ECB’s Lagarde: Rising Credit Risk to Become Fully Visible Only Over Time

1 July 2021

By David Barwick – FRANKFURT (Econostream) – European Central Bank President Christine Lagarde on Thursday said that credit risk associated with the pandemic’s impact will be apparent only with time.

In the foreword to the 2020 annual report of the European Systemic Risk Board (ESRB), Lagarde noted that the banking sector was ‘a particular point of focus’ for the report, ‘as rising credit risk related to the economic impact of the pandemic will only become fully visible over time.’

The ‘economic and financial consequences of the pandemic continue to evolve rapidly’, she said. The ESRB assessed the main risks as of June to be a potential rise in private sector insolvencies; a challenging environment for banks and other financial institutions; risk repricing and possible market illiquidity; sharp real estate market corrections; and possible sovereign financing risk, she reported.

The report commented that short-term uncertainty is still high ‘on account of delays in the rollout of vaccinations and concerns about the effectiveness of vaccines with respect to COVID-19 virus mutations.’

‘To bridge the gap until the uncertainty recedes and the economic recovery is firmly entrenched, policies to support favourable financing conditions and an expansionary fiscal stance remain essential’, it said.

But in fact, it continued, ‘[s]ignificant uncertainty also prevails over the medium term, as the scope of permanent structural changes in supply and demand patterns remains unclear.’

The changes would have positive or negative effects on different sectors and could aggravate economic divergence across the area depending on the relative importance of affected sectors for member states’ economies, it said. The structural changes could also compromise financial stability via solvency issues, it added.

‘This could be exacerbated through cliff effects caused by a premature withdrawal of public support measures, notably in countries where concerns about limited fiscal space and high sovereign debt may constrain further fiscal support’, it said.

The potential for solvency pressures to mount and to feed back into the financial system constituted the primary systemic risk in Europe, the report said. Policy support has mitigated this to date, but will become more targeted and ultimately be withdrawn, it said.

As the crisis persists, non-financial corporations’ balanced sheets will deteriorate more sharply, forcing companies to weaken their cash buffers, according to the report.

‘At the same time, the NFC sector will be increasingly confronted with a rising debt burden – the dark side of the far-reaching reliance on large-scale liquidity-support measures in 2020’, it said. ‘Research based on firm-level data suggests that the number of firms in distress could significantly increase.’

While ‘relatively resilient’ thus far, ‘many banks are facing a combination of rising asset-quality concerns, ongoing pressures on profitability, persistent structural problems and, in some countries, persistently high levels of legacy non-performing loans’, the report warned.

NPL ratios have held steady so far, but other signs of loan quality deterioration are apparent, it said. Banks should acknowledge and provision for new NPLs sooner rather than later; ‘[r]ecognising losses only when moratoria and guaranteed loan programmes expire would compound the risk of cliff effects, which could trigger an abrupt deleveraging process.’

The report cautioned against repeating mistakes of previous crisis and allowing NPLs to pile up over a long period. ‘Banks should avail themselves of all NPL resolution options’, it urged.

Although housing markets have withstood the crisis, ‘vulnerabilities related to residential real estate have further increased’, the report asserted. ‘In 2020 house prices continued to rise, further compounding overvaluation risks that already prevailed in several member states prior to the crisis.’