Financial Stability in the European Union: IMF Assessment

In its first ever European Union-wide assessment of the soundness and stability of the financial sector, the International Monetary Fund this month pointed to the need to step up regional efforts to manage financial crises and risks to keep the 27 countries that form the world’s largest economy safe and stable.

“Restoring financial stability in the European Union has not been easy, and the priority is now to establish single frameworks for crisis management, deposit insurance, supervision and resolution, with a common fiscal backstop for the banking system, especially for the monetary union,” said Charles Enoch, Deputy Director in the IMF’s Monetary and Capital Markets Department and head of the mission that conducted the assessment.

“The IMF said policymakers and banks have made good headway to fix recent financial problems in the European Union.”

Repair and Reform

The IMF said policymakers and banks have made good headway to fix recent financial problems in the European Union. But the region remains vulnerable, and policymakers and banks need to intensify their efforts across a wide range of areas:

Bank balance sheet repair.

Banks need to build strong capital buffers. Greater disclosure requirements, especially of impaired assets, would buttress credibility in the improvement in banks’ health. National authorities and the prospective Single Supervisory Mechanism should undertake selective asset quality reviews, coordinated at the European Union level. This would add credibility to the stress tests envisaged by the Single Supervisory Mechanism and the European Banking Authority.

An effective banking union.

Maintaining momentum to establish an effective Banking Union will anchor financial stability and ongoing crisis management. Allowing the European Stability Mechanism to directly recapitalize banks would help break the adverse link between government finances and banks, which has caused so much trouble in several European countries now undergoing painful adjustment. It will be critical for the Single Supervisory Mechanism to deliver supervision of the highest quality from the outset. Ultimately, its effectiveness will depend on strong governance and common safety nets in the form of a single resolution authority and deposit guarantee scheme. This recommendation builds on IMF research released in February 2013.

Stronger European Union financial oversight framework.

Prompt passage and implementation of capital requirements and resolution directives and regulations, as well as strong coordination across the various oversight institutions are important to achieve policy consistency, including with national policies. The IMF underscored that standards adopted through these directives should be well above internationally agreed minima.

The IMF’s assessment of the European Union covers a region rather than a single country and draws on the analysis and findings in individual European country reports, as well as visits to the key European Union and euro area financial oversight institutions in November and December 2012.

“Banks need to build strong capital buffers.”

Main Risks

The IMF outlined three main financial risks facing the European Union:

• Further declines in growth leading to deterioration in the balance sheets of banks and governments.
• Stresses and dislocations in wholesale funding markets that could lead to adverse liquidity and refinancing conditions.
• A major further drop in asset prices.

The IMF said uncertainty about the regulatory environment and the burden it may place on banks and financial institutions are also sources of risk. In several countries, the high degree of concentration in the banking sector creates too-big-to-fail problems that could amplify the country’s vulnerability.

Mind the Gaps

Policymakers are urged to promptly agree and implement proposals by the European Commission to harmonize capital requirements, bank resolution, and insurance supervision frameworks, according to the IMF.

Separating banks’ retail activities from those deemed more risky, along the lines of proposals set out in the Liikanen and Vickers reports, and currently being examined or implemented in a number of European Union member states, may assist authorities to resolve banks if necessary, but they are no panacea and should not substitute for other ways to improve loss-absorption capacity, the IMF said.

The IMF assessment found that the present weak economic outlook provides a challenge to the life insurance and pensions industries, parts of which have also been affected by exposures to weak banks and sovereigns. Careful attention will be needed by the supervisory authorities, particularly as the European Commission’s insurance supervision proposals are implemented.

Strong coordination across Europe’s various supranational agencies will be critical, the IMF said. This will help ensure smooth decision making and make policies consistent, especially for crisis management.

The IMF said European officials expressed interest in another assessment within about three years to assess progress in setting up the banking union and the changes to the financial oversight framework envisaged for 2014.