking indicators, such as non-financial firms assessments of their order books or consumers plans for major purchases in the next year, therefore remain subdued.
• A premature withdrawal of policy support and a protracted pandemic could prolong the recession and have permanent scarring effects.
• Chart 1.3 Deterioration in the outlook, pointing to a more protracted recovery, as global risks are dominated by economic policy uncertainty due to the pandemic

• While the Chinese economy rebounded strongly in the second quarter of 2020, other emerging market economies, as well as the United States and the United Kingdom, are experiencing protracted health and economic crises.
• Accordingly, the Global Economic Policy Uncertainty Index reached record highs in the first half of 2020, receding only partially since then (see Chart 1.3, right panel).
• Financial stability risks related to a possible no-deal Brexit at the end of the year are mostly contained and authorities have prepared for this scenario.
• A possible no-deal scenario would probably also trigger substantial financial market volatility and an increase in risk premia.
• Cliff-edge risks in the area of centrally cleared derivatives have been addressed via the time-limited equivalence decision of the European Commission for UK central counterparties adopted on 21September 2020.
• [1] The ECB will contribute to ESMAs comprehensive review of the systemic importance of UK CCPs and their clearing services,[2] and support any appropriate measures to preserve the EUs financial stability.

1.2 Rising medium-term sovereign debt sustainability risks

• The fiscal response to the pandemic entails sizeable budget deficits in 2020, which are expected to decline in 2021.
• Governments across the euro area have deployed a wide range of fiscal support measures in response to the pandemic.
• A fiscal tightening at a time when output gaps are still projected to be negative could exacerbate the current economic situation.
• That said, in 2020, euro area countries that recorded a larger output gap in general adopted a tighter fiscal stance.
• Chart 1.4 Large fiscal deficits and falling output raise sovereign debt ratios
• Government debt-to-GDP ratios have increased sharply in 2020, reflecting both an increase in outstanding debt and a drop in GDP.
• In order to fund the fiscal response to the pandemic, governments have issued close to one trillion euro of net debt in the first ten months of 2020.
• In addition to this increase in outstanding nominal debt, the drop in GDP has further raised sovereign debt-to-GDP ratios in 2020 compared with the previous year (see Chart 1.4, right panel).
• While this increase in debt ratios will partially reverse once GDP recovers, the elevated nominal debt levels will have a persistent effect on governments debt service needs going forward.
• Elevated debt service needs are partly alleviated by higher cash buffers and favourable funding conditions in the short run.
• At the same time, the cash holdings of governments with the Eurosystem have increased markedly since the end of last year.
• Taking into account these cash buffers, the net debt service needs in the coming year are therefore lower than the increase in gross short-term debt suggests.
• At the same time, the prevailing low-yield environment implies that sovereign debt servicing costs increase only moderately from 20% to 23% of GDP over the next two years, despite the substantial increase in outstanding debt, which further alleviates governments debt service needs in the short term.
• Over the medium-to-long term, the loan component therefore provides additional support for countries with high funding costs whose debt service capacity has been strained by the pandemic.
• Chart 1.6 Contingent liabilities and the sovereign-corporate nexus are weighing on debt sustainability as the pandemic continues
• Contingent liabilities could increase sovereign debt levels further, if the economic situation deteriorates and loan guarantees are called.
• These contingent liabilities do not immediately affect official government deficit and debt levels, but can be relevant for debt sustainability as they could result in additional cash outflows if the underlying loans do not perform (see Chart 1.6, left panel).
• The drop in corporate profits has been especially pronounced in countries that already had high debt levels going into the crisis.
• This coincidence of stretched sovereign debt ratios and a vulnerable corporate sector gives rise to a sovereign-corporate nexus, especially considering that sovereigns are increasingly exposed to corporates through contingent liabilities.
• Governments have stepped in to soften the economic fallout from the pandemic which has increased fiscal deficits and sovereign debt levels.
• However, the large exposure of governments to a weaker corporate sector through contingent liabilities and the bleak outlook for the macroeconomy increase the risks to sovereign debt sustainability over the medium term.

1.3 Euro area households cushioned by government support

• Despite recent improvement, euro area consumer confidence remains weak, reflecting bleak unemployment expectations and elevated uncertainty(see Chart 1.7, left panel).
• Survey-based indicators point to higher expectations of unemployment across all main business sectors, albeit with a marked improvement from earlier lows.
• The retail and services sectors record among the biggest improvement in unemployment expectations, reflecting the effectiveness of short-time work schemes and the easing of lockdown measures.
• Chart 1.7
• Government support schemes have shielded the spending capacity and balance sheets of euro area households.
• Short-time work schemes effectively preserved a large share of employment, thus limiting the decline in aggregate gross wages (see Section1.1).
• At the same time, household gross disposable income was cushioned by a substantial increase in net social transfers and temporary tax relief, adding on average 5 percentage points to the annual growth rate in disposable income for the euro area.
• Despite the support measures, disposable income contracted by 2.7% in the second quarter, mainly due to the decline in compensation paid to employees and falling property income (see Chart 1.8, left panel).
• Households net worth has been supported by a recovery in the value of financial assets, record savings and still buoyant residential real estate markets (see Chart 1.8, right panel).
• Chart 1.8 Household income shielded by government support schemes as social transfers increased, while gains in net worth boosted household resilience
• Growth in aggregate bank lending to households has fallen by 0.2 percentage points since the start of 2020.
• Households debt sustainability has been supported by government schemes and record low debt servicing costs.
• So far, the pandemic has had a relatively modest effect on household debt ratios, as income has been largely preserved by government support schemes.
• Delinquency rates have increased, in particular among the self-employed, but remain close to their long-run average as some euro area countries removed the obligation to file for insolvency.
• Overall, this means that household debt has been largely cushioned from the economic impact of the pandemic.
• Chart 1.9 Bank lending slowed down amid tighter lending standards, as highly indebted households look vulnerable to increasing debt service burdens
• Countries with buoyant housing markets have also experienced a gradual build-up of household debt in recent years.
• Moreover, high-debt countries show high unemployment expectations, making them more vulnerable to possible cliff-edge effects from the ending of support (see Chart 1.9, right panel).
• As a result, whether risks materialise will depend in part on the ability of governments to keep supporting households that experience declining incomes.

1.4 Euro area corporates shielded by government support but facing rising solvency pressures

• Corporates experienced a continued deterioration in profits, profit margins and retained earnings as economic activity contracted amid tight social distancing measures (see Chart 1.10, left panel).
• As a result, corporate vulnerabilities increased substantially in the euro area (see Box 1).
• As net loan flows to corporates abated over the summer, firms continued to replace the short-term funding they took on in March with longer-dated loans.
• Borrowing from banks remained at elevated levels in the second quarter, while corporate debt issuance reached record highs (see Chapter 2).
• Chart 1.10 Corporate profits collapsed and net loan flows rose during the initial lockdowns, but net loan flows slowed as of April as firms shifted towards longer-maturity debt
• Despite an increase in underlying credit risk, credit conditions remain favourable but could tighten if government support ends.
• Unlike in previous periods of stress, bank lending to non-financial corporations (NFCs) increased substantially at the onset of the pandemic (see Chart 1.10, right panel).
• Governments that provided loan guarantees thereby underwriting credit risk played a crucial role in that context.
• In turn, a premature withdrawal or suspension of loan guarantee schemes could cause banks to tighten credit standards further, resulting in a credit crunch for NFCs.
• Chart 1.11 Guarantees support funding conditions despite higher credit risk especially for SMEs, but credit standards are tightening
• In the first half of 2020 the credit quality of new loans deteriorated more for SMEs than for large enterprises in the four largest euro area countries (see Chart 1.11, left graph in right panel).
• In addition, SMEs are generally less likely to have access to market-based funding sources, which leaves them more exposed to a sudden deterioration in bank lending conditions.
• They are therefore particularly vulnerable to a possible expiration of state guarantees and a subsequent tightening of credit conditions.
• Although corporate debt ratios are likely to remain elevated, they may fall back somewhat once the economy recovers.
• Chart 1.12 Gross NFC indebtedness increased on the back of lower GDP, while insolvencies are expected to rise despite higher cash holdings
• However, this overall picture masks substantial heterogeneity reflecting the asymmetric impact of the pandemic across industries (see Section 1.1).
• Corporate insolvencies are likely to increase as the pandemic continues and liquidity constraints morph into solvency issues.
• In the first half of 2020 corporate insolvencies across a range of euro area countries were lower than during the same period in the previous year.
• The deterioration in corporate solvency would be exacerbated if government support measures were withdrawn prematurely, as viable companies could face a sudden tightening of credit conditions before earnings have sufficiently recovered.
• Box 1Assessing corporate vulnerabilities in the euro area Prepared by Sndor Gard, Benjamin Klaus, Mika Tujula and Jonas Wendelborn By bringing much of the euro area economy to a temporary halt, the coronavirus pandemic has threatened the existence of many euro area firms.
• Against this backdrop, this box assesses euro area NFC vulnerabilities and the underlying factors.

1.5 Euro area property markets at risk of correction

• Euro area residential real estate (RRE) prices continued rising throughout the first half of 2020.
• At the euro area level, nominal house prices increased by around 5% in annual terms in the first half of 2020 (see Chart 1.13, left panel).
• While prices continued to trend upwards in the euro area as a whole, growth rates varied greatly across countries and between capital cities and rural areas.
• Tighter lending standards and fading demand could accelerate the slowdown in the euro area housing cycle anticipated for 2021.
• A number of euro area countries have both household debt-to-disposable income ratios at or above 100% and increasing signs of overvaluation (see Chart 1.13, right panel).
• Chart 1.13 Despite resilience over the first half of 2020, house prices are expected to moderate against the background of high indebtedness in some euro area countries
• In contrast with residential markets, the pandemic led to an abrupt and sustained drop in CRE market activity.
• Moreover, there has been a pronounced increase in the role of international buyers in euro area CRE markets in recent years as a result of the search for yield.
• [6] The observed decline in transactions has been driven by both euro area and non-euro area investors.
• Chart 1.14 A sharp and sustained drop in commercial real estate (CRE) market activity, with a shift in buyer composition
• Moreover, there is significant dispersion within the euro area.
• This reflects the uneven economic impact of the pandemic across euro area economies.
• A sharper CRE market correction could have implications for bank balance sheets, although exposure varies.
• Against this background, a large decline in the value of CRE could contribute to bank vulnerability in some euro area countries in the context of a wider coronavirus shock.
• The CRE sector has been affected by the pandemic faster than the RRE sector and may have entered a period of risk materialisation.
• Chart 1.15 CRE assets are still vulnerable to a price correction, which could feed through to bank balance sheets

2 Financial markets

2.1 Recovery and stabilisation in financial markets following policy support

• Financial conditions have continued to ease on the back of monetary and fiscal policy measures to almost unprecedentedly accommodative levels.
• Better than expected macroeconomic data, strong policy support and, most recently, positive news on coronavirus vaccine trials have led to a considerable improvement in global risk sentiment.
• This has eased global financial conditions to almost unprecedentedly accommodative levels, reflected in narrower credit spreads and recovering equity markets (see Chart 2.1, left panel).
• Financial conditions remain somewhat tighter in the euro area given the appreciation of the euro and an incomplete equity market recovery.
• The accommodative financial conditions are largely predicated on the significant monetary and fiscal policy measures.
• The accommodative monetary policy environment has provided support to financial markets.
• Advanced economy central bank balance sheets have ballooned by more than 5 trillion in 2020 to above 20 trillion.
• This has outpaced any previous expansion and provided extensive support to financial markets (see Chart 2.2, left panel).
• The agreement on the EU recovery fund on 21July has also supported risk sentiment and sovereign spreads.
• [7] Chart 2.2 Strong policy support has helped to stabilise financial markets, with EU debt issuance expected to provide a large amount of highly rated euro area bonds
• Euro area sovereign bond yields have continued to decline despite growing indebtedness, but longer-term vulnerabilities have increased.
• The overall narrowing of sovereign bond spreads has been accompanied by reduced dispersion among individual countries (see Chart 2.3, left panel).
• The decline in yields has been underpinned by the Eurosystems sovereign bond purchases and the EU recovery fund announcement.
• [8] Chart 2.3 Sovereign bond market fragmentation pressures have eased and asset price inflation has resumed
• The share of global fixed income instruments yielding less than 2% in nominal terms has risen to 90% (see the Overview).
• Global financial asset price inflation has resumed, partly on account of large-scale fiscal and monetary policy support, following a temporary reversal earlier in the year.
• For example, the average real yield of a basket of 17 global financial assets has reached 0.8 standard deviations below its long-term average (see Chart 2.3, right panel).
• Low asset yields continue to present challenges for investors looking to generate returns and incentivise a shift into riskier assets.
• This may contribute to a build-up of financial stability risks, including in the non-bank financial sector (see Chapter4), if such risk-taking becomes excessive.

2.2 Divergent trends in equity markets

• Global equity markets have partially recovered the losses suffered during the turmoil in the spring.
• Lower real interest rates, coupled with the improved sentiment stemming from the global monetary and fiscal policy response and a string of positive macroeconomic data surprises, prompted the initial equity market recovery.
• By contrast, the US equity market has received a stronger boost from declining risk-free rates.
• Concerns eased and equity markets rose in November on positive news about coronavirus vaccine trials.
• The US equity market has outpaced euro area equity markets, with markets exhibiting a K-shaped recovery.
• Chart 2.4 Heterogeneous performance in equity markets reflects different earnings prospects
• The market recovery in the summer led to some analysts perceiving a disconnect from fundamentals, but different valuation metrics provide somewhat contrasting evidence, with regional variation also being evident.
• Strong advances in equity markets until September compared to the underlying economy, particularly in the United States and in the technology sector (see Chart2, right panel, in the Overview), supported by the unprecedented monetary policy response, gave rise to analysts perceptions in the summer that equity market developments might be disconnecting from actual underlying economic developments.
• This perception was partly due to the difference in sectoral make-up and the different importance that some companies have in the stock market compared to the real economy, for example in employment.
• Nevertheless, forward price/earnings ratios in most euro area economic sectors are elevated against historical benchmarks owing to a subdued earnings outlook.
• Chart 2.5 Equity prices relative to estimated earnings are at elevated levels, but cyclically adjusted price/earnings ratios remain at more moderate levels
• Equity market performance has been broadly in line with forward-looking indicators, but the risk of an abrupt equity market correction remains elevated, albeit diminishing.
• Despite some concerns over potentially stretched valuations, euro area equity index developments, reflecting expectations about future economic activity, have been broadly in line and increasingly converged with forward-looking sentiment indicators.
• More recently, the equity market declined in October on renewed concerns about further economic lockdowns, but reacted positively in November to news of successful coronavirus vaccine trials (see Chart 2.6, left panel).
• This may reflect both a decrease in investor risk aversion and a fall in perceived probabilities attached to downside risk scenarios.
• Chart 2.6 Euro area equity market developments are in line with sentiment indicators and the cost of hedging downside risks remains elevated Sources: Refinitiv, Bloomberg Finance L.P., European Commission, Sentix, Westpac and ECB calculations.

2.3 Credit spreads narrow despite increasing corporate sector vulnerability

• Corporate bond spreads have recovered almost entirely from the tensions experienced in March.
• This development has been supported by continued investor inflows into euro area corporate bond funds (see Chapter4) and occurred despite a large increase in corporate debt supply (see Chart 2.10, right panel).
• Corporate bond spreads have narrowed against a backdrop of direct and indirect policy support.
• The narrowing of corporate bond spreads was also in line with a compression in the excess bond premium (see Chart 2.7, right panel).
• Chart 2.7 Corporate bond spreads are near pre-pandemic levels, supported by the Eurosystem purchase programmes, fiscal support and stronger risk appetite
• Credit spreads have also been supported by comparatively resilient credit risk metrics that so far remain below the levels seen during the global financial crisis.
• Credit risk data appear to anticipate a continuation of significant monetary and fiscal policy support, which would limit defaults.
• Credit spreads do, however, appear tight in view of the near-term economic outlook, particularly for the high-yield segment of the corporate bond market.
• But this highlights the upside risks to corporate spreads from a deterioration in the credit market environment.
• [9] Chart 2.8 Credit risk metrics have increased, but remain below global financial crisis levels, and corporate bond spreads appear tight relative to the economic outlook
• Corporate credit quality has deteriorated and negative rating outlooks stand at historically high levels.
• Credit rating agencies downgrades of euro area non-financial corporations (NFCs) spiked in March and April.
• The majority of downgrades have taken place in the high-yield segment, while investment-grade ratings have been comparatively resilient.
• Chart 2.9 Many companies remain at risk of further downgrades and credit quality has also deteriorated in the leveraged loan market
• The European leveraged loan market has experienced increased downgrade rates, especially in March and April, and elevated default rates, although the latter remain below historical highs.
• Firms drew heavily on their revolving credit facilities to access liquidity at the start of the coronavirus crisis and, in many cases, these drawdowns triggered springing covenants.
• This led to borrowers increasingly requesting loan condition relief, which points to a deterioration in credit quality (see Chart 2.9, right panel).
• Corporates, particularly investment-grade firms, have made more use of capital markets to access precautionary funding, resulting in record bond issuance in recent months.
• Despite deteriorating credit quality and a highly uncertain economic outlook, euro area NFCs substantially increased their funding.
• Chart 2.10 Large increase in net corporate funding and record high investment grade bond issuance
• An increasing share of corporate bonds issued in 2020 has lower investment-grade ratings (see Chart 2.11, left panel).
• These include fallen angels, given the associated sizeable increase in funding costs (see Chart 2.7, left panel).
• Equity financing activity has been concentrated in a limited number of sizeable transactions by large companies.
• Elevated uncertainty and the practical challenges of issuing equities at the start of the lockdown in March severely constrained euro area initial public offerings.
• Large, already listed companies stepped up their follow-on equity offers substantially, generating a notable rebound in equity issuance volumes.
• Chart 2.11 Debt issuance has been most prominent in the low investment-grade segment, while equity issuance has rebounded but is dominated by a few large transactions


Box 3Understanding what happens when “angels fall” Prepared by Marco Belloni, Tobias Helmersson, Mariusz Jarmuzek, Benjamin Mosk and Filip Nikolic

3 Euro area banking sector

3.1 Weaker bank profitability and rising credit risks

Profitability unlikely to recover to pre-pandemic levels before 2022

• Euro area banks profitability weakened in the first half of 2020 amid the economic fallout from the pandemic.
• In an international comparison of listed banks, euro area institutions now rank below their Japanese counterparts but slightly above UK banks (see Chart 3.1, left panel).
• The results from third quarter earnings releases of listed banks suggest that profitability of euro area banks declined further to below 1%.
• Looking ahead, market expectations of future ROE of listed euro area banks for 2020 have declined slightly to 1.7%, while expectations for 2021 and 2022 have remained so far broadly unchanged at 3.1% and 5% respectively.
• Chart 3.1 Euro area banks profitability declined substantially in the first half of 2020, trailing most global peers, and recovery is expected to be slow as the pandemic continues
• Higher loan loss provisions drove the decline in profitability of euro area banks, which was only partially offset by cost reductions.
• Other profit and loss items declined the most in Spain and Italy, largely due to extraordinary items and non-recurring expenses.
• Notably, banks in the lowest profitability quartile had a pre-pandemic cost-to-income ratio of 85% as against only 57% for the most profitable banks.
• This suggests that consolidation in the industry, as seen in Italy and Spain, might improve future profitability.
• Chart 3.2 Cost-cutting only marginally offset the impact of higher impairments on euro area bank profitability on aggregate, although it helped the least profitable banks more
• The decline in NII reflects lower income from loans to corporates and households, probably as a consequence of lower margins on state-guaranteed loans, which were partly offset by the lower cost of deposits.
• Among the four largest euro area countries, Spain and Italy experienced a decline in NII whereas Germany and France saw a rise (see Chart 3.3, left panel).
• The government guarantee schemes for bank loans accounted for most of the strong growth in lending to firms since March 2020 (see Special Feature A).
• This indirectly highlights the impact of lower market interest rates coupled with loan guarantees (see Chart 3.3, right panel).
• Chart 3.3 Net interest income of euro area banks declined mainly due to lower interest rates, with volume growth providing only a partial offset
• Future lending growth will depend on whether state guarantees expire or are extended and whether banks tighten lending standards, as they have indicated.
• While mortgage lending remained stable amid favourable interest rates and consumer lending fell substantially in the first half of 2020, corporate lending grew on the back of state guarantees.
• The fact that the volume of state-guaranteed loans exceeded the amount of net lending might partly reflect the conversion of pre-existing loans into guaranteed loans, in particular in Spain and Italy (see Chart 3.4, left panel).
• Chart 3.4 Lending to NFCs in the first half of 2020 was strongly driven by loan guarantees, credit standards are expected to tighten amid higher credit risk going forward
• The sovereign-bank nexus strengthened in some euro area countries amid a rise in banks exposure to domestic government debt.
• In their efforts to increase liquidity buffers and reduce risk in response to the coronavirus uncertainty, but also potentially to benefit from carry trades, banks have increased their holdings of government bonds, albeit with substantial variation across countries (see Chart 3.5, left panel).
• The rise in banks exposure to domestic governments, together with the extraordinary policy measures and the associated increase in sovereign debt, has increased the risk from the sovereign-bank nexus (see Chart 3.5, right panel) in some countries (see Box4).
• Chart 3.5 Banks in some euro area countries greatly increased their holdings of domestic government bonds, raising the potential risk from the sovereign-bank nexus
• In the early 2010s, banks in a number of euro area countries held high shares of their governments debt at the same time that governments were providing guarantees or other support to their banking systems.
• In recent years, many euro area countries have observed a decline in sovereign-bank interlinkages and, in turn, in the risk of intertwined crises.
• In addition, the sovereign-bank nexus may develop also via indirect channels, including banks exposure to the state of the domestic economy; whereby direct holdings can amplify these indirect effects.
• This box assesses how the interlinkages, via the direct exposures of banks to sovereign debt securities[15], have increased so far and whether this has led to an increase in crisis risk.


Chart 3.6 Euro area banks have been provisioning less than US banks, with policy and profitability differences as potential explanatory factors

• Downside risks to profitability arise from signs of optimistic provisioning and a weaker outlook for lending volumes.
• Listed euro area banks have increased their loan loss provisions to a smaller extent than their US peers (see Chart 3.6, left panel).
• According to results from third quarter earnings releases of listed euro area banks loan loss provisioning declined in the third quarter.
• It appears that the relationship between pre-provisioning profits and provisioning levels is much stronger for euro area listed banks but this may also reflect a lower risk profile.
• Looking ahead, there is a risk that low profitability might lead to under-provisioning.
• Provisioning levels were widely dispersed across both countries and banks within the same countries (see Chart A, right panel).

Credit risk has increased since the start of the pandemic and asset quality is likely to deteriorate going forward

• Extraordinary policy measures have so far mitigated losses materialising in the banking sector, but this may also weaken the informational value of certain risk indicators.
• Asset quality has started to deteriorate and inflows into higher asset stages, approximated by observed flows in impairments, have increased.
• The broad-based deployment of government support to borrowers, through moratoria and public guarantees, may lead to this lag being longer than in past recessions.
• In addition, as macroeconomic performance differs across countries, the respective GDP decline will generate different NPL profiles.
• The share of loans under forbearance measures has also started to rise again (see Chart 3.7, right panel).
• Chart 3.7 Provision inflows into Stage 2 assets and exposures under forbearance have increased, pointing towards higher credit risks for euro area banks
• The outlook for bank asset performance is dependent on a combination of economic recovery and continued state support.
• Government support measures have provided a crucial backstop for firms since the pandemic started, thereby also underpinning bank asset quality.
• In addition, property markets face significant headwinds going forward, further contributing to the uncertain outlook (see Section 1.5).
• Chart 3.8 The default risk in sectors heavily affected by the pandemic increased in the second quarter, implying that bank asset quality depends on public support going forward
• Furthermore, loan data reported in AnaCredit indicate a larger increase in PDs reported by banks for new and existing loans to sectors heavily affected by the pandemic.
• This suggests that banks risk differentiation between sectors has intensified during the pandemic (see Chart 3.8, right panel).
• Business operations and ICT security need to continue adapting and responding adequately to the modified ICT risks and cyberrisks.
• Efforts must be maintained to raise awareness of the techniques adversaries use to specifically target people working from home.
• Chart 3.9 The number of cyberrisk incidents has increased over recent months, with DDoS attacks being the most frequent type
• While cyber incidents reported by euro area banks have increased over time, institutions have not been impacted severely so far.
• Cyber incidents reported to the ECB by significant institutions have increased somewhat both over recent months and compared to last year (see Chart 3.9, left panel).
• Distributed denial-of-service (DDoS) attacks in particular are trending upwards, including ransom DDoS by large threat actors (see Chart 3.9, right panel).
• Banks could, in the light of the economic outlook and likely lower profitability, end up hesitating to address these weaknesses in due course.

Recent improvements in solvency positions, but headwinds ahead

• Banks capital generation has been negatively affected by weak profitability, although an increased share of lower-risk assets has supported capital ratios.
• Banks aggregate CET1 ratios showed some volatility in the first half of 2020, with a moderate decline in the first quarter followed by an increase of the same magnitude in the second.
• The combined impact of changes in capital in the first two quarters was close to neutral.
• Chart 3.10 Banks capital generation was negatively affected by weak profitability, but the increase in the share of lower-risk assets supported capital ratios
• The improvement in banks capital ratios in the second quarter partly reflects the impact of the quick fix amendments to the Capital Requirements Regulation (CRR).
• [19] For a sub-sample of listed banks which disclosed a positive impact from these regulatory changes, the median CET1 ratio uplift amounted to 30 basis points (see Chart 3.11, left panel).
• Although banks aggregate leverage ratio fell in the first half of the year, it will likely benefit from some temporary relief in the coming quarters.
• Based on March 2020 data, this exclusion is estimated to raise the aggregate leverage ratio by about 0.3 percentage points.
• Chart 3.11 The improvement in banks capital ratios in the second quarter partly reflects the impact of regulatory changes, while non-risk-based leverage ratios dropped
• Looking ahead, more intense credit risk migration over the next few quarters could put pressure on capital ratios.
• As a result, no significant negative impact from higher credit risk has yet been observed in terms of RWA inflation.
• That said, enhanced capital buffers due to capital relief measures should help banks to absorb these possible negative impacts.

Mixed evidence on banks’ response climate transition risk

• Estimates of euro area banks lending to carbon-intensive sectors a proxy for climate change transition risks[20] show few signs of declining.
• At the same time, issuance of green bonds and banks holdings of green bonds have increased; however, their role in lowering issuers carbon emissions, thus reducing transition risks, is unclear (see Box 7).
• The rebound in carbon emissions since the May 2020 FSR suggests that the fall in emissions in sectors that banks are exposed to was temporary.
• This suggests that a permanent, sizeable reduction in transition risks for the banking system stemming from these changes is unlikely.
• Chart 3.12 Lending data provide mixed evidence of transition risk dynamics for banks, while carbon emissions themselves have rebounded from lows earlier in 2020
• Economic losses due to physical risks from climate change could increase going forward[24] and possibly translate into bank losses.
• The frequency of weather- and climate-related economic damage has been increasing over recent decades.
• The frequency and intensity of these types of extreme weather and climate events are expected to increase further at least over the next decade.
• Loan exposures to countries with relevant physical risk drivers ranged between 2% and 20% across significant institutions in the third quarter of 2020.
• [29] The materialisation of physical risks in these areas could pose financial stability risks (see Chapter 5).

Historically low valuations but more favourable market funding conditions than in the first quarter

• While global stock markets saw a large rebound over the summer, global bank stock prices remained up to 50% below their end-February levels (see Chapter 5).
• There has also been substantial cross-country variation compared with the broader market, with euro area banks found at the bottom of the range (see Chart 3.13, left panel).
• With an aggregate price-to-book ratio of 0.44, euro area banks now rank below Japanese and UK banks.
• More positively, low market valuations of the target bank might facilitate sector consolidation, and M&A discussions have moved the stock prices of Italian banks in particular (see Overview chapter).
• Chart 3.13 Bank stock prices have recovered less than the broad market, and euro area bank price-to-book ratios are below global peers
• The bond funding costs of euro area banks continued to decline, although they remain elevated for more junior instruments.
• On aggregate, bond spreads of euro area banks have declined substantially since peaking at the end of March.
• This has helped to lower banks market funding costs, thus providing tailwind to bank profitability in the second quarter.
• However, spreads are still above pre-pandemic levels (see Chart 3.14, left panel).
• The record levels of reliance on central bank funding coincide with a significant decline in bank bond issuance, in particular for non-global systemically important banks.
• The extraordinary support measures have now led to central bank funding increasing to 9% of the total assets of euro area banks on aggregate.
• The provision of funding at favourable conditions via new TLTRO series helps banks to build up lending to the real economy in a period of unprecedented economic uncertainty.
• In particular, funding risks could arise to the extent that some smaller banks may face limited market access and would have to progressively rebuild an investor base.
• Chart 3.15 Reliance on central bank funding increased substantially and led to a rise in banks liquidity ratios, while bond issuance volumes of non-G-SIBs fell to historic lows
• Some banks could also face an abrupt increase in funding costs from ratings downgrades which have not yet materialised despite the deteriorated outlook.
• This increase was less pronounced in Italy, where more banks are closer to the non-investment grade threshold.
• If a worsening in the economic outlook prompts downgrades particularly from investment grade to high yield this could lead to substantially higher market funding costs for the banks concerned (see Box 3).
• Chart 3.16 The mix of a weaker rating outlook for banks and largely unchanged issuer ratings raises risks from negative macroeconomic surprises

3.2 Using scenario analysis to evaluate the resilience of the euro area banking sector

• This section presents a top-down assessment of the solvency and profitability of euro area credit institutions under two scenarios.
• The impacts of a baseline and an adverse scenario are assessed using the ECBs macro-micro model[30] relying on information about the banking sector up to the second quarter of 2020.
• The model covers over 90 large and medium-sized euro area banks in the 19 euro area countries.

The baseline and adverse scenarios

• The baseline scenario is consistent with the September 2020 ECB staff macroeconomic projections.
• Real GDP in the euro area is projected to fall by 8.0% in 2020 before rebounding by 5.0% in 2021 and 3.2% in 2022 (see Chart 3.17).
• This reflects the assumption that there will be some success in containing the virus but that targeted containment measures will continue.
• The adverse scenario is derived as a tail event reflecting the risk of a protracted pandemic and continued weakness in the global economy (see Box 6).
• Chart 3.17 A gradual rebound in economic conditions in the baseline scenario and a prolonged recession in the adverse scenario Euro area GDP falls significantly in 2020 and 2021 in the adverse scenario (percentages)

Impact on banks

• The subdued economic growth assumed in the September 2020 ECB staff projections points to a potential decline in banks ROE to below zero in 2020 and a slow rebound thereafter (see Chart 3.18, bars in the left panel).
• The negative outlook for bank profitability follows negative economic growth in 2020, with credit risk losses increasing towards the end of 2020 in particular (see Chart 3.18, right panel).
• Under the adverse scenario, credit risk losses rise close to 20% of banks equity, driving profitability lower in 2021 and 2022 (see Chart 3.18, right panel).
• This reflects a significant worsening in the probability of default and loss given default of loans.
• Chart 3.18 Credit risk losses are the main negative driver of bank profitability going forward
• Lending to the non-financial private sector is expected to decelerate at the end of 2020.
• Nevertheless, the growth rate of lending to the real economy is expected to remain positive (see Chart 3.19).
• Under the adverse scenario, lending volumes are expected to contract in both 2021 and 2022 (see Chart 3.19).
• Chart 3.19 Slowdown in lending in the baseline scenario and strong contraction in the adverse scenario Annual growth of loans to the non-financial private sector (percentages)
• Under the baseline scenario, the aggregate Common Equity Tier 1 (CET1) ratio of euro area banks is projected to decrease by about 1.3 percentage points to 13.6% by the end of 2022.
• The deterioration in banks capital ratios reflects low profitability combined with a continued increase in bank assets, and to a lesser degree an increase in average risk-weighted assets, summing up to an overall increase in banks risk exposure amounts (see Chart 3.20, left panel).
• Chart 3.20 Low profitability and an increase in risk-weighted assets weigh on CET1 ratios Sources: Individual institutions financial reports, EBA, ECB and ECB calculations.
• In the adverse scenario, the aggregate CET1 ratio of euro area banks falls by 5 percentage points, but the sector remains resilient overall.
• The aggregate CET1 ratio falls from 14.9% to 9.9% by 2022,[33] reflecting a sharp contraction in banks profitability and a moderate increase in risk exposure amounts (see Chart 3.20, right panel).
• Even so, the majority of euro area banks continue to meet their CET1 capital requirements.
• [34] Banks accounting for about 4% of euro area total banking sector assets in the baseline scenario and for about 28% in the adverse scenario would go below their combined buffer requirement.

4 Non-bank financial sector

4.1 Non-bank financial sector supports the recovery while exhibiting renewed vulnerabilities

• The non-bank financial sector has become increasingly important for the real economy in recent years.
• Market-based credit marketable debt securities as opposed to loans now accounts for around 20% of total external credit to non-financial corporations (NFCs).
• Non-bank credit, where the ultimate lender is a non-bank financial institution rather than a bank irrespective of the mode of financing, makes up around one-third of total credit from financial institutions.
• [38] Chart 4.1 Non-bank credit has expanded since the global financial crisis and continued to provide financing to euro area corporates after the initial coronavirus shock
• The sector continued to provide significant financing for companies after the initial coronavirus shock, thus helping to support the recovery.
• Non-bank financial institutions have absorbed the vast majority of the new issuance, thereby supporting the economic recovery (see Chart 4.1, right panel).
• But the non-bank financial sector harbours structural vulnerabilities, such as maturity mismatches of life insurers or the mismatch between the liquidity of investment funds assets and their redemption terms (see Section4.2).
• Such liquidity mismatches made parts of the money market and investment fund sector vulnerable to the large price corrections and redemptions seen during March.
• Chart 4.2 Increased selling of debt securities by non-banks during the initial coronavirus shock and renewed inflows and risk-taking thereafter
• Euro area MMFs also sold off assets, almost exclusively short-term bank debt, worth around 80 billion (i.e.
• approximately 8% of their portfolio assets), while increasing their bank deposits and buying government debt securities.
• [39] Such procyclical selling of assets was less pronounced among ICPFs, whereas, on a net basis, banks bought government and bank bonds.
• Non-banks have rebalanced their portfolios towards higher-yielding but riskier and potentially more illiquid assets after the market turmoil.
• Going forward, renewed risk-taking and persistent structural vulnerabilities in parts of the non-bank financial sector could threaten the sectors resilience.
• [41] Any significant rise in corporate credit risk would adversely affect the asset portfolios across the wider non-bank financial sector and could precipitate outflows from investment funds.
• [42] Given that companies are increasingly reliant on non-bank finance, such vulnerabilities highlight the need to strengthen the resilience of the non-bank financial sector to ensure that it represents a resilient source of funding at all times (see Section 5.2).

4.2 Investment funds increase their risk-taking

• Since the pandemic emergency purchase programme (PEPP) started, euro area money market funds and corporate bond investment funds have consistently experienced significant inflows.
• Euro area-domiciled money market funds and investment-grade corporate bond funds have seen cumulative inflows of about 15% of assets under management (AuM).
• Nevertheless, the growth of the whole investment fund sector was limited to 7.7% of AuM, held back mostly by equity funds.
• Funds of this type account for half of the sector in terms of AuM, and flows into such funds have not fully recovered to pre-pandemic levels.
• In turn, investment and money market funds directed the inflows of funds into NFC and sovereign debt securities (see Chart 4.3, right panel).
• In the second quarter of 2020, investment funds expanded their portfolio of NFC debt by 100 billion after selling 150 billion of mostly sovereign debt securities in the dash for cash during the market turmoil.
• Around one-third of total investment fund purchases in the second quarter were of securities issued by euro area residents, highlighting the important role that investment funds have been playing in financing the recovery.
• [43] Chart 4.4 After a brief reversal during the market turmoil in March, investment funds have reverted to their pre-pandemic trend of increasing liquidity risk
• Over the past years, investment funds have taken on more liquidity risk in the search for assets offering higher returns.
• For instance, the share of liquid debt securities held by euro area investment funds has constantly declined, from 36% in 2013 to less than 30% in June 2020 (see Chart 4.4, left panel).
• [44] Liquidity risk in funds has started to increase again, after a temporary improvement in liquidity positions following the March turmoil.
• A decline in the liquidity of euro area investment funds coincides with an increase in exposure to securities with longer durations and lower credit ratings (see Chart 4.5).
• In the second quarter, investment funds increased their holdings of riskier securities: around 70% of new investments were in securities with longer durations (i.e.
• The increase in investment funds exposure to longer-duration and lower-rated corporate debt reflects a changing market environment and riskier bond portfolios.
• At the same time, investment funds hold a higher share of relatively high-yielding assets compared with the overall market.
• Chart 4.5 Investment funds increased their exposure to longer-duration and lower-rated NFC debt, with about half of the debt portfolio offering a yield of 2% or less
• Assets under management of euro area bond and equity ESG funds have tripled in the past ten years to reach 1.3 trillion in 2020 (see Box 7, Chart A, left panel).
• During the pandemic, ESG funds have proved more resilient than their non-ESG peers (see Chart 4.6, left panel, left chart) with cumulative inflows of around 15-20% since the turmoil in March.
• In comparison, both equity and bond non-ESG funds have not recovered as well from the outflows in March despite a similar performance between ESG and non-ESG funds in terms of returns (see Chart 4.6, left panel, right chart).
• Among euro area investors, investment funds are the largest holders of green bonds, with a gradually increasing share that has reached 20% in 2020.
• Chart 4.6 Increasing investor interest in green financial products: growth and better resilience of ESG funds and green bonds
• Box 7The performance and resilience of green finance instruments: ESG funds and green bonds Prepared by Marco Belloni, Margherita Giuzio, Simon Krdel, Petya Radulova, Dilyara Salakhova and Florian Wicknig[47] Green financial markets are growing rapidly globally.
• Assets of funds with an environmental, social and governance (ESG) mandate have grown by 170% since 2015 (see ChartA, left panel).
• It focuses on the resilience of ESG funds and the absence of a consistent greenium a lower yield for green bonds compared with conventional bonds with a similar risk profile reflecting the fact that green projects do not benefit from cheaper financing.

4.3 Profitability pressures could induce further risk-taking by insurers

• Asset valuation losses in the first quarter of the year and a further decline in interest rates weighed on solvency ratios (see Chapter 2).
• In view of the greater sovereign vulnerabilities due to the pandemic, financial markets also link the solvency of insurers to the creditworthiness of their respective sovereigns.
• Credit default swap (CDS) spreads indicate a close relationship between the default risk of euro area insurers and their sovereigns (see Chart 4.7, right panel).
• This reflects the fact that insurers in some euro area countries invest heavily in domestic sovereign debt.
• Chart 4.7 Insurers solvency ratios remain strong despite recent deterioration, while their creditworthiness is also linked to that of their sovereign
• The pandemic has weighed on insurers profitability due to lower revenues.
• The market turmoil in March led to the average return on investment plummeting, with several insurers suffering negative investment income in the first quarter of the year (see Chart 4.8, left panel).
• The lockdown and the resulting economic contraction caused the growth of gross premiums written to collapse as well, with life insurers more heavily affected (see Chart 4.8, right panel).
• Also, household demand for life insurance products is likely to remain feeble amid the recession.
• Insurers and reinsurers face potentially higher claims stemming from the pandemic and a relatively large number of natural catastrophes.
• Chart 4.8 Insurers profitability declined because of lower investment and premium revenues, coupled with potentially higher claims going forward
• The ongoing rise in the cost of premiums could help to improve non-life insurers and reinsurers profitability in the future, but this may also lead to insurance protection gaps.
• Global non-life insurance prices have risen sharply over the last three years (see Chart 4.9, left panel).
• In Europe, this hardening of the market is mainly driven by rising underwriting losses from natural catastrophes and other property insurance lines.
• [53] Chart 4.9 Non-life insurers profitability could benefit from the ongoing rise in premium prices, while investors have a pessimistic view of the life insurance sector
• Rising insurance premiums and the accompanying positive market sentiment could help non-life insurers to recapitalise if needed.
• While remaining volatile, price/earnings ratios of non-life insurers and reinsurers have broadly recovered from their trough during spring (see Chart 4.9, right panel).
• Several insurance companies have already managed to raise additional capital this year, allowing them to strengthen their solvency positions.
• Chart 4.10 While insurers aggregate liquidity positions appear solid, low rates for longer may induce further risk-taking
• The pressures on profitability from low interest rates and higher claims could induce further risk-taking by insurers.
• Maintaining sufficiently high investment income in the current interest rate environment could require insurers to rebalance their portfolios towards higher-yielding, but riskier assets.
• Instead, keeping the portfolio income at its 2019 level would require insurers to increase the share of high-yield assets from 2% of their debt securities portfolio to 30% by 2025.
• A significant reduction of investment income over the medium term thus seems inevitable, despite higher risks being taken on.
• As a result, insurers may also continue to invest larger shares of their portfolios in alternative asset classes.
• [54] The liquid asset holdings of insurers have remained relatively stable overall, but may mask some heterogeneity.

5 Macroprudential policy issues

5.1 Banking sector policies

• Since the May 2020 FSR, prudential authorities and regulators have taken further steps to ensure that banks remain resilient.
• After the initial actions to reduce banks incentives to constrain credit,[57] prudential authorities took additional steps to prevent banks capital positions being unduly weakened by dividend distributions.
• [58] Targeted revisions to the Capital Requirements Regulation known as the quick fix were published on 26 June.
• First, the changes included adjustments to the minimum amount of capital that banks are required to hold for non-performing loans (NPLs).
• This was done by extending the preferential treatment of such loans guaranteed by export credit agencies to NPLs guaranteed or counter-guaranteed by national governments or other public sector guarantors.
• [59] As macro-financial conditions evolve, prudential authorities will need to monitor the effectiveness of policies and develop contingency plans for further measures.
• Therefore, prudential authorities will need to monitor the effectiveness of policies, including banks willingness to use buffers.
• At the same time, however, these banks continued to expand assets via lending (see Chart 5.1, right panel).
• Against this backdrop, on 28July 2020 ECB Banking Supervision encouraged banks to use their capital and liquidity buffers for lending purposes and loss absorption.
• [61] Further policy measures may also be required if distressed assets on bank balance sheets increase significantly.
• A large-scale, system-wide increase in NPLs would require a comprehensive approach at the national and EU levels.
• At the same time, the choice of instruments should be tailored to the nature of the specific NPL problem.
• [62] Banks need to become better prepared individually to handle the increased NPLs[63] and recognise asset quality problems in a timely and accurate manner.
• In the medium term, a rebalancing between structural and cyclical capital requirements seems desirable to create macroprudential policy space.
• Releasing regulatory capital buffers accumulated in good times can support loss absorption and lending in a downturn.
• Finally, recent events demonstrate the need to close the gaps in the institutional set-up of the banking union.
• The banking union remains unfinished, however, and efforts are required to improve its crisis management framework, establish its missing third pillar, the European deposit insurance scheme, and facilitate the flow of capital and liquidity within banking groups, while guaranteeing adequate safeguards for host Member States.

5.2 Non-bank financial sector policies

• The resilience of the non-bank financial sector needs to be enhanced in a way that reflects macroprudential perspectives.
• Parts of the non-bank financial sector, including money market funds (MMFs) and some investment funds, experienced significant stress during the March market turmoil.
• The resilience of parts of the sector proved to be insufficient, and it became clear that existing (ex post) crisis management tools could not adequately mitigate the stress.
• The episode in March underlined the need for authorities to take a holistic and system-wide view, consider the role of different players and assess and design policies to address vulnerabilities in the non-bank financial sector, as also outlined by the Financial Stability Board (FSB).
• [66] For instance, structural vulnerabilities in MMFs and investment funds should be addressed and liquidity risks from procyclical margins mitigated.
• [67] Throughout, policies should reflect the fact that the non-bank financial sector comprises a diverse set of entities and activities.
• Implementing macroprudential regulatory reforms should help both increase the resilience of the non-bank financial sector, ensuring that it provides a stable source of funding to the real economy at all times, and support the effective transmission of monetary policies.
• Such policies should be used to mitigate risk in the fund sector from a system-wide perspective.

5.3 Completing the capital markets union and managing climate change

5.3.1 Capital markets union

• Establishing a genuine single European capital market is a long-term ambition, and progress towards it can address many of the challenges that the EU is currently facing.
• [71]For example, bond and equity markets could complement bank lending and help ensure that businesses have access to funding.
• Well-functioning capital markets will also play an important role in the European Commissions new bond issuance programme in the context of Next Generation EU.
• The Commissions new Action Plan on Capital Markets Union (CMU) published on 24September 2020[72] is an important step towards building more integrated and resilient European capital markets.
• Since progress in sustainable finance and digitalisation is closely linked to effective capital markets, advancing in these areas will also make capital markets more integrated, efficient and sustainable.

5.3.2 Climate change

• Climate change requires policy action both to foster the transition to a more sustainable economy and to guard against climate-related risks to the financial system.
• [74] The stress test will make it possible to assess the impact of potential regulatory and policy measures aimed at mitigating climate risks to the financial sector in a forward-looking way and for different climate scenarios.
• The stress test will allow the sectors that are most vulnerable to climate change risks to be identified.
• This feature, combined with adequate climate scenarios, will make it possible to assess the implications of policy reforms.
• Finally, the stress test will help to reveal data gaps that need to be filled to enable climate risks to be evaluated more effectively.
• The relatively low home bias in green bond markets suggests that financing the climate transition could help to drive further financial integration.
• [78],[79] Given the lower levels of home bias for green bonds, beyond financing the climate transition the sustainable finance agenda could also have a positive impact on financial integration.
• Enhancing disclosure and information is an essential first step in managing the financial stability risks posed by climate change.
• Improving disclosure of climate-related risks requires a revision of corporate disclosure, notably a review of the Non-Financial Reporting Directive (NFRD).
• [80] Overall, improved climate-related disclosure requirements could contribute to a smooth transition towards a resilient and sustainable economy (see Figure 5.1).


Box 9 A macroprudential perspective on replenishing capital buffers Prepared by Katarzyna Budnik, Matthieu Darracq Pariès, Christoffer Kok, Jan Hannes Lang, Marco Lo Duca, Elena Rancoita, Costanza Rodriguez d’Acri, Ellen Ryan and Matthias Rottner[81]

Special features

Financial stability considerations arising from the interaction of coronavirus-related policy measures

• Importantly, the combination of policy actions has done more to limit the materialisation of risks to households and firms than each policy individually.
• Exploiting policy complementarities and ensuring the most effective combination of policies will, however, be equally important when authorities start to phase out the various relief measures.
• The differences in the enacted fiscal and labour market measures across the largest euro area economies, as well as their phase-out schedules, further complicate the challenge of obtaining the most effective policy combination.

Prospects for euro area bank lending margins in an extended low-for-longer interest rate environment

Prepared by Ugo Albertazzi, Desislava Andreeva, Marco Belloni, Alberto Grassi, Christian Gross, Jonas Mosthaf and Tamarah Shakir