On the same day that the Bank of Canada warned that risks to the financial system haven’t abated, the European Central Bank echoed that position, as it also worries that a weak economy could undermine progress to repair the financial system.

The ECB said Monday that many of the downside risks to euro area financial stability that were identified in the December 2008 issue of its financial stability review have materialized. “In particular, the further significant deterioration of global macroeconomic conditions, as well as sizeable downward revisions to growth forecasts and expectations, have added to the stresses on global and euro area financial systems. The contraction of economic activity and the diminished growth prospects have resulted in a further erosion of the market values of a broad range of assets,” it said.

Large banks have been adjusting to the weak economic environment by deleveraging their balance sheets, it said, “although this has been hindered by the illiquid and stressed conditions that have characterised many financial markets.”

“The adjustment of bank balance sheets has entailed adverse feedback on the market pricing of assets and on banks’ financial intermediation role of channelling funds from savers to investors. Moreover, increasing signs of an adverse feedback loop between the real economy and the financial sector have posed new challenges for the safeguarding of financial stability,” it warned.

It notes that policymakers’ efforts to ease financial market strains have helped narrow money market spreads, yet it notes that illiquid assets remain on bank balance sheets, “and the marked deterioration in the economic outlook has created concerns about the potential for sizeable loan losses. Reflecting this, uncertainty prevails about the shock-absorption capacity of the euro area banking system.”

Similar to the Bank of Canada, the ECB worries that a deeper, more prolonged global economic downturn could lead to further risks materializing, including the possibility of: a further erosion of capital bases and the risk of a renewed loss of confidence in the financial condition of large banks; significant balance sheet strains emerging among insurers; and, more widespread asset price declines coupled with high volatility.

It concludes that “policymakers and market participants will have to be especially alert in the period ahead. There is no room for complacency because the risks for financial stability remain high, especially since the credit cycle has not yet reached a trough.”

“Banks will, therefore, need to be especially careful in ensuring that they have adequate capital and liquidity buffers to cushion the risks that lie ahead, while providing an adequate flow of credit to the economy. Over the medium to longer term, banks should undertake the appropriate restructuring to strengthen their financial soundness and resilience to shocks. This may well include adapting their business models to the challenging operating environment,” it adds. “At the same time, banks should be alert in ensuring that risks are priced appropriately, but not excessively or prohibitively so.”

It also encourages banks to take advantage of the commitments made by euro area governments to support the financial sector, “in order to improve and diversify their medium-term funding, enhance their shock-absorption capacities and protect sound business lines from the contagion risks connected with troubled assets.”

IE