The French financial system's main short-term vulnerabilities have stabilised
Although they remain elevated, uncertainties connected with the Covid-19 crisis have eased. The main economies around the world are beginning to start up again as vaccination campaigns make headway.
Yet amid these hopeful developments, it is important not to lose sight of the fact that the French financial system's vulnerabilities have increased overall due to the crisis. The debt carried by the economy as a whole – but especially by non-financial corporations (NFCs) – remains the number-one area to watch in this regard. Most NFCs took a cautious tack in 2020 as they sought to obtain cash to get through a challenging period. This resulted in a sharp run-up in gross debt, but also brought a parallel and similarly sized increase in cash holdings.
By the end of the first half of 2021, gross debt was stabilising, while net debt remained at the levels reached in late 2019, owing to the simultaneous increase in cash. Although debt is still at record high levels, the fact that it is stabilising after years of trending upwards is welcome. However, initial analyses of cash accounts point to variety in corporate cash positions, notably according to sector and size, indicating that some firms have used the cash that they acquired during the crisis. The sustainability of debt taken on during the crisis is a major question. Some firms will need to strengthen their capital to facilitate the financing of productive investments whilst supporting their solvency and future profitability.
Financial markets adjusted their expectations to reflect the prospects of higher US inflation in light of the recovery taking shape globally, which looks set at this stage to be more vigorous in the United States than in Europe. This propelled US interest rates upwards, which did not make a structural difference to the low interest rate environment but which did exert a moderate upside impact on the euro area interest rate universe. The low interest rate environment also offers explanations for several volatility-generating market events reflective of a hunt for returns by investors. Although these one-off developments did not have systemic effects, they highlight intrinsic vulnerabilities.
If interest rates were to rise from their current low level in the euro area, the scale of the associated impact would vary across different categories of participant. Non-financial participants and the central government borrow at fixed rates and at medium/long-term horizons, so an interest rate shock would not be reflected in their overall borrowing terms unless it was permanent and gradually affected their interest burden. In the case of financial intermediaries, interest rate risk is covered by regulations, and higher market returns could ease asset/liability management restrictions for insurers, while rebuilding bank net interest margins. Meanwhile, market valuations would see greater volatility, with potential impairment for some financial assets, based on the magnitude of the shock.
The interest paid by the French central government has decreased over the last two decades, reflecting a fall in the cost of servicing government debt, despite an increase in the volume of that debt. In return for helping to cushion the blow of the health crisis for French economic participants, issuance of government debt went up sharply. The increase in interest rates during the first half of 2021 was sufficiently small that it did not affect the central government's repayment capacity. But it serves as a reminder that market conditions may change and that a long-term deleveraging strategy is a requisite condition for the central government to be able to play its role in absorbing economic shocks again in the future.
From the perspective of French credit institutions, the steepening yield curve could help to mitigate risks to future profitability. Against a backdrop of upbeat earnings reports in first half of 2021 and continued favourable Eurosystem refinancing conditions, the main French institutions saw their market valuations increase. While levels remain low from a historical perspective, the appreciation reflects a return not only of investor appetite but also of confidence in the soundness of financial participants. And indeed, bank regulatory ratios remain solid: solvency levels edged upwards in 2020, leverage was steady and liquidity ratios rose significantly. Insurers are in a similar situation to banks, reporting regulatory ratios that are well above minimum levels.
Growing vulnerabilities linked to the adjustment to structural changes
The economy's digital transition, which is having a major impact on the financial sector and payment instruments, gained momentum amid the Covid-19 crisis. Traditional bank business models must adjust to respond to the emergence of new ways of consuming financial services and new competitors in the provision of these services, a process entailing major technological investments and impacting banks’ profit & loss accounts in the short term.
The accelerated pace of digitalisation could also increase vulnerabilities to cyber-attacks, whose nature and size could take on systemic qualities.
Another key challenge concerns climate-related issues, particularly via the risks linked to the transition to a carbon-neutral economy, as well as the physical risks associated with climate change. While these risks may seem far off, initial analyses by the international community – in which the Banque de France and the Autorité de Contrôle Prudentiel et de Résolution (ACPR – Prudential Oversight and Resolution Authority) have played a trailblazing role – show that introducing measures immediately and smoothing them over time would create the fewest vulnerabilities and be most effective for financial stability. This was one of the findings of the pilot climate risk exercise for insurers and banks conducted by the ACPR and published in May 2021.
The financial system continues to display factors of resilience
In the face of these clearly identified vulnerabilities, which remain elevated, the financial system continues to display factors of resilience that allow it to perform its overall role in financing the real economy. The economic and financial stress of 2020 took place at a time when financial institutions were reporting high levels of solvency and liquidity; it nevertheless revealed that some segments of the non-bank sector needed to improve their resilience further. International work was begun in this area, led by the Financial Stability Board, with particular emphasis on money market funds.
Authorities also deployed an arsenal of measures to combat the effects of the health crisis. These measures will have to be withdrawn gradually once the crisis is over. Reflecting this situation, the updated matrix of risks in this assessment shows factors of resilience alongside identified vulnerabilities.