Today the European Central Bank (ECB) issued its December 2009 edition of the ECB Financial Stability Review. The Review which is published twice a year was last issued in June. The analysis contained in the Review was provided by the Banking Supervision Committee which a forum for cooperation among the national central banks and supervisory authorities of the European Union and the ECB. Mr. Lucas Papademos, Vice President of the ECB noted that a “primary objective of the Review is to consider 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.”

The Review acknowledges that the extraordinary remedial measures implemented by central banks and governments in response to the financial crisis have been successful in part in bolstering confidence in, and improving the stability of, financial systems around the world. The Review also attributes a decrease in systemic risk to “an abatement of tail risk, thanks primarily to the downside protection by governments of financial institutions’ balance sheets.”

The Review also notes that improved financial conditions have strengthened the profitability of many of large and complex banking groups (LCBGs) “to such an extent that they were able to absorb considerable write-downs on securities and loans while still, on average, reporting material improvements in profitability over three consecutive quarters.” However, despite measured improvement in the financial markets and financial performance of euro area LCBGs, the Review identifies the following risks that may impact the long term outlook for the financial stability in the euro area:

  • weaknesses revealed in the balance sheets of non-financial institutions due to “high leverage, low profitability and tight financing conditions;”
  • increased household sector credit losses due to rise in unemployment;
  • increase in government indebtedness which may raise “concerns about the sustainability of the public finances, as well as the crowding out of private investment;” and
  • an adverse feedback between the financial sector and public finances due to the implementation of financial system support measures and other factors.

The Review also identifies the possibility of the following risks threatening the stability of the euro area financial system:

  • recent bank profitability proving insufficient and renewed financial strains;
  • weaknesses of financial institutions "associated with concentrations of lending exposures to commercial property markets and to central and eastern European countries being unearthed;" and
  • failure of macroeconomic outcomes “to live up to optimistic expectations” that will lead to a setback for the recent recovery of financial markets.

The Review stresses that “exit decisions by governments will need to carefully balance the risks of exiting too early against those of exiting too late.” Exiting before the underlying strength of key financial institutions are reinforced may lead to adverse consequences including the possibility of “triggering renewed financial system stresses.” Further, challenges facing the euro area banking sector in the future will “call for caution in avoiding timing errors in disengaging from public support.”

In addition, the Review cautions that “[t]o cushion the risks that lie ahead, banks will need to be especially mindful in ensuring that they have adequate capital and liquidity buffers in place.” The Review also notes that in certain instances “banks may need to raise new and high-quality capital,” in addition, banks that have been recipients of state support, “may need fundamental restructuring in order to confirm their long-term viability when such support is no longer available.” The Review emphasizes, however, that “banks should take full advantage of the recent recovery in their profitability to strengthen their capital positions, so that the necessary restructuring of businesses and the enhancement of shock-absorbing capacities do not impinge materially on the provision of credit to the economy.”