Emergency measures deployed by fiscal, monetary and supervisory authorities curbed the impact on financial stability of the economic shock unleashed by the Covid-19 pandemic and the spring lockdown. The ensuing upturn in activity over the summer was interrupted when fresh restrictions were introduced across much of Europe during the autumn. Unlike in March, however, this did not trigger increased market volatility or financing difficulties. Financial system participants, including investors, borrowers and issuers, appear to be benefiting from a decrease – albeit from elevated levels – in the factors of uncertainty that have been present until now, thanks to the prospects for an improved health situation, but also because of the commitment by central banks and governments to keep financing conditions and fiscal support expansionary beyond the end of the crisis.
Accordingly, financing on financial markets for private issuers, notably non-financial corporations and banks, has recovered, with interest rates and liquidity getting back to pre-crisis levels, although lower-rated companies continue to be subject to higher credit risk premiums. Similarly, sovereign debt yields are at record lows. These developments caused the losses seen in the first part of the year on equity markets to be wiped out, and stocks recently surged back to higher levels, breaking records in some cases, most notably American indices. These movements may seem at odds with current levels of economic activity and could constitute a source of vulnerability, materialising in a sharp and sudden fall in asset values in the event of a new adverse shock. Two thematic chapters address these questions specifically: one considers the reasons for the high valuation levels, while the other examines weaknesses observed in March and April on short-term financing markets in euro for non-financial corporations (NFCs), due in particular to reliance on money market funds.
Developments since March have also exacerbated pre-existing vulnerabilities with potential systemic importance to the French financial system.
A key vulnerability concerns the deterioration in the financial situation of NFCs. While the second wave of the virus and the measures required to curtail its spread had a weaker overall impact on companies, they further accentuated differences in individual net debt trajectories, with growth prospects varying widely across different sectors of activity. By complicating the repayment of debts taken out in the spring to cope with the treasury shock due to the first lockdown, a muted recovery could severely impact the financial situation of the weakest companies, i.e. those carrying the most debt and/or hardest hit by the shock. In a slow recovery scenario, a substantial increase in NFC defaults could depress bank earnings through increased loses and provisions for corporate credit risk. Consolidation of NFC liabilities, through steps to strengthen capital, looks necessary to promote a macroeconomic rebound. A thematic chapter is devoted to questions relating to NFC debt.
The sharp run-up in government debt, linked to the need to extend support measures, could crimp fiscal leeway further out, especially if growth remains weak for a protracted period. This could potentially undermine confidence in sovereign credit quality. Investor confidence, as reflected in the French government's ability to issue debt at a negative average interest rate in 2020, coupled with the Eurosystem’s securities purchasing programmes alleviate these concerns in the short term.
The reduced profitability of financial intermediaries is another major area of concern. This decline has been underway for several years and is continuing, driven by a combination of structural and cyclical factors: banks are having to contend not only with a structural decrease in their net interest margin in the low interest rate environment, which is spreading and looks set to last, but also with a cyclical increase in the cost of risk amid rising corporate credit risk. The protracted low interest rate environment is likewise undermining the profits of insurance institutions. However, French banks boast extremely stable solvency ratios, while for insurers they have seen a notable downtrend, from historically high solvency ratios in both cases. This financial strength is a factor of resilience that is supporting the economic recovery through solid momentum in lending to businesses.
Given the scale of public support, the situation of households does not raise major concerns for the stability of the financial system at this stage. Easing credit standards for housing loans in recent years have played a part in weakening the situation of households, but measures taken by France's Haut Conseil de Stabilité Financière (HCSF – High Council for Financial Stability) in December 2019 and in 2020 are aimed at stopping the slippage.
The crisis has further increased the need for digital transformation among financial institutions, which also represents a new source of risk. Changes to business models in this regard need to be stepped up, under the dual constraints of fierce competition and thin profits. This assessment looks particularly at two risks associated with digitalisation. Specifically, it considers the cyber-risk that affects all financial institutions directly. But there is also a separate chapter on the consequences for financial stability of a pronounced depreciation in commercial real estate connected with more widespread use of remote working practices and the rise of retail e-commerce.
There is international consensus among financial authorities that challenges related to climate change pose serious risks to the financial system. They are calling for swift action, notably through the development of measurement capabilities, stress testing and standardisation of climate risks to improve the comparability of non-financial data.