Spring 2015 Overview of Financial Stability Overview of Financial Stability De Nederlandsche Bank Overview of Financial Stability Spring 2015 © 2015 De Nederlandsche Bank n.v. Edition: 750 This document uses information available up to 27 march 2015, unless stated otherwise. Country abbreviations according to ISO norm. Publication and multiplication for educational and non-commercial purposes is allowed, with acknowledgements. Westeinde 1, 1017 ZN Amsterdam – PO Box 98, 1000 AB Amsterdam, the Netherlands Telephone +31 20 524 91 11 – Telefax +31 20 524 25 00 Website: www.dnb nl Overview of Financial Stability Contents Introduction 5 1. Overview of Financial Stability 6 2. Low interest environment 16 3. Ending too-big-to-fail? 23 4. Incentive effects: the role of governance and variable remuneration 30 Annex 1: Macroprudential indicators 38 Annex 2: Review of DNB actions based on the OFS 40 Overview of Financial Stability Introduction DNB monitors financial stability in the Netherlands, paying explicit attention to the interaction 5 between financial institutions and their environment: other institutions, financial markets and the financial infrastructure. As part of this task, DNB publishes the Overview of Financial Stability (OFS) twice a year. The OFS outlines risks that affect groups of institutions or entire sectors within the Dutch financial system, and that could eventually disrupt the economy. DNB prepares the OFS to raise awareness among stakeholders — financial institutions, policymakers and the general public. The first chapter summarises the principal risks to financial stability in the Netherlands. The following three thematic chapters analyse relevant topics in more detail. The OFS does not provide forecasts, but instead analyses scenarios. DNB aims to present the best possible risk assessment of potential future threats to the financial system based on current knowledge. Where possible, DNB proposes risk-mitigating policies. The assessments and recommendations made in the OFS present institutions and policymakers with an understanding of how to reduce both the risk and impact of shocks in the financial system. 1 Overview of Financial Stability 6 Priorities and recommendations ▪ The budding economic recovery in the euro area is surrounded by downward risks to financial stability. The developments in Greece have put the European debt crisis in the limelight again, and geopolitical tensions have increased. The current exceptionally accommodative monetary policy is aimed at bringing inflation back to the price stability target and underpinning economic recovery. This policy, however, also has side effects. It leads to increased risk appetite among investors and a search for yield in the financial markets, which aids the formation of bubbles. In addition, despite the very loose liquidity conditions provided by central banks, some financial markets are less liquid than before the crisis, which may amplify the impact of a downward price correction. ▪ The low level of interest rates is affecting the buffers of financial institutions, especially those of insurance companies and pension funds. The situation at life insurance providers gives cause for worry as their recovery options are limited. Low interest rates are fuelling the current concerns about the sustainability of their business models. DNB expects the sector to adjust to fundamental changes in the market and prepare for the situation in which their solvency may inadvertently prove to be inadequate. As the sector is shrinking, life insurers will also need to reduce costs. ▪ In response to the financial crisis, supervisory authorities and governments have developed policies that both reduce the likelihood and the impact of failure of systemic banks. In order to enhance the effectiveness of these policies, it will be necessary to make additional demands on the level and composition of the bail-in capacity. To curb contagion risks, bail-in securities must be subordinated to operating liabilities and the investments that banks make in these securities should preferably be limited. ▪ In the run-up to the crisis, governance at financial institutions was insufficiently effective to manage risks, and variable remuneration induced excessive risk taking. Since the crisis, supervision of governance, conduct and culture has been tightened, and remuneration policies have been developed that aim to curb the incentive to take excessive risks. It is important that the financial sector continues to implement these adjustments. The culture at financial institutions should be changed accordingly, so that management and staff internalise the purpose of the policies and changes are solidly anchored. Overview of Financial Stability Figure 1 - Risk map 7 Structurally International risks low growth and to financial stability Geopolitical European Interest rate risk low interest rates unrest debt crisis and search for yield with unfavourable prospects for life insurers Low profits and insucient Bank capital Stability risks funding risk strenghtening to the Dutch by banks financial system Misconduct Cyber risk due to threats perverse incentives Losses on Risks for real estate financial institutions and corporate loans fast burning slow burning The risk map provides a schematic overview of the key risks threatening financial stability. The size of the circle reflects the magnitude of the risk, and its colour depicts whether the risk is increasing (red), decreasing (green) or constant (grey). International environment The budding economic recovery in the euro area continues to be surrounded by downward risks to financial stability. The developments in Greece have put the European debt crisis in the limelight again. Geopolitical tensions have increased, e.g. in Ukraine and the Middle East. The relative calm in the financial markets is not an adequate reflection of the prevailing risks. The exceptionally accommodative monetary policy is providing for apparent calm in the financial markets (see Chart 1). From time to time, slumbering vulnerabilities re-surface and lead to volatility in some markets. US treasury bonds for instance showed exceptional volatility on 15 October 2014, when the yield on 10-year treasury bonds fell by nearly 0.4 percentage points in a matter of minutes. Several currencies recently came under heavy pressure. The decision by the Swiss central bank on 15 January to abandon its currency peg to the euro caused the Swiss franc to appreciate substantially. Some foreign financial institutions were taken by surprise by the move and incurred losses. 8 Chart 1 - Financial stress is low Stress-index based on indicators of equity, bond and currency markets relevant to the Netherlands and a health index of financial institutions. 4 Bankruptcy Lehman 3 Brothers 2 First support package for Greece Dotcomcrisis ‘whatever it takes’ 1 Expansion of purchasing programme 0 -1 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 Source: DNB. The situation in Greece continues to give cause for concern. As long as no sustainable solution is found for Greece, the country will continue to demand a great deal of attention. As long as deposits continue to flow out of the country, the already fragile liquidity position of Greek banks will continue to weaken, which may translate into solvency problems. An unforeseen bankruptcy of the government would also seriously disrupt the Greek economy. The effects of such an event on other euro area countries are uncertain. It is important for Greece to continue implementing economic reforms and adhere to the agreed programme, both for the stability of the country itself and that of the currency union. The experiences gained in other countries with adjustment programmes (e.g. Ireland and Spain), illustrate that implementing structural reforms can in due course foster economic recovery based on sound foundations. In light of the resurging European debt crisis, it is favourable that the European financial system has become more robust with the launch of European banking supervision. Under the Single Supervisory Mechanism (SSM) the ECB took up supervision of the largest European banks in early November 2014. The successful completion of the Comprehensive Assessment (CA) at the end of October 2014 was a milestone that marked the start of European banking supervision. In the CA, problems on balance sheets were identified and repaired by means of balance sheet evaluation and stress tests. In anticipation of the CA, a large number of banks had already Overview of Financial Stability taken measures to strengthen their balance sheets. Partly owing to this, the CA brought 9 relatively few problems to light. Capital deficiencies totalling EUR 25 billion were identified at 25 of the 130 participating banks. These banks were then given between six and nine months to address their deficiencies. The seven Dutch banks that were examined – ING Bank, Rabobank, ABN AMRO, SNS Bank, BNG Bank, NWB Bank and RBS N.V.) – all remained well above the minimum requirements. Against the backdrop of low inflation and slow economic recovery in 2014, the ECB in January decided to ease monetary conditions further. With large-scale liquidity injections, the ECB aims to bring inflation back to the price stability target, through lower borrowing rates and a lower euro exchange rate. To this end, the ECB extended the existing purchasing programme for covered bonds and asset-backed securities to bonds issued by euro area governments and European institutions (including the EFSF and EIB). The combined monthly purchases of public and private sector securities will amount to EUR 60 billion, lifting the level of the total purchasing programme to over EUR 1,100 billion. Assuming that the current purchasing rate will be continued within the existing programmes, an estimated total of EUR 45 billion of Dutch government bonds will be bought up, or around 15% of the outstanding Dutch bonds with maturities of between two and 30 years. Chart 2 - Growing market for European high-yield bonds, amid falling yields Issuing volumes (EUR billion). Yield (%). 120 30 80 20 40 10 0 0 05 06 07 08 09 10 11 12 13 14 Issuing volume Yield (right axis) Source: Dealogic DCM, Thomson Reuters Datastream.