ECB Warns Financial Weakness Could Break Best Lull in Two Years

The European Central Bank said weakness in the euro-area economy and the fragility of the region’s banks risk ending what it describes as the calmest period in financial markets since 2011.

“The main message is that financial stability has improved since the last issue,” ECB Vice President Vitor Constancio said today in Frankfurt as he presented the ECB’s twice-yearly Financial Stability Review. “But the situation remains fragile. The year 2012 was not good at all for banks.”

While the central bank credits its own so-called OMT bond-buying program for helping to produce an easing of tensions in the 17-member currency area after fears of a break-up peaked last year, six straight quarters of recession are eroding the resilience of banks. ECB President Mario Draghi says his staff are looking at ways to stimulate lending to small businesses.

“Particularly vulnerable are banks that are confronted with a significant deterioration of asset quality with high and rising non-performing loan levels,” the ECB said in the report. “Continued and prompt progress in proactively tackling bank balance sheet problems is required.”

Italian, Spanish and Portuguese bonds soared after Draghi’s July 26 pledge to do “whatever it takes” to defend the euro.

The extra yield investors demand to hold Spanish 10-year securities instead of similar-maturity German bunds shrank to as little as 2.71 percentage points on May 3, the least since August 2011. It swelled to a euro-era record of 6.498 percentage points last July as Europe’s debt crisis worsened. It was 2.87 percentage points at 3:38 p.m. London time.

‘Downside Risks’

As the euro-region economy faces “considerable downside risks,” countries must restore competitiveness, boost the flexibility of wages and prices and increase productivity as banks repair their balance sheets, the ECB said.

“The prospects for the euro area remain well below those for international peers –- including major advanced and emerging market economies,” the ECB said. “Both private and public sector forecasts indicate an only gradually improving near-term economic outlook in the euro area. The latest ECB staff projections suggest a gradual recovery in the second half of this year, largely driven by a pick-up in domestic demand.”

The ECB will publish new staff forecasts for growth and inflation at its rate-setting meeting on June 6. It currently predicts the euro-area economy will contract by 0.5 percent in 2013 before growing 1 percent next year.

The report called on governments to speed up work on a European banking union and stronger fiscal pillars in the region, adding that any procrastination risks renewed tensions in sovereign debt markets.

Continued Momentum

“Progress in adjusting public finance vulnerabilities should not unravel,” the ECB said. “Beyond this, continued momentum is needed towards completing a genuine Economic and Monetary Union, notably including a full banking union and a strengthening of fiscal frameworks.”

While banking union, which should receive its first pillar in the form of ECB bank supervision next year, will be an important contributor to financial stability, countries need to focus on bank recapitalization and deficit reduction now, the ECB said.

“Stressed countries have over the past few years made considerable efforts to adjust their public finances,” the ECB said. “Weaknesses in public finances, in particular, persist in several countries, with expectations for government deficits in 2013 having worsened in approximately half of the euro area countries since December.”

Disorderly Unwinding

Backtracking on consolidation could therefore risk “renewed tensions in sovereign debt markets,” the report warned. At the same time, as investors have bought into the improvement in market sentiment after the ECB announced its Outright Monetary Transactions program in mid-2013, the possibility of a correction in credit markets is now rising, the ECB said.

“An abrupt adjustment in benchmark sovereign interest rates, generally considered as the riskless rate in asset pricing models, or risk premia in specific market segments where yields are compressed, could result in a disorderly unwinding of flows,” leading to bank losses, the report said.

Looking back to the turbulent Cypriot bailout in March, the ECB said financial markets largely shrugged off the imposition of the euro area’s first depositor bail-in.

Contagion to other euro-area markets “appears to have been largely contained in most cases.”

That improvement is partly due to financial market participants having “internalized” the commitment of euro-area politicians and monetary policy makers to keep the currency area together, the ECB said.

“The current resilience of the euro area macro-financial environment is in stark contrast to earlier stages of the financial crisis,” the report said. ’’

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