The deteriorating global economic outlook and the geopolitical tensions have heightened the uncertainty and the risks to financial stability.
The sharp decline in interest rates worldwide is improving debt sustainability and helping to contain the rise of macroeconomic risks, although this may spur investors to seek out higher returns on risky assets and encourage the accumulation of excessive levels of debt. Protracted low interest rates may squeeze the profitability of banks and insurance companies.
Economic activity weakened in the euro area and there was an increased risk of a reduction in inflation; as a result, the ECB Governing Council adopted a broad package of expansionary measures. The new measures include provisions to mitigate the impact on banks' profitability arising from the further reduction of the already negative deposit facility rate.
European banks are continuing to gradually strengthen their balance sheets and the sector is sound overall, although there are still pockets of vulnerability. Banks' profits are still low as are price-to-book ratios for shares, especially for banks that are larger and more complex. In several countries, there has been an increase in risks arising from a potential overvaluation of property prices and from household indebtedness.
In Italy, the risks to financial stability have abated somewhat in recent months, following the decline in sovereign risk premiums. The deterioration in the macroeconomic outlook and the high level of public debt continue to represent a source of significant vulnerability and expose the entire economy to the risks associated with a reigniting of market tensions.
The weak cyclical conditions are negatively impacting firms' profitability, but the adverse effects on their ability to repay debts are being mitigated by the low interest rates. Households' financial conditions remain sound. The reduction in interest rates has led to an increase in the value of financial assets and a decrease in debt servicing costs. According to our models, the share of debt held by financially vulnerable firms and households would only increase in the event of particularly adverse macroeconomic events.
Italian banks are continuing to reduce the riskiness of their assets by selling their non-performing loans and by implementing highly selective lending policies. With the easing of tensions on sovereign debt, banks have resumed the sale of government bonds. The fall in risk premiums has helped banks to place bonds on the international markets at low costs, though they remain higher than those borne by banks in the other main euro-area countries. The capital strengthening of Italian banks is continuing, albeit gradually; for some smaller banks the process needs to be intensified. The average cost of funding is close to zero and further interest rate falls could have more marked effects on profitability than in the past.
The solvency ratios and the profitability of Italian insurance companies have improved as a result of the reduction in sovereign risk. The matching of the duration of financial assets and liabilities makes the balance sheets of Italian insurers less exposed to risks arising from a prolonged period of very low interest rates, if compared with insurers in other European countries. If this scenario worsens, however, it could be more costly to offer guaranteed life insurance policies, with negative consequences for insurance companies' profits.
In Italy the investment fund sector has reached an appreciable size, even if the strong growth of past years seems to have come to a halt. The risks associated with investments by open-end funds in less liquid assets are limited to segments that represent only a very small share of the funds sector.