Many of the downside risks to euro area financial stability that were identified in the December 2008 issue of the FSR have crystallised. In particular, the further significant deterioration of global macroeconomic conditions, as well as sizeable downward revisions to growth forecasts and expectations, have added to the stresses on global and euro area financial systems. The contraction of economic activity and the diminished growth prospects have resulted in a further erosion of the market values of a broad range of assets.

Large and complex banking groups (LCBGs) in the euro area have been responding to the challenging macro-financial environment by making efforts to de-leverage and de-risk their balance sheets, although this has been hindered by the illiquid and stressed conditions that have characterised many financial markets. The adjustment of bank balance sheets has entailed adverse feedback on the market pricing of assets and on banks’ financial intermediation role of channelling funds from savers to investors. Moreover, increasing signs of an adverse feedback loop between the real economy and the financial sector have posed new challenges for the safeguarding of financial stability.

Because of the continued stresses and impaired liquidity of many financial markets, a range of remedial policy measures have been taken both by central banks and by governments, with the aim of preventing this adverse feedback and fostering the flow of credit. The significant narrowing of money market spreads over the past few months indicates that the central bank measures have contributed to improving the functioning of money markets. At the same time, hard-to-value assets have remained on bank balance sheets and the marked deterioration in the economic outlook has created concerns about the potential for sizeable loan losses. Reflecting this, uncertainty prevails about the shock-absorption capacity of the euro area banking system.

Looking forward, there is a concern that many of the risks identified in this issue of the FSR could materialise if the global economic downturn proves to be deeper and more prolonged than currently expected. In particular, the main risks identified within the euro area financial system include the possibility of:

* a further erosion of capital bases and the risk of a renewed loss of confidence in the financial condition of LCBGs;

* significant balance sheet strains emerging among insurers; and

* more widespread asset price declines coupled with high volatility.

Outside the euro area financial system, important risks include the possibility of:

* US house prices falling further than currently expected;

* the economic downturn in the euro area being even more severe than currently projected; and

* an intensification of the stresses already endured by central and eastern European countries.

All in all, and notwithstanding the measures that have been taken by the Eurosystem and governments in the euro area to stabilise the euro area financial system and the recent recovery of the equity prices of most LCBGs, policy-makers and market participants will have to be especially alert in the period ahead. There is no room for complacency because the risks for financial stability remain high, especially since the credit cycle has not yet reached a trough. Banks will, therefore, need to be especially careful in ensuring that they have adequate capital and liquidity buffers to cushion the risks that lie ahead, while providing an adequate flow of credit to the economy. Over the medium to longer term, banks should undertake the appropriate restructuring to strengthen their financial soundness and resilience to shocks. This may well include adapting their business models to the challenging operating environment. At the same time, banks should be alert in ensuring that risks are priced appropriately, but not excessively or prohibitively so. The commitments made by euro area governments to support the financial sector have been sizeable across a range of measures. Given the risks and challenges that lie ahead, banks should be encouraged to take full advantage of these commitments in order to improve and diversify their medium-term funding, enhance their shock-absorption capacities and protect sound business lines from the contagion risks connected with troubled assets.