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Low profitability and valuation concerns pose risk to EU financial system, say ESAs

24 Apr 2017, 2:50 pm

The current protracted period of low profitability for banks and insurers, alongside political and economic uncertainty, represents the greatest risk to the European Union financial system, the Joint Committee of the European Supervisory Authorities (ESAs) has said.

The ESAs are the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA).

Low interest rates and elevated political and economic uncertainties "pose substantial risks to the banking and insurance sector", the Committee said in its spring 2017 Report on risks and vulnerabilities in the European Union's financial system.

"Many banks struggle with asset quality concerns and attempt to mitigate discrepancies between returns and their respective funding costs. Costs of banks’ equity exceed respective returns on equity, while insurers predominantly face reinvestment risks, as available long term interest rates may eventually not suffice to fund the contractually guaranteed returns of the outstanding policies," the report said. "In the asset management industry, low returns on assets directly translate into low returns on fund shares, potentially further reinforced by the reduction of clients’ returns through fees charged by the fund industry and the costs of distribution."

Valuation risk for financial instruments and volatility remain high, the Committee said, as episodes of high volatility continue to occur. High levels of political risk, conduct of business risk and cyber risk all add to the situation, it said.

A recent improvement in yield may improve profitability but also poses valuation concerns, while high levels of non-performing loans (NPLs), inefficiencies, overcapacity and a lack of business strategies designed to improve profitability all affect the sector, the report said.

Interconnectedness, in particular via asset price contagion and direct financial exposure, also adds to financial sector risks, it said.

"High co-movements in equity prices for insurers and banks, and high exposures of EU insurers to EU banks indicate the concentration of risk within those two sectors. Persistent search for yield supports the potential of price contagion among risky asset classes and reinforces valuation risk, while short-term reactions of the prices for fixed income instruments observed in late 2016 did not translate in higher geographic price heterogeneity, again pointing to the preservation of valuation risk," the report said.