ESAs Warn on deteriorating risk conditions in the EU Financial Markets.

The Joint Committee of the European Supervisory Authorities (ESAs) published om May 5th, 2015,  its fifth Report on Risks and Vulnerabilities in the EU Financial System. Here is he -somewhat frightening- executive  summary.

Since the last issue of this report in August 2014, financial system risks have not changed in substance, but have intensified further. Risks related to broad macroeconomic conditions, in particular low interest rates, and the resulting search-for-yield behaviour, as well as political developments at EU and international level prevailed and in some cases grew stronger. Concerns over operational risks generated by inappropriate business conduct and negligence of proper maintenance, management and development of sustainable IT systems complemented this menu.

Feeble economic prospects for the EU cautiously improved in early 2015. The risk of deflationary tendencies nevertheless persisted and risk drivers such as subdued investment demand and structural frictions in the financial system remained in place. Neither economic policies nor regional geopolitical tensions, the global economic slow-down, economic and financial uncertainty around the long-term trajectory of the Greek fiscal position and potential impacts on sovereign bond markets, or fluctuating commodity prices were conducive to revive prospects for the real economy substantively. Monetary policy kept interest rates at near-zero level, reinforcing the low-interest rate environment. Low interest rates and remaining uncertainties about the economic recovery affected the outlook for the financial industry adversely. The profitability of banks remained under pressure. Risk-weighted assets continued to be under scrutiny, though investor confidence picked up, as the EU-wide stress test made steps towards addressing concerns about asset quality and capital levels. Balance sheets expanded slightly, albeit further de-risking. Insurers remained exposed to stagnating business volumes, reduced profit margins and rising liabilities. Asset prices increased, while becoming more volatile due to increased yield sensitivity of investors. Volatilities were reinforced by uncertainties about economic prospects, expectations for reversals in interest rate level and fluctuations in commodity prices and exchange rates. Accordingly, valuation risk intensified, implying increasingly skittish investors and elevating liquidity risks due to highly sensitive investment positions. The withdrawal of market makers from secondary markets due to structural reasons impeded liquidity in some market segments additionally. Higher valuation and market liquidity risk raised concerns about the outlook for financial entities’ stability in the event of reversals in interest rates and asset prices. Recent stress tests illustrated that the insurance industry could face substantial fractions of undertakings not meeting solvency requirements for the case of adverse scenarios. Risks to banks’ capital positions as identified in the EU wide stress test appeared manageable, even if volumes of non-performing loans in corporate and real estate portfolios rose. Deflationary tendencies are likely to preserve the current high valuation risk. Concerns about asset bubbles are rising, as interest rates are expected to stay below expected growth for some time. As market expectations also may demonstrate positive probabilities for interest rate reversals, valuation concerns are concentrated on such events. In addition, investments flows attracted to overheating asset market segments distort funding flows to the real economy and impede future economic prospects. Low profitability is motivating financial institutions and other investors to search for yield. Thus, new risks are increasingly concentrated into the balance sheets of financial entities, as those extend maturities and enter risky business areas. Financial entities are starting to change their business models. The fund industry became active in the field of loan origination accepting new credit risk in its activities. Similarly, insurers and some banks are reaching for new markets and products. Concerns about misconduct and IT risks remain high. As banks’ litigation and redress costs further increased in 2014, market withdrawals, such as from price-fixing, are becoming more likely, and a rising number of system outages endanger market functioning. Benchmarks’ continuity and integrity remain a source of concern even if key panels remained stable. IT risk rose due to costs pressures, outsourcing, the need for additional capacities and a mounting number of cyber-attacks. The EU Commission’s plan for achieving a Capital Market Union, including the facilitation of funding channels complementing traditional channels through the banking system, is expected to provide a valuable stimulus for economic activity in the future. On-going regulatory reforms, including further completion of harmonised regulatory frameworks, and supervisory reforms improved the stability and safety of the financial industry. The results of the Comprehensive Assessment provided considerable transparency into and improved market confidence towards the EU banking sector. Additional supervisory measures are recommended. Bank regulators should continue to assess business model viability and promote consistency in the risk-weighting of assets. Efforts to improve the insurance industry’s asset-liability and risk management deserve further attention in the transition to Solvency II. Restructuring in financial entities’ business models should be monitored. Legislative measures, such as for European Long Term Investment, Venture Capital and Social Entrepreneurship Funds, are fostering new forms of market-based funding. However, further promotion of sound and innovative business models could – assuming adequate risk regulation and supervision – deliver additional stimulus. Concerning operational risks, adequate inclusion of misconduct costs in future stress tests, further progress towards benchmark reforms, and appropriate application of supervisory instruments would be desirable. Awareness of regulators and industry of IT risks rose, but systematic integration of IT risk in overall risk management still needs to progress.