Publication of the December 2005 ECB Financial Stability Review

The European Central Bank (ECB) today publishes its December 2005 Financial Stability Review.

The review, which has been published biannually since December 2004, assesses the stability of the euro area financial system with regard to both the role it plays in facilitating economic processes and its ability to prevent adverse shocks from having an inordinately disruptive impact.

The purpose of publishing this review is to promote awareness in the financial industry and among the public of issues relevant to safeguarding the stability of the euro area financial system. By providing an overview of sources of risk and vulnerability with regard to financial stability, the review also seeks to play a role in preventing financial crises.

There are three important aspects of producing a comprehensive assessment of financial stability. The first entails forming a judgement about the individual and collective strength and robustness of the constituent parts of the financial system – institutions, markets and infrastructures. The second involves identifying the plausible and systemically important sources of risks and vulnerabilities that could pose challenges to financial stability in the future. The third is an appraisal of the potential costs – that is, the ability of the financial system to cope – should some combination of these identified risks and vulnerabilities materialise.

It should be stressed that calling attention to such sources of risk and vulnerability does not mean seeking to identify the most probable outcome. Rather, it entails highlighting potential and plausible downside risks, even if these are unlikely to materialise.

The analysis contained in the review has been prepared with the close involvement of the Banking Supervision Committee (BSC), which is a forum for cooperation among the national central banks and the supervisory authorities of the EU and the ECB.

The main points of the overall assessment of the stability of the euro area financial system contained in the review can be summarised as follows:

The strength and resilience of the euro area financial system has further improved over the past six months, contributing to a positive outlook for financial stability. At the same time, however, financial imbalances have grown larger and seem likely to continue expanding, primarily at the global, but also at the euro area, level.

Continued strength in the pace of global economic growth in 2005 (despite further oil price rises), low interest rates in the euro area and indications of a further improvement in corporate sector credit quality provided a favourable environment for financial institutions and markets. Global credit markets successfully weathered a test of their resilience in the first half of the year, prompted by the downgrading of two large US automobile manufacturers. In addition, the conditions for raising funds in equity markets remained favourable, and financial market volatility stayed very low across most asset classes. In this environment, there was further and broad-based improvement in the profitability of banks, and the balance sheets of insurance companies were strengthened. In addition, key financial infrastructures – including payments systems, such as TARGET, and securities clearing and settlement systems – remained robust and continued to operate smoothly.

However, several potential sources of risk and vulnerability have grown in importance in the past six months. Despite recent improvements, the durability of euro area banking sector profitability could be tested in the period ahead, especially if long-term interest rates remain low for a protracted period. Declining loan loss provisioning flows could also adversely affect the ability of banks to cope with unforeseen disturbances. In addition, the possibility exists that a reappraisal could take place with regard to far-reaching market risks stemming from the aggressive search for yield that began in the course of 2003. This has left some financial markets and institutions vulnerable to changes in global liquidity conditions and unexpected credit events. A disorderly correction of the level of long-term yields could potentially disrupt the intermediation of funds through global capital markets, which would have implications for the euro area. Moreover, some euro area financial institutions, including banks, would be likely to endure losses – at least in the short term – from an upturn in long-term interest rates. On the other hand, the life insurance industry would most likely benefit as this would help to relieve remaining balance sheet vulnerabilities. Looking ahead, the risk of an abrupt unwinding of global imbalances remains, especially because these imbalances may yet widen further. It also cannot be excluded that further oil price increases could test the resilience of firms’ balance sheets, especially those of small and medium-sized enterprises. Household balance sheets may also be vulnerable in countries where house prices seem to have risen beyond their intrinsic value.

Overall, with shock-absorption capacities improving, but risks and vulnerabilities rising, the financial stability outlook continues to rest upon a delicate balance. While the probable outcomes could, at this stage, best be described as bi-modal, a positive outcome remains the most likely prospect in the period ahead.

Further information

The review 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 at the address given below.