The ESRB publishes a report on the macroprudential policy issues arising from low interest rates and structural changes in the EU financial system

Today the European Systemic Risk Board (ESRB) has published a report on the macroprudential issues arising from low interest rates and structural changes in the financial system of the European Union. The report has been jointly prepared by the Advisory Scientific and Advisory Technical Committees of the ESRB and the Financial Stability Committee of the European Central Bank. The report analyses potential macroprudential issues arising from both a prolonged period of low interest rates and structural changes and discusses what impact these may have on financial markets and the real economy over a long-term horizon. The analysis in the report takes a forward-looking and holistic approach by considering all major sectors in the financial system as well as cross-sectoral spillovers and contagion channels. The annexes to the report cover these aspects in more detail.

The ESRB has identified three main areas of risk related to financial stability: (1) the sustainability of certain financial institutions’ business models; (2) broad-based risk taking; and (3) the move towards a market-based financial system. These risks are interrelated and their magnitude varies across financial sectors and Member States. First, in an environment of low interest rates over a prolonged period, characterised also by weak economic growth, profitability and solvency may come under pressure at financial institutions that offer guaranteed returns (notably life insurers and pension funds). Low interest rates are also a contributing factor in the falling net interest income of banks. Second, financial stability risks related to financial markets may increase in the low interest rate environment because of a search for yield, crowded positions in some categories of assets (including real estate) and uncertainty about fundamental asset price values. Accordingly, any future episodes of sharp re-pricing could leave the balance sheets of market participants exposed to revaluation risks. Third, the ESRB considers that structural changes and the prolonged period of low interest rates could result in a shift to a more market-based financial system. This would be a welcome development and in line with the initiative of the European Commission for a capital markets union. However, it may also lead to the emergence of new financial stability risks accentuating those risks that are less prominent in a banking-based financial system. Such new risks could include an increase in leverage in non-banks.

There is already evidence that some of the identified financial stability risks may develop over time as interest rates and growth remain low, while other identified risks can only be conjectured at present. The report includes evidence in the areas of business model sustainability and, to some extent, broad-based risk taking. Some of the identified risks can only be conjectured at present on the basis of forward-looking analysis. Risks related to the shift towards a more market-based financial system and the risks identified in the area of broad-based risk taking belong to this category.

The ESRB report discusses a series of policy options to mitigate and prevent the emergence of the financial stability risks that have been identified. The policy options in the report are not to be taken as ESRB recommendations within the meaning of the ESRB Regulation[1], but rather as a set of proposals for further consideration by the relevant stakeholders. Furthermore, the policy options should be considered from a holistic and system-wide perspective given interrelations between the risks and the need to mitigate regulatory arbitrage. Examples of policy options include the monitoring of credit standards by macroprudential authorities, the review of the risk free rate within the Solvency II framework, and the development and operationalisation of resolution frameworks for insurers.

The report also discusses the financial stability risks that could arise from a gradual increase in interest rates from their current levels. In a scenario of a gradual increase in interest rates, financial stability risks would become less severe from a macroprudential perspective, partly because the increase would be accompanied by stronger economic growth. Therefore there is less reason to focus on risks when interest rates are rising. The policy options discussed in the report are of more relevance in an environment of low interest rates for a prolonged period. However, some of the policy options would also be beneficial to the stability of the EU financial system in the event of a gradual return to higher interest rates.

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[1]Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board (OJ L 331, 15.12.2010, p. 1).