Stresses on the financial systems in mature economies persisted over the summer months of 2008 as banks had to absorb further asset valuation write-downs in an environment where wholesale funding costs remained elevated.

At the same time, uncertainty about the global economic outlook grew, risk aversion among financial market participants surged and the prices of most financial assets fell. Following the bankruptcy of Lehman Brothers, the persistent liquidity stresses eventually gave way to deeper concerns about the creditworthiness of even the largest financial institutions and the adequacy of their capital buffers. This left many key financial firms facing mounting challenges in accessing short-term funding and capital markets, which triggered sharp drops in their stock prices and ultimately threatened their liquidity and solvency positions.

The extraordinary remedial actions taken by central banks and governments, which are aimed at addressing liquidity stresses and strengthening capital positions, thus contributing to restoring confidence in, and improving, the resilience of financial systems, were successful in stabilising the euro area banking system. Over time, once fully implemented, these measures should lower the cost of bank credit and facilitate its provision to the economy. That said, in order to revive the process of efficient financial intermediation, financial institutions will need to play their part in the adjustment process by taking advantage of these measures.

Looking forward, a number of risks and vulnerabilities remain which the financial system may have to cope with, notably the possibility of:

- a further deterioration in the US and the euro area housing markets and the impact this may have on banks’ loan quality and the value of securities backed by mortgage-related assets;

- a deeper and more prolonged slowdown in both the global and the euro area economy than currently expected that could cause a sharper and broader deterioration in borrowers’ ability to service their debt;

- a more pronounced deleveraging by banks, due to persistently high funding costs and concerns about the adequacy of capital buffers, which could negatively affect the flow of credit extended to the broader economy; and

- a surge in financial market volatility caused by a further unwinding of positions by hedge funds.

All in all, given the risks that lie ahead, banks will need to be especially watchful in ensuring that they have adequate capital and liquidity buffers in place to cushion the challenges ahead.