ESAs: Spring 2023 Risks and Vulnerabilities Report in the EU Financial System

RegCORE Client Alert | Capital Markets Union

QuickTake

On 25 April 2023, the three European Supervisory Authorities (ESAs) – the European Banking Authority (EBA), the European Insurance and Occupational pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) – published their Spring 2023 Joint Committee Report (the Report) on risks and vulnerabilities in the EU financial system. It describes that EU financial markets remained broadly stable in the second half of 2022 and calls on ESAs, national supervisors, financial institutions as well as market participants to remain vigilant and prepared in the face of mounting risks.

The Joint Committee is a forum with the objective of strengthening cooperation between the three ESAs and allowing them to coordinate their supervisory activities within the scope of their responsibilities while ensuring consistency in their practices. Together, the ESAs and the Joint Committee explore and monitor potential emerging risks for financial markets participants and the financial system as a whole.See Joint Committee, available here.Show Footnote

In this latest Report, the Joint Committee emphasises that uncertainty in global financial markets remains high in light of a combination of the ongoing war in Ukraine, the uncertainty on future monetary policy and continued subdued economic activity in the United States and Europe. The Report underlines that equity markets have been characterised by rapid movements in prices and sustained high volatility levels, most recently linked to the collapse of three US banks and pressures on Credit Suisse. The ESAs also point to the sharp decline in EU banks’ stock prices as highlighting the continuing sensitivity of the European financial system to exogenous shocks and high ongoing market uncertainty. With regards to the banking sector, the Report underlines that volatile financial markets and the fast pace of interest rate increases have affected bank wholesale funding conditions, leaving the medium-term outlook for sustainable bank profitability uncertain. Even though the European banking sector is considered resilient with strong capital and liquidity positions, the Joint Committee stresses that supervisors should not be complacent and should assess for potential, yet-to-be-fully identified risks and vulnerabilities in light of recent events, including those related to banks’ business models.

ESAs are of the view that banks should be prepared for an expected deterioration in the quality of loans and debt securities and rising NPL levels. Concerning the insurance sector, the ESAs found that the inflationary environment can affect insurers through different channels, demarcating the non-life and health segment as most impacted by rising interest rates.In particular, rising interest rates could further reduce the value of fixed income assets and can also have an impact on the solvency position of insurers with an asset duration considerably higher than their liability duration.Show Footnote The Joint Committee notes that the reinsurance capacity continues to be under pressure from increasing losses to properties and businesses due to climate change.

The Joint Committee also reports on the level of continuing growth in 2022, albeit at a slower pace, of markets for environmental, social and governance (ESG) products with such trend showing resilience to broader market developments. They also noted that the sell-off in crypto assets illustrates once again the need to regulate effectively the crypto-asset sector. On the same note, the Report highlights the borderless nature of crypto assets as keeping continuing coordination and efforts to achieve convergence at the international level a priority Not surprisingly, the continuing Russian war in Ukraine is maintaining the overall level of cybersecurity risk elevated for the EU financial sector.

Key Takeaways from the Report

Against this backdrop, the Joint Committee advised on a number of policy actions to be taken by the ESAs, national competent authorities, financial institutions, and market participants in preparation for the challenges ahead.

With regards to an environment characterised by high macroeconomic uncertainty, the risk of a recession, high inflation, volatile energy and commodity prices and the prospect of further interest rate increases, the Joint Committee advises supervisors to continue monitoring closely asset quality and loan loss provisioning. Supervisors, together with financial institutions should remain prepared for a deterioration in asset quality in the financial sector. Higher interest rates and likely risk premia result in higher funding costs and operating costs, which may affect the ability of highly indebted borrowers to service their loans. This includes real estate lending, in particular at variable rates and commercial real estate - as highlighted by the European Systemic Risk Board (ESRB) in its recent Recommendation Available hereShow Footnote – unsecured lending consumers, assets which benefitted from pandemic-related support measures and assets regarded as particularly vulnerable to rising inflation as well as to volatile energy and commodity prices. What is more, the Joint Committee reminds, banks will need to replace until 2024 substantial amounts of central bank finding they have attained by other funding sources and maintain adequate liquidity buffers. This includes issuing, at significantly increased costs, further – MREL Minimum requirement for own funds and eligible liabilitiesShow Footnote eligible – loss absorbing instruments given the recent events of failing US banks and the merger in Switzerland.

The Report further points to liquidity risks arising from investments in leveraged funds and the use of interest rate derivatives contracts suggesting that these should continue to be closely monitored. On this note, the turmoil in the UK, in September and October, confirmed the importance for investment funds to maintain their resilience and adequately reflect risks in appropriate risk management practices. It underlines that the high market volatility, resulting from the above-described economic and geopolitical mix, could raise short-term concerns and disruptions for market infrastructures.Considering the current heightened credit and liquidity risk exposures and their role in an interconnected financial system, stress in the funds sector could be transmitted more widely to other parts of the financial system and to the broader economy.Show Footnote

Financial institutions and supervisors should, moreover, be aware of and closely monitor the impacts of inflation risk. For financial institutions on the one hand, inflation can have an impact in as much as asset valuation and asset quality is concerned, as borrower’s debt servicing capacities can be affected. The Joint Committee stresses that inflation is not only relevant from a risk perspective but has also an impact on the appropriateness of products in that product testing, monitoring and review should all account for inflationary trends. Financial institutions and supervisors are therefore called upon to make extra efforts to ensure investor awareness of the effects of inflation on real returns of assets and how these can vary across different types of assets.

Despite current profitability levels and adequate capital ratios, banks are not spared from the ESA’s advice but instead are asked to pursue prudential capital distribution policies amid an uncertain medium-term outlook for profitability in order to ensure their long-term financial resilience. To this end, the EBA and the European Central Bank (ECB) have, in a recent ECB blog post, called on the European co-legislators not to fall behind in the implementation and finalisation of Basel III in the EU with as little deviation as possible from such international standards. In similar fashion, the Joint Committee underlined that it is important not to fall behind internationally agreed standards and to follow through swiftly with the finalisation of Basel III in the EU as well as avoiding deviation from EIOPA’s advice on the Solvency II review.

The Joint Committee also raised expectations for financial institutions to further their efforts in climate-related risk management, in particular ESG risk management, as these risks are becoming increasingly a source of financial risk on their balance sheets. ESG considerations should become integrated into the overall risk management process such that risks related thereto can be disclosed and risks and vulnerabilities for ESG related asset prices adequately captured as well. Financial institutions should further consider climate-related risks when developing their overall business strategy, business objectives and risk management frameworks in order to ensure resilient transitioning (i.e., facilitating required funding) to a sustainable and low carbon economy.

In pointing to an elevated level of overall cybersecurity risk, the Joint Committee underlined the importance of financial institutions having adequate skills and capacities to ensure information and communication technology (ICT) security as well as providing adequate resources for ICT risk management. Financial institutions should implement procedures aiming to minimise the frequency and impact of ICT security breaches and cyber incidents, such as regular risk assessments and repeated testing of security measures to identify possible information leakages, malicious code and other security threats.

Growth outlook ahead

In October 2022, the international Monetary Fund (IMF) cut its global real gross domestic product (GDP) growth estimation for 2023 to 2.7% from 2.9% in July, with the European Commission (the Commission) reducing its EU estimate compared to July 2022 by 1.2% to 0.3% for 2023. IMF (2022), World Economic Outlook – Countering the Cost-of-Living Crisis, Washington DC; European Commission (2023), European Economic Forecast - Winter 2023; Directorate-General for Economic and Financial Affairs, Publications Office of the European Union, Luxembourg.Show Footnote Fast-forward to 2023, in January the IMF revised its global GDP forecast upward, by 0.2% to 2.9%, with the Commission raising its estimate in February 2023 by 0.5% to 0.8% (still down 0.7% from the Summer 2022 forecast) amid signs of an improving inflationary outlook and the global economy proving more resilient than expected in 2022.

Notwithstanding the mitigating effect of this recent, more positive, data on the 2023 macroeconomic outlook, uncertainty in global financial markets remains high, marked by the ongoing war in Ukraine, uncertainty on future monetary policy and continued subdued economic activity in the US and Europe. Elevated geopolitical risks both at global and regional level as well as ongoing deglobalisation trends add to the mix.

At the current juncture, it is more likely that market shocks are amplified by liquidity supply and demand imbalances. Specifically, the Joint Committee notes, public and corporate indebtedness levels may rise in view of the higher debt refinancing costs resulting from a tighter monetary policy, ultimately weakening public and corporate balance sheets, and thereby, raising concerns over debt sustainability.

Market developments

Overall volatility in commodity prices remained notably elevated, although the composite index of commodity prices showed little change, there were wide price moves for energy prices during H2 2022. Performance in government bond markets was negative in 2022. European sovereign yields continued to rise after a decline in July related to the ECB announcement of a policy transmission protection tool. Press Release on the Transmission Protection Instrument, available here.Show Footnote Likewise, performance in EU corporate bond markets was negative in 2022, with both investment grade and high yield bond indices, respectively lower by -14% and -12%. Most recently, in mid-March 2023, long-term bond yields fell sharply amid pressures on several banks and changing market expectations on interest rates.

The markets for ESG products continued to grow in 2022, albeit at a slower pace, with this trend showing resilience relative to broader market developments. The total value of ESG bonds outstanding reached EUR 1.5 trillion in December 2022, up 12% from June 2022. Corporate issuance, however, dropped by 19% over tat period compared with a year earlier, in line with broader corporate bond market developments, while public sector issuance picked up again by 22%. The EBA risk assessment questionnaire (RAQ) shows that banks have the appetite to offer various sustainable loans to non-financial corporates (NFCs), small and medium enterprises (SMEs) and retail borrowers. Available hereShow Footnote The Joint Committee notes that analysts in the banking sector expect green corporate lending, green consumer credit and further segments such as green mortgages to increase in the next 12 months, with a lack of uniform definitions and standards seen as major impediment to market growth.

In the same vein, the Joint Committee reports that ESG factors and risks have become increasingly important in the financial system with the first ever EU-wide climate change stress test for the financial sector. The exercise, which is to be conducted by the ESAs in cooperation with the ECB and ESRB, is expected to be completed by end-2024.
Reinsurance capacity continues to be under pressure from increasing losses to properties and businesses due to climate change. The withdrawal of reinsurance in certain lines of business, price increases and higher net retentions for cedents, may lead to a further widening of the insurance protection gap for climate related natural catastrophes. In this context, the European Insurance and Occupational Pensions Authority has developed a dashboard monitoring the insurance protection gap for natural catastrophes in Europe which will be key to assessing the resilience of the insurance industry and society to climate relate events.

With regards to crypto markets, the report highlights that the collapse of FTX (one of the largest global crypto exchanges) sent the values of crypto assets down by 20% in H2 2022. The pace of shockwaves and contagion fears spreading across the entire crypto industry triggered by the collapse highlighted the close interconnectedness of crypto firms. Total market capitalisation fell to around EUR 770bn at the end of 2022, but rose back to EUR 1tn by February 2023, however, still considerably lower than its historical peak of EUR 2.6tn in November 2021. To this end, the Basel Committee on Banking Supervision (BCBS) published global standards for the prudential treatment of banks exposures to crypto assets, the implementation of which will help mitigate financial risks if the banking sector were to gain more exposures to crypto assets in the future. Available hereShow Footnote To this extent, in the EU, the recently adopted Markets in Crypto Assets Regulation and related framework of instruments (collectively MiCA) introduces for the first time a comprehensive set of rules for the public offering and provision of services in relation to crypto assets, with a view to protecting EU investors and financial stability.

In the context of EU legislation, January 2023 saw the entry into force of the Digital Operational Resilience Act (DORA) Regulation (EU) 2022/2554 of the European Parliament and the Council of 14 December 2022 on digital operational resilience for the financial sector and amending Regulations (EC) No 1060/2009, (EU) No 648/2012, (EU) No 600/2014, (EU) No 909/2014 and (EU) 2016/1011, available here.Show Footnote, enhancing the security of digital financial operations in a heightened cyber risk environment, as highlighted above. The effects of a successful attack on a major financial institution or on a critical infrastructure could spread across the entire financial system through three channels: (i) direct contagion of software across systems; (ii) propagation of a liquidity shock via operational outages; (iii) a negative shock to investor confidence which is, in turn, likely to be exacerbated by uncertainty in a crisis. To this end, the Report states that the ESAs have commenced their DORA preparations which includes an effective EU-level coordinated response in the event of a major cross-border cyber incident impacting the EU financial sector.Compare, ESRB Recommendation to start preparing for the gradual development of a pan-European Systemic Cyber Incident Coordination Framework (EU-SCICF), available here.Show Footnote

Developments in the financial sector

The euro area asset management industry went through a challenging 2022, with assets under management (AUM) experiencing their sharpest decline since the global financial crisis (6% year-on-year, down to EUR 16 trillion AUM) mostly as a result of valuation effects. Performance in most fund categories remained negative, with most fund types recording net outflows in H2 2022. The Joint Committee reports, that commodity funds in particular, despite their positive performance, experienced substantial outflows (-23%), albeit from a low base. Money market funds (MMFs) did not initially benefit from their status as low-risk asset and experienced outflows in Q3 2022 (-1%) before recovering in Q4 2022, up to total inflows of 11% in 2022.

As for the banking sector, the Report notes, capital and liquidity positions remain robust despite a slight decline observed in recent quarters. The average Common Equity Tier 1 (CET1) ratio declined to 14.8% on a fully loaded basis in Q3 2022, from 15.4% in Q3 2021. This declining ratio was mostly driven by increasing risk weighted assets (RWAs), mainly stemming from rising credit risk and slightly declining CET capital sources. Notwithstanding some capital ratio contractions, the Joint Committee reports that banks maintain considerable capital headroom over regulatory requirements, a point also highlighted by the Supervisory Board, most recently in its written overview ahead of exchanging views with the Eurogroup on 15 May. Such headroom above regulatory requirements can act as an important safeguard for banks to continue lending to the real economy in times of economic difficulties. Indeed, lending growth continued since the beginning of the Russian war, and banks’ total loans increased by 2.8% between Q1 2022 and Q3 2022. The Joint Committee points out that loan growth was mainly driven by lending to non-financial conglomerates, while mortgage lending growth slowed down, mostly because of rising rates and increasing uncertainty. To the same extent, despite the economic environment, bank profitability was supported by rising net interest income amid continued loan growth and higher net interest margins in the rising interest environment. Specifically, the average return on equity (ROE) remained benign in Q3 2022 at 7.7% and at the same level as in Q3 2021.

In the insurance sector, the Joint Committee reports that the solvency position of insurers provides buffers to absorb potential losses in view of the macro headwinds ahead. In Q3 2022, the aggregate SCR ratio of life undertakings was 289% compared with 273% in Q4 021.  Composite undertakings experienced a moderate decrease in their solvency positions from 251% to 244%, while there was a slight increase for non-life companies from 250% to 256%. For institutions for occupational retirement provisions (IORPs), the value of assets decreased in Q3 2022 compared to Q3 2021. Overall, the Report states, the insurance sector could be affected by the ban on the provision of insurance for the shipment of Russian oil to third countries which is sold above the price cap.

Main risks to the financial sector

With persisting high uncertainty in global financial markets, financial risks have increased due to the extraordinary inflation shock, substantially higher interest rates and a slowdown of economic growth. The Joint Committee points out that while vulnerabilities related to liquidity, credit and interest risk can materialise separately, given the interconnectedness within the financial sector and the mix of vulnerabilities in the current environment, it is systemic risk which is most likely to crystallise.

The Report finds that fixed-income funds are especially exposed due to the high level of inflation and the ensuing monetary tightening. To this end, bond funds continued to decrease the maturity of their portfolios, down to an average affective maturity of 6.9% years for investment grade funds and 3.5 years for high yield funds, reaching an 8-year low at the end of H2 2022. In similar fashion, MMFs reduced their average weighted maturity substantially to strengthen resilience to rate rises, down to a 10-year low of 19 days.

For the insurance sector, the ESAs are of the view that the inflationary environment can affect insurers through different channels and found that the most impacted by claims inflation are the non-life and health segment. The Report underlines that higher interest rates can have both positive and negative effects on insurers. Where the duration of liabilities exceeds those of the assets (especially for life insurers) the higher discount rates increase the excess of assets over liabilities. However, this might be counterbalanced by the possibly accompanying repricing of risk premia and the negative impact on growth. According to estimates, risk premia could rise by 190bps before fully offsetting the on balance positive effect of inflation and higher interest rates. The critical level of risk premia expansion varies considerably across types of business, ranging from +80bps for non-life undertakings and +145bps for composite undertakings to a +240bps increase in risk premia for life undertakings.

As for the banking sector, the volatility in financial markets and the fast pace of interest rate increases have affected bank wholesale funding conditions. High volatility also contributed to challenges for some banks to smoothly place all instruments across the capital ladder to investors. The Report finds that issuance volumes and the access of some banks to certain types of debt instruments, in particular subordinated, are also affected by heightened volatility. Those banks more reliant on wholesale funding or in need to build up, or refinance, parts of their MREL buffer might be more exposed to heightened market volatility, increasing yields, as well as widening spreads. Wholesale funding costs are expected to increase further, in particular for riskier instruments ranked lower on the capital ladder, as monetary policy continues to tighten, and central banks continue to rise interest rates coupled with the negative economic outlook.

Capital markets trends have not only affected bank funding costs but also determine asset prices and affect bank profitability. The medium-term outlook for sustainable bank profitability is uncertain, as the expected macroeconomic deterioration will likely result in slower lending growth and rising impairments. Although rising rates have a positive effect on interest income, the effect of rising funding costs, including expected further increasing cots for deposits and implications on lending growth might offset additional income from asset repricing and affect profitability.

With regards to credit risk, the ESAs state that deteriorating macroeconomic conditions increased the likelihood of materialisation of credit risk for all financial institutions. As for the insurance sector, credit risk remained stable at a medium level, however, there has been a slight increase in the median exposure towards below investment grade assets. As for the banking sector, the mix of deteriorating economic prospects, high inflation with a phasing-out of accommodative monetary policy and rising rates, slowing down real estate markets and loan portfolios with pre-existing vulnerabilities from the pandemic, are all adversely affecting the outlook for asset quality. Particularly for financial institutions holding illiquid assets, a sudden market repricing could potentially trigger investor runs and asset fire sales. On top, as noted above, high volatility and fragile market liquidity are limiting the resilience of financial markets against external shocks. It is also reported that the UK episode in the fall of 2022 showed some pockets of vulnerability in the EU market, especially through the fund sector, while direct exposures of the EU insurers and IORPs to UK pension funds are negligible.

Outlook and next steps

The Joint Committee of the ESAs is expected to publish its next bi-annual report on the risks and vulnerabilities in the EU financial system in the fall of 2023, which will consider those risks which have worsened or emerged since this March 2023 Report.

This latest Report focused on a range of risks including persisting levels of high uncertainty in global financial markets, and the vulnerabilities underlying the current environment reflected by a combination of high inflation, rising interest rates and a worsening economic outlook. To this end, the Joint Committee has advised ESAs, national competent authorities, financial institutions and market participants to take a range of policy actions to prepare for the challenges ahead.

ESA’s Joint Committee Report on risks and vulnerabilities in the EU financial system is available here.

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