The Euro Area Financial System: On-going Transformation

IMF News, July 19, 2018

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Published: July 19, 2018

Overview and progress (publication: July 19, 2018)

The euro area financial system—and especially the banking sector—has been transformed over the last five years.
It is described as "safer, stronger and more integrated than ever before" but "much work remains to build an efficient, truly integrated financial system with banks that are sufficiently resilient to respond to new challenges."
The recently completed Financial Sector Assessment Program (FSAP) for the euro area takes an in-depth look at progress and urgent remaining needs.

Institutional framework and supervision

A common framework to oversee the banking sector now exists: the "Single Supervisory Mechanism" (SSM).
- Under the SSM, euro area and national supervisors work together to identify concerns early and deal with them before they become acute.
Policies are now more geared toward addressing macro-prudential risks (example given: when the price of housing in a region rises to unsustainable levels).
The "Single Resolution Mechanism" provides instruments, procedures and facilities to handle problem banks with minimal collateral damage to the economy or support from the taxpayer.
- The mechanism is embedded in detailed contingency planning and the accumulation of needed financial buffers.

Bank resilience and market developments

Banks are, in many ways, stronger and more resilient, with more and better capital and more stable funding.
Risk profiles are heterogeneous:
- "Some banks are especially vulnerable to credit risks and others more to market risks or funding risks."
Financing from non-bank sources such as investment funds has increased significantly, supported by the Capital Markets Union (CMU) project.
- CMU aims to create a fully integrated capital market and includes measures to help small firms raise financing across borders.

Remaining fissures and vulnerabilities

Financial markets remain fissured along national borders.
Many banks suffer from chronic low profitability even under present buoyant conditions, which reduces resilience.
- Causes cited include stockpiles of nonperforming loans and high operating costs.
Current conditions noted: "For now, liquidity is plentiful and funding is cheap, but some banks may face challenges when monetary policy begins to normalize."
The SSM must cope with a patchwork of national laws that create gaps and inconsistencies and work against the level playing field.
- A particular concern is the treatment of nonperforming loans, where a focused supervisory effort is beginning to pay off.

Key policy recommendations and priorities

Require banks to write down nonperforming loans in a time-bound way.
Improve the consistency of legal frameworks across countries (example: credit rights).
Sharpen valuation rules.
Advance practice of proactively addressing weak banks and streamline legal and regulatory frameworks for resolution to bolster the credibility of the new system.
- Address wide variation in national frameworks and incentives that may lead to "working around" approaches that minimize overall cost but involve bailing in certain creditors.
Build up additional buffers to enhance credibility:
- "Bail-in-able" liabilities that can absorb some losses.
- Resources for funding in resolutions.
- The European Deposit Insurance Scheme.
- Ensure enough flexibility so contagion can be contained in a truly systemic event.
Further reforms to deliver a genuinely single and integrated capital market:
- Greater harmonization of national insolvency regimes and securities regulations.
- Encourage the emergence of a large investor base interested in innovative and cross-border products.

Source: The Euro Area Financial System: On-going Transformation, July 19, 2018 — https://www.imf.org/en/news/articles/2018/07/17/na071918-the-euro-area-financial-system-on-going-transformation