Publication of the December 2007 ECB Financial Stability Review

The European Central Bank (ECB) today publishes its December 2007 Financial Stability Review.

The Review, which has been published semi-annually since December 2004, assesses the stability of the euro area financial system both with regard to the role the system plays in facilitating economic processes and to its ability to prevent adverse shocks from having inordinately disruptive impacts.

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

The purpose of publishing the Review is to promote awareness in the financial industry and among the public at large of issues relevant for safeguarding the stability of the euro area financial system. By providing an overview and an assessment of the main sources of risk and vulnerability for financial stability, the Review also seeks to play a role in preventing financial crises.

As has been stressed in the past, 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 sources of downside risk, even if the probability of their realisation is relatively low.

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:

With financial systems undergoing a process of de-leveraging and re-intermediation at the time of finalisation of this issue of the Financial Stability Review, 9 November 2007, the uncertainty surrounding the financial stability outlook for the euro area has heightened.

This uncertainty could persist for a considerable period until it becomes clearer how the total valuation and income losses, which could be sizeable, facing the euro area financial system will be spread across individual financial institutions. Clarity will also be needed on how liquidity providers intend to deal with their commitments to off-balance sheet investment vehicles, and how much risk will eventually flow back onto the balance sheets of banks. Moreover, until conditions in the US housing market show signs of improvement, the possibility of further tensions surfacing in structured credit markets cannot be excluded, especially if credit quality were to deteriorate in the broader US mortgage market.

Looking forward, as the adjustment process in the financial sector over the coming months is likely to prove challenging, the financial system could be more vulnerable than before to the crystallisation of other risks that have been identified in previous issues of the Financial Stability Review and which remain relevant. Specifically, these risks are related to the following facts and developments: First, within the euro area, the substantial increase in household sector indebtedness together with signs of vulnerability in some housing markets adds to the credit risk facing euro area banks in the short to medium term. Second, the surge of leverage in parts of the corporate sector, especially that related to leveraged buyout (LBO) activity, raises the possibility of an adverse turn in the credit cycle involving a rise in the default rates of the most heavily indebted firms. The indications so far are that the hedge fund sector was relatively unaffected by the recent market turmoil. Nevertheless, some uncertainties remain regarding hedge funds’ exposures, leverage and liquidity risk. Finally, outside the euro area, persistently wide global imbalances continue to pose a risk that they will be unwound in a disorderly manner. This could bring about further tensions in global capital markets and, if this risk were to materialise, it could pose a challenging test for the risk management and loss-absorption capacities of key financial institutions. All in all, the risks to euro area financial system stability had materially increased at the time of finalisation of this issue of the Financial Stability Review when compared to the assessment made six months ago.

There are, however, several mitigating factors. The economic outlook remains broadly favourable and, although pockets of vulnerability can be identified, the balance sheets of households and firms are largely in good shape, supporting the overall creditworthiness of the non-financial sector. Moreover, the capital positions of core financial firms are also generally sound.

This overall positive assessment of shock-absorbing capacity should not provide any grounds for complacency given the heightened uncertainties. In an environment where balance sheet conditions could unexpectedly change, vigilance is of the essence and financial institutions in particular should step up their efforts to effectively manage the risks that may lie ahead.

Further information

The Review can be downloaded from the “Publications” section of the ECB’s website. Printed copies are also available free of charge from the ECB’s Press and Information Division at the address given below.