Foreword

The recent economic recovery in the euro area has also brought a recovery in corporate activity that has reduced many of our worst fears about economic scarring and rising credit risk. Instead, risks of high rates of corporate defaults and bank losses are now significantly lower than six months ago. Across the euro area, reliance on policy support schemes has been shifting and a number of schemes have expired without creating disruption.

But risks stemming from the pandemic have not disappeared entirely, not least because vaccination progress has remained slow in many areas of the world, while global supply chain pressures and rising energy prices pose new challenges to the strength of the recovery and the outlook for inflation. Pandemic-related losses are likely to continue materialising for some time, amid a legacy of higher debt.

Meanwhile, a number of vulnerabilities have intensified. The markets for equity and risky assets have maintained their striking buoyancy, making them more susceptible to corrections. There have been examples of established market players exploring more novel and more exotic investments. In parallel, euro area housing markets have expanded rapidly, with little indication that lending standards are tightening in response.

Against this backdrop, the November 2021 Financial Stability Review (FSR) assesses financial stability vulnerabilities and their implications for financial market functioning, debt sustainability, bank profitability and the non-bank financial sector.

This issue of the FSR also includes three special features focused on addressing some long-standing challenges which affect the strength of euro area banks. They examine the usability of capital within the regulatory buffer framework, consider how mergers and acquisitions (M&As) could help the sector to return to more sustainable levels of profitability and explore approaches for managing non-performing loans, which can be a long-term drag on bank balance sheets.

This issue of the FSR has been prepared with the involvement of the ESCB Financial Stability Committee, which assists the decision-making bodies of the ECB in the fulfilment of their tasks. The FSR exists to promote awareness of systemic risks among policymakers, the financial industry and the public at large, with the ultimate goal of promoting financial stability.

Luis de Guindos
Vice-President of the European Central Bank

Overview

Near-term pandemic risks lessen, as vulnerabilities ahead build up

Improved economic conditions have reduced near-term tail risks to financial stability. Indicators of near-term financial stress have fallen to pre-pandemic lows since the previous FSR (see Chart 1, panel a), in line with the recovery seen in euro area economic activity in the first half of 2021. While the recovery has broadened across euro area countries and sectors as lockdown measures have eased, some near-term risks remain, as corporate fragility remains high in certain sectors which were more heavily impacted by pandemic restrictions and had higher pre-existing indebtedness. There is also a risk that recent strains in global supply chains and the spike in energy prices could have longer-lasting effects on inflation than expected and weigh on the economic recovery.^[1] Low vaccination rates in some parts of the world and growing vulnerabilities in major emerging market economies, notably the strains experienced by major property developers in China, also add to risks.

Vulnerabilities further out have been building up. Indicators of medium-term systemic risk have continued increasing in recent months (see Chart 1, panel b), while rising medium-term growth-at-risk estimates also point to a changing time profile of risks (see Chart 1, panel c). Concerns particularly relate to pockets of exuberance in credit, asset and housing markets as well as higher debt levels in the corporate and public sectors as a legacy of the pandemic.

Generally improved outlook for sovereigns and firms

Sovereign debt positions in the euro area, although historically high, have benefited from the ongoing recovery and continued favourable financing conditions. Sovereign debt levels have risen sharply since 2019 to nearly 100% of GDP on aggregate for the euro area. While government action was instrumental in avoiding deeper pandemic-related scars on the euro area economy, it still adds to medium-term sovereign debt challenges, particularly for the more highly indebted countries. For the time being, current favourable financing conditions, driven in part by European initiatives such as the Next Generation EU instrument, have allowed governments to lock in long-term financing at historically low interest rates across the rating spectrum (see Chart 2, panel a). The related increase in the residual maturity of outstanding government debt helps reduce rollover risks going forward.

The ongoing economic recovery has also helped debt-to-GDP ratios to stabilise. The transition from blanket fiscal support to more targeted measures, coupled with the gradual exit from support schemes, has reduced strains on public finances. The positive role that fiscal (and monetary) policies have had in limiting lasting damage to corporates and banks has in turn limited negative feedback to governments via the sovereign-bank-corporate nexus (see Chart 2, panel b). That said, if financing costs were to rise and economic growth were to fall short of expectations, this could put sovereign debt dynamics on an unfavourable trajectory, in particular in higher-debt countries (see Box 1), and contribute to some reassessment of sovereign risk by market participants going forward.

Near-term euro area corporate insolvency concerns have fallen, although some firms remain vulnerable, notably in pandemic-sensitive sectors. Corporate profitability has shown a broad-based recovery in 2021 as economic activity has expanded. Corporate debt servicing capacity has also improved on account of low financing costs, improved revenues and continued public support measures. On average, corporate defaults have come in lower than the most optimistic expectations earlier in the pandemic (see Chart 3, panel a), while insolvencies have remained around 15% below pre-pandemic levels. However, insolvencies in those sectors most affected by the pandemic did rise strongly and without being offset by a rise in new business registrations, suggesting a more pessimistic outlook for those sectors (see Chart 3, panel b). Going forward, corporate insolvencies could still rise further, due to a backlog of unresolved bankruptcy cases and a gradual phasing-out of policy support measures, although by less than feared in the initial phases of the pandemic. That said, more vulnerable and highly leveraged firms may be challenged by the scaling-back of support measures and, in the medium term, debt sustainability concerns may re-emerge given the sizeable debt accumulation during the pandemic.

Euro area banks’ structural problems resurface as pandemic-induced vulnerabilities dissipate

Market sentiment towards euro area banks has remained favourable, as the near-term profitability outlook has improved. Continuing the trend that started in July 2020, banks’ equity price valuations have returned to pre-pandemic levels (see Chart 4, panel a). This was driven, among other things, by better than expected bank results on aggregate in the first half of the year, the lifting of the ECB Banking Supervision recommendation on limiting dividends as of October 2021^[2] and a steeper yield curve. At the same time, the overall credit risk outlook for banks has improved in tandem with more benign conditions in the non-financial corporate sector (see Chart 4, panel b). Bank valuations were additionally bolstered by the confirmation of the resilience of the sector to adverse shocks in both the July 2021 stress test and the October 2021 macroprudential stress-test exercise (see Box 6). Taken together, these factors seem to indicate that investors consider the banking sector to have largely overcome the initial pandemic-induced challenges.

Looking ahead, bank profitability remains hampered by euro area banks’ structural challenges. Bank profitability has improved overall since the start of 2021 on the back of lower loan loss provisions and stronger revenue streams from investment banking (see Box 5), but the profitability outlook continues to depend on the path of overall economic recovery and the pandemic. While the non-performing loan (NPL) ratio has dropped to levels last seen before the global financial crisis on account of further progress made in NPL sales, asset quality concerns may resurface as government support measures are gradually withdrawn, reinforcing the need for effective NPL solutions (see Special Feature C). Euro area bank profitability remains lower than in other jurisdictions (see Chart 4, panel c). Thus, even as pandemic-related challenges abate, pre-pandemic structural challenges, such as low cost-efficiency, limited revenue diversification, overcapacity and compressed margins in a low interest rate environment, remain. Consolidation via mergers and acquisitions could be one potential avenue for helping the sector to return to more sustainable levels of profitability (see Special Feature B). Looking ahead, euro area banks also face increasing urgency to meet digital transformation needs and to manage the implications of the transition to a greener economy.

Continued exuberance leaves parts of real estate and financial markets increasingly susceptible to corrections

Euro area house prices rose at their fastest pace since 2005 in the second quarter of 2021, amid signs of easing mortgage lending standards. While the economic recovery has also supported near-term fundamentals for the housing market, continued strong house price growth of around 7% at the euro area aggregate level remains a cause for concern amid signs of more broad-based price increases across both urban and non-urban areas (see Chart 5, panel a). Some of this rise could reflect an increase in demand for housing (including larger properties) during the pandemic. But growing signs of overvaluation for the euro area as a whole render residential real estate (RRE) markets more prone to a correction, in particular in countries with more elevated valuation levels (see Section 1.5). In some countries, the strength of RRE markets is coupled with buoyant mortgage lending, and there is evidence of a progressive deterioration in lending standards, as reflected by the increasing share of loans with high loan-to-value and loan-to-income ratios (see Chapter 5). High and rising levels of household indebtedness also contribute to heightened medium-term vulnerabilities in some countries (see Chart 5, panel b). Taken together, these developments have strengthened the case for considering further activation of macroprudential policy measures, where appropriate.

Commercial real estate (CRE) markets have benefited from the improving economic outlook, but parts of the market remain vulnerable to further price corrections. Investor sentiment has improved over recent quarters, but a substantial share of CRE investors still see the market in a downturn. The outlook seems particularly poor for lower quality CRE assets, with market intelligence flagging remote working, health concerns and the rush for greener property as channelling demand towards the prime segment. This intersects with elevated vulnerabilities among those sectors most affected by the pandemic, namely retail and office assets. Transaction data suggest substantial holdings of these most vulnerable assets across the euro area financial system, in particular for non-banks.

Signs of exuberance are increasingly visible in some financial market segments as real yields fall and the search for yield continues. Real yields fell to all-time lows amid indications of a moderating pace of the economic recovery and increased inflationary pressures (see Chart 6, panel a), incentivising risk-taking in financial markets. Euro area and global equity markets have continued to advance since the publication of the previous FSR, also bolstered by a better than expected corporate earnings season and continued accommodative financial conditions. The stock prices of pandemic-sensitive firms have continued to underperform the market, indicating a continued concentration of risk in some sectors. Issuance activity in high-yield corporate credit markets has reached new highs in 2021 (see Chart 6, panel b). Despite large issuance volumes, spreads remain at record lows, pointing to strong investor appetite for risky assets.

Buoyant financial asset price developments raise overvaluation concerns in some markets, increasing the likelihood of market corrections. The combination of historically low real yields and elevated valuations (see Chart 6, panel c) leave sub-investment-grade bond and some equity markets vulnerable to adverse interest rate and growth shocks (see Chapter 2). The presence of a cohort of vulnerable firms could increase the sensitivity of corporate securities prices to risk-off shocks (see Box 3). A correction in markets could be triggered by a weaker than expected economic recovery, spillovers from adverse developments in emerging market economies, a re-intensification of stress in the non-financial corporate sector or abrupt adjustments in market expectations regarding the prospective path of monetary policy normalisation. In addition, more persistent inflationary pressures than currently anticipated could push nominal yields higher, which may put valuations under pressure. Beyond core markets, some more exotic market segments, such as crypto-asset markets, also remain subject to speculative bouts of volatility, with the growing popularity of stablecoins increasing interlinkages between crypto-asset and conventional financial markets (see Box 4).

In parallel, the non-bank financial sector continues to face elevated credit risk. Non-banks continue to be an important source of financing for non-financial corporations (NFCs) as the economy recovers. However, in their search for yield, investment funds (IFs) have increased credit risk in their portfolios by purchasing around 70% of euro area-domiciled NFCs’ newly issued BBB and high-yield bonds, leading to increased holdings of lower quality bonds in their portfolios (see Chart 7, panel a). Similarly, insurance corporations and pension funds (ICPFs) have further expanded their lower-rated corporate debt holdings (see Chart 7, panel b). While reduced corporate sector vulnerabilities alleviate related credit risks in the short run, non-banks remain exposed to the risk of substantial credit losses should conditions in the corporate sector deteriorate. For insurers, risks are partly mitigated by a more favourable operating environment, underpinned by the sector’s robust capitalisation.

For investment funds, growing credit risks are exacerbated by high liquidity risk as well as increasing duration risk exposure. Low liquidity holdings leave the sector vulnerable in the event of large-scale outflows (see Chart 7, panel a). At the same time, the average duration of exposures has increased during the pandemic. Were bond yields to rise, valuation losses could trigger outflows from investment funds which – when coupled with the low liquidity buffers – could force bond funds to liquidate assets to meet investor redemptions. Such procyclical selling behaviour could also amplify other financial market shocks. Overall, elevated levels of credit, liquidity and duration risks underscore the importance of strengthening the resilience of the non-bank financial sector, including from a macroprudential perspective.

Climate change-related vulnerabilities call for policies to support an orderly transition

A rapid deepening of green financial markets continues, but greenwashing risks warrant monitoring. Investor interest in green finance has continued to grow rapidly over the course of 2021, alongside green investment more generally (see Chart 8, panel a), indicating increasing awareness of the need to transition to a low-carbon economy. While financial markets can play an important role in financing this transition, greenwashing concerns persist. These need to be tackled through better information, especially in relation to forward-looking commitments and plans, and enhanced standards, both to ensure that green finance effectively supports the transition and to foster efficient market mechanisms. Ongoing official sector initiatives in Europe and in global standard-setting bodies to shore up disclosures, standards and taxonomies should help in addressing some of these issues.

Timely, concerted action would ensure an orderly transition to a greener economy and the resilience of the financial system to climate-related risks. The results of the ECB’s recent top-down climate stress test highlight the benefits of a timely and orderly transition to mitigate climate-related vulnerabilities, in particular for the tail of banks most exposed to climate risks (see Chart 8, panel b). The floods and wildfires in Europe earlier this year illustrate financial impacts of climate-related hazards. This includes not only impacts on bank lending, but also on insurers directly exposed to losses from natural catastrophes. From a systemic perspective, insufficient and potentially diminishing insurability of climate-related risks and associated risk pooling could also significantly amplify future economic losses.

As near-term risks fall, policy moves to address financial stability vulnerabilities further out

Recent months have seen attention shift from near-term financial stability risks associated with the pandemic to increasing medium-term vulnerabilities. Improved economic conditions have contributed to a decline in near-term vulnerabilities for sovereigns, corporates and banks, even if heterogeneity at the country and sector levels remains. Vulnerabilities from mispricing in some financial and tangible asset markets have increased, however, amid continued risk-taking by non-bank financial institutions. Moreover, the pandemic has left a legacy of significantly higher levels of indebtedness across sectors. These vulnerabilities could unravel in a disorderly manner through shocks such as: (i) an abrupt change in market expectations regarding the pace of monetary policy normalisation; (ii) a premature withdrawal of government support to non-financial sectors; or (iii) a re-intensification of the spread of the coronavirus. The potential for these vulnerabilities to materialise simultaneously and to possibly amplify each other further increases the medium-term risks to financial stability.

Policies are also shifting from providing short-term support towards addressing financial stability vulnerabilities ahead. Fiscal, supervisory and monetary policies have remained supportive, thereby avoiding strong adverse real-financial feedback loops. However, policies have started to shift from containing the immediate economic fallout from the pandemic and ensuring the near-term recovery to managing medium-term risks to financial stability. While the new ECB monetary policy strategy foresees a flexible approach to considering financial stability going forward (see Box 8), macroprudential policies remain the first line of defence against the build-up of systemic risk. A tightening of macroprudential policies may need to be considered in a number of countries as the economic recovery progresses and medium-term vulnerabilities rise, notably in property markets (see Section 5.1). At the same time, there is a need for structural policies to play a greater role in managing the transition to more resilient economic and financial structures that support sustainable economic growth.

Strengthening the regulatory framework, in both the bank and non-bank financial sector, is crucial for the stability of the financial system. From a broader regulatory perspective, strengthening the banking union and the timely, full and consistent implementation of the final leg of Basel III reforms are essential to address shortcomings in the existing framework. That said, the effectiveness of the framework could be improved, as some banks may be reluctant to use available capital buffers in periods of economic distress (see Special Feature A), while some features of the current structural buffer regime could unintentionally create disincentives for cross-border mergers (see Special Feature B). Finally, from a system-wide perspective, further progress towards developing a macroprudential approach for non-banks is needed given their increasing role in funding the real economy and their close interlinkages with the wider financial system (see Section 5.2). In particular, the Financial Stability Board (FSB) has recently issued policy proposals to tackle vulnerabilities in money market funds, with a key aim being to ensure that they hold sufficient safe and liquid assets. It is now important for the FSB to move towards developing concrete policy proposals in relation to open-ended investment funds and margining practices.

1 Macro-financial and credit environment

1.1 The economy reopens, but inflationary pressures pose downside risks to the recovery

Economic growth surprised to the upside in the first two quarters of 2021, although growth momentum has slowed more recently. Overall, real GDP in the third quarter of 2021 was about 0.5% below its level in the fourth quarter of 2019, as the euro area continued to recover. However, the momentum of the growth has moderated to some extent recently, with the rise in energy prices and supply chain bottlenecks posing downside risks to economic growth going forward. At the same time rising coronavirus (COVID-19) incidence rates had a more limited impact so far on hospitalisations and deaths than in previous waves (see Chart 1.1, panel a). Moreover, mobility data indicate that time spent at home as well as time spent on retail and recreational activities remain near pre-pandemic levels (see Chart 1.1, panel b). Despite the slowdown in the recovery, it is still likely that real GDP will surpass its pre-pandemic levels in the fourth quarter of 2021, two quarters earlier than had been expected at the start of the year.

While vaccination progress has helped to balance the risks to the economic recovery in the euro area, some downside risks remain. Higher vaccination levels compared with the spring have reduced the level of downside risks for both this year and next (see Overview and Chart 1.2, panel a). However, current economic expectations are still surrounded by uncertainty stemming from the possible need for new containment measures during the winter months. The virus is continuing to spread, possibly affecting vaccine-induced immunity or creating new mutations, which might translate into new constraints on economic activity. In addition, although economic activity has rebounded, the number of people in employment and total hours worked remain below pre-pandemic levels (see Section 1.3). Moreover, labour shortages, reflecting increasing job reallocation and labour mismatches, could affect the labour market for sectors that are facing a more permanent drop in demand. As such, the pandemic continues to be one of the main risks to economic growth going forward.

Divergence in gross value added between sectors and countries narrowed, in part reflecting lockdown measures becoming more targeted. The reopening of the euro area economy since the spring and increasingly targeted containment measures have reduced divergence in gross value added between sectors and countries (see Chart 1.2, panel b). In addition, although they have softened since the summer, confidence indictors are signalling a recovery in economic activity in both services and manufacturing going forward. However, despite the economic recovery, the unequal impact of the pandemic on these countries continues to be reflected in economic projections. Although the euro area economy as a whole is expected to surpass pre-pandemic growth levels this year, private sector expectations show that for some of the countries hardest hit by the pandemic this is not likely to happen before the second half of next year. Moreover, activity in the most-affected sectors remains significantly below pre-pandemic levels (see Chart 1.2, panel b). These sectors would also be subject to the greatest downside risk in the event of a new lockdown. As such, if the uncertain environment prevails, this could result in lower investment and subdued employment prospects, leading to scarring in those sectors that remain vulnerable to an intensification of the pandemic.

Supply chain disruptions and surging oil, gas and electricity prices have resulted in rising global inflationary pressures, which could be amplified by unequal vaccination levels. In many advanced economies, inflation reported in 2021 so far has been higher than was projected last year. Although this widespread spike in headline inflation rates around the world largely reflects a sharp increase in energy prices, increases in input costs related to supply disruptions have also contributed to upward pressure on inflation. Moreover, enterprises in both the manufacturing and the services sectors report that production is being hampered by a shortage of material (manufacturing) and labour (services, see Chart 1.3, panel a). Going forward, supply chain disruptions could intensify if further virus outbreaks warrant new lockdowns, notably in emerging markets, where vaccination campaigns are less advanced than they are in developed markets. At the same time, if persistent bottlenecks feed through into higher than anticipated wage rises or the economy returns more quickly to full capacity, price pressures could become stronger. A more persistent high inflation scenario could translate into an untimely tightening of financial conditions, weighing on the economic recovery.

High uncertainty in relation to China, combined with evidence of weakening economic activity, has added to downside global economic risks. While China recovered swiftly from the contraction induced by the pandemic in the first quarter of 2020, private sector forecasters have revised down their 2021 economic projections for the Chinese economy as credit impulse has declined and economic policy uncertainty remains elevated (see Chart 1.3, panel b). The deceleration in economic activity has been compounded by the authorities’ efforts to limit leverage among Chinese property developers. Tighter regulations are also aimed at reducing reliance on residential real estate sector growth, which is a key growth driver in China’s economy. Following these developments, Evergrande – one of China’s largest and most indebted property developers – prompted wider market concern in the autumn over the health of the Chinese property sector. So far, the impact on global growth projections and financial markets has been limited, as foreign exposure seems relatively small. However, these developments add to the downside risks for global economic growth prospects^[3], given China’s increasing role in global economic and trade developments.

1.2 Sovereign risks are contained in the near term, but elevated debt poses a medium-term vulnerability

Although the pandemic continues to weigh on public finances, the need for further stimulus is gradually declining as the recovery solidifies. With the euro area economy recovering faster than anticipated, governments are expected to run smaller deficits in 2021 and 2022 than projected at the beginning of 2021 (see Chart 1.4, panel a). Moreover, support measures have become more targeted on those sectors of the economy that are still affected by restrictions, thereby reducing their fiscal impact compared with the early days of the pandemic. According to the September 2021 ECB staff macroeconomic projections, the contribution of discretionary stimulus related to the pandemic is expected to decline from 4.6% of GDP in 2021 to 1.5% and 1.2% in 2022 and 2023 respectively. Meanwhile, additional fiscal stimulus measures for 2022 have been adopted by most governments in the context of their draft budgetary plans. These include an expansion of some pandemic-related spending, additional measures to alleviate the adverse impact of the increase in energy prices and other fiscal loosening measures in several countries.

Scaling back pandemic-related stimulus implies a tightening of the fiscal stance in 2022. Current projections for the euro area indicate that, as the economy recovers and government support measures unwind, the fiscal stance will tighten in 2022 (see Chart 1.4, panel a). Although the projected economic outlook allows for such tightening, pandemic-related downside risks surrounding economic projections could make it necessary to introduce new stimulus measures (see Section 1.1).

Despite governments running sizeable budget deficits, the increase in debt-to-GDP levels this year is projected to remain limited. While deficits will be at similar levels to 2020, the increase in debt ratios is expected to be far less pronounced this year, mainly reflecting robust economic growth (see Chart 1.4, panel b). Moreover, the gradual scaling back of fiscal support measures will serve to improve public finances and will contribute to a further decline in debt levels going forward. In 2020, approximately 35% of the increase in the euro area debt-to-GDP ratio was driven by the fall in GDP, but as the economy recovers this denominator effect will subside. Despite these favourable developments, however, government debt is expected to remain significantly above pre-pandemic levels, increasing the vulnerability of the economy to a deterioration in financial conditions and negatively affecting its resilience to future economic shocks (see Box 1).

Governments have continued to benefit from low debt servicing costs and reduced rollover risk by increasingly issuing long maturity debt. Moreover, sovereign stress has fallen to its lowest level since 2001, as monetary support measures have continued to support financing costs (see Chart 1.5, panel a, and Chapter 2). As a result, governments have increasingly made use of easy financial conditions to issue longer-term debt (see Chart 1.5, panel b). The issuance of such debt fits with the ongoing trend of lengthening the maturity of the government debt portfolio, as the average maturity increased from 6.7 years in December 2010 to 7.9 years in September 2021 for the euro area on aggregate. In terms of debt servicing needs over a period of two years, this increased residual maturity translates into a 15% reduction in principal repayments compared with running the same amount of debt against the maturity profile in 2010.^[4] However, debt servicing needs remain elevated, with some euro area countries facing refinancing and interest expenditure in excess of 40% of GDP over the next two years.^[5] As such, a future deterioration in financial conditions could weigh on public finances in higher indebted euro area countries, hampering the recovery.

Projected negative interest rate-growth differentials should facilitate a decline in debt levels over time, though their trajectory is surrounded by uncertainty. The economic recovery and the low interest rate environment will result in a negative interest rate-growth differential in the coming years (see Chart 1.6, panel a). As a result, debt levels are expected to decline gradually from their present level.^[6] Moreover, current expectations only show marginally higher interest rate-growth differentials for higher debt countries than for lower debt countries. Historically, the relationship between a country’s debt level and its interest rate-growth differential grows stronger in times of elevated stress levels. This illustrates how the higher debt levels resulting from the pandemic could be more detrimental for government finances going forward if left unchecked (see Box 1).

The EU recovery package could improve long-term economic prospects and, therefore, sovereign debt sustainability. Moreover, positive spillovers of investments under the NGEU between euro area countries could further boost economic growth^[7] and could help to sustain the recovery without national budgets being directly negatively affected^[8]. Currently, most euro area governments have submitted their recovery and resilience plans for the €750 billion NGEU funding envelope: the plans are composed of grants and loans (see Chart 1.6, panel b). Countries have until August 2023 to apply for loans: not all euro area countries have requested a full allocation so far, possibly reflecting the fact that most countries currently enjoy very favourable financing conditions. In the plans submitted to date, the largest share of the funds is allocated to public administration, construction, transport and energy. This may be because governments are looking to finance projects that will promote growth, in line with the digitalisation, green transition and social objectives of the NGEU package, rather than just focusing on the sectors hardest hit by the pandemic. But as only a few countries have set out a timeline for planned spending, uncertainty surrounding actual absorption rates, and hence the effectiveness of the NGEU package, remains high.

While favourable financing conditions mitigate short-term risks, higher debt leaves euro area sovereigns more vulnerable in the medium term. Although financing conditions have limited the impact of increased sovereign debt levels on budgets and debt servicing costs, the increased debt burden resulting from the pandemic could potentially represent a longer-lasting drag on the economy. Moreover, the sizeable increase in contingent liabilities since the start of the pandemic might weigh on government debt levels should economic growth slow. At the current juncture, the increase in sovereign indebtedness is not expected to reverse for at least another decade, and a return to less favourable financial conditions could imply less benign debt dynamics (see Box 1).

1.3 Households remain resilient, but pockets of vulnerabilities may emerge

Euro area households’ aggregate balance sheets have remained robust, although some uncertainty persists. The financial situation of euro area households has improved further on aggregate, with indicators of financial health signalling vulnerabilities below long-term averages (see Chart 1.7, panel a). The largest uplift comes from households’ debt servicing capacity being bolstered by lower interest payments and a high savings rate as household income was shielded by government support throughout the pandemic and containment measures limited spending opportunities. In addition, financing conditions and credit provision have remained favourable. Consumers gained confidence as vaccination campaigns accelerated and economies reopened over the summer, which has supported GDP growth (see Chart 1.7, panel b). Households further benefited from a decline in unemployment throughout the second and third quarters of 2021, with the unemployment rate of 7.4% in September back to pre-pandemic levels. With several sectors reporting labour shortages, the general outlook for employment remains positive. That said, global supply chain bottlenecks could weigh on the economic recovery, and jobs created in the hospitality and leisure sectors could be vulnerable to a renewed deterioration in the pandemic situation.

Record savings have enhanced households’ resilience but are unevenly distributed, which may limit any additional boost to consumption. Households continued to accumulate excess savings as containment measures limited spending. Substantial parts of these are held in deposits and cash, but an increasing share is invested in less liquid financial assets like equity and investment fund shares (see Chart 1.8, panel a). Households may hold these savings for precautionary reasons, to pay down debt or in anticipation of possible price or tax rises as survey data suggest that they do not intend to increase their spending on durables beyond pre-pandemic levels, thus limiting hopes that pent-up demand would translate into higher consumption.^[10] In addition, higher-income households, which tend to have a lower marginal propensity to consume, account for the highest savings. While the importance of government support schemes is receding overall, they still play a significant role in stabilising income, consumption and debt servicing capacity, especially for lower-income households that will be left vulnerable to cliff effects if support schemes are withdrawn prematurely (see Chart 1.8, panel b). Together with robust house price and stock market valuation gains, households’ net worth surged to 772% of disposable income in the second quarter of 2021 (see Section 1.5).

Household debt continues to grow amid record low debt servicing costs. While the situation differs across countries, aggregate household debt grew at the highest rate in a decade – almost 4% in annual terms in the second quarter of 2021 (see Chart 1.9, panel a), mainly on the back of robust mortgage lending (see Section 1.5). Household income, on the other hand, has grown at a slower rate, increasing the debt-to-disposable income ratio to 97.9%. Record low interest rates support households’ debt servicing capacity as only around 2.2% of disposable income needs to be spent on interest payments (see Chart 1.9, panel b). In addition, the increasing share of fixed-rate loans in new credit flows makes the household sector less vulnerable to interest rate shocks going forward (see Chart 1.9, panel c). Nevertheless, should debt continue to grow faster than income, vulnerabilities could build up in the household sector.

Overall, financial stability risks stemming from the household sector remain contained, but some medium-term vulnerabilities are rising. With excess savings, robust net wealth and record low debt servicing costs, households retain their capacity to weather economic headwinds. However, lower-income households are disproportionally reliant on government support and have likely benefited less from higher financial wealth, leaving them in a potentially vulnerable position when policy support is scaled back. In addition, should higher inflation persist and households’ spending on essential goods increase, both their ability to support the broader economic recovery and their debt servicing capacity could be hurt. Concerns over household debt sustainability could rise, especially in those countries where the take-up of policy support is substantial, residential properties are overvalued and debt levels are elevated.

1.4 Corporate outlook improves, reducing near-term risks

Near-term corporate sector vulnerabilities declined as economic activity picked up. Corporate earnings showed a large, broad-based improvement in the second quarter of 2021, returning to pre-pandemic levels for listed firms, thereby alleviating solvency concerns (see Chart 1.10, panel a). Despite this marked improvement, corporates face challenges stemming from the swift pick-up in economic activity as energy prices soar, supply chain bottlenecks limit production among manufacturers and labour shortages start to weigh on the services sector, potentially slowing its recovery going forward (see Section 1.1). Moreover, profitability has lagged behind in those sectors where activity continues to be supressed by pandemic restrictions and which have experienced only a marginal improvement on their pandemic lows, such as the travel industry (see Chart 1.10, panel b). In addition, corporates will probably need a prolonged period of growth to make up for lost earnings, as backward-looking cumulative earnings are still 6.5% below pre-pandemic levels.

Insolvencies remain strikingly subdued, although they have materialised in some of the sectors most affected by the pandemic. On aggregate, the level of insolvencies in the euro area remained 15% below pre-pandemic levels in the second quarter of 2021. However, more granular data show that insolvencies have risen in those sectors hardest hit by the pandemic (e.g. in the accommodation and education sectors). At the same time, the swift economic recovery makes it unlikely that insolvency numbers will rise to match earlier private sector projections (see Chart 1.11, panel a). Policy support measures as well as the suspension of the obligation to file for insolvency have likely prevented the large-scale materialisation of additional bankruptcies. However, assessing corporate viability remains challenging in the light of the post-pandemic prospects for different business models. This is also signalled by the balance of positive and negative rating outlooks for companies with a credit rating, as many firms are still at risk of a credit rating downgrade (see Chart 1.11, panel b). As such, insolvencies and bond defaults could still pick up if less favourable economic outturns were to materialise.

Corporate credit growth increased moderately, reflecting large liquidity buffers and improving economic activity. Demand for bank loans increased in the third quarter of 2021 on account of slightly higher fixed investment, debt refinancing needs and financing needs for inventories and working capital (see Chart 1.12, panel a). However, non-financial firms built up significant liquidity buffers, with gross debt remaining elevated, while net debt declined to below pre-pandemic levels, contributing negatively to the demand for new loans. This largely reflects the position of large listed corporates, whereas SMEs were more heavily affected by the pandemic and are less likely to have access to market-based funding, resulting in lower cash buffers. Finally, large firms also partially replaced borrowing from banks with market-based debt to benefit from favourable market conditions. Going forward, banks expect a small net increase in demand for loans to firms (see Chart 1.12, panel a).

Although demand for liquidity declined, guaranteed loans still account for a non-negligible share of new loan origination in some countries. Guaranteed loans still make up between 5% and 10% of new loan origination in Italy and Spain. Public guarantee schemes play a less material role in other euro area countries. Moreover, the results of the ECB’s bank lending survey indicate that demand for guaranteed lending has started to decline among large and small and medium sized enterprises, reflecting lower demand amid broadly unchanged lending standards (see Chart 1.12, panel b). Unless it is decided to prolong them further, national guarantee programmes are generally expected to wind down at the end of 2021. As they still attract sizeable demand in some countries, there is a risk that their termination could lead to an unwarranted tightening of lending conditions and lower credit volumes, which could weigh on the economic recovery in those countries where the share of guaranteed lending remains significant.

Longer-term corporate sector vulnerabilities remain elevated, despite the improvement in economic prospects compared with the spring. On aggregate, corporate debt levels declined to 115% of GDP in the second quarter of 2021 from 119% of GDP in the first quarter of 2021 as the economy recovered.^[11] However, pockets of highly indebted companies have so far not succeeded in bringing their debt levels down (see Chart 1.12, panel c). These firms are more likely to encounter permanent scarring and remain vulnerable to a further scaling back of support measures. Moreover, highly indebted firms are also likely to run at lower levels of investment and employment,^[12] which could represent a longer-term drag on the euro area economy. Adding further to these vulnerabilities, highly-indebted firms applied for guaranteed loans and moratoria in greater numbers than did companies with a lower level of indebtedness (see Chapter 3). While this mitigated the short-term impact of the pandemic, the sizeable uptake in guaranteed lending in some countries could weigh on sovereign debt sustainability if the economic recovery is weaker than anticipated or if financial conditions deteriorate.

1.5 Vulnerabilities are growing in euro area property markets

Euro area residential real estate (RRE) prices showed robust growth throughout the first half of 2021. Nominal house prices grew at 7.3% at the euro area aggregate level in the second quarter of 2021 – the fastest rate observed since 2005 (see Chart 1.13, panel a). Policy measures have helped to maintain household incomes during the pandemic, while favourable financing conditions have allowed households to obtain financing for house purchase at record low interest rates (see Chart 1.13, panel a). Together with a possible preference for more living space as people worked from home, this fuelled demand for housing during the pandemic. Despite the recovery in residential construction, labour shortages, global supply chain bottlenecks and input price increases are weighing on the construction sector’s ability to expand housing supply, which is putting upward pressure on house prices.^[13] Rents have not followed the strong increases in house prices in most countries, which may partly reflect regulations in many rental markets.

Medium-term vulnerabilities in euro area residential property markets have continued to build up. While short-term risks have declined markedly since the height of the pandemic as financial conditions have eased, risks of price corrections over the medium term have increased substantially (see Chart 1.13, panel b) amid rising estimates of house price overvaluations. As price and lending dynamics are outpacing household income growth, household indebtedness and RRE overvaluation are increasing (see Chart 1.14, panel a), adding to the build-up of medium-term vulnerabilities and concerns over a debt-fuelled housing bubble. In particular, households with variable rate mortgages or shorter fixed-rate periods on their mortgages are exposed to an unexpected rise in interest rates, which could adversely affect their ability to service their debt (see Section 1.3).

House price and lending dynamics have been much stronger in many of the countries with pre-existing vulnerabilities. House prices have generally risen more in countries which had stretched valuations prior to the pandemic (see Chart 1.14, panel b), resulting in further increases in estimated overvaluation. Coupled with higher mortgage lending growth in some countries where households face higher debt levels (see Chart 5, panel b, in the Overview), the risks of a price correction and the build-up of vulnerabilities appear unevenly spread across euro area countries. Particularly notable are developments in countries that had already received a warning or recommendation from the European Systemic Risk Board (ESRB). This has strengthened the case for considering activating further macroprudential policy measures (see Chapter 5). Lending standards like loan-to-income and loan-to-value ratios had eased prior to the pandemic and there is some indication that they have eased further, adding to concerns about household and bank resilience going forward (see Chart 5.1 in Chapter 5).^[14]

Commercial real estate (CRE) markets started to recover following marked declines during the pandemic, but the outlook for the non-prime segment remains poor. While overall market sentiment has improved in tandem with the wider economy, an elevated share of investors still sees the market in a downturn (see Chart 1.15, panel a). Recent market intelligence suggests that this downturn is particularly pronounced for the lower-quality end of CRE markets. Pandemic-related experience with remote working, health concerns and stronger demand for more environmentally friendly buildings may move demand towards modern, high-quality office spaces over the medium term. The shift towards e-commerce may also have an outsized impact on lower-quality retail space. This division is clearly visible in survey data which show that investors expect rents for non-prime office and retail properties to decrease strongly over the next 12 months (see Chart 1.15, panel b). Should these trends prove to be lasting structural changes, non-prime segments could face risks of pronounced market corrections.

A sustained decline in CRE markets could feed through the wider financial system and negatively affect the real economy. The financial system is exposed to a deterioration in CRE prices via increased credit risk, decreased collateral values and losses on direct holdings. Transaction data show that over the five year period preceding the pandemic, euro area insurance corporations and pension funds, investment funds and non-financial corporations (NFCs) predominantly purchased non-prime retail and office properties (see Chart 1.15, panel c), suggesting that exposures to the most vulnerable CRE asset types could be substantial. In addition, banks in some countries have high exposures to CRE via loan purposes and collateral. A significant drop in CRE prices and the associated reduction of collateral values could hamper NFCs’ access to finance and thus result in lower scope for investment and economic activity. Other market participants, such as investment funds faced with redemption pressure, could behave procyclically and amplify the price decline, thereby exacerbating negative feedback loops.

Risks to financial stability stemming from real estate markets remain elevated and have increased for the medium-term horizon. A sharper than expected decline, particularly in lower-quality CRE valuations, might set off negative economic feedback loops. In residential property markets, while credit dynamics and household balance sheet vulnerabilities look less concerning than in the run up to the global financial crisis, buoyant expansion of RRE prices and a sense of deteriorating lending standards may warrant monitoring going forward (see Box 2). Against this background, the financial sector may be exposed to the risk of real estate market corrections, especially in those countries where debt levels are elevated, exposures are high and properties are overvalued.

2 Financial markets

2.1 Real yields fall due to risks of higher inflation and slower global recovery

Financial market pricing has adjusted in recent months for a continued but slower global recovery amid increasing supply-side constraints and surging energy prices. During the first half of 2021, markets were dominated by positive risk sentiment following the November 2020 news on the development of COVID-19 vaccines. As the recovery unfolded and economic data surprised on the upside (see Chart 2.1, panel a), markets started to focus on emerging global inflationary pressures and the implications of increasing yields. Over the course of the summer, however, disappointing economic data and concerns about the Delta variant of the coronavirus started to adversely affect market sentiment. The global economic recovery has continued, but momentum has slowed and risks are skewed to the downside.^[17] Despite the slowdown in global growth dynamics, inflationary pressures have persisted, driven in part by supply-side constraints and surging energy prices (see Chart 2.3, panel a). Although inflationary pressures in the euro area are expected to decline in the course of next year, recent inflation surprises, notably in the US, have led a growing number of market participants to see risks that higher inflation rates last for a more extended period. The market-implied probability for “high inflation scenarios” remains relatively subdued for the euro area, but has risen sharply for the United States (see Chart 2.1, panel b). At the same time, market prices now imply a very low probability for scenarios of very low inflation (below 1%) or deflation.

Inflationary pressures and risks to the strength of the economic recovery drove real yields to all-time lows, incentivising risk-taking. Between the publication of the May 2021 FSR and August of this year, nominal yields declined and global yield curves flattened, reflecting the perception that growth momentum had reached its peak (see Chart 2.2, panel a). Real yields fell to all-time lows (see Chart 2.2, panel b) and remained low even after nominal yields rebounded in August. Lower real yields have incentivised risk-taking in financial markets, despite growing risks. In September, equity indices reached record highs in the United States and various euro area countries. Increased risk-taking does not necessarily imply that growing risks do not lead to any downward adjustment of market pricing; equity markets declined over the course of September in response to concerns about rising inflationary pressures, supply bottlenecks and problems at the large Chinese property developer Evergrande. Markets rebounded relatively quickly; this reflects the continued strong risk appetite. In an inflationary environment, equities may also be more attractive than fixed income products, as the coupon payments on nominal bonds do not offer protection against inflation.

Nominal yields rebounded in August, driven by the inflation component, and may be sensitive to market participants’ expectations around policy normalisation going forward. Potential drivers of bond yield dynamics include the evolution of inflation dynamics, the strength of the recovery and market participants’ anticipation of policy normalisation.^[18] Recent nominal yield increases happened in the context of a perceived slowdown in the global recovery and were driven by the inflation component as supply-side constraints intensified and energy prices surged. Market participants also focus on central banks’ reaction functions to these inflationary pressures. Adjustments of market participants’ expectations can lead to volatility in bond markets, whereby cross border spillovers can also affect euro area bond markets.

The sharp increase in energy commodity prices contributes to inflationary pressures and poses wider risks to the recovery and to markets. The second half of 2021 has seen sharp increases in energy commodity prices due to insufficient supply in combination with low reserves, especially in Europe (see Chart 2.3, panel a). Surging prices affect industries that rely heavily on these commodities, can have a negative impact on growth and can weigh on market confidence. Corporate defaults may be triggered in the event of unhedged exposures. Carbon prices have increased in tandem with the demand for energy commodities.

Financial markets also reflect a growing divergence between emerging and developed economies. Emerging market equities started to underperform global equities over the course of 2021 (see Chart 2.3, panel b). To some extent, this may be attributed to relatively low vaccination rates in some emerging markets.^[19] The impact of the emerging market slowdown on developed economies is twofold: first, adverse developments in emerging markets can lead to spillovers through a decline in global demand; and second, emerging markets play a key role in global supply chains, and disruptions may further fuel inflationary pressures in developed economies.

Emerging market underperformance has, in part, been driven by developments in China. The relative underperformance of emerging markets cannot entirely be attributed to the impact of the vaccine roll-out and the Delta variant. Actions by Chinese authorities are having a profound impact on China’s technology, education and real estate sectors (see Chart 2.3, panel b, and Section 1.1). To date, bouts of volatility in Chinese high-yield credit markets following problems with the property developer Evergrande have not led to significant spillovers to global markets, as direct exposures are limited. An economic downturn in China may, however, adversely affect developed markets via global demand. So far, tensions were largely contained to the (“off-shore”) market for Chinese dollar-denominated high-yield bonds. Some Chinese firms with a speculative grade rating may struggle to refinance their dollar-denominated debt, while a number of investment grade firms might be vulnerable to rating downgrades to high yield.

2.2 The pandemic scars of debt and duration form long-lasting vulnerabilities in markets

Increased debt leaves the financial system more vulnerable to credit risk. Government, corporate and household debt have increased over the course of the pandemic (see Chart 2.4, panel a, and Section 1.4). Borrowers’ ability to service this debt is contingent on low financing costs and also depends on the strength of the economy (see Chapter 1). These dependencies not only increase the economy’s vulnerability to a deterioration in financial conditions, but can in turn also cause financial market conditions to respond more strongly to unforeseen adverse shocks.

Increased duration leaves markets and financial intermediaries more exposed to upward shocks to interest rates.^[20] Over the past decade, the duration of euro area fixed income securities has increased, most notably for bonds issued by sovereigns and sub-sovereigns (see Chart 2.4, panel b). The duration of a bond increases mechanically when yields decline,^[21] but issuers have also increased the maturity of newly issued securities in the context of lower rates and flatter curves.^[22] As a consequence of the increase in duration and overall debt, losses associated with a given increase in underlying yields have now reached historically high levels (see Chart 2.4, panel c). Increased sensitivity to rates could be destabilising in the event of a material interest rate shock.^[23] Open-ended bond funds may also exacerbate such a shock, as redemptions could trigger forced sales (see Chapter 4).

Equity markets also appear to have become more sensitive to interest rates. Price-to-dividend ratios for the EURO STOXX index have increased by almost 60% between 2017 and 2021 (see Chart 2.4, panel b). Shares with a higher price-to-dividend ratio are generally more sensitive to interest rate changes.^[24] Corporate leverage provides a second channel through which equities have become more sensitive to interest rates, as higher debt levels per unit of earnings leave the latter more sensitive to the cost of debt. Corporate leverage measured as debt/EBITDA^[25] has risen during the pandemic (see Chart 2.6, panel a), and the firms in the upper tail still show elevated leverage above pre-pandemic levels. Leverage also increased during the global financial crisis and remained elevated even after earnings recovered. The long-term impact of the pandemic on corporate balance sheets remains to be seen (see Chapter 1). The sensitivity of equity valuations to interest rates through the inflation component is somewhat ambiguous, as some firms may be able to increase earnings by raising the prices of their products.

Financing costs have remained low despite large debt issuance, but may come under pressure. The Eurosystem has expanded its balance sheet by around €3.7 trillion since the start of the pandemic (see Chart 2.4, panel a), helping to safeguard favourable financing conditions despite newly issued “pandemic debt”. Between March 2020 and September 2021, net purchases of public sector securities under the asset purchase programme (APP) and the pandemic emergency purchase programme (PEPP) surpassed the net issuance by euro area governments and European institutions (see Chart 2.5, panel b). Together with fiscal support, this has helped economies to overcome the pandemic-related crisis, but also poses challenges as the recovery takes hold and policy support is scaled back.

Successful issuances of Next Generation EU (NGEU) bonds and bills have contributed to governments’ ability to support the recovery. Investor demand for newly issued NGEU and SURE (Support to mitigate Unemployment Risks in an Emergency) bonds has been strong, and spreads relative to German government bonds have narrowed since the first SURE issuance in October 2020 (see Chart 2.5, panel c). EU spreads stand well below those of the bonds issued by some of the Member States with a considerable take-up of NGEU funds (see Chapter 1).

Corporate vulnerabilities may resurface as policy support is reduced and could be a source of instability in financial markets. Default rates for speculative-grade firms have remained well below even the most optimistic forecasts made in March 2020 (see Chart 3, panel a, in the Overview), likely in part owing to the strong fiscal and monetary policy responses to the pandemic. While the median firm may look healthy, some evidence points to the existence of a tail of vulnerable corporates, which could lead to “catch-up defaults”.^[26] A market correction might also be more severe in the presence of corporate vulnerabilities (see Box 3).

The increased reliance on market-based debt has enabled firms to benefit from a more diverse array of funding sources, but has rendered the financial system and the real economy more vulnerable to market corrections. A market correction does not automatically give rise to financial stability concerns. However, such concerns may arise when a sell-off turns disorderly, when it spills over to the wider market, or when it starts to affect the availability and cost of corporate financing. The increased importance of corporate bond markets (see Chart 2.6, panel b) leaves firms more exposed to such risks. It also increases the amount of risky, tradable debt in the system. High-yield debt is, to a large extent, being absorbed by investment funds (see Chapter 4). Open-ended investment funds are subject to redemption risk, and a liquidation of assets may amplify a sell-off.

2.3 Optimistic earnings expectations and low real yields further stretch some valuations despite growing risks

Valuations of certain asset classes are vulnerable if high earnings expectations fail to materialise. During the third quarter of 2021, equity markets reached record highs in both the euro area and the United States, as earnings expectations were increasingly revised upwards. Forward and trailing earnings recovered to just above pre-pandemic levels (see Chart 2.7, panel a), while equity prices advanced considerably more over the same period of time (see Chart 2.3, panel b). Despite the positive outlook for corporate earnings in the euro area, the uncertainty surrounding the outlook remains elevated, and the gap between trailing (realised) and forward earnings indicates risks to the realisation of the optimistic expectations (see Chart 2.7, panel b).

Some markets are showing signs of stretched valuations, especially given current uncertainties. The cyclically adjusted earnings yield in excess of the risk-free rate (excess CAPE yield) is hovering around post-global financial crisis lows, suggesting that equity valuations are stretched, particularly in the United States (see Chart 2.8, panel a). The post-vaccine rally in equity markets may also partly have been driven by the use of leverage, which could precipitate large concentrated losses if volatility increases. For example, in the United States debit balances in customers’ securities margin accounts, a measure of investor leverage, stand close to all-time highs.^[28]

Structural developments in markets also point to a degree of complacency. Since the global financial crisis, markets have tended to move more homogeneously. In equity markets, this is reflected by the increasingly narrow distribution of individual stock returns, as well as by the increasing extent to which equity returns can be explained by common factors (see Chart 2.8, panel b). The increased importance of common factors mechanically implies a diminished role for the non-common components of typically more fundamental, firm-specific factors. This may hamper the price discovery mechanism and could mean that risks are no longer priced in a way that appropriately differentiates between assets with different characteristics.^[29] These developments may be linked to the growing importance of passive investment strategies. Some market participants also point to the impact of central bank liquidity injections, which may affect asset prices in a relatively uniform manner.

Changing cross-asset correlations are limiting market participants’ ability to diversify risks. The vaccine-driven “everything rally” seen in the first half of 2021 led to changes in a number of cross-asset relationships. Notably, in the United States the correlation between bond and stock returns turned positive. Together with the growing importance of common factors, as described above, such increased cross-asset correlations hamper market participants’ ability to diversify risks.

Speculative-grade debt and equity issuance have reached record highs in 2021, with investors exhibiting a continued strong appetite for risky assets. Immediately after the March 2020 market turmoil, investment-grade corporate bond issuance surged as firms hoarded cash. Speculative-grade issuance initially stalled in 2020, but restarted during the second half of the year and has reached record highs in 2021 (see Chart 2.9). Equity and leveraged loan issuance have also surged. Markets have soaked up the newly issued debt without signs of credit spread widening. High-yield bonds have been absorbed largely by investment funds (see Chapter 4). In the United States, the start of 2021 also saw sizeable issuance volumes from special-purpose acquisition companies (SPACs), but activity has been subdued since then. SPAC issuance in the euro area also rose, but remains insignificant from a financial stability perspective. Investors also made increasing use of the right to redeem their shares, instead of participating in the acquisition of a target company. This suggests that the appetite to obtain equity exposures through SPACs has moderated.

Crypto-asset markets have grown in importance and complexity, and their market capitalisation is subject to bouts of speculation. The growing popularity of stablecoins has strengthened links between crypto-asset and conventional financial markets (see Box 4). In addition, the development of a crypto-based market infrastructure under the name of “decentralised finance” (DeFi) has increased the complexity of crypto-asset markets. DeFi typically involves the use of smart contracts covering financial services such as lending, insurance, exchanging crypto-assets, derivatives platforms and staking.^[30] Finally, some crypto-asset investors use leverage, which increases the potential relevance of the segment for financial stability as such practices can lead to large, concentrated losses.^[31]

3 Euro area banking sector

3.1 Asset quality performing better than anticipated so far

The aggregate non-performing loan (NPL) ratio of euro area banks declined further during the first half of 2021, mainly due to the disposal of legacy NPLs. The aggregate NPL ratio stood at 2.4% at the end of the second quarter of 2021, down 31 basis points compared with the end of the previous year, confirming the downward trend observed since 2014. When excluding central bank reserves from the denominator,^[34] the aggregate NPL ratio came out at 3.0%, falling at a slower pace than during the pre-pandemic period. The second quarter of 2021 still registered the highest decrease in the NPL ratio since the outbreak of the pandemic, mainly on the back of decreasing NPL stocks (see Chart 3.1, panel a). Banks in Greece and Cyprus reduced their NPL ratios by more than 8 percentage points after the outbreak of the pandemic, while in all other euro area countries changes in NPL ratios were still far from pre-pandemic levels (see Special Feature C and Chart 3.1, panel b). At the sector level, NPL ratios remain highest in the corporate portfolio, at 4.6% in the second quarter of 2021, mainly driven by loans to small and medium-sized enterprises.

Forward-looking credit risk metrics indicate a slowdown in asset quality deterioration during the first half of 2021, although heterogeneous across sectors. Following the surge registered at the outbreak of the pandemic, the increase in latent credit risk, as measured by net loan inflows to the “underperforming” Stage 2 asset class, was more contained in the second quarter of 2021 (see Chart 3.2, panel a).^[35] The increase was driven both by reduced inflows (almost halved compared with the same quarter of 2020) and by record-high outflows, mostly back to Stage 1. That said, inflows are still more than double pre-pandemic levels; and in the first half of 2021 the share of loans migrating from “performing” Stage 1 to Stage 2 over a period of six months decreased by only 0.5 percentage points in pandemic-sensitive sectors versus 1.1 percentage points in other sectors relative to the second half of 2020 (see Chart 3.2, panel b). Within pandemic-sensitive sectors, declines in Stage 2 inflows were only seen in some (e.g. F – construction, H – transport, M – professional and N – administrative services), while inflows continued to increase in others (e.g. I – accommodation and R – arts and entertainment).

Loans reclassified to the “underperforming” Stage 2 category tended to have pre-existing vulnerabilities or be in banks closer to key capital thresholds. Firms whose loans were reclassified to Stages 2 and 3 during 2020 entered the crisis with higher debt-to-assets ratios, a lower return on assets and lower liquidity ratios, compared with firms whose loans remained in Stage 1 (see Chart 3.3, panel a). Loans to firms in sectors most affected by the lockdowns, notably services, were more likely to be reclassified to higher stages, although the noisiness of the relationship between turnover shocks and loan migrations suggests that other factors were significant too. Indeed, regression analysis suggests that banks with low capital buffers reclassified a larger share of loans to Stage 2 and Stage 3, holding borrower characteristics constant. However, reclassification of loans by banks with low capital buffers appeared less sensitive to corporate borrowers’ pre-pandemic vulnerabilities, especially their liquidity ratio, than reclassification by better capitalised banks (see Chart 3.3, panel b, dark blue and yellow lines). In line with the literature on zombie banks and zombie firms, this may hint at forbearance being granted to weaker borrowers.^[36]

Nearly all euro area loan moratorium schemes have now expired with a limited immediate impact on banks’ asset quality, but risks of losses from loans still under moratoria have increased. Around 88% of moratoria granted to loans had expired as at June 2021 (see Chart 3.4, panel a) and the active moratoria still represent a material share (i.e. at least 5%) of total corporate loans only for banks in two euro area countries. While the expiry of moratoria has not immediately translated into a deterioration of banks’ asset quality, the coverage ratio of NPLs under moratoria increased from 24% in June 2020 to 36% in June 2021, signalling a higher concentration of risks in this portfolio. This development is observed in most euro area countries and suggests that, while stronger borrowers have gradually resumed payments, weaker borrowers – which usually require higher provisioning – are still taking advantage of this measure. At the same time, the share of loans taken up under government guarantee schemes reached its steady state at the beginning of 2021 and represents 3.4% of total loans to the non-financial private sector.

Despite the positive signs, the full impact of the pandemic on bank asset quality could take another two years to become visible. The future level of NPLs depends on the strength and continuation of the economic recovery, as well as the effectiveness of policy measures in preventing corporate defaults. An analysis of loan performance in all euro area countries for nine economic sectors from 2014 to 2020 finds that NPL ratios rise around four years after aggregate corporate profitability and liquidity ratios worsen, and two years after an increase in the debt-to-assets ratio.^[37] Combining these historical relationships with the observed country-sector-level data and turnover paths consistent with the September 2021 ECB macroeconomic projections^[38] suggests that the corporate NPL ratio could continue its gentle downward trend in most country-sector groups over the next few years (see Chart 3.4, panel b). At the same time, this approach implies that NPL ratios for the weakest country-sectors (i.e. the 90th percentile of the distribution of NPL ratios) will rise in 2023 and decrease again in 2024.

Overall, the outlook for euro area banks’ asset quality has gradually improved over the last year, in line with the economic recovery. Standard indicators of asset quality do not yet signal a material deterioration in credit quality, most likely influenced by two factors. First, policy measures seem to have provided adequate support to euro area firms; and second, the latest ECB macroeconomic projections expect real GDP to grow by 5.0% in 2021 and 4.6% in 2022 (compared with 3.9% and 4.2% respectively, predicted in December 2020) despite continued uncertainty related to the future development of the COVID-19 pandemic. In this context of uncertainty, supervisors have also identified several deficiencies in banks' credit risk management frameworks, which will have to be addressed and may have potentially negative impacts on asset quality indicators.^[39]

3.2 Profitability recovering towards pre-pandemic levels

Euro area banks’ profitability improved in the first half of 2021 on the back of lower loan loss provisions and higher revenues. After a substantial decline in 2020 due to pandemic-induced impairments, especially during the second and fourth quarters, the aggregate return on equity (ROE) of euro area significant institutions rose from 1.3% at the end of 2020 to 5.2% in the second quarter of 2021.^[40] For euro area banks on aggregate, the largest part of the profitability improvement can be attributed to lower impairment costs reflecting reduced downside risks to growth after the vaccine approval and the gradual reduction in containment measures. However, differences across banks remain pronounced. For better performing banks, the profitability improvement was mainly driven by higher operating profit, while worse performing banks saw a decline in their operating profit which was compensated for by lower impairments and positive contributions from one-off other profit and loss items (see Chart 3.5, panel a). The third quarter earnings releases of listed banks reveal that the profitability of euro area banks improved slightly compared with the previous quarter on the back of higher operating profits. This was mainly driven by improved NII and NFCI.

Trading as well as fee and commission income supported profitability, while interest income declined. Significant institutions’ aggregate operating profit rose in the first six months of 2021 amid higher net trading income (NTI) as well as net fee and commission income (NFCI), which compensated for the decline in net interest income (NII). As this outcome for the euro area aggregate was mainly driven by the strong contribution of trading income, it benefited institutions with a larger role of investment banking (see Box 5). The heterogeneity across banks is also visible in the changes in operating profit. More profitable banks exhibited higher operating profit on the back of rising NII in particular but also due to higher NFCI and NTI. For less profitable banks, operating profit fell as cost-cutting could not compensate for the decline in NFCI and, especially, in NII (see Chart 3.5, panel b).

Net interest income remains subdued, but its decline has slowed recently. While net interest income accounts for almost 60% of the aggregate net income of euro area significant institutions, it has declined by 6% since the fourth quarter of 2015 owing to margin compression in a low interest rate environment. An open question in the light of declining margins is whether the interest earned on new lending is commensurate with the credit risk (see Chart 3.6, panel a). Starting from around 2018, banks tried to counter the margin decline by increasing loan volumes. When the pandemic hit, state guarantees helped banks to limit their credit risk while supporting the lending flow to the real economy, but the resulting decline in risk premia also intensified margin compression. With the gradual reopening of economies and the expiry of state support measures, the decline in net interest income has slowed recently (see Chart 3.6, panel b).

The profitability of euro area banks is expected to normalise further in 2022, but at a slower pace than this year. Due to the reopening of economies, the euro area macro outlook for 2021 and 2022 has improved since June (see Chapter 1). In tandem, market analysts have revised upwards their estimates of banks’ return on equity in 2021 to 7.2%, from 4.2% at the end of May (see Chart 3.7, panel a). As the GDP projection for 2022 has only improved slightly over the same period, the expected rise in bank profitability for 2022 is also more modest. The bulk of the increase in future bank profitability is due to lower loan loss provisions. With regard to the expected improvements in operating profit and net interest income, model estimates suggest that they are mainly driven by higher fee income and lending volumes respectively (see Chart 3.7, panel b). Even if downside risks from a potential resurgence of the coronavirus do not materialise, bank profitability is set to remain under pressure from the low interest rate environment. According to forward rates, the yield curve slope – an indicator of the potential for maturity transformation – is expected to increase in the coming years, but less than it was a few months ago. Bank consolidation through mergers and acquisitions can also help to address these structural challenges and act as a catalyst for improving efficiency and ultimately profitability (see Special Feature B).

Recent lending volumes have exceeded pre-pandemic levels on the back of markedly higher mortgage lending, while corporate loan growth is still expected to pick up. During 2018 and 2019, lending flows of euro area banks were broadly balanced between corporate lending and lending for house purchases. At the onset of the pandemic, corporate lending increased to meet firms’ liquidity needs, but has since become more muted, and banks’ new lending volumes have become dominated by mortgage lending (see Chapter 1 and Box 2). In the second half of 2021^[41], average monthly lending to the private non-financial sector exceeded the pre-pandemic levels seen during 2018-19 for the first time. But while lending for house purchases is 68% above the levels observed prior to the pandemic, lending to households for consumption is still 55% lower and lending to non-financial corporations (NFCs) only picked up recently. Between July and September it was, on average, 14% above pre-pandemic levels (see Chart 3.8, panel a). Owing to the reopening of euro area economies, indicators of consumer and industrial confidence have improved substantially and results from the euro area bank lending survey point to rising corporate loan demand. As both confidence indicators and loan demand typically lead lending growth, a pick-up in NFC loan growth can be expected going forward. At 5.5%, mortgage loan growth is at the highest level observed since the global financial crisis and is trending upwards (see Chart 3.8, panel b). To the extent that banks rely on higher loan volumes to compensate for the margin decline, intense competition might lead to a deterioration in underwriting standards, which might affect banks’ credit risk in the future. And as mortgages have been granted increasingly at fixed rates with longer maturities, interest rate risk has shifted from borrowers to banks.

Losses from operational risk events have declined compared with the previous year. The gross losses from operational risk events which occurred during the first six months of 2021 have declined by 7% to €4.2 billion (corresponding to around 0.3% of total equity) compared with the same period last year, but are 2% above the levels seen in 2019. The share of losses related to execution, delivery and process management, which had increased after the start of the pandemic and accounted for almost half of the total losses, decreased and fell below pre-pandemic levels (see Chart 3.9, panel a). In terms of the number of operational risk events in the first half of 2021, external fraud represents, at 68%, the most common event type and its share is trending upwards, but it accounts for only 11% of the total losses (see Chart 3.9, panel b).

Cyber incidents reported by euro area banks have remained broadly unchanged in 2021. While cyber incidents reported by euro area banks have increased during the pandemic, there was no major change in the overall number and structure of reported incidents during the first half of 2021. Distributed denial-of-service attacks represent the most frequent type of incident, but institutions have not been severely impacted so far. In addition, ransomware attacks, which have been increasing in other industries, have also been observed in the financial industry, mostly via banks’ third-party service providers. These attempts did not, however, lead to substantial damage to banks.

3.3 Favourable funding costs and slightly lower capital ratios

Consistent with euro area banks’ loan and profitability performance, costs of funding remain favourable and are expected to stay low in the period ahead. After a sharp increase during the first half of 2020 amid the uncertainty induced by the coronavirus, bond funding costs gradually returned to pre-pandemic levels. Having marginally increased since August in tandem with inflation expectations, bond funding costs are currently slightly higher than prior to the pandemic, while the costs of deposit funding have declined further (see Chart 3.10, panel a). Even though forward contracts suggest a slight increase in interest rates over the next three years, banks’ average bond funding costs will continue to decline since maturing bonds can be refinanced at rates that are still lower than their previous yields at issuance. The spreads banks are paying above the risk-free rate to compensate their bondholders for their inherent credit risk have also declined since March 2020, consistent with the recent decrease in the share of banks with a negative rating outlook (see Chart 3.10, panel b). But while this suggests that the bulk of the banking sector’s downside risk has receded, the share of institutions with a positive rating outlook has remained unchanged, which indicates that the sector is still considered vulnerable to structural problems, climate-related challenges^[45] and profitability pressures from the low-rate environment.

Euro area banks have seen extraordinary deposit inflows since the start of the pandemic, with the pass-through of negative rates to depositors intensifying. Higher household savings, as a consequence of containment measures and corporate borrowing to create liquidity buffers at the start of the pandemic, led to substantial deposit inflows. Between the fourth quarter of 2019 and the second quarter of 2021, the volume of household and corporate deposits at euro area significant institutions increased by €600 billion (+9%) and €500 billion (+18%) respectively, which contributed to a lower need for wholesale funding (see Chart 3.11, panel a). While deposits are typically used for payments, the recent rises seem more likely to reflect precautionary saving motives. In turn, while the pass-through of zero or negative deposit rates has largely been extremely gradual since 2014, the extraordinary deposit inflow resulting from the pandemic eventually prompted banks to lower the rates of more household deposits to zero and into negative territory (see Chart 3.11, panel b). To compensate for the gradual decline in interest income, banks have also increased fees related to current accounts, credit cards and payment transactions, which is reflected in the increasing contribution of fee and commission income.

While still at robust levels, regulatory capital ratios of euro area banks declined marginally on aggregate during the first half of 2021. While retained earnings and declining average risk weights contributed to a higher Common Equity Tier 1 (CET1) ratio, this was more than offset by pronounced balance sheet expansion as well as capital erosion (see Chart 3.12, panel a). Noteworthy are the different drivers of the changes in the CET1 ratio across country groups. Balance sheet expansion led to a lower capital ratio in countries less affected by past crises and a mix of balance sheet expansion and capital erosion were the main drivers in more affected countries. Looking at the decomposition of changes in risk-weighted assets reveals that banks in countries less affected by past crises were expanding their risk-weighted assets in the first six months of 2021, whereas banks in more affected countries were still in a risk-off mode (see Chart 3.12, panel b). The increase of risk-weighted assets in the “less affected” country group was mainly driven by higher credit risk associated with an expansion in corporate lending.

Despite signs of a substantial reduction in pandemic-related tail risks and robust capital positions, credit risks are likely to materialise with a lag. While banks are equipped with solid capital buffers above regulatory minimum requirements, they face challenges due to the expiry of public support measures alongside a potential rise in corporate insolvencies. The macroprudential stress test conducted by the ECB, given its dynamic balance sheet perspective, complements the EU-wide stress test run by the European Banking Authority and ECB Banking Supervision (see Box 6).

Equity prices of euro area banks have returned to pre-pandemic levels. The rally in bank stock prices that started in November 2020 with the vaccine approval and was later on driven by higher inflation expectations brought banks’ equity prices back to pre-pandemic levels in June (see Chart 3.13, panel a).^[46] Since then the magnitude of the anticipated economic recovery, the related inflationary implications and also bank stock prices were affected by fears of coronavirus mutations, on the one hand, and supply-chain price pressures, on the other. That bank stock prices have reached, but not yet substantially exceeded, pre-pandemic levels suggests that market participants consider the sector to have overcome pandemic-induced challenges, but that structural challenges resulting from cost inefficiencies and low profitability still prevail.

Better capitalised banks tended to outperform other banks on rising prospects of a resumption of dividend payouts and share buybacks. Since June when the lifting of caps on euro area banks’ capital distributions was discussed more actively, stocks of better capitalised banks have tended to outperform the overall sector. Even though only a small number of banks have outlined their payout plans, banks with stronger capital positions seem to have more room for manoeuvre (see Chart 3.13, panel b).

4 Non-bank financial sector

4.1 While credit risks moderate, non-banks’ vulnerability to duration risk builds amid persistently high liquidity risk

Although non-banks increased their risk-taking during the pandemic, the economic recovery has reduced their credit risk vulnerability lately. Credit rating downgrades and the absorption of the relatively high issuance by lower-rated corporates implied that the average credit quality of non-banks’ debt portfolios worsened following the start of the pandemic (see Chart 4.1, panel a). For example, the share of high-yield assets in investment funds’ bond portfolios has increased by 3 percentage points to 22% since the end of 2019. However, near-term vulnerabilities have begun to moderate as macroeconomic conditions have improved amid favourable financing conditions for firms. As a result, the number of downgrades and debt holdings with a negative rating outlook is converging back towards pre-pandemic averages (see Chapter 2), reducing the credit risk vulnerability of non-banks’ portfolios (see Chart 4.1, panel b).

Non-banks play an important role in debt securities markets (see Chart 4.2, panel a). For example, euro area investment funds (IFs) and insurance corporations and pension funds (ICPFs) hold some 50% of euro area non-financial corporate bonds. Short-term commercial paper markets are dominated by money market funds (MMFs), which alone hold about 40% and 50% of the financial and non-financial segments respectively. Moreover, non-banks hold around half of the free-floating euro area sovereign bonds not held by domestic and foreign public sectors. A disruption in market-based credit supply, triggered for example by sudden outflows from MMFs and IFs, could significantly affect the financing cost of sovereigns and firms and have sizeable effects on the real economy (see Box 7).

The duration exposure of non-banks has continued to rise, rendering their portfolios vulnerable to interest rate shocks. In their search for yield, non-banks have increased the duration of their debt securities portfolios over recent years. In the absence of hedging strategies, a 1 percentage point rise in yields would lead to bond valuation losses equivalent to 7.5% and 9% of the total fixed income portfolio of IFs and ICPFs respectively (see Chart 4.2, panel b). The wider implications of such valuation losses would depend on the macroeconomic environment. In an adverse scenario, where economic growth deteriorates and yields rise abruptly, such valuation losses could trigger outflows from IFs. Given the continued high liquidity risk among IFs, this could result in forced asset sales that amplify the shock in a procyclical manner (see Section 4.2). By contrast, an increase in yields could instead lead to net capital gains for ICPFs, as a decline in the value of their liabilities could more than offset their losses on assets due to their negative duration gap (see Section 4.3).

4.2 Bond funds could amplify market dynamics in a scenario of abruptly increasing global rates

After an extended period of strong inflows into riskier fund types, investors’ risk appetite has softened in recent months. Investor demand for riskier fund types surged at the end of 2020 on the back of rising optimism regarding the vaccination outlook and economic recovery, and this lasted well into 2021.^[52] Since mid-2021, however, there have been signs that risk-taking is moderating, with investors rebalancing towards less risky assets. There have been outflows from some riskier fund types such as small cap and emerging market equity funds, while flows into money market funds, sovereign bond funds and high-quality corporate bond funds have increased.^[53] Environmental, social and governance (ESG) funds have continued to grow rapidly and still exhibit comparably large inflows, albeit at a slightly slower pace (see Chart 4.3, panel a). Combined with other evidence, this suggests that ESG fund flows may depend less directly on financial performance than on investor sensitivity to environmental and social issues.^[54]

Flows into inflation-protected bond funds and commodity or energy-dominated funds have increased sharply since the end of 2020, on the back of positive economic and inflation outlooks. The value of tangible asset classes such as commodities, materials and energy tends to increase as economic growth and inflation pick up. Funds exposed to these asset classes received strong inflows starting from the end of 2020 as investors sought profit opportunities and looked to hedge against inflation risks (see Chapter 2). Flows into energy and materials/commodities funds have stabilised more recently, while inflows into euro area and US inflation-protected bond funds are still growing strongly (see Chart 4.3, panel b).

Investment funds have taken on lower duration risk in recent transactions, although they have still accumulated an increased duration risk exposure in recent years. Investment funds have slowed their purchases of long-duration bonds and increased their exposures to bonds with relatively short maturities (see Chart 4.4, panel a). However, these recent developments have not reversed the steady increase in duration risk in the sector’s bond portfolio, which has accumulated over several years of search-for-yield behaviour (see Chart 4.2, panel b). This elevated duration exposure will leave the unhedged parts of investment funds’ bond portfolios vulnerable to valuation losses if there is a material increase in global yields (see Chapters 1 and 2). In an adverse economic scenario characterised by deteriorating growth and an abrupt rise in yields, such valuation losses could trigger outflows from bond funds.

Investment funds have further increased their exposure to credit risk, although this risk is unlikely to materialise in the short run. Once again, the sector absorbed a large share of the record high issuance of BBB and high-yield bonds by euro area non-financial corporations in the first two quarters of 2021 (see Chapter 2 and Chart 4.4, panel b), providing financing to these companies and increasing the credit risk on funds’ bond portfolios. However, this risk is unlikely to materialise in the short term as the economy is recovering and financing conditions remain favourable on the back of official sector support (see Section 4.1).

Real estate markets may give rise to additional risks. The real estate fund segment in the euro area is fairly small, with total assets standing at €1.1 trillion in August 2021 representing 6.5% of the total investment fund sector. This segment might, however, be vulnerable to future price corrections stemming from continued weakness in the commercial real estate market or from medium-term downside risks in the residential real estate market. Funds exposed to non-prime commercial real estate segments might be especially vulnerable in the short term (see Section 1.5). In addition, given the fact that open-ended real estate funds – which account for 80% of the total assets of real estate funds – are invested in highly illiquid assets, material price corrections could trigger procyclical sales and further exacerbate negative market dynamics.^[55] This highlights the importance of better aligning the redemption terms of such funds with their asset liquidity (see Chapter 5).

Liquid asset holdings in certain bond fund categories remain low, and there is evidence of pockets of high leverage in bond and hedge funds.^[56] Both financial and synthetic leverage amplify returns in good times, but in bad times leverage amplifies losses. In addition, if leverage is built up synthetically by using derivatives for instance, margin calls could add to the liquidity needs of funds during periods of stress. Funds are also exposed more generally to high liquidity risks. Given the low liquid asset holdings in certain fund types (see Chart 4.5, panel b), large redemptions prompted by valuation losses or other shocks might force funds to sell assets that are less liquid. This could lead to a negative feedback loop between asset valuations and redemptions which could amplify adverse market dynamics. In addition, investors tend to behave more procyclically in riskier and less liquid fund segments, such as corporate bond funds (see Chart 4.5, panel a), as well as in more highly leveraged funds.^[57] These structural vulnerabilities highlight the need to strengthen the resilience of the investment fund sector from a macroprudential perspective (see Chapter 5).

4.3 Insurers’ financial condition improves, though the sector faces several medium-term headwinds

The euro area insurance sector continued to withstand the impact of the pandemic and other shocks well. Overall insurance sector profitability improved in the first half of 2021 (see Chart 4.6, panel a). Underwriting and investment income went up, in line with the economic recovery and buoyant financial markets (see Chapters 1 and 2). Claim-related losses and expenses as a proportion of earned premiums – known as the combined ratio – decreased further and remained well below 100% for most non-life insurers (see Chart 4.6, panel b). The improved combined ratios resulted from (i) subdued claims volumes in some business lines (e.g. health), and (ii) premium and rate increases at recent renewals (see Chart 4.7). This solid performance, coupled with a slight increase in long-term risk-free interest rates, enabled insurers to continue accumulating capital during the first half of the year, with the median Solvency Capital Requirement (SCR) ratio at over 214%, significantly higher than the 100% regulatory requirement (see Chart 4.6, panel b).

The outlook for insurers’ profitability and credit ratings has also been improving on the back of supportive trends for demand, pricing and cost-cutting. Demand for insurance products has increased amid growing risk awareness among corporates and households coupled with the strong and swift economic recovery (see Chapter 1). This is reflected in the growth in life (mainly driven by sales of unit-linked products) and non-life gross written premiums (see Chart 4.7, panel a). Non-life insurance lines are still benefiting from a positive pricing environment (see Chart 4.7, panel b), with renewals made at sustained double-digit price increases for the last five quarters in Europe. A second shift relates to consumer demand for digitalisation, which has accelerated insurers’ initiatives to build up new digital capabilities, paving the way for cost reductions and enhanced profitability. These improvements in the operating environment are reflected in the increasing changes from negative to stable rating outlook for some insurers.

Despite the improved outlook, insurers still face conjunctural and structural challenges, including from the cost of cyber incidents. While pandemic-related claims have been lower than expected, there is still considerable uncertainty in some euro area jurisdictions about some 2020 claims with pending resolution of coverage disputes (mainly in life, health and business interruption lines). Separately, the pandemic has accelerated the digitalisation of the economy, leading to an increase in the amount and cost of cyber incidents, including several high-profile breaches.^[58] Despite the potentially systemic^[59] and cross-border nature of cyber risk, cyber insurance still represents a small proportion of the global non-life insurance market. Patchy data and a poor understanding of cyber risks by both underwriters and policyholders remain major obstacles for greater growth in this business line and hamper the closing of the cyber insurance protection gap.

Notwithstanding some limited increases in long-term yields during the first half of 2021, the protracted low interest rate environment weighs on insurer profitability and incentivises risk-taking.^[60] While the biggest issues arise for small and medium-sized life insurers offering longer-term products with guaranteed returns, low rates affect the sector as a whole through different channels.^[61] Despite a recent improvement in profitability, pressure for further risk-taking remains high in the low interest rate environment. In particular, insurers have (i) increasingly shifted their fixed income portfolios towards higher yielding bonds (see Chart 7 in the Overview, panel b), (ii) gradually increased their exposures to higher yielding but potentially riskier alternative assets,^[62] and (iii) increased their duration exposure (see Chart 4.2, panel b). An increase in interest rates might benefit insurers’ capitalisation in a benign scenario characterised by an improvement in the economic outlook, given negative duration gaps.^[63] But in a stress scenario featuring a sharp and sudden increase in risk premia, the negative impact on insurers could be significant, especially if they faced correlated and larger than expected losses under strong liquidity pressures. For this reason, the Solvency II framework should introduce a symmetric volatility adjustment and more stringent liquidity measures for insurers with a vulnerable liquidity profile (see Section 5.3).

Climate change poses significant and increasing challenges for the euro area insurance sector.^[64] Global insured losses from natural catastrophes in the first half of 2021 made this the second-highest six-month period on record after 2011. The summer floods and wildfires in Europe, together with a worse than average Atlantic hurricane season, have also generated significant losses, setting 2021 on course to be one of the most expensive years for (re)insurers ever in terms of natural hazards.^[65] Insured losses from both primary and secondary perils have been on an upward trajectory in recent years (see Chart 4.8, panel a).^[66] In Europe, secondary perils have already caused significantly more insured losses than primary perils in the last decade. The rise in losses from weather-related secondary perils underscores how climate-related physical risks are already more frequent and have a larger average magnitude than before. In the medium term, increasing risks related to climate change may also lead to lower insurance coverage against natural catastrophes which would worsen the macroeconomic and fiscal impact of such events.^[67] This reaffirms the need to act quickly to tackle the risk of a growing insurance protection gap.

The natural catastrophe bond market continues to grow, providing stable extra funds to reinsurance capacity.^[68] Catastrophe bonds have been issued at a record-breaking pace in 2021 (see Chart 4.8, panel b), despite the increasing trend of natural catastrophe events and insured losses. In the ongoing search-for-yield environment, natural catastrophe bonds continue to attract inflows as they offer significantly uncorrelated and relatively high returns. In addition, investors prefer the more liquid, transparent and better understood nature of catastrophe bonds (which focus on primary perils) over other segments of the insurance-linked securities (ILS) market (like private ILS funds and collateralised reinsurance) that deal with the greater uncertainty of secondary perils and have suffered some unexpected losses during the last year.

5 Macroprudential policy issues

5.1 Emphasis gradually shifts from providing short-term policy support to addressing emerging vulnerabilities

As the economic recovery proceeds, macroeconomic policies that helped limit economic scarring at the height of the pandemic are being gradually adjusted. Given the rebound of the euro area economy sparked by the progress made in the vaccination campaign and the subsequent easing of containment measures, fiscal stimulus has been gradually reduced. It is expected to decline further, from 4.6% of GDP in 2021 to 1.5% and 1.2% in 2022 and 2023 respectively (see Chapter 1). Where not removed completely, fiscal support measures have become more targeted and focused on strengthening solvency of viable firms rather than broad liquidity support, through grants and quasi-equity instruments. At the same time, monetary policy has continued to underpin the recovery by maintaining accommodative financing conditions (see Chapter 2 and Box 8).

Since the May 2021 FSR, a number of financial sector policies that helped preserve financial stability during the pandemic have expired or have been adjusted further. Almost all loan moratoria and government guarantee schemes which helped to support banks’ asset quality have now elapsed, while the recommended restrictions on dividend distributions and share buybacks that had been imposed on euro area banks were lifted in September 2021 (see Chapter 3).^[69] At the onset of the pandemic, ECB Banking Supervision allowed banks to temporarily operate below the level of capital defined by Pillar 2 guidance (P2G) and the combined buffer requirement until the end of 2022 at the earliest, making the timeline for P2G replenishment conditional on economic conditions.^[70] After the latest stress test results, the ECB confirmed the previously stated timeline for P2G replenishment.

As the recovery progresses, policies should gradually shift to addressing emerging medium-term vulnerabilities in a proportionate and targeted manner. Most notably, residential real estate (RRE) vulnerabilities are on the rise. Although they vary across countries, indicators of household indebtedness, credit and price developments, and overvaluation have risen since the start of the pandemic (see Overview, Chapter 1 and Box 2), while the signs of the loose or deteriorating RRE lending standards in the euro area that had been noted before the pandemic broke out are still there (see Chart 5.1, panel a).^[71] Consistent with the role of macroprudential policy as first line of defence in preserving financial stability, a gradual shift towards addressing medium-term vulnerabilities is therefore warranted. In order not to hamper the economic recovery and the ability of banks to provide credit, such action should be proportionate and should target the identified risks.

Countries where emerging vulnerabilities are primarily driven by RRE markets should consider gradually adjusting targeted macroprudential policy measures. Some countries have adopted capital measures, such as higher risk weights, which would enhance banks’ loss-absorption capacities if accumulated housing market risks were to materialise (see Table 5.1). Moreover, several euro area countries have implemented borrower-based macroprudential policies, such as loan-to-value (LTV) or debt service-to-income (DSTI) limits.^[72] However, in some countries that received a European Systemic Risk Board (ESRB) warning or recommendation on medium-term vulnerabilities in the RRE sector in 2019,^[73] either no macroprudential measures are active or those that are seem to have room for tightening. The implementation (or further tightening) of macroprudential measures should therefore be considered in some of the countries where RRE vulnerabilities are continuing to build up, especially in relation to the deterioration of lending standards and growing household indebtedness. The timely activation of borrower-based measures helps to ensure that borrowers and banks are resilient, while they can be designed and calibrated to limit side effects.^[74] Many countries have also tailored the calibration of these measures to allow different limits for different types of borrower (e.g. first-time or buy-to-let buyers) and to allow a certain proportion of new lending to be above the limits. Such targeted limits and allowances can prevent access to mortgage credit from becoming impaired for certain groups of borrowers (e.g. young or low-income borrowers) and can therefore keep the undesired side effects of borrower-based macroprudential measures to a minimum. “Hybrid” measures, such as risk weights calibrated according to different levels of lending standards (e.g. LTV or DSTI), may also be used to increase banks’ resilience while targeting the riskiest borrower segments.

As signs of medium-term vulnerabilities continue to emerge, authorities could start considering gradual increases in macroprudential capital buffers, where economic and financial conditions allow. Where justified by rising cyclical systemic risk indicators and relevant credit indicators (see Chart 5.1, panel b), increases in the countercyclical capital buffer could be considered. Considering timely CCyB increases is important to allow for the default one-year implementation lag after announcement as well as gradual policy changes. Such increases should take place when supported by favourable economic and banking sector conditions, such as sufficient capital generation capacity, to avoid hampering the economic recovery and impairing the provision of credit. It is reassuring that the latest stress test results show that under the baseline economic scenario, banks would be able to increase their relatively strong capital ratios still further.^[75] This implies that unless economic conditions deteriorate markedly, there are unlikely to be bank credit supply constraints in most euro area countries. Overall, the prudential action should be mindful of the potential effect of the European banking supervision timeline for replenishing the P2G and the implementation of the final leg of Basel III reforms on the supply of credit.

More generally, relatively favourable macro-financial conditions in some countries may provide an opportunity to create additional macroprudential policy space by increasing the amount of releasable capital buffers. The pandemic has been a reminder that large, disruptive systemic shocks may occur independently of a country’s position in the financial cycle to respond to unexpected shocks. A higher amount of releasable buffers would strengthen the ability of macroprudential authorities to act countercyclically even in the event of such shocks.

5.2 Enhancing the regulatory framework to ensure the long-term resilience of the financial system

Structural improvements to the regulatory framework, in both the bank and the non-bank sectors, will support the financial system and bring long-term benefits. In the banking sector, on 27 October 2021 the European Commission issued legislative proposals for the EU-wide implementation of the final set of Basel III reforms agreed by the Basel Committee on Banking Supervision (BCBS) in 2017. For non-banks, policy options to address risks in money market funds (MMFs) are being finalised at both the international and the European level, while future policy should target a broader set of entities and activities, including investment funds and margining practices.

5.2.1 Finalising the implementation of Basel III

Implementing the final Basel III reforms is essential to address the shortcomings of the existing framework and to further enhance the long-term resilience of the financial system. Recent events have demonstrated that the international regulatory initiatives introduced after the global financial crisis made the financial system more resilient and more able to withstand a large unexpected shock such as that caused by the COVID-19 pandemic. The final package of Basel III reforms aims to address the remaining shortcomings in the existing framework, among other things by introducing an output floor.^[77]

The ECB, the European Banking Authority (EBA) and a large group of European national supervisors and central banks are committed to the full, timely and consistent implementation of the final set of Basel III reforms.^[78] The EU must continue to uphold its commitment to international financial standards and cooperation. Implementation approaches that are inconsistent with international agreements should be avoided and, in any case, do not remedy deficiencies in the existing framework. The Commission’s legislative proposals for amending the Capital Requirements Regulation and the Capital Requirements Directive (“CRR III” and “CRD VI”) to implement the final Basel III reforms, published on 27 October, are therefore welcomed. The ECB will publish its opinion on the proposals in due course.

The finalisation of the Basel III reforms as internationally agreed will lead to a level playing field across banks, with only moderate phase-in costs. The impact of the reforms will vary across banks, depending on their business models, size and degree of reliance on internal models. The overall increase in capital is not expected to be significant, save for a few banks that have benefited the most from reduced capital requirements thanks to risk optimisation from the use of internal models. Recent impact studies by the ECB and the EBA show that implementing the final Basel III reforms is likely to entail only modest transitional costs which will be outweighed by the long-run economic benefits.^[79] Further delays in the implementation of the final leg of the reforms would only postpone, without any appreciable benefits, the necessary adjustments in the banking sector.^[80]

5.2.2 Strengthening the policy framework for non-banks

The policy framework for non-banks should be strengthened to ensure the financial system is resilient. Given the increasing role played by non-banks in financing the real economy and their interconnections with the wider financial system, it is crucial for risks in the sector to be tackled from a system-wide perspective. The market turmoil in March 2020 highlighted the need to strengthen the policy framework for non-bank financial intermediaries,^[81] and there has been considerable progress with regard to the international policy agenda for MMFs in 2021. The next step is to develop policies for open-ended investment funds and margining practices.^[82] Strengthening the resilience of non-banks from a macroprudential perspective will help mitigate systemic risk in good times, while also reducing the likelihood of the need for costly policy interventions in a crisis.

The reforms should be embedded in international policy coordination. The Financial Stability Board (FSB) has recently issued policy proposals to tackle vulnerabilities in MMFs internationally.^[83] The FSB proposals aim to increase the resilience of MMFs by reducing liquidity mismatches and unintended cliff effects arising from any breaches of regulatory requirements, enhancing loss absorption and imposing costs on redeeming investors. Against this background, the ESRB is discussing policy options which could inform the European Commission’s review of the EU’s MMF Regulation^[84] in 2022.

Strengthening the asset liquidity of private debt funds should be a key element of MMF reforms in the EU. The overall liquidity requirements should be raised and private debt MMFs required to hold a minimum share of their assets in liquid short-term public debt as a complement to the existing daily and weekly maturing asset requirements.^[85] This would limit liquidity mismatches in these funds and diversify their sources of liquidity, thereby helping managers to meet large and unexpected outflows. ECB analysis shows that public debt holdings of, say, 15% would have allowed around 61% of low-volatility net asset value (LVNAV) funds (and 67% of variable net asset value (VNAV) funds) to meet their weekly outflows during the March 2020 market turmoil without having to draw down their other liquidity buffers or sell private debt assets (see Chart 5.2, panel a).^[86] To further increase the resilience of MMFs, any impediments to the use of all their liquidity buffers during a crisis should be removed. In addition, the consistent implementation of liquidity management tools, such as anti-dilution levies, could complement the reform agenda.

The calibration of liquidity requirements should take into account possible costs and constraints, while aiming to strengthen the resilience of MMFs. First, if MMFs are required to hold a certain share of public debt, this might lead to a reduction in short-term funding to banks and non-financial corporations (NFCs). This effect would probably be small for NFCs, as MMFs would be more likely to reduce their holdings of higher-rated bank debt than NFC debt, whereas banks would have good alternative sources of short-term funding, including deposits and interbank liabilities.^[87] Second, the requirements would increase the footprint of MMFs in short-term public debt markets. However, ECB analysis shows that the amount outstanding of euro-denominated short-term public debt would be more than sufficient to absorb the expected increased demand from a 5-15% public debt requirement (see Chart 5.2, panel b). Finally, public debt requirements might reduce the yields that MMFs could offer should a part of the private debt assets be replaced by lower-yielding public debt. Overall, the calibration should ensure that any costs would be outweighed by the benefit of increased resilience.

In addition, policies for the broader investment fund sector should address liquidity mismatches as a key priority. An important objective is to ensure that asset liquidity is better aligned with redemption terms. For funds investing in illiquid assets such as real estate, minimum notice periods or lower redemption frequencies are often in place in many jurisdictions. Similar measures could also be considered for funds that currently offer daily liquidity but invest in relatively illiquid assets such as loans or high-yield debt. Liquidity buffers or limits on less liquid assets would likewise help to bolster the resilience of funds that offer daily redemptions and invest in less liquid assets. Liquidity management tools, such as swing pricing or anti-dilution levies, may be complementary and can help to reduce first-mover advantages. However, such tools are often difficult to calibrate and can be difficult to deploy in crisis situations without generating adverse effects. In addition, they are not effective in reducing the underlying liquidity mismatch vulnerability.

Furthermore, it is important to understand and tackle the risks associated with leverage in the non-bank financial sector. To monitor and address vulnerabilities arising from the use of leverage, it is important to have globally consistent leverage metrics. Further work should be undertaken internationally to assess the extent and distribution of non-bank leverage, including from the use of derivatives to generate synthetic exposure. This will help inform the policy discussion with a view to mitigating the systemic risk arising from the use of leverage outside the banking sector.

International work on margining practices should aim to increase transparency, reduce excessive margin procyclicality and ensure that non-banks are better prepared for margin calls. As the initial margins collected by some central counterparties (CCPs) may be overly procyclical (too low in good times and/or too high in bad times), their fluctuations can amplify liquidity stress and lead to selling pressures in financial markets. Changes in initial margins during March 2020 suggest that it is important to better understand the models used by CCPs to calibrate initial margin requirements and to possibly review such models (see Box 9).^[88] The transparency and predictability of initial margin models used by both CCPs and clearing members should also be improved to ensure that both banks and non-banks are better prepared for margin calls. In addition, all types of non-bank should have adequate liquidity management frameworks in place which ensure they are sufficiently prepared to meet margin calls. This will mitigate liquidity risk across the system, including among MMFs which are used for storing cash, as well as among investment funds, insurers and pension funds, which use derivatives and are therefore subject to margin calls.^[89]

5.3 Other ongoing policy initiatives that support euro area financial stability

Special features

Bank capital buffers and lending in the euro area during the pandemic

Prepared by Cyril Couaillier, Marco Lo Duca, Alessio Reghezza, Costanza Rodriguez d’Acri and Alessandro Scopelliti

Bank capital buffers are supposed to help banks to absorb losses while maintaining the provision of key financial services to the real economy in times of stress. Capital buffers that are usable along these lines should lessen the damaging effects that can arise from credit supply shortages. Making use of buffers entails using the capital space on top of regulatory buffers and minimum requirements and, in case of need, also using regulatory buffers. This special feature analyses bank lending behaviour during the pandemic to gain insights into banks’ propensity to use capital buffers and the impact of the regulatory capital relief measures implemented by the authorities. From a macro perspective, the euro area banking system as a whole was able to meet credit demand and withstand stress. However, this aggregate view reflects several factors, including the impact of extraordinary policy measures. A micro perspective thus can help to comprehend how the capital buffer framework and capital releases affected banks’ behaviour during the pandemic. The microeconometric analysis performed in this special feature shows that the banks that had limited capital space above regulatory buffers adjusted their balance sheets by reducing lending which could be interpreted as an attempt to defend capital ratios. This suggests that they were unwilling to use capital buffers. The results also show that the regulatory capital relief measures adopted during the pandemic, which added to banks’ existing capital space, were associated with higher credit supply. While more research is desirable, also on macro aspects, these findings suggests that more releasable capital could enhance macroprudential authorities’ ability to act countercyclically when a crisis occurs.

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Bank mergers and acquisitions in the euro area: drivers and implications for bank performance

Prepared by Isabel Figueiras, Sándor Gardó, Maciej Grodzicki, Benjamin Klaus and Laura Lebastard

Bank mergers and acquisitions (M&As) have been subdued in the euro area since the global financial crisis. Most M&A activity has had a domestic focus and has involved smaller targets, with larger and sounder acquirers acting as consolidators. Consolidation seems on average to have had a moderately positive impact on the profitability of the banks involved, although high levels of variance reveal the presence of large execution and design risks amid low overall returns on capital in the banking sector. Improved post-transaction profitability can be linked to targets’ lower cost efficiency, liquidity and capitalisation. Cross-border M&A transactions have been concentrated within a few small groups of euro area countries, supported by prior financial links and geographical proximity. Such transactions tend to be followed by a stronger improvement in profitability than domestic mergers, although this effect has diminished since the global financial crisis.

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Creditor coordination in resolving non-performing corporate loans

Prepared by John Fell, Miha Cajnko, Maximilian Fandl, Maciej Grodzicki, Claudia Mayer, Edward O’Brien, Martina Spaggiari and Pär Torstensson^[93]

Numerous European and national initiatives have been launched since 2014 to reduce non-performing loan (NPL) stocks on euro area bank balance sheets. NPL ratios have fallen as a result, but very gradually, mainly thanks to sales to non-bank investors. Despite stronger market activity, prices paid by NPL investors have only improved marginally and continue to stand well below values assigned to NPLs by banks. One type of NPL that has proven particularly difficult to resolve is loans to non-financial firms that have borrowed from multiple banks – multi-creditor loans. Analysis of these and other loans finds lower provision coverage by the lending banks, reflecting more optimistic valuations by individual banks and limited recognition of the expected costs of multi-creditor coordination. This special feature proposes a strategy to overcome creditor coordination failures and costs, through the use of data platforms providing ex ante transparency to NPL investors. These, together with NPL securitisation, could substantially reduce the gap between the value of the loans carried on banks’ balance sheets and the prices offered by investors for NPL portfolios.

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