swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

Europaudvalget 2017
SWD (2017) 0171
Offentligt

EUROPEAN

COMMISSION

Brussels, 19.5.2017

SWD(2017) 171 final

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European Financial Stability and Integration Review (EFSIR)

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

This document has been prepared by the Directorate-General for Financial Stability, Financial

Services and Capital Markets Union (DG FISMA).

This document is a European Commission staff working document for information purposes.

It does not represent an official position of the Commission on this issue, nor does it

anticipate such a position. It is informed by the international discussion on financial

integration and stability, both among relevant bodies as well as in the academic literature. It

presents these topics in a non-technical format that remains accessible to a non-specialist

public.

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

Contents

Chapter 1 MACRO-ECONOMIC AND FINANCIAL DEVELOPMENTS

1.1 Macro-economic and financial developments ................................................................................ 12

1.2 International capital flows and trade in financial services ............................................................. 18

1.3 Non-financial corporations, households and public sector funding ............................................... 23

Chapter 2 EU BANKING SECTOR

2.1 Profitability performance of the EU banking sector ....................................................................... 30

2.2 Cyclical and structural drivers of bank profitability ....................................................................... 32

2.3 Profitability challenges linked to costs ........................................................................................... 33

2.4 Effects of banking sector concentration and network structures .................................................... 36

2.5 Challenges linked to non-performing loans.................................................................................... 38

2.6 Performance of banking stocks and bank funding markets ............................................................ 41

2.7 Recent trends in bank credit ........................................................................................................... 44

Chapter 3 CAPITAL MARKETS AND INSURANCE

3.1 Equity markets ................................................................................................................................ 50

3.2 Fixed-income markets .................................................................................................................... 55

3.3 Investment funds, exchange-traded funds and pension funds ........................................................ 60

3.4 Other types of funding .................................................................................................................... 67

3.5 Insurance sector .............................................................................................................................. 74

Chapter 4 COMPLETING BANKING UNION

4.1 Introduction .................................................................................................................................... 81

4.2 Existing elements of the Banking Union architecture .................................................................... 81

4.3 Progress in breaking the link between banks and sovereigns ......................................................... 83

4.4 Missing elements of the Banking Union ........................................................................................ 87

4.5 Risk reduction and risk sharing in the euro area ............................................................................ 88

4.6 Concluding remarks........................................................................................................................ 91

Chapter 5 FINANCIAL CYCLES, HOUSING MARKETS AND

MACRO-PRUDENTIAL POLICY

5.1 Introduction .................................................................................................................................... 92

5.2 The importance of residential real estate in financial cycles .......................................................... 93

5.3 National developments and macro-prudential policies in the real estate sector ............................. 96

5.4 Putting EU macro-prudential policy in a broader perspective...................................................... 100

5.5 Concluding remarks...................................................................................................................... 104

5.6 Annex

—

Housing market characteristics across Member States ................................................ 106

References

108

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

CKNOWLEDGEMENTS

This document was prepared in the Directorate-General for Financial Stability, Financial

Services and Capital Markets Union (DG FISMA) under the direction of Oliver Guersent

(Director-General), Sean Berrigan (Deputy Director-General), Nathalie de Basaldúa (Director,

Investment and company reporting) and Mario Nava (Director, Financial system surveillance

and crisis management).

The production of the document was coordinated (in alphabetical order) by Staffan Linden

and Geert Van Campenhout. Individual contributors to the document were (in alphabetical

order) Chris Bosma, Javier Villar Burke, Matteo Cominetta, Johanne Evrard, Helen Ginter,

Anna Grochowska, Max Langeheine, Jouni Lehto, Staffan Linden, Stan Maes, Juri Mara,

Santosh Pandit, Harald Stieber, Mariana Tomova, Diego Valiante, Eleuterio Vallelado

Gonzalez, Geert Van Campenhout, Ivar Van Hasselt, Tomas Vaclavicek, Nicolas Willems

and Alexandru Zeana.

Several colleagues from DG FISMA and other parts of the European Commission provided

comments and suggestions that helped to improve the text. We are particularly grateful to (in

alphabetical order) Sean Berrigan, Nathalie De Basaldua, Dilyara Bakhtieva, Yann Germaine,

Nathalie Berger, Ivo Jarofke, Anna Kelber, Guido Moavero Milanesi, Mario Nava and Adrian

Steiner.

Comments would be gratefully received and should be sent to:

Directorate-General for Financial Stability, Financial Services and Capital Markets Union

(DG FISMA)

Unit B2: Economic analysis and evaluation

Unit E1: EU/Euro area financial system

European Commission

B-1049 Brussels

Belgium

Or by e-mail to

[email protected]

[email protected].

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

IST OF ABBREVIATIONS

Countries

Austria

Belgium

Bulgaria

Cyprus

Czech Republic

Germany

Denmark

Estonia

Greece

Spain

Finland

France

Great Britain

Greece

Croatia

Hungary

Ireland

Italy

Lithuania

Luxembourg

Latvia

Malta

Netherlands

Norway

Poland

Portugal

Romania

Sweden

Slovenia

Slovakia

United Kingdom

United States of America

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

Others

APRC

BCBS

BIS

BME

BoE

BoP

BRRD

C/I

CAPM

CCD

CDS

CEE11

CET1

CoCo

CoE

CMU

CRD IV

CRR

DGS

DLT

DSTI

DTI

EBA

EBAN

ECB

EDIS

EEA

EFAMA

EFSI

Annual percentage rate of charge

Basel Committee on Banking Supervision

Bank for International Settlements

Spanish Capital Markets Holding Company

Bank of England

Balance of payments

Bank Recovery and Resolution Directive

Cost to income

Capital asset pricing model

Consumer credit directive

Credit Default Sswap

Bulgaria, Croatia, Czech Republic, Estonia, Latvia, Lithuania,

Hungary, Poland, Romania, Slovenia and SlovakiaK

Common Equity Tier 1

Credit institutions

Contingent convertibles

Cost of equity

Capital Markets Union

Capital Requirement Directive

Capital Requirement Regulation

Defined benefit

Deposit guarantee scheme

Distributed ledger technology

Debt service to income

Debt to income

Euro area

European Banking Authority

European Business Angel Network

European Commission

European Central Bank

European Deposit Insurance Scheme

European Economic Area

European Fund and Asset Management Association

European Fund for Strategic Investments

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

EIB

EIOPA

EONIA

EPPF

ESIS

ESMA

ESRB

ETF

EU-28

EUR

EURIBOR

FDI

Fintech

FSR

FTSE

G-SII

G20

GBP

GDP

GWP

HHI

HICP

HNWI

IBEX

ICI

ICT

IFRS

IMF

IORP

IOSCO

IPO

JPY

JRC

European Investment Bank

European Insurance and Occupational Pensions Authority

Euro over-night index average

European Personal Pension Framework

European Standardised Information Sheet

European Securities and Markets Authority

European Systemic Risk Board

Exchange traded funds

European Union

European Union 28 Member States

Euro

Euro interbank offered rate

Foreign direct investment

Financial technology

Financial stability review

Financial Times Stock Exchange

Global systemically important institutions

Group of 20 major economies

Great Britain pound

Gross domestic product

Gross written premiums

Herfindahl-Hirschman index

Harmonised index of consumer prices

High net worth individual

Spanish exchange index

Insurance corporation

Investment Company Institute

Information and communication technology

International Financial Reporting Standards

International Monetary Fund

Institutions for Occupational Retirement Provision

International Organisation of Securities Commissions

Initial public offering

Japanese yen

Joint Research Centre

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LCR

LGD

LIBOR

LTI

LTV

M&A

MCD

MFI

MiFID

MiFIR

MMF

MREL

MTF

NFC

NPL

OECD

OFI

OIS

OPEC

PAYG

PEPP

q-o-q

RoE

SAFE

SDD

SECCI

SFT

SRB

SNL

SRF

SRM

Liquidity coverage ratio

Loss given default

London interbank offered rate

Limited partner

Leverage ratio

Loan to income

Loan to value

Mergers and acquisitions

Mortgage Credit Directive

Monetary financial institution

Markets in Financial Instruments Directive

Markets in Financial Instruments Regulation

Money market fund

Minimum required for own funds and eligible liabilities

Multilateral trading facility

Non-financial corporation

Non-performing loan

Organisation for Economic Co-operation and Development

Other financial institution

Overnight index swap

Organization of the Petroleum Exporting Countries

Pay-as-you-go

Pan European personal pensions

Private placement

Third quarter

Quarter-on-quarter

Return on equity

Survey on access to finance of enterprises

Security and derivative dealers

Standard European consumer credit information

Securities financing transactions

Single Resolution Board

Standard & Poor’s database

Single Resolution Fund

Single Resolution Mechanism

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

SSM

STOXX

STS

TFA

TLAC

UCITS

USD

y-o-y

Single Supervisory Mechanism

Dow Jones STOXX index

Simple, transparent and standardised (securitisation)

Total financial assets

Total loss absorbing capacity

Undertakings for the collective investment in transferable securities

American dollar

Year-on-year

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

XECUTIVE

UMMARY

The annual European Financial Stability and Integration Review (EFSIR) provides an analysis

of recent developments in financial markets and the financial sector and their impact on

financial stability and integration. The European Commission regularly monitors these

developments and analyses the underlying structural drivers in order to assess the

effectiveness of existing policy actions and gain insight into the need for future actions in

view of emerging risks and opportunities.

The report first describes the recent general developments in financial markets and the

financial sector (Chapters 1-3). This is followed by a more in-depth analysis of two particular

policy areas that impact European financial stability and integration (Chapters 4-5). In this

edition, the first focus chapter reviews the current achievements of the Banking Union and the

progress towards its completion. The second focus chapter discusses the EU macro-prudential

policy framework. The Banking Union and macro-prudential policy have gone a long way in

providing authorities with the tools to reinforce financial stability in the EU. They will remain

important policy areas in view of the need to improve risk sharing and reduce risk as part of

the long-term vision to deepen the Economic and Monetary Union.

These policies are further developed and implemented in a period in which the European

economy has continued to recover, despite remaining economic and political uncertainties.

Chapter 1

argues that the recovery is now well established, with private consumption as the

main growth driver, supported by other drivers such as rising employment, favourable

exchange rate conditions and low commodity prices. Several factors, including a better

regulatory and supervisory framework as well as improved bank funding, seem to have

outweighed the concerns at the beginning of 2016 of a global economic slowdown led by the

US and China and increased political uncertainty.

Chapter 2

underlines the importance of securing a sustainable and healthy banking sector, as

well as the need to diversify the sources of funding to the EU economy. The chapter discusses

the challenges banks face to ensure a sufficient level of profitability. The combination of low

interest rates, high operational costs and rising competition from non-banks could compress

profit margins. This in turn could affect bank stock prices and their cost of capital. Achieving

a sustainable banking sector requires banks to adjust to a changing economic and regulatory

environment, focusing on diversifying income sources and containing costs. Although

financial technology (Fintech) has put pressure on traditional bank business models, it also

provides opportunities for banks to reduce costs. The diversification of funding sources is

addressed in the ongoing work on the Capital Markets Union, which will nurture more

integrated, deeper and liquid financial markets.

Chapter 3

shows that EU capital markets stabilised and grew regardless of occasional

volatility outbursts. Share prices rose and corporate bond yields remained low, lifted by the

emerging economic recovery. Corporate bond issuance continued to expand. Investors seem

to be shifting their portfolio to bonds with longer maturities and higher credit risk in search of

The Capital Markets Union complements the Banking Union and as an umbrella project envisages building deeper and

more integrated capital markets and increasing funding sources and investment opportunities. It will also help make the

financial system more resilient and lower the cost of funding.

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

higher yields. Equity issues of banks shrank given that banks have largely completed

strengthening their balance sheets. The latest data for alternative funding, like private equity,

business angels, and crowdfunding, also showed good performance of these market segments.

Chapter 4

presents the various existing and proposed parts of the Banking Union and

discusses the progress towards its completion. The measures currently in place, such as

increased capital requirements and common frameworks for supervisions and resolution, have

boosted financial stability with stronger balance sheets for banks and a common application of

rules. Completion of the Banking Union is an ongoing project. In June 2016, EU finance

ministers delivered a road map that laid out further guidelines for completing the Banking

Union. To this end, the Commission delivered a comprehensive bank reform package in

November 2016 to tackle remaining weaknesses, by strengthening the loss absorbency of EU

banks and facilitate their resolution in case of risk of failure. The measures envisage both

increased risk reduction and risk sharing and the new features try to find the right balance

between these two objectives.

The chapter also attempts to gauge any progress on the overall objective of Banking Union,

i.e. to break the link between banks and sovereigns. It is difficult to isolate the effects of

Banking Union from other relevant factors, notably post-crisis risk aversion and the policy

actions of the European Central Bank (ECB). The analysis shows there are signs that the links

between sovereigns and banks have been weakened, while these links persist. It is therefore

necessary to move forward to complete the Banking Union as a means to break links between

banks and sovereigns.

Chapter 5

provides a perspective on how macro-prudential policies in the EU complement

other economic policy measures seeking to dampen financial cycles. These financial cycles,

the movements in credit and asset prices, which have been shown to be distinct from

traditional business cycles, have been a source of banking crises. The chapter shows that

developments in the housing market are of particular importance for macro-prudential

policies. For instance, high home ownership rates and strong growth in mortgage credit can be

linked to strong feedback loops between the housing market, the financial system, and the real

economy.

Understanding the drivers of developments in real estate markets is key to designing an

appropriate policy response. Many structural characteristics linked to the housing market,

including home ownership rates and mortgage characteristics, vary profoundly across

Member States and are at the centre of social, fiscal and income policies. The macro-

prudential policy can therefore not be set in isolation, as it is just one of numerous interacting

policies contributing to the sustainability of the financial system. In the context of a robust

European coordination and oversight framework, it also follows that it is essential to take into

account specific national characteristics to prevent spill-overs and ensure the good functioning

of the single market. As such, the macro-prudential policy framework will need to be

permanently assessed and improved so that it can respond to continuously changing financial

structures in the EU.

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

Chapter 1 MACRO-ECONOMIC AND FINANCIAL DEVELOPMENTS

In 2016, the European economy continued to recover in a challenging economic environment

with increased political uncertainty. Favourable exchange rate conditions, low commodity

prices, accommodative monetary policy, and supporting endogenous factors, such as

improving labour markets, underpinned this recovery. The ECB announced additional

expansionary measures in March 2016, further easing the funding conditions for non-financial

corporations (NFCs).

In terms of funding, the funding mix not only differs between NFCs, households and the

government sector, but also shows significant intra-sector variation across countries. NFCs

are mainly financed through equity (representing 50% of firms’ liabilities), while households

(including non-incorporated businesses) rely mainly on bank loans (representing 76% of their

liabilities). Net access to new funding has recovered since 2015, especially in the case of bank

loans. Governments are still significantly exposed to bond markets given that bonds, on

average, make up 70% of their liabilities.

Reflecting gradually rising current account surpluses, net capital inflows continued

moderating in 2016, and eventually switched to net outflows. The ECB bond-buying

programme may have resulted in lowering the holdings by foreign residents of EU debt

securities. Foreign direct investments (FDI), followed by bank-related flows, are the most

stable sources of foreign capital for EU Member States.

1.1 Macro-economic and financial developments

1.1.1 Macro-economic developments

Against a challenging political and financial background, the European economy continued to

recover in 2016. Recovery was supported by relatively low commodity prices, a favourable

euro exchange rate, a continued accommodative monetary policy, and improving labour

market conditions.

Chart 1.1: Real GDP growth, quarter-on quarter

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

2014Q1 2014Q4 2015Q3 2016Q2 2017Q1 2017Q4 2018Q3

EU-28

-0.4

-0.42014Q1 2014Q4 2015Q3 2016Q2 2017Q1 2017Q4 2018Q3

2014Q1 2014Q4 2015Q3 2016Q2 2017Q1 2017Q4 2018Q3

EU-28

0.8

0.4

0.0

Chart 1.2: HICP inflation, year-on-year

1.6%

1.6

1.2

Source: European Commission

Note: Actual data (2014-2016) and forecast (2017-2018)

Source: European Commission

Note: Actual data (2014-2016) and forecast (2017-2018)

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Economic activity in the EU had a relatively strong start in 2016, with first quarter GDP

growing by 0.5% quarter-on-quarter (q-o-q) in both the euro area and in the EU

. This was

driven by expanding private consumption and investment. The pace of activity slowed

somewhat in the second quarter (0.3% q-o-q in the euro area; 0.4% q-o-q in the EU), amid

slowing investment. There was a steady increase in the pace of economic growth in the

second half of the year, despite increased political uncertainty.

The recovery in the EU economy is expected to continue at a largely steady pace in 2017,

with annual GDP growth projected at 1.7% in the euro area and 1.9% in the EU) .

In 2016,

private consumption, the main driver of growth in recent years, expanded at its fastest pace in

10 years. However, consumption growth is set to moderate this year as inflation partly erodes

gains in the purchasing power of households. Investment is expected to increase fairly

steadily, but remains hampered by the modest growth outlook, and the need for further

deleveraging in some sectors. A number of factors support a gradual pick-up in investments,

such as rising capacity utilisation rates, corporate profitability, attractive financing conditions,

but also through the Investment Plan for Europe.

The labour market in the EU and euro area has continued to recover during 2016 and early

2017, with net employment increasing and unemployment declining.

These developments

were supported by the ongoing economic expansion, modest wage growth and structural

reforms in several Member States. However, despite this recovery, which started in mid-2013,

unemployment at the aggregate level has not yet returned to pre-crisis levels. Although cross-

country differences are declining, unemployment remains unacceptably high in several

Member States.

Inflation in the EU and euro area was very subdued in the first two quarters of 2016, but

picked up during the second half of the year. The trend in inflation was a consequence of

developments in energy prices, which first continued to be low but then picked up in the

second half of 2016. Core inflation has remained subdued, without a clear upward trend yet;

this is consistent with the remaining slack in labour markets and the effects of structural

reforms implemented in some Member States.

Outside of the EU, GDP growth slowed in the first half of 2016 before recovering in the

second half of the year. After the initial weakness, global activity gained momentum in the

third quarter of 2016, registering 0.9% q-o-q growth, the fastest in two years. In the final

quarter of the year, global GDP grew by 0.7% q-o-q. The annual growth rate for the global

economy (ex-EU-28) was just 3.0% in 2016, which was the weakest since 2009. The pick-up

in global economic activity in the second half of 2016 should be seen against the background

of the G20 commitment to use all economic policy tools available, i.e. monetary, fiscal and

structural, to strengthen growth, investment and financial stability. Global growth is projected

In this case EU growth excludes Ireland. In 2015-16, there was a statistical re-classification of some activities in Ireland.

Despite the relatively small weight of Irish GDP in the euro-area and EU aggregates, the size of the changes makes

developments in Ireland a key determinant of aggregate figures.

See European Commission Spring Forecast 2017.

By February 2017, the unemployment rate had fallen to 9.5% of the labour force in the euro area and 8.0% in the EU, the

lowest levels since May 2009 and January 2009, respectively. This compares to pre-crisis levels of 7.5% in the euro area

and 7% in the EU in 2008.

In 2016, the harmonised index of consumer prices (HICP) in the euro area increased by 1.1% and in the EU by 1.2%.

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to pick up further in 2017, but the outlook is surrounded by considerable geopolitical

uncertainty in both advanced and emerging market economies. Globally, inflation seems to be

picking up, supported by the rebound of energy prices and the strengthening pace in global

growth.

Economic activity in the US disappointed in the first half of 2016, as a drawn-out inventory

correction coincided with a prolonged weakness in investment in the energy and

manufacturing sectors. However, in the third quarter, GDP growth recovered due to a rebound

in inventory investment and was followed by a 0.5% GDP growth rate in the fourth quarter.

Meanwhile, growth in emerging markets seems to have bottomed out at the end of 2015, early

2016. It recovered gradually in 2016, supported in particular by a turnaround in commodity

prices.

However, growth rates differed across countries and regions. At the end of 2016,

downside risks to growth in the emerging markets increased due to uncertainties about US

economic policy and the possible impact through trade and financial channels.

1.1.2 Monetary policy developments in the EU

Accommodative monetary policies from all the major central banks have continued to support

economic activity and ensured price stability at the global level. In the euro area, the ECB

announced additional expansionary measures in March 2016 to further ease funding

conditions for the non-financial private sector. The ECB lowered its major policy rates,

increased the amount of monthly purchases under the ongoing asset purchase programme and

broadened the range of purchasable securities to include euro-denominated investment-grade

non-bank corporate bonds.

Furthermore, four new quarterly targeted longer-term refinancing

operations with a maturity of 4 years were announced. During the remainder of the year, the

ECB did not change its monetary policy stance. However, at its December 2016 meeting, the

Governing Council announced a reduction of its asset purchase programme to EUR 60 billion

per month from April 2017 onwards. The ECB did, though, specify that the size and duration

of the programme could be expanded again, should the outlook become less favourable, or if

financial conditions became inconsistent with further progress towards a sustained adjustment

to inflation.

Monetary policies remained accommodative in most non-euro EU Member States, with

central banks in Hungary and Sweden undertaking additional expansionary measures. Despite

inflation and inflation expectations moving up somewhat, monetary policy has remained

supportive in the early months of 2017. Following the outcome of the UK referendum on EU

membership, the Bank of England immediately eased its macro-prudential policy stance by

reducing the countercyclical capital buffer that banks have to hold. Further, in August, it

announced a package of easing monetary measures, lowering the policy rate by 25 basis

points (bps) to 0.25% for the first time since 2009. The Bank of England also expanded its

quantitative easing by purchasing an additional GBP 10 billion of corporate bonds and GBP

60 billion of government bonds and introducing a new Term Funding Scheme aimed at

Oil prices bottomed out early 2016, rebounded strongly in spring and have trended slightly upwards since as the oil

market tried to find an equilibrium price. Continued supply overhang and slower growth in oil demand weighed on

prices, but the OPEC agreement on limiting oil production and increasing market confidence that the agreement would be

respected put a floor under the oil price.

The ECB lowered the interest rate on its deposit facility (by 10 bps to -0.40% after lowering it to 0.30% in December

2015), main refinancing operations (by 5 bps to 0%), and its marginal lending facility (to 0.25%).

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providing cheap financing to banks. At the end of the year, the Bank of England’s Monetary

Policy Committee maintained its policy rate at 0.25%, and decided to continue its previously

announced asset purchases for monetary policy purposes, while both headline and core

inflation reached 1.6%.

Monetary policy divergence between the euro area and the US has increased further. After its

first rate hike in 9 years at the end of 2015, the US Federal Reserve (Fed) kept its monetary

stance on hold throughout most of 2016. However, in December, the Fed raised its target

range for the policy rate by another 25 bps to 0.50%-0.75%, a hike largely priced in by

financial markets. In March 2017, the US Federal Reserve subsequently increased the target

range for its policy rate by an additional 25 bps.

1.1.3 Financial-market developments

In recent years, global and EU financial markets have witnessed a number of sharp asset price

corrections, which in hindsight have turned out to be short-lived. In early 2016, global

financial markets experienced strong headwinds as investors became increasingly risk-averse

amid rising concerns of a global economic slowdown led by the US and China. In addition,

there were concerns about the potential adverse impact of very low interest rates on banks’

profits, particularly in the euro area and Japan. In equity markets, the financial segment

significantly underperformed the broader indices (see Chart 1.3). Meanwhile, high-grade

sovereign bonds served as safe-haven assets, and yields fell close to historically low levels

(see Chart 1.4). However, renewed concerns about the links between banks and sovereigns

created upward pressure on bond spreads in the euro-area periphery.

Chart 1.3: Share prices by financial sector, Europe

Jan 2015=100

140

Chart 1.4: Benchmark 10-year government

bond yields

3.0

2.5

120

2.0

1.5

100

1.0

0.5

0.0

Jan 15

-0.5

Jan 15

May 15

Sep 15

Jan 16

Insurance

May 16

Sep 16

Jan 17

Banks

May 15

Sep 15

Jan 16

May 16

Sep 16

Jan 17

Eurostoxx 600

Financials

Source: Bloomberg

Financial-market sentiment turned positive in February 2016, amid expectations that

monetary policies in some regions (notably the EU) could become even more accommodative

as the economic outlook for emerging markets improved. While stock markets recovered

globally, euro-area indices

—

especially relating to bank shares

—

continued to

underperform. The announcement by the ECB to include investment-grade non-bank

corporate bonds in its asset purchase programme led to a narrowing of corporate bond spreads

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swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

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1.2 International capital flows and trade in financial services

The dynamics of gross and net capital flows

reflects the extent of interlinkages between

the economic and financial sectors across

countries. After a period of rapid

international financial interlinkages before

the financial crisis in 2008-2009, the post-

crisis period has been characterised by

more subdued international capital flows

and in some cases by diverging economic

and financial trends. The effect of reduced

integration in terms of financial stability is

ambiguous, as declining capital flows

simultaneously reduce contagion risk and

opportunities for international risk sharing

and diversification.

Chart 1.5: European and international financial

integration, 2008-2015,% of GDP

5.0

3.5

Intra-EU

4.6

3.0

4.2

2.5

Extra-EU

3.8

2.0

3.4

2008

2009

2010

2011

2012

2013

2014

2015

Intra-EU (lhs)

Extra-EU (rhs)

1.5

Overall, global net capital flows continued

Note: International financial integration is measured by the sum of

to moderate in 2016 and turned negative

gross external assets and liabilities divided by GDP at current

market prices, excluding reserves and financial derivatives.

(with outflows exceeding inflows) for most

of the major world regions including the

EU. Capital outflows from emerging markets seem to have levelled off in 2016, although a

change in the policy mix in major advanced economies may trigger further adjustments in

2017. In the last quarter of 2016, EU capital outflows to third countries are expected to have

accelerated.

The EU’s current account surplus is mostly driven by trade in goods and services. Trade in

financial services with third countries continued to show a surplus in 2016, although the

surplus declined compared to a very strong outcome in 2015.

In terms of composition, FDI continues to be the most stable source of foreign capital for EU

Member States followed by bank-related flows. The net portfolio investment position of the

EU with third countries showed net outflows instead of net inflows, possibly owing to the

ECB bond-buying program. This net outflows position constitutes a major shift in 2016 given

that previously net outflows were only recorded in 2012-2013 during the sovereign debt

crisis.

1.2.1 Financial claims and gross external positions

Source: Eurostat BoP Quarterly Statistics and National Accounts

The financial claims of an economic area or country can be measured by the sum of the

holdings that domestic residents have of financial claims on the rest of the world and the

claims of non-residents on the domestic economy scaled by GDP at current market prices.

Using this measure, EU financial claims both between the EU Member States and between the

EU and the rest of the world continued to progress in 2015. Financial claims within the EU

See Lane and Milesi-Ferretti (2003).

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are still much higher than towards the rest of the world, although in 2015 growth in extra-EU

foreign assets and liabilities was faster than growth in intra-EU foreign assets and liabilities.

Chart 1.6: Net capital flows by world regions,

rolling 4-quarter sums

USD billion

1 600

Chart 1.7: EU balance of payments with non-EU

countries

EUR billion

200

1 200

100

800

400

-100

-200

-400

-800

2008Q1 2009Q2 2010Q3 2011Q4 2013Q1 2014Q2 2015Q3

EU excluding bilateral flows

Emerging markets**

World*

-300

2008Q1 2009Q2 2010Q3 2011Q4 2013Q1 2014Q2 2015Q3 2016Q4

Current and capital account balance

Financial account, net foreign assets

Source: IMF and Eurostat BoP Statistics

Note: Excluding reserves and related items, EU

—

excluding

reserves, financial derivatives and bilateral intra-EU flows.

Source: Eurostat quarterly BoP Statistics

Note: Excluding intra-EU flows; Net foreign assets, excluding

reserves and financial derivatives. Current and capital account

balance: (+)/(-) indicates a surplus or net lending/deficit or net

borrowing; Financial account: (+) indicates capital outflows, (-)

indicates capital inflows.

1.2.2. Net current and financial accounts

Global developments

Against the backdrop of a gradual normalisation of monetary policy in the US, a subdued

global economic recovery, and political uncertainty, global net capital flows moderated

further in 2015 and in the first three quarters of 2016 (see Chart 1.6).

After receiving record-

high capital inflows in the post-crisis period, emerging markets have been experiencing net

capital outflows since 2014.

These were triggered by the normalisation of monetary policy

conditions in the US and declining growth differentials.

EU net current and financial accounts with non-member countries

EU net capital flows with third countries turned negative at the beginning of 2015 and

continued to decline in 2016.

In 2016, the current account of the EU recorded a surplus of EUR 217 billion, compared with

EUR 167 billion in 2015 (see Chart 1.7). The increase in the current account surplus of the

EU is mainly explained by the surplus maintained by the euro area, which is expected to have

Global

flows are approximated by a sample of 77 countries including both advanced and emerging economies as well the

EU excluding EU bilateral flows between Member States (i.e. EU flows with the rest of the world only).

Net

capital flows

are defined as gross inflows minus gross outflows.

Gross capital inflows

are defined as net changes in domestic resident

liabilities to non-residents.

Gross capital outflows

are defined as net changes in foreign assets owned by domestic

residents, excluding reserves.

Approximated by a sample of 56 emerging market economies including, 14 EU Member States. For more details and the

sample see: Recent experiences in managing capital flows. IMF, 2015, Annex I.

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increased to EUR 365 billion in 2016, up from EUR 319 billion in 2015. The EU current

account surplus has increased in every quarter since the second quarter of 2016.

The financial account, which shows how the current and capital account are financed, has

been much more volatile and recorded capital outflows in the second and third quarters of

2016.

1.2.3. Composition of the current and financial accounts

The EU’s current account surplus with third countries is mainly a result of trade in goods and

services, while the share of net earnings from foreign assets and liabilities is relatively small

(see Chart 1.8). Since 2015, the investment income balance has mostly been negative, as the

income earned from assets in third countries was lower than the return paid to non-residents

for liabilities in the EU.

In the financial account, the net acquisition of foreign securities by EU residents (capital

outflows) exceeded the net incurrence of liabilities (capital inflows) during the first half of

2016.

Chart 1.8: Composition of the EU current account

surplus with non-EU countries

EUR billion

120

-40

-200

Chart 1.9: Euro-area portfolio investment flows

with non-euro area, rolling 12-month

sums

EUR billion

800

600

400

200

-80

-400

-120

2008Q1 2009Q2 2010Q3 2011Q4 2013Q1 2014Q2 2015Q3 2016Q4

Services balance

Goods balance

Current and capital account balance

Investment income balance

-600

2010Feb 2011Jun 2012Oct 2014Feb 2015Jun 2016Oct

Net foreign assets (assets minus liabilities)

Assets (Net acquisition of)

Liabilities (Net incurrence of)

Source: Eurostat quarterly BoP Statistics

Note: Excluding intra-EU flows.

Source: ECB balance of payments monthly statistics

Remarkably, portfolio investment outflows exceeded inflows in the second and third quarter

of 2016 because of a decline in euro-area portfolio investment inflows (liabilities) relative to

broadly unchanged outflows (see Chart 1.9). Such a positive net EU portfolio investment

position only occurred very rarely in the past (i.e. during the sovereign debt crisis in 2012).

This outcome can partly be attributed to the disinvestment (sales) by non-residents of their

holdings of EU securities in relation to the extended ECB’s bond purchasing programme.

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Chart 1.10: EU financial account transactions with non-EU countries, cumulated four-quarters

EUR bn

500

300

100

-100

-300

-500

-700

2009Q1

2009Q4

2010Q1

2010Q2

2010Q3

2011Q2

2011Q3

2011Q4

2012Q4

2013Q1

2013Q2

2014Q2

2014Q3

2014Q4

2015Q4

2016Q1

2016Q2

2009Q2

2009Q3

2010Q4

2011Q1

2012Q1

2012Q2

2012Q3

2013Q3

2013Q4

2014Q1

2015Q1

2015Q2

2015Q3

2016Q3

2009

2010

2011

2012

Direct investment, net

2013

2014

2015

2016

Financial account balance, quarterly

Portfolio investment, net

Other investment, net

Source: Eurostat BoP Statistics

Note: excluding bilateral intra-EU flows. Positive figures indicate outflows (an increase of foreign assets), negative figures indicate

inflows (an increase in the incurrence of liabilities).

Another significant development was the increase in the disinvestment by non-EU residents

of their FDI in the EU. Based on preliminary data, extra-EU disinvestment accelerated in the

last two quarters of 2016, and it remains to be seen whether this was a temporary development

linked to merger and acquisitions (M&A) activities or a more permanent shift.

1.2.4. Volatility of capital flows

The impact of international capital flows on financial integration and financial stability

depends not only on the volume of capital flows but also on their volatility. Chart 1.11

illustrates the volatility of net capital inflows in the US and in the EU by their main

components.

Chart 1.11: Volatility of capital flows for the EU and the US

EUR billion

160

A. Volatility of extra-EU net inflows

USD billion

180

B. Volatility of US net inflows

140

120

100

2010Q1 2011Q1 2012Q1 2013Q1 2014Q1 2015Q1 2016Q1

Direct Investment

Other Investment

Portfolio Investment

-20

2007Q1 2008Q3 2010Q1 2011Q3 2013Q1 2014Q3 2016Q1

Direct Investment

Other Investment

Portfolio Investment

Source: Eurostat quarterly BoP statistics and IMF BoP statistics

Note: Excluding bilateral intra-EU flows; Net capital flows are defined as the net increases in the liabilities of the country or groups

of countries in a given instrument, that is, all increases in the liabilities (inflows) in an instrument netted against all increases in the

assets (outflows) of the same instrument. Volatility is calculated as the standard deviation of capital flows.

2016Q4

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Foreign direct investment remained the most stable component of capital flows both in the EU

and the US over the period 2010 to the third quarter of 2016. Regarding EU net inflows from

third countries, portfolio investment has been the most volatile component since the beginning

of 2011. Towards the end of the reporting period its volatility became almost twice as high as

that of the other two components of capital flows. The volatility of other EU investment,

which mainly consists of bank-related flows, declined sharply in mid-2010, most likely as a

result of the extension of the first financial assistance programmes for euro-area Member

States. In contrast, other investment flows were the most volatile component of US capital

flows between 2011 and 2015. Overall, EU capital flows to third countries seem to have been

more volatile than those of the US, mostly due to portfolio investment.

1.2.5. Trade in financial services

Since 2008, the EU has consistently

generated trade surpluses in financial

services. In 2015, exports of financial

services exceeded imports by almost

EUR 46 billion

and

2016

EUR 41 billion (see Chart 1.13). The UK

share of the EU trade surplus in financial

services with third countries is around 70%.

In 2015, exports to countries outside the

EU were up by more than 13%, while

imports from countries outside the EU grew

more moderately by 6%. Exports to third

countries, in particular to the US (2.5%),

and offshore financial centres (1.9%), grew

the fastest in 2015.

Chart 1.13: Trade in financial services with non-EU

countries

EUR billion

120

100

Exports

Imports

2008

2009

2010

2011

2012

2013

2014

2015 2016*

Balance (exports-imports)

quarterly

statistics

In 2016 year-to-date, the surplus in trade in

Source: Eurostat,sum of theBoP 4 quarters up to Q3 2016.

Note: *2016 is a

last

financial services declined slightly (down

by almost EUR 5 billion). This decline was

due to falling exports to all major trading partners and especially for those trading partners

whose exports grew the fastest in the previous year. The sharpest reversals were registered

with the US (-1.6%), Japan (-0.74%) and Switzerland (-0.64%).

Intra-EU trade in financial services showed uneven patterns across different groups of

Member States (see Chart 1.14). All groups of Member States had surpluses in trade in

financial services between in 2009 and 2016, except CEE11.

Exports of financial services

declined the most in Denmark, Sweden and the UK. Almost the entire decline in EU-28

exports in 2016 was due to these three Member States. Imports remained almost flat in 2015-

2016 across all Member States. Developments in CEE11 countries sometimes diverge from

those other EU countries. The deficit of CEE11 in trade in financial services has been on a

Data for 2016 is up to Q3 on a rolling four-quarter basis.

The CEE11 Member States are: Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland,

Romania, Slovenia and Slovakia.

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downward path since 2010 and declined to EUR -432 million in 2016 from EUR -

1 415 million in 2010.

Chart 1.14: Trade in financial services by groups of Member States

EUR billion

EA peripheral 7

EA core 7

DK, SE, UK

CEE 11

EUR billion

-20

-5

-10

-70

-15

-20

-120

-25

Thousands

2016*

EA peripherial 7 imports

EA peripherial 7 exports

CEE11 imports (right axis)

Net exports CEE11 (right axis)

EA core 7 imports

EA core 7 exports

CEE11 exports (right axis)

DK, SE and UK imports

DK, SE and UK exports

Net exports

Source: Eurostat, quarterly BoP statistics

Note: *2016 is a sum of the last 4 quarters up to Q3 2016; EA peripheral: Cyprus, Greece, Ireland, Malta, Italy, Portugal and Spain;

EA core 7: Austria, Belgium, Finland, France, Germany, Luxembourg and the Netherlands; CEE11: Bulgaria, Croatia, the Czech

Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovenia and Slovakia.

1.3 Non-financial corporations, households and public sector funding

This section provides an overview of the different sources of funding used by non-financial

corporations, household and governments. It summarises the changes in certain variables over

time and differences and particularities across countries.

Chart 1.15: Sources of funding (financial liabilities) by sector, outstanding amounts, euro area

EUR billion

12 000

100%

10 000

80%

8 000

60%

6 000

40%

4 000

20%

2 000

NFCs

Bank loans

Other equity

Other loans

Trade credit

Households

Bonds

Other liabilities

Governments

Quoted shares

2000

NFCs

Bank loans

Quoted shares

2016

2000

2016

2000

2016

Households

Other loans

Other equity

Governments

Bonds

Other liabilities

Source: ECB euro area accounts

Note: For governments, trade credit is included in other liabilities.

The funding mix differs from one sector to another. Non-financial corporations (NFCs)

finance their activities through a variety of sources, while households and governments tend

2016*

2009

2010

2011

2012

2013

2014

2015

2009

2010

2011

2012

2013

2014

2015

2013

2014

2015

2009

2010

2011

2012

2013

2014

2015

2009

2010

2011

2012

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to concentrate their funding mix in a few sources (see Chart 1.15, left panel). The right panel

in Chart 1.15 shows that over time a progressive shift in the funding mix has taken place.

1.3.1 Non-financial corporations

In the euro area, more than half of NFCs’ activities are financed through equity, most of it in

the form of equity other than quoted shares. Among debt instruments, loans are the most

widely used by euro-area NFCs, with bank loans representing on average about 14% of total

liabilities.

Other loans, which include intercompany loans, private loans, loans from public

entities, or loans stemming from a supplier-customer relationship, are an even larger source of

funding for euro-area NFCs, representing on average almost 20% of liabilities. The issuance

of bonds is still a relatively marginal source of financing, representing on average 4.4% of

liabilities and is only slightly more significant (between 6.0% and 7.5% of liabilities) in the

UK, France, the Netherlands, Austria and Portugal.

Euro-area NFCs also make use of trade credit (9% of liabilities). Other liabilities, which

include items such as taxes due, derivatives, factoring, or leasing, are a more marginal source

of funding, representing 3.6% of liabilities. There are just a few countries where they

represent more than 10% of liabilities, e.g. in the UK, Romania, Bulgaria, Poland, Portugal,

Croatia, Estonia and Germany. Overall, European companies finance about 35% of their

activities through the financial sector, either by borrowing from banks, or by issuing bonds or

shares.

Chart 1.16: Sources of funding (financial liabilities) by sector in the euro area, flows

EUR billion

600

500

400

300

200

100

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

-100

-200

Bank loans

Other loans

Bonds

EUR billion

500

400

300

200

100

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

-100

-200

-300

Listed shares

Trade credit

Other equity

Other liabilities

Source: ECB: euro-area accounts and own calculations

Note: Other liabilities also include trade credit until 2014.

The net provision of funding through bank loans has been highly volatile over the last 15

years (see Chart 1.16), expanding extraordinarily from about EUR 100 billion a year in mid-

2000 to almost EUR 600 billion a year in 2008.

During this period, bank loans provided up

to 50% of the new financing obtained by European firms, in spite of the fact that bank loans

represent only 15% of the NFCs’ outstanding liabilities (see Chart 1.15). With net bank flows

See Box 2 for a discussion on the role of shadow banking in non-banking credit intermediation.

Net transactions correspond to the difference between increases and decreases in transactions.

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receding with the financial crisis, NFCs turned to other sources of funding. Net flows of loans

became positive in late 2015, and have gained traction throughout 2016, indicating an

increasing recourse to this important source of funding by EU corporations. Within the

context of CMU, it remains important to promote alternative funding to facilitate

diversification of funding sources.

Since the outbreak of the crisis, NFCs have issued more bonds. Annual net issuance of bonds

has mostly remained above EUR 50 billion since late 2008, with some peaks above EUR

100 billion. Loans other than bank loans have also been an important source of funding for

European firms since the outbreak of the crisis. However, they seem to have lost traction in

2016, probably because of improved access to bank loans. Equity, in particular non-listed

shares, has been another source of funding available to firms throughout the crisis. The

increasing amount of unquoted equity since early 2015 may originate from the cyclical

economic upturn and the increased capacity of companies to generate profits. Net access to

trade credit and other accounts payable has been very volatile. The increase in net flows of

trade credit observed since early 2015 and in other liabilities observed since early 2016 may

reinforce the idea that EU companies are consolidating their financial positions, and that

confidence underpinning new business is returning.

Box 2 Shadow banking as an alternative source of financing

Under a widely accepted definition provided

by the Financial Stability Board, shadow

banking is credit intermediation which

involves entities and activities fully or partially

outside the regular banking system. In effect,

shadow banking often breaks down the credit

intermediation process between various

entities and involves the use of structured

financial products.

Chart B2.1: Credit provision by euro-area shadow

banks

EUR trillion

2 500

2 000

1 500

The size of the broadly defined shadow

1 000

banking system in the EU was EUR 37 trillion

in total assets in Q4 2015, or 36% of total EU

500

financial sector assets.

This accounts for

various financial actors such as financial

vehicle corporations, security and derivative

2010

2011

2012

2013

2014

2015

2016

dealers, money market funds, and bond funds,

Loans

NFC debt securities

Government debt securities

which are not regulated as banks, but engage

in credit intermediation as well as maturity

Source: Doyle et al. (2016)

transformation. They are active in derivative,

repo as well as securities lending markets. The EU shadow banking system has grown significantly,

tripling in size since 2004 thanks to increased transactions, as well as asset valuation and other

effects. The EU shadow banking system has also become bigger compared to the traditional banking

system. Between the end of 2012 and the end of 2015, for instance, the shadow banking system

measured by assets grew by 22%, compared to a decrease in assets of 5% in the traditional banking

system.

The European Systemic Risk Board (ESRB) broad measure of shadow banking includes all entities of the financial sector

except banks, insurance corporations and pension funds.

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The European aggregates conceal differences across countries in the use of various funding

sources. To a large extent, the mix of funding sources that NFCs use to finance their

activities depends on the funding conditions and available sources in their country of

residence, e.g. the level of financial development.

EU NFCs finance most of their activities with equity issuance, which in general represents

about 50% of firms’ liabilities. However, there are some differences across countries in the

use of equity. In Member States that joined the EU before 2004, equity is often raised on

organised markets (i.e. through the issuance of quoted shares). In Belgium, Denmark, Finland,

France, Germany, Ireland, the Netherlands, Sweden and the United Kingdom, quoted shares

represent between 15% and 30% of financial liabilities, or 70% or more of their respective

GDP. In the majority of Member States which joined after 2004, quoted shares represent at

most 5% of total liabilities, and at most 20% of GDP. However, the use of other forms of

equity as a source of funding is significantly greater than quoted shares in the vast majority of

Member States, with the exception of Finland, Germany, Ireland, and the UK, where quoted

shares have a similar, or even larger, size than other equity instruments (see Chart 1.17).

Chart 1.17: Funding sources used by NFCs across Member States, end of second quarter 2016

100%

80%

60%

40%

20%

EL CY

AT ES NL DE PT EA MT SK LV DK LT

Trade credit

Other equity

CZ EE PL FR BG SE HR RO UK HU BE LU

Bonds

Other loans

Bank loans

Other liabilities

Quoted shares

Source: ECB euro-area accounts and own calculations

Usually, NFC debt funding represents less than 50% of liabilities. However, in some Member

States, such as Belgium, Ireland, Luxembourg, Malta, Portugal and Sweden, debt levels are

rather high for NFCs. As regards bank loans, in Member States such as Bulgaria, Croatia,

Romania or Hungary, with a still developing banking system, the limited amount of

household deposits constrain the availability of banks loans for corporates, which represent

less than 10% of liabilities. In these Member States, NFCs often compensate their restricted

access to bank loans with other sources of funding, such as trade credit and

‘other

loans’. On

the other hand, in countries like Sweden, the UK and Ireland, with well-developed capital

markets, firms tend to more often issue quoted shares (up to 25% of liabilities). NFCs in these

countries therefore make less use of bank loans.

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stability mechanisms created during the crisis (e.g. the European Stability Mechanism) is

reflected in the series of loans from official

sources (i.e. ‘other loans’).

Since early 2015, the net annual issuance of sovereign bonds by euro-area governments has

gone down to pre-crisis levels. However, the accumulation of debt during the crisis meant a

significant increase in public sector leverage. Similarly, the recourse to official loans has

significantly declined (see Chart 1.20).

In most Member States, governments finance more than 50% of their debt by issuing bonds,

except for Portugal, Luxembourg, Croatia, Cyprus, Greece and Estonia. This is due to two

distinct reasons. In Estonia and Luxembourg, issuances are carried out only at infrequent

intervals, and the general level of debt is low. For Greece, Cyprus and Portugal, the stock of

loans remains high due to past international financial assistance. On the other hand, the

financial support provided by European stability instruments (European Financial Stability

Facility, European Financial Stabilisation Mechanism and European Stability Mechanism) are

accounted for as

‘other

loans', and imply a lower use of bonds in relative terms in countries

like Ireland, Greece, Cyprus and Portugal.

Most countries also make use of bank loans, trade

credit and other sources of funding, but generally to a lesser extent (see Chart 1.21).

Chart 1.21: Funding sources used by governments across Member States, end of second quarter 2016

100%

80%

60%

40%

20%

EE CY SE LU PL RO SK FR LV PT MT HU IE NL UK CZ

Other liabilities

Trade credit

Other equity

IT DK BG LT SI EA FI

Bonds

Other loans

EL HR ES AT BE DE

Bank loans

Source: ECB euro-area accounts and own calculations

Note that the financial stability programmes were successfully completed in all countries except for Greece; however,

the loans remain outstanding as the repayment is spread across several years.

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Chapter 2 EU BANKING SECTOR

This chapter focuses on the profitability of the EU banking sector, discussing the impact of

recent developments in cyclical and structural drivers including increased competition by non-

banks, on the profitability of banks.

Despite the recent years’ of expanding EU bank credit, the conditions in EU banking remain

challenging. Although the circumstances vary significantly across both banks and Member

States, the combination of continued low interest rates and high bank operational costs are

compressing bank profit margins. Low market expectations of future bank profitability, in

turn are putting downward pressure on bank share prices, raising banks’ cost of equity and

therefore the cost of external funding. On a more positive note, the enhanced bank solvency

and resilience, confirmed by the overall comforting results of the EU-wide stress test

published in the summer of 2016, support confidence in the EU banking sector. The

accommodative monetary policy supports bank funding conditions and banks’ lending

activity to the private sector.

The analysis in this chapter underlines the importance of securing a sustainable and healthy

banking sector as well as diversifying the sources of funding to the European economy. Many

EU banks are successful in adjusting to changing conditions, and these efforts must continue.

This includes a continued focus on diversifying income sources and higher-margin lending

activities. In developing and implementing these revenue-boosting and cost-reduction

initiatives, including introduction of new technologies and broader use of consumer data,

sufficient attention should also be devoted to ensuring

financial stability and a sufficient high

level of consumer protection

(see Box 3). It also requires ongoing efforts to contain costs

through further branch reductions, consolidation initiatives and the effective use of innovative

technologies to streamline business processes. A more diversified spectrum of funding

sources available to the European economy will be achieved through ongoing efforts that are

part of the Capital Markets Union initiative.

2.1 Profitability performance of the EU banking sector

European banks have faced several challenges in recent years. The global financial crisis of

2007-2008 severely disturbed the functioning of the EU banking sector, with strong negative

effects on the broader economy. In response to the crisis, wide-ranging regulatory reforms

have been introduced to strengthen banks’ capital and liquidity positions, and to make banks

safer and more resilient to shocks. However, the long-term viability of the banking sector has

emerged as a concern amid very low bank profitability for EU banks over a period of many

years. The low profitability can be attributed to the combined impact of many factors,

including persistently weak economic conditions, a low interest rate environment,

deleveraging needs, excess competition from financial technology companies and other non-

bank entities, litigation costs, as well as regulatory and compliance costs.

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Despite moderate improvements in 2015, bank profitability in the EU remains far lower than

in the pre-crisis period. The annualised return on equity (RoE)

fell to 5.4% in the third

quarter of 2016, one percentage point below the third quarter of the previous year. The

annualised RoE also fell relative to the second quarter of 2016, when it stood at 5.7%.

Return on equity (RoE) for EU banks is very unevenly distributed across Member States (see

Chart 2.1). CEE banks have recently performed better than the average for the EU, while

banks in the southern periphery have underperformed relative to the average. Croatia,

Hungary, Cyprus and Greece witnessed the greatest improvements over last year, although the

RoE for Greek banks remains significantly negative. Portuguese banks also recorded negative

RoE in 2016, and the RoE of Italian banks

—

although still positive

—

declined to 1.5%,

amid concerns about asset quality.

Chart 2.1: Banks’ return on equity

0.4

0.3

0.2

0.1

HU RO BG CZ LV SK SE EE HR MT PL LT NO SI DK BE IE NL AT

-0.1

FI FR ES LU CY GB DE IT PT GR

-0.2

-0.3

Q3 2015

Q3 2016

Source: EBA, own calculations

Meanwhile, the cost of equity (CoE)

for EU banks increased to around 10% on average

contributing to a renewed widening of the RoE-CoE gap. When costs exceed returns over an

extended period of time, a bank may experience higher costs of debt funding and equity

issuance. The currently low market valuations of EU banks and low expectations of future

profitability demonstrate the challenges that lie ahead. For the euro area, analysts are

systematically lowering their RoE forecasts for banks, with the median ROE forecasts

between 6% and 7% for 2017 and 2018.

RoE is defined as the ratio of net income to shareholders equity. It measures a firm's profitability by showing how much

profit a company generates with the money shareholders have invested.

CoE is defined as the return that the market demands from firms in exchange for bearing the risk of ownership and

investing their capital.

EU weighted average for 2016, by EBA, estimated using the CAPM model, see more details in 'Risk Assessment of the

European Banking System', European Banking Authority (EBA), December 2016, p. 48.

See more in ECB Financial Stability Review, p. 75.

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2.2 Cyclical and structural drivers of bank profitability

Bank income statements comprise a number of key components that shape its operating

profitability: net interest income, non-interest income, operating expenses, and impairments.

Aggregate data for the EU banking sector indicate that the weakness in post-crisis profitability

has been driven mainly by subdued macro-economic conditions, and related lower net interest

income and high loan-losses and the one-off shocks to profitability stemming from

impairment provisions. Analysis shows a persistently declining trend in net interest income,

while the negative contribution from loan-loss provisions eased, which supported bank

profitability in recent years.

Interest income is the main source of overall income in the traditional bank business model.

The low interest rate environment has compressed this important source of income.

Illustrating this phenomenon, the ratio of net interest income to total assets dropped to 1.2%

for euro-area banks in 2015 and remained close to this low level after that. In particular,

interest income derived from lending activities fell significantly and by more than interest

income from banks’ debt securities portfolios.

Non-interest income of euro area banks failed to compensate for the weakness in net interest

income. Following an increase in 2015, banks

reported a 4% year-on-year decline in net fee

and commission income in 2016, mainly due to a drop in fees from securities issuance, asset

management, and the distribution of investment products. All these sources of income are

sensitive to financial market volatility. The ECB has identified net non-interest income as the

greatest contributor to RoE decline in the euro-area banking sector, both in Member States

significantly affected by the financial crisis and other Member States.

Likewise, banks’

trading income was negatively affected by repeated bouts of market volatility during the

course of 2016, resulting in approximately a 20% annual decline compared to 2015.

The phenomenon of low profitability in the EU banking sector reflects a range of cyclical and

structural factors, varying across banks and across Member States. The most crucial cyclical

challenge to banks has been the protracted low interest rates in combination with low

economic growth. Persistently low interest rates erode bank profitability by compressing net

interest margins. The impact differs across institutions, depending on the composition of the

loan portfolio (e.g. the share of floating rate loans) and its funding mix (e.g. the share of

deposit funding). Generally, however, when interest rates are low, the difference between the

rate of interest paid on bank liabilities and the rate charged to borrowers is smaller. This is

because banks are constrained in their capacity to lower the rate on deposits below zero.

Finally, low interest rates translate into lower profitability from government bond portfolios.

The following definitions are used:

net interest income

is defined as income stemming from loans and other financial

products net of funding costs;

non-interest income

is income stemming from financial operations such as trading

activities, gains/losses on repurchase of own debt & asset disposals, fees and commissions;

operating expenses

are

general expenses on premises and equipment, staff remuneration, depreciation and amortisation, other costs; and

impairments

refer to provision expenses for impaired loans (NPLs, doubtful loans).

Data based on euro-area significant banks, directly supervised by the ECB.

Based on ECB's supervisory data, for details see ECB's Financial Stability Review, November 2016, p. 73.

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On the positive side, it has been estimated

Chart 2.2: Bank profitability measured by RoE

by ECB staff that the overall impact on

bank profitability of recent monetary policy

actions is net positive compared with a

scenario

assuming

monetary

intervention.

There are several reasons for

this. First, the lower interest rates and other

interventions have improved the macro-

economic environment, which has helped

loan loss provisions to fall amid a better

debtors’ repayment performance. In

-5

addition, whilst lower rates have

compressed margins, they have increased

-10

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

overall demand for loans and enhanced

EU-28

Asia-Pacific

debtors’ repayment performance, therefore

Source: Standard & Poor’s Global Market Intelligence data, own

supporting bank interest income through

calculations.

rising loan growth and higher lending

volumes. Moreover, low interest rates have benefited banks by lowering the refinancing costs

at the ECB. Lastly, lower rates have also lead to some capital gains on the bond portfolio of

banks.

Next to cyclical challenges, the profitability of European banks also suffers from structural

challenges, which amplify cyclical difficulties, such as: a large stock of unresolved legacy

assets in some Member States, high cost-to-income ratios, business models dependent on

interest income, increasing competition from financial technology companies (‘fintechs’) and

other non-banks. Some of these factors, which are described in more detail in the following

sections, explain why bank profitability in the EU appears structurally lower than overseas,

e.g. in the US or in Asia.

2.3 Profitability challenges linked to costs

Low bank profitability in Europe is partly the result of high costs. Continued challenges to

revenue generation shifted banks’ focus to cost-cutting

and restructuring efforts, including

staff reductions, branch closures, and an increased use of digital distribution channels. Still,

cost efficiency varies widely across banks and Member States, suggesting that some banks

still have room to improve operational efficiency via cost-cutting, including by consolidation.

Consolidation could bring some profitability at the sector level by enhancing cost and revenue

synergies. However, progress in bank consolidation in the euro area, in particular across

borders, remains somewhat limited to date.

See Rostagno et al. (2016).

Fintechs are companies that use new technology and innovation in the delivery of financial services. They sometimes

compete with traditional financial institutions, but can also help make business processes more efficient.

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Data shows that costs continued to rise over

the course of 2016 for the average of EU

banks (see Chart 2.3), which contributes to

bank profitability challenges. The most

typical measure of bank costs are cost-to-

income ratios (C/I), which are high for EU

banks compared to historical standards.

The EU-wide C/I average stood at 63.0% in

Q3 2016. Over the course of 2016, the C/I

ratio increased by 3 percentage points.

When contrasted with declining bank

revenues, this trend in C/I ratios indicates

that costs have been reduced less than

proportionally, and confirms a long-term

trend of a rising C/I ratio, which recently

increased quite significantly from around

55% in 2010 to 63% in 2016.

Chart 2.3: EU banks’

cost-to-income

ratio, weighted

average

0.70

0.65

0.60

0.55

0.50

2009

2012

2015

Source: EBA

There is a wide dispersion of C/I performance across Member States (see Chart 2.4). C/I

ratios tend to be lower in eastern European countries and in most central European and Nordic

markets. The large dispersion in C/I ratios partially reflects prevailing business models in the

region.

Sweden and other Nordic countries are notable examples of banking sectors achieving

high profitability while not being burdened with legacy credit quality issues or excessive cost

inefficiency.

Some banks in the region have reduced their branch presence by more than 50%

and eliminated cash service in branches. On the other hand, the highest C/I ratios can be

found in Germany (77.4%), Austria (69.2%) and France (68.8%), dominated by banks with

traditional business models and high branch presence.

Chart 2.4: Cost-to-income dispersion by Member State

1.0

0.8

0.6

0.4

0.2

0.0

DE AT FR IT

PT GB HU BE

NL LU

IE DK ES GR CY PL

FI SK SE MT RO LT CZ HR LV EE NO BG

Source: EBA

Cost-to-income ratios capture bank operating expenses relative to net revenues. A rise in C/I ratio can reflect rising costs

in absolute terms or a situation where cost reductions are not keeping pace with dropping revenues.

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As shown in Chart 2.5, C/I rose in 18 countries of the EBA sample of banks last year, while it

declined in eight. The increase was the largest in Austria, Cyprus and Italy.

C/I dispersion

among individual banks has grown since Q3 2015, particularly in the first half of 2016.

Chart 2.5: Change in cost-to-income ratio compared to Q3 2015

10%

-5%

-10%

-15%

ES DE DK FR BE

PL NO LU

CZ HR BG GR LT RO HU

Source: EBA

While Fintech has put pressure on traditional business models, it also provides opportunities

for banks to reduce costs. Recent developments in areas such as cloud computing, mobile

applications and big data analytics have the potential to increase the efficiency of banks

business models. For instance, it may lead to more efficient pricing and better risk

management practices, and many business processes could become less resource intensive.

An entire category of financial technology solutions helping firms comply with regulatory

requirements has become known as RegTech. Subject to appropriate assessment of its

compatibility with Union policies, in particular as regards data protection, Distributed Ledger

Technology (DLT) systems could in the future lead to even more efficiencies and lower costs

by improving processes and making resource-intensive back-office functions redundant. In

March 2017, the Commission launched a public consultation on the opportunities and

challenges of Fintech.

Attention should also be paid to other costs, including litigation and regulatory compliance.

According to the results of the EBA’s risk assessment questionnaire, more than 44% of banks

have paid out more than EUR 500 million in compensation, litigation and similar payments

since the financial crisis. The share of banks which have paid out more than EUR 1 billion is

37%. The first half of 2016 brought a decline in legal settlements, according to Scope ratings,

but the threat of further litigation costs for banks remains in the light of recent scandals.

Banks have cited rising regulatory and compliance costs over the last years, further weighing

on profit margins. These concerns are related to a combination of tighter conduct standards,

additional reporting requirements and stricter capital rules. While the benefits of these

measures are key to enhance financial stability and consumer protection, they have been cited

Estonia, Malta and Slovenia were missing in the Q3 2015 sample.

See https://ec.europa.eu/info/sites/info/files/2017-fintech-consultation-document_en_0.pdf.

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as a source of rising operational costs. However, the concluding result of the Commission’s

Call for Evidence was that overall the benefits outweighed the costs. The Commission is

committed to following its better regulation principles and applying the Regulatory Fitness

and Performance programme, which ensure that EU legislation delivers results for individuals

and businesses effectively, efficiently and at minimum cost.

2.4 Effects of banking sector concentration and network structures

At individual bank-level, costs are highly influenced by the size and role of a bank’s branch

network. Despite a sharp decrease in branch density (from 33.1 branches per 100 000 people

in 2010 to 27.5 in 2015), the reliance of EU banks on branches remains very high compared to

other regions of the world. The International Monetary Fund hints that there remains potential

for further rationalisation, as 46% of branches in the EU service only 5% of client deposits.

Chart 2.6: Branch density, relative change from 2010 to 2015

0.4

0.2

-0.2

-0.4

-0.6

AT SE CZ MT PL HR HU FR DE LU SK BE

ES NO BG GR CY NL DK EE

Source: World Bank, own calculations

The trend of reducing branch density has been relatively widespread since 2010. Only four

EU Member States have experienced growth in branch density (see Chart 2.6), while on

average EU Member States have reduced their branch network by about 20%. Several

Member States, notably Estonia, Latvia and Finland, have reduced their networks by 40% or

more, to radically cut costs and broaden the use of digital services. Statistical analysis shows

that the reduction of the branch networks is linked to initial bank branch density (see

Chart 2.7). Countries with the highest branch density in 2010 have seen the highest reduction

in the branch network in the following years, both in absolute and relative terms. This

convergence hints at possible overcapacity in countries with large branch density, coupled

with decreasing demand for branch-based services.

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Chart 2.7: Changes in bank branch density

2010-2015 abs. change in branch density

Chart 2.8: Number of credit institutions

10 000

9 000

8 000

7 000

-10

6 000

5 000

-20

4 000

3 000

-30

2 000

1 000

-40

100

Bank branches per 100 000 people, 2010

120

2005

2007

2009

2011

2013

2015

Source: World Bank, own calculations

Source: ECB

Meanwhile, the number of credit institutions has steadily decreased since the financial crisis

(see Chart 2.8), driven by pressure to achieve cost containment. Market concentration not

only negatively affect competition, but could also be an important factor influencing bank

revenues and costs, as large parts of costs in banking are fixed

and because of that the sector

exhibits to some degree economies of scale and scope.

Chart 2.9: Market concentration for banks, measured by the Herfindahl-Hirschman Index (HHI)

4000

3000

2000

1000

EE GR NL LT MT CY HR SK DK PT

LV BE CZ BG ES HU SE RO IE

2010

2015

PL FR

GB AT LU DE

Source: ECB, own calculations

The overall

Herfindahl-Hirschman index

(HHI)

for EU banks is estimated to be 675. This can

be interpreted as a quite competitive market. Data show a moderate increase in market

concentration since the crisis started.

The EU-wide average is largely influenced by the

largest countries, which tend to have a more competitive financial environment. The HHI

Kovner and Zhou (2014).

Market concentration is typically measured by shares of largest companies in the sector or by the Herfindahl-Hirschman

index (HHI) for credit institutions. The HHI is defined as the sum of squares of individual company's market shares, and

it can range from 0 to 10 000, which would be the level corresponding to one company with a 100% share in the market.

Thus a lower level of HHI indicates a more competitive market. See ECB (2016a) for the value of this index.

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differs significantly among Member States and appears to be related to the RoE and C/I of the

banks sampled. Between 2010 and 2015, it declined in Member States with relatively

concentrated credit markets (e.g. Finland and Estonia), while it either remained flat or

increased somewhat in Member States with relatively less concentrated markets (see

Chart 2.9).

Chart 2.10: Market concentration and RoE

0.3

Chart 2.11: Market concentration and C/I

0.2

Average RoE in Q3 2016

0.8

C/I ratio

0.1

0.6

0.4

500

1000

1500

2000

2500

3000

0.2

-0.1

-0.2

HH index, 2015

500

1000

1500

2000

HH index, 2015

2500

3000

Source: Eurostat, EBA, own calculations

Bank concentration in a country seems to be related to RoE and C/I aggregated at national

level (see Charts 2.10 & 2.11). Statistical analysis of a small sample of EU Member States

suggests that national banking systems with HHI below 500 points tend to have relatively low

RoE and high costs. This may serve as an argument in favour of further consolidation in the

European banking sector, as most markets with RoE above 10% and C/I below 60% have an

above-average HHI of around 1 000 points.

2.5 Challenges linked to non-performing loans

Loan-loss provisions, which are used by banks to offset potential losses on the loan portfolio,

have constituted an important cost for EU banks in the years following the crisis. The elevated

levels of loan-loss provisions in recent years have been closely related to higher amounts of

non-performing loans (NPLs) accumulated by some of the banks during the crisis, as well as

by greater banks’ caution about resulting risks. According to the latest data, the EU average

NPL ratio continues to trend downward, decreasing by 10 bps to 5.4% in the third quarter

2016 (see Chart 2.12).

Nevertheless, the level remains high by historical standards and is

still higher than in the US and Japan (below 2%).

Notwithstanding the substantial reduction in NPLs observed over the past years, the progress

uneven across Europe.

In some banking sectors, e.g. in Finland or Sweden, the NPL ratio

stands at around 1%, and

many other Member States have ratios of less than 3%. At the other

end of the spectrum, NPL ratios have reached high double-digit levels in some Member

Nevertheless, a sufficient level of competition should be present to ensure consumer choice.

The NPL ratio is defined as gross non-performing loans in % of total loans.

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States.

In Cyprus and Greece, nearly half

of total loans are non-performing,

accounting for about one third of total bank

assets. According to ECB statistics, banks

directly supervised by the ECB still held

EUR 921 billion of such troubled loans at

the end of September 2016, representing

6.4% of total loans and nearly 9% of the

euro-area GDP.

Chart 2.12: NPL ratio, weighted average for

EU banks

7.0%

6.5%

6.0%

5.5%

5.0%

Not only the severity, but also the root of

the NPL problem varies significantly across

4.5%

Member States. In Spain and Ireland, the

high level of NPLs is linked to the earlier

4.0%

collapse of the property markets, whereas

Dec 14

Sep 15

Jun 16

in Italy the increase in NPLs resulted from

Source: EBA, own calculations

sluggish economic growth and a weak post-

crisis recovery. In some Member States, the sharply rising numbers of bankruptcy or

restructuring cases have also strained the judicial system, causing long delays in formal debt

liquidation. As a consequence, NPLs were kept on balance sheets longer, aggravating their

impact on bank profitability and long-term viability. The distribution of non-performing loans

by sector is also mixed. More than half of currently impaired loans were extended to non-

financial companies. But lending to households also constitutes a significant share, accounting

for more than half of the NPLs in some Member States.

NPLs impact bank profitability in manifold ways. NPLs imply higher provisioning needs and

therefore absorb bank capital and lower operating income. Net profits are further reduced by

the greater need for human resources and higher administrative expenses to monitor and

manage the NPL stock. Profitability can also be reduced by higher funding costs for banks as

concerns about asset quality challenges are associated with higher risk premia on bank

liabilities. NPLs also generate legal costs.

A sizeable part of the NPL stock is covered with provisions, reducing the risk to bank balance

sheets. On average, 46% of NPLs were covered by provisions. However, as shown in

Chart 2.13, coverage ratios

—

share of the face value of the loan covered by loan loss

provisions

—

vary widely in the euro area, ranging from 28% to roughly 68%. Next to

provisions some NPLs may also be covered with collateral. Nevertheless, while being a key

tool to secure the repayment and/or recovery of a loan, acquisition of collateral is often a

lengthy and costly process, eroding the net present value of the collateral concerned.

Notably Italy, Ireland, Portugal and Slovenia.

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Chart 2.13: Cross-country dispersion in NPL coverage ratios

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

SI RO CZ HU HR PL BG AT SK FR GR IT

ES BE PT DE LU CY IE

NL MT LT DK NO GB SE EE LV

Source: EBA

Note: The coverage ratio is the share of the face value of the loan covered by loan loss provisions.

The currently low levels of trading in NPLs on secondary markets can be explained to a large

extent by substantial information asymmetries intrinsic to this kind of markets.

On the

demand side, banks’ informational advantage over investors on the quality of loan portfolios

and prospective recoveries may deter potential market activity. Moreover, barriers to entry

such as licensing requirements further inhibit the market. On the supply side, banks may be

insufficiently capitalised to recognise loan losses, or they may want to wait for an economic

recovery before reducing their NPLs. To avoid an increase in NPLs and defaults, some banks

choose to renew high-risk loans that they would otherwise not renew. Finally, at macro level,

structural inefficiencies in debt and collateral enforcement may further contribute to the lack

of market turnover.

Notwithstanding the described difficulties, important action at national and at EU level is

being taken to tackle the NPL problem in Europe. At EU level, the Commission is conducting

a benchmarking review of loan enforcement (including insolvency) regimes to establish a

reliable picture of the outcomes that banks experience when faced with defaulting loans in

terms of delays, costs and value-recovery. The Commission is also assessing the case for

initiatives to facilitate the development of a secondary market for distressed debt, such as

information standardisation, with a view to sharing the risks across a greater pool of capital

market participants. The Council,

following Commission’s proposal,

has addressed NPLs in

Country-specific Recommendations in 2016.

At national level, Member States faced with high NPL ratios, such as Cyprus, Greece, Ireland,

Spain and Slovenia, have introduced policy measures and reforms aimed at reducing NPL

stocks. The Commission supports policy responses by Member States in this area through its

Structural Reform Support Service (SRSS). If the efforts to reduce the NPL ratios across the

EU are successful, this should have a positive impact on the profitability of the banking

sector.

See Akerlof (1970) for more details.

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2.6 Performance of banking stocks and bank funding markets

Underscoring the challenges to EU banks,

Chart 2.14: European banking share prices

compared to other sectors

banks’ share prices showed relatively high

Jan 2015=100

volatility in the course of 2016 (see

140

Chart 2.14).

Over the summer, banking

stock indices reached new lows. Mounting

market concerns about banks’ profitability

120

drove this revaluation of bank equity. A

further decline in long-term interest rates

100

and narrowing interest rate margins led

analysts to revise banks’

earnings prospects

down. Investors seemed to distinguish

between weak and strong banks. This led,

in particular, to selling pressure on banks

with a large stock of legacy non-performing

Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16 Jan 17

assets or expected high litigation costs.

Eurostoxx 600

Insurance

Financials

Banks

However, spill-over effects to the sector as

Source: Bloomberg

a whole cannot be excluded. Since mid-

2016, bank stock performance has improved amid stronger than expected earnings reports and

favourable macro-economic conditions.

The two most significant marked corrections in bank equity valuations occurred after the UK

referendum and, to a much lesser degree, after the disclosure of EU-wide stress-test results in

late July. In the second half of 2016, bank share prices recovered amid a steepening of yield

curves which could support

banks’

net interest margins and

rising market expectations that

global bank regulation (Basel III) might end up less tight than previously feared.

Bank share

prices finished 2016 at levels similar to those seen at the beginning of the review period.

While the weakness in bank share prices made banks’ equity financing more challenging,

euro-area money markets remained functional and supportive for banks’ lending activity to

the private sector. ECB operations, including the second series of targeted longer-term

refinancing operations and the expanded asset purchase programme, boosted excess liquidity,

which exceeded EUR 1 trillion towards the end of 2016.

Overall, bank funding markets have also improved, and funding stress remains generally

contained. Spreads on subordinated bank debt widened markedly in the aftermath of the UK

referendum, and spreads on senior bank debt widened more moderately. Following that,

funding conditions improved, with spreads for bank debt tightening back to levels below

those observed before the early episode of market turbulence in 2016.

Illustrating benign money market conditions, interest rates on unsecured and secured

instruments hovered close to the ECB deposit facility rate. In the unsecured segment, the

Euribor rate and the Euribor to OIS spread

have reached their multi-year minima (see

The Euribor spread to OIS spread is the difference between the rate at which European banks lend to each other

(EURIBOR) for 3 months and the overnight risk-free swap rate (EONIA), also for 3 months, among the same two banks.

The measure is considered to reflect the health of the banking system.

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Chart 2.15), with certain interbank transactions conducted at rates below the deposit facility

rate.

In the secured segment, repo rates continued to trend deeper into negative territory (see

Chart 2.16) amid high levels of cash holdings by market participants.

Chart 2.15: Euribor rates and spreads to OIS

(3-months)

Chart 2.16: EONIA volumes and rates

EUR billion

10-day moving average

1.2

Basis points

0.4

0.8

0.2

0.4

-0.2

-0.4

Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17

Euribor 3M (lhs)

Euribor over OIS (rhs)

Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16 Jan 17

EONIA volume (lhs)

EONIA rate (rhs)

-0.4

Source: Bloomberg

Box 3 Ensuring consumer protection in lending

At EU level, the relevant legislative instruments to ensure a high level of consumer protection are

the main credit institutions’ regulation, the Consumer Credit Directive 2008/48/EC (CCD), and the

Mortgage Credit Directive 2014/17/EU (MCD). In addition, general consumer protection legislation

applies to consumer lending contracts. The Unfair Contract Terms Directive 93/13/EEC (UCTD)

protects consumers against the use of unfair standard contract terms. Unfair terms are not binding

for the consumer. Based on the UCTD, the Court of Justice of the European Union issued a number

of important rulings during the last years, enhancing consumer protection against banks’ unfair

contract terms, in particular in mortgage loan contracts. Moreover, the Unfair Commercial Practices

Directive 2005/29/EC (UCPD) protect consumers against misleading and aggressive commercial

practices by financial services providers. The UCPD applies to all commercial practices before,

during or after the transaction. These two Directives apply to both online and offline environments,

and to all products, including financial services.

Key consumer protection requirements in lending ensure that consumers: (i) understand the product

they are purchasing before entering into the contract; (ii) are not confronted with standard contract

terms in lending that are unfair; (iii) can afford to pay the loan back; and (iv) do not become subject

to poor market practices. These requirements also aim to safeguard financial stability.

Transparency and access to information for consumers have been improved by obliging credit

institutions to provide advertisements containing standardised information and standardised pre-

contractual information. In the case of mortgage loans, the pre-contractual information should

Some euro-area banks have offered institutions with no access to the ECB facilities the possibility to deposit their cash

with them for subsequent placing at the ECB deposit facility rate.

Repo rates are interest rates at which a central bank repurchases government securities from commercial banks.

The UCPD provides for full harmonisation of the respective rules across the EU with the exception of financial services

and immovable property.

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follow the form of a European Standardised Information Sheet (ESIS). In the case of consumer

loans, they should follow the form of a Standard European Consumer Credit Information (SECCI).

The ESIS and SECCI, together with the Annual Percentage Rate of Charge (APRC), enshrined in

MCD and CCD as compulsory information, allow consumers to compare loan offers. For consumer

credits, those standards were introduced in 2008 and have been binding since June 2010. For

mortgage credits the standards were introduced in 2014 and have been binding since March 2016.

They apply to EU and EEA Member States.

Creditworthiness assessments protect lenders from non-performing loans and borrowers from over-

indebtedness. A standardised and harmonised assessment of creditworthiness could facilitate cross-

border lending, leading to lower prices, and more choice for consumers. The MCD, together with

EBA guidelines for creditworthiness assessments, provides for rather detailed requirements for these

assessments. Article 8 of the CCD provides that consumer’s creditworthiness must be based on

sufficient information. However,

‘sufficient

information’ is not defined in more detail at EU level.

So, the assessment of unsecured consumer credit is carried out differently across Member States.

The Commission services are currently assessing the need to introduce more detailed

creditworthiness assessment standards and principles in the area of consumer credit.

Also, data used for creditworthiness assessments differs across the EU, making it difficult to collect

the required information from other countries. This is the case despite the MCD and CCD granting

creditors non-discriminatory access to credit registers’ databases in other Member States. Therefore,

to facilitate cross-border lending, the Commission services are looking into developing a minimum

set of data to be exchanged between credit registers across borders.

Given the transparency and other consumer protection requirements, effective supervision and

enforcement are central to ensure that these requirements are met in practice. Traditional lenders,

such as banks and mortgage intermediaries, are regulated and authorised firms and are subject to

supervision. Member States are obliged to ensure that all consumer credit providers are supervised

or regulated. In recent years, the online lending market has developed quickly, with new types of

organisations, e.g. peer-to-peer lending platforms, offering unsecured loans to consumers. These

new developments pose a challenge for existing EU legislation, given that currently these new

business models do not fall under harmonised registration/authorisation or financial supervisory

requirements. This creates uncertainty for consumers as to which requirements apply and which

supervisors are monitoring the activities of these firms.

The Commission services are now seeking to better understand the changes in this market and to

explore ways of giving borrowers easier access to loans across borders, notably by making online

lending easier, while fostering a high level of consumer protection.

The euro repo rates remain lower than the ECB’s deposit facility rate as some counterparties

borrow euros on the foreign exchange swap market at levels significantly below the ECB

deposit facility rate. These are then lent in repo markets at higher rates, closer to the deposit

facility rate. Elevated volatility in repo rates persisted around dates for balance sheet

reporting, reflecting supply-demand imbalances in the market for high-quality collateral.

Despite a favourable impact on borrowing costs, the low and negative level of short-term

interest rates has weighed on lending and borrowing activity in interbank markets. Unsecured

EONIA daily trading volumes have fallen from close to EUR 30 billion in 2014 to just above

COM(2017) 139 final.

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EUR 10 billion in 2017 (see Chart 2.16). A similar trend can be observed in terms of secured

lending volumes in the repo markets.

Any systemic implications of the recent

weakness in bank share prices were also

limited. Over the past few years, banks

have significantly strengthened their

balance sheets and built up resilience to

adverse shocks. Illustrating these positive

changes, the CET1 ratio has increased by

50 bps to 14.1% in Q3 2016 thanks to both

an increase in capital and a decrease in risk-

weighted assets. Euro-area

banks’ leverage

ratios also continued to improve, rising to

5.7% in June 2016 from 5.5% six months

earlier.

Chart 2.17: EU

banks’ CET1 ratio,

weighted average

14.5%

14.0%

13.5%

13.0%

12.5%

12.0%

The enhanced bank solvency and resilience

11.5%

Dec 14

Sep 15

Jun 16

have also been confirmed by the overall

comforting results of the EU-wide stress

Source: EBA

test published in the summer of 2016.

The EBA’s

2016 EU-wide

stress test and transparency

exercise revealed that the average fully loaded common equity Tier 1 capital stood at 13.4%

in significant institutions in the euro area. The capacity of banks to further shore up their

capital buffer is nevertheless hampered by low profitability, limiting organic capital

generation, and by their low market valuation, making equity capital very expensive.

2.7 Recent trends in bank credit

Along with constantly improving bank resilience, and despite the profitability challenges

faced by some banks, net lending flows to households and non-financial corporations (NFCs)

continued to be positive over the last year, leading to a further rise in the annual growth rate

of loans to the private sector. For the whole euro area, the annual growth rate of MFI loans to

the private sector (adjusted for loan sales and securitisation) increased to 2.3% in 2016 from

0.4% in 2015. In particular, the annual growth rate of adjusted loans to households stood at

2.0% in 2016, up from 1.4% in 2015. Meanwhile the annual growth rate of adjusted loans to

non-financial corporations (NFCs) increased to 2.3% in 2016 from 0.3% in 2015.

The median of euro-area significant banks.

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Chart 2.18: Growth of credit to NFCs

Chart 2.19: Growth of mortgage credit

selected Member States

-5

-1

-15

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

-6

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: ECB

The positive trends in bank lending were supported by persistent low interest rates for NFCs

and households across euro-area Member States, suggesting an efficient transmission of the

accommodative monetary policy of the ECB through the euro-area banking system. Euro-area

banks have been further lowering interest rates to NFCs and households over the past year,

which contributed to the gradual recovery in lending volumes in the euro area. However,

differences remain across euro-area Member States with higher interest rates for some

countries. Such differences could partly explain the still uneven recovery in lending volumes.

Chart 2.20: Interest rates on loans to NFCs

Chart 2.21: Interest rates on mortgage credit

selected Member States

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: ECB

In Spain and Portugal, credit to NFCs is still shrinking year-on-year, while interest rates are at

higher levels than in other euro-area Member States. Italian credit to NFCs has continued to

shrink despite low levels of interest rates. This could be explained by other factors on the

supply side such as high NPLs or lower demand compared with the euro area’s average.

Declining interest rates have also contributed to increased bank lending activity, either via the

provision of new loans or through renegotiation of existing credits. Rising business volumes

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are a sign that businesses and households

took advantage of the improved price

conditions by either taking new loans or

getting a reset of interest rates at lower

levels. This activity was particularly

buoyant one year ago (end 2015-early

2016) and took place in most euro-area

countries. Mechanically, the activity

decreased somewhat compared with a year

ago, as NFCs and households perceived

fewer opportunities with a slower pace of

interest rates declines.

Chart 2.22: Loans to NFCs–volumes, y-o-y growth

-20

-40

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

The latest results from the relevant surveys

confirm the positive trends in bank lending.

The ECB’s latest bank lending survey

Source: ECB

released in January 2017 indicates that

credit standards in the euro area tightened marginally for non-financial corporations (NFCs)

while remaining broadly unchanged for housing loans and continuing to ease for consumer

credit. Easing credit standards for consumer might entail a risk if credit is extended to less

credit worthy households. Noteworthy though, the slight tightening for corporate credit is due

to one country in particular, the Netherlands. Meanwhile, loan demand continued to improve

for all loan categories, further supporting the credit growth for corporations and households.

For the first quarter of 2017, banks covered by the latest bank lending survey expect a net

easing of credit standards across all loan categories and a further increase in net demand. The

latest Survey on the Access to Finance of Enterprises (SAFE) takes a corporate perspective

and confirms the views of banks expressed in the latest bank lending survey.

It signalled a

further improvement in the availability of external sources of finance and in particular an

increased willingness of banks to provide credit at lower interest rates. As in previous survey

rounds, small and medium-sized enterprises (SMEs) in the euro area considered that finding

customers remains the dominant concern while access to finance was the least important

problem that they faced.

Looking forward, the situation in the banking sector will continue to be of importance for

credit supply, particularly in some Member States where banks face balance sheet constraints

and funding pressures. Overall, however, euro-area banks have further improved their

capacity to support lending, as they continued to adjust to regulatory and supervisory actions

by further strengthening their capital positions and reducing the risk on their balance sheets.

In addition, the ECB’s policies continue to help banks by offering attractive price conditions

for their funding. Meanwhile, demand for credit is picking up across all euro-area countries.

This should enable credit volumes to rise further, tracing the economic cycle.

In summary, there are challenges and uncertain prospects for some parts of the European

banking sector, and that might bear important repercussions for the European economy. The

combination of continued low interest rates and high bank operational costs creates the risk of

The latest SAFE survey was released in November 2016 and covers April to September 2016 (see ECB, 2016b).

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further compressed bank profit margins. Low market expectations of future bank profitability

may put further downward pressure on bank stock prices, raising banks’ cost of equity and

increasing the cost of external funding. Taken together, these trends may make it more

expensive for banks to fund new lending.

Despite the profitability challenges, EU banks have proven resilient and well capitalised, and

no significant slowdown in lending activities has been observed. In fact, recent bank lending

surveys show positive developments in credit conditions across the EU.

This suggests that

many banks have been able to adjust relatively well to the changing business conditions.

Substantial cost rationalisation, through branch reductions, consolidation initiatives and

effective use of innovative technologies to streamline business processes, as well as income

diversification, have been observed across the EU.

These trends must continue to secure a

sustainable and healthy EU banking sector, while giving sufficient attention to ensuring

financial stability as well as an adequately high level of consumer protection

(see Box 3).

Alongside these developments, it is crucial to reduce the dependency on banks by diversifying

the sources of funding available to the European economy through completing the actions that

are part of the Capital Markets Union (CMU).

Box 4: Level III assets

—

What are they and what do they do?

Level III assets are assets that do not have directly or indirectly (similar assets) observable market

quotations. Those are mainly assets that at

the measurement date no longer are traded

Chart B4.1: Level III assets, top 50 EU banks,

EUR billion, 2015

on the secondary market. For instance, this

category includes some securitised products,

like those sold just before the financial

crisis, which no longer have a market price

or similar assets traded on secondary

markets. According to IFRS 13, the entity, in

this case a credit institution, would use all

the necessary information (including own

data) and reasonable assumptions to give

GB FR DE SE IT BE NL ES DK FI IE PL AT HU

those assets a fair value. Therefore, in good

Source: SNL Financial and own calculations

times, level III assets tend to shrink, due to

Note: Selection of the top 50 banks that participated in the EBA

favourable market circumstances that can

Stress Test 2016. Data for Raiffeisen Bankengruppe, NV Bk

make

optimistic

assumptions

Nederlandse Gemeenten, NRW.BANK and Volkswagen

Financial Svcs AG were not available.

‘reasonable’.

In bad times, though, their fair

value can quickly drop, as these reasonable assumptions are less tenable in worsening market

conditions. The illiquid nature of those assets (lack of publicly available inputs) does not grant

them any role as liquid assets for the Liquidity Coverage Ratio (LCR) treatment. In addition, on

top of the standard capital requirements, determined according to the book they are in (trading or

banking) and the type of counterpart, level III assets are generally subject to a required stable

funding factor of either 50% or 85% for the Net Stable Funding Ratio (respectively, if maturity is

below or above 1 year).

For more details see : Results of the April 2017 euro area bank lending survey, Press Release, ECB, 25 April 2017

Approximately 35% of the banks participating in the EBA risk assessment questionnaire mentioned reducing operating

expenses as a primary target area for cost reduction, followed closely by impairments. More than 80% of banks whose

main priority is to cut costs plan to focus on reducing staff costs and increasing automation.

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The 50 largest banks in the EU held EUR 245 billion in level III assets in 2015.

Level III assets

are mainly concentrated in the UK and France, followed by Germany (see Chart B4.1), as these

countries host the largest investment banks that have mainly dealt with illiquid assets during and

after the crisis.

Chart B4.2: Level III assets, in % of total assets,

top 50 EU banks, 2015

2.0%

1.8%

Chart B4.3: Level III assets, in % of CET1,

top 50 EU banks, 2015

40%

35%

30%

25%

1.6%

1.4%

1.2%

1.0%

0.8%

0.6%

0.4%

20%

15%

10%

0.2%

0.0%

DE PL GB FR

AT NL DK ES HU

BE DE GB FR

NL DK AT ES HU

Source: SNL Financial and own calculations

Note: Selection of the top 50 banks that participated in the

EBA Stress Test 2016. Data for Raiffeisen Bankengruppe, NV

Bk Nederlandse Gemeenten, NRW.BANK and Volkswagen

Financial Svcs AG were not available.

Source: SNL Financial and own calculations

Note: Selection of the top 50 banks that participated in the

EBA Stress Test 2016. Data for Raiffeisen Bankengruppe, NV

Bk Nederlandse Gemeenten, NRW.BANK and Volkswagen

Financial Svcs AG were not available.

In relative terms, level III assets represent a smaller proportion of the overall balance sheet of EU

banks, but there are differences across national banking sectors. On average, level III assets

represent less than 1% of total assets and less than 10% of CET1, but they are more concentrated

in a handful of countries, including Belgium, Finland, Germany, Poland and the UK (see Chart

4.2). Relative to capital, the proportion of level III assets can be significant. Indeed, it represents

roughly 25% of CET1 in Belgium, Germany, the UK, France and Finland (see Chart 4.3).

At the level of individual banks, there are a few that hold significant amounts of level III assets. In

particular, at the end of 2015, level III assets were between 40% and 90% of CET1 for Barclays,

Deutsche Bank, DekaBank and Belfius.

In effect, the presence of level III assets is linked to the

business model of the bank. Banks with strong wholesale or investment operations tend to have a

larger proportion of level III assets than predominantly retail banks. This may call for targeted

monitoring actions based on the actual business model of the financial institution to reduce the

pro-cyclicality issue embedded in this type of exposure.

The sample of banks corresponds to the ones covered by the EBA Stress Test 2016. However, Data on level III assets

were unavailable for Raiffeisen Bankengruppe, NV Bk Nederlandse Gemeenten, NRW.BANK and Volkswagen

Financial Svcs AG.

See EBA Stress Test (2016).

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Chapter 3 CAPITAL MARKETS AND INSURANCE

This chapter reviews recent developments in equity and fixed income markets, discusses the

importance of investment funds, as well as the role of alternative finance and the insurance

sector.

European equity markets performed well despite challenging market conditions. Share prices

increased, supported by low interest rates, while dividend yields fell, even if they remained

substantially higher than the return on most fixed-income securities. Equity issuance and the

merger and acquisitions (M&A) market showed diverging trends in 2016. Equity issuance

—

less supported by bank issuing equity to rebalance their balance sheet

—

shrank, while there

was a significant increase in intra-European M&As, largely owing to two major acquisitions

in the Food and Beverage and Oil and Gas sectors.

European debt markets evolved positively despite volatility outbursts caused by economic and

political uncertainty and monetary policy developments. Corporate issuance continued to

expand, with investors shifting their portfolio to bonds with longer maturities and higher

credit risk in search of higher yields.

Assets under management by the European asset management industry, dominated by the

UCITS

sector, increased by 4% in 2016. About 27% of total assets are invested in equity

funds, compared to 24% and 21% in debt and mixed funds respectively. Pension funds

increased their assets under management by 90% over the period 2008-2015, supported by the

recovery of the equity market and the increase in bond valuations.

Alternative funding like private equity, business angels, and crowdfunding showed good

performance in 2015, with, for instance, crowdfunding gradually developing in a more mature

market. Overall, the size of the EU alternative finance industry remains limited with

alternative funding activities often strongly concentrated in a few countries. Positively, the

overall access of small and medium-sized businesses to finance has continued to improve

since the financial crisis.

The European insurance industry

—

the largest in the world

—

faced concerns about the

effect of the low interest rate environment. This should not come as a surprise, knowing that

fixed-income

securities make up 60% of insurers’ investment portfolio. With EUR 10 trillion

of assets under management in 2015, insurance companies continue to be major institutional

investors.

UCITS refers to undertakings for the collective investment in transferable securities.

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3.1 Equity markets

3.1.1 Relevance of EU equity markets in the world

The capitalisation in European equity markets has increased steadily in the past few years, just

not as quickly as in some other markets. As a consequence, the relevance of European equity

markets has diminished in the last decade.

The capitalisation of European equity markets

represented almost 30% of global market capitalisation in 2005, whereas by 2016 it had

declined to less than 20% (see Chart 3.1).

Since 2013, this relative decline has become more

pronounced. Within Europe, the EU-28 has accounted for some 82% of the equity market

capitalisation in the last decade, falling to 55%, if we consider the EU27 without the UK.

Finally, the euro area accounts for 46% of European equity markets and less than 12% of

world equity markets in the last decade (see Chart 3.2).

Chart 3.1: Market shares in terms of stock market

capitalisation, selected areas

100%

90%

80%

70%

60%

50%

40%

30%

5 000

20%

10%

2005

2007

2009

2011

2013

2015

Rest of Americas

Asia-Pacific

Europe

Africa and Middle East

2005

2007

2009

2011

2013

2015

Asia-Pacific

Europe

EU-27

Rest of Americas

Africa and Middle East

EU-28

15 000

10 000

25 000

20 000

Chart 3.2: Market capitalisation, selected areas

EUR billion

30 000

Source: ECB, Datastream, FESE, NASDAQ, LSE, WFE, and AFME

Non-financial corporations (NFCs) are the predominant issuers of equity, mainly in their

domestic markets. In the last decade, the share of NFCs accounted for an average of 78% of

total outstanding equity issuance, and this share is growing. Banks and other financial

corporations account for the remaining share, with banks becoming more important relative to

other financial corporations (see Charts 3.3 & 3.4). Globally, 94% of the listed companies

were domestic, which implies that only 6% of all companies engage in cross-border equity

listings. The EU and the US equity markets are the ones attracting most foreign companies. In

the last decade, 42% of all cross-border company listings were recorded in the EU-28, while

27% were recorded in the US.

In many Member States, non-listed equity is an important source of financing (see Chapter 1.3).

European equity markets include those of the EU-28 countries as well as Belarus, Norway, Russia, Switzerland, Turkey,

and Ukraine for which the World Federation of Exchanges provides information.

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Chart 3.3: Share of new issuance by issuer type,

euro area

90%

80%

70%

60%

50%

40%

30%

20%

10%

2005

2007

2009

2011

2013

2015

Non-financial corporations

Banks (MFIs)

Other financial corporations

Chart 3.4: Outstanding stocks (%) by issuer type,

EA average 2005-2016

Non-financial corporations

Banks (MFIs)

Other financial corporations

Source: ECB, EFAMA, Dealogic

3.1.2 EU equity markets performance

Dividend yields in EU equity markets

declined in 2016, but remained substantially

higher than yields on most fixed-income

securities. The dividend yield in the

STOXX600 index, which represents large,

mid and small capitalisation companies

across 17 EU Member States, has been on a

declining trend since 2008. In particular,

rising share prices, driven by low interest

rates, have lowered dividend yields. The

Spanish

stock

market

consistently

outperformed other main EU markets in

terms of dividend yield. In 2016, the Spanish

index IBEX35 reported a dividend yield of

4.4% (see Chart 3.5).

Chart 3.5: Dividend yield, selected European

indices

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

STOXX 600

IBEX 35

FTSE 350

CAC 40

DAX 30

Average

The price-earnings ratio and the price-to-

book value of the STOXX600 came down

somewhat in 2016, but valuations are still high (see Charts 3.6 & 3.7). The STOXX600 index

shows that equity valuations are high on European markets. Overall, conventional valuation

measures show few signs of excessive risk-taking for European equity markets.

Stock

markets have remained on the defensive, without moving in any clear direction. Political

Source: ECB, EFAMA, Dealogic

In comparison, US assets show signs of overvaluation, recently driven by optimistic assumptions about the prospects and

impact of the new administration's announced pro-growth policy. Various measures (i.e. market capitalisation + debt -

cash) / corporate gross value added and several price/earnings ratios) approach levels commensurable with those

observed during previous bubbles.

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uncertainty and subdued corporate profits counterbalance the positive impact of the ongoing

economic recovery and the search for yield by investors.

Chart 3.6: Price-to-earnings ratio

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

STOXX 600

IBEX 35

FTSE 350

CAC 40

DAX 30

Average

0.5

2.0

Chart 3.7: Price-to-book ratio

3.0

2.5

1.5

1.0

0.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

STOXX 600

STOXX EUROPE LARGE 200

STOXX EUROPE MID 200

STOXX EUROPE SMALL 200

Average

Source: ECB, EFAMA, Dealogic

In terms of risks, emerging market shocks could affect equity markets globally, including the

EU. This could happen if confidence eroded based on re-emerging uncertainty about

emerging markets’ growth prospects. Indeed, the sharp decline in Chinese equity

markets in

mid-2015 and early 2016 led to significant volatility across global markets, suggesting

emerging markets have an increasing potential to trigger confidence and financial shocks that

affect the global market. In particular, confidence shocks may prompt large portfolio

reallocations and large price swings.

3.1.3 New equity issuance of financing companies

One of the main functions of equity markets is to make it easier to finance corporate

investment projects.

Both gross and net issuances of shares have declined in the last year, partly because banks

already had progressed in strengthening their balance sheets.

Gross issuance of equity in the

euro area was more than EUR 76 billion in 2016 (see Chart 3.8), while in net terms, issuance

was EUR 47 billion. New equity issuance in 2016 was below the ten-year average, both in

gross and net terms. Non-financial corporations accounted for 70% of net equity issuance.

The share of other financial corporations was 18%, and banks accounted for the remaining

12%. Bank issuance, which was the highest among all firms between 2010 and 2015, has

declined significantly in the past couple of years. Banks’ re-adjustment

to lower issuance

levels reflecting that they are close to completing the adjustment of their balance sheets in

view of the new capital requirements introduced after the financial crisis (see Chart 3.9).

Companies may not only issue new shares, but also redeem shares or delist. To properly account for this, one

distinguishes between gross and net issuances.

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Chart 3.8: Equity issuance, euro area

EUR billion

140

120

100

Chart 3.9: Net equity issuance by issuer, euro area

EUR billion

2005

2007

2009

2011

2013

2015

-10

2005

2007

2009

2011

2013

2015

Non-financial corporations

Banks (MFIs)

Other financial corporations

EA Gross issues

EA Net issues

Source: ECB

3.1.4 Equity underwriting by type of asset

Equity underwriting totalled EUR 147

billion in 2016. Almost two thirds of

underwritings were follow-on issues,

another 20% were initial public offerings

(IPOs), and the rest convertible securities

(see Chart 3.10). Follow-on underwriting

constitutes the bulk of the business every

year.

Chart 3.10: Equity underwriting

EUR billion

250

200

150

100

On average, companies located in the euro

area have issued 47% of the total amount of

IPOs in euros. UK companies represent

27%, and companies located in other parts

of the EU and the rest of the world make up

2005

2007

2009

2011

2013

2015

IPOs

Follow-ons

Convertible securities

the remaining quarter (see Chart 3.11).

However, while IPO underwriting for UK

Source: Dealogic

firms is relatively stable, underwriting for

companies in the euro area and other parts of the world has been more volatile. This volatility

is illustrated by the share of corporate IPOs in the euro area increasing to over 60% in 2016,

while the share of IPOs by firms located outside Europe became insignificant at around EUR

100 million (see Chart 3.12).

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Chart 3.11: IPOs by nationality of issuer;

average value 2000-2016

14.10%

Chart 3.12: IPO value by nationality of issuer,

2016

14.7%

0.4%

14.26%

44.79%

23.6%

61.3%

26.86%

Rest Europe

ROW

Rest Europe

ROW

Source: Dealogic

3.1.5 European mergers and acquisitions

M&A activity has continued to recover

Chart 3.13: M&A deals by industry in 2016

EUR billion

globally after the crisis. M&A volume has

140

been increasing since the low of 2012,

120

when volumes were only EUR 267 billion.

100

The volume of total deals increased by 19%

in 2016, which was partly the result of two

major acquisitions (Royal Dutch Shell

bought the BG group, and Anheuser Busch

acquired SAB Miller). As a consequence,

the food and beverage and oil and gas

industries accounted for the highest

volumes of M&A in 2016 (see Chart 3.13).

Intra-European deals account for EUR 531

billion out of EUR 1 013 billion of

completed European M&A deals. In about

Source: Dealogic

45% of non-intra-European deals, a

European company bought a non-European

company, and in the other 55% a non-European company acquired a European company.

The volume of intra-European M&As increased by 25% from 2015 to 2016. UK companies

have been particularly active in this market, either as target companies or as buyers. By

nationality of the target companies, almost half of all M&As involved UK companies (EUR

264 billion). Euro-area target companies constituted 45% of the deals, and the remaining 5%

were companies located in the rest of Europe. Most of the acquiring firms were residing in the

euro area and responsible for 77% of the value of all intra-European deals. The share of deals

in which UK companies were the acquiring firm was 16%, and the companies in the rest of

Europe accounted for the remaining 7%. 2016 was a year with an unusually high flow of

intra-European M&As, where UK firms were bought by euro-area companies.

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3.2 Fixed-income markets

Even though 2016 proved to be a difficult year, European fixed-income markets continued to

perform well. In particular, (euro-denominated) corporate issuance continued to expand. In a

search of yield, investors increased the risk level of their portfolio by shifting their

investments to bonds with longer maturities and higher credit risk. Boundaries on the yield

curve were indeed pushed ever further, with negative yields up to 12 years in German Bunds.

Maturities were extended to new levels, as illustrated by the introduction of a new 70-year

benchmark issue by Austria.

At the same time, the year was marked by several episodes of high volatility, driven by

macro-economic shocks, political and monetary uncertainty. The combination of (ultra) low

interest rates, elevated levels of volatility and high volumes was already steering markets in

2015. The strong volatility at the start of the year, usually an attractive window used by

(frequent) issuers to frontload their funding programmes, caused the European corporate and

high-yield markets to remain subdued until March. Sovereign issuers, even though less

affected by such volatility spikes, also spread out their funding programme (somewhat) more

evenly throughout the year.

3.2.2 Public sector

The market for public debt instruments

(sovereigns, supra-nationals, agencies and

local authorities) experienced considerable

volatility in 2016. Net issuance rebounded

from EUR 193 billion in 2015, which was

the lowest since 2007 (see Chart 3.14). Net

issuance in 2016 was EUR 193 billion (7%

of euro-area GDP).

Chart 3.14: Net issuance in historical perspective

EUR billion

800

600

400

200

Central banks, primarily the ECB, the US

-200

Federal Reserve and the Bank of England

continued to influence debt markets.

-400

Market participants generally welcomed the

-600

2001

2003

2005

2007

2009

2011

2013

2015

ECB’s decision (March 2016) to undertake

NFCs

OFIs

MFIs

Governments

new

stimulus

measures

(including

extension and expansion of the public

Source: ECB SDW and own calculations

sector purchase programme and the

corporate sector purchase programme, leading to a significant tightening of spreads and a

flattening of yield curves.

Towards the end of the second quarter, investors became more risk averse, induced by the

Federal Reserve’s stated intention to raise interest rates and by the approaching date of the

UK referendum on EU membership. The lower appetite for risk continued for most of the

year. In this context, lower-risk instruments were performing well, as investors sought safe-

haven assets to safeguard their investments. As a result, for example, the yields on 10-year

German Bunds reached all-time lows, crossing the zero bound to attain a new record low

of -0.19% in July (see Charts 3.15 & 3.16). At a certain point, the German yield curve

exhibited negative yields up to a maturity of 12 years. Globally, the total amount of

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outstanding sovereign debt with negative yields reached no less than EUR 11 trillion by the

end of the first half of 2016. The amount fell towards the end of the year, falling below EUR 9

trillion.

Chart 3.15: 10-year benchmark yield

1.0

Chart 3.16: 10-year benchmark yield

0.8

0.6

0.4

0.2

0.0

-0.2

Jan-16

Mar-16

Germany

May-16

Jul-16

Sep-16

Belgium

Nov-16

France

Jan-16

Mar-16

May-16

Jul-16

Spain

Sep-16

Italy

Nov-16

Netherlands

Ireland

Portugal

Source: Thomson Reuters DFO and Eikon

In general, sovereigns frontloaded their issuance less in 2016 than in 2015, reflecting lower

funding needs due to budgetary consolidation. In view of low rates and cheap funding costs

and with the public sector purchase programme on track until March 2017 (at the least)

—

strongly supporting the primary market

—

issuance has been progressively spread throughout

the year.

Chart 3.17: EA public debt maturity in 2015

>15-year

12%

2015

3-year

>15-year

23%

Chart 3.18: EA public debt maturity in 2016

2016

3-year

15-year

16%

7-year

28%

7-year

29%

15-year

11%

10-year

34%

10-year

32%

Source: Dealogic and own calculations

The supply of bonds by sovereigns remained heavily skewed towards (ultra) long maturities,

as issuers continued to exploit the historically low interest rate environment to lengthen their

maturity profile (see Charts

3.17 & 3.18). Issuers capitalised on investors’ search for yield to

secure long-dated financing at attractive funding costs. Building on solid demand at the ultra-

long end of the curve, some countries

—

Belgium, France and Spain

—

successfully issued a

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new 50-year benchmark. This was possible with the support of a large range of high-quality

institutional investors, large redemption flows (particularly in the second quarter), and

attractive pricing. Belgium and Ireland even issued 100-year papers in smaller private

placements of EUR 100 million each. Italy also joined the league of ultra-long issuers, by

issuing EUR 5 billion of its first 50-year syndication (while demand surpassed EUR

18.5 billion). Austria joined in pushing the boundaries of fixed maturity duration sovereign

bonds ever further by issuing a new 70-year benchmark (issue size of EUR 2 billion). As a

result, ultra-long dated bonds have become an important asset class.

3.2.3 Non-financial corporations

2016 was also a remarkable year for corporate issuers, with tight spreads and low premiums.

Even though the corporate bond market experienced several bouts of elevated volatility, credit

spreads were the tightest ever, premiums for new issues were very low, and investors’

appetite remained strong.

Total gross corporate issuance in 2016 was EUR 534 billion, down slightly from 2015 (see

Chart 3.19). Net issuance increased substantially from the previous year and amounted to

EUR 84 billion in 2016 compared to EUR 50 billion in 2015. Net issuance of private euro-

denominated long-term debt securities has been persistently positive, contrasting with other

types of issuance (see Chart 3.20).

Chart 3.19: Gross issuance of private euro-

denominated long-term debt securities

EUR billion

150

Chart 3.20: Net issuance of private euro-

denominated long-term debt securities

(12-months moving average)

EUR billion

125

-5

100

-15

-25

-35

Jan 15

MFI

Jul 15

Jan 16

Jul 16

Non-financial corporations

-45

Jan 15

MFIs

Jul 15

Jan 16

Jul 16

Non-financial corporations

other financial intermediaries

other financial intermediairies

Source: ECB / Thomson Reuters DFO and Eikon

Amid several geopolitical and macro-economic shocks in 2016, NFC issuance volumes were

supported by an environment of ultra-low interest rates, enduring continued bank

disintermediation, as well as robust refinancing activity for M&As. The ECB’s announcement

of additional monetary policy measures in March included an expansion of the asset purchase

programme (including corporate bonds), which changed the conditions for euro-denominated

debt markets. ECB purchases of eligible corporate bonds in both secondary and primary

markets also had an impact. Aggregate corporate spreads narrowed significantly

—

notably

for lower-rated issuance

—

in the months following the ECB announcement (see Chart 3.21).

Primary market activity picked up substantially following the ECB announcement, driven also

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by NFCs reinforcing their liability management by capitalising on low interest rates. The most

prominent primary-market issuances occurred in the context of M&As.

Issuance volumes were strong across all

Chart 3.21: Euro-area corporate bond spreads

Basis points

credit buckets. Total (euro-denominated)

issuance volume of investment-grade bonds

200

was EUR 285 billion in 2016 and exceeded

the issuance of EUR 239 billion in 2015.

The high-yield market steadily recovered

150

from a poor start of the year, with a healthy

increase in volumes reaching EUR 57

100

billion in 2016 compared to EUR 55 billion

in 2015. Spreads in the high-yield segment

fell below their long-term averages, in spite

of weak fundamental data and slow

earnings growth. The improving market

Jan 15

Jul 15

Jan 16

Jul 16

Jan 17

sentiment encouraged many issuers to

BBB

AAA

exploit the low interest rates, which in turn

Source: Thomson Reuters DFO

stimulated investor appetite for higher

Note: The AAA index is currently not updated due to the lack of

yielding assets. Most corporate issuance

qualifying corporate bonds required for the index.

was at the long end of the curve, with over

one third having a maturity of at least 10 years, again reflecting a search for yield. NFCs are

thus significantly altering the maturity structure of their corporate debt. The resulting

extension in their debt maturity profile could hold implications for growth opportunities,

particularly considering the risks posed by debt overhang in terms of underinvestment in the

future.

3.2.4 Monetary and financial institutions

Funding activity (volumes as well as patterns) of monetary and financial institutions (MFIs)

has been impacted specifically by the volatility in interest rates, currency exchange rates, and

credit spreads. Moreover, market-based funding needs have diminished particularly in the EU,

mainly due to the cost-efficient funding offered by central banks. Bank funding via deposits

has also been strong despite very low retail deposit interest rates.

MFI issuance of bonds has been adjusted to minimise liquidity reserves as much as possible.

Issuance plans have also been geared towards strengthening capital buffers to fulfil regulatory

requirements, although the issuance of subordinated debt seems to have stalled, pending

finalisation of the relevant legislative proposals on bank resolution.

swd (2017) 0171 (forslag) - COMMISSION STAFF WORKING DOCUMENT European Financial Stability and Integration Review (EFSIR)

Gross issuance of bonds by MFIs in 2016

was EUR 2 298 billion, down from

EUR 2 645 billion in 2015. Net issuance

remained

negative,

but

rebounded

substantially from EUR -330 billion in

2015 to EUR -84 billion in 2016. Net

issuance has been persistently negative in

recent years and is gradually recovering

from the low in 2013, following the

sovereign debt crisis. Alongside this

recovery in issuance, there has also been a

visible improvement in the spreads for MFI

bonds and credit default swaps (see

Chart 3.22).

Chart 3.22: Spreads of bonds issued by banks

Basis points

200

150

100

Jan 15

Jul 15

Covered

Jan 16

Banks

Jul 16

Jan 17

State-guaranteed

In an environment of elevated volatility,

Source: Thomson Reuters Eikon / Markit Iboxx

suitable issuance windows have been few

and short. The distribution of issuance volumes has been linked to risk perceptions,

determining the relative suitability of different debt instruments. MFIs have adjusted their

strategies accordingly, by frontloading covered bond issuance in the first half of the year

when market conditions were less favourable. Less defensive issuances were postponed until

markets stabilised. As such, when the environment was more favourable to riskier

instruments, issuers focused on senior unsecured debt.

As in the past few years, regulation and higher capital requirements for financial institutions

have continued to influence the market for senior unsecured debt in 2016. For banks, the

Minimum Requirement for Own Funds and Eligible Liabilities (MREL) and the Total Loss-

Absorbing Capacity (TLAC) requirements play a crucial role in their capital planning. Last

year banks were still waiting for the final implementation framework and required levels.

Nevertheless, they are searching for the most cost effective ways to build up the envisaged

capital buffers.