Publication of the June 2008 ECB Financial Stability Review

The European Central Bank (ECB) publishes today its June 2008 Financial Stability Review (FSR). The FSR assesses the stability of the euro area financial system both with regard to the role the system plays in facilitating economic processes and to its ability to prevent adverse shocks from having inordinately disruptive impacts on the functioning of markets and the performance of the economy more generally. The Review has been prepared with the close involvement of the Banking Supervision Committee, which is a forum for cooperation among the ECB and the national central banks and supervisory authorities of the EU.

By publishing the FSR and providing an overview and an assessment of the main sources of risk and vulnerability for financial stability, the ECB seeks to promote awareness in the financial industry and among the public at large of issues relevant for safeguarding the stability of the euro area financial system and to play a role in preventing financial crises.

The overall assessment of the June 2008 FSR can be summarised as follows:

Since the publication of the last FSR in December 2007, the euro area financial system has undergone further substantial adjustment to the financial turmoil, while large and complex banking groups’ (LCBGs) capital buffers have remained largely intact. Some of the risks identified in the previous FSR materialised – including a further deterioration in US housing market conditions and a broadening of credit market stresses. At the same time, since mid-March credit default swap (CDS) indices in Europe and the US have declined, corporate bond spreads have narrowed across the board and the functioning of the leveraged loan market has been showing some tentative signs of improvement. This notwithstanding, by the cut-off date for including information and data in this issue of FSR (8 May 2008), the risks to euro area financial system stability on balance had increased compared to the situation six months before. This assessment reflects several factors, including: conditions in the US housing market had further deteriorated; valuation losses endured by banks in advanced economies were larger than anticipated six months ago; and banks have tightened their lending standards significantly.

Looking forward, 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 outlook also depends on the extent to which initiatives and measures – both by policy-makers around the world and by the financial industry itself - aimed at restoring confidence and strengthening financial system resilience are eventually implemented.

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. It is probable that the adjustment process within the financial system will be protracted as banks attempt to strengthen their liquidity and capital positions. This means that balance sheet expansion is likely to be somewhat curtailed in the period ahead. In a negative scenario, the adjustment could risk perturbing the smooth intermediation of credit in the economy. So far, however, the availability of bank credit to households and non-financial corporations has not been significantly affected by the financial market turbulence. At the same time, the financial system may be more vulnerable than before to the crystallisation of other risks that have been identified in previous issues of the FSR, such as disorderly developments owing to global imbalances.

It should be recalled that the losses disclosed so far by affected financial institutions are mostly mark-to-market losses on hard-to-value assets. It remains to be seen whether 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, 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.

The Review can be downloaded from the “Publications” section of the ECB’s website (http://www.ecb.int/pub). Printed copies are also available free of charge from the ECB’s Press and Information Division at the address given below.