Eurozone financial stability under ‘severe’ threat

Alarm bells are ringing in the upper echelons of the EU that the bloc’s financial system is on a shaky footing, thanks to the energy shock, the war in Ukraine, inflation and rising interest rates.

The EU’s danger detector has sounded its first major alarm about “severe systemic risk” in the economic bloc since its creation in 2010. The European Systemic Risk Board (ESRB) was formed on the eve of the eurozone’s sovereign debt crisis, as a response to the lingering impact of the global financial crisis.

It first highlighted “heightened uncertainty” and an increased probability of tail-risk scenarios materialising earlier this year, but released an official general warning on September 22.

“The probability of tail-risk scenarios materialising has increased since the beginning of 2022 and has been exacerbated by recent geopolitical developments,” the ESRB wrote. “Risks to financial stability may materialise simultaneously, thereby interacting with each other and amplifying each other’s impact.

“Rising geopolitical tensions have led to an increase in energy prices, causing financial distress to businesses and households that are still recovering from the adverse economic consequences of the Covid-19 pandemic. In addition, higher-than-expected inflation is tightening financial conditions.”

Weak spots

The economic outlook in Europe looks increasingly fragile. Gross domestic product growth forecasts have been cut for 2023 and the probability of a recession during the coming winter is increasing. The ESRB cites three severe systemic risks to financial stability. These are:

• A deterioration of the macroeconomic outlook

• A possible sharp asset price correction

• The implications of such developments for asset quality

First, a deterioration in the macroeconomic outlook plus a tightening of financing conditions suggests heightened balance sheet stress for companies and households, and their ability to manage their debt as inflation eats into their income. Countries and sectors most affected by rapidly rising energy prices are most vulnerable, which includes the Baltics, the Netherlands, Italy and Cyprus.

Add in rising mortgage rates, and house prices could take a knock. “In turn, this could trigger the materialisation of accumulated cyclical risks in real estate markets,” the ESRB wrote. “In addition, the probability of large-scale cyber incidents impacting the financial system has increased.”

Second, the ESRB warned that risks to financial stability stemming from a sharp fall in asset prices “remain severe”. This could trigger large mark-to-market losses, which may spike market volatility and put a strain on liquidity.

Some market players such as utilities and energy trading houses are already under strain from outlandish margin calls, triggered by the increase in the level and volatility of energy and commodity prices.

German utility Uniper, for example, borrowed billions over the past year to meet its margin calls, but ultimately had to be nationalised by the German government for €8bn. Governments around Europe have been forced to intervene with generous liquidity programmes running into the billions to keep utilities up and running, and to protect the banks behind them.

Third, a macroeconomic downturn could hit asset quality and the profitability of credit institutions. Even though the European banking sector as a whole is well capitalised by global banking standards, the ESRB warned that a pronounced deterioration in the macroeconomic outlook could increase credit risk at a time when some firms are still figuring out Covid-19 pandemic-related asset quality problems.

Some of these bloated firms are under pressure from new, more nimble competitors in financial services, as well as other risks including cybersecurity and climate change. Financial stability risks also exist outside the traditional banking sector that need to be addressed, the ESRB stressed. It recommended authorities monitor non-bank financial institutions and crack down where needed.

The ESRB did not expand beyond its published warning, but a spokesman told Global Risk Regulator: “We prefer to just let the warning speak for itself.”

The ESRB does not have any policy levers of its own, so its warning is effectively food for thought for policy-makers, says Nicolas Véron, senior fellow at EU economic think tank Bruegel and the Peterson Institute in the US. Mr Veron is broadly bullish on the bloc. “At this point in the eurozone, we’re not at a time of financial instability,” he says.

What will it take?

Nevertheless, the ESRB’s warning is a milestone. The last time it sounded the alarm was in 2010 over the impending sovereign debt crisis. Two years later, then-president of the European Central Bank, Mario Draghi, famously said he would do “whatever it takes” to save the euro. An era of expansive monetary policy ensued, which ultimately calmed the crisis.

This time around, however, financial stability experts are questioning what more policy-makers and supervisors can do to keep the bloc on an even keel. A war raging in Europe, ballooning energy prices and red-hot inflation call for tighter, not looser, monetary policy.

However, European countries have spent or will spend more than €300bn on additional fiscal support measures, ranging from price caps and tax cuts to subsidies and direct transfers to households, according to data compiled by Bruegel.

Former director of the Central Bank of Ireland (CBI), Jonathan McMahon, oversaw the CBI during the global financial crisis. The former supervisor and now-chairman of Parallel Wealth Management says: “The challenge, whether it’s the Federal Reserve, the Bank of England or the European Central Bank [ECB], is inflation. It has to be squeezed out of the system, and that’s going to happen by putting up interest rates and reversing quantitative easing.

“The big problem with that is that we’ve been in this period of ultra-cheap financing for a long time at both a corporate and a government level. Europe, like the UK and the US, is walking into an actual stress test now.”

All European governments will face policy dilemmas at some point, warn sovereign specialists at ratings agency Moody’s. In October, they wrote in a research note that, unlike the pandemic, the effects of the Russia-Ukraine crisis are structural because Europe’s move away from Russian supplies will keep the region’s energy prices well above historical levels for years to come.

“As a result, it will be politically challenging for governments to roll back the support they have already extended just as weaker economic growth makes their fiscal impact felt much stronger,” they wrote.

“This is potentially significant for some sovereigns because their balance sheets remain scarred by the pandemic. As a result, we believe fiscal and social risks are set to intensify across the continent over the next few years.”

The ESRB, which is chaired by ECB president Christine Lagarde, urged regulators in the 30 countries it oversees to step up preparations for a potential financial crisis with bigger capital buffers and more loss-absorbing provisions.

The ESRB wrote: “Preserving or further building up macroprudential buffers would support credit institutions’ resilience and enable the authorities to release these buffers, if and when risks materialise and negatively impact credit institutions’ balance sheets. This, in turn, would strengthen credit institutions’ ability to absorb losses, while maintaining the provision of critical services to the real economy.”

Limited options

European banks could try to issue loss-absorbing provisions to bolster their balance sheets, but experts caution that investors might show little interest, given the headwinds facing the banking sector. Some banks have already resorted to state bailouts by the back door, while many are plagued by persistently low profitability, thus making it harder to use profits to navigate stormy periods. However, the ECB’s third interest rate hike this year of 0.75%, which boosts rates to 1.5%, may help increase banks’ net income and increase profits.

Nevertheless, weaker banks would struggle to issue bonds as a way of raising capital. “It would have to be an equity raise and, in the case of banks like Banca Monte dei Paschi di Siena, a heavily discounted equity raise,” says Mr McMahon. “If something is cheap enough, somebody will buy it. But it may be that the government would have to recapitalise it or stand behind it in some way.”

Financial consultant and eurosceptic Bob Lyddon is more blunt in his appraisal of the eurosystem. “There’s an absolutely huge black hole in the middle of the European banking system and there’s nothing they can do,” he says. “Nobody’s going to buy any more shares in these banks’ new rights issues. The best that can happen is that the little banks can be bailed out by other banks. For example, Banca Intesa Sanpaolo acted as white knight for a few banks.”

The central bank could try to intervene more heavily, with the reintroduction of dividend bans as seen during the pandemic, or even resort to more quantitative easing. In July, the ECB announced looser monetary policy in the form of the transmission protection instrument (TPI).

Under the TPI, the ECB will make secondary market purchases of mostly public debt issued by countries suffering a deterioration in financing conditions “not warranted by country-specific fundamentals, to counter risks to the transmission mechanism to the extent necessary”. The scale of the programme is open-ended.

Experts are wary, however, regarding how much faith markets would put in such a measure, given the general consensus that economies need to reverse loose monetary policy.

“The eurosystem, according to my calculations, owns or controls as collateral 50% of the market supply of bonds already, so it’s not a free market,” says Mr Lyddon. “The TPI works as long as it [doesn’t involve] any investors from outside the EU. The minute the EU actually needs any money from outside, things get very dodgy.”

A fundamental loss of credibility around sovereigns and central banks could trigger major financial instability, says Alfredo Bello, managing director at professional services firm, Alvarez & Marsal. “I think the two bogeys out there are sovereign debt and central bank actions that they’ve had to take over many years now,” he says. “That’s where the problems will [arise].”

If worst comes to worst, poorer European countries may need to turn to their richer neighbours for a bailout. Traditionally, richer nations have resisted such a last resort but, given the war raging in Ukraine, this may unite the EU.

“I think it’s easier because there’s a war going on not very far from Europe’s borders,” says Mr McMahon. “I think it’s easier for the German chancellor to say disunity in Europe at this time is worse than us doing all these things with German taxpayers’ money to support different areas of Europe.

“Europe can afford to manage any problems which might arise. The risk is that there is political indecision and paralysis in terms of gripping the issue early on. I think that’s what’s behind the ESRB’s warning.”

Next steps

The ESRB’s advisory scientific committee will publish a report in the coming months that fleshes out its options for the bloc. It will focus on monetary policy, namely two specific instruments that central banks around the world have used in strained times. Enhanced lending operations and direct interventions involve purchases of illiquid financial instruments; the report will explain the design and potential costs of both instruments, as well as the rationale behind them.

Despite the ESRB’s warning, there are hopes that regulators’ actions can avert a financial crisis. The EU can take comfort from the UK’s success in coming back from the brink of a full-scale collapse of the pension system. A disastrous ‘mini-Budget’ announcement triggered such sharp falls in gilts and the pound that UK pension funds faced margin calls of as much as £100m each.

However, the Bank of England’s subsequent emergency gilts purchase programme – and the government’s retreat from its ambitious budget – calmed markets and restored order. In addition, the ESRB itself is much more bullish on EU banks and governments today than it was in the aftermath of the global financial crisis.

Today it lists the probability of a simultaneous default by two or more large and complex banking groups at around 4.5%, compared with around 15% in 2012. It also lists the probability of a simultaneous default by two or more EU sovereigns as less than 2%, compared with between 15% and 20% at the height of the sovereign debt crisis.

“Banks are entering this in a better shape than 15 years ago, at the start of the great financial crisis, where their capital levels were extremely low,” says Mr Veron. “I think that levels at this point are much higher, which means more absorption capacity to take in some unexpected shocks.”

Despite Russia’s war with Ukraine showing no signs of abating, there are signs that energy prices are finally coming down, giving the EU some breathing room. Gas prices have fallen steadily since their summer peak and Europe has replenished its stocks of natural gas. A spell of mild weather that is predicted by meteorologists to persist well into November is also helping ease the energy crisis.

Still, the EU faces serious headwinds. Sanctions against Russia, such as the new price cap on oil sales, which are designed to hamper Russia’s ability to wage war against Ukraine are not working. In fact, they are increasing Russia’s revenues, because countries are still willing to buy petroleum products from Russia. The sanctions have driven up energy prices, causing huge spikes in inflation that threaten financial instability.