Financial stability report - December 2024

The return of inflation to its target and the gradual reduction in key interest rates, against a backdrop of moderate growth in France, are favourable factors for the stability of the French financial system. The French financial system has weathered a series of major shocks since 2020 and has adapted to a higher interest rate environment since 2022. The soundness of the banking and insurance sectors, the strong cash positions of nonfinancial corporations and the high household savings rate, which is still above its pre-Covid average, are still important shock absorbers. However, pockets of vulnerability remain for the most heavily indebted non-financial participants in an uncertain macroeconomic environment.

Renewed uncertainties, associated with the domestic political climate, the international economy and heightened geopolitical tensions, could affect economic activity and markets. Although volatility remains moderate, it increased in the second half of 2024 with brief episodes of market stress. The spike in volatility observed on global markets on 5 August 2024 reflects market participants' heightened sensitivity to uncertainty. The political transition in the United States also raises questions about the economic and trade policies that will be pursued by the new administration, which could exacerbate existing vulnerabilities for the European economy and markets. In France, domestic political uncertainty has led to an increase in the spread between French and German sovereign bond yields, while the spread between French and Italian yields has narrowed. While the French case remains largely idiosyncratic, the convergence of spreads within the euro area reflects investor confidence in the soundness of European institutions.

Based on this assessment of the overall resilience of the French financial system, this report highlights the main cyclical and structural risks to financial stability.

Non-financial participants have adapted to higher interest rates, but some remain vulnerable to a downturn in the macroeconomic environment

Non-financial corporations have generally remained resilient, but vulnerabilities are increasing for the most
heavily indebted among them. While interest rates on new business loans have begun to fall, financing costs
continue to rise gradually, as borrowers roll over the loans they took out during the period of low interest rates. Despite rising interest expenses, companies generally have cash reserves that are still above their pre-Covid levels. The number of business failures in October 2024 increased, albeit at a slower rate than in June 2024, reflecting in particular a “catching-up” process after the sharp slowdown recorded during the 2020-21 period. The sector therefore retains a good capacity to absorb shocks, but vulnerabilities are still on the rise for the most heavily indebted companies, especially given that the economic climate is no longer conducive to increasing selling prices. The fact that credit spreads on corporate bonds have remained at historically low levels reflects investors' confidence in the financial strength of major French companies. On average, spreads on high-yield bonds fell in 2024, as the specific difficulties of some companies did not affect the market as a whole.

While the correction in the residential real estate market appears to be coming to an end, the commercial real estate sector is continuing to weaken. The decline in interest rates that began in June 2024 led to a rebound in new housing loans and a gradual stabilisation of residential real estate prices in the second quarter of 2024, as households' purchasing power increased. Macro-prudential standards in place and the structural characteristics of household credit also contribute to limit the risks to financial stability posed by this sector. At the same time, the commercial real estate market is continuing to contract due to a combination of structural and cyclical factors, but the French financial system's exposure to these assets remains moderate.

Despite the more volatile environment, the French sovereign debt market benefits from a diversified investor base

Greater political uncertainty and the worsening fiscal outlook have led to a widening of the yield spread between French and German sovereign bonds. Nevertheless, the state's borrowing costs declined between May and December 2024, as the widening of the spread was offset by the fall in inflation and expectations of a more accommodative monetary policy. As sovereign bond yields serve as a benchmark for the rest of the economy, it is essential to clarify the path of public finances in order to ensure that businesses and households’ financing conditions remain favourable.

The French sovereign debt market has a diversified investor base and is fully operational. Demand for French sovereign debt still appears strong on the primary market and liquidity conditions remain very good on the secondary market. The investor base on the French sovereign debt market is diversified, with an increase in the share of non-resident investors since 2022, in the context of the reduction in the size of the Eurosystem's balance sheet. However, increasing political uncertainty is also prompting some investors to adopt a wait-and-see attitude. While there are still large volumes of sovereign debt to be absorbed by the market, in France as in other developed economies, it is essential to maintain the conditions that make it attractive.

Uncertainty could lead to more frequent spikes in market volatility, with the risk of a disorderly correction.

French and European equity markets underperformed their U.S. counterparts in 2024. European equities gained almost 10% between January and mid-December 2024, while their U.S. counterparts returned 28% over the same period. Subdued growth prospects, heightened political uncertainties and fears of an increase in protectionist measures around the world all help to explain the weaker performance of European equities, and French equities in particular. At the same time, U.S. markets remain underpinned by stronger short-term growth expectations.

Market volatility remains limited, but the frequency of stress episodes could increase as traders become more sensitive to macroeconomic and political surprises. The heightened sensitivity of market participants to economic surprises, particularly relating to the US economy, and to political and geopolitical uncertainty could result in further spikes in volatility on equity and bond markets. This risk is compounded by the high concentration of market capitalisation among a small number of stocks, particularly in the United States. Furthermore, the cryptoasset market, which surged in the wake of the U.S. election, is structurally volatile, and its lack of regulation is a risk factor.

The spike in volatility on global markets on 5 August 2024 is a reminder that the vulnerabilities specific to nonbank financial intermediaries (NBFIs) are likely to exacerbate downturns in the financial markets. On 5 August 2024, markets briefly overreacted to U.S. economic data and Japanese policy announcements, leading to an unprecedented spike in the U.S. equity volatility index. These swings were amplified by low liquidity and massive unwinding of highly leveraged positions (carry trades), particularly by hedge funds. These tensions were quickly resolved, but they once again highlighted the vulnerabilities of certain non-bank players. In particular, high leverage and liquidity constraints may force these players to unwind their positions, with the risk of procyclical effects amplifying market stress. These vulnerabilities underscore the need for an appropriate regulatory framework for non-bank intermediaries.

The soundness of the banking and insurance sectors is contributing to resilience

French banks have diversified business models and their solvency and liquidity levels are still well above regulatory requirements. The Liquidity Coverage Ratio (LCR) of French banks is close to 147% at the end of September 2024, well above the 100% required by the prudential authorities, while the share of high-quality liquid assets has remained stable since 2022. The banking sector also benefits from high and generally stable capital ratios, which contribute to its resilience. French banks have diversified business models, which contribute to their stability, even if their profitability remains lower than that of their euro area peers, due in particular to slower growth in interest income due to the predominance of fixed-rate loans.

Despite a slight increase, French banks' credit risk remains under control. The non-performing loan ratio in their balance sheets stood at 2.61% in the third quarter of 2024, up slightly on 2023 but still close to historic lows. The six major French banking groups have limited exposure to French government debt, which accounts for 3.3% of their total assets and 71% of their Common equity Tier 1 (CET1) capital. Their financing conditions on the markets are stable, with contained credit risk premia.

Insurers have also maintained a robust balance sheet structure. Insurers' holdings are concentrated in highquality, liquid assets, while their exposure to commercial real estate remains limited. However, insurance companies may find it difficult to reinsure certain extreme risks against a backdrop of increased geopolitical risk and more frequent and severe natural disasters.

Cyber and climate risks are better identified but financial institutions must continue to take actions to address these risks

The number of cyber attacks has stabilised, including in the financial sector, but risk remains high in a difficult geopolitical environment, resulting in a variety of hybrid threats. Phishing attacks remain the main threat for all sectors, while the development of artificial intelligence tools is likely to create new vulnerabilities. The Digital Operational Resilience Act (DORA), which will come into force in January 2025, will enhance the resilience of financial institutions to cyber threats by requiring, among other things, formalised risk management and better coordination of responses to incidents. As regards supervision, the European Central Bank (ECB) also organised its first cyber stress test from January to July 2024 to gauge how banks would respond to and recover from severe but plausible cybersecurity incidents.

The climate and environmental crisis requires continued international coordination. The Central Banks and Supervisors Network for Greening the Financial System (NGFS) is actively pursuing its work, which is contributing to a better understanding of the effects of climate change and the biodiversity crisis on financial stability. The Banque de France and the Autorité de contrôle prudentiel et de résolution (ACPR) are also fully committed to the various international initiatives on climate risk. However, the change of administration in the United States raises questions as to whether multilateral work in this area can continue, without calling into question the efforts of the NGFS coalition of the willing.