It focuses on the resilience of ESG funds and the absence of a consistent “greenium” a lower yield for green bonds compared with conventional bonds with a similar risk profile reflecting the fact that green projects do not benefit from cheaper financing. This is partly due to their different industrial structure which is more dependent on highly affected sectors such as tourism and hospitality, in particular in southern Europe (see Chart 1.6, right panel). Substantially higher regulatory capital ratios since the global financial crisis increase banks’ capacity to absorb potential losses. This special feature uses a novel euro area dataset from a dedicated data collection covering significant institutions supervised by ECB Banking Supervision to analyse trends in real estate lending standards and derive implications for financial stability. In response, prudential authorities across the euro area announced a series of measures to make it easier for banks to use capital to absorb losses and reduce their incentives to constrain credit. As its exposure to the sensitive sectors is very low in relation to buffers, data are not shown for Luxembourg. In particular firms that are most affected by social distancing may therefore face severe solvency issues or a more permanent disruption to their business models, the longer the pandemic lasts, even as the rest of the economy recovers. In some countries which have established schemes to subsidise short-time work, such as Germany, applications for such subsidies have increased sharply (see Chart 1.3, right panel). Liquid assets of high-yield corporate bond funds have declined since March, but are still twice the size seen in the fourth quarter of 2019. In addition, rating agencies have increased the number of downgrades, notably in the high-yield segment (see Chart 1.11, right panel). The relatively low home bias in green bond markets suggests that financing the climate transition could help to drive further financial integration. Despite some concerns over potentially stretched valuations, euro area equity index developments, reflecting expectations about future economic activity, have been broadly in line and increasingly converged with forward-looking sentiment indicators. [49] Looking ahead, solvency ratios could weaken on the back of credit downgrades and defaults, changes in the valuation of illiquid asset exposures, such as real estate, a reversal in the regulatory volatility adjustment or higher claims. Household borrowing has slowed, and households face tighter lending standards from banks (see Chart 1.9, left panel). While the average liquidity coverage ratio (LCR) is moderately higher in countries more affected by past crises[10] than in countries less affected by past crises, the former are relying more on government bonds to form their HQLA (see Chart 3.3, right panel). Right panel: the chart shows the maximum value of the government response stringency index. The compression of margins reflects the sluggish response to further policy rate cuts of deposit rates as they approach the zero lower bound. Newly originated loans have also tended to have higher credit risk. Right panel: 2020 issuance is year to date (up to November 2020). Household real disposable income had continued its expansion in 2019, underpinned by employment gains and robust wage growth (see Chart 1.7, right panel). Equity market performance has been broadly in line with forward-looking indicators, but the risk of an abrupt equity market correction remains elevated, albeit diminishing. Moreover, the Governing Council’s decision to maintain collateral eligibility of bonds that had recently lost or would at some point lose investment-grade status helped to halt the widening of lower investment-grade sovereign spreads. While insurers’ aggregate liquidity positions appear stable, cash needs, for example arising from margin calls, might rise if the risk of renewed market volatility were to materialise. Sharp movements in indices of financial conditions and systemic stress. Volatility-targeting and risk parity strategies might have procyclical effects on asset prices. Since mid-March, bond spreads have declined by around 1,000 basis points for AT1 bonds and 20 basis points for senior unsecured bonds, while spreads of covered bonds remained unchanged. They can now be used to absorb some of the fallout from the pandemic. Bank valuations fell to record lows and bank funding costs increased, despite the enhanced resilience since the global financial crisis. The extraordinary support measures have now led to central bank funding increasing to 9% of the total assets of euro area banks on aggregate. Guaranteed loans refer to the flow of guaranteed loans by firm size based on national sources for France, Germany, Italy and Spain. Right panel: the budget deficit is not cyclically adjusted. While the rise in the stock of Stage 3 assets has been moderate, changes in credit risk and the drawdowns of off-balance-sheet credit lines have more than doubled the provision inflows into Stage 2 assets (see Chart 3.7, left panel). One year after the collapse of Lehman Brothers, the largest credit rating agency had downgraded one in six NFCs that were rated BBB prior to the pandemic to high-yield status. [39] Such procyclical selling of assets was less pronounced among ICPFs, whereas, on a net basis, banks bought government and bank bonds. The vast majority of insurance technical reserves to cover potential future claims by policyholders relate to life insurance products (see Chart 4.9, left panel). From 12 March, euro area money market and sovereign funds also began experiencing rapid outflows, driven by rising cash demand from end-investors. Credit standards reflect backward-looking actual credit standards up to the third quarter of 2020. Core revenues were recently supported by higher lending volumes in particular for mortgage loans, but coronavirus uncertainty may reduce loan demand. Bond funds have increased the share of liquid bonds in their portfolios, but the fund sector as a whole has ventured further into less liquid assets. Large increase in net corporate funding and record high investment grade bond issuance. There is some heterogeneity at the country level, with capital increases and asset reductions being the main drivers in countries less affected by past crises, whereas risk-weight reductions played a more important role in countries more affected by past crises. High-yield bond funds refer to euro area-domiciled funds which primarily invest in high-yield bonds. The record levels of reliance on central bank funding coincide with a significant decline in bank bond issuance, in particular for non-global systemically important banks. [19] For a sub-sample of listed banks which disclosed a positive impact from these regulatory changes, the median CET1 ratio uplift amounted to 30 basis points (see Chart 3.11, left panel). After NFCI growth declined temporarily from 2018, it rebounded in the second half of 2019 mainly on the back of stronger asset management activities, while fees related to payment services continued to contribute as robustly as in previous years (see Chart 3.16, right panel). Against this backdrop, on 28 July 2020 ECB Banking Supervision encouraged banks to use their capital and liquidity buffers for lending purposes and loss absorption. These measures will be in place until the recovery is well established. Sources: Bloomberg Finance L.P., Refinitiv and ECB calculations.Notes: Left panel: based on national/regional stock price indices. This issuance will further expand a green bond market that has already grown rapidly in recent years, doubling in size in 2019. Overall, estimates from the valuation models are subject to considerable uncertainty and should be interpreted with caution. Credit risk data appear to anticipate a continuation of significant monetary and fiscal policy support, which would limit defaults. Vulnerabilities in the bank and non-bank financial sectors can contribute to contagion across the financial system due to the high degree of interconnectedness. The interaction effect, which is positive due to the negative co-movement of debt and GDP, is attributed to GDP but of second-order importance quantitatively. The ECB’s economists have downgraded their growth forecasts in the short term. As a result, insurance companies might seek to boost their returns by taking on more credit risk, liquidity risk and market risk, including by continuing to move into alternative asset classes. In a mechanical simulation, available capital buffers can be compared with hypothetical losses on exposures to economic sectors that appear most sensitive to the consequences of the coronavirus outbreak. But provisioning remains below levels observed during previous crises and those in other jurisdictions, notably the United States. In this context, communication by prudential authorities will play an important role in ensuring that banks are willing to use the buffers if needed. The explanatory variables and estimated signs (in brackets) are as follows: asset quality factors: non-performing assets ratio (+), annual change in non-performing assets ratio (+) and reserves/non-performing assets (+), pre-provision return on assets (+), loans/total assets (+), log of total assets (+); macro factors: output gap (-) and annual real GDP growth (-), year fixed effects, country fixed effects. While large claims can be expected for some business lines, such as trade credit, other lines, such as business interruption insurance, usually have explicit exemptions for pandemics written in their contracts. This would be particularly useful for insurers with a vulnerable liquidity profile, such as those that hold derivatives and are subject to margin calls. In this regard, ESMA addressed a number of recommendations to financial market participants. However, the level of reliance on central bank funding, and the coincidental shrinkage in private markets, could pose financial stability challenges in the future, if central bank operations normalise more quickly than market depth can adjust. During the most severe stress period in March, bid-ask spreads widened in most asset markets and dealers in various financial assets were increasingly unable or unwilling to absorb the sharply increasing supply of securities, including due to balance sheet constraints. Prime CRE price dynamics were moderating in line with the signs of a maturing cycle, while the stock market reaction to the pandemic in the CRE sector was strong. That said, the drawdowns of NFC credit lines and the granting of new loans with public guarantees did lead to higher NFC loan growth in March, but the margins of State-guaranteed loans might be low. Sources: ECB, European Commission Spring 2020 Economic Forecast, Eurostat and ECB calculations.Note: Left panel: budget deficit in absolute terms relative to 2019 nominal GDP. Nevertheless, the growth of the whole investment fund sector was limited to 7.7% of AuM, held back mostly by equity funds. Prudential authorities across the euro area acted to maintain the flow of credit to the economy, complementing monetary and fiscal measures. While liquidity shortages were seen as the major threat to non-financial corporate (NFC) health at the beginning of the pandemic, more recently firms’ solvency has become the primary concern. Even then, risks for households and firms facing a cliff edge from the withdrawal of policy support must be balanced against the risks related to prolonged support (e.g. In the model, banks adjust their balance sheets in response to economic conditions[31] and economic conditions are influenced in turn by collective bank responses. First, supporting measures in the form of payment moratoria and job protection schemes have successfully mitigated its impact on household debt servicing capacity and total wealth. Right panel: Global Economic Policy Uncertainty until September 2020, World Trade Uncertainty covers data until Q3 2020 and Geopolitical Risk until August 2020. During the pandemic, ESG funds have proved more resilient than their non-ESG peers (see Chart 4.6, left panel, left chart) with cumulative inflows of around 15-20% since the turmoil in March. Sources: ECB supervisory statistics, Bloomberg Finance L.P., Consensus Economics, ECB and ECB calculations.Notes: Left panel: figures are on a trailing four-quarter basis. Corporate bond prices signal a considerable risk of imminent downgrades from investment grade to high yield, with some sectors more exposed than others. 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The solid blue and yellow lines show cumulated bond issuance between 1.January and 15 May 2020. Third, despite schemes to keep employees in the labour market, there is a risk that a significant number of workers could still lose their jobs if firms ultimately need to scale down their business in response to changes in demand. Sources: Refinitiv, Bloomberg Finance L.P., European Commission, Sentix, Westpac and ECB calculations. This action was intended to protect capital for absorbing losses and supporting lending. Right panel: HH: households, NFC: non-financial corporations. While the presence of these vulnerabilities amplified some of the response to the coronavirus shock, the financial system nonetheless proved broadly resilient, partly reflecting the regulatory reforms of the past decade. Data on loan loss provisions are based on a sample of 21 listed euro area banks. The red horizontal and vertical lines indicate sample medians. As housing demand is set to slow along with the drop in economic activity and employment, the risk of house price corrections has increased (see Chart 5, right panel).
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