Special features

Abstract

Over the last decade, exchange-traded funds (ETFs) have grown at a fast pace both globally and in the euro area. ETFs typically offer low-cost diversified investment opportunities for investors. ETF shares can be bought and sold at short notice, making them efficient and flexible instruments for trading and hedging purposes. At the same time, the wider use of ETFs may also come with a growing potential for transmission and amplification of risks in the financial system. This special feature focuses on two such channels arising from (i) liquidity risk in ETF primary and secondary markets and (ii) counterparty risk in ETFs using derivatives and those engaging in securities lending. While ETFs still only account for a small fraction of investment fund asset holdings, their growth has been strong, suggesting a need for close monitoring from a financial stability and regulatory perspective, including prospective interactions with other parts of the financial system.

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G24 : Financial Economics→Financial Institutions and Services→Investment Banking, Venture Capital, Brokerage, Ratings and Ratings Agencies

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

Abstract

On aggregate, bank profitability in the euro area has improved in recent quarters along with the cyclical recovery. However, the level of earnings for many banks is still below that required by investors and bank profitability is still vulnerable to a possible turnaround in the business cycle. This special feature looks at possible avenues for banks to reach more sustainable levels of profitability in the future. It highlights the need to overcome structural challenges in the form of low cost-efficiency, limited revenue diversification and high stocks of legacy assets (in some jurisdictions).

JEL Classification

E37 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Forecasting and Simulation: Models and Applications

F13 : International Economics→Trade→Trade Policy, International Trade Organizations

F18 : International Economics→Trade→Trade and Environment

F47 : International Economics→Macroeconomic Aspects of International Trade and Finance→Forecasting and Simulation: Models and Applications

Abstract

The intensification of trade tensions this year has raised concerns about the potential adverse impact on global growth and asset prices. So far, the isolated effects of introducing tariffs on selected goods on asset prices have been adverse mainly for specific companies that rely heavily on international trade. At the same time, global financial markets have overall been fairly resilient to the announcements and implementation of tariff measures. This special feature finds that an escalation of trade tensions could trigger a global repricing in asset markets. For the euro area, asset prices would be strongly affected in the event of a full-blown global trade war, in which all countries impose tariffs on each other, while the impact of a regionally contained trade dispute escalation would be rather subdued.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The real economy repercussions of financial crises are the ultimate focus of financial stability monitoring and policymakers. By extending a standard set of financial stability indicators with indicators capturing spillover and contagion risks, this special feature proposes a financial stability risk index (FSRI) that has predictive power for the near-term risk of deep recessions. It is shown that the empirical performance of the index benefits from combining a large set of macro-financial indicators and, notably, that the information content of the spillover and contagion risk indicators is important.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature presents a tractable, transparent and broad-based cyclical systemic risk indicator (CSRI) that captures risks stemming from domestic credit, real estate markets, asset prices, external imbalances and cross-country spillovers. The CSRI increases on average several years before the onset of systemic financial crises and its level is highly correlated with measures of crisis severity. Model estimates suggest that high values of the CSRI contain information about large declines in real GDP growth three to four years down the road, as it precedes shifts in the entire distribution of future real GDP growth and especially of its left tail. Given its timely signals, the CSRI is a useful analytical tool for macroprudential policymakers to complement other existing analytical tools.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature analyses the distribution of interest rate risk in the euro area economy using balance sheet data and information on derivatives positions from significant credit institutions. On aggregate, banks’ interest rate risk exposure is small relative to their loss absorption capacity, but exposure varies across institutions. This variation is driven by loan rate fixation practices at country level. Banks use derivatives for hedging, but retain residual interest rate risk exposures. In fixed-rate countries the main vulnerability to rising interest rates lies with the banks that have the greatest interest rate risk, while households would be directly affected in countries with predominantly variable-rate loans. In the latter case, increased loan servicing costs due to rising interest rates could affect banks through lower asset quality.

JEL Classification

G00 : Financial Economics→General→General

Abstract

When banks judge that more value can be extracted by offering non-performing loans (NPLs) for sale rather than working them out themselves, potential investors cannot be sure that the credit quality of the assets is as good as the banks portray it to be. Such information asymmetries in the NPL market drive a wedge between the prices that investors are prepared to pay for NPLs and the prices that banks are prepared to sell them for. While information asymmetries can be overcome through investor due diligence, this requires specialist expertise and the costs of valuing NPL portfolios can be very high. As few investors have the resources to absorb such costs, barriers to entering the market are compounded. This appears to explain why the euro area NPL markets display the features of an oligopsony, a situation where there is a concentration of market power among a limited number of investors, which pushes traded prices even lower. At the same time, potential NPL investors can face coordination challenges when debtors have multiple loans with different banks. In such situations, investors must face the prospect of competing with other creditors for the debtor’s resources. While coordination between banks for common exposures may alleviate this problem, this too can be costly, weighing further on market prices. By offering the prospect of greater transparency in NPL markets, fostering wider investor participation and addressing coordination issues, NPL transaction platforms could help in overcoming all three of these market failures. The attendant improvement in market liquidity would allow banks to achieve better prices for NPL sales, preserve their capital and mitigate financial stability risks. This special feature outlines the desirable features of NPL transaction platforms and discusses their operational implementation.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature examines the potential drivers of the post-crisis retrenchment in cross-border banking in the euro area, which stands out in international comparison. Examining a wide range of possible determinants of this phenomenon, it establishes a significant link between deteriorating asset quality and the retrenchment in cross-border banking. Conversely, tighter prudential policies and the introduction of bank levies do not contribute to explaining the reduction in cross-border banking activity. Therefore, tackling the persistent asset quality problems, along with the completion of the banking union, would seem to be pivotal to reaping the potential benefits of cross-border banking within the euro area in terms of risk diversification and risk-sharing.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Effectively functioning repo markets are of key importance for both financial stability and monetary policy, but the excessive use of repos may also be a source of systemic risk as witnessed during the recent financial crisis. Regulatory reforms introduced since the start of the crisis have aimed to contain systemic risk related to the excessive build-up of leverage and unstable funding, but recently some concerns have been raised about their potential effects on the functioning of the repo market. This special feature presents new evidence on the drivers of banks’ activity in the repo market with respect to regulatory reforms. In addition, it takes a closer look at the repo market structure and pricing dynamics, in particular around banks’ balance sheet reporting dates. While the observed volatility around reporting dates suggests that the calculation methodology for some regulatory metrics should be reviewed, overall, the findings indicate that unintended consequences of regulatory reforms on the provision of repo services by euro area banks have not been material.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The reduction in asset price volatility in recent years has taken place in tandem with investors lowering the premia required for lower-rated assets. The current favourable market sentiment could however change abruptly if, for instance, investors were to reassess the outlook for growth or monetary policy. Potential surges in asset price volatility could be amplified by: (i) investors selling off assets perceived as overvalued; (ii) the high levels of corporate leverage; and/or (iii) a rapid unwinding of market positions that benefit from low volatility. Low volatility in financial markets is therefore being closely monitored by financial stability authorities, as it may mask an underpricing of risks and a build-up of financial imbalances.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature analyses the recent decoupling between measures of financial conditions and economic policy uncertainty. In 2016, several risky asset prices surged and financial market volatility hovered at low levels while measures of economic policy uncertainty increased sharply, the latter partly triggered by the outcomes of the UK referendum on EU membership and the US presidential election. This special feature attempts to explain these diverging trends. It starts out by reviewing the existing academic literature on uncertainty and its implications for financial conditions. In the empirical part that follows, it provides model-based estimates of the drivers underlying the benign financial conditions prevailing in UK and US financial markets. The results suggest that the adverse impact of economic policy uncertainty on financial conditions in the United States was more than offset by a positive demand shock. In the case of the United Kingdom, however, it was the resolute accommodative monetary policy actions by the Bank of England that supported financial conditions after the referendum. Turning to the euro area, policy uncertainty increased in several countries in the first months of 2017. Looking ahead, further shocks stemming from the political sphere may, in the absence of offsetting factors, tighten domestic financial conditions, increase risk premia and potentially raise debt sustainability concerns.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Excessive credit growth and leverage have been key drivers of past financial crises, notably the recent global financial crisis. For the appropriate setting of countercyclical macroprudential policy instruments, it is therefore important to identify periods of excessive credit developments at an early stage. This special feature discusses the standard statistical method for computing credit gaps and compares it with an alternative approach to measuring credit excesses based on fundamental economic factors. Theory-based credit gaps could provide a useful complement to statistical measures of cyclical systemic risk.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Large stocks of non-performing loans (NPLs) on euro area bank balance sheets continue to present risks to financial stability. Significant legal and administrative reforms have been undertaken over recent years in countries with high levels of NPLs to streamline insolvency proceedings and maximise NPL recovery values. Yet, the market continues to provide low NPL valuations that result in wide bid-ask spreads, thus impeding large-scale NPL sales. This special feature highlights the potential role and benefits of co-investment strategies (between the private sector and the state) for addressing NPLs. These co-investment strategies may reduce information asymmetries between buyers and sellers, thereby enabling transactions that might otherwise not occur, or facilitate sales at higher prices. Moreover, the proposed schemes are priced at market levels and may, therefore, be free of state aid.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Alternative investment funds (AIFs) in Europe operate without regulatory leverage limits. Competent authorities within the EU have the legal power to impose macroprudential leverage limits on AIFs, but no authority has implemented this tool so far. This joint European Central Bank-De Nederlandsche Bank (DNB) special feature (i) presents a macroprudential case for limiting the use of leverage by investment funds, (ii) develops a framework to inform the design and calibration of macroprudential leverage limits to contain the build-up of leverage-related systemic risks by AIFs, and (iii) discusses different design and calibration options. By way of example, it uses supervisory information on AIFs managed by asset managers based in the Netherlands. The article concludes by recommending a way forward to develop an EU-level framework for a harmonised implementation of macroprudential leverage limits for AIFs, which forms a key part of the agenda of the European Systemic Risk Board (ESRB) to develop macroprudential policy beyond banking.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The high stock of non-performing loans (NPLs) on the balance sheets of euro area banks continues to be an important cause for concern for policymakers. Efforts to resolve this problem have increased significantly in the course of 2016, by supervisors and macroprudential policymakers alike. To relieve capital constraints, these efforts, however, must be complemented with structural reforms to recover the value of NPLs in some countries. Against this background, this special feature focuses on impediments to the functioning of a market for NPL sales. It highlights sources of informational asymmetry and structural inefficiencies. Among indicators of market failure, it distinguishes between supply and demand factors that impede market functioning. In light of the identified externalities, public policy responses are warranted to reduce the cost and duration of debt recovery while also addressing information asymmetries between better-informed banks and potential investors. In certain circumstances the establishment of asset management companies (AMCs) may help to accelerate the value recovery process for banks, while avoiding adverse macroeconomic side effects. Constraints on and limitations of AMCs are also reviewed in this special feature.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The euro area banking sector is faced with cyclical and structural challenges, which are hampering many banks’ ability to generate sustainable profits. In particular, the prolonged period of low nominal growth and low yields compresses net interest income, which traditionally has been (and still is) euro area banks’ main source of income. One way for banks to compensate for compressed net interest margins could be to adapt their business models, moving towards more fee and commission-generating activities. This article discusses the challenges involved in boosting fee and commission income and highlights some of the potential financial stability implications related to a greater reliance on these income sources.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Financial institutions can build up leverage via the use of derivatives and securities financing transactions (SFTs). In order to limit the build-up of excessive leverage and the associated liquidity risks, as well as the pro-cyclical effects of margin and haircut setting practices, the macro-prudential toolkit needs to be extended. This special feature presents the general case for setting macro-prudential margins and haircuts using theoretical and empirical evidence on the effectiveness of various design options. Furthermore, it addresses implementation and governance issues that warrant attention when developing a macro-prudential framework for margins and haircuts. It concludes by recommending a way forward that is intended to inform the ongoing policy discussions at the European and international levels.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The new bail-in tool in the EU bank resolution toolkit is an important step forward to safeguard financial stability in Europe, notably in relation to mitigating moral hazard and other problems inherent in a strong reliance on bailouts. At the same time, it is important to understand the potential contagion channels in the financial system following a bail-in and prior to resolution in order to assess potential systemic implications of the use of the bail-in tool. This special feature outlines salient features of the new requirements and then presents a multi-layered network model of banks’ bail-inable securities that could help in gauging potential contagion risk and, prior to a resolution, identifying mitigating measures to avoid systemic implications.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature reviews recent trends in business model characteristics, discusses their relationship with bank stability and performance, and looks at how this relationship has changed over time, comparing the period before the crisis with the crisis years and the current situation.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The Basel III leverage ratio aims to constrain the build-up of excessive leverage in the banking system and to enhance bank stability. Concern has been raised, however, that the non-risk-based nature of the leverage ratio could incentivise banks to increase their risk-taking. This special feature presents theoretical considerations and empirical evidence for EU banks that a leverage ratio requirement should only lead to limited additional risk-taking relative to the induced benefits of increasing loss-absorbing capacity, thus resulting in more stable banks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The current environment of protracted low interest rates poses major challenges to euro area insurance companies. This special feature discusses how a prolonged low-yield period might affect the profitability and the solvency of euro area insurers. In the article, it is argued that if interest rates were to stay low for a long time, this could have material implications for the profitability and the solvency of many insurers. However, it is also shown that the impact of low interest rates is likely to differ markedly across insurance companies depending on their business model and balance sheet structure. In particular, the impact is expected to be highest for small and medium-sized life insurers with large government bond portfolios and high guarantees to policyholders that reside in countries where these guarantees are rigid and where contracts embed a long time to maturity.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature proposes a methodology to measure systemic risk as the percentage of banks defaulting simultaneously over a given time horizon for a given confidence level. The framework presented here is applied to euro area banks. It is observed that since the announcement of the comprehensive assessment in October 2013 banks have significantly reshuffled their security portfolios. This has resulted in a decline in the probability of systemic events occurring.

JEL Classification

G00 : Financial Economics→General→General

Abstract

In a monetary union, targeted national macroprudential policies can be necessary to address asymmetric financial developments that are outside the scope of the single monetary policy. This special feature discusses and, using a two-country structural model, provides some model-based illustrations of the strategic interactions between a single monetary policy and jurisdiction-specific macro-prudential policies. Counter-cyclical macro-prudential interventions are found to be supportive to monetary policy conduct through the cycle. This complementarity is significantly reinforced when there are asymmetric financial cycles across the monetary union.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Macro-prudential measures implemented in individual Member States may have cross-border or cross-sectoral repercussions. This special feature discusses cross-border spillover channels. To limit negative spillover effects, macro-prudential instruments should be applied consistently across countries, and reciprocity agreements must be applied transparently.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Weak profitability among euro area banks is one key risk to financial stability. This special feature examines the main drivers influencing banks’ profitability, including bank-specific, macroeconomic and structural factors. The empirical part of the special feature finds that challenges appear to be mainly of a cyclical nature, although there may also be material structural impediments to reigniting bank profitability.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The weight of non-performing exposures (NPEs) on the balance sheets of European banks is a cause for concern for policy-makers; yet resolving the issue presents a number of challenges. This special feature presents an overview of the scale of the NPE problem, highlights several operational aspects that are critical for effectively resolving the problem, and outlines the merits of various resolution strategies.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature studies the effects of fire-sale externalities in the euro area banking sector. Using individual bank balance sheet data and a framework developed by Greenwood et al. (forthcoming), an indicator is constructed to quantify the effects of fire-sale spillovers in terms of losses in equity capital in the banking system. For some countries, loans to monetary financial institutions are the most systemic assets, while for others loans to households can pose systemic risks. Thanks to the fine granularity of the background data and monthly updates, the index can be used as an early warning indicator and a measure of systemic risk.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature discusses ways of measuring financial cycles for macro-prudential policymaking. It presents some estimates and empirical characteristics of financial cycles. Existing studies on financial cycle measurement remain quite nascent in comparison with the voluminous literature on business cycles. In this context, two approaches – turning point and spectral analysis – are used to capture financial and business cycles at the country level. The results of the empirical analysis suggest that financial cycles tend to be more volatile than business cycles in the euro area, albeit with strong cross-country heterogeneity. Both aspects underscore the relevance of robust financial cycle estimates for macro-prudential policy design in euro area countries.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis led to a broad consensus among policy-makers and regulators that macro-prudential frameworks, in addition to micro-prudential policy, must be part of the solution to ensure the resilience of the financial system. The counter-cyclical capital buffer represents the first step in this direction taken by the Basel Committee on Banking Supervision. Regarding liquidity issues, two micro-prudential standards have been designed. The delegated act implementing the liquidity coverage ratio (LCR) at the European level has recently been adopted by the European Commission and the net stable funding ratio (NSFR) standard has just been finalised by the Basel Committee on Banking Supervision and was published on 31 October. After implementing these new standards, it will be necessary to monitor their impact on banks’ behaviour, market liquidity, monetary policy and financial stability before considering introducing any additional instruments. At this stage, the need for a liquidity-based macro-prudential tool is in the early stages of identification and discussion. Therefore, this special feature aims to provide some initial technical considerations regarding the macro-prudential use of the NSFR. The discussion considers two broad perspectives. The first is the need for a counter-cyclical NSFR to complement the counter-cyclical capital buffer. While capital and liquidity standards pursue different objectives, the two can also be used in conjunction depending on the specific risk to financial stability being targeted. The second perspective regards the use of the NSFR as a stand-alone macro-prudential tool, together with its potential trigger mechanism and its use in the current low yield environment.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The global financial crisis revealed a need for macro-prudential policy tools to mitigate the build-up of systemic risk in the financial system and to enhance the resilience of financial institutions against such risks once they have materialised. In the EU, macro-prudential policy is an area that is in an early stage of development. This is also true as regards the use of instruments to address systemic risk for which there is so far only limited experience to draw on. Hence, there is general uncertainty about the effectiveness of such instruments in practice. Nevertheless, country-level experience can serve as a useful yardstick for formulating macro-prudential policy in the EU. This special feature considers the experience of European countries with macro-prudential policy implementation. Overall, the evidence surveyed here indicates that macro-prudential policies can be effective in targeting excessive credit growth and rapidly rising asset prices, although other policies can be a useful complement to reduce the build-up of imbalances. At the same time, the appropriate timing of macro-prudential policy measures remains a challenging task.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Excessive credit growth has often been associated with the build-up of systemic risks to financial stability. With the entry into force of a new macro-prudential policy framework in the EU on 1 January 2014, a set of policy instruments has been made available to regulators to address such risks by curbing excessive leverage and/or imposing capital buffers which increase the resilience of the system against potential future losses. This special feature presents an early warning system designed to support macro-prudential policy decisions. Drawing on the historical experience of EU countries, the model aims to assess whether observed leverage dynamics might justify the activation of macro-prudential tools such as the counter-cyclical capital buffer proposed by the Basel Committee on Banking Supervision. The early warning indicators are based on aggregate credit-related, macroeconomic, market and real-estate variables, while the early warning thresholds are derived by considering conditional relationships between individual indicators in a unitary framework.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature discusses the potential differences, tensions and complementarities between micro- and macro-prudential policies. It argues (i) that in spite of the frictions that may arise between them, micro- and macro-prudential policies overall complement each other, and (ii) that the two policy domains play an equally important role in ensuring financial stability. To benefit most from their complementarities, it is essential that there is constructive cooperation and information sharing between micro- and macro-supervision.

JEL Classification

G00 : Financial Economics→General→General

Abstract

In light of the recent emerging market tensions, this special feature takes stock of euro areabanks’ emerging market exposures by identifying the major sources and types of related risks and highlighting some of the potential financial channels of contagion. Euro area banks’ emerging market exposures are analysed in time and cross-sectional dimensions, at the country and individual bank level, as well as in absolute terms and relative to some bank balance sheet metrics. Within a panel regression framework, the special feature also seeks to identify those emerging economies that – based on their credit metrics and fundamentals – are the most exposed to financial stability risks, which, if they materialise, may have negative repercussions for euro area banks with sizeable exposures to those economies.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature briefly outlines the work currently being undertaken at the European Central Bank, in close cooperation with the national competent authorities of the participating Member States, for the assumption of supervisory responsibilities in November 2014. Following a short introduction, which summarises some of the features of the single supervisory mechanism, the preparatory developments are outlined, around five main themes, which reflect the organisation of the preparatory structures.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The systemic dimension of the financial crisis has underscored the need for an expanded set of policies to contain systemic risk throughout the financial cycle. Counter-cyclical capital buffers (CCBs) form an integral part of the expanded European macro-prudential toolkit in this respect, with a “time series” focus in that they increase the resilience of the banking sector to shocks arising from financial and economic stress over the cycle and thereby provide a means to attenuate pro-cyclicality inherent in the financial system. To guide the setting of CCBs, the Basel Committee on Banking Supervision (BCBS) has proposed a focus on, inter alia, the deviation of the domestic credit-to-GDP ratio fromits backward-looking trend (also known as the domestic credit-to-GDP gap), given its track record of signalling financial stress well in advance. The Capital Requirements Directive (CRD) IV specifies that other variables should also be taken into consideration in addition to the credit gap. This special feature assesses the usefulness of private sector credit and other macro-financial and banking sector indicators in guiding the setting of CCBs in a multivariate early warning model framework. The analysis shows that in addition to credit variables, other domestic and global financial factors such as equity and house prices, as well as aggregate banking sector balance sheet indicators, help to predict historical periods of financial vulnerabilities in EU Member States. Consequently, policy-makers deciding on CCB measures could benefit from considering a wide range of indicators.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature examines various macro-prudential tools through the lens of recent advances in the study of interbank contagion. The specific set of tools analysed are those designed to contain the “cross-sectional” dimension of systemic risk – that is, those designed to limit the systemic risk stemming from factors such as correlations and common exposures across financial institutions. These include tools such as large exposure limits and other regulatory requirements designed to limit the spread of systemic risk between banks. The analysis rests on the basic notion that interbank network structures, and hence the risk of contagion across the banking system in response to shocks, are influenced by banks’ optimising behaviour subject to regulatory (and other) constraints. Changes in macro-prudential policy parameters, such as large exposure limits, capital charges on counterparty exposures and capital and liquidity requirements more generally, will affect the contagion risk because of their impact on banks’ asset allocation and interbank funding decisions. This in turn implies that well-tailored macro-prudential policy can help reduce interbank contagion risk by making network structures more resilient. The analysis shows that to capture the full extent of potential interbank contagion, all of the different layers of bank interaction should be taken into account. Hence, if the regulator only focuses on one segment of interbank relationships (e.g. direct bilateral exposures), the true contagion risks are likely to be grossly underestimated. This finding has clear policy implications and flags the importance of micro- and macro-prudential regulators having access to sufficiently detailed data so as to be able to map the many interactions between banks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis highlighted the importance of systemic risks and of policies that can be employed to prevent and mitigate them. Several recent initiatives aim at establishing institutional frameworks for macro-prudential policy. As this process advances further, substantial uncertainties remain regarding the transmission channels of macro-prudential instruments as well as the interactions with other policy functions, and monetary policy in particular. This special feature provides an overview and some illustrative model simulations of the macroeconomic interdependence between macro-prudential instruments and monetary policy.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Asset management companies (AMCs) have been established in a number of euro area countries to resolve large stocks of impaired bank assets following the financial crisis. This special feature describes some of the fundamental characteristics of such entities from a financial stability perspective. In particular, it reviews some of the lessons learned from the AMCs’ establishment and early operations, notably regarding the eligibility of banks and assets, which has implications for the size and capital structure of an AMC, as well as the valuation of assets to be transferred, strategies for their management and disposal and other operational issues.

JEL Classification

G00 : Financial Economics→General→General

Abstract

In the run-up to the global financial crisis that began in mid-2007, leverage and risk-taking in the financial system increased substantially, in particular in the shadow banking system. This increase was facilitated by an erosion of credit terms in securities financing and over-the-counter (OTC) derivatives markets, which served as important conduits for leverage in the financial system. Recognising the lack of information on such developments, a number of major central banks, including the ECB, have started to conduct regular qualitative surveys on changes in credit terms and conditions in these wholesale credit markets. This special feature presents the key features and some of the first results of the recently launched quarterly ECB survey on credit terms and conditions in euro-denominated securities financing and OTC derivatives markets (SESFOD). It also discusses how the survey could be used for macro-prudential monitoring purposes.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Financial institutions have played a central role in the ongoing financial crisis. The bank bailout costs associated with the current global financial crisis and the large output losses experienced in several countries clearly motivate the attempts to develop early warning models for predicting banking crises and individual bank failures. This special feature presents an early warning model based on publicly available bank-specific and country-level indicators for predicting vulnerable European banks that could potentially experience distress given suitable triggers. A novel model extension incorporates an estimated tail dependence network of European banks to the early warning model in order to take into account vulnerabilities arising from estimated interdependencies.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The persistent feedback loop between tensions in the sovereign debt market and the banking sector has increased the fragmentation within the euro area bank funding market, with banks in distressed countries facing much greater funding difficulties than banks operating in other countries.This special feature analyses how, against the background of the sovereign debt crisis, funding market fragmentation has affected the capacity of banks to provide credit to the economy. A quantitative assessment based on macroeconomic models provides estimates on the effect that the market fragmentation could exert on economic activity. Overall, while the impact on the euro area as a whole is assessed to be limited, some regions have been affected disproportionately.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The establishment of a banking union is a major component of the framework required for a genuine Economic and Monetary Union (EMU). The legislative proposals published by the European Commission on 12 September 2012 regarding the establishment of a Single Supervisory Mechanism (SSM) as part of a “Roadmap towards a Banking Union” represent a major step in this direction. The proposals follow up on the euro area summit statement of 29 June, and are in line with the European Council’s call for an integrated financial framework. This special feature argues that while the building of a banking union is an arduous and complex process, it is nevertheless essential to support an effective EMU. The financial crisis has illustrated the fundamental inconsistency of banking supervision being carried out at the national level in a currency area with a single monetary policy. Under the current setting, fragility in national banking systems can be quickly transmitted to the national fiscal side and vice versa, triggering an adverse feedback loop between fiscal and banking problems. This is damaging from a financial stability perspective and hampers the smooth transmission of monetary policy. In the short term, the SSM should contribute to weakening significantly the link between banks and sovereigns persisting in a number of euro area countries. In the long term, the stronger institutional framework of the SSM should exert a beneficial influence on the euro area and the global economy. From this perspective, this special feature highlights the importance of moving towards a common supervisory system and implementing a common resolution regime. In particular, an independent European resolution authority is urgently required to meet the challenges posed by the resolution of banking institutions, also at a cross-border level. Such an authority is also necessary in order to align the incentives of the SSM and the resolution function.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Deleveraging by EU banks over the medium term is to be expected owing to funding and capital-related pressures of both a cyclical and especially a structural nature. Major EU banks have already reduced their leverage ratios since the outbreak of the financial crisis, mainly via improving nominal capital levels. Going forward, the deleveraging process is, however, likely to focus primarily on the asset side, given the current difficult conditions in capital markets and the subdued growth outlook. The externalities associated with this process need not necessarily be negative. Deleveraging can reflect a more efficient allocation of financial resources, a correction of over-inflated asset prices or a reduction of debt overhangs, all of which would bring the economy onto a more sustainable growth path. This notwithstanding, authorities need to monitor the process closely to ensure that it occurs in an orderly fashion and thus avoid negative repercussions on the real economy and the financial system more broadly.

JEL Classification

G00 : Financial Economics→General→General

Abstract

In response to the flaws in banks’ liquidity risk management revealed by the global financial crisis, the Basel Committee on Banking Supervision has proposed a new set of liquidity requirements to complement its revised capital requirements framework. This special feature reviews, from a research perspective, the role of liquidity requirements in mitigating not only liquidity risks, but also solvency risks in banking. It highlights how liquidity requirements differ from capital requirements and discusses how selected features of the Basel III liquidity rules can help to reap the benefits of liquidity outlined by research theories.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Multiple levels of analysis are required to assess banks’ fragility in a complex banking system. On the one hand, network analysis using existing data for the euro area shows a banking structure which is well integrated across euro area countries, with some banks playing an important role at the euro area level while others have a more domestic focus. On the other hand, a dynamic network modelling approach can illustrate important aspects and fragilities of interbank activity in a simulated network in the absence of real micro data. This special feature first describes a static approach to financial network analysis and then gives a specific illustration of a dynamic network in a stress-testing context. Both provide important insights for financial stability analysis. The static analysis of existing financial networks and the use of a simulated network for stress testing exploit information on the microstructure of banking activities to characterise the robustness of the banking sector to operating shocks. This is a unique application of conceptual and analytical techniques that have only recently been introduced in financial analysis.

JEL Classification

G00 : Financial Economics→General→General

Abstract

In the ongoing reform of the financial system, a key regulatory objective is to increase the soundness and resilience of banks. In line with this objective, regulators have placed emphasis on higher common equity capital requirements. The industry has been critical of a higher reliance on equity. Since equity is the most expensive source of capital, it is often asserted that higher equity ratios may materially increase banks’ funding costs, with adverse consequences for credit availability. Based on a sample of large international banks, this special feature provides an assessment of the relationship between banks’ equity capital, riskiness and required return on equity. Following a methodology employed in recent papers, an attempt is made to measure these relationships in the light of the hypothesis of Modigliani and Miller on the irrelevance of the capital structure for the value of the firm. The empirical evidence discussed in this special feature supports the notion that higher capital requirements tend to be associated with a decrease in the riskiness of equity returns and thus of the required risk premium, in line with the theoretical argument. This conclusion counters the industry’s concern about a material increase in funding costs and further supports the regulators’ focus on higher equity requirements.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature reviews trends in the credit quality of banks’ loan books over the past decade, measured by non-performing loans, based on an econometric analysis for a panel of 80 countries. The assessment of overall asset quality and credit risk in the financial sector is an important element of macro-prudential surveillance. A thorough understanding of the main drivers thus facilitates the identification of key vulnerabilities in the financial sector.Results suggest that – not surprisingly – real GDP growth has been the main driver of non-performing loans during the past decade. Exchange rate depreciations are also linked to an increase in non-performing loans in countries with a high degree of lending in foreign currencies to unhedged borrowers. In addition to these two factors, equity prices also have an impact on non-performing loans, in particular in countries with large stock markets relative to the size of the economy. Finally, interest rates also tend to affect loan quality. While these findings are found to be robust in the heterogeneous panel dataset, such results should only be applied with great caution to individual countries where additional country and sector-specific factors might have an impact on non-performing loans.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Global liquidity, both in times of abundance and shortage, has a range of implications for financial stability. Surges in global liquidity may be associated with strong asset price increases, rapidly rising credit growth and – in extreme cases – excessive risk-taking among investors. Shortages of global liquidity may lead to disruptions in the functioning of financial markets and – in extreme cases – depressed investor risk appetite, leading to malfunctioning markets. This special feature takes a broad perspective and starts by defining and identifying the key drivers behind the multifaceted concept of global liquidity, all of which are related to more accommodative global financing conditions. Thereafter, a conceptual framework is proposed for how policy-makers can monitor global liquidity. This involves looking in depth at a broad set of indicators such as: (i) short-term interest rates in advanced and emerging economies; (ii) asset price valuation indicators; (iii) uncertainty, risk appetite and financial liquidity indicators; and (iv) capital flows, international reserves and cross-border credit growth. Building on this framework, the special feature also discusses policy responses to global liquidity developments from a financial stability viewpoint.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The ongoing global financial crisis has demonstrated the importance of understanding the sources of systemic risk and vulnerabilities that may lead to systemic financial crises. An early identification of sources of vulnerabilities is essential as it makes it possible to take preventive, targeted policy actions. This special feature presents the Self-Organising Financial Stability Map (SOFSM), which is a novel methodology based upon data and dimensionality reduction for mapping the state of financial stability, visualising the sources of systemic risks and predicting systemic financial crises.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature outlines the evidence on the relationship between different bank characteristics and risk before and during the recent financial crisis. A significant amount of bank risk materialised during the crisis. It is argued that two major structural developments in the banking sector (namely deregulation and financial innovation) probably had a large effect on banks’ business models and capital levels. This, among other factors, affected banks’ incentives to take on new risks in the decade leading up to the crisis. The empirical evidence from a number of studies suggests that banks with higher levels of capital, more stable funding and stronger risk controls performed better during the recent crisis. It also suggests that greater regulation of banks experiencing large increases in stock market valuation is warranted. The main empirical findings are in line with the Basel III recommendations.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature describes the recent wave of private capital flows to emerging market economies (EMEs), analyses the drivers of the flows and discusses the impact of portfolio flows on domestic macro-financial conditions. Currently, private capital flows to emerging markets are characterised by a surge in portfolio inflows which have reached similar levels to those prevailing prior to the onset of the financial crisis in 2007. The prospect of sudden stops and reversals sometimes associated with strong portfolio inflows can complicate the management of domestic macro-financial conditions in EMEs with potential negative financial stability implications. One of the key risks over the medium term linked to such flows is a boom/bust cycle in one or more systemically important emerging economies, along with the unwinding of imbalances and possible contagion. A bust could create severe disruptions in global financial markets and affect the euro area through a rise in global risk aversion, as well as through direct real economy and financial market linkages.

JEL Classification

G00 : Financial Economics→General→General

Abstract

During the recent financial crisis, euro area firms, and especially small and medium-sized enterprises (SMEs), reported severe problems gaining access to finance. Using new survey data for a sample of more than 5,000 firms in the euro area, this special feature presents the results as a means of tracking the financing obstacles faced by non-financial corporations, as well as a structural analysis of this issue during the recent crisis. After disentangling the impact of various factors, it is shown that firm age and size are key determinants of whether a company experiences problems accessing financing. As SMEs are often unable to switch from bank credit to other sources of finance, experiencing major financing obstacles can be a considerable challenge and can endanger economic growth. Looking forward, expanding access to finance while ensuring financial sector stability through responsible practices and an appropriate evaluation of risks appears essential for a sustained economic recovery.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has illustrated the importance of timely and effective measures of systemic risk. The ECB and other policy-making institutions are currently devoting much time and effort to developing tools and models which can be used to monitor, identify and assess potential threats to the stability of the financial system. This special feature presents three such models recently developed at the ECB, each focusing on a different aspect of systemic risk. The first model uses a framework of multivariate regression quantiles to assess the contribution of individual financial institutions to systemic risk. The secondmodel aims to capture financial institutions’ shared exposure to common observed and unobserved drivers of financial distress using macro and credit risk data, and combines the estimated risk factors into coincident and early warning indicators. The third model relies on standard portfolio theory to aggregate individual financial stress measures into a coincident indicator of systemic stress.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Fundamental reforms of regulation and supervision are currently under way – both at international and European level – to address the deficiencies exposed by the financial crisis. In this context, a range of policy approaches have been developed, aimed at mitigating the burden on taxpayers and minimising future reliance on public funds to bail out financial institutions. This special feature examines the recent initiatives undertaken by several EU Member States to implement bank levies and resolution funds, in some cases exploiting synergies with deposit guarantee schemes (DGSs). These financing mechanisms are fully supported by the European Commission in the context of the proposed EU framework for bank recovery and resolution.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature describes the key characteristics of macro stress tests for banks specifically in relation to their use during financial crises. The analysis draws on recent experiences in the United States in 2009 and in the EU in 2010, where macro stress tests for banks were used in one of the most severe financial crises in decades.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has revealed a number of shortcomings in the existing framework of prudential regulation. This special feature outlines the main elements of the Basel Committee on Banking Supervision’s proposals to strengthen global capital and liquidity regulations, commonly referred to as Basel III.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Macro-prudential policy aims to secure the stability of the financial system. The global financial crisis has shown how linkages between countries play a significant role in transmitting financial shocks. It is therefore of interest to examine macro-prudential policy for a group of countries as a whole. The macro-prudential policy stance based on an analysis of a group of countries may differ from the policies resulting from an analysis of each country in isolation. This special feature examines how similar stand-alone macro-prudential policies would have been for a selected group of countries and compares the desired stand-alone policies to a policy derived from a portfolio analysis. The desired macro-prudential policy stances (tight, neutral or accommodating) are derived from a set of historical indicators intended to measure systemic risk, but which clearly need further refinement. The degree of similarity between the countries’ policy stances varies over time. During some time periods it is quite high. Furthermore, the analysis shows that the desired macro-prudential policy stance derived from individual country data at times broadly corresponds to the policy stance derived from aggregated data for the portfolio. In Europe the increased focus on macro-prudential policy has led to the establishment of the European Systemic Risk Board (ESRB). The ESRB will have responsibility for EU-wide macro-prudential oversight and policy recommendation.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The global financial crisis has revealed important deficiencies of the standard macroeconomic models in capturing financial instabilities. Realistic characterisations of such instabilities include bank defaults, financial market illiquidity, extreme events, and related non-linearities. None of these feature in the macroeconomic models regularly used for forecasting and monetary policy analysis and only recently has more emphasis been given to better developing the role of financial sectors in these models. This gap is of particular concern given the ongoing efforts to establish serious macro-prudential oversight and regulation to counter systemic risks. The aim of this special feature is to provide an overview of the recent upsurge in research papers trying to integrate more developed financial sectors in standard macroeconomic models and to compare this work with what is needed for the support of macro-prudential policies. One conclusion is that very significant further research efforts are needed, including attempts using modelling approaches that deviate from the currently dominating macroeconomic paradigm. It is of great importance that the academic and policy-oriented research communities join forces in working towards this objective.

JEL Classification

G00 : Financial Economics→General→General

Abstract

A host of new quantitative measures of systemic risk have recently been proposed in the academic and central banking literature. The stated purpose of these tools is to support macro-prudential oversight and inform policy decisions. This special feature surveys these measures, focusing primarily on the most recent developments that have not yet been covered in the ECB’s Financial Stability Review, and explains what can be learned from them. The strengths and weaknesses of approaches when applied in a macro-prudential context are discussed. Significant research in this area has addressed how to measure the systemic importance of specific financial intermediaries, for example by estimating the externalities they may exert on the financial system. With the rising number of different analytical measures and models it becomes increasingly important to prioritise between them and to construct a system of measures that, overall, covers all dimensions of systemic risk and how they relate to each other.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The need for a framework for macro-prudential policy has been widely recognised in the aftermath of the financial crisis. This special feature discusses, in a tentative way, core elements of this framework: namely its objectives and the policy tools that could be used to achieve them. The bulk of the policy tools, for which concrete proposals have been put forward at the global level, tend to aim at enhancing the resilience of the financial system. A different set of tools, aimed at addressing financial imbalances directly, could also be of importance in mitigating system-wide risks. Central banks’ involvement in macro-prudential policy advice could relate to this latter set of tools more prominently, supported by their systemic risk surveillance and assessment tasks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The identification and assessment of systemic risks is a core function of macro-prudential supervision. There are four broad approaches for analytical models and tools that can support this function. The first three each aim to detect early one of the three main forms of systemic risk, namely the endogenous build-up and unravelling of widespread imbalances, exogenous aggregate shocks and contagion. First, early-warning models and indicators use information in current data in order to signal the presence of emerging imbalances and risks without adding exogenous shocks that are not priced in by the market. Second, macro-stress-testing models are used to assess the resilience of the financial system against extreme but plausible scenarios of widespread exogenous shocks, irrespective of whether current market data give a particular weight to them. Third, contagion and spillover models assess the transmission of instability among financial intermediaries and among financial markets to the extent that the sources are not common. Financial stability indicators, the fourth approach, display the current state of systemic instability in order to, for example, identify the presence of crises. The specific tools underpinning these approaches are broadly available, although further research efforts are also necessary.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has demonstrated the critical role played by some large and complex financial institutions in undermining financial stability. Particular attention is currently being paid by policy-makers to the question as to how systemically important financial institutions (SIFIs) should be regulated and how failures, if they occur, should be resolved.This special feature provides an overview of the ongoing initiatives at the European and international level to deal with these institutions in the broader context of measures aimed at curbing moral hazard and institutions’ contributions to systemic risk.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The recent global financial crisis has illustrated the role of financial linkages as a channel for the propagation of shocks. It also brought to the fore the concept that institutions may be “too interconnected to fail”, in addition to the traditional concept of being “too big to fail”. This special feature introduces recent research on networks in disciplines other than economics, reviews its application to financial networks and discusses how network analysis can be used to gain a better understanding of the financial system and enhance its stability.

JEL Classification

G00 : Financial Economics→General→General

Abstract

As the impact of the recent financial crisis began to spread beyond mature economy financial systems, attention was increasingly drawn to the potential systemic risks associated with the prevalence of foreign currency lending in some EU Member States. Although the direct exchange rate risk for banks in most of these countries is controlled by regulatory limits on open foreign exchange positions, banks are still exposed to the indirect exchange rate risk that can arise from currency mismatches on their clients’ balance sheets. This special feature summarises the measures that have been taken by several EU countries to address the financial stability risks related to rapidly expanding foreign currency lending to the non-financial private sector. The experience gained so far indicates that the effectiveness of these measures has been rather limited. Although a variety of factors appear to explain this, what has been particularly important is the persistence of wide differentials in the interest rates paid on loans in domestic currency over those paid in foreign currency, as well as the intensity of bank competition. Moreover, countries’ experiences have revealed that when the presence of foreign-owned banks in local markets is significant, as is the case in non-euro area EU countries in central and eastern Europe, the impact of implementing these measures has been materially curtailed.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The financial crisis has raised questions about the effectiveness of the current supervisory architecture. As a result, policy recommendations for regulatory reform have emerged at the European and global level which aim at enhancing the tools and structures devoted to macro-prudential oversight, as well as at ensuring an effective interplay with the monitoring of individual financial institutions. The overall objective of these policy actions is to strengthen the resilience and robustness of the financial system and thus enhance financial stability. Against this background, this special feature describes the framework being proposed for macro-prudential oversight in the EU and is structured as follows: first, it describes the decisions and actions taken at the international and EU level to strengthen macro-prudential supervision. Second, it elaborates on the envisaged framework for contributing to the safeguarding of financial stability at the EU level. Finally, the processes of the proposed macro-prudential supervisory framework, as well as the challenges for the proposed framework to work effectively, are analysed.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Research, in conjunction with market intelligence and current policy analysis, can make an important contribution to the understanding of systemic risk. It is one element in learning the lessons from the financial crisis and in supporting ongoing efforts to further develop the macro-prudential dimension of financial supervision. This special feature briefly discusses the concept of systemic risk and surveys the existing research literature. Research in the last two decades has made significant progress in analysing systemic risk, in particular contagion risks. It has also documented the relevance of macroeconomic shocks and started to analyse endogenously pro-cyclical behaviour from the perspective of systemic risk. Some of the analyses described important features of the present crisis. Substantial further research efforts, however, need to be made, inter alia, to develop aggregate modelling frameworks that capture realistic features of financial instability, to better understand the endogenous build-up and unravelling of widespread imbalances and to assess the systemic importance of non-bank financial intermediaries.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The purpose of this special feature is to review the ongoing academic debate on the potential pro-cyclical effects of bank capital regulation under Basel II, as well as the initiatives undertaken and new proposals put forward to reduce such potential effects. The main conclusions that seem to emerge are fourfold. First, based on simulation exercises, Basel II may increase the volatility of bank capital requirements over the business cycle. Second, available empirical micro-economic evidence on the relationship between bank capital and the credit supply suggests that bank lending may become more cyclical with Basel II, but mostly as far as undercapitalised and illiquid banks are concerned. Hence, at the aggregate level, the extent to which Basel II may amplify the business cycle depends on the degree of undercapitalisation and access to liquidity of the banking sector as a whole. Third, given the data limitation and identification problems, it is still too early to precisely assess whether or not Basel II has affected the business cycle in the countries where it is already implemented. Fourth, while there seems to be a view among academics that Basel II, as it currently exists, may not be adequately designed to cope with all sources of risks in the financial system, financial regulatory authorities have recently been discussing a comprehensive set of measures to enhance the Basel II framework with the aim to contain leverage and promote the build-up of counter-cyclical capital buffers in the banking sector.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Asset markets seem to have been playing an increasingly important role in many economies, and policy-makers have become far more aware that the sizeable changes and, sometimes,significant corrections of asset prices may lead to financial and, ultimately, macroeconomic instability. Not least against the background of the recent financial turmoil, many international institutions and academics have focussed on the development of early warning indicator models for asset price misalignments. After providing a short review of the literature and the methodologies used in this context, this special feature presents some empirical results related to defining and predicting asset price misalignments. An asset price composite indicator is constructed which incorporates developments in both the stock price and house price markets, and a method for identifying asset price busts is presented. An empirical analysis carried out on the basis of a panel probit-type approach finds that credit aggregates, nominal long-term interest rates and the investment-to-GDP ratio, together with developments in either house or stock prices, are the best indicators that help to predict busts up to eight quarters ahead.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Insurance companies can be important for the stability of financial systems mainly because they are large investors in financial markets, because there are growing links between insurers and banks and because insurers are safeguarding the financial stability of households and firms by insuring their risks. This special feature discusses the main reasons why insurance companies can be important for the stability of the financial system. It also highlights the special role of reinsurers in the insurance sector and discusses some of the key differences between insurers and banks from a financial stability point of view.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Banks are key providers of funds to firms and households in the euro area. The analysis of bank lending standards – banks’ internal guidelines or criteria governing their loan policy – is therefore important for understanding the provision of credit in the euro area. This special feature first analyses the determinants of bank lending standards in the euro area and how changes in lending standards impact on banks’ risk taking. Second, it shows that, generally, the risk built up by banks in good times may – via its impact on capital – imply future restrictions on the supply of loans and that bank balance sheet constraints may have a detrimental impact on the loan supply in the current crisis.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Interbank markets play a key role in banks’ liquidity management and the transmission of monetary policy. With the onset of the financial crisis, liquidity has been reduced in some segments of the interbank market. Moreover, since late September 2008, banks have hoarded liquidity instead of lending excess funds in the interbank market. The malfunctioning of interbank markets endangers the stability of the banking system. This special feature argues that asymmetric information about credit risk is an important factor contributing to these patterns.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The identification of vulnerabilities, trigger events and channels of transmission is a fundamental element of financial stability analysis. Using data for the euro area, this article combines measures of leverage and volatility with interlinked balance sheets to show how local financial shocks can spread through the financial system and affect balance sheets and risk exposures in other parts of the system. Analysis of this network of interlinked assets and liabilities leads to the conclusion that the cross-sector balance sheet exposures in the euro area financial system constitute important channels through which shocks can be transmitted across sectors. High financial leverage and elevated asset volatility are key factors in increasing a sector’s vulnerability to shocks and contagion.

JEL Classification

G00 : Financial Economics→General→General

Abstract

A failure of an individual hedge fund or a group of hedge funds can have adverse implications for financial stability, mainly through an impact on asset prices and market liquidity and through potential losses for the hedge funds’ creditors. Therefore, it is important to understand the underlying reasons behind hedge fund failures and to create indicators that would allow strains in the hedge fund sector to be monitored. To this end, this special feature focuses on cases of hedge fund liquidation and estimates the main factors that could point to a higher liquidation risk, using a panel logit analysis. On the basis of the estimation results, a composite indicator is proposed, which shows that the probabilities of hedge fund liquidation increased substantially in 2008 and remained elevated at the beginning of 2009.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature discusses some of the market-based indicators that are used regularly in the Financial Stability Review (FSR), focusing in particular on indicators whose information content was distorted by the financial crisis owing to factors such as extreme risk aversion, impaired market liquidity and high uncertainty about the intrinsic values of assets traded on some markets. The analysis shows that, particularly during times of crisis, great analytical efforts are required for an appropriate interpretation of developments in these indicators. This is due to the fact that credit default swap (CDS) spreads, interest rates and equity prices all include a range of risk premia, so that it is important to be aware how much and in what ways these premia are driving asset prices. If these factors are properly taken into account, market-based indicators still provide a very rich source of up-to-date information for financial stability analysis.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature summarises the main policy initiatives that are aimed at strengthening the resilience of the financial system, both at the international and at the European level. Because events in financial markets are continuing to unfold, triggering prompt responses by governments and supervisors, this special feature can, at this stage, only provide an interim overview of the major initiatives taken thus far.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature presents some observations on what were good risk management practices at large financial institutions, as well as the main lessons that could be learnt from the recent period of financial market distress and the recommendations that could be made from a risk management perspective.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature attempts to evaluate the resilience of lending by euro area large and complex banking groups to the financial turmoil, using recent quarterly balance sheet data. The analysis suggests that loans to customers will decline in the coming quarters. While a further drop in the value of assets in the financial sector would accentuate and prolong this process of deleveraging until the end of 2009, efforts to raise bank capital would help mitigate the expected decline in customer loan growth.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Unsecured interbank money market rates such as the EURIBOR increased strongly with the start of the financial market turbulences in August 2007. There is clear evidence that these rates reached levels that cannot be explained solely by higher credit risk premia charged by lenders in interbank transactions. This special feature presents this evidence and provides an explanation which draws on the funding liquidity risk of lenders in unsecured money markets.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Securitisation has become an increasingly important element of structured finance and has seen rapid development in recent years. In light of the tumultuous events in financial markets since August 2007, however, the securitisation process has come under increasing scrutiny. This special feature explores the securitisation process from a supply-side perspective, highlighting the benefits and drawbacks of this approach. An overview of developments in the market, in the context of the recent turbulence, is also provided. A new source of data on securitisation is then introduced and results on emerging trends in the market are highlighted.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature examines whether securitisation activity and banks’ risk-taking have had any impact on euro area banks’ lending behaviour. It finds this to be the case. In particular, based on a sample covering around 3,000 intermediaries over the first seven years of EMU, it is found that the favourable financial condition of banks together with strong securitisation activity seem to have diminished the importance of the bank lending channel and strengthened the ability of banks to supply loans. However, it is also found that this capacity depends upon business cycle conditions and, notably, upon banks’ risk positions. In other words, deterioration in either could have an adverse affect on bank loan supply.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Information from equity and credit market based indicators of banks is commonly used for financial stability assessment. In this practice, it is often assumed that equity market-based indicators provide information on the markets’ assessment of the outlook for, and the risks surrounding, future banking profitability. At the same time, for the credit-based indicators the prior assumption is that these provide information on the credit risk outlook for banks or the likelihood of bank failure. However, such indicators are likely to exhibit some co-movement owing to common drivers, such as the business cycle or interest rate changes. This special feature confirms that this is the case even for bank-specific (or idiosyncratic) equity and credit measures. In order to pin down the nature of the interaction between credit and equity markets and key macroeconomic drivers, a dynamic model is estimated, revealing a large role for a risk aversion driver, and a weaker one for changes in interest rates and oil prices. The analysis also finds that risk measures based on equity lead those stemming from the credit default swap (CDS) market.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The general repricing of credit risk which started in summer 2007 has highlighted significant problems in the valuation of collateralised debt obligations (CDOs). This special feature analyses the determinants of movements in CDS index tranche premia. The main finding is that the repricing of credit risk led to a heightened impact of risk aversion and liquidity measures on market prices. Overall, the results imply that even in the most liquid segment of the CDO market, market prices still contain a sizeable liquidity premium.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This Special Feature presents evidence on the level and cross-sectional dispersion of large publicly-traded banks’ capital ratios, both regulatory and economic, in Europe and the US. It reveals that banks’ holdings of capital are well in excess of the regulatory minimum and that there is a surprisingly large dispersion of banks’ capital ratios, warranting further investigation. It then goes on to show that standard cross-sectional determinants of firm leverage also explain the capital structure of most large banks in the US and Europe. An important finding is that most banks seem to be optimising their capital structure in much the same way as firms.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This Special Feature discusses the effect of short-term interest rates on bank credit risk-taking. In addition, it examines the dynamic impact of monetary policy on the credit risk of loans. It presents evidence that low short-term interest rates encourage bank risk-taking and reduce the credit risk of outstanding loans. However, credit risk becomes high at times when interest rates return to or rise above their average level after having been very low for a long period.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Commercial property markets are important for financial system stability mainly because commercial property constitute large holdings of different kinds of investors and because of the considerable amounts of bank lending that such holdings entail. Volatility in commercial property prices has proved to be a source of financial system instability in the past. Hence, from a financial stability viewpoint, it is important to monitor the nature and scale of exposures to commercial property within the financial system.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The relationship between risk aversion and financial market liquidity is usually found to be negative – i.e. higher risk aversion is typically associated with lower market liquidity. However, this is not the case all of the time. Indeed, there have been rather lengthy periods when higher financial market liquidity has been associated with increasing risk aversion. This Special Feature examines the co-movement of these series for the euro area from the beginning of 1999 until late 2007. The analysis suggests that close monitoring of financial market risks is needed when financial market liquidity is rising but risk aversion is increasing. Even though such states can persist for a considerable period, they seem to be followed by periods of higher risk aversion and reduced market liquidity as has been the case from July 2007 onwards.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Hedge funds are flexible and relatively unconstrained institutional investors, which may also use leverage to boost their returns.This investment freedom and their ability to leverage can pose risks for their creditors and trading counter-parties, who need to safeguard their credit exposures. Triggers based on the cumulative decline in the total net asset value of a fund are frequently used by banks to protect themselves against credit losses stemming from hedge fund failures. An empirical examination of the indicator properties of such triggers as early warning signals of impending hedge fund liquidation finds that they are not very precise in detecting future problems. Nonetheless, they still provide opportunities for banks to review the risk profiles of the hedge funds they are exposed to, thereby allowing them to take necessary protective action against risks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Since the enaction of the Second Banking Directive of 1989, European banks have been permitted to engage in any degree of functional diversification that they consider optimal in terms of risk and return. From a financial stability assessment perspective, it is useful to ask how functional diversification affects risk in the banking system. This Special Feature uses statistical techniques to generate a market-based risk measure, and examines how developments in banks’ income components affect this risk measure during times of extreme equity market movements. The main findings are that size and trading income have a positive effect on the systemic risk measure used, while income from traditional intermediation activities is negatively related to the risk measure used.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Identifying the macro-financial factors that drive the default probability of banks’ borrowers and thus the default risk in banks’ loan books is important in order to obtain a better understanding of conjunctural sources of risk in the financial system. This Special Feature presents an original approach for modelling the links between a global macroeconomic model already used at the ECB for modelling international economic and financial linkages and corporate sector expected default frequencies (EDFs) in the euro area. The results show that euro area default probabilities are strongly affected by shocks to GDP, stock prices, exchange rates and oil prices. Furthermore, the model is capable of providing robust estimations under a wide range of shocks. It could thus be particularly useful for generating scenarios in order to stress test the resilience of individual banks along with the entire banking system.

JEL Classification

G00 : Financial Economics→General→General

Abstract

In terms of economic capital, credit risk is the most significant risk faced by banks. This Special Feature implements a credit risk model – based on publicly available information – with the aim of developing a tool to monitor credit risk in a sample of large and complex banking groups (LCBGs) in the EU. The results indicate varying credit risk profiles across these LCBGs and over time. Notwithstanding some caveats, these results demonstrate the potential value of this approach for monitoring financial stability.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The willingness of investors to bear financial risk, commonly referred to as investors’ risk appetite, has been a subject of growing interest among market participants and observers alike not least on account of the buoyancy of financial markets over the past three to four years. Many different indicators of risk appetite have been developed but patterns in them are not always the same even though they are supposed to capture the same phenomenon. This Special Feature aims at unearthing a common component between several commonly followed indicators and it develops a composite measure of risk appetite. The resulting composite measure appears to capture well several periods when markets underwent episodes of stress.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The value of global corporate leveraged buyout (LBO) transactions has expanded substantially over the past couple of years. Many of the deals have been characterised by high debt-to-equity ratios, which have reached levels comparable to those seen in the US LBO boom of the 1980s. Putting recent developments into historical perspective, this Special Feature recalls the implications of theories of optimal capital structure for recent developments and it explains how recent LBO activity has been facilitated by recently developed techniques for credit risk transfer. From a financial stability perspective, there are some concerns as it cannot be excluded that intense competition to win new deals in the pursuit of fee income, together with the strength of the bargaining power of private equity firms in negotiating terms for LBO transactions, may have led to an inadequate pricing of risks by investors invarious forms of LBO debt. To mitigate these risks, banks will need to ensure the adequacy of stress-testing of their direct exposures and exercise vigilance in the monitoring of counterparty risks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

For the purposes of financial system stability assessment, it is important to identify and monitor the activities of banking groups whose size andnature of business is such that their failure and inability to operate would most likely have adverse implications for financial intermediation, the smooth functioning of financial markets or other financial institutions operating within the system. A simple and common approach for identifying such institutions – often grouped under the heading large and complex banking groups (LCBGs) – is to rank them by the size of their balance sheets. However, asset size alone may fail to shed much light on the importance and complexities of the interconnections that a banking group may have within a financial system, especially given the growing importance of banks’ off-balance sheet activities. Knowledge about such interconnections is important because it can help in mapping how, or if, strains in a large banking group could spread to otherinstitutions or markets. Based on a multiple indicator approach, this Special Feature takes a first step towards statistically identifying banking institutions that meet certain “largeness” characteristics that go beyond balance sheet size.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Information extracted from credit default swap (CDS) index tranches can provide an important contribution to a forward-looking assessment of banking system risk. The market prices of CDS index tranches provide the basis forconstructing an indicator of the level of systematic risk in the credit market. Inparticular, this indicator describes traders’ views on the future relative development of systematic and idiosyncratic portfolio credit risk. Thus, it shows whether traders are more concerned about economy-wide credit risk or about firm-specific credit risk such as the default of a particular firm. This Special Feature constructs an estimate of the implied correlation for the euro credit market and describes its use in financial stability analysis. The three main results of this analysis are as follows. First, after January 2006, there was evidence that the focus of credit traders had moved from firm specific credit risk towards systematic credit risk. This finding can be linked to a number of fundamental determinants of credit market valuation, all of which point in the same direction. Second, the implied correlation provides detailed information about how the credit markets functioned during the May 2005 market turbulence. Third, most of the variation in the implied correlation is not linked to other financial market indicators.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Credit growth has accelerated in recent years in some central and (south-) eastern European countries (CEECs).While low starting levels of financial intermediation help explain the speed of credit growth, its fast pace could raiseconcerns from a financial and macroeconomic stability perspective. This Special Feature suggests a methodology for analysing these episodes that explicitly accounts for both macroeconomic developments and the catching upprocess associated with the transition from planned to market economies that countries in the region have been undergoing. However, even if both factors are taken into account evidence is still found in some countries of higher credit growth than the empirical model would suggest. In these cases the dynamics ofcredit growth are nevertheless not markedly different for foreign or domestic currency lending, or for lending to households and corporations. Given the limited available data, however, these results must be interpreted with caution, and further research is called for to address issues such as the mechanisms through which the exchange rate regime, the presence of foreign banks and the range of lending products on offer may impact credit developments in the region.

JEL Classification

G00 : Financial Economics→General→General

Abstract

If very large changes in the stock prices of individual insurance undertakings tend to occur simultaneously, it can be said that extreme-value dependence is present. If such dependence is found to be present, it can indicate that these firms are exposed to common sources of risk. With a focus on gaining insight into systemic risk within the insurance sector, this Special Feature examines the incidence of extreme-value dependence across different types of insurance undertakings and it goes on to examine the main drivers of such co-movement, to the extent that it is present. A key finding is that extreme-value dependence is evident among larger composite insurers. In addition, two important drivers of extreme-value dependence between insurance companies are found: exposure to extreme financial market events, and to non-life underwriting.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Since the introduction of the euro, the progress made in the integration of financial markets and market infrastructures in the EU, the growing number of internationally active institutions and the diversification of financial activities have increased the liquidity and efficiency of the relevant markets. At the same time, however, such developments have also increased the likelihood that systemic disturbances could affect more than one Member State, and possibly increase the scope for cross-border contagion. In this context, the specific arrangements for handling crises at the EU level between the authorities responsible for safeguarding financial stability have been considerably enhanced since the introduction of the euro. The enhancements include legislative initiatives in the framework of the Financial Services Action Plan (FSAP), the implementation of the Lamfalussy framework for regulation and supervision in all financial sectors, the adoption of agreements on voluntary cooperation between responsible authorities, and the development of practical arrangements, such as the organisation of financial crisis simulation exercises. This Special Feature provides a structured overview of the progress made in the specific arrangements for financial crisis management between central banks, banking supervisors and finance ministries. Arrangements involving other authorities, such as other sectoral financial supervisors or deposit-insurance schemes, are not dealt with in this Special Feature.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Just as banks are increasingly using stress testing to assess risk at the institution level, macro stress tests are becoming an increasingly important tool for financial stability analysis by central banks. These tools can be used by central banks to assess the capability of the financial system, especially the banking system, to weather extreme but plausible shocks to its operating environment. Given the importance of credit risk for banks, this Special Feature discusses various conceptual aspects of designing macro stress-tests for the banking system, with a special emphasis on credit risk.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The literature has proposed a number of approaches how to assess the stability of banking systems. In this Feature a novel approach is described that is based on extreme value theory (EVT). EVT is particularly suitable for the analysis of financial instabilities, as it is designed to deal with the occurrence of extremely rare events (“tail risk”). For example, it has been used to examine the severity of stock market crashes, the pricing of catastrophic loss risk in reinsurance or the extent of operational risk in banks. The present application to systemic risk in banking derives a parameter from market returns that can capture the exposure of an arbitrary large number of banks to each other and to aggregate risk. The 25 systemically most important banks are analysed for the euro area and the United States, respectively, between 1992 and 2004. The results suggest that multi-variate spill-over risk among banks may be more pronounced in the United States than in the euro area. One explanation for this finding seems to be that cross-border linkages are still weaker in Europe. Exposure to extreme systematic risk, however, is rather similar in the two banking systems. On both sides of the Atlantic the two forms of banking system risk increase during the second half of the 1990s. Increases in spill-over risk in Europe are, however, very gradual. The findings raise interesting policy questions about the relationship between financial integration as well as financial consolidation and the stability of banking systems.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Information about the factors that drive bank level stock return variability can provide useful input to financial stability analysis. In this Special Feature, the dynamic dividend-discount model is combined with an accounting-based VAR framework that decomposes EU banks’ stock returns into cash flow and expected return components. The main findings are that while the bulk of the variability of EU banks’ stock returns is due to cash flow shocks, the expected return shocks are relatively more important for large than for small banks. This suggests that large banks could be more prone to market-wide events that, in the literature, are associated with the expected return news component as opposed to the bank-specific news component, typically assumed to be incorporated in the cash flow component.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Financial stability assessment as currently practised by central banks and international organisations probably compares with the way monetary policy assessment was practised by central banks three or four decades ago – before there was a widely accepted, rigorous framework. The measurement challenges that lie ahead for financial stability assessment are formidable. However, it is important to acknowledge that significant progress has been made in recent years. Even though there is no obvious framework for summarising developments in financial stability in a single quantitative measure, a growing number of central banks around the world are making financial stability assessments and publishing financial stability reports, many of them based on a broad and forward-looking conception of financial stability.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Recent research has greatly improved the understanding of financial contagion. There are two main channels though which contagion may emerge among financial markets: physical exposure and asymmetric information. Contagion can be empirically identified through the propagation of extreme negative returns, the increase in interdependence compared to normal times, and the distinction from common shocks. The evidence on international financial market contagion suggests that it is a relevant phenomenon that has indeed occurred in various crises, but in severe form, it is rather rare. In most instances the breadth of contagion seems to be limited to specific countries or geographical regions. In addition, it is less frequent across different asset classes than within the same asset class. Finally, simple measures for market comovements, such as standard correlation coefficients, do not usually perform well as indicators of contagion.

JEL Classification

G00 : Financial Economics→General→General

Abstract

From a financial stability viewpoint, the condition of household sector balance sheets can have an important bearing on the credit risks that banks face. As in other mature economies, increasing household sector indebtedness in the euro area over recent years has raised some concerns about sustainability and, as a corollary, creditworthiness. Drawing upon survey information contained in the European Community Household Panel (ECHP) database, this Special Feature highlights some of the characteristics of indebted households in the euro area, and analyses the degree of vulnerability of mortgage-indebted households.The picture that emerges from an analysis of micro data covering euro area households over the period 1994-2001 suggests an overall improvement in resilience. In particular, mortgage debt appeared to be held mostly by high-income households, which tend to have good prospects for servicing debt. Nevertheless, considering the substantial increase in house prices and the significant accumulation of mortgage debt in some Member States after theperiod covered by the data examined in this Special Feature, continued monitoring of household sector indebtedness is called for.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Banks are key components of the euro area financial system. Understanding the interplay between banks and their operating environment assists in identifying sources of risk and vulnerability within the system. This Special Feature attempts to examine the empirical importance of bank-specific, market structure and macro-financial factors on euro area banks’ financial performance over the last decade or so.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The EU Regulation requiring all listed companies, including banks, to prepare consolidated financial statements in accordance with International Financial Reporting Standards (IFRS) has been a positive development that will increase the transparency and comparability of financial statements in the EU. However, the first-time application of these new rules will have a significant impact on financial statements which should be taken into account when analysing the accounting figures. The aim of this Special Feature is to provide a brief overview of the main ways in which IFRS will affect banks’ primary financial statements.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Central counterparty clearing houses (CCPs) play an important role in efficiently reallocating counterparty credit risks and liquidity risks in financial markets. However, as systemically important players, they must manage their risks in an adequate way in order to avoid creating new risks for financial stability.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Central banks have a strong and natural interest in safeguarding financial stability. This special feature discusses some key ingredients that are needed for a systematic approach to financial stability monitoring and assessment. A good understanding of what is meant by financial stability and what is meant by financial instability, taken together, can serve to define the boundaries of the scope of the analysis. A balancing of financial efficiency and stability objectives may require an understanding of the safeguarding of financial stability less as a zero tolerance of bank failures or of an avoidance of market volatility, than as avoiding financial disruptions that have adverse consequences for the real economy.

JEL Classification

G00 : Financial Economics→General→General

Abstract

This special feature analyses the indicator properties of macroeconomic variables and aggregated financial statements from the banking sector in providing early signals of distress in the banking sector. Identifying leading indicators of financial distress is important when assessing systemic risk within a broader financial stability analysis. An empirical model is estimated using data for 15 mature countries over the period 1980-2001. The analysis suggests that low economic activity, high domestic credit growth, rapid growth in property prices, as well as low profitability and low liquidity in the banking sector, have good properties as leading indicators of financial distress.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Knowledge of the determinants of financial distress in the corporate sector can provide a useful foundation for analysing the degree of credit risk facing banks, and represents a key input for assessing risks and vulnerabilities to financial stability. This special feature examines the determinants of corporate failure in Italian, Spanish and French SMEs in order to shed light on whether the predictors of financial distress in these countries are the same or not. This is done by estimating models for each of these countries and a common model for the three. This allows an assessment of the differences in the determinants of financial distress and in the predictive ability of the two model set-ups.

JEL Classification

G00 : Financial Economics→General→General

Abstract

A market for collateralised debt obligations (CDOs) has evolved rapidly in Europe in recent years. Synthetically created CDOs based on credit default swaps have become a popular vehicle for transferring corporate related credit risk from the banking sector to other parts of the financial system. As with other new markets, CDOs contribute to financial efficiency, but also present new risks that central banks need to understand. From a financial stability viewpoint, concerns have been expressed about mispricing and inadequacies in risk management, even by the most sophisticated market players, as well as excessive reliance on rating agencies. Furthermore, public authorities face challenges in tracking credit risk around the financial system. Innovation and improvements in market functioning have helped to mitigate some of these concerns. In particular, the evolution of credit indices has fostered standardisation and secondary market activity. However, challenges for financial stability remain, requiring an ongoing monitoring of market developments by central banks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Contagion across banks is widely perceived to be an important element in banking crises and thus a major systemic stability concern. For example, the private sector rescue operation of Long Term Capital Management (LTCM), which was coordinated by the Federal Reserve Bank of New York, was justified on the grounds of the risk of contagion to banks. Similarly, contagion risks transmitted through the interbank market played a major role in the decisions of the Bank of Japan to react to the failures of major Japanese securities houses in the early 1990s. Generally, however, evidence of the significance of contagion is fairly limited. This special feature analyses the risk of cross-border contagion for large European banks.

JEL Classification

G00 : Financial Economics→General→General

Abstract

After the near-collapse of LTCM in September 1998, recently hedge funds have again started to capture the attention of financial stability watchers. However, this time the renewed interest is motivated by their impressive growth and increasing proliferation as a mainstream alternative investment vehicle.

JEL Classification

G00 : Financial Economics→General→General

Abstract

Securities settlement systems form an essential part of the financial market infrastructure. If they are badly designed, they may contribute to severe disruption of the functioning of financial markets. Awareness of the importance of securities settlement systems is especially high in Europe, as the European securities settlement infrastructure has been changing rapidly in many ways. This Special Feature describes the most important reasons why robust securities settlement systems are important for safeguarding financial stability, and states how they should be designed to ensure that they do not contribute to instability in financial markets.

JEL Classification

G00 : Financial Economics→General→General

Abstract

On 26 June 2004, the central bank governors and the heads of banking supervisory authorities of the G10 countries endorsed the Revised Framework for Capital Measurement and Capital Standards, commonly known as Basel II or the New Accord. Basel II is the culmination of a highly challenging project that was carried out by the Basel Committee on Banking Supervision (BCBS) and its member agencies over a period lasting more than five years. Following the publication of the first round of proposals in June 1999, two additional consultative packages were circulated in 2001 and 2003 for comments, involving industry representatives, supervisory agencies, central banks and other observers in all member countries. For many countries the next step will be the implementation of the Revised Framework by the end of 2006, according to the timetable developed by the BCBS. The deadline for the implementation of the most advanced approaches to risk measurement foreseen by the new framework is the end of 2007. This Special Feature provides an overview of the comprehensive approach of the New Accord, placing emphasis on the innovative elements of Basel II and relevant aspects from a financial stability perspective. It concludes with an assessment of the key remaining challenges for a successful implementation of the New Accord.

JEL Classification

G00 : Financial Economics→General→General

Abstract

The household sector is one of the key sectors for financial stability analysis in EU and in the euro area for two main reasons. Firstly, the household sector accounts for a significant proportion of non-bank lending in terms of the stock of credit outstanding. At the end of June 2004, approximately 30% of loans granted to euro area residents were to households. By contrast, about 25% were granted to non-financial corporations. This share has not changed very significantly since the start of EMU. Secondly, the growth rate of lending to this sector has also been the fastest among the non-financial sectors in recent years. The growth rate of loans extended to households in some EU countries has been very strong over recent years. There has been little sign yet of a reversion to more conventional growth patterns in 2004, and this category has been the fastest growing type of lending in the euro area for the past two years. This Special Feature concentrates on lending trends to households over the period 2002-2003, though longer periods are used where relevant. It assesses the most important exposures for euro area and EU banks to the household sector as far as the data allows.