 Financial stability is a term that has been popping up a lot in recent months. Bank failures in the US and Switzerland have people asking how stable our financial system is, while high inflation and interest rate hikes continue to affect people, banks and companies. We've just released our latest financial stability review, which twice a year looks at just that. Today, we'll talk about whether our financial system is stable, and we'll take a closer look at the risks we see for two big areas, banks and property markets. You're listening to the ECB Podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. I'm joined today by John Fell, who works in our financial stability department here at the ECB, and is actually a regular guest here on the podcast. Nice to see you again, John. Thanks, Katie. It's great to be back. Now, I say it almost every time, John, but it's only been six months since we last spoke, and once again, quite a bit has happened. Some good, some not so good. On the one hand, energy prices have come down, and the supply chain disruptions that we saw across the world are easing. The economy is continuing to recover from the pandemic, and companies are making good profit, so that's all very positive. But on the other hand, inflation is still high, and rising interest rates are weighing on people's debt burdens. Now, more recently, huge shocks in the US and the Swiss banking sectors caught everybody off guard, I think it's fair to say, and this has shifted more focus onto the resilience of banks in this new environment. Now, John, there is really a lot to unpack in this edition of the report, but I want to talk specifics with you. Can you tell us one positive thing that you've seen over the past six months, and perhaps two things that you're worried about going forward? Sure. I'm glad you asked for a positive, as we do aim for balance in our assessments, and this edition is by no means all doom and gloom. At a moment when sentiment towards the banking sector, as you mentioned, basically across all advanced economies turned decisively negative, I think the silver lining has to be the resilience of euro area banks. If you just look at bank stock prices, markets have clearly discriminated in favor of euro area banks, and that's something we haven't seen in the past. And it's in large part thanks to all the effort that went into strengthening banks' capital and also their liquidity offers. But it's not only that. Banks' asset quality has improved to a point where non-performing loans, but here I mean non-performing non-racials, really couldn't get much lower. And many banks have reported strong profits for the first quarter of the year. So we still think the main sources of risk reside outside the banking system. Okay. So what are the things that are worrying you then? Okay. So on the negative side, and you asked for two. So first, I mean, after the exceptionally strong rebound in financial markets at the start of the year, I think we can say that some of the old concerns have returned. So asset valuations are stretched again, and as central banks have been pulling back from asset purchases, that's basically meant the two-way risk has returned while market liquidity is eroding. And that's making markets, especially bond markets, vulnerable to adverse dynamics or episodes of intense volatility. And second, even though there are signs of vulnerabilities in the non-bank sector are easing, we see investment funds adopting more cautious strategies, for example. We still have concerns that some of them may not be holding sufficient amount of liquid securities to cope with stress. By liquid securities, I mean assets that could be easily sold, if necessary, and quickly without moving prices. We know that investors are often spooked by unusually large asset price declines. And in situations like that, some can even panic and look for their money back. Holding liquid assets allows funds to absorb shocks like that are, if they're using derivatives, to meet margin calls. But if they don't have sufficient amount of liquid assets available, they might find themselves in a situation where they're forced into selling less liquid assets in a hurry, and of course at low prices. And that could amplify market stresses even further. So these two negatives have the potential to reinforce one another. Okay, so we're going to be keeping an eye on markets and non-banks. And I'm hearing that liquidity is really the word of the moment there. Let's zoom in now on one area that you've already mentioned and where we've seen a lot happening since we last spoke, and that's banks. Now we had three US banks failing in the space of just a few weeks. And during that time, Global Bank Credit Suisse was also taken over by UBS in Switzerland. For some, it no doubt brought back memories of the fear and the turmoil of 2008. John, can you talk us through how this episode has affected banks here in the Euro area? You won't find anything in the last issue of our episode. So that's a November issue, suggesting that the epicentre of financial stability was lurking in the banks. And if you were to leave through the pages of the financial stability report that the Fed published last November, there are a few hints there either. So it's really been a complete surprise. It has been a total surprise. But the effects on Euro area banks were very limited. We did see large drops in bank stock and bond prices, especially on so-called AT1 instruments, and also credit defaults spreads widened. But there were no serious stresses of the kind that we saw in 2008. And tensions eased very quickly. So why was that? Well, I mean, banking crisis can spread through at least three channels. And so let me just mention those channels, interconnection between banks, common exposures to the same risks, are simply swings in confidence or sentiment. So if we think about the first channel, all of the banks that failed in the U.S. were regional banks. So they were not international banks, but regional banks. And also by definition, interconnection with Euro area banks was, there was somebody who was very, very limited. As for common exposures, the idiosyncratic business model of Silicon Valley Bank is often pointed out as setting it apart. There was an article in the Wall Street Journal where there was a quote, for startups, all roads lead to Silicon Valley Bank. And that was true. It took deposits from startups, it extended loans to them, and it even invested in them. And that business model was working fine as long as the tech sector was booming, as it did during the pandemic. Deposits were coming in, and the funds were sent back out to work in the tech sector. The music stopped, though, when the loan demand of tech firms weakened, and the deposits were continuing to flow in. So the bank needed to earn an income to pay those deposit depositors, many of whom had large accounts, well in excess of the $250,000 deposit insurance threshold. So that's basically how much the government, 250K is how much the government would pay back immediately in the case of a bank, bank failure. And so to pay the depositors, it chose to do that by investing in U.S. treasuries. Now, essentially what the bank was doing was taking two massive bets. The first was betting that interest rates wouldn't rise, and the second was that their clients wouldn't withdraw their deposits. Of course, as we saw, neither of those bets paid off. In fact, deposits left because interest rates rose, but depositors fleeing on a scale and at a speed never seen before. Now, there are no systemically important banks in the Euro area with business models like that. And so up to a point, the common exposure channel has not really been relevant in the Euro area either. Now, I say up to a point because it's not uncommon for banks to invest in government securities, but not on the scale that Silicon Valley bank did. So, I mean, it's positive for Euro area banks, but it's not that we didn't feel it at all in the Euro area, right? Right. There was substantial repricing of Euro area bank stocks, bond prices also. Arguably, the confidence channel was relevant here with the investors in bank securities asking what I would say, describe as what if question. So, the pricing of complex securities like 81s is based on assumptions and probabilities. Now, if those assumptions are questioned or if those probabilities change, that can be a recipe for repricing and also volatility. Now, after Silicon Valley bank was closed by the FDIC, investors in Euro area banks were asking how would the value of senior bonds be affected if all depositors, so that's both insured and uninsured, were made whole in a resolution. Now, as that is not foreseen in the European resolution framework, it would actually make them worse off. Likewise, after Credit Suisse was taken over by UBS, markets were surprised by the full write down of 81 bonds. Now, this time we, and here I mean the ECB together with the EBA and the single resolution board came out rapidly with the communication which clarified that this is not foreseen in the EU framework. And from the feedback that we've heard from market participants, that helped to ease the tensions. Okay, so that's good news. But is there anything in the turmoil that could be seen as a warning flag for us here in the Euro area or even a lesson to learn? So, the turmoil, I mean it's really raised many issues across the effectiveness of market discipline, regulation, supervision, resolution frameworks. The list is too long to go through everything. But on the positive side and with all the shocks that banks have had to contend with since the outbreak of COVID-19 and since we've been doing these podcasts, followed by the Russian invasion of Ukraine. And now this, I think we have evidence that Basel III has genuinely helped in safeguarding financial stability. Okay, so Basel III, they're the rules that govern things like capital for banks, capital requirements. Exactly. And then we've also learned that bank resolution choices made in one jurisdiction can have spillovers to other jurisdictions. So the what-if questions that I mentioned, that's new. But if I was to pick out one lesson, the speed and scale of bank runs witnessed in the US really stands out as a warning flag. Now there was a study published very recently by the Federal Reserve Bank of St. Louis that compared the three recent runs on US regional banks with earlier episodes. So for example, in the case of Washington Mutual Bank, that was the largest US bank failure in September 2008, 10% of deposits were lost over 16 days before it failed. Now fast forward 15 years and Silicon Valley Bank lost 25% of its deposits in a single day. And had it not been closed, it could have lost a further 62% the next business day. It was incredible. We haven't seen anything like that before. But the case was special as many of the depositors knew one another personally, and that appears to have speeded up the run. But if you look at also at first Republic, I mean that's the latest recent failure in the US, 57% of its deposits were lost in about 10 days. So in comparison with Washington Mutual, you could say that the intensity was about five times greater. So I mean you say that the speed and the scale of these bank runs really stood out, but what exactly contributed to it? What was behind it? Well the factors that are often cited as drivers of the speed and scale of bank runs include the share of insured deposits in the total, insured depositors won't run, electronic banking and the influence of social media in spreading information. That was something quite new I'd say here compared to 2008. It was and I think care is going to be needed in the final diagnosis of the role of each of those factors and the role that they played in what we saw. Now it certainly looks like social media in combination with electronic banking speeded up the runs. But then look at the funding of Silicon Valley Bank, 6% of the depositors were insured. So 94% were not and their incentives to run were huge. If you look at Washington Mutual, more than 74% of deposits were insured and that might explain why we saw lower intensity in that run. Now if it does turn out to be the case the flip side of all of the benefits that we've been enjoying of electronic banking is the potential for faster runs then that could well have implications for the amounts of liquid assets that banks will need to hold to avoid situations where liquidity stresses are transformed into solvency crisis and so quickly the crisis managers don't even have a chance to respond. Okay so this kind of leads on to another important topic in the financial stability review and it's something we've talked about before John and that's bank profitability. Now a lot of factors go into how profitable a bank is and if we just think about where we stand right now after years of cheap money it's got more expensive for banks to get funding because we're raising interest rates here at the ECB to fight inflation. Now previously on the podcast on we've talked about how banks profitability has been low and that's something that we've been concerned about. How do things look now for banks in this new environment? So I mean as interest rates have been rising banks are having to pay more for their funding as you said and that's particularly true for market funding and just to give an idea the average rate that banks were paying on senior unsecured bonds at the end of 2021 so 18 months ago or so it wasn't much more than 0%. Now they're paying closer to 4% that's a big change but the contribution of bond funding to the total is only about 15% so banks only get about 15% of their funding on average from the bond markets far more important are deposits and they account for about they account for about 70% of banking sector funding. That's a big amount much more than I expected. It ensures stable funding for the banks and I mean also as interest rates have risen banks were able to pass through higher interest rate costs actually far more rapidly to their loans than to their deposits. Now we've seen it in the in the first quarter financial results of the banks this has given a boost to their profitability so that's yeah the higher interest rates so far have boosted the profitability but we don't expect that to last for too long as we again the ECB that is retreat from asset purchases and as TLGRO funding is repaid that's going to induce more competition among the banks for funds so we can expect further pass through the deposits over time and that's going to erode that boost that we've seen profitability. Okay I want to revisit a different topic now that we spoke about in our last episode back in November John and that's real estate markets. Now back then we discussed that although house prices were still rising there was a possibility of things being at shall we say a turning point after a very long boom cycle. What exactly have we seen in the last six months how things developed since then? So well first of all if I look at housing markets first they've continued to show signs of cooling down now that was to be expected as affordability obviously worsens as interest rates increase. So by cooling down you mean that prices aren't rising as fast as they were? Or even that in some cases declining but the downturn has been orderly so I mean nominal prices are below their peaks in some countries but so far if you compare year on year house prices so comparing how they are today relative to a year ago they're still actually positive during the final quarter last year. Now that said disorderly adjustment can't be ruled out now because we haven't seen the full pass through. Higher interest rates are going to raise mortgage borrowing costs and that's a process that is obviously taking place more rapidly in countries where people have variable rate mortgages but that's the prevalent way of borrowing to buy a house. Now some indications of this I think were apparent in the sharp reduction of mortgage demand that was revealed in our latest bank lending survey and we also saw in that survey the simultaneous tightening of credit standards by banks for mortgage lending and that suggests uneasiness let's say among banks to increase their housing market exposures. So that means that they're basically making it harder or they're making their standards more restrictive for people to get mortgages? Yes. And how about the commercial real estate front? So I mean on commercial real estate the downturn is it's more firmly entrenched the first quarter data that we've seen it's reported in our review which shows valuations and transactions are both contracting and they're contracting at double digit rates. Now it looks like what's happening is demand has declined but we think that supply has reduced as well so that liquidity in the commercial property market has been eroded too so you might ask why might that be? Well the way I think about it is that just like the denial stage of the five stages of grief it can take time for valuations to reflect the true market reality and so unwillingness to sell at low prices might explain why we see low transactions now but ultimately the future market dynamics are going to depend on the cash flows the rents basically that are generated by those properties and they are vulnerable to things like for example adverse economic surprises or interest rate surprises. Well I don't think I've ever heard the five stages of grief being used for real estate markets but that's super interesting thank you so much John as always this has been a really insightful conversation and I hope that the next few months will bring some calm on the financial stability front. Now before we wrap up we ask all our guests on the podcast for a hot tip linked to the topic that we've been discussing today so broadly speaking financial stability. John your hot tips are always very interesting and useful very practical so what have you got for us today? So since we spent a bit of time today discussing bank runs I have two movie recommendations for those listeners who would like to learn more about bank runs how they can happen how damaging they can be so the recommendations are Mary Poppins it was a 1960 movie starring Julie Andrews and Dick Van Dyke and the other is it's a wonderful life that was a 1946 movie starring James Stewart and Donna Reed. Now in Mary Poppins the trouble starts when a boy is overheard shouting give me my money back and he's shouting at the bank manager and misunderstanding what is going on one woman says to another there's something wrong the bank won't give someone their money and so you can imagine what happens next and it's a wonderful life there is a great scene after the run where James Stewart's character is in a discussion with his uncle the uncle is asking how does something like this ever start now I've I've often wondered whether these movies had provided inspiration for Diamond and Didvick to write their Nobel Prize winning paper in 1983 and that paper showed that runs can happen even when a bank is sound once depositors become nervous that other depositors will run and that they will run before they do a solvent bank can soon become an insolvent one and that was the big insight of that paper. So two really interesting hot tips again there John and they really highlight the the psychology behind it all I think as well which is is the key factor the human factor here this brings us to the end of this episode I want to thank John fell from our financial stability department for joining the conversation today thank you so much John thank you very much now listeners be sure to check out the show notes for more on this topic you've been listening to the ECB podcast with Katie Ranger if you like what you've heard please subscribe and leave us a review until next time thanks for listening