Assessment of risks to the French financial system – December 2023
The new high interest rate environment represents a regime shift for financial and non-financial participants alike. Following a phase of swift adjustments to monetary policy beginning in July 2022, euro area policy rates may have reached a plateau in September 2023, as inflation, including its core component, showed further signs of easing in the second half of 2023, despite remaining too high. However, these expectations remain conditional on the absence of additional shocks. Furthermore, long-term interest rates are exhibiting greater volatility in the new environment, as shown by their rapid run-up in autumn 2023, which has since been more than corrected.
These interest rate adjustments have so far taken place in an orderly fashion but new macroeconomic or geopolitical shocks or cyberattacks could test the resilience of some participants in the financial system. Market participants expect a soft landing of the economy, i.e. that inflation will return to its target without a recession. If these expectations are challenged, markets could come under renewed stress, potentially putting a strain on the liquidity position of the most vulnerable non-bank financial intermediaries. A deterioration in the economic environment and in market conditions would heighten the financial vulnerabilities of the most heavily leveraged participants in the real economy and could increase the credit risk of financial intermediaries. French banks and insurers, however, exhibit solid balance sheets that should allow them to cope with these risks while continuing to provide financing to the economy.
Previous rate increases are still being passed through to the real economy, because the debt carried by non-financial participants is mostly at fixed rates and over relatively long maturities. Their full impact on financial stability will depend on how long interest rates remain in restrictive territory. Short-term vulnerabilities linked to the elevated debt of some participants are increasing, owing to steadily rising costs of debt service. Conversely, the slowing debt dynamics of non-financial corporations (NFCs) and households is helping to contain some of the vulnerabilities.
To sum up, the rapid tightening of monetary policy has not resulted in major financial instability at this stage. The high risk of geopolitical or macroeconomic shocks calls for close vigilance, first for non-bank financial intermediaries and second for non-financial participants - for which the transmission of higher interest rates is ongoing - more than on banks and insurers themselves. This Assessment of Risks to the French Financial System therefore looks at risks in this order.
Amid heightened geopolitical tensions and ongoing macroeconomic uncertainties, financial markets remain exposed to shocks that could create liquidity stress for the most vulnerable non-bank intermediaries
The risk of a market shock persists, especially if expectations of an economic soft landing turn out to be overly optimistic. Volatility remains elevated on global bond markets. Short-term yields are responding to shifting monetary policy expectations and continued uncertainties over inflation and growth trajectories. Meanwhile, as monetary policy normalises, long-term interest rates are seeing increased volatility, fuelled by uncertainty about the future path of public finances. Between the end of August and October 2023, long yields spiked before easing back, in a trend that seems to have been driven essentially by spillovers from the United States. Despite significant sector and geographical disparities, equity and corporate bond valuations reflect expectations of a soft landing of the economy. A repricing of risk, in the event of a macroeconomic or geopolitical shock, could trigger adverse market movements, which could potentially be amplified by some participants’ procyclical reactions.
A localised market shock could put a strain on the liquidity of some vulnerable non-bank financial participants, with potential side effects for the wider financial system. 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. A thematic chapter in this report maps the risks of French non-bank financial intermediaries and their interconnections with the rest of the financial system. This classification spans a wide diversity of participants with varying risk profiles. Relative to the financial sector as a whole, the share of NBFIs remain small in France. High interconnectedness, not just between non-bank financial intermediaries, but also between NBFIs and the banking sector, increases the risk that a shock could spread. The risks posed by non-bank finance to the French banking sector are not limited to resident entities, as two-thirds of the direct exposures of French banks to non-bank financial intermediaries are cross-border.
Short-term vulnerabilities are rising for the most heavily leveraged participants in the real economy, while the real estate market continues its orderly correction
Monetary policy continues to be transmitted to French businesses. Although the debt structure of French non-financial corporations (NFCs) protected them from a sharp interest rate shock, their debt burden cost is steadily rising as higher interest rates are passed through to balance sheets. Situations vary across companies and sectors, but the French NFC sector remains in a sound financial situation overall, thanks to elevated cash buffers inherited from the Covid-19 crisis and a decline in leverage from historically high levels. NFCs are still well financed on the whole, but with higher volumes of debt poised to mature in the coming two years, the most heavily indebted companies could face increased refinancing risk. These vulnerabilities could be exacerbated in the event of a macroeconomic slowdown or if financing conditions tighten further.
The risks to financial stability from the downturn on residential and commercial real estate markets remain contained so far. A thematic chapter of this report examines the gradual correction of the residential real estate market, which is chiefly attributable to a decline in demand against a backdrop of tighter financing conditions. The related risks to financial stability are limited owing to the resilience of France’s home financing model and measures taken by the prudential authorities. The commercial real estate market is continuing to experience a more pronounced contraction. Overall, the French financial system has limited exposure to this sector. However, for some real estate investment funds, vulnerabilities linked to liquidity mismatches between assets and liabilities call for careful vigilance as the market adjusts.
The government debt ratio remains persistently above the euro area average, but the French government retains a good financing capacity. In the absence or new measures, the government debt ratio is expected to settle at around 110% of GDP until 2026. Controlling the trajectory of public finances is critical to preserving the sustainability of French government debt. The supply of French sovereign debt on the market is increasing, against a backdrop of persistently elevated deficits and normalisation of the Eurosystem’s balance sheet. For this debt issuance to be properly absorbed, sustained demand must be maintained among the private and non-resident investors.
Banks and insurers are adapting to the interest rate environment thanks to their solid balance sheet structure
In a context of higher funding costs, French banks exhibit robust liquidity and solvency levels. French banks got temporarily less of an income boost from higher interest rates than banks in other jurisdictions. Their net interest margin contracted slightly as the cost of their liabilities rose faster than interest income. However higher rates will benefit them over the longer term. French banks have a diversified funding structure, with broadly stable outstanding deposits and good access to market financing. Reflecting this, liquidity indicators are not signalling vulnerabilities, whether at the individual or system-wide levels. Similarly, the quality of banking assets remains stable, and the cost of risk continues to be moderate at this stage, including for commercial real estate exposures. Solvency ratios at French banks remain elevated, as confirmed to by the results of the European Banking Authority (EBA)'s 2023 stress-testing exercise. However, French banks must continue to exercise caution when managing credit risk.
Insurers are maintaining a solid balance sheet structure, but remain exposed to inflation and redemption risk. For life insurers, redemption risks remain under control, but continued vigilance is required, as higher interest rates could lead to reallocations to other savings products, potentially involving greater risk of capital loss and higher liquidity risk. The pace of surrenders remains contained and at this stage is still well below its record high observed at the end of 2011. Non-life insurers remain exposed to an increase in the cost of claims and to the risk of tougher terms for reinsurance contracts, in a setting of higher inflation and increased frequency and severity of climate events.
The financial system needs to step up its efforts to adapt to cyber and climate risks
The financial system remains exposed to elevated threats of cyberattacks, which are becoming increasingly sophisticated with generative artificial intelligence. On 9 November 2023, a ransomware cyberattack on a U.S. subsidiary of the Industrial and Commercial Bank of China paralysed its IT systems and temporarily disrupted liquidity on the U.S. Treasury market. The attack was a reminder that all financial system participants need to keep investing to strengthen the protection of their information systems. It also highlighted the systemic dimension of cyber risk resulting from the interconnectedness of participants. Indirectly, cyber risk may also cause losses for banks and insurers, in the event of attacks on companies to which they are financially exposed.
Finally, financial institutions must manage their exposure to transition risk while supporting at the same time the decarbonisation of the economy. The implementation of transition policies in line with carbon emissions reduction targets could lead to significant losses for financial institutions that are insufficiently prepared. French financial institutions have moderate exposure to transition risk, but their portfolios are still insufficiently aligned with decarbonisation targets. It is critical for financial institutions to establish and communicate transition plans, in order to establish specific and measurable carbon reduction targets for their portfolios. They must also continue reducing their exposures to the most at-risk activities and pay close attention to implementation by their counterparties of transition plans that are consistent with European emissions reduction targets.