The European Central Bank said euro-area governments must swiftly implement the reforms they agreed to at a Dec. 9 summit to reduce the risk of the sovereign debt crisis spreading.
The possibility that more governments will face difficulties refinancing their debt “remains among the most pressing risks to euro-area financial stability,” the ECB said in its biannual Financial Stability Review published in Frankfurt today. “A swift and complete implementation” of the measures announced by European leaders “would mitigate this risk considerably,” it said.
The debt crisis has already taken on systemic proportions not seen since the collapse of Lehman Brothers Holdings Inc. in 2008, the ECB said. Risks to financial stability increased “considerably” in the second half of 2011 as the crisis worsened and economic growth slowed.
The ECB said the main factor that could trigger an intensification of the crisis is political uncertainty in vulnerable countries combined with fiscal consolidation that lags behind targets.
Further potential triggers could be “negative news on euro-area banks’ profitability and solvency,” credit-rating downgrades, uncertainty about the details of private-sector involvement in a Greek debt haircut, and the implementation risk with respect to the European Union’s new fiscal compact and the effective size of the region’s rescue fund.
The report didn’t examine a scenario of a nation leaving the 17-nation currency bloc or its break-up, ECB Vice President Vitor Constancio said.
“It is really unthinkable that that could happen for all sorts of reasons, so we don’t see the need for such analysis,” Constancio told Bloomberg Television in an interview. “The consequences could be so huge and unpredictable that it’s virtually impossible to plan for. It’s unthinkable in all dimensions.”
The ECB said bank earnings could be hurt should funding costs remain “elevated for a prolonged period.” Lenders could also reduce credit should their access to funding markets be impaired to the degree that they’re forced to engage in or accelerate deleveraging of their balance sheets.
While there are still risks in the sector from the “heavy reliance” of some lenders on “short-term and volatile” U.S. dollar funding, these have been alleviated by foreign-exchange swap lines between central banks, it said.
“Looking ahead, leading indicators of the euro-area business cycle point to an ongoing weakening,” the report said. “In line with experience following past financial crises, the recovery is expected to remain muted, implying a slow narrowing of the output gap.”
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