ANNUAL REPORT 2008 - Polymer Bank Notes of the World

1 FINANCIAL STABILITYThe Eurosystem contributes to the smoothconduct of policies pursued by the competentnational authorities relating to the prudentialsupervision of credit institutions and the stabilityof the financial system. It also offers advice tothese authorities and the European Commissionon the scope and implementation of Communitylegislation in these fields.1.1 FINANCIAL STABILITY MONITORINGThe ECB, in collaboration with the ESCB’sBanking Supervision Committee (BSC), aims tosafeguard the stability of the financial system. 1Key activities are monitoring risks to financialstability and assessing the financial system’sshock-absorbing capacity. The principal focus ison banks, as they are still the primaryintermediaries of funds. At the same time, theincreasing importance of financial markets andother financial institutions and their linkageswith banks means that vulnerabilities in thesecomponents of the financial system are alsomonitored by the ESCB.CYCLICAL DEVELOPMENTSIn 2008 the stresses on the euro area financialsystem, which had been sparked in 2007 bylosses incurred by financial institutions aroundthe world on securities backed by US subprimemortgages, intensified further. As theyear progressed, euro area banks experiencedfurther asset valuation write-downs, higherloan impairments and credit costs, as wellas large falls in trading revenues. The maindevelopments and the lessons that may belearned from this episode are treated elsewherein this report (see Section 2 of Chapter 1), aswell as in a number of other ECB publications,notably the Financial Stability Review.As uncertainty grew about the global economicoutlook, with the balance of risks increasinglyskewed to the downside, risk aversion amongfinancial market participants rose, with mostfinancial asset prices falling as a result. Creditmarket liquidity and funding conditionsdeteriorated markedly during the course of theyear and securitisation markets became moreor less inactive. Persistent liquidity stresseseventually gave way to deeper concerns aboutthe creditworthiness and sufficiency of capitalbuffers. In this environment, investors andcreditors began to lose confidence in the abilityof some financial companies to meet theirobligations. This left many key financial firmsfacing mounting challenges in accessing shorttermfunding and capital markets. Some of theworld’s largest financial institutions sufferedboth rating downgrades and sharp drops in theirshare prices. This development ultimately forcedseveral euro area and international financialinstitutions to consolidate or to seek additionalsupport from shareholders or the government.However, for a number of international financialinstitutions, bankruptcy could not be avoided.Euro area banks initially faced the financialturmoil with their solvency positions generallywell above regulatory minimum requirementsfollowing several years of strong profitabilityperformances. Although some large euro areabanks were badly affected by valuation writedownson structured credit securities and relatedmarket stresses, which had persisted for morethan a year, they seemed to be broadly resilientto adverse disturbances until the situationdeteriorated considerably in September 2008.Euro area banks’ return on equity generallyfell during the first half of 2008, burdened bymark-to-market losses. In addition, impairmentcharges on loans and securities rose significantlywhile fee and commission income as well astrading revenues fell, given the challengingconditions in capital markets. Despite the fall inprofitability, regulatory capital ratios increasedduring the first half of 2008. This improvement1 Since the end of 2004 the ECB has published its FinancialStability Review, a semi-annual report on the stability of theeuro area financial system. In 2008 it also published the seventhedition of its report on “EU banking structures”, as well as adhoc reports on “Commercial property markets”, “The incentivestructure of the ‘originate and distribute’ model”, “Coveredbonds in the EU financial system” and “EU banks’ liquiditystress testing and contingency funding plans”. These publicationspresent the main findings of the monitoring by the BSC of thestructure and stability of the banking sector, and are available onthe ECB’s website.150 ECBAnnual Report2008