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Progress in strengthening euro area banks and sovereigns being made

09 June 2014

Progress in strengthening euro-area banks and sovereigns is being made, according to the Financial Stability Review (FSR).

Led by the European Central Bank (ECB), the FSR finds that euro-area banks have accelerated the clean-up and strengthening of their balance sheets since the third quarter of 2013, when discussions about the ECB’s comprehensive assessment intensified. Sovereign risk has also improved with the implementation of fiscal consolidation and structural reforms, although progress has been uneven.

In addition, investor concerns regarding the global financial crisis have continued to diminish, amid on-going action to address “legacy” risks of past crises for both banks and sovereigns.

However, the FSR has identified new risks that are emerging – particularly a growing search for yield across regions and market segments, driven by increased investor confidence and some rebalancing of portfolios away from emerging markets, among other factors. As the search for yield intensifies, so do concerns regarding the build-up of imbalances and the possibility of a sharp and disorderly unwinding of recent investment flows.

According to the FSR, three key risks for euro area financial stability includes abrupt reversal of the global search for yield, amid pockets of illiquidity and likely asset price misalignments. The ECB states that as the potential for disorderly adjustment in financial markets remains, financial institutions need to have sufficient buffers and/or hedges to withstand it.

Another risk is the continuing weak bank profitability and balance sheet stress in a low inflation and low growth environment. The ECB states that caction is needed to mitigate lingering scepticism regarding euro area bank balance sheets.

The third and final risk identified is the re-emergence of sovereign debt sustainability concerns, stemming from insufficient common backstops, stalling policy reforms, and a prolonged period of low nominal growth. According to the ECB, despite the continued improvement in sentiment towards euro area sovereigns, public debt sustainability challenges persist and complacency or reform fatigue must therefore be avoided.

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