The selection of countries is determined by data availability constraints. Even if temporary, there will be a significant contraction in euro area economic activity this year. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. Measures of market volatility, systemic stress and financial conditions reached historical highs. Furthermore, governments have directed subsidies towards SMEs to help them manage immediate liquidity shortages. These sectors were affected the most by the lockdown measures. At the same time, financial conditions tightened sharply as economic uncertainty increased and market participants priced in the possibility of a sharp slowdown in global growth. Technical reserves constitute the largest share of insurers’ liabilities (91%). Targeting a medium level of volatility, such strategies can afford a high degree of leverage during spells of low volatility. The valuation losses in the securities portfolios of euro area non-bank financial sectors between February and March are estimated to range from about 6% for insurance companies to over 11% for investment funds (see Chart 4.1, left panel). [5] Investments following strategies which are reliant on low market volatility have grown over recent years, with varying estimates. Relatively low liquid asset holdings reflect increased risk-taking by funds over recent years. Rollover risk is higher in adverse financial conditions, but mitigated by a favourable maturity structure. While important, these policies may not fully offset the effect of the sudden and sizeable shock on credit risk and defaults. Downgrades of BBB-rated issuers, in particular, could have non-linear effects on bond prices, as the markets for high-yield and (lower) investment-grade bonds are highly segregated (see Section 2.2). In view of the uncertain economic outlook and weaker corporate credit quality, the strength of some asset prices points to growing vulnerability to market corrections. Despite increasing core revenues during 2019, weak non-interest income was still weighing on revenues. The risk of corrections in euro area residential and commercial real estate markets has increased in the wake of the pandemic. The pace of recovery will depend on the ability of governments to ease containment measures and the effectiveness of the implemented fiscal and monetary policy measures. Insurers’ solvency could be significantly weakened by a double hit from asset price declines and lower-for-longer interest rates. This included, among other things, revising the implementation dates of new standards and providing guidance on loan loss provisioning, taking account of national measures on loan moratoria. At the same time, in relation to the size and pace of the economic shock these liquidity buffers have proven insufficient in many cases. These effects could be exacerbated if risk-free rates remain lower for longer. Several forces are behind the downside risks: first, not only countries but also economic sectors have been affected to different extents by the lockdown measures. These measures build on the regulatory framework that was designed in response to the 2008 global financial crisis and, for the first time, aim to support banks to exploit fully the flexibility that it provides to respond to economic and financial distress. This box provides an overview of the main developments in the PE buyout market and assesses potential financial stability risks to both investors in PE funds and the overall financial system. As the market sell-off intensified, investment funds experienced outflows resembling those seen during the global financial crisis. The equity risk premium is derived from a dividend discount model. Sources: ECB supervisory statistics, Bloomberg Finance L.P., Consensus Economics, ECB and ECB calculations.Notes: Left panel: figures are on a trailing four-quarter basis. This is because lower risk-free rates typically increase the present value of insurers’ liabilities more than that of their assets, especially for life insurers.[31]. Otherwise, the fund will trade at a variable price, which can result in mark-to-market losses for investors. Banks have increased their solvency positions substantially since the global financial crisis and are hence now much better positioned to absorb potential losses. Global financial markets responded to expected fallout from the coronavirus pandemic, Developments in major global financial asset markets, (first panel: index; second panel: volatility index; third panel: basis points; fourth panel: percentages per annum; fifth panel: basis points; sixth panel: US dollars per barrel (left-hand scale) and US dollars per ounce (right-hand scale)). During the recent stress, overall market liquidity improved following central bank policy interventions. Figures are expressed as a percentage of 2019 GDP. Transitional arrangements for the output floor have also been extended by one year to 1 January 2028. Real estate funds play a prominent role in some countries, but cash holdings are relatively high. Non-financial firms, many already highly indebted and facing profitability challenges prior to the pandemic, now face cash-flow strains and higher financing costs. Volatility-targeting and risk parity strategies might have procyclical effects on asset prices. less than the fall otherwise (see Chart 5.2, right panel). The European Commission launched a support scheme for short-time working, a pan-European guarantee fund to support small and medium-sized enterprises (SMEs) via the European Investment Bank, and pandemic crisis support for Member States via the European Stability Mechanism. More broadly, while the euro area has made good progress in tackling legacy NPLs, the pandemic may lead to a deterioration of bank asset quality. The main drivers behind the increase in the aggregate Tier 1 ratio are capital increases of around €450 billion, followed by a reduction in risk weights of 4.5 percentage points and reductions in total assets of €2 trillion over the same period (see Chart 3.10, left panel). Although there is considerable uncertainty about the asset quality of corporate loans going forward, a sensitivity analysis, using a scenario in which corporate cash flows would drop by 50% for a period of three months and companies which exhaust their cash buffers default, suggests that loan losses – before the effect of any mitigation from policy measures – could amount to just over 3% of total loans to NFCs, adding up to about €160 billion and forming the lower bound of the range of estimates (see Chart 3.8, right panel). Growth at risk is defined as the observation corresponding to the 5th quantile of the one-year-ahead annual GDP growth density given information in the fourth quarter of 2019 and the first quarter of 2020, respectively. Rising macroeconomic and market uncertainty contributed to widening risk premia. Overall, while euro area banks started 2020 with increased resilience, the pandemic is now set to weigh on banks’ balance sheets and future profitability. Downside risks to corporate earnings could unearth debt vulnerabilities. Reinsurers’ underwriting losses are expected to emerge in particular from trade credit and event cancellations, such as the postponement of the Tokyo Olympics. See Economic Bulletin, Issue 4, ECB, 2018, for more details. This may partly reflect capacity constraints of banks which were busy providing loans to NFCs, but was also due to lower loan demand. Applying such downgrade rates to the universe of BBB-rated bonds outstanding today, a nominal amount of €110 billion of NFC bonds would be downgraded to the high-yield segment over the next year, approximately one-third of the current size of the high-yield market (see Chart 2.11, right panel). Taken together, these measures should help the euro area banking system to sustain lending to households and companies, while weathering losses. Downgrades in the first quarter of the year exceeded those in the 2008-09 financial crisis. Life insurers have come under pressure in recent years as the return on their assets in the low interest rate environment has fallen and the maturity of assets tends to be shorter than the duration of their contractual obligations with relatively high guaranteed rates. The current prudential framework includes provisions to ensure that asset liquidity is consistent with a fund’s redemption policy. Downgrades and defaults among high-yield issuers and leveraged loans are projected to increase (see Chart 2.12, left panel). This has included direct support and support via guarantees to banks on loans. Implementation of the Basel III standards, including those for market risk and Pillar 3 disclosures, has been deferred by one year to 1 January 2023.
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