Summary of the June 2010

Financial Stability RevieW

The primary objective of the ECB’s Financial Stability Review (FSR) is to identify the main sources
of risk to the stability of the euro area financial system and provide a comprehensive assessment of
the capacity of the financial system to absorb adverse disturbances.

Many euro area large and complex banking groups (LCBGs) returned to modest profitability in
2009, and their financial performances strengthened further in the first quarter of 2010. These
developments, together with a bolstering of their capital buffers to well above pre-crisis levels,
suggest that most of these institutions have made important progress on the road to financial
recovery. The broad-based enhancement of shock-absorption capacities during 2009 meant that
systemic risks for the financial system dissipated to some extent and risks within the financial sector
became more institution-specific in character. Indeed, the dependence of the financial system,
especially of large institutions, on government support and the enhanced credit support measures
of the Eurosystem tended to wane. That said, the profitability performances of some large financial
institutions in receipt of government support remained relatively weak.

Outside the financial system, the progressive intensification of market concerns about sovereign
credit risk among the industrialised economies in the early months of 2010 opened up a number of
hazardous contagion channels and adverse feed back loops between financial systems and public
finances, in particular in the euro area. By early May, adverse market dynamics had taken hold
across a range of asset markets in an environment of diminishing market liquidity. Ultimately,
the functioning of some markets became so impaired that, for the euro area, it was hampering the
monetary policy transmission mechanism and thereby the effective conduct of a monetary policy
oriented towards price stability over the medium term.

To help restore a normal transmission of monetary policy, the Governing Council of the ECB
decided on 9 May 2010 on several remedial measures. Taking into account that these decisions
have not only a European but also a global outreach, the G7 and G20 welcomed the ECB’s action
in their communiqués. In parallel, the EU Council adopted a regulation establishing a European
Financial Stabilisation Mechanism. Subject to strong conditionality, this back-stop device will have
funds of up to €500 billion at its disposal. Following the implementation of these measures, market
volatility was significantly contained.

Considering the financial stability outlook, although the profile of ECB estimates of the potential
write-downs on loans confronting the euro area banking system displays a peak in 2010, it is
probable that loan losses will remain considerable in 2011 as well. This prospect, combined with
continued market and supervisory authority pressure on banks to keep leverage under tight control,
suggests that banking sector profitability is likely to remain moderate in the medium term.

Overall, although the main risks to euro area financial stability essentially remain the same as those
to which attention was drawn in the last issue of the FSR, their relative importance has changed
significantly over the past six months.

ECB
Financial Stability Review Summary
June 2010 1
 The main risks for the euro area financial system include the possibility of:

• concerns about the sustainability of public finances persisting or even increasing with an
associated crowding-out of private investment; and

• adverse feedback between the financial sector and public finances continuing

Other, albeit less material, risks identified outside the euro area financial system include the
possibility of:

• vulnerabilities being revealed in euro area non-financial corporations’ balance sheets, because
of high leverage, low profitability and tight financing conditions; and

• greater-than-expected euro area household sector credit losses if unemployment rises by more
than expected.

Within the euro area financial system, important risks include the possibility of:

• a setback to the recent recovery of the profitability of large and complex banking groups and of
adverse feedback with the provision of credit to the economy;

• vulnerabilities of financial institutions associated with concentrations of lending exposures

to commercial property markets and to central and eastern European countries; and

• heightened financial market volatility if macroeconomic outcomes fail to live up to expectations.

A key concern is that many of the vulnerabilities highlighted in this FSR could be unearthed by a
scenario involving weaker-than-expected economic growth.

The measures taken by the ECB to stabilise markets and restore their functioning as well as the
establishment of the European Financial Stabilisation Mechanism have considerably lowered tail
and contagion risks. However, sizeable fiscal imbalances remain, and the responsibility rests on
governments to frontload and accelerate fiscal consolidation so as to ensure the sustainability of
public finances, not least to avoid the risk of a crowding-out of private investment while establishing
conditions conducive to durable economic growth.

With pressure on governments to consolidate their balance sheets, disengagement from financial
sector intervention means that banks will need to be especially mindful of the risks that lie ahead.
In particular, they should ensure that they have adequate capital and liquidity buffers in place to
cushion the risks should they materialise.

Against this background, the problems of those financial institutions that remain overly reliant on
enhanced credit measures and government support will have to be tackled decisively. At the same
time, fundamental restructuring will be needed when long-term viability is likely to be threatened
by the taking away of state support. This could involve the shrinking of balance sheets through the
shedding of unviable businesses with a view to enhancing profit-generating capacities.

ECB

2 Financial Stability Review Summary

June 2010
riSKS outSiDe the euro area financial chart 1 intra-euro area yield spreads
SyStem on ten-year government bonds

(Jan. 2008 – May 2010; basis points)

Public finances in the euro area have deteriorated
Greece
rapidly, primarily on account of the activation Portugal
of automatic stabilisers and discretionary fiscal Spain
Italy
measures in many countries …
1,000 1,000
900 900
… by early may, the concerns about sovereign 800 800
700 700
credit risk contributed to adverse market dynamics 600 600
500 500
which, ultimately, hampered the monetary policy 400 400
transmission mechanism. to help restore the 300 300
200 200
normal transmission of monetary policy, the ecb 100 100
decided on several remedial measures. 0 0
2008 2009 2010

Sources: Thomson Financial Datastream and ECB calculations.

Note: The chart shows ten-year yield spreads relative
to Germany.

the rise in sovereign credit risk premia was passed chart 2 Sovereign and bank cDS spreads
through to private sector funding costs ... in selected euro area countries

(first snapshot: 26 Nov. 2009; second snapshot (*):

… which resulted in increased correlation between 19 May 2010; basis points)
credit default swap (cDS) spreads for large banks y-axis: sovereigns
and sovereign cDS spreads for the governments x-axis: banks
of the countries where the banks have their 400 650
GR* 400
headquarters. 350 350
600
600 650
300 300
PT*
250 250
GR
200 200
ES* IE*
150 IT* 150
IE
100 IT PT ES BE* 100
AT FR*
50 FR BE 50
DE* NL*
0 DE NL 0
50 100 150 200 250 300 350 400

Sources: Bloomberg and ECB calculations.

Notes: For each country, the CDS spreads of the five largest banks
for which CDS quotes were available were used to calculate the
average CDS spread of banks in that country. For some countries
there were less than five banks with quoted CDSs.

for the euro area non-financial corporate sector, chart 3 bankruptcies and real GDP growth in
balance sheet conditions have improved slightly the euro area
since the last issue of the fSr ...
(Q1 2000 – Q1 2010)

… but the high leverage of non-financial bankruptcies (index, Q4 2000 = 100, left-hand scale)
real GDP growth (percentage change per annum,
corporations, coupled with very low profitability right-hand scale)
in both 2008 and 2009 and persistently tight 200 5
190 4
lending standards, has translated into high default 180 3
rates for non-financial firms. 170 2
160 1
150 0
140 -1
130 -2
120 -3
110 -4
100 -5
90 -6
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Sources: National central banks, national statistical offices, Euler

Hermes (“Insolvency Outlook”, 2/2009) and ECB calculations.
Notes: GDP growth refers to total euro area, while data for
bankruptcies only refers to 12 euro area countries (Cyprus,
Malta, Slovakia and Slovenia not included). The index is
weighted by GDP. Bankruptcies in 2009 are partly estimated.

ECB
Financial Stability Review Summary
June 2010 3
 the condition of euro area household balance
sheets has changed little, but there are downside
income risks if unemployment in the euro area
were to remain at high levels for longer than
expected …
… however, there are signs that the sharp fall
in house prices, together with low interest rates,
has improved housing affordability, which, in
part, helps to explain the recent turnaround in
the extension of new loans to households for
house purchases.
chart 4 loans for house purchase and house
prices in the euro area
(Jan. 2000 – Mar. 2010; percentage change per annum)
loans for house purchase (right-hand scale)
house prices (left-hand scale)
8 16
7 14
6 12
5 10
4 8
3 6
2 4
1 2
0 0
-2 -2
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: ECB.

riSKS Within the euro area financial chart 5 euro area large and complex
SyStem banking groups’ profitability and breakdown
of income sources
(2006 – Q1 2010; maximum, minimum and inter-quartile
many euro area large and complex banking groups distribution)
(lcbGs) returned to modest profitability in the median net interest income
course of 2009, and their financial performances weighted average net fees and
commissions income
strengthened further in the first quarter net trading income
of 2010 … return on equity
(%; max., min., inter-quartile income sources
distribution and weighted average) (% of total assets)
… net interest income continued to be the most 40 40 1.6 1.6
important profitability driver among this group 30 30 1.4 1.4
20 20
1.2 1.2
of banks throughout 2009. also, the capital ratios 10 10
0 0 1.0 1.0
of euro area lcbGs improved substantially. -10 -10 0.8 0.8
-20 -20
0.6 0.6
-30 -30
-40 -40 0.4 0.4
-50 -50 0.2 0.2
-60 -60 0.0 0.0
-70 -70
-80 -80 -0.2 -0.2
-90 -90 -0.4 -0.4
Q1 Q3 Q1 Q1 Q3 Q1
2006 2009 2009 2010 2006 2009 2009 2010

Sources: Individual institutions’ financial reports and ECB

calculations.
Notes: The left-hand chart is based on the Tier 1 measure of
equity. Quarterly returns have been annualised.

the latest estimate of the potential cumulative chart 6 Potential write-downs on securities
write-downs on securities and loans for the euro and loans facing the euro area banking sector
area banking sector is €515 billion over the
(EUR billions)
period from 2007 to 2010, which is lower than
the estimate published in the December 2009 fSr, loans
securities
owing to a recovery in securities prices in 2009 200 200
and in early 2010 … 77 77
55 100
104
150 150
94 125134135
… at the same time, the total estimate of potential 105
100 100
50 43 43
write-downs on loans for the period from 2007
50 50
to 2010 has increased slightly and further loan
write-downs are likely during 2011. 0
28 28 28 104 104 104 32 66 51 0 0
0

-50 -32 -50

1 2 3 1 2 3 1 2 3 1 2 3 1 2 3
2007 2008 2009 2010 2011
1 June 2009 FSR
2 December 2009 FSR
3 June 2010 FSR

Sources: Association for Financial Markets in Europe, Banking

Supervision Committee, national central banks, ECB and ECB
calculations.

ECB

4 Financial Stability Review Summary

June 2010
commercial property prices and rents have
continued to fall in most countries in the euro
area, albeit at a more moderate rate …
chart 7 Potential write-downs on commercial mortgage-backed
securities (cmbSs) and commercial property mortgages facing
the euro area banking sector over the period from 2007 to 2010
(EUR billions)

… estimates of losses facing banks on their CMBSs

commercial property mortgages
commercial property loan portfolios have been
70 70
revised upwards by almost 50% over the past 60 60
six months. this more than offset the recovery 50 50
in the valuations of commercial mortgage backed 40 40
securities held by banks in the euro area. 30 30
20 20
10 10
0 0
December 2009 FSR June 2010 FSR
Sources: Association for Financial Markets in Europe, Banking
Supervision Committee, national central banks, ECB and ECB
calculations.

the economic outlook in central and eastern chart 8 consolidated lending exposures of
european (cee) countries has improved, but new selected eu banking systems to selected
vulnerabilities have emerged, especially a broad- non-euro area eu countries
(2009; percentage of GDP, per lending country)
based deterioration in the fiscal positions of these
countries … Bulgaria Hungary
Czech Republic Poland
Estonia Romania
… given that the exposures to the cee region Latvia Other
Lithuania
are rather concentrated among some euro area
50 50
member States’ banking sectors, the risks remain
material in these cases. 40 40

30 30

20 20

10 10

0 0
AT SE BE GR PT NL IT FR DE

Sources: BIS and Eurostat.

Notes: BIS statistics on consolidated foreign claims of domestically
owned banks in lending countries on individual non-euro area
EU countries on an immediate borrower basis. The largest three
exposures to each particular country are shown in the chart, while
smaller exposures are combined under other countries.

long-term (cyclically adjusted) valuation measures chart 9 implied volatility and price/earnings
suggest that equity prices are not particularly ratios (based on ten-year trailing earnings)
high by historical standards … for the euro area stock markets
(Jan. 1999 – May 2010)

… but there is a risk of a heightened financial P/E ratio

implied volatility (percentage)
market volatility, if macroeconomic outcomes fail
60 60
to live up to expectations. 55 55
50 50
45 45
40 40
35 35
30 30
25 25
20 20
15 15
10 10
5 5
0 0
1999 2001 2003 2005 2007 2009

Sources: Thomson Reuters Datastream and Bloomberg.

Note: The last observation for the implied volatility is 19 May
2010.

ECB
Financial Stability Review Summary
June 2010 5
 THIS ISSUE OF THE FINANCIAL STABILITY REVIEW ALSO CONTAINS THE FOLLOWING SPECIAL FEATURE
ARTICLES:

A Macro-prudential policy objectives and tools

B Analytical models and tools for the identification and assessment of systemic risks
C Recent regulatory initiatives to address the role of systemically important financial institutions
D Financial networks and financial stability
E Addressing risks associated with foreign currency lending in EU Member States

ECB

6 Financial Stability Review Summary

June 2010