Report on EU banking sector stability

The European Central Bank (ECB) has today published a report on EU banking sector stability that was prepared by the Banking Supervision Committee of the European System of Central Banks (ESCB). This Committee comprises representatives of EU national central banks and banking supervisory authorities and the ECB. Such a report has been published regularly since 2003.

The report examines the performance of the banking sectors of the 25 EU Member States in 2005 and the first half of 2006, as well as the risks surrounding their outlook. A prudent approach to analysing banking sector stability requires the identification and evaluation of the implications for banks of plausible sources of downside risks to the most probable outcome. In this respect, the report also provides an assessment of the financial soundness and shock-absorbing capacity of banks. The present issue also contains a special chapter on risks related to foreign currency lending by EU banks in several Member States where such lending has been growing very rapidly.

The contents of the report can be summarised as follows:

The financial condition of EU banks continued to improve in 2005 and the first half of 2006, thus consolidating the improvements that have taken place since 2003. While the transition to the new International Financial Reporting Standards (IFRS), the pace of which is uneven across the EU countries, complicates the assessment at the current point in time, the overall impact on key performance indicators nevertheless appears to have been rather minor. In 2005, the profitability figures for EU banks improved across the board, irrespective of the accounting standards followed. The main drivers of the further improvement in profitability were strong lending growth both to households and to the non-financial corporate sector, as well as the rise in fee and commission income and trading revenues, all of which benefited from the favourable economic environment and mostly buoyant conditions in financial market. Profits were also supported by continued cost-containment and by a further decrease in impairment charges (formerly known as provisions), which reached new historic lows. The strong performance of EU banks in 2005 continued in the first half of 2006. Although the solvency position of EU banks dropped slightly in 2005, the solvency levels of EU banks remained strong and comfortably exceeded regulatory requirements.

In view of the favourable earnings performance of the banking sector over the past three to four years, the vulnerability of the EU banking sector to adverse disturbances has diminished considerably and the outlook points towards a further strengthening of profitability. Nevertheless, there are still some risks to this favourable outlook. Where risks external to the banking sector are concerned, changes in the global macro-financial environment – including incipient shifts in the relative growth patterns of the major economic areas and the gradual removal of liquidity from the global financial system – could expose vulnerabilities in banks’ balance sheets. With regard to risks internal to the banking sector, EU banks’ exposures to credit risks have grown further as banks’ lending has continued to expand (in some non-euro area EU countries, this has also been driven by lending in foreign currency), while loan impairment charges have declined and credit standards have not been tightened. Although the quality of EU banks’ loan portfolios remains relatively high, pockets of vulnerability may be developing, mainly driven by intense competition among banks in most of their product markets. On the household lending side, increasing indebtedness and signs of an erosion of credit standards in new lending in many Member States could become causes of concern if the macroeconomic environment should develop less favourably than expected. In the case of lending to the non-financial corporate sector, an acceleration of growth in short-term loans to finance merger and acquisition (M&A) activity could, insofar as it reflects growing competitive pressures, imply the risk that banks may be forced to compromise their risk-based pricing of loans. Moreover, it cannot be excluded that banks’ appetite for risk-taking has been supported by persistently low volatility across various financial asset classes that may have allowed them to increase their trading exposures without necessarily breaching their risk limits. While banks’ risk management systems have improved over recent years, there are some uncertainties about the ways in which risks have been redistributed by credit risk transfer products, both within the banking system and between banks and other financial institutions, and about how the market for these products would perform in a more challenging macro-financial environment.

The generally positive assessment of the financial condition of banks outlined in the report is also corroborated by forward-looking market-based indicators that continue to suggest a robust outlook for the EU banking sector in terms of profitability and credit quality, possibly reflecting a favourable assessment of the capacity of the banking system to absorb shocks.

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