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The euro area financial stability outlook is highly uncertain and a lot will depend on how economic conditions, especially in the US housing market, develop and how banks respond to an operating environment which is much more challenging, the ECB’s June Financial Stability Report says stating that systemic risks had increased compared to the situation six months before.
“It is probable that the adjustment process in the financial system will be protracted as banks continue to strengthen their liquidity and capital positions”, Lucas Papademos said introducing the report.
In a negative scenario, the adjustment could risk perturbing the smooth intermediation of credit in the economy, the report says while at the same time the financial system may be more vulnerable to other, possibly global imbalances.
“Given heightened uncertainty and an environment in which balance sheet conditions could change unexpectedly, vigilance by financial institutions and market participants is of the essence and those with relevant exposures will need to step up their efforts to effectively manage the risks that may lie ahead”, Papademos warned.
Recalling that the losses disclosed by financial institutions so far are mostly mark-to-market losses on hard-to-value assets, the ECB states that “the full extent of the implied credit losses will eventually be realised on the underlying loans”.
“If the outturns ultimately prove less severe than currently feared”, the report states, “then it cannot be ruled out that those financial firms still holding these assets will see some offsetting valuation gains on the asset-backed securities and structured credit products in their portfolios.”