Looking at a Continent: Stress-Testing Banks and Insurers

The European Central Bank’s financial stability review, published in November 2016, predicts “steady, but modest, euro area economic recovery, despite continued headwinds.”

The review is designed to assist Europe’s policy making authorities by providing information about the bank’s microprudential and macroprudential roles, along with the risks and vulnerabilities of the financial system of the continent.

Good News on Systemic Stress

Although global financial markets became increasingly volatile through 2016, by three important measures of systemic stress the euro area economy continues to look tranquil compared especially to the jittery days of 2011-2012. The three measures at issue are as follows:

• The probability of default of two or more large and complex banking groups within one year;
• A composite indicator of systemic stress in financial markets; and
• A composite indicator of systemic stress in sovereign bond markets.

In late 2011, the probability of default of two or more LCBGs rose above 25%. The two composite stress indicators each rose above 0.6.

As of the issuance of this report though, late last year, the default probability was below 4%. The sovereign bond stress indicator was at 0.1 and had been there or quite close, throughout the year. The financial markets stress indicator, which had been above 0.3 in the early summer (though that was itself a brief spike induced by the Brexit vote) had spent the intervening months falling and was closing in on 0.1 itself.

On a related front, the report observes that “[m]ost of the market segments affected by the turbulence following the UK referendum quickly recovered the bulk of their losses, not least given a resolute policy response by the Bank of England.”

Cautionary Words About the Banks

The ECB does have some cautionary words for policymakers about the banking industry, though.

That industry has been living with a high level of non-performing loans (NPLs) of late.  In a well-functioning market, banks would get the NPLs off of their balance sheets by selling them to non-bank institutions at a mark-down on their face value as dictated by supply and demand. But that market hasn’t been working all that well, due to “sources of informational asymmetry and structural inefficiencies,” so this weight remains on the banks’ balance sheets.

More than 60% of Europe’s NPLs are “related to various forms of corporate lending.”

One of the consequences of those weights still sitting on the banks’ balance sheets may be that they will impair the effectiveness of monetary policy. The usual levers for stimulating an economy via the money supply work through the banks, and may not work as well as desired as bank resources are tied up as a consequence of inefficient lending.

Four scenarios

In one fascinating section the ECB offers “a quantitative assessment of four macro-financial scenarios that map the main strategic risks” facing Europe’s financial system at present. The scenarios are:

• Heightened political uncertainty in the advanced economy combined with “continued fragilities in emerging markets” leads to a broad re-pricing of risks;
• Weak bank profitability and low nominal growth worsen one another in a feedback loop;
• The re-emergence of private sector and sovereign debt concerns creates a sustainability crisis; and
• Investment funds are forced into disorderly asset sales, which have spillover effects for the broad financial system and, thereby, for the real economy.

Of these, the second, the weak bank operating environment scenario, looks the most frightening from the ECB’s office windows.  The report provides the following table, estimating the overall impact on GDP growth in the Eurozone (in percentage deviation from a presumed baseline) under each scenario:

Adapted from ECB Financial Stability Review Nov. 2016, Table 3.2, p. 108

The good news arising from this quantification, though, is that the “vast majority of banks would remain well capitalized” under each of these scenarios, illustrating the over-all resilience of the banking system.

Likewise, the exercise indicates that the European insurance system is in good shape for surviving such shocks as contemplated above.

Banking Union

Finally (or at any rate, finally for this brief survey), the ECB report includes an earnest plug for banking union. More than a year ago, the EC proposed a regulation that would establish a single European Deposit Insurance Scheme (EDIS). In the view of the ECB, “it is important that such a scheme is in place and operational as soon as possible and that progress continues to be made on the risk-reduction agenda.”