Assessment of risks to the French financial system – June 2023
The financial system came under severe strain in the first half of 2023, in the wake of several US regional bank failures and problems at Credit Suisse. Risks of contagion to the French financial system were contained, thanks in particular to the solid fundamentals of French banks and to the strengthened regulatory framework along with a robust supervision of banks. More generally, however, these tensions serve as a reminder that pre-existing vulnerabilities, linked to excessive leverage at some participants, both financial and non-financial, or to inappropriate risk management, are more likely to materialise in an environment where funding is more expensive
Since late 2022, the economic outlook has rather improved but, in the short term, the context remains marked by slowing growth and a high level of inflation. To fight the risk of persistent inflation, and thus preserve the stability of the financial system, the European Central Bank has raised its key rates eight times since July 2022.
The financial system is proving resilient in the face of the swift tightening of financing conditions and the changing macroeconomic environment. Since the end of 2022, the growth rate of financing volumes and real estate prices has slowed. If the credit slowdown remains orderly, it will, over time, help to correct vulnerabilities linked to high levels of leverage among non-financial participants and to high property prices. But at a time of economic uncertainty and rising funding costs, the risk of a potentially disruptive shock for the most vulnerable participants remains.
Given the persistently elevated risks to financial stability, careful vigilance must be maintained to preserve the resilience of the French financial system. Banks and insurers can rely on high solvency and liquidity ratios to manage adverse developments in macro financial risks. Market tensions have abated since the early 2022, but markets are still at risk of a disorderly correction. Procyclical fire-sales from non-bank financial intermediaries could fuel such correction.
Highly leveraged non-bank intermediaries with high liquidity risk are the most vulnerable to adverse market movements. Besides, a sharper than expected economic slowdown or a disorderly tightening of financing conditions could weaken the most indebted non-financial players. These differentiated risks are developed below.
The French banking sector is not exposed to the same vulnerabilities as those affecting the banks that caused the March 2023 crisis and must cope with higher funding costs
Poor risk management and non-viable business models were the fundamental reason for the banks’ failures that erupted in march 2023. Following a spell of severe market volatility, contagion risks were swiftly contained owing to the low direct exposures of the French financial system to these institutions, coupled with the resilience of French banks. This strength is underpinned by Europe’s strict prudential and supervisory framework within the Banking Union. In the European Union, the Basel III regulatory framework established internationally following the global financial crisis applies to all banks, even the smallest, whereas in the United States it applies to just 13 banks. US regional banks are therefore subject to considerably less strict requirements. A robust regulatory framework needs to be accompanied by robust supervision. The euro area’s model of active supervision under the Single Supervisory Mechanism (SSM) contributes to the strength of French banks. It features an intrusive approach tailored to banks’ characteristics and completed with rigorous and regular stress tests, including for interest rate risk.
French banks continue to exhibit high levels of solvency and liquidity. French banks are subject to strict rules on interest rate risk and can draw on a diversified and sound funding structure characterised by a stable deposit base. For this reason, they are well positioned to adapt to monetary policy tightening and to take advantage of higher interest rates. In the short term, however, they must cope with higher funding costs owing to the impact of an increased share of interest-bearing deposits in total deposits and the rollover of their market debt at higher rates. After the solid financial performances of 2022, the increased cost of liabilities and more muted credit activity could reduce the profitability of French banks in the short term, but they will benefit from higher interest rates in the medium run. Assessment of risks to the French financial system.
Insurers maintain a solid balance sheet structure, but must continue to adapt to an environment of higher interest rates
The effects of inflation and higher interest rates vary across segments and entities. In the non-life segment, inflation may impact the cost of benefits for several years, because activities are exposed to higher costs of claims and expenses (as benefits may be spread over several years, but prices are not always revised annually). Life insurers, meanwhile, need to cope with an average return on assets lower than market returns and a risk of increased surrenders, particularly for non-unit-linked funds. However, surrender rates remain contained, thanks especially to the revaluation of insurance contracts that took place in 2022. Furthemore, tax incentives specific to life insurance contracts should continue to limit outflows.
The risk of a disorderly market correction remains very elevated and could disrupt non-bank institutions with the greatest exposure to leverage and liquidity risk
Financial market vulnerabilities could amplify the transmission of shocks. Interest rate volatility remains at historically high levels, owing to uncertainty about the speed with which inflation is set to slow. This is undermining market liquidity. At the same time, some valuation indicators for risky assets, especially on equity markets, are signalling excessive optimism and hence the risk of a correction in the event of a shock. Valuations remain vulnerable to an abrupt and unexpected repricing of risk premia. The market stress of recent months (energy markets, UK pension funds, US regional bank failures) shows that pockets of vulnerabilities can quickly have broader repercussions for the prices, liquidity and volatility of financial assets.
Some categories of non-bank financial intermediaries are exposed to significant liquidity risk, which could lead them to adopt procyclical behaviour that might exacerbate adverse market dynamics. According to the Financial Stability Board (FSB), approximately 14% of global financial assets are managed by non-bank financial intermediaries exposed to similar risks to those of banks. These participants could experience significant financing needs in the event of a market shock, via margin calls or redemption requests, which could strengthen adverse market dynamics through forced asset sales. Heavily leveraged participants are especially vulnerable to these dynamics, making it essential to bolster the regulatory framework applicable to them.
A dedicated thematic chapter analyses the risks for investment funds invested in private equity and private debt, whose growth has slowed markedly since the second half of 2022. Following several years of brisk growth, these funds now account for a major share of financing in certain economic sectors (growth companies and heavily leveraged companies). Today, they are exposed to significant valuation and credit risks, which need to be properly understood by investors.
Vulnerabilities linked to the elevated debt of government and certain large corporations need to be watched
Despite carrying high levels of debt compared with European averages, French non-financial corporations (NFCs) are displaying resilience. They are benefiting from relatively stable earnings and also from the fact that their debt is mostly at fixed rates and over relatively long maturities, which insulates them from a sudden interest rate shock. Since December 2022, the growth rate of NFC financing has slowed but remains positive. The number of business failures continues to normalise, pursuing a trend in place since November 2021, and is reverting to pre-pandemic levels. However, risks for the business sector, and particularly for the most heavily leveraged firms, continue to increase owing to the gradual pass-through of higher interest rates to funding costs, against the backdrop of a slowing economy. Vulnerabilities could increase if credit standards are tightened.
Public finances are on a trajectory that must be controlled if sovereign debt is to remain sustainable. Government support measures, including first and foremost the electricity and gas price shields, have protected households and companies by absorbing much of the energy shock. These measures contributed to maintaining debt and the fiscal deficit in 2022 at far higher levels than had been projected before the energy crisis. Assuming no change in policy, this debt will not decrease in the coming years. Stepped-up efforts to lower the level of public debt is a prerequisite to maintaining the investor appeal of French government securities.
Real estate markets are showing signs of cooling, especially the commercial segment, which has experienced a marked dip since the fourth quarter of 2022
As interest rates continue to go up, home lending is normalising in a progressive and orderly fashion in France, where loan production continues to be brisker than in the rest of the euro area. Normalisation is due to the increase in interest rates, which nevertheless remains less pronounced in France than in neighbouring European countries partly because of the usury rate. House prices, which respond with a lag to interest rate increases, are slowing, after several years of extremely vigorous growth. A moderate and orderly house price correction, such as is being observed at present, should make it possible to bring the household price/income ratio back to more moderate pre-Covid levels. Although households have a high debt ratio, their repayment capacity is protected by France's home financing model, which is almost exclusively based on fixed rates, and by the improvement in credit standards following the introduction of the measure by the Haut Conseil de stabilité financière (HCSF – High Council for Financial Stability) in late 2020. This measure set a maximum debt-service-to-income ratio of 35% for borrowers and a maximum credit period of 25 years for home loans, with flexibility allowed for up to 20% of loan production. The two technical adjustments relating the 20% flexibility margin announced by the HCSF in June 2023 maintain this safety net for borrowers while allowing some flexibility for lenders (cf. section on the measures taken by the authorities).
Commercial real estate has slumped since the fourth quarter, following a decade of strong growth and a marked slowdown following the Covid-19 crisis. Commercial real estate prices could be particularly sensitive to rising funding costs owing to significant use of leverage by market participants, overvaluation risks and the reduced appeal of buy-to-let investing on certain segments in the wake of the pandemic. The decrease in prices and trading volumes is not however uniform across all sectors and is less pronounced than in other advanced economies. For banks and insurers, these exposures remain modest relative to their total assets. Open-end real estate investment funds are exposed to liquidity risk in the event of an investor withdrawal, but these risks are offset by the presence of investors displaying stable behaviour and the introduction of liquidity management tools.
All financial institutions must step up their adaptation to the structural risks posed by cyber and climate change threats
Climate risks continue to increase, as confirmed by the synthesis report by the IPCC published on 20 March 2023, and are going to become harder for financial institutions to manage. Financial supervisors are therefore paying increased attention to assessing and monitoring the transition and physical risks associated with climate change, notably through stress tests. Furthermore, regulatory requirements in terms of climate risk management and extra-financial disclosures are being strengthened.
The financial system remains exposed to an extremely elevated risk of cyberattacks. The threat of cyberattacks is exacerbated by geopolitical tensions, while artificial intelligence developments could make these attacks more sophisticated and easier to implement.