The strength and resilience of the euro-area financial system has benefited from generally favourable economic and financial conditions in the six months since the publication of the December 2006 Review. Profitability in both the banking and insurance sectors has been improving and the amount of problem loans has remained low. For the most part, financial markets have been characterised by unusually subdued volatility, credit spreads have remained very low and many asset prices have reached historically high levels. In February and March 2007, the shock-absorbing capacity of the financial system was again tested by the third significant burst of market volatility in the past two years which it weathered comfortably. Improvements in the risk management practices of financial firms appear to have contributed to ensuring that higher financial market volatility did not prevent capital markets from facilitating the intermediation of capital.

The fact that the global and euro area financial systems have so far proven resilient to a series of adverse disturbances, while comforting, does not provide any ground for complacency. The disturbances endured by financial systems over the past couple of years have all been rather small in scale and although market volatility rose, it still remained well below longer-term historical averages. Moreover, these episodes occurred in an environment where market liquidity remained fairly abundant, macroeconomic fundamentals were strong and where the balance sheets of financial firms were generally in good shape. The experience of these episodes, therefore, is unlikely to offer much guidance on how financial systems would perform if subjected to a larger disturbance at a less favourable stage of the credit cycle, especially if investors’ risk appetites were to diminish. However, these episodes have served to reaffirm concerns about pre-existing vulnerabilities and potential risks. They have also raised new concerns related to markets of structured mortgage and credit products.

Looking forward, with the euro area financial system in a generally healthy condition and the economic outlook remaining favourable, the most likely prospect is that financial system stability will be maintained in the period ahead. However, there are some vulnerabilities and associated risks which, if they were to materialise, could pose significant challenges and which financial firms should seriously be taking into account in their risk management arrangements. In some markets, above all in the credit markets, there are concerns about “pricing for perfection”, in the sense that valuations appear to be based on very favourable expectations regarding future economic outcomes and very low risk premiums. In this context, the vulnerability of the financial system, especially financial markets, to an abrupt and unexpected sharp decline in market liquidity appears to be increasing. There are also concerns that greater and possibly excessive leverage in parts of the corporate sector is being facilitated by the remarkable growth in credit derivatives markets and by the growing presence of new participants in these markets, such as credit portfolio investors, hedge funds and private equity firms. In particular, there are concerns that this could have led to some slippage in credit risk assessment standards and pricing.

All in all, although the most likely prospect is that financial stability will be maintained in the period ahead, several of the previously identified main potential sources of risk and vulnerability have remained and some have grown in the past six months. Against this background, low-probability but plausible and challenging risk scenarios for financial systems could be triggered by adverse disturbances which resulted in unexpected changes in global market liquidity conditions or by unanticipated credit events. Looking further ahead, the possibility of an abrupt unwinding of global imbalances continues to pose a medium-term low-probability but potentially high impact risk for global financial stability. Although triggers for adjustment of financial imbalances cannot be predicted with any degree of certainty, financial institutions can mitigate potential problems before they occur through appropriate risk management including stress-testing and vigilant monitoring of the financial soundness of their counterparties.