MNI POLICY: Covid-19 Raises Financial Stability Risks - ECB

By Luke Heighton

     FRANKFURT (MNI) - The Covid-19 pandemic has 'greatly amplified' existing

vulnerabilities in the financial sector, non-bank financials, highly-leveraged

corporates and some sovereigns, the European Central Bank's May 2020 Financial

Stability Review reported Tuesday.

     "The pandemic has caused one of the sharpest economic contractions in

recent history, but wide-ranging policy measures have averted a financial

meltdown", ECB Vice-President Luis de Guindos said. "However, the repercussions

of the pandemic on bank profitability prospects and medium-term public finances

will need to be addressed so that our financial system can continue to support

the economic recovery."

     Here are key points from the report:

     - Legacy debt and the potential for financial fragmentation poses

pronounced medium-term challenges to both economic recovery and financial

stability.

     - A further sharp correction in asset prices may materialise if GDP and

earnings growth outturns match the more pessimistic scenarios, "which have

become more probable."

     - Weaker bank intermediation is also possible as a result of declining

profitability, leading to decreased loss-absorbing capacity, and in conjunction

with deteriorating asset quality, continued margin compression and historically

low market valuations.

     - The degree of expected loan loss provisions by eurozone banks "might

still be too low relative to the predicted GDP decline for 2020, with the

implication of potential negative surprises ahead."

     - Vulnerable non-banks have amplified market movements, with high exposures

to risky non-financials, sizeable portfolio valuation losses, large outflows

testing funds' liquidity, and a decline in insurers' solvency and profitability

     - Further declines in the market value of assets or a sharp increase in

volatility could prompt renewed outflows from funds, which remain exposed due to

the search for yield and liquidity risk-taking over recent years.

     - Riskier, highly-leveraged firms are likely to face downgrade risk, while

private equity markets "also warrant close monitoring." Downside risks to

corporate earnings "could unearth debt vulnerabilities," while corporates in

sensitive sectors face significant debt refinancing needs over the next two

years.

     - The increase in public debt levels could trigger a reassessment of

sovereign risk by market participants and reignite pressures on more vulnerable

sovereigns going forward. A more severe and prolonged economic contraction than

envisaged, if coupled with higher sovereign funding costs for some euro area

countries and the materialisation of contingent liabilities, would risk putting

the public debt-to-GDP ratio on an unsustainable path in already highly indebted

countries.

     - Risks to household debt sustainability could arise as a result of the

economic contraction and if the recovery is slow.

     - Sizeable sovereign-bank links in some euro area countries create risks of

negative feedback loops arising from sovereign or bank rating downgrades. Such a

development could reactivate the negative feedback loops of the sovereign-bank

nexus, "especially for Italy and Portugal, as well as for Spain, where bank

ratings are closest to non-investment grade."

     - Open-ended real estate investment funds may face pressures as the

commercial real estate cycle begins to turn. Investment fund sector financing in

real estate varies across the euro area, with a particularly large real estate

fund presence in the Netherlands and Germany.

     - Insurers' solvency could be significantly weakened by a double hit from

asset price declines and lower-for-longer interest rates. Solvency ratios could

be adversely affected by the high concentration of sovereign debt in insurers'

portfolios - up to 70% of total debt securities portfolios in some countries.

--MNI Frankfurt Bureau; +49-69-720-146; email: luke.heighton@marketnews.com

[TOPICS: M$X$$$]