For the third successive year since the intensification of the financial turmoil in the autumn of 2008, risks are still prevailing across major sectors of the euro area economy, which poses challenges not dissimilar to those in many other advanced economies. In particular, concerns of financial market participants regarding the interplay between sovereign and financial sector risk remain elevated. In view of challenges related to the implementation of the consolidation programme in Greece, which have grown since the publication of the last FSR in December 2010, market concerns have risen, as evidenced for example by an inversion of its sovereign credit default swap curve. In light of the potentially very dangerous implications of sovereign debt restructuring for the debtor country, including its banking, a determined and unwavering focus on improving fundamentals through both macroeconomic and structural policy reforms in vulnerable countries is required and within reach. In fact, programmes of adjustment, negotiated with the European authorities and the IMF, are now in place and should be rigorously implemented.

Five key risks to euro area financial stability

• The interplay between the vulnerabilities of public finances and the financial sector with their potential for adverse contagion effects.

• Bank funding vulnerabilities and risks related to the volatility of banks’ funding costs.

• Losses for banks stemming from persistently subdued levels of, or further decline in, commercial and residential property prices in some euro area countries.

• Risk of a market-driven unexpected rise in global long-term interest rates, with possible adverse implications for the profitability of vulnerable financial institutions.

• Tensions related to international capital flows, asset price growth in emerging countries, and the risks associated with a re-emergence of global imbalances.

More generally, however, tensions in countries that have culminated in requests for EU/IMF support contrast with a positive development in the form of indications that sovereign risk can be contained.

Confidence is being strengthened, in particular in other euro area countries that had been exhibiting high government bond yields, reflecting not only efforts made to push forward bank restructuring and transparency with respect to the state of the banking system as a whole, but also efforts undertaken to strengthen fiscal and macroeconomic fundamentals. Such efforts are crucial for the effective containment and mitigation of risks relating to sovereign debt in the euro area. Another positive element is the improving fundamentals of the aggregate euro area banking sector, evident in the evolution of key profitability indicators and solvency statistics for numerous large and complex banking groups (LCBGs) in the euro area – which should contribute to increased general resilience in terms of absorbing any prospective future losses. The latest available data for LCBGs indicate that all main income sources improved in 2010 and in early 2011, while a reduction of loan loss provisions had a major impact on profits. Regulatory (Tier 1) capital ratios amounted to 11.4% on average at the end of 2010, up from 7.7% in 2007.

The results of the stress tests undertaken by the European Banking Authority (EBA) should yield further insights into the health of the euro area banking system and will, in particular, shed further light on banks' shock-absorption capacity. Despite the beneficial developments in banking sector resilience, notably the fact that banks' reliance on wholesale funding decreased further in 2010 and in early 2011, funding vulnerabilities continue to be an Achilles' heel for many euro area banks, in particular those resident in countries facing acute fiscal challenges. At the same time, the heterogenous impact of the crisis has, in turn, led to divergent macroeconomic recovery and expansion paths across countries not only within the euro area, but also at the global level. These divergences contribute to a further exacerbation of the risks emanating from large international capital flows, global imbalances and their root causes.

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