The European Central Bank has published an assessment of the stability of the euro area financial system, which finds that the strength and resilience of the system has improved over the past six months.

However, financial imbalances have grown larger and seem likely to continue expanding, primarily at the global, but also at the euro area, level.

Continued strength in the pace of global economic growth in 2005 (despite further oil price rises), low interest rates in the euro area and indications of a further improvement in corporate sector credit quality provided a favourable environment for financial institutions and markets, the ECB says.

“Global credit markets successfully weathered a test of their resilience in the first half of the year, prompted by the downgrading of two large U.S. automobile manufacturers. In addition, the conditions for raising funds in equity markets remained favourable, and financial market volatility stayed very low across most asset classes,” it reports. “In this environment, there was further and broad-based improvement in the profitability of banks, and the balance sheets of insurance companies were strengthened. In addition, key financial infrastructures – including payments systems, and securities clearing and settlement systems – remained robust and continued to operate smoothly.”

However, several potential sources of risk and vulnerability have grown in importance in the past six months, the ECB notes. “Despite recent improvements, the durability of euro area banking sector profitability could be tested in the period ahead, especially if long-term interest rates remain low for a protracted period. Declining loan loss provisioning flows could also adversely affect the ability of banks to cope with unforeseen disturbances,” it says.

“In addition, the possibility exists that a reappraisal could take place with regard to far-reaching market risks stemming from the aggressive search for yield that began in the course of 2003. This has left some financial markets and institutions vulnerable to changes in global liquidity conditions and unexpected credit events,” the ECB adds. “A disorderly correction of the level of long-term yields could potentially disrupt the intermediation of funds through global capital markets, which would have implications for the euro area. Moreover, some euro area financial institutions, including banks, would be likely to endure losses – at least in the short term – from an upturn in long-term interest rates.” On the other hand, the ECB suggests that the life insurance industry would most likely benefit as this would help to relieve remaining balance sheet vulnerabilities.

“Looking ahead, the risk of an abrupt unwinding of global imbalances remains, especially because these imbalances may yet widen further,” it cautions. “It also cannot be excluded that further oil price increases could test the resilience of firms’ balance sheets, especially those of small and medium-sized enterprises. Household balance sheets may also be vulnerable in countries where house prices seem to have risen beyond their intrinsic value.”

“Overall, with shock-absorption capacities improving, but risks and vulnerabilities rising, the financial stability outlook continues to rest upon a delicate balance. While the probable outcomes could, at this stage, best be described as bi-modal, a positive outcome remains the most likely prospect in the period ahead,” it concludes.