European Supervisory Authorities on Risk in EU Financial Systems

27 09 2014

The bi-annual report of the Joint Committee (JC) of the European Supervisory Authorities (ESAs) – i.e. the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) – has identified a number of risks to financial stability in the EU. These risks include uncertainties in global emerging market economies, an intensified search for yield in a protracted low interest rate environment, prolonged weak economic growth in an environment marked by high indebtedness and the risks related to conduct of business and Information Technologies (IT). Subsequent to the last report in spring 2014, the instant report focuses on the delicate economic recovery within the EU that can be observed in weak balance sheets both in private and public spheres. Presently favourable market conditions may conceal shortcomings in a weak economic environment and the ESAs consider high indebtedness and low private sector credit growth to be particularly testing and they place emphasis on continued structural reforms that drive improvements in competitiveness and revive lending.

On the one hand, the report explains that ongoing asset quality reviews and stress tests in the banking and insurance sector will present a clearer picture of asset quality and help improve the reliability of balance sheets of EU financial institutions. However, on the other hand, the report emphasises that ongoing balance sheet repair and debt restructuring should remain a key priority in moving forward.

The ESAs take the view that detrimental business conduct by financial institutions, such as the mis-selling of financial products and benchmark manipulation, remains a important concern. Therefore, operational and business-conduct risks remain profoundly important.

The Chairperson of the JC and EBA, Andrea Enria, explained that:

The Joint Committee has seen an improvement in overall market conditions, however this should not be taken for granted as a number of issues persist, including high indebtedness, low interest rates and geopolitical issues, which have the potential to undermine the recovery if not addressed.

As regards ethics and conduct, she also expressed further concern and said that:

Another key area of concern is related to inappropriate behaviour and misconduct in the financial sector, which pose risks from both a consumer and financial stability perspective.

Moreover, the report also flagged up IT related/cyber dilemmas and noted that competent authorities and market participants were taking increasingly larger steps to mitigate these risks, but that in some cases supervisors and institutions needed to enhance their understanding and recognition of such matters.

The report said that in relation to financing conditions, the sustained accommodative monetary policy and further measures taken by central banks were found to have contributed to improvements. Low interest rates, it was explained, resulted in pressure for insurers, pension funds and asset managers. Centrally, the intensified protracted nature of the low-interest-rate environment has amplified a search-for-yield behaviour from investors and as a result risks to asset valuations, generated by the potential for a sudden reversal, have been exacerbated.

Furthermore, with special reference to the potential geopolitical risks in Ukraine and Russia, the report also focused on the risk that EU financial institutions may be affected by political and economic uncertainties in a number of global emerging market economies.

There is a lot of work in progress – that aims to ensure a higher level of efficiency and the stability of the financial system – in the regulatory context. In relation to reforming the structure of the EU banking system, the Council and the European Parliament are examining proposals to reform the structure of the EU Banking system, setting out rules for “too big to fail” banks.

The report noted that key elements of the Banking Union were adopted with the final agreement on the Single Resolution Mechanism (SRM) and the Single Resolution Fund in May 2014, and the implementation of these elements is progressing rapidly. Similarly, the reform of Money Market Funds, and the implementation of MiFID II (see here) are also underway and negotiations are nearing completion on anti-money laundering regulation and on the Insurance Mediation Directive (IMD II). The report stated that:

The Bank Recovery and Resolution Directive (BRRD), which establishes harmonised rules on how to deal with failing banks, will apply as of 2015, although Member States may opt to apply the bail-in tool only in 2016. However, the 2013 Commission Communication on banking in the context of state aid generally requires burden sharing from shareholders and junior debt holders before any public support in the form of recapitalisation or asset protection is given to an entity. Nevertheless, pending the introduction of burden-sharing provisions in national legislation, some uncertainties may still undermine investor confidence. Therefore, the close coordination of national activities in this area is needed at a European level.

The report observed that “macroeconomic recovery is underway, but is still weak and uneven across the EU” and highlighted that “the income and profitability of EU banks continued to be weak.” In particular, the report stressed that:

In 2013, the total operating income of banks (EBA Key Risk Indicator sample) declined by EUR 10 billion (following a decline of EUR 39 billion in 2012). In the last quarter of 2013, the annual flow of profits declined by 58% (EUR 54 billion), although, to some extent, the decline can to be attributed to implications from front-loading and de-risking measures ahead of asset quality reviews and the EU wide stress test. No substantial improvements on income and profitability are expected for 2014. The necessary balance-sheet clean-up and litigation costs are impacting the economic performance of EU banks, as costs related to detrimental business practices have increased significantly. The new regulatory environment, a modest growth outlook, the prolonged low-interest-rate environment and low profitability will continue to present a challenge for management in terms of the sustainability of some banks’ business models.

As regards risks related to key benchmarks in the EU, the report concluded that:

  • The integrity and continuity of key financial benchmarks in the EU remains a concern for ESMA, EBA and EIOPA as well as national competent authorities.
  • The alleged manipulation of interest-rate benchmarks and other widely used indices potentially affects the integrity and reliability of price signals for a large volume of financial contracts and assets traded in both wholesale and retail markets. Ongoing investigations into the potential manipulations of interbank interest reference rates, derivatives prices, oil price benchmarks, the gold benchmark and exchange rates are being carried out by competent authorities in the EU and elsewhere.
  • With respect to EURIBOR, it is worth noting that the dispersion of submitted quotes increased around mid-2013, i.e. following the issue of Recommendations and Principles by EBA, ESMA and IOSCO. Dispersion has remained elevated ever since, although it has weakened somewhat over time. Enhanced governance and submission rules at administrator and panel bank level provide some assurance that the quality and reliability of contributions has improved.
  • Meanwhile, administrators of key interest reference rates have made significant progress in enhancing the governance, transparency and reliability of their benchmarks as also recently highlighted by IOSCO. Wider reform measures are also being discussed at FSB level, which propose addressing the issues related to transitioning from existing to reformed benchmarks in a non-disruptive manner.
  • Operationally, the continuity of submission panels of certain interbank reference rates remains a key risk concern. While most interest benchmark panels have remained stable since the last risk report, the EURIBOR experienced further withdrawals and the EONIA Swap Index was discontinued as of 1 July 2014. Risks of non-viability are elevated in particular in the case of EURIBOR, where a legal framework that includes a power to compel submitting banks is currently being negotiated by the co-legislators. The number of contributors to the EURIBOR panel dropped from 31 to 26 banks in the first half of 2014. The decline coincides with the introduction of enhanced rules for panel banks, by which the administrator seeks to ensure a minimum level of quality and the reliability of individual contributions to the benchmark.
  • Key risks from the discontinuation of benchmarks include contract continuity and the inability of market participants to value outstanding contracts and collateral, with potential knock-on effects on price and liquidity in both derivatives and lending markets. EURIBOR is also used as a reference rate for millions of variable rate mortgages in the EU and its discontinuity or lack of reliability could have a large impact on the banking sector, consumers and market confidence.

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