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

Russia's invasion of Ukraine is contributing to a downturn in the global macroeconomic environment by exacerbating pre-existing inflationary pressures and dimming growth prospects, which remain however positive in the baseline scenario of Banque de France macroeconomic projections. Price increases on commodity markets – particularly energy markets – are the main transmission channel in terms of both growth and inflation. The effects of the war in Ukraine are compounded by uncertainty over the Chinese economy, at a time when supply challenges in place since the health crisis continue to plague every link in the production chain.

Against this backdrop of higher inflation, rising interest rates in the euro area and elsewhere in the world, driven by monetary policy normalisation, represent the key factor of influence impacting the French financial system in the first half of 2022. It will be primarily through the lens of this shift and the outlook for interest rates that we review vulnerabilities of the French financial system in order to assess its risks.

French banks and insurers continue to boast high solvency and liquidity levels, enabling the former to absorb the economic consequences of the war connected with a deterioration in the credit quality of some exposures. These essentially include exposures to non-financial firms with the greatest sensitivity to higher commodity prices and inflation. The initial effects of the geopolitical shock to the French financial system were tempered by the system's modest direct exposure to Russia and Ukraine.

Normalisation, and thus an orderly increase in interest rates, should boost the net interest margin of French banks, although it may exert a negative impact on fair value portfolios during the transition phase. Higher interest rates will also improve the return on insurers’ future investments, but could introduce an increased risk of investors surrendering life insurance investments to take advantage of higher rates of return. This risk has yet to materialise, and insurers enjoy a sufficiently solid liquidity position to cope should it arise.

Interest rates are going up at a time when the outstanding consolidated gross debt of French non-financial corporations (NFCs), despite shrinking since mid-2021, remains relatively high when considered in a Europe and international comparison. While market financing rates for French companies are rising, with yields for the lowest-rated companies showing an especially pronounced increase, volumes of issuances via the bond market do not indicate any particular difficulties in accessing market financing, apart from a slowdown in issuances by these speculative-grade NFCs. Since their debt maturity profile is spread over time and as much of their borrowing is at fixed rates, French NFCs should be resilient to additional interest rate increase.

The government deficit is expected to be on a downward trajectory in 2022 and 2023, although the size of the reduction will be restricted by new budget measures, particularly connected with cushioning the effects of the war in Ukraine. As sovereign yields rise, the debt burden is expected to go up steadily in France and all euro area countries, albeit with more marked growth for certain euro area sovereign debts. The Governing Council of the Eurosystem is particularly attentive to this risk of fragmentation, which will be mitigated by tools intended to ensure the adequate transmission of monetary policy.

On the whole, households continue to enjoy a favourable situation in terms of their financial savings. Short-term vulnerabilities for the household sector remain contained at this stage. The solvency risks to indebted households linked to higher interest rates remain extremely low, since virtually all home loans are at fixed rates in France. In addition, access to credit remains favourable. Despite the normalisation of benchmark market rates, interest rates on home loans remain historically low at this stage and new loan production is extremely high, while credit standards for home loans have been significantly strengthened through decisions taken by France’s Haut Conseil de Stabilité Financière (HCSF – High Council for Financial Stability).

Given the geopolitical environment, vigilance is also being stepped up to guard against the risk of a systemically important cyberattack. A thematic chapter of this report is devoted to cyber risk and provides an overview of the threat before discussing its potentially systemic dimension and discussing regulatory and other responses.

A second thematic chapter looks at commodity markets, in view of their central role in the developments of the last six months. It describes the mechanisms underpinning the surge in prices for each commodity type, and discusses the importance of the role played by derivatives on commodity markets and the financial linkages between different categories of participants on derivatives markets. The financial stability challenges connected with the functioning of these markets, notably in connection with the liquidity stress observed in March 2022 due to margin calls, are significant and require adequate responses, including at regulatory level, to protect against new shocks going forward. In this respect, current price developments in energy commodities highlight the macrofinancial risks linked to the transition to a carbon-neutral economy. The transition is expected to be accompanied by rising fossil fuel prices, with the Network for greening the financial system (NGFS) scenarios predicting that they will double at least; this increase will be compounded by pressures on availability and/or prices of commodities, such as ores, needed for the transition. The increase in commodity prices (and hence in inflation) will be even larger and on a par with the trends seen over the last six months if the transition is delayed or disorderly. The final portion of the cross-cutting analysis addresses these aspects by examining the climate challenges raised by current developments.