The three European Supervisory Authorities (ESAs) have concluded in their most recent risk and financial stability reports that Europe’s financial markets are generally in sound health and improving, but that significant risks remain. Their reports are generally more optimistic than their previous ones.
As part of the European System of Financial Supervision (ESFS), the three bodies – the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) – must monitor trends and risks in Europe’s financial markets.
They must compile twice-yearly reports, as well as quarterly ‘risk dashboards’, and submit them to the European Parliament (EP), Council of the European Union, European Commission (EC), the other ESAs, and the European Systemic Risk Board (ESRB). In turn, the ESRB publishes cumulative market risk reports – the ESRB Risk Dashboard – every quarter. This monitoring and reporting procedure has been in place since 2012.
The EBA’s Risk Assessment Report
The EBA published its semi-annual report, entitled Risk Assessment of the European Banking System, in December 2013. On the positive side, it noted that there were improvements in market confidence from both debt and equity investors in the second half of 2013. Funding conditions for banks also improved across the EU, due to increased demand from EU and non-EU investors for European bank debt, and an ability to attract more deposits. Following the EBA’s re-capitalisation exercise, capital levels also continued to improve and are now in line with major banks outside Europe.
On the negative side, the report highlights several concerns. The first is about the value of bank assets. “The continuous deterioration of the quality of banks’ loan portfolios, as well as low profitability levels, may pose challenges in maintaining adequate capital levels,” it states. “Uncertainties about asset valuation were found to persist and remain a fundamental issue in the EU.” This highlights the need for the rigorous Asset Quality Reviews (AQRs), which are currently being carried out by the European Central Bank (ECB) and national regulators in each eurozone member state, and will be completed in October 2014. Similar reviews are being conducted in non-eurozone states.
Bank profitability is a second concern, one which is “not likely to dissipate in 2014”. The continued low interest rate environment is putting pressure on bank net interest margins, and earnings may not be sufficient to cover rising bad loans, “leaving question marks over some banks’ future profitability and viability”.
A third worry is the fact that many banks will have to restructure and change their business models as a result of market and regulatory changes. Regulations likely to cause the most upheaval for banks throughout the EU are the recovery and resolution plans (RRPs), and the structural reforms recommended by the High Level Expert Group; and for banks in the eurozone, the banking union with its single supervisory mechanism (SSM), single resolution mechanism (SRM) and single deposit guarantee scheme.
A fourth emerging risk that needs to be managed is the increasing number of “detrimental business practices” – or mis-selling, bad conduct and illegal activity, in plain English. These have “affected consumer confidence and increased reputational risks”, says the report. “This will require heightened supervisory oversight and improvements in institutions’ risk management functions, and a more general reassessment of the relationship between banks and their customers.”
Finally, the EBA says that policymakers and regulators at the EU and national level need to coordinate their efforts to bring about a true single market in banking. “The EU banking sector continues to be fragmented and the need for continued regulatory and supervisory convergence across the EU will remain a key challenge for the EBA,” it concludes.
ESMA’s view on trends, risks and vulnerabilities
ESMA published its Trends, Risks, Vulnerabilities report on the European securities markets last September, which covers the first half of 2013. The next report, due out imminently, will cover the second half of the year.
Last September’s report found that market conditions improved in the first half of 2013compared with the final quarter of 2012. Even so, “systemic risk persisted at medium to high levels”. Market risk remained high due to concerns over funding sources, low interest rates and market fluctuations, while liquidity, credit and contagion risk continued to be significant.
“While the easing of stress in financial markets is a positive sign, systemic risks in the EU remain high and uncertainty in the international market environment has risen,” said Steven Maijoor, ESMA’s chairman. “Valuations in securities markets, volatility in fund flows, and continuity issues around financial benchmarks remain a matter of concern. Faced with these issues regulators and market participants should remain vigilant.”
The report identified the following key trends:
- Market conditions improved moderately.
- Issuance was subdued.
- Equity prices declined.
- Inter-bank lending increased.
- Asset managers benefited from improved market conditions, mainly driven by bond, equity and alternative funds. However, money market fund (MMF) assets decreased.
- Trading increased in early 2013. Central clearing of interest rate swaps continued to grow. But “potential continuity issues around financial benchmarks” were a cause for concern.
The report identified the following major risks:
- Liquidity risk. Even though action by the authorities helped reduce liquidity risk in main market segments, others rose, “leaving the overall liquidity risk at high levels”.
- Credit risk. Despite recent debt refinancing, overall credit risk remains high.
- Market risk. Equity and bond markets risks increased, mainly due to concerns over the valuation of assets.
- Contagion risk. The risk of contagion between market segments remained unchanged, while the level of credit default swap exposures declined.
EIOPA’s monitoring of financial stability
EIOPA’s Financial Stability Report on Europe’s insurance, reinsurance and occupational pensions sectors, published in December and covering the year to 20 November 2013, was less upbeat than the other ESA reports. It made two key observations. The first was that economic conditions are still “fragile”. The second was that that the sectors face three main risks: a prolonged low-yield environment, a weak macroeconomic climate, and possible contagion risk arising from exposure to national governments and financial institutions.
For insurance companies, the weak economy and low yields are constraining sales and prompting firms to set up new operations in emerging markets in Latin America and south-east Asia. As for life companies, low yields are encouraging them to move away from guaranteed life products and focus more on unit-linked products and products with more flexible guarantee structures. Solvency I capital levels for life and non-life insurers are falling, “but remain well above the 100% minimum requirement”, said the report.
Reinsurance companies are benefiting from strong global growth. Major loss events from natural catastrophes in the first half of 2013 were relatively low compared with previous years. “Profitability for the reinsurance sector has been sustained, but remains under pressure due to the low yield environment,” noted EIOPA.
The issuance of insurance- linked securities (ILS) in 2013 reached its highest level since 2007. As a result, global reinsurer capital increased to an all-time high. On the other hand, ILSs “need close monitoring by supervisors” as their extensive use could cloud the true picture.
In the occupational pensions sector, defined benefit (DB) schemes still dominate, but the “sustained shift towards defined contribution schemes in many countries continues”. The investment allocation of pension funds remains stable, but low interest rates are making it more difficult for DB schemes to achieve their guaranteed returns.
Gabriel Bernardino, EIOPA’s chairman, said the authority is creating an analytical framework to identify more accurately the “risks and vulnerabilities” in the insurance and pensions’ sectors. However, he added that “the efficiency of the framework will strongly depend on the availability of data provided to EIOPA by national supervisors”.
It is clear from these reports that Europe’s financial system is in a better state than it was. But, as ever, there are plenty of risks looming large, or lurking just over the horizon.
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