Assessment of Risks to the French Financial System Assessment of the French financial system - December 2022

The macroeconomic and financial environment remains highly uncertain, although the likelihood of the most adverse scenarios occurring has diminished since the summer. The global economy remains affected by multiple large-scale shocks, which are clouding the economic growth outlook and keeping inflation at an overly high level. This environment, coupled with the rapid rise in interest rates, could amplify pre-existing sources of vulnerability, particularly in connection with market volatility and weaknesses at some lightly regulated non-bank financial institutions (NBFIs). Adjustments have been orderly so far, and the main financial and non-financial participants still have significant capacity to absorb shocks. But today's uncertain setting is conducive to sizeable shocks that could lead to disorderly corrections. To ensure continued resilience, micro- and macroprudential authorities, as well as financial participants, must remain vigilant.

Major sources of vulnerability for the financial system remain in place and some are increasing

The financial system is exposed to severe volatility. Financial markets, especially equity and bond markets, have been characterised by severe volatility and lower liquidity since June, in response to the swift increase in interest rates. Localised pressures have cropped up from time to time, notably due to liquidity stress affecting some less regulated participants. Soaring gas and electricity prices on physical markets caused renewed liquidity stress on derivatives markets in August 2022. Faced with reduced supplies of Russian gas, European countries took steps to reduce the risks of shortages in winter 2022/23, but the threat persists, fuelling volatility in this market segment.

Vulnerabilities in the less regulated NBFIs could lead to disorderly market adjustments. Among these institutions, those in the weakest positions, including some pension funds, open-end funds and alternative funds, could face significant liquidity requirements in the event of market stress. Heavily leveraged participants are especially vulnerable to adverse market movements. Liquidity risk management by these entities could lead to procyclical behaviour that contributes to disorderly increases in volatility movements in certain market segments. In a volatile market environment, French investment funds showed resilience in the second half of 2022. A thematic chapter of this assessment concludes that leverage at France’s NBFIs remains under control overall. Even so, our financial system could be exposed to spillover risk via financial markets from pressures connected with non-resident NBFIs, many of which are more lightly regulated.

The financial system remains exposed to the high debt of non-financial participants. Bank lending ensured that the real economy continued to enjoy plentiful financing in the second half of 2022. As a result, however, the outstanding net debt of French non-financial corporations (NFCs) remains at a high level relative to European standards.

Households and NFCs are however insulated against increased rates by the structure of their debt, which features fixed rates and medium- and long-term maturities. As a result, they are favourably positioned compared with other European households and corporations in the current setting of rising interest rates.

Furthermore, companies’ repayment capacity is supported by profitability levels, which remain relatively elevated, while the failure rate remains contained, although it is normalising towards levels on a par with 2019. At this stage, therefore, French NFCs (non-financial corporations) look to be equipped to cope with a macroeconomic environment comprising high inflation, rising interest rates and more subdued growth, even if some sectors are in a weaker situation than others.

In addition, French households and corporations continue to benefit from access to inexpensive bank credit. Interest rates on home and business loans, while rising, remain below those seen in other European markets and are also below bond financing rates in the case of companies. France's home loan distribution model, which has been strengthened by compliance with the credit standards set by the Haut Conseil de stabilité financière (HCSF – High Council for Financial Stability), also protects households against house price volatility. In that regard, house prices continue to grow at a faster pace than during the pre-Covid period, even if transaction volumes are down slightly from the high levels of 2021.

Finally, measures to offset energy prices, the dimmer macroeconomic outlook and higher interest rates are putting pressure on France's sovereign debt trajectory. Given the elevated level of French government debt, the factors that will enable the trajectory to remain sustainable in order to preserve credit quality need to be taken into consideration now. Yet French government debt remains attractive to investors, and yield spreads over German benchmarks of equivalent maturities are moving in an orderly fashion.

The French financial system (banks and insurance companies) has the capacity to absorb significant shocks, which nevertheless require a careful monitoring

French banks and insurers have a sound balance sheet structure and continue to report healthy earnings, which stand to benefit in the medium term from higher interest rates. They are therefore well positioned to deal with a potential increase in credit risk, which has not materialised so far. Over the coming quarters, banks’ net interest margin (NIM) is poised to benefit from the positive impact of an orderly increase in interest rates, although the cost of deposits may rise slightly faster than the return on assets in the short term. Consistent with the resilience of French companies and households, non-performing loan ratios and the cost of risk remain low. However, the uncertain macroeconomic and financial environment makes it necessary to keep a close eye on provisioning policies. As at end-September 2022, the policies of the major banks looked sufficiently conservative, having regard to the resilience of credit exposures.

For insurance undertakings, the effects of higher interest rates and inflation vary across business lines. Non-life insurers offering long-term coverage are more vulnerable to the impact of inflation on the cost of claims. Meanwhile, higher rates expose life insurers to the risk of surrenders, although these remained contained and inflows stayed positive in 2022. A gradual increase in interest rates will allow insurers to reinvest in higher-earning assets as their previous investments mature.

Beyond the current uncertainties, the financial system is also facing structural risks that are increasing and require action to be taken in the near term

Extreme weather events over the summer highlighted the increased risks of a disorderly energy transition, which could push up the cost of climate risk for the financial system relative to that of a swift and orderly transition. Stress tests conducted by the ACPR and the ECB highlighted the progress that still needs to be made in terms of managing these risks. Other environmental risks, which interact with climate risk, could also affect the financial system. A thematic chapter in this report explores the risks linked to the decline of nature and biodiversity loss, whose financial materiality is now recognised by the community of central banks and supervisors.

Last but not least, geopolitical stress in the wake of the Russian war in Ukraine and the growing digitalisation of the financial sector continue to exacerbate the already elevated threat of cyberattacks. Heightened vigilance is vital to preventing attacks, which are growing increasingly sophisticated. Regulatory responses at European level will ensure that these risks are tracked and prevented more effectively.

Based on this assessment, the French financial system continues to display major factors of resilience that have enabled it to absorb numerous recent shocks in the still uncertain macroeconomic environment. However, the increase in risks in the short term calls for all financial-system participants and authorities to step up their vigilance.