ECB Says Financial-Stability Risk From Market Turmoil Has Risen

The European Central Bank said the risk to financial stability from global market turbulence has increased in the past six months, even as measures of systemic stress have declined.

The market turmoil earlier this year amid changing expectations of U.S. monetary policy “might be a harbinger of further realignment of risk premia with fundamentals in bond markets, or even an overshooting,” the ECB said in its bi-annual Financial Stability Review published today. “Reduced cash buffers, combined with low secondary market liquidity in emerging and corporate bond markets, could amplify future asset price developments.”

Federal Reserve Chairman Ben S. Bernanke’s comments on June 19 that the U.S. central bank was preparing to taper its asset purchases sent money-market rates and bond yields surging across the 17-nation euro region, threatening the currency bloc’s economic recovery. The ECB responded on July 4 with an unprecedented pledge to keep interest rates low for an extended period.

“Stable and predictable macroeconomic policies, as well as efforts such as forward guidance to reduce market uncertainty surrounding central banks’ reaction functions, are key to ensuring a smooth exit from non-standard central bank measures without an abrupt rise in bond yields,” the ECB said.

Bank Funding

Other risks to financial stability identified by the central bank included economic and financial shocks that affect asset valuations and bank profitability; and renewed tensions in sovereign-debt markets as a result of delayed national reforms, unforeseen bank-recapitalization needs or a rise in global bond yields.

The ECB said risks from bank funding challenges in stressed countries that force lenders to deleverage excessively continue, albeit at a lower level than six months ago.

“Financial stress has remained moderate in the euro area in recent months, despite periods of considerable global financial market turbulence,” the ECB said. “Measures of systemic stress in the banking sector have declined markedly” since 2011 and a measure of systemic stress across major euro-area financial asset classes “has fallen even further, to lows not seen since global financial strains first emerged in the summer of 2007,” according to the report.

The resilience partially reflects the progress euro-area countries have made in reducing budget deficits and implementing structural reforms, the ECB said. Higher capital and liquidity buffers at the region’s lenders has also contributed to more stability.

“Notwithstanding these advances, the euro-area adjustment process remains incomplete,” the ECB said. “First, there is a need to correct a loss of competitiveness which has restrained economic growth in some countries, as well as to further address remaining public and private sector indebtedness. Second, the outlook for bank profitability remains weak.”