ECB develops new indicators to track vulnerabilities in euro area banks

New quarterly measures aim to identify emerging capital losses and weakening profitability between regular stress tests, giving financial supervisors a more timely picture of banking sector resilience.

The European Central Bank (ECB) has developed two new indicators designed to monitor vulnerabilities in euro area banks between scheduled stress tests, providing regulators with more frequent information on lenders’ ability to withstand economic shocks, absorb losses and maintain their financial strength.

The indicators, introduced in a new ECB working paper titled Monitoring Banks’ Vulnerabilities Using Stressed Depletion Indices, are intended to provide quarterly assessments of banking sector risks. They draw on information collected through European Union-wide solvency stress tests conducted every two years by the ECB and the European Banking Authority (EBA).

The new framework addresses a gap in the existing monitoring system by allowing authorities to assess developments in banks’ financial vulnerabilities more regularly, rather than relying exclusively on periodic stress-testing exercises.

It comprises two complementary measures: the Stress Vulnerability Index (SVI), which estimates potential capital losses under adverse economic conditions, and the Profitability Vulnerability Index (PVI), which assesses banks’ ability to generate earnings and build capital internally.

Together, the indicators are intended to help supervisors distinguish between the risk of future losses and the capacity of banks to generate sufficient profits to absorb those losses when economic conditions deteriorate.

Two indicators to measure different sources of risk

The Stress Vulnerability Index focuses on the potential depletion of bank capital under particularly adverse economic scenarios. Its primary concern is the possibility of severe credit losses, especially when the likelihood of unusually large loan defaults increases.

The measure examines how much capital banks could lose under stressed conditions, taking account of credit risk and changes in risk-weighted assets. Its methodology follows the approach used in EBA stress tests, which assess how banks would perform under hypothetical economic and financial shocks.

Capital is essential to a bank’s ability to absorb unexpected losses while continuing to provide financial services. A substantial deterioration in asset quality, for example, could force a lender to use part of its capital to cover losses arising from borrowers who cannot repay their loans.

The SVI is therefore intended to capture vulnerabilities that might not yet be fully visible in current financial results but could become significant if economic conditions worsen.

The Profitability Vulnerability Index addresses a different aspect of resilience: the ability of banks to generate earnings and accumulate capital through their ordinary operations.

It focuses particularly on net interest income, which represents the difference between the interest a bank receives from lending and the interest it pays on deposits and other sources of funding. It also reflects broader pressures on earnings and operating profitability.

A bank that consistently generates strong profits can build capital internally, strengthening its capacity to withstand future losses without necessarily having to raise additional funds externally.

Conversely, a prolonged decline in earnings can weaken a lender’s ability to replenish capital, even if its immediate exposure to severe credit losses has diminished.

The distinction between the two measures is central to the ECB’s approach. A bank may face considerable potential losses under a future recession scenario while remaining profitable in the present. Equally, its immediate exposure to severe losses may decline while its earnings remain under pressure.

Assessing these risks separately allows supervisors to obtain a more complete picture of the financial system’s condition.

Historical crises reveal how vulnerabilities develop

The researchers examined how the two indicators behaved during major periods of financial instability, including the global financial crisis and the European sovereign debt crisis.

Both measures increased during these episodes, reflecting the deterioration in banking sector conditions and the emergence of wider financial vulnerabilities.

However, the profitability indicator recorded sharper increases during periods of acute financial stress, highlighting how quickly banks’ capacity to generate earnings can come under pressure when economic and financial conditions deteriorate.

The research also found that the two indicators do not necessarily move together at all times.

This divergence is important because the risks facing banks can change in different ways. The likelihood of severe future capital losses may decline even while weak economic activity, compressed interest margins or higher operating costs continue to constrain profitability.

Alternatively, concerns about a potential recession may intensify even as banks report improving earnings in the current economic environment.

Such differences mean that a single measure of banking sector health could provide an incomplete assessment. Strong current profitability does not automatically eliminate the possibility of significant future losses, just as elevated stress-related risks do not necessarily mean that banks are already experiencing a deterioration in earnings.

The two indicators are designed to identify these contrasting developments and provide supervisors with a more nuanced assessment of the risks building up within the banking system.

Implications for capital buffers and financial supervision

One of the principal applications of the new indicators is to support decisions on prudential safeguards, including whether authorities should introduce additional protections, increase existing requirements, maintain them or eventually release them.

Capital buffers are resources held by banks to absorb losses during difficult economic periods. They are intended to help lenders remain operational during downturns and reduce the risk that financial distress will spread through the wider economy.

The ECB paper highlights a recent divergence in which the Stress Vulnerability Index remained slightly elevated despite an improvement in profitability captured by the second indicator.

This development supports a cautious approach to decisions about reducing capital buffers.

Although stronger earnings can improve a bank’s ability to withstand shocks, they do not necessarily eliminate the possibility of substantial losses under adverse economic scenarios.

Where uncertainty remains elevated, reducing safeguards solely because current profits have improved could leave the banking system less prepared for a future deterioration.

The indicators could therefore help authorities determine whether improving financial results reflect a broader reduction in vulnerabilities or merely a temporary improvement in banks’ earnings.

They may also help policymakers identify circumstances in which profitability weakens sufficiently to undermine banks’ capacity to absorb losses, even if the immediate threat of severe capital depletion appears to have receded.

By distinguishing between these developments, the framework is intended to make macroprudential policy decisions more responsive to the changing nature of financial risks.

Links to public support after the global financial crisis

To assess whether the indicators could identify meaningful banking sector vulnerabilities, the researchers also examined their relationship with the likelihood that euro area banks received state aid following the global financial crisis.

Both the Stress Vulnerability Index and the Profitability Vulnerability Index were strongly associated with the probability of banks receiving public financial support.

The researchers found statistically significant positive relationships during periods of high stress for both country-wide and bank-specific recapitalisation schemes.

Country-wide recapitalisation measures involve broader public efforts to strengthen the banking system, while bank-specific schemes target individual institutions requiring additional capital support.

The findings suggest that the indicators capture vulnerabilities associated with a greater likelihood of banks needing government assistance during periods of severe financial strain.

This historical relationship strengthens the case for using the measures as part of the financial authorities’ monitoring framework. By identifying institutions or national banking systems showing signs of heightened vulnerability, supervisors may be better positioned to assess where additional scrutiny or preventive measures could be warranted.

The results do not mean that elevated readings automatically predict a future bailout. Rather, they demonstrate that the indicators have a meaningful association with the financial difficulties that contributed to public support being required after the crisis.

A broader assessment of banking sector resilience

The ECB’s approach reflects the fact that banking sector resilience depends on several interconnected factors.

The ability to withstand large losses is one component of financial strength, but a bank must also maintain a sustainable earnings base to replenish its capital and support continued lending.

A lender can appear financially strong when profits are high, yet remain vulnerable to a severe deterioration in borrowers’ repayment capacity. Another institution may face comparatively limited immediate credit risks but struggle to absorb future shocks because weak earnings constrain its ability to build capital.

Monitoring both dimensions can help authorities identify these differences and assess whether vulnerabilities are accumulating across individual institutions or entire countries.

The quarterly frequency of the indicators is also intended to provide a more continuous picture of developments between the EU’s regular stress-testing exercises. Although the underlying information comes from tests conducted every two years, the new measures are designed to track changes in vulnerabilities on a quarterly basis.

This approach could give financial supervisors earlier indications of changing risks and help them assess whether the resilience demonstrated by banks in previous stress tests remains consistent with evolving economic conditions.

Strengthening preparedness for future shocks

The introduction of the two indicators adds another analytical tool to the ECB’s financial stability monitoring framework, with a particular emphasis on distinguishing potential solvency problems from weaknesses in banks’ capacity to generate profits.

The Stress Vulnerability Index measures the extent to which capital could be depleted under adverse conditions, while the Profitability Vulnerability Index examines whether banks can generate the earnings needed to build capital and absorb losses over time.

Their combined use is intended to improve the identification of vulnerabilities, inform decisions about capital buffers and support a more targeted response to emerging financial risks.

The historical evidence presented in the research, including the relationship between both indicators and the likelihood of state support after the global financial crisis, suggests that the measures could be useful in identifying periods when banks are more exposed to financial distress.

For policymakers, the central implication is that current profitability alone should not be treated as a complete measure of banking sector strength. Assessing resilience also requires consideration of the losses banks could face under severe scenarios and their ability to replenish capital if those losses materialise.

By providing complementary information on these two dimensions, the ECB’s new indicators aim to help supervisors maintain a clearer view of euro area banking vulnerabilities and make better-informed decisions about preserving financial stability.

By fLEXI tEAM