Financial Stability Report No. 2 - 2018

The risks to financial stability posed by developments in the world economy are increasing. Protracted trade tensions are escalating uncertainty and could have negative repercussions on growth. The ending of monetary stimulus in the United States has tightened global financial conditions, with the risk that episodes of tension could lead to a generalized increase in yields.

In Europe, the results of the EBA's stress tests show that the major banks are solid, although some vulnerabilities remain. There is still deep uncertainty about the outcome of the negotiations for the United Kingdom's withdrawal from the European Union (Brexit).

In Italy, the main risks to financial stability stem from low growth and high public debt. Uncertainty about the economic and fiscal policy stance has caused yields on public sector securities to rise sharply, also due to investors' fears of a hypothetical redenomination of the debt in a currency other than the euro. Liquidity conditions in the secondary market for government securities are tighter than they were in the early months of the year and the intraday volatility of prices has increased.

Several factors are mitigating the repercussions of the financial turbulence on the economy. Private sector debt is among the lowest in the euro area, the trade surplus is ample and the net international debt position has decreased to almost nil. The high average residual maturity of the public debt slows down the transmission of an increase in government securities yields to the average cost of the debt.

Large and lasting increases in risk premiums on government securities hinder the reduction in the debt-to-GDP ratio, affect the value of household wealth, curb lending to the private sector and make borrowing more costly, and worsen the liquidity and capital positions of banks and insurance companies.

Households' financial conditions remain solid, though the fall in security prices has already led to a decline in the value of their wealth. The capital structure of firms has strengthened in recent years, even if the cyclical slowdown is denting earnings growth.

In the banking sector credit quality has continued to improve as has profitability. The stock of NPLs is still diminishing at a fast pace. The results of the EBA's stress tests of the four Italian banks included in the sample are in line with the average results for the other European banks. The strengthening of banks' balance sheets is being adversely affected by the tensions in the sovereign debt market, which have led to a deterioration in liquidity and capital adequacy indicators and to an increase in market risks. The capital of the less significant banks would be more affected by any further falls in the value of government securities than would that of the significant banking groups.

The insurance sector is especially exposed to sovereign risk, given the investments needed to cover liabilities towards customers and the high share of government securities in these companies' portfolios. On average, solvency ratios are well above the minimum requirements; they have, however, recorded a significant reduction. Further large drops in the prices of government securities could have significant effects on the solvency position of insurers.

Financial market turbulence has been accompanied by outflows of capital from Italian bond funds. For Italian open-end investment funds the risk of increased requests for redemptions leading to a rapid unwinding of portfolios and greater market volatility is nonetheless limited.

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