23 January 2013

EBA: Report on the Risk Assessment of the European Banking System

Since the publication of the EBA’s last risk assessment report (Report on Risks and Vulnerabilities of the European Banking System, July 2012) the EU banking sector has seen some improvement in market confidence – from both debt and equity investors. Nevertheless, these signals may prove temporary and the macroeconomic environment for most European banks remains fragile, especially for banking systems in countries where the sovereign itself is financially-stressed. Thus, serious challenges remain due to increasing credit risk and low profitability levels that could be further depressed by rising loan-loss provisions.

Measures adopted by policy-makers, central banks and supervisors have addressed some immediate concerns. The improvement in markets for bank funding has been noticeable since the second half of August, when vital policy and regulatory steps were seen as positive moves which reduced the risk of the eurozone disintegration or outright sovereign defaults. Secondary-market prices for both debt and equity have improved and a number of banks – including some in financially-stressed sovereigns – have been able to issue new debt, the greater part of which is senior unsecured. However, spreads remain high and the level of asset encumbrance, particularly for some banks, may eventually have a negative effect on the availability and cost of funding, unless banks, with the aid of supervisors, return to greater reliance on diversified market funding. Promoting the use of regulatory convertible bonds as a buffer to increase loss absorbency of banks is one of the solutions which will increase confidence and cause funding costs to fall.

The ongoing improvement in the bank funding situation cannot alter the fact that the EU banking sector remains fundamentally fragile overall, with structural stresses still to run their course. A large number of banks have been massively supported by central bank funding. The banking industry needs to return to diversified private funding sources on a sustainable basis and the transition should be pro-actively managed by banks and properly overseen by supervisors.

The risk appetite of banks is changing and business models are adapting both due to internal drivers as well as in response to regulatory and market developments. Although there is variation within Europe, de-risking is proceeding, albeit at a slower pace than in other parts of the world. Indeed in a majority of EU countries, excessive or disorderly asset deleveraging has not occurred, especially insofar as assets related to the real economy are concerned. In addition, while the search for more stable and sustainable business models is a welcome development, it creates heightened strategic risks, especially during the transition period to new business models.

EU banks have significantly strengthened their capital positions over the last two years, also following the EBA capital exercise launched in 2011. However, concerns remain about the impact on capital of future loan losses. Indeed, uncertainty about the quality of banks’ asset and valuation criteria in many jurisdictions creates challenges in attracting private investors. Market confidence in credit portfolios needs to be restored and this process will need to be supported by the supervisors. Bank credit forbearance, though not universal, is widespread, as indicated by the respondents to the Risk Assessment Questionnaire (RAQ). While this has helped address difficulties and support banks’ borrowers and their ability to honour their obligations, forbearance may have also led to an underestimation of the scale of problem loans. The actual magnitude of credit risk in banks’ portfolios and adequate provisioning levels must be made clear so as to renew market confidence and stabilise private funding markets at viable spreads.

The emerging new regulatory landscape can create the framework for a more resilient banking sector. However, uncertainty about the timing and content of the incoming regulations remains a short-term challenge for banks’ business models, funding and capital planning.

The crisis has had a material impact on cross-border banking. A major risk, already flagged in the EBA’s risk assessment report last July, is that of pan-EU fragmentation and retrenchment within national boundaries by the larger cross-border banking groups, potentially leading to market inefficiencies and to an erosion of the single market. This development could and should be countered by the timely implementation of an effective and credible framework for a Single Supervisory Mechanism (SSM) in the eurozone, a single rulebook for EU bank regulation and supervision, and other specific EU support measures.

Finally, a large number of banks across the EU are currently dealing with poor reputation and low levels of customer trust due to those banks’ past involvement in inappropriate practices. In addition to leading to a potential loss of reputation, such misguided practices can also generate prudential risks for those banks, such as regulatory penalties and provisions for litigation resulting from banks’ breaching of consumer protection rules. Banks are aware of this situation and there does seem to be a drive to improve institutional governance and culture, plus the selective build-up of provisions to offset costs from fines or legal action.

Full report

© EBA