Yield curve

SPEECH

The yield curve and monetary policy

Speech by Philip R. Lane, Member of the Executive Board of the ECB, Public Lecture for the Centre for Finance and the Department of Economics at University College London

London, 25 November 2019

Introduction

• In my contribution, I wish to share some thoughts about the yield curve and monetary policy.
• Over the past 200 years, gilt yields have never been as low as today.
• [2],[3] Long-term rates in the euro area have even reached negative territory.
• [4] Chart 1 UK, US, DE and euro area OIS long-term interest rates (percentages per annum) Sources: Bank of England, Bloomberg, FRED, Jord et al.
• Notes: The slope of the yield curve shown is the spread between ten-year and one-year OIS yields since 1999.
• German data back to 1972 are computed by the Bundesbank using the method of Svensson.
• German data prior to 1972 are extrapolated backwards based on historical series of short and long-term yields provided by the OECD.
• Long-term OECD yields refer to yields on outstanding listed federal securities with residual maturities of over nine to ten years traded on the secondary market.
• [5] The yield curve isa central element in the transmission of monetary policy.
• Standard and non-standard monetary policy instruments affect the whole of the term structure, which in turn is a key determinant of the financing conditions of the economy.
• [6] The financing conditions prevailing for firms and households in turn affect the level of economic activity and inflation.
• While current monetary policy is an important factor affecting the yield curve, beliefs about future monetary policy and risk premia also play a role.

Response of the yield curve to monetary policy in normal times

• Let me first revisit the benchmark case of how the yield curve reacts to the standard policy tool of variations in short-term interest rates.
• When measuring the effect of monetary policy on the yield curve, macroeconomists typically focus on monetary policy shocks: that is, surprise changes in the policy rate that occur independently of other structural shocks, such as innovations in aggregate demand or cost-push shocks.
• Since monetary policy decisions respond to these other shocks, naive calculations of the co-variation between monetary policy and the yield curve cannot distinguish the contribution of monetary policy from the impact of the underlying structural shocks.
• Accordingly, the independent role of monetary policy is revealed by focusing on the surprise element in monetary policy decisions, and there is a buoyant literature trying to identify these shocks and measure their impact on the yield curve and the economy.
• [8] A standard rate cut primarily affects the short end of the curve, while the impact peters out monotonically across the curve (Chart 3, left panel).
• Taking an average over such an expected rate path gives rise to the observed hump-shaped footprint.
• Besides the average of expected short-term rates (the expectations component), long-term bond rates typically contain term premia, which are time-varying.
• [11] Monetary policy exerts its effects on the yield curve not only through pure rate expectations but also through term premia.
• Chart 4 shows a model-based estimate of the yield curve response to a change in policy rates for the euro area.
• While Chart 4 shows that changes in rate expectations explain the bulk of the yield curve response, part of it is attributable to changes in term premia.
• Chart 4 Instantaneous impact of conventional policy surprise on expectations and term premia (basis points) Source: ECB calculations.
• Some studies have looked at specific channels by which term premia help explain certain yield curve phenomena that can hardly be reconciled by the expectations hypothesis alone.
• For instance, Hanson and Stein (2015) observe that monetary policy rate decreases tend to coincide with surprisingly strong reactions in long-term forward rates.
• Those players may try to reallocate their portfolios in response to the policy-induced short rate decline in order to keep their average portfolio yields constant.
• While this is one promising way to rationalise term premium responses to a monetary policy rate change, overall, our understanding of the interaction between monetary policy and term premia is still very limited.

Assessing the impact of non-standard monetary policy on the yield curve

The transmission of negative rates to the yield curve

• Chart 5 shows the characteristic footprint of a cut in the policy rate in negative territory on the yield curve.
• There is a clear difference: compared with standard rate cuts in positive territory, rate cuts in negative territory have had a stronger effect further out along the yield curve.
• Chart 5 Estimated effect of policy rate (deposit facility rate) cut in negative territory on the OIS curve (basis points) Sources: Based on Altavilla et al.
• This type of communication about the scope of negative rates can provide accommodation even in the absence of actual rate cuts.
• In technical terms: the presence of the lower bound induces a censored distribution for future short rates.
• [14] Communicating about a decrease in the lower bound makes rates possible that were previously perceived to be infeasible and, ceteris paribus, decreases expected future rates.
• That is, the rate cut in negative territory would lead to a more accentuated search for yield that could amplify the yield curve reaction compared with what is observed on average in positive territory.
• Through a similar mechanism negative rate policy can also be seen as complementary to our bond purchase programme (whose impact on the yield curve I will discuss in more detail later on).
• Accordingly, the presence of negative rates provides a strong incentive for banks to participate in the TLTROs, which support credit provision to the real economy at attractive conditions.

The transmission of asset purchases to the yield curve

• Let me now turn to large-scale asset purchases, including our own asset purchase programme (APP).
• There is a wide array of studies quantifying the effects of various forms of asset purchases on financial markets and macroeconomic variables.
• Extracting a quantitative easing factor from high-frequency interest rates and other financial market data confirms that news about ECB asset purchases had yield compression and flattening effects on the term structure, as shown in Chart 6.
• Chart 6 Estimated effect of quantitative easing surprise on the OIS curve (basis points) Sources: Based on Altavilla et al.
• [19] Under the signalling channel, central bank asset purchases serve as a commitment device to keep policy rates at low levels for an extended period of time.
• Under the signalling channel, the expectations component of bond yields decreases upon news about asset purchases, whereas under the portfolio rebalancing channel, the term premium component is compressed.
• Econometric modelling is required to discriminate between the two components and provide a deeper understanding of the transmission channels of asset purchases.
• An important episode studied by ECB researchers is the period before the announcement of the APP in January 2015.
• The second bar in Chart 7 also shows that the observed yield compression can be explained exclusively by the term premium.
• [22] Chart 7 Decomposed changes in ten-year Bund yields (percentage points) Sources: Based on Lemke and Werner (forthcoming).
• For instance, buying a French eight-year bond decreases the supply of that bond available in the market.
• For given demand, this drives up the price of the bond and compresses its yield.
• Securities of similar maturity are close substitutes, so their yield would also be affected, but those with very short and much longer maturities would not be greatly affected.
• Another way in which the portfolio rebalancing channel is set in motion is through duration extraction.
• In terms of asset pricing terminology, central bank bond purchases decrease the market price of duration risk (the expected excess return on a long-term bond per unit of risk).
• Similar to analysis that accompanied the asset purchases of the Federal Reserve, ECB economists have quantified the effect of our asset purchases on the yield curve.
• Chart 8 APP impact on the euro area sovereign term structure (basis points) Sources: ECB, based on Eser et al.


Chart 9 APP impact on ten-year euro area sovereign yield over time (basis points) Sources: ECB, based on Eser et al. (2019). Notes: Evolution of the APP impact on the ten-year synthetic sovereign yield (weighted average of Germany, France, Italy, Spain). The impact is derived on the basis of an arbitrage-free affine model of the term structure with a quantity factor (see Eser et al. 2019).

• For shorter-term bonds the effects are lower, such that the expectation of asset purchases is estimated to have led to a flattening of the curve.
• Moreover, by virtue of the stock effect, the yield compression was expected to be long-lasting and to halve only after five years.
• Owing to changes in macroeconomic conditions and the need to adapt the monetary policy response, several recalibrations were made to the APP.
• When the end of net purchases was announced in June 2018, the impact on ten-year sovereign bond yields was estimated to be around 90 basis points.
• The additional duration extraction associated with the renewed net purchases that started this month has contributed to a further compression of the term premium.

Summary of the yield curve effects of the ECB’s non-standard policies

Putting several pieces of analysis together, ECB economists have come up with the following summary assessment of how the various non-standard policy measures since 2014 have affected the yield curve. Chart 10 Compression of euro area sovereign yield curve due to ECB’s non-standard measures (percentage points) Sources: Based on Rostagno et al. (2019).
• As we see in Chart 10, covering the annual averages from 2014 to 2018, the APP accounted for the bulk of the estimated yield compression at the long end of the curve.
• Negative interest rates and forward guidance, by contrast, account for the lions share at the short end of the curve.
• These yield compressions have been transmitted further to an easing of financing conditions for non-financial corporations and households.

Interpreting signals from a flattening curve under central bank asset purchases

• An important and currently relevant example is the question as to what extent a flattening yield curve signals a weakening of the economic outlook.
• I will just briefly highlight how important it is to take our own action into account when interpreting the signals reflected in the yield curve.
• A recent paper examines how economists and commentators, when confronted with a flattening curve in the past, often argued that this time is different.
• First, the current flattening of the curve has mainly been induced by the long end of the curve coming down, rather than by the short end coming up.
• Hence, the inversion of the yield curve observed this time is not occurring in a context of monetary policy contraction raising the short end of the curve.
• Chart 11 Decomposition of change in the slope of the yield curve (percentage points) Sources: Bundesbank, OECD, Thomson Reuters and ECB calculations.


Chart 12 APP impact on the euro area OIS curve (percent per annum) Sources: ECB, based on Eser et al. (2019).

• Second, the flattening of the curve is to some extent driven by our own asset purchases conducted for the purpose of stimulating the economy.
• As is shown in Chart 12, one observes that the current slope would be around 70 basis points higher in the absence of the APP and thus much closer to the historical average.
• [33] What we learn from this example is that we need to be careful when reading the yield curve especially during times when our own actions have a significant influence on it.

Conclusion

Foreword

• The Financial Stability Review (FSR) assesses developments relevant for financial stability, including identifying and prioritising the main sources of systemic risk and vulnerabilities for the euro area financial system.
• 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.
• Financial stability can be defined as a condition in which the financial system which comprises financial intermediaries, markets and market infrastructures is capable of withstanding shocks and the unravelling of financial imbalances.
• The FSR also plays an important role in relation to the ECBs microprudential and macroprudential competences.
• By providing a financial system-wide assessment of risks and vulnerabilities, the Review provides key input to the ECBs macroprudential policy analysis.

Overview

Amid prominent downside risks to economic growth, low interest rates support economic risk-taking and near-term debt sustainability

• The euro area economic outlook has deteriorated, with growth expected to remain subdued for longer.
• Mirroring global growth patterns, information since the previous FSR indicates a more protracted weakness of the euro area economy, leading to a downward revision of real GDP growth forecasts for 2020-21.
• Chart 1 Tail risks to euro area growth have increased amid elevated global uncertainty
• Downside risks to global and euro area economic growth have increased.
• The risks to the euro area growth outlook are tilted to the downside.
• These risks include the effects of persistent uncertainty, an escalation in trade protectionism, a no-deal Brexit and weak performance of emerging markets, in particular a sharper slowdown in China.
• Action taken by the ECBs Governing Council and the US Federal Open Market Committee in their respective September meetings extended market expectations that short-term rates would remain low.
• However, if economic conditions worsen significantly, underlying fiscal vulnerabilities may come to the fore again in those euro area countries with more fragile public finances.
• Similarly, renewed political and policy uncertainties could trigger a reassessment of sovereign risk and reignite pressures on more vulnerable sovereigns.
• In euro area countries with high debt levels and only limited or no fiscal room for manoeuvre, fiscal policy can support economic recovery through a more growth-friendly composition of public finances.

Asset valuations, reliant on low interest rates, could face future corrections

• Risk-free yield curves are used to price many other financial instruments, from credit risk-bearing bonds to equities and derivatives.
• Therefore, lower yields have repercussions for asset prices benchmarked against the risk-free yield curve.
• Chart 3 Low rates support asset prices, but may prompt some investors to search for yield
• As yield curves have flattened and credit spreads remain tight, the phenomenon of negative yields has extended to longer maturities as well as to lower-rated issuers.
• In sum, around USD13.5 trillion (or one-quarter) of all bonds outstanding globally implicitly require investors to pay for holding the bond.
• Negative-yielding debt holdings are sizeable in some segments of the euro area financial system (see Chart 3, right panel).
• Financial institutions low-yielding/high-duration portfolios could come under pressure, if there were to be a repricing in bond markets.
• Chart 4 Capital losses for low-yielding/high-duration portfolios could be substantial in the event of a repricing in bond markets
• The higher valuation of some asset classes may leave them vulnerable to future market corrections.
• In tandem with the rally in risk-free asset markets, assets with higher credit risk extended the rally that had started early in the year following the market corrections at the turn of the year (see Chart 5, left panel).
• Chart 5 Disorderly asset price corrections may be amplified by procyclical investor behaviour

Signs of excessive leverage and risk-taking in some sectors require targeted action

• Stress from an abrupt repricing of financial assets could be amplified by the behaviour of investment funds with high liquidity mismatches and elevated leverage.
• Higher leverage, for example in hedge funds, can add to procyclical investor behaviour and accelerate outflows.
• Beyond supporting economic growth, low funding costs might also lead to higher leverage among riskier firms.
• The lower and flatter term structure has reduced significantly market-based funding costs for corporates, facilitating higher levels of leverage.
• Chart 6 Pockets of vulnerability in the non-financial corporate sector as well as property markets warrant close monitoring
• Buttressed by the low interest rate environment, the euro area residential real estate sector continued its gradual expansion.
• Alongside decreasing transaction volumes, commercial real estate price growth has shown signs of slowing, indicating that the commercial real estate cycle may be turning.
• Valuations also seem stretched following a strong upswing, supported by the search for yield by foreign investors, in particular US investment funds.
• Where available and warranted, macroprudential policy can increase the resilience of the financial sector while containing the build-up of financial imbalances.
• Thus, pockets of vulnerability outside the traditional banking system cannot be effectively addressed by the macroprudential measures taken to date.

While the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain

• Bank profitability concerns remain prominent.
• Bank profitability prospects have weakened against the backdrop of the deteriorating growth outlook (see Chart 7, left panel) and the low interest rate environment, especially for banks also facing structural cost and income challenges (see Special FeatureA).
• Reflecting these concerns, euro area banks market valuations remain depressed with an average price-to-book ratio of around 0.6.
• Chart 7 Low profitability prospects continue to weigh on bank valuations
• Banks continue to benefit from the positive volume effects, higher asset valuations and lower credit risk of low interest rates.
• Banks have made slow progress in addressing structural challenges to profitability.
• Going forward, weaker economic activity and the related increase in new default inflows may make further reductions in NPL ratios more challenging.
• In addition, low cost-efficiency, limited revenue diversification and overcapacity continue to weigh on many banks long-term profitability prospects.
• Chart 8 The euro area banking sector is assessed to be resilient to a range of downside risks, but bank consolidation may help boost efficiency and profitability
• Banks solvency positions appear resilient to the materialisation of the main financial stability risks in an adverse scenario.
• The previous upward trend of bank solvency ratios has come to a halt in recent quarters.
• Management buffers remain sizeable on aggregate though, but a significant part of these is likely to be consumed by the Basel III finalisation package, with systemically important institutions being particularly affected.
• At the individual bank level, the majority of euro area significant institutions would remain above the CET1 capital requirement (see Section 3.2).
• Banks remain susceptible to abrupt changes in market conditions which could require them to issue MREL-eligible debt at significantly higher costs.
• This would call for a rebalancing of the current capital requirements towards a more prominent role for the CCyB.

Identified vulnerabilities could unravel in the medium-to-long run

• There remain four key vulnerabilities for euro area financial stability.
• Beyond the near-term horizon, however, there is a risk that the identified vulnerabilities could unravel in a disorderly manner.
• Macroprudential policies can help contain many of these vulnerabilities and should be used more actively in some countries.

1 Macro-financial and credit environment

1.1 Weaker economic outlook amid elevated uncertainty

• Euro area economic growth is expected to remain subdued in the near term.
• Real GDP growth remained moderate in the first half of 2019 and survey-based data suggest a slight deceleration in the second half of 2019.
• Much of the slowdown stems from the current weakness of international trade in an environment of elevated and prolonged global political and policy uncertainty, which has had a particularly adverse impact on the manufacturing sector.
• Since the start of the year, the weakness has spread to more countries and sectors within the euro area (see Chart 1.1, left panel), clouding the already uncertain outlook (see Chart 1.1, right panel).
• Chart 1.1 Weaker economic outlook spreading to more euro area countries and sectors, with risks tilted to the downside
• The ECBs accommodative monetary policy stance is expected to remain in place for an extended period of time.
• Exports are expected to benefit from a projected recovery in foreign demand, also related to accommodative monetary policy across the globe.
• There are prominent downside risks to the growth outlook, primarily from geopolitical factors.
• A further rise in (geo)political and policy uncertainty across the globe may weigh on the euro area growth momentum.
• Global growth has already decelerated, with indications that recent tariff announcements and actions by the United States and China and the associated uncertainty are weighing on investment and trade (see Chart 1.2, left panel).
• 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.
• [3] Downside risks to the US economy cloud the global economic outlook.
• However, the ongoing US-China trade conflict, somewhat elevated corporate leverage and weaker global growth prospects pose downside risks to US economic growth and feed market perceptions of higher near-term recession risks in the late phase of the business cycle (see Chart 1.3, left panel).
• Chart 1.3 Materialisation of large downside risks to the US and/or Chinese economies could have adverse repercussions for global growth and financial stability
• Risks to growth remain tilted to the downside and include a further escalation of the trade conflict with the United States and uncertainty about available policy space in China.
• The materialisation of these risks to global and euro area economic growth could create challenges for financial stability.
• A more severe and protracted economic downturn could weaken corporate profits and household incomes, putting pressure on the ability of households and companies to service debts.
• Similarly, government finances, particularly for some vulnerable countries, could come under renewed stress.

1.2 Near-term sovereign debt sustainability concerns mitigated by favourable financing conditions

• Despite a deteriorating macroeconomic environment, public debt positions appear manageable currently.
• Although still at an elevated level exceeding 85% of GDP, public debt is projected to remain on aggregate on a downward trajectory, reflecting in part a favourable interest rate-growth differential associated with favourable financing conditions.
• In high-debt countries, governments need to pursue prudent policies that will create the conditions for automatic stabilisers to operate freely.
• Chart 1.4 A mildly expansionary fiscal stance provides some support to economic activity, but a number of countries have more fiscal space available
• Sovereign risk is mitigated by favourable financing conditions and accumulated liquidity buffers.
• Supported by the renewed Eurosystem asset purchase programme, pricing conditions for the vast majority of euro area countries have remained benign.
• Taking advantage of low rates, countries with higher sovereign risk have prolonged their debt maturity profile, reducing to some extent the vulnerability to abrupt changes in market sentiment.
• Under a more severe and protracted economic downturn scenario, risks to debt sustainability would increase, particularly in highly indebted countries.
• The combined effect of lower growth and higher premia, accompanied by fiscal relaxation, could potentially compromise debt sustainability for both groups, with the deterioration of their debt paths above any public debt sustainability benchmark (see Chart 1.5).
• Political and policy uncertainty could challenge sovereign debt sustainability.
• Overall, stress in euro area sovereign debt markets has remained contained since May.
• But there have been temporary episodes for some countries facing heightened political uncertainty.
• Chart 1.6 Heightened political instability may exacerbate sovereign risk, with potentially negative repercussions on public debt sustainability
• Notwithstanding the continuation of the favourable financing conditions and the accumulation of fiscal buffers, a significant deterioration of the macroeconomic outlook could make public debt sustainability in the most indebted countries more challenging.
• A further rise in political and policy uncertainty would exacerbate sovereign risk in many indebted countries.

1.3 Euro area households’ resilience supported by low interest rates

• Household incomes have been largely insulated from the recent growth slowdown, but there are some signs of waning consumer confidence.
• Household real disposable income has continued its expansion in 2019, underpinned by employment gains and robust wage growth (see Chart 1.7, left panel).
• Employment growth continued to be broad-based across countries and sectors, although survey-based indicators point to some deceleration, especially in the manufacturing sector.
• While consumer confidence has remained broadly resilient to the slowdown, there are some signs that households have become more pessimistic about employment (see Chart 1.7, right panel).
• Chart 1.7 Despite the weakening economy, solid income generation continues to mitigate risks, although with some signs of waning consumer confidence
• Bank lending to households has remained robust, with continued divergence across countries and types of loans.
• Aggregate bank loan growth has remained on its gradual upward trend, but with variation across euro area countries, reflecting different economic conditions and real estate cycles.
• More specifically, solid mortgage lending dynamics in the euro area continued to be supported by further improvements in labour markets, broadly resilient consumer confidence, and favourable financing conditions reflected in lower interest rates and supportive credit standards (see Chart 1.8, left panel).
• Interest rates for consumer credit have remained stable, although banks have slightly tightened lending standards in recent quarters (see Chart 1.8, right panel).
• Chart 1.8 Continued credit extension to households, although with moderation and credit standard tightening in the consumer loan segment Sources: ECB and ECB calculations.
• Household indebtedness has been stable at the euro area aggregate level, but this reflects deleveraging in some countries and releveraging in others.
• Euro area household debt has recently stabilised at around 95% of disposable income and 58% of GDP, close to pre-crisis levels.
• There is however considerable heterogeneity across euro area countries.
• Risks to household debt sustainability have been contained by the low level of interest rates, but would increase in the event of a severe slowdown.
• Interest payments as a share of disposable income have fallen below 2.5%, given robust incomes and the low interest rate environment.
• Chart 1.9 While some countries have high household debt levels, debt repayments across the euro area are generally low

1.4 Emerging pockets of corporate sector vulnerabilities

• Slower economic growth has led to a continued deceleration in corporate profits.
• Business sentiment in the euro area has weakened sharply as the economic outlook has softened, and competition in domestic and foreign markets has increased (see Chart 1.10, left panel).
• Growth in corporate profits and retained earnings has moderated (see Chart 1.10, right panel).
• Chart 1.10 Corporate profits and retained earnings have been decelerating in the euro area
• External financing to the corporate sector has increased, with credit standards remaining favourable.
• Despite recent growth, external financing to corporates remains below its mid-2018 level (see Chart 1.11, left panel).
• The lower level of external financing reflects the ongoing weakness of the economy, especially in manufacturing and trade, and the resulting lower financing needs of corporates.
• Bank lending to corporates in the services sector has remained robust, whereas lending to manufacturing and trade sectors has deteriorated.
• Chart 1.11 Increasing external financing flows to corporates, with credit standards remaining favourable
• While corporate indebtedness is slightly elevated, market-based indicators point to only limited credit risk.
• Corporate indebtedness on a consolidated basis in the euro area has stabilised in recent quarters and is now close to pre-crisis levels (see Chart 1.12, left panel).
• The market price-based credit risk assessment of the euro area non-financial corporate sector has been still quite favourable, with expected default frequencies for listed corporates remaining so far at low levels (see Chart 1.12, left panel).
• Chart 1.12 Slightly elevated corporate debt levels are cushioned by favourable financing conditions and significant liquidity buffers, as reflected in expectations of low credit risk
• Risks to corporate debt sustainability are also mitigated by favourable financing conditions and large liquidity buffers.
• Debt servicing capacity is supported by record-low gross interest payments and high interest coverage ratios in most countries (see Chart 1.12, right panel).
• All of the above factors reduce in particular rollover risks, making corporate debt more resilient to shocks.
• [4] In the event of a severe slowdown, corporate fundamentals would weaken, prompting rating downgrades for a considerable amount of debt, market dislocations and risk premia spikes.
• The vulnerabilities in the corporate debt market could, under a severe stress, be transmitted to the wider corporate sector, jeopardising corporate debt repayment capacity.
• Chart 1.13 Some pick-up in leverage in the high-yield segment along with a high stock of BBB-rated debt warrant monitoring

1.5 Diverging residential and commercial real estate cycles

• The euro area residential property market continued its robust expansion.
• [5] Across the euro area, nominal house prices continued to rise at a relatively high rate of 4% in the first half of 2019 (see Chart 1.14, left panel), exceeding nominal GDP growth.
• With favourable financing terms supporting property markets, the housing cycle has remained firmly in an expansionary phase across the majority of the euro area.
• Estimates of the euro area average suggest continued overvaluation, now exceeding 7% (see Chart 1.14, left panel), but with a high degree of cross-country heterogeneity.
• [6] Chart 1.14 Buoyant residential real estate prices amid growing vulnerabilities in some countries
• The commercial real estate cycle has continued to moderate.
• Survey-based data suggest that the current euro area commercial real estate (CRE) cycle is either at its peak or has already entered a downturn phase (see Chart 1.15, left panel).
• Led by developments in the prime segment, euro area CRE price growth has still been positive, albeit clearly moderating.
• Transaction volumes in recent quarters have remained strong, but have decreased from peak levels in line with a maturing market cycle.
• Chart 1.15 CRE prices have moderated recently in a maturing CRE cycle
• Risks to financial stability stemming from real estate markets have increased.
• Reflecting these risks, a number of countries have activated or strengthened policies that aim to limit the weakening of lending standards.
• Box 1Explaining cross-border transactions in euro area commercial real estate markets Prepared by Barbara Jarmulska and Dorota cibisz The upswing in euro area commercial real estate (CRE) markets in recent years has reflected, in part, a strong appetite from international investors, including US investment funds.
• Since 2013 transactions in euro area CRE markets have more than doubled, alongside a 20% increase in prices (15% in real terms) and a decline in average yields from 5.2% to 3.5%.
• In parallel, the share of transactions by foreign investors increased to 54% in 2018, from an average of 49% in 2013 when a particularly strong pick-up in transaction volumes started.
• The higher share of foreign investors could make domestic CRE markets more exposed to a sharp or disorderly adjustment as exuberance fades.
• Funds domiciled in Asia, which have an almost 10% average share in funds euro area CRE market purchases, are not covered.
• An analysis of recent trends in CRE markets suggests that search-for-yield behaviour could have been a significant driver of foreign transactions.
• This behaviour seems to have contributed to the strength of cross-border transaction flows into euro area CRE markets.
• Chart B The aggregated excess of foreign transactions in euro area CRE markets by investment funds driven by yield differentials and not explained by expected drivers is substantial

2 Financial Markets

2.1 Rally in safer asset markets

• Benchmark yield curves have moved downwards significantly since May, including further shifts into negative territory.
• For the first time in history, large segments of the yield curves of euro area sovereigns with high credit ratings are in negative territory (see Chart 2.1, left panel).
• [8] Also the US Federal Open Market Committee lowered its target rate three times over the review period, adding to the global downward trend in benchmark bond yields.
• Chart 2.1 Euro area yield curves largely negative as term premia and rate expectations declined
• Sovereign issuers make up most of the approximately USD13 trillion of negative-yielding bonds outstanding.
• As yield curves have flattened, the phenomenon of negative yields has extended to very long maturities for highly rated sovereign (see Chart 2.2, left panel).
• Higher demand for alternative safe stores of liquidity suggests investors are seeking substitutes for negative-yielding cash and bonds.
• An alternative interpretation of this pattern is that markets expect secularly low rates in the euro area, perhaps comparable to developments in Japan over the last years.
• Chart 2.2 Negative yields concentrated at lower maturities and higher credit ratings appear to be supporting demand for gold
• In parallel, declines in coupons have raised the average duration risk of the euro area bond market.
• The secular downward trend in nominal bond yields has gradually brought down the average level of coupons paid by bond issuers in the euro area (see Chart4, left panel, in the Overview).
• Lower coupons make bond prices more sensitive to changes in the yield curve and thus more volatile overall (see Chart 2.3, left panel).
• Chart 2.3 Lower coupon rates and longer maturities raise bond market duration risk
• Signals from financial derivatives markets point to firming expectations of persistent low rates.
• Recent trends in institutional investors hedging behaviour reflect firming expectations of even lower future interest rates; both price and volume-based measures point to investors preference for protecting their portfolios against lower rather than higher rates (see Chart 2.4, right panel).
• [10] Moreover, investment funds remain predominantly positioned in long EURIBOR futures contracts, indicating expectations of a further decline in ECB policy rates over the coming twelve months (see Chart 2.4, left panel).
• These indicators suggest that markets currently assess the risk of a sudden increase in interest rates as being remote.
• Chart 2.4 Positioning in interest rate derivatives points to consensus on low-for-long interest rates
• Euro money markets remained unaffected by an episode of extreme volatility in US repo rates.
• The funding strains prompted the Federal Reserve to assume a more active role in the repo market and to provide additional liquidity by means of Treasury bill purchases.
• However, collateral shortages in the euro area repo market could ensue from the announced expansion of the ECBs public sector purchase programme.
• These benign trends are confirmed by survey-based evidence on liquidity in euro area collateral markets.
• Financial institutions should step up their preparations for the phasing-out of the EONIA benchmark rate to reduce operational and legal risks in euro area money markets.
• Chart 2.5 US repo market stress did not spill over to other currency areas

2.2 Riskier asset prices reliant on low rates

• Equity and corporate bond prices continued to appreciate, despite short-lived fluctuations in response to uncertainty surrounding trade tariffs.
• Announcements of additional US tariffs on Chinese goods prompted a sell-off in equity and credit markets in late July.
• But declines were once more quickly reversed, extending the rally that had started in January (see Chart 2.6).
• Chart 2.6 Riskier asset prices appreciate despite strong safe-haven dynamics Developments in equity prices, corporate bond spreads and sovereign bond spreads since the beginning of the year and over the review period (1 Jan 2019-12 Nov. 2019; left panel: percentages; middle and right panels: basis points)
• The simultaneous rally in risky and safe asset prices over the year points to the distinct role of monetary policy in recent financial market developments (see Chart 2.7, left panel).
• In the presence of an accommodative monetary policy shock, yields decline in expectation of lower policy rates and/or central bank asset purchases.
• This, in turn, raises the present value of earnings and thus also equity valuations.
• Finally, model estimates suggest economic developments in the year to date have only had a limited impact on riskier asset prices.
• Chart 2.7 Financial market dynamics explained by monetary policy easing, while recession risk continued to pick up
• Chinese and emerging economy equity markets have so far been most affected by recent escalations of the trade conflict between China and the United States.
• Similarly to previous episodes, the increases in US tariffs on Chinese goods announced in July triggered a brief sell-off in global equity markets.
• The impact was strongest and most persistent for Chinese and other emerging economies equity markets (see Chart 2.8), according to model estimates, as these economies are more reliant on trade than the United States.
• [12] Chart 2.8 Chinese and other emerging economy equities suffer more than advanced economy equities from trade tariff news
• Very low benchmark bond yields have been the main driver behind increasing corporate bond and equity valuations.
• Low or negative interest rates are expected to lead to search-for-yield behaviour and higher riskier asset prices, as investors seek a higher return from assets with lower credit quality and longer maturities (see Chapter4).
• Some of this increase in risk-taking would be an intended effect of accommodative monetary policy.
• But the persistence of a low yield environment can lead to some valuations becoming misaligned, and therefore being at risk of abrupt correction in the future.
• Box2 presents an analysis of the relationship between developments in risk-free rates and prices of corporate bonds and equities and concludes that valuations of riskier assets are consistent with, but highly dependent on, the historically low level of the benchmark yield curve.
• Low funding costs incentivise higher levels of corporate leverage, which might amplify market corrections in a severe economic downturn.
• Equity prices relative to earnings expectations are at the upper end of their historical distribution (see Chart 2.9, left panel) and corporate bond yields in the euro area are on aggregate at a historical low.
• The decline in benchmark yields has been one of the main drivers of asset price increases in euro area equity and corporate bond markets.
• According to ECB staff valuation models, falling discount rates have played a major role in the appreciation of euro area equity prices over the past seven years (see Chart A, left panel).
• Likewise, the historically low levels of corporate bond yields are largely due to their negative benchmark rate (see Chart A, right panel).
• Chart A Equity price inflation and corporate bond yields reflect to a significant extent the decline in benchmark yields
• The key role of declining benchmark/discount rates for developments in both equity and corporate bond markets implies that current valuations could rapidly unwind if benchmark yields (or discount rates) were to increase.
• With nominal growth stalling and global monetary policy entering another easing round, the risk of higher interest rates may appear today more remote than in recent years.
• Corporate bond valuations are moreover contingent on current corporate ratings, which are at risk of downgrades in adverse economic conditions.
• In particular, higher leverage ratios among corporates may be appropriate in an environment of lower funding costs.
• In such downturn scenarios, both markets and rating agencies noticeably discriminate between corporates with high and low levels of leverage (see Chart B).
• Low yields have also encouraged the issuance of riskier corporate bonds, increasing investors exposures to credit and duration risk.
• The tendency among non-financial corporates to increase leverage and secure low financing costs is also reflected in the changing maturity and credit risk profile of newly issued corporate bonds.
• The issuance of high-yield securities, including leveraged loans and related collateralised loan obligations, has also increased considerably over the past five years.
• That said, more recently there have been tentative signs of this pattern reversing, perhaps reflecting the deterioration in the economic outlook.
• In addition, corporates have been increasingly issuing at longer maturities since 2012 to secure low financing costs (see Chart 2.10, right panel).
• Lower yields can also spur demand for less liquid assets, raising the likelihood of events where market liquidity is scarce and adverse price movements are amplified.
• Institutional investors have recently increased their holdings of illiquid assets since they are often associated with higher and positive returns (see Chapter4).
• [14] Chart 2.11 Recent episodes indicate that bond market liquidity could dry up rapidly in some markets

3 Euro area banking sector

3.1 Increased challenges to the profitability of the sector

Banks’ profitability weakened further by cyclical factors

• Euro area banks profitability remained low in the first half of 2019 amid a challenging macroeconomic environment.
• A moderate increase in impairments and a further, albeit small, decline in operating profits both contributed to the decline (see Chart 3.1, left panel).
• By country group, banks in countries more affected by the sovereign debt crisis continue to show generally weaker profitability than their peers in other countries (see Chart 3.1, right panel).
• Chart 3.1 Bank profitability has worsened slightly, partly driven by higher impairments
• Banks net interest income grew at a modest pace, as the impact of margin compression was outweighed by robust lending volumes.
• Net interest income, which accounts for nearly 60% of significant institutions total operating income, remained under pressure in an environment of low interest rates and flat yield curves as customer loan-deposit margins (on outstanding amounts) narrowed further and significant banks net interest margin also compressed in 2019 having been stable over the past two years (see Chart 3.2, left panel).
• Moreover, some large, internationally active banks also benefited from the continued growth of higher-margin lending in some non-European countries.
• Chart 3.2 Banks customer loan-deposit margins continued to be compressed, but net interest income was relatively resilient due to still robust loan growth
• At the same time, net fee and commission income declined slightly, mainly driven by lower asset management fees.
• At the same time, payment service-related fee income continued to grow at a steady pace, reflecting banks efforts to compensate for narrowing loan-deposit margins.
• Other non-interest income continued to weigh on aggregate profits, although to a lesser extent than last year.
• Overall, other non-interest income has been the largest negative contributing factor to the change in SIs aggregate ROE since 2015, with a cumulative -2.5 percentage point impact.
• Chart 3.3 Growth of net fee and commission income turned slightly negative, while other non-interest income continued to make a negative, albeit smaller, contribution to profits
• In contrast to previous years, when the falling cost of credit risk significantly supported overall profitability, banks loan loss provisioning costs rose slightly amid a slowdown in economic activity.
• In the twelve months to June 2019, more than two-thirds of SIs have reported higher impairments (as a percentage of loans) compared to full year 2018.
• By country group, the median cost of credit risk rose in countries that were less as well as those more affected by the crisis, albeit from very low levels in the former country group (see Chart 3.4, left panel).
• Chart 3.4 The cost of credit risk rose in most countries that were less affected by the crisis, albeit from low levels, with more heterogeneous patterns in countries burdened by high legacy NPL stocks

Structural factors continue to weigh on banks’ profitability

• Euro area banks have made little progress overall in improving their cost-efficiency since the global financial crisis.
• Having steadily risen between 2009 and 2012, euro area banks aggregate cost-to-assets and cost-to-income ratios have remained stubbornly elevated above ten-year average levels (see Chart 3.5, left panel).
• Euro area banks cost-to-income ratios are also elevated relative to international peers: their costs absorbed 66% of income in 2018 versus only 57% in the United States.
• Given the difficulties in growing revenues, a number of banks have sought to optimise cost structuresand invest in digitalisation, but these efforts require time to yield net benefits.
• As capitalised software is typically amortised over 3-5 years, higher investment spending will also add to banks future operating expenses through increased amortisation.
• Chart 3.5 Euro area banks have overall made little progress in improving their cost-efficiency since the global financial crisis Sources: ECB consolidated banking data, ECB supervisory statistics and ECB calculations.
• The 2019 risk assessment by ECB Banking Supervision identified cybercrime and IT disruptions as one of the top-three key risk drivers affecting the euro area banking system.
• [15] While significant institutions have so far not reported any major incident, cyberattacks could lead to material financial losses or can affect banks negatively through confidence channels.
• Banks inability to improve cost-efficiency over a longer period could be related to structural impediments.
• Empirical studies have found that euro area banks cost inefficiencies can be mostly attributed to persistent inefficiencies, suggesting that long-term structural factors play a significantly bigger role in bank efficiency than time-varying factors.
• [17] Therefore, in some, but not all, cases consolidation can help overcome some of the structural profitability problems in the euro area banking sector (for a detailed discussion, see Special Feature A).
• Box 3Implications of bank misconduct costs for bank equity returns and valuations Prepared by Filippo Busetto, Sndor Gard and Benjamin Klaus Over the past decade, banks have been called to account for their past misconduct.
• The redress for misconduct has reduced the net income of euro area banks by one-third since the global financial crisis.
• Analysis further suggests that misconduct costs have had a negative impact on major euro area banks one-year buy-and-hold stock returns, after controlling for other bank-specific variables as well as bank and time fixed effects.

Banks’ profitability prospects weakened amid expectations of a more challenging macro-financial environment

• On average, underperforming banks have projected stronger improvements in their profitability.
• However, these projections, based on end-2018 economic assumptions, do not factor in the significant downward revisions in macroeconomic forecasts this year.
• Downward revisions to GDP growth forecasts and, in particular, a marked downward shift in interest rate expectations for 2020-21 relative to those embedded in banks projections (see Chart 3.7, right panel) have rendered SIs revenue and thus profitability expectations too optimistic.
• Chart 3.7 Banks project some improvement in their profitability until 2021, but growth and interest rate expectations have fallen since these projections were made
• Market expectations of future bank profitability have already been downgraded this year, in line with weaker revenue growth expectations.
• Bank market valuations remain depressed, reflecting continuing concerns over the outlook for banks profitability.
• Bank stock prices have underperformed the broad market in the year to date, with market perceptions of banks linked to changes in growth and interest rate expectations (see Chart 3.8, left panel).
• In international comparison, the median 2020-21 ROE forecast of 6-6.5% for large euro area banks is well below that for large US banks (10-11%).
• Chart 3.8 Investor perceptions of banks appear linked to changes in interest rate expectations, while weaker market expectations have been driven by cuts to revenue forecasts
• In an environment of negative rates and flat yield curves, banks net interest margins are likely to remain under pressure.
• On the assets side, the pricing of banks new customer loans remains well below that of their outstanding loans, which coupled with intense competition among banks and from capital market-based financing could keep lending margins under pressure.
• On the liabilities side, banks may opt to charge negative rates on a larger share of non-financial corporation (NFC) deposits.
• At the same time, banks may find it difficult to charge negative rates on retail deposits for reputational or, in some cases, legal reasons.
• Chart 3.9 Banks may find it difficult to pass through negative rates to retail deposits and are more likely to charge negative rates on a larger share of NFC deposits
• Steady growth in bank lending has helped so far to offset the impact of compressed margins, in particular in countries less affected by the crisis, with loan growth expected to further benefit from low borrowing costs.
• Furthermore, the two-tier system for reserve remuneration will provide some offset to margin pressures for banks with high excess liquidity, while the more favourable terms of TLTROIII could slightly benefit the larger users of central bank funding.
• Overall, the prospect of weaker economic growth and lower interest rates is likely to weigh further on profitability expectations for euro area banks in the period ahead.
• Baseline ROE projections using the ECBs top-down stress-testing framework point to a gradual decline in bank profitability over the next two years, implying a nearly 1 percentage point cumulative drop in euro area banks aggregate ROE by 2021.

Asset quality improvement continued, although at a slowing rate

• The improvement in banks asset quality continued in the first half of 2019, but at a slowing pace.
• Significant institutions aggregate NPL ratio has declined further since end-2018, but the reduction of NPL stocks has decelerated somewhat (see Chart 3.10, left panel).
• While in some countries NPL ratios are below 8% (Ireland, Italy and Slovenia), they are still at double-digit levels in other countries, with Greece lagging behind in the risk-reduction process.
• Chart 3.10 NPL reductions continued, although at a slower pace
• At the same time, weaker cyclical conditions led to a net increase in underperforming assets, signalling worsening asset quality further ahead.
• Net flows into the Stage 2 category, which includes loans that are still performing but show signs of significant credit risk deterioration, picked up in late 2018 and early 2019, although they dropped to low levels in the second quarter of 2019 (see Chart 3.11, left panel).
• Chart 3.11 Net flows into the underperforming assets category increased in late 2018 and early 2019
• Provisioning coverage of NPLs remained broadly unchanged from 2018 on average, but levels of coverage vary widely across countries.
• Significant banks aggregate coverage ratio remained at around 46%.
• However, there remains significant cross-country heterogeneity in coverage ratio levels (see Chart 3.11, right panel), including in high-NPL countries.
• Within this country group, the provisioning coverage of NPLs is in the rather wide range of 28% to 63%, although this disparity is partly due to differences in the composition of remaining NPLs (e.g.

Bank lending continues to grow at a steady rate despite the economic slowdown

• Continued strong lending growth in countries less affected by the crisis contrasted with meagre growth in countries more affected by the crisis (see Chart 3.12, left panel).
• Growth in lending to both households (for house purchase) and non-financial corporations remained at around 5-6% in countries less affected by the crisis, but closer to 1% in countries more affected by the crisis (based on median growth rates).
• Consumer lending continues to be the fastest-growing segment of bank lending, despite some moderation since mid-2018.
• Chart 3.12 Bank lending remains heterogeneous in different parts of the euro area
• Despite the slowdown in economic activity in 2019, reported credit risk measures did not signal a deterioration in borrower creditworthiness.
• Expected loss ratios reflected still benign credit risk, although the downward trend came to a halt for most IRB loan portfolios (see Chart 3.13, right panel).
• At the same time, the latest reported changes in bank lending standards appear to show signs of a maturing credit cycle.
• According to the ECBs bank lending survey, credit standards eased slightly for NFC loans in the third quarter of 2019, following some net tightening in the previous quarter.
• Chart 3.13 Credit risk measures reported by banks remain at subdued levels despite a slowdown in the economy and a weaker macroeconomic outlook
• [21] One indicator of such risks is banks exposures to high carbon-emitting firms that would be vulnerable if the transition to a low-carbon economy is delayed and disorderly.
• Over a longer time horizon, evidence from syndicated loans points towards increased transition risk for a number of large banks.
• As a complementary approach, evidence from syndicated loans for a sample of large banks was used to assess longer-term trends in transition risk.
• In other words, the carbon intensity of syndicated loans, and therefore the related transition risk, has increased for these banks.
• Chart 3.14 Evidence from syndicated loans points towards increased transition risk over a longer time horizon, but this risk has shown signs of decline more recently
• This box investigates climate-related disclosures of large euro area banks and insurers and their impact on stock market valuations.
• Most of a financial institutions exposure to climate-related risk is likely to stem from the financial activities it undertakes.
• For financial firms, emissions related to their main business of financial intermediation should fall into scope3.
• Even where information on carbon emissions related to investment portfolios is available, it is partial, inconsistent and presented separately from the scope3 measure.
• Although the correlation between the two indicators has improved over time, it still remains low, signalling significant discretion in environmental scoring (see Chart B, left panel).
• Perhaps reflecting inconsistent reporting, environmental disclosures appear to have no impact on stock market valuations for banks, but some impact for insurers.
• This result might reflect greater investor scrutiny of insurers owing to their higher exposure to physical climate-change risk, given insurance liabilities.
• [27] Chart B Environmental market scores are highly dispersed and seem to matter more for the valuation of insurers than banks

Funding challenges abated somewhat amid lower funding costs and improved bond market access

• Banks wholesale funding costs have declined in the year to date across the credit hierarchy.
• As a result, spreads on bank debt tightened across all seniorities, reaching levels close to the early 2018 trough (see Chart 3.15).
• Chart 3.15 Bank funding conditions eased further
• Banks access to bond markets has improved this year, but banks differ in terms of their progress in MREL debt issuance.
• Moreover, the issuer base broadened as some banks with lower credit quality also regained access to debt markets even if at high cost.
• At the same time, MREL debt issuance by smaller and weaker credit quality banks still lags behind (see Chart 3.16, right panel).
• Chart 3.16 Banks access to bond markets improved, reflected in higher year-to-date issuance volumes
• On aggregate, euro area banks liquidity ratios improved further, but liquidity positions in some foreign currencies remain less comfortable.
• The aggregate liquidity coverage ratio of significant banks reached 147% in the second quarter of 2019, compared with 141% a year earlier.
• Some areas of vulnerability requiring supervisory follow-up relate to foreign currencies and collateral management.
• Regarding banks market risk exposures, aggregate risk measures dropped in the first half of 2019 on the back of lower volatility.
• Chart 3.17 Measures of banks market risk have declined since late 2018

Solvency positions remained stable, but some banks may need to accelerate capital generation to meet future requirements

• Euro area banks regulatory capital ratio remained stable in the first half of 2019.
• While capital increases and declining average risk weights contributed to a higher (transitional) Common Equity Tier 1 (CET1) ratio, this was offset by a marked increase in total assets (see Chart 3.18).
• Looking at cumulative changes in the contribution of different factors since 2015, the effect of capital increases dominated in countries less affected by the crisis (around 1.5 percentage points).
• Chart 3.18 Capital ratios remained stable, but there are still significant differences across banks regarding their ability to build up capital
• Regarding capital generation, significant heterogeneity remains across countries and banks.
• On average, banks organic capital build-up (through retained earnings) remains lower in countries more affected by the crisis, although the contribution of retained earnings has increased since 2015 (see Chart 3.19, right panel).
• Capital requirements increased as of 2019, but banks management capital buffers appear comfortable relative to current minimum requirements.
• As a result, euro area banks management capital buffers decreased compared with end-2018 but, on aggregate, remain in comfortable territory at around 3% of risk-weighted assets (see Chart 3.20, left panel).
• Looking ahead, some banks may need to generate more capital to meet future capital requirements.
• While banks buffers above current minimum capital requirements appear comfortable (see Chart 3.20, left panel), in the medium term, BaselIII finalisation will have a significant impact on banks capital requirements.
• This will likely consume a significant part of these buffers, with systemically important institutions being particularly affected (see Chart 3.20, right panel).
• Chart 3.20 Basel III finalisation will have a significant impact on large banks capital requirements

3.2 Evaluating the resilience of the euro area banking sector

• This section assesses the solvency and profitability of euro area credit institutions under a baseline and an adverse scenario.
• The assessment covers over 90 large and medium-sized euro area banks in the 19 euro area countries.
• Beyond that, the results presented in this section are not comparable with those from the supervisory stress test of the EBA and ECB Banking Supervision because of methodological, scenario and sample differences.
• Box 5The ECBs new euro area banking sector macro-micro model The new macro-micro model was created for the purpose of macroprudential stress testing of the banking sector.
• The dynamics of each euro area economy are modelled separately, although they are interconnected via trade linkages.
• Lending to the non-financial private sector is broken down by country and sector, i.e.non-financial corporations, residential mortgages and consumer lending.
• Trading book assets, the market risk capital surcharge, banks dividend holdings and the operational risk capital surcharge follow similar simplified dynamics.

The baseline and adverse scenarios

• The baseline scenario is characterised by positive but subdued economic growth.
• The baseline scenario is based on the September 2019 ECB staff macroeconomic projection exercise, in which real GDP growth was projected to be 1.1% in 2019, before gradually increasing to 1.4% in 2021 (see Chart 3.21).
• In comparison to the June 2019 Eurosystem staff projections, real GDP growth in the baseline scenario has been revised down in 2019 and 2020, by 0.1 and 0.2 percentage points, respectively.
• The projections of short-term and long-term interest rates were revised down by 20-40 basis points and 40-80 basis points, respectively, up to the end of 2021.
• Chart 3.21 Weaker economic conditions in the baseline scenario and a significant deterioration in the adverse scenario In the adverse scenario, euro area GDP declines significantly in 2020 and 2021 (percentages)
• The adverse scenario represents a tail event, consistent with the main systemic risks to the euro area materialising.
• The final adverse scenario is selected as the one most consistent with the main systemic risks.
• This approach means that the scenario is constructed within the model, rather than by employing the methodology used for the EBA stress-test scenarios.
• [30] Global macroeconomic conditions deteriorate significantly and risks are repriced in the adverse scenario.
• The adverse scenario results in a peak-to-trough year-on-year decline of euro area real GDP of around 1.7% in 2021.

Evaluation of banks’ profitability

• In the baseline scenario, subdued economic growth points to a potential decline in banks ROE by about 1 percentage point by 2021.
• Bank profitability measured in terms of ROE is projected to decline to 5.2% by 2021 (see Chart 3.22, left panel).
• The subdued evolution of bank profitability relates to the weak growth outlook combined with low interest rates.
• However, their contribution to ROE declines slightly over time (see Chart 3.22, right panel) given an expected increase in banks own funds (the denominator of ROE).
• Under the adverse scenario, loan losses are the main driver of weaker bank profitability.
• In 2021, loan losses are projected to be more than 15% of banks equity.
• Net interest income and net fee and commission income likewise decline, which is however counterbalanced by a marked reduction in banks own funds, implying broadly stable contributions in ROE terms.

Implications for bank lending

• Lending to the non-financial private sector is expected to remain modest in the baseline scenario, but to decline significantly in the adverse scenario.
• The subdued loan growth under the baseline scenario reflects weak economic conditions and low bank profitability.
• Under the adverse scenario, however, lending volumes are expected to materially contract in both 2020 and 2021 (see Chart 3.23).
• Lending to NFCs appears the most sensitive to changing economic conditions and the deterioration of banks own situation.

Banks’ solvency

• Under the baseline scenario, the solvency position of the significant euro area credit institutions is projected to improve.
• The aggregate CET1 capital ratio is projected to increase by about 0.9percentage points to 15.3% by the end of 2021 (see Chart 3.24).
• The improvement in banks capital ratios relates to high earnings retention as well as some reduction in average risk weights over the three-year horizon.
• The overall contribution of risk-weighted assets is nevertheless negative owing to an increase in exposure amounts (e.g.
• Chart 3.24 Under the baseline scenario, banks solvency position would improve
• In the adverse scenario, the CET1 ratio of the euro area banking system could fall by up to 3.1percentage points.
• The aggregate CET1 ratio falls from 14.4% to 11.3% by 2021 in the adverse scenario described above.
• The reduction in banks capitalisation reflects a contraction in banks P&L, driven primarily by rising loan losses (see Chart 3.24) and an increase in risk exposure amounts.
• Overall, the decline in the CET1 ratio under the adverse scenario reflects that the deterioration of asset quality and increasing economic risk outweigh the effect of banks deleveraging.
• Banks accounting for about 19% of euro area total banking sector assets would, however, see their regulatory capital buffers diminish.

4 Non-bank financial sector

4.1 Non-banks increased risk-taking while facing profitability challenges in the low interest rate environment

• The size of the euro area non-bank financial sector increased in the first half of 2019 due to valuation gains and inflows.
• The growth in the sector is reflected in the higher flow of market-based debt financing to euro area non-financial corporations (NFCs) relative to bank financing.
• In these periods, the net flow of bank loans turned negative and debt securities became an important source of financing for euro area NFCs.
• But more recently, the low cost of market-based debt has supported a further increase in NFCs debt issuance particularly of investment-grade bonds.
• Chart 4.1 The share of market-based debt financing of the euro area economy has increased
• Internationally integrated capital markets also allow global investors to provide funding to the euro area should domestic financing conditions tighten.
• Finally, the debt securities at the heart of non-bank financing are a useful source of transferable, easy-to-value collateral.
• Non-banks have increased their exposure to highly indebted segments of the corporate and government sectors in recent years.
• Also, the upturn in euro area commercial real estate markets has reflected, in part, a strong appetite for such assets from global investment funds (see Box1).
• Furthermore, despite improving risk sharing, a larger share of non-bank financial intermediation also potentially increases interconnectedness across the financial system.
• This could amplify the effects of any downturn, leading to a reduction in funding flows to the real economy more broadly.
• Since then, portfolio flows of investment funds actively searching for yield in financial markets worldwide have increased.
• [36] This box investigates the role of international investment funds in the transmission of global financial conditions to the euro area.
• This may suggest that euro area financing conditions improve after an easing in global financial conditions, proxied by US monetary policy developments.
• These include monetary policy in the euro area, as well as short and long-term interest rate differentials between the United States and the euro area.
• Further analysis shows that bond and equity indices rise in both regions after the US monetary policy shock.
• Also, euro area equity markets experience inflows from non-domestic investment funds and there is increased equity issuance in the euro area.

The profitability of non-banks faces strong headwinds in a prolonged period of low interest rates

• Most of these bonds have high credit quality being rated between AAA and A and low residual maturity.
• At the same time, higher-yielding bonds securities with a yield to maturity above 3% represent only 22% of funds bond holdings and 2% of ICPFs bond holdings.
• The share of bonds yielding negative rates increased significantly in the first half of 2019 (see Chapter2).
• Most of these securities are highly rated euro area government bonds with a residual maturity of between 3 and 15 years.
• Should they decide to avoid investing in negative-yielding bonds while keeping a similar risk profile, their investment universe would shrink significantly.
• Chart 4.2 Exposure to low-yielding bonds accounts for over 70% of ICPFs portfolios and one-third of funds portfolios
• Short-term capital gains from falling yields are still providing a sizeable offset to the lower level of yields.
• Valuation gains in funds and insurers portfolios have generally increased in 2019, reaching 5% and 4% of their bond holdings, respectively (see Chart 4.3).
• At the same time, investment income from floating rate coupons has gradually declined as yields have fallen.
• Should global bond yields decrease further, longer-dated assets are likely to experience higher valuation gains than short-dated securities.

Exposure of non-banks to credit, liquidity and exchange rate risk has increased

• Both investment funds and insurers have increased investments in BBB and high-yield bonds to boost investment returns (see Chart 4.4).
• Given the associated credit and liquidity risk, elevated and increasing exposure of non-bank financial intermediaries to such assets could result in greater losses, should, for example, the corporate credit cycle turn.
• And possible downgrades from BBB to sub-investment-grade ratings pose a risk in terms of forced asset sales due to investment mandate restrictions.
• Finally, given the rising exposure to US securities, this risk may be further amplified by the elevated leverage in parts of the US corporate sector and weaker global growth prospects.
• Most are also denominated in local currencies, which also generates high foreign exchange risk arising from local currency volatility.
• Chart 4.4 Non-banks have increased their exposure to credit and exchange rate risk
• More generally, the liquidity of euro area non-banks portfolios continues to be a concern, particularly for investment funds.
• The share of cash and euro area government bonds in funds portfolios has continued to decrease (see Section4.2).
• Over recent years, the overall effect of this on portfolio liquidity has been partially offset by increased holdings of short-term US government bonds.
• These offer a higher yield with a similar degree of liquidity but at the expense of exchange rate risk (see Chart 4.4).
• ICPFs have also increased the duration of their bond holdings to match the long-term nature of their liabilities more closely.
• Despite reducing interest rate sensitivity on their balance sheet and ensuring higher returns, investing in these assets may increase liquidity risk in ICPFs portfolios, should they need to liquidate some of their assets in a severe stress scenario.

4.2 Euro area bond funds continue to expand and increase liquidity risk

• Flows into bond and money market funds globally have continued in recent months, with weaker flows into equity funds.
• Strong inflows into money market and bond funds over 2019 are consistent with concerns about downside risks to growth, expectations of monetary easing and falling yields in bond markets.
• It remains to be seen whether the expansion of euro area bond funds will be sustained as monetary conditions are expected to remain accommodative for longer.
• Chart 4.5 Concerns about downside risks to growth and expectations of monetary easing are driving the expansion of bond funds globally and in the euro area
• Over the last six months, euro area funds have expanded their exposure to global high-yield corporate debt, leaving them vulnerable to any repricing of these assets.
• The most recent data point to an increase in holdings by funds of BB and B-rated securities.
• These now represent 15% of euro area funds total bond holdings (see Chart 4.6, left panel).
• BBB securities the lowest-rated type of investment-grade debt also form nearly one-third of these funds total bond portfolio.
• An increase in exposure to credit risk has coincided with a decline in the liquidity of euro area investment fund bond portfolios.
• In particular, the share of euro area government bonds has decreased, while the share of US government debt has risen partially compensating for the decline in euro area government bond holdings (see Chart 4.6, right panel).
• While both euro area and US government bonds are highly liquid assets, the latter could expose euro area funds to exchange rate risk if exposures are unhedged.
• Euro area bond funds hold less cash as a percentage of total assets compared with the average in the period from 2009 to 2014.
• Increased liquidity mismatch in funds increases the risk of procyclical selling of less liquid assets in a market downturn.
• Chart 4.7 Lower holdings of liquid assets could increase the potential for liquidity spillovers in a future market downturn
• [39] For example, in trying to avoid incurring losses on illiquid assets, managers might choose to sell the most liquid securities first.
• And in the hope of increasing returns and attracting future inflows, they might choose to take on more risk in their portfolio.
• This box investigates empirically how euro area bond funds have responded to outflows over the past year, assessing whether they modified the liquidity and risk profile of their portfolio.
• [40] First, the effect of rebalancing on funds liquidity profile is measured by changes in the portfolio share of cash and liquid bond holdings.
• The sample includes data on over 2,500 euro area active bond funds between June 2018 and June 2019.
• In general, bond funds experienced cumulated net outflows of around 4.5% towards the end of 2018, followed by mild inflows in 2019.
• By contrast, institutional funds experiencing outflows improved their liquidity profile by increasing both cash and liquid bond holdings and selling illiquid bonds more than proportionately.
• [43] Chart A Funds reduced cash and illiquid bond holdings following outflows, while increasing residual maturity and reacting procyclically to rating changes
• Controlling for the initial asset allocation, the empirical evidence shows that funds altered their portfolio weights according to individual bond characteristics, such as residual maturity and recent changes in credit rating.
• On average, funds increased their relative holdings of securities with longer residual maturity (see ChartA, right panel).
• In particular, leveraged and institutional funds increased the portfolio weight of longer-term bonds by 6% and 2%, respectively.
• Increasing residual maturity also increases duration risk of the portfolio, which makes funds more vulnerable to changes in interest rates.
• Asset managers typically maintain liquid asset holdings, credit lines and cash to accommodate outflows under normal and stressed conditions.
• These regulatory requirements aim to ensure sufficient portfolio liquidity, reliable valuation and adequate (liquidity) risk management.
• Nevertheless, recent cases have highlighted that funds invested in illiquid assets could face severe difficulties in dealing with large-scale outflows.
• Synthetic leverage among some UCITS bond funds tends to increase the procyclicality of investor flows, especially in a market downturn.
• Empirical evidence shows that investors in leveraged funds react more strongly to past negative performance compared with investors in unleveraged funds.
• [46] The change in rules coincided with an increase in the use of derivatives by leveraged funds (see Chart 4.8, right panel), indicating that these funds use derivatives to generate leverage.
• Chart 4.8 Flows in leveraged funds tend to be more procyclical compared with unleveraged funds; use of derivatives in leveraged funds has increased after the 2010 regulatory change

4.3 Stable outlook for euro area insurers, despite the challenge from low yields

• The insurance sector is playing an increasingly important role in the euro area financial system and capital markets, providing key financial services to firms and households.
• In terms of total assets, the euro area insurance sector grew by a strong 7% in the first half of 2019, compared with growth of 4.5% in the rest of the euro area financial system.
• Popular insurance products sold in the euro area include traditional life insurance policies with guaranteed rates and defined-benefit pensions, which help to ensure that a retiree does not outlive her/his financial resources.
• In fact, these types of policies represent 80% of all euro area (life and non-life) insurers technical reserves.
• As a result, insurers provide an important source of long-term financing to the real economy and other financial players.
• In this respect, insurers tendency to search for yield in more risky and less liquid securities out of their preferred habitat warrants close monitoring.
• Beyond the signs of accumulating credit and foreign exchange risk (see Section 4.1), insurers have been shifting their portfolios away from less risky fixed income instruments (e.g.debt securities and deposits) towards more risky equity and investment fund shares (see Chart 4.9, left panel).
• Within the class of investment fund shares, insurers exposures to riskier types of funds have increased most rapidly: over the last three years, the holdings of hedge fund shares almost doubled, while those of real estate funds increased by two-thirds (see Chart 4.9, right panel).
• Market intelligence also suggests an increasing appetite for investment in other alternative asset classes such as private equity, loans and infrastructure investments, with demand sometimes exceeding supply.
• [50] Chart 4.10 Solid profitability results contributed to an improvement in market valuations, though challenges remain, particularly for life insurers
• Another positive factor was an improvement in investment income, which generated fairly good returns of around 3-4% for the median company.
• Valuation gains on insurers portfolios driven by a strong rebound in equity prices at the beginning of 2019 and declining yields throughout the first half of 2019 contributed positively to this improvement.
• [51] Solid profitability contributed to the strong appreciation of non-life and reinsurers equity prices over the review period (see Chart 4.10, right panel).
• Since the end of May, equity valuations for these two market segments have risen by 12% and 18% respectively.
• For life insurers, very low and further declining yields have weighed on their market valuations.
• The price-to-book ratio of life insurers has remained at a low level of below 0.85 over recent years.Historically, the price-to-book ratios of euro area life and non-life insurers co-moved at similar levels.
• In particular, the yield curve used for discounting technical provisions for insurance obligations in euro which represent the bulk of euro area insurers liabilities moved into negative territory up to a maturity of 16 years.
• [55] Chart 4.11 The market outlook for life insurers is challenging compared with that for non-life insurers, owing inter alia to the persistently low-yield environment

5 Macroprudential policy issues

5.1 Activating macroprudential instruments to counter vulnerabilities in the euro area financial system

• All euro area countries have used macroprudential measures to strengthen lending standards or bank resilience in recent years.
• Regulatory reforms since the global financial crisis have put in place a number of macroprudential instruments that authorities in the SSM area can use to protect financial stability (see Box8).
• These include limits on loan-to-value (LTV) ratios, limits on debt service-to-income (DSTI) ratios, maturity limits and amortisation requirements.
• Finally, all euro area countries are in the process of phasing in, or have already phased in, buffers for significant institutions (O-SII and G-SII buffers).
• [58] Chart 5.1 Use of macroprudential policy instruments has increased across the euro area
• The Single Supervisory Mechanism (SSM) Regulation assigns macroprudential responsibilities to both national authorities and the ECB. According to Article 5 of the Regulation, whenever appropriate or deemed required, national authorities shall implement macroprudential measures and the ECB has the power to set higher requirements than those implemented by national authorities for the instruments covered by the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR). Following recent amendments of the CRD and the CRR,[60] these instruments include:
  • The countercyclical capital buffer (CCyB; Article 130 and Articles 135 to 140 of the CRD): this buffer is designed to increase resilience during periods of excessive credit growth and to counter procyclicality in the financial system.
  • The capital buffers for global systemically important institutions (G-SIIs) and other systemically important institutions (O-SIIs) (Article 131 of the CRD): the G-SII buffer is mandatory for banks identified as having global systemic importance. The O-SII buffer allows authorities to require institutions that are systemically important at the national or EU level to maintain a higher capital buffer.[61] When both measures are activated, the higher of them applies.
  • The systemic risk buffer (SyRB; Articles 133 and 134 of the CRD): this buffer is designed to prevent and mitigate macroprudential or systemic risks not covered by the CRR or by the CCyB or G/O-SII buffers. The SyRB is a flexible instrument that can be applied to all or a sub-set of banks as well as to sectoral exposures located in the Member State that sets the buffer.
  • The asymmetric nature of the powers assigned to the ECB reflects its role as a backstop to national authorities.
  • The powers support the ECB in taking action should national authorities not implement macroprudential measures in an adequate and timely fashion.
  • The ECB and the national authorities in the SSM engage in broad discussions on the use of macroprudential instruments, both at analytical and policy level.
  • These measures have helped to contain risks to euro area financial stability and strengthen the capacity of euro area banks to absorb losses.
  • In countries that have applied borrower-based measures, standards on new lending appear to have been preserved in line with the tolerance specified by authorities.
  • [62] Furthermore, as highlighted in recent assessments by national authorities, borrower-based measures have improved the expected resilience of borrowers and banks in adverse scenarios.
  • But in some countries, there is merit in further strengthening those capital buffers that can be released if risks materialise.
  • [66] Overall, prevailing macro-financial conditions and the ability of banks to accumulate capital should be taken into account when activating the CCyB.
  • Chart 5.2 Despite a drifting up of cyclical risk, the countercyclical capital buffer still only forms a tiny fraction of euro area banks capital requirements
  • The ESRB[67] recently identified a number of EU countries with medium-term vulnerabilities in the RRE sector.
  • In the euro area, two countries received ESRB warnings (Germany and France), while four countries received ESRB recommendations (Belgium, Finland, Luxembourg and the Netherlands), following ESRB warnings in 2016.
  • Vulnerabilities in all these countries originate from trends in mortgage lending, dynamics of RRE prices and fragilities in the household sector.
  • Finally, targeted macroprudential risk weight policies could be used in countries where real estate vulnerabilities are already elevated, in order to strengthen bank resilience over the real estate cycle.
  • Therefore, at this stage of the cycle it is important that banks in countries exposed to CRE risks remain resilient to adverse shocks.

5.2 Tackling structurally weak bank profitability

• The euro area banking sector has faced low profitability, characterised by high costs, overcapacity and limited revenue diversification, since 2012.
• On aggregate, euro area banks return on equity is expected to remain low, limiting the sectors ability to increase resilience through retained earnings (see Chapter 3).
• But analysis suggests that the low profitability of euro area banks, compared with other jurisdictions, can be primarily attributed to the structural issues of low cost-efficiency and limited revenue diversification.
• [68] A banking system operating with significant overcapacity is also vulnerable to weak competitors driving down lending standards and an underpricing of risk.
• The low level of consolidation in the euro area banking sector, particularly across borders, suggests that barriers to consolidation do exist.
• Potential uncertainty about the regulatory and supervisory requirements faced by the merged entity may further discourage cross-border consolidation.

5.3 Developing macroprudential measures to enhance the resilience of euro area capital market financing

• The development of deep, liquid, integrated and resilient capital markets in the euro area benefits the economy and financial stability.
• The share of euro area companies financing coming from capital markets and euro area non-banks has grown significantly over the last decade (see Chapter 4).
• Diversifying the sources of financing for businesses and reducing reliance on banks should enhance the resilience of credit flows to shocks that primarily affect one part of the financial system.
• [69] A successful capital markets union should foster deep and resilient EU capital markets, helping unlock their potential for the economy.
• [70] But excessive risk and leverage in non-banks tends to be procyclical, potentially amplifying cycles in capital markets and contagion of stress to the wider financial system.
• Such asset price amplification may have potential implications for the ease and cost of corporate financing which could exacerbate any stress or downturn.
• More broadly, the ongoing search for yield may also intensify the build-up of vulnerabilities, not least by lowering current financing costs for riskier borrowers.
• Currently, authorities lack adequate macroprudential tools to act ex-ante against the build-up of risks in non-banks in upswings.
• While credit and market risk are explicitly covered in the capital requirements under the SolvencyII framework, this is less so for liquidity risk.

5.4 Responding to climate change-related financial stability risks

• As the recognition of the impact of climate risk on the financial sector grows, so does the need for better climate risk measurement and monitoring.
• Progress has been made in understanding how the financial system may be vulnerable to the physical risk of climate change and to risks from a slow response to the need for a transition to an economy with lower carbon emissions.
• A roadmap for countering financial stability risks from climate change has been agreed and is being implemented internationally.
• Central banks and financial authorities globally and within the EU are stepping up efforts on: (i)monitoring climate risks; (ii)developing taxonomies; (iii)promoting disclosures; and (iv)incorporating climate-related risks into prudential frameworks (see Table 5.1).
• Table 5.1 Initiatives with a focus on financial stability from the European Commissions action plan on financing sustainable growth

Special features

Euro area bank profitability: where can consolidation help?

• Prepared by Desislava Andreeva, Maciej Grodzicki, Csaba Mr and Alessio Reghezza[83] Low aggregate bank profitability in the euro area, which weakens the resilience of the euro area banking sector, is partly explained by the persistent underperformance of a sub-set of banks.
• These banks all stand out in terms of elevated cost-to-income ratios.
• The common cost inefficiency problem seems most pronounced for the largest and smallest banks.
• But in systems with many weak-performing small banks, consolidation within their domestic system could improve performance.

Assessing the systemic footprint of euro area banks

Prepared by Michał Adam, Paul Bochmann, Maciej Grodzicki, Luca Mingarelli, Mattia Montagna, Costanza Rodriguez d’Acri and Martina Spaggiari

• The "US Inverted Yield Curve: Economic Recession Indicator Suggests Difficult Times Ahead" report has been added to ResearchAndMarkets.com's offering.
• The inverted yield curve is feared by many investors in the world as many claim that it is a signal that a recession in the economy will soon take place.
• Individual investors are initiators of the inverted yield curve.
• Does the inverted yield curve signal a recession?

• The report identifies a deteriorating outlook for the asset management industry and continued very high market risk.
• Recent trade tensions have triggered renewed volatility, and concerns over a no-deal Brexit remain key risk drivers for the second half of 2019.
• Investors are facing very high market risk, as they navigate an environment of potentially inflated asset valuations, subdued economic growth prospects, and flattening yield curves.
• Changed monetary policy expectations may boost their risk appetite and reignite search-for-yield strategies, leaving investors vulnerable to volatility episodes and abrupt shifts in market sentiment.