If government indebtedness reaches a sufficiently high level that it triggers a loss of confidence in fiscal sustainability, investors will require additional risk premia to compensate for having to bear greater sovereign credit risk. The resulting rise in sovereign risk premia can be passed through to private sector funding costs, especially if there is doubt about the ability of the public sector to counter adverse disturbances to non-financial and financial sectors. Chart 2 on slide 6 shows how CDS spreads for large banks have become increasingly correlated over the past seven and half months with the sovereign CDS spreads of the countries where these banks have their headquarters. Two snap-shots are shown in the chart: one for 26 November 2009 and the other for 19 May 2010. As can be seen from the chart, between these two dates, as sovereign CDS spreads have risen, so have bank CDS spreads. It is furthermore interesting to note that, in the cases where concerns about fiscal imbalances have been greater, the co-movement has been substantial. The third risk we have identified outside the euro area financial system is the possibility of vulnerabilities being revealed in non-financial corporations’ balance sheets, because of high leverage, low profitability and tight financing conditions. The balance sheet conditions for the euro area non-financial corporate sector have slightly improved since the last issue of the FSR, which has translated into a moderate lowering of the expected write-downs facing euro area banks on their corporate loan portfolios by end–2010.
The turnaround of the profitability of the LCBGs in 2009 is also attributable to a remarkable recovery of net trading revenue in the second quarter of 2009, which was more or less sustained throughout the year and in early 2010, despite a progressive lowering of market volatility, a tightening of bid-ask spreads and a stalling of the recovery in financial markets. Finally, income from fees and commissions has continued to produce a stable revenue flow for euro area LCBGs, and even increasing somewhat in the late 2009 and early 2010, boosted in particular by revenues from underwriting government and non-financial corporate sector debt securities issuances. Looking ahead, although their financial performance has much improved, the challenges facing euro area LCBGs remain considerable. The central scenario is one of subdued banking sector profitability in the short to medium term for a variety of reasons. First, the recovery in the financial markets that has taken place in late 2009 has lowered the ECB estimates of banks’ cumulative mark-to-market losses on holdings of securities throughout the entire period of the financial turmoil. However, the new estimate in the current FSR indicates that the potential cumulative write-downs on securities and loans for the euro area banking sector for the period 2007 to 2010 is EUR 515 billion, which is lower than the estimate published in the December 2009 FSR.