EU supervisors tell financials to prepare for asset quality deterioration
The financial sector has so far proven resilient to the impact of the Covid-19 crisis, argued the European financial regulators joint committee in introduction of its Spring 2021 risks and vulnerabilities report. But how long can the EU financial system hold on? For the European supervisors (ESAs), the answer makes no doubt. The longer the pandemic continues, the greater will be its impact on households and the non financial corporates sector as well as the spillover effects on financial institutions, they argued. According to them, market players should be prepared for possible further market corrections since the ESAs suspect macroeconomic uncertainty has not been really reflected in asset valuations and market volatility.
“Currently, a potential decoupling of financial market performance from underlying economic activity not least raises questions about the sustainability of the recent market recovery. The pandemic has also added to pre-existing profitability challenges of financial institutions, led to liquidity challenges in segments of the investment fund sector, and is expected to result in deteriorating asset quality in the EU banking sector,” the report pinpointed.
Hence, in ESAs’ view, banks should brace for asset quality deterioration. Rising levels of impairments are a signal as they “presumably reflect” the expectation of defaults to come. “Banks’ asset composition is expected to determine the extent to which they will be affected by the crisis,” said the EU regulators for whom banks’ provisioning policies “should continue to be a point of particular attention.” They should engage to restructure over indebted but viable exposure efficiently, said the supervisors. Banks should also continue to make “thorough” risk assessments to ensure that lending remains viable, including after public support measures such as loan moratoria and public guarantee schemes will expire.
Additionally, ESAs joint committee called on financial institutions to continue to develop further actions to accommodate a “low-for-long” interest rate environment and its risks. ESAs said, financial institutions should be prepared for changes in interest rates, “especially in light of the recent upward shifts of long-term interest rates and the consequent concerns about re-emerging inflationary pressures.”
Besides, the committee advised financials to keep conservative policies on dividends and share buy-backs and recommends investment funds to further strengthen their preparedness in the eventuality of further increases in redemptions and valuation shocks.