EU banking sector stability

The European Central Bank (ECB) is today publishing a report on the stability of the EU banking sector. This is the second publication of its kind. The report was prepared by the Banking Supervision Committee of the European System of Central Banks, which comprises representatives from the national central banks and banking supervisory authorities of the EU and the ECB.

The main purpose of the report is to assess the financial soundness and risk-absorbing capability of the EU banking sector. In particular, the report examines the implications of recent developments in the economy and financial markets on EU banks' performance in 2002 and the first half of 2003. It hence summarises the outcome of the Committee's regular monitoring of sources of vulnerability in the EU banking sector. A wide range of quantitative and qualitative information, including expert views provided by the Committee's member organisations, forms the basis of the analysis.

The report takes as a baseline the expectation that the current moderate pick-up in economic activity will broaden and strengthen in the course of 2004. Moreover, it sees the short-term risks to this scenario as being broadly balanced. However, a prudent approach to analysing banking sector stability entails highlighting and evaluating the implications for banks of potential, albeit relatively remote, sources of downside risk to the most probable outcome.

The contents of the report can be summarised as follows:

Profitability and solvency of EU banks 2002 – mid-2003. EU banks were confronted with a challenging operating environment in 2002, largely owing to the global economic slowdown, which also affected the EU, as well as to further downward correction in turbulent global stock markets. While profitability deteriorated in 2002, the banking sector proved to be resilient. Moreover, an effective response by EU banks to their business environment – involving cost-cutting, business reorganisation and better risk management – contributed to improving profits in the first half of 2003. By mid-2003, the levels of regulatory solvency ratios of EU banks remained favourable, thereby contributing positively to banking sector stability. The ratios of some banks, however, benefited from extraordinary asset sales, which contributed to a lowering of risk-weighted assets, rather than from either new equity issuance or from internal income generation. Nonetheless, the assessment is that EU banks are in an adequate financial condition, having buffers which should enable them to withstand past losses and further plausible downside risk scenarios.

Recent indications of banks' financial conditions. Reflecting perceptions in markets that corrective measures would likely support ongoing viability, forward-looking market-based indicators of the financial health of the banking sector (equity market-based signals, subordinated debt spreads, and ratings) began to stabilise, with some indicators improving, from the second quarter of 2003 onwards. The more favourable appraisal of banking sector conditions continued, despite the emergence of turbulent conditions in global bond markets in the summer months, as bond yields, which had been falling, swiftly changed direction. As the trading book exposure of banks to bonds is typically small, market participants have assessed the impact on banks as being rather limited. Despite all this, several market indicators continued to suggest that risks to the outlook for banks had not fully receded by October. Hence, although there were indications of improving performances in the first half of 2003, close monitoring of bank performances in the second half of the year continues to be required.

EU banks' risk outlook. Looking ahead, the key to future banking sector performance will be the momentum of the economic recovery. The gradual pick-up in economic activity that is expected should bring with it a commensurate gradual recovery in bank income. This should allow banks to consolidate their financial condition. Moreover, if continued, cost containment should support banking sector stability in the medium to long run. However, adverse deviations from the most likely scenario could intensify some of the risks facing EU banks. In particular, slower than expected growth could have an impact on important income sources for banks from retail operations. Although the emergence of significant asset quality problems is not expected, as banks have generally adopted sound lending standards, some risks for banks do remain, relating to specific industries and households. For households, real estate price developments could prove to be an important factor in the period ahead. Nevertheless, in the medium term, EU banking sector stability is not considered to be at risk.

The report can be downloaded from the "Publications" section of the ECB's website (http://www.ecb.europa.eu/pub). Printed copies are also available free of charge from the ECB's Press and Information Division (fax: +49 69 1344 7404).