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Brussels, 14 December 2010

Stricter financial regulation can help contain future asset bubbles and reduce macroeconomic imbalances

As part of the effort to broaden macroeconomic surveillance, this Quarterly Report on the Euro Area investigates the extent to which financial supervisory and regulatory reform can help avoid future harmful credit and asset price booms, for instance in housing markets. Stricter financial supervision can help directly reduce risks to financial stability by keeping banks' leverage in check and by establishing more stringent lending standards. Further topics in this issue highlight the effect the crisis has had on cross-border banking integration in the euro area. Furthermore, the sovereign debt crisis of 2010 is shown to complicate the ongoing process of balance sheet repair. Finally, the freezing of interbank markets in 2008 has caused non-financial corporations to switch to greater bond issuance, thereby diversifying away from their traditional bank-based funding.

In keeping with the prominent role occupied by financial marked issues in recent months, this edition of the Quarterly Report on the Euro Area features analysis of a number of closely related topics in this area. The Focus Section starts with the observation that excessive credit and asset price booms in some parts of the euro area created an important source of vulnerability in the run-up to the crisis. A single monetary policy for the euro area is by itself unable to effectively address the adverse effects of excessive credit growth, which in the past has shown strong regional divergences. The financial crisis has further exposed the limits of the current regulatory and supervisory structure in dealing with the build-up of balance sheet vulnerabilities in the banking sector. In this respect, the newly created European Systemic Risk Board (ESRB) will play a pivotal role for the identification of risks and will thereby support a stronger focus on macroprudential surveillance. Furthermore, changes to banks’ loss provisioning standards, combined loan-to-value and loan–to-income rules, as well as more demanding capital adequacy rules stand out as promising regulatory instruments to prevent excessive credit build-up in the future. Within the euro area, the supervisory toolbox should be considered as part of a wider macro-financial surveillance framework.

Turning to the set of special topics in this edition, the report examines the impact of the financial crisis on the euro-area banking sector, in particular on cross-border integration of financial institutions through bank mergers and acquisitions (M&A). The results show that the process of market integration is still ongoing, although at a slower pace as a consequence of the crisis and the ensuing restructuring of the banking sector. The process of market integration is however not uniform across countries, as smaller economies are integrating internationally more quickly than larger ones, for whom M&A activity is predominantly domestic. But irrespective of country size, the crisis has led to a clear slowdown of M&A activity and a refocusing on domestic activities for almost all euro-area countries.

This edition further investigates the effects of the sovereign debt crisis on the recovery process in the euro-area financial sector. The deterioration of investors' perception of sovereign risk has contributed to a negative feedback loop between public finances and financial market developments. Challenging fiscal positions have raised funding costs for banks in some Member States in the Southern and Western periphery, while rising banking sector guarantees and implicit liabilities to the public sector have increased the perception of sovereign credit risk. This negative spiral can complicate the process of banks' balance sheet repair. The emergence of some sovereign bonds as risky assets has segmented the investor basis and led to higher funding costs for some sovereigns, despite falling benchmark interest rates. This illustrates that the pace of recovery in the financial system is highly dependent on the strength of recovery in the real economy.

Finally, this issue shows that the euro-area corporate sector's traditional reliance on bank lending (rather than capital markets) may be changing. The surge in bond issuance by non-financial corporations in 2009 and the persistently high share of bonds in corporations' external funding in 2010 suggest that the euro-area corporate sector may have responded to the financial crisis and the tightening of bank credit conditions by diversifying its sources of external funding. If persistent, this diversification process would make part of the euro-area corporate sector – mostly large companies – less reliant on banks. At the same time, it may free up greater lending capacity in banks, which could be directed towards SMEs, for whom bond issuance is typically not feasible.

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