Disorderly Brexit biggest risk to financial stability – Central Bank

Disorderly Brexit biggest risk to financial stability – Central Bank

A new review from the Central Bank shows that the main risk to the country’s financial stability and the wider economy is a larger than expected macroeconomic shock in a case of a disorderly Brexit.

As well as Brexit, the other risks to the financial sector are related to external developments and include a sudden tightening in global financial conditions and a re-emergence of sovereign debt sustainability concerns in the euro zone.

Domestic risks facing the financial sector include an abrupt fall in Irish property prices and banks’ profitability as well as the possibility of elevated risk-taking behaviour in the banking sector.

The Central Bank’s first Financial Stability Review outlines key risks facing the financial system and assesses the resilience of the economy and financial system to adverse shocks.

It is not aimed at providing an economic forecast, but instead focuses on the potential for negative outcomes to materialise.

The Central Bank cautioned today that the risks to the country’s financial stability have increased slightly over the last six months and some of the possible triggers have now become more imminent.

It noted that global growth prospects have been downgraded and the trade row between the US and China has created increased uncertainty about global trade deals.

A key lesson from the last crisis is that different risks can crystallise at the same time, challenging financial stability, and the Central Bank said it is key to recognise that the risks could interact.

“For example, a disorderly Brexit would act as a trigger for an abrupt tightening in global financial conditions and lead to a macroeconomic disruption in Ireland, both of which would have adverse implications for domestic property prices,” it cautioned.

However, the Central Bank also said that the banking system here has strengthened considerably in recent years – despite vulnerabilities remaining.

It noted that domestic lending is now funded mainly through retail deposits, rather than less stable sources of short-term, wholesale financing.

Non-performing loans on the banks’ balance sheets have fallen by 79% since 2014, however they still remain higher than international standards, it also noted.

“Overall the banking system is now better able to absorb shocks, rather than amplify them,” the Central Bank wrote in today’s review.

But it added that further progress is needed to strengthen resilience and maintain sustainable profitability in a changing operating environment.

It also warned that while domestic households and companies have also become more resilient, a significant number of consumers with restructured mortgages could be especially vulnerable to economic stress.

The share of mortgage holders in negative equity has fallen from 40% in 2012 to 5% last year, but the Central Bank said the level of average household debt to income – which stands at 123% – is also high compared to international standards.

Last November, the Central Bank concluded its most recent review of the mortgage measures and decided to make no changes to its loan-to-value or loan-to-income limits or exemptions.

The bank said the measures were meeting their objectives in guarding against an excessive loosening of underwriting standards, strengthening both borrower and lender resilience, and minimising the potential for a credit-house price spiral emerging.

But it said that after consultation with the Minister for Finance, the Central Bank in June decided to exempt “lifetime mortgages” from the loan to income limit.

Lifetime mortgages are equity-release home loans to elderly people whose debts are later repaid from their estates after they die.

“These products do not have a contractual regular repayment of capital and interest, so the affordability of regular repayments, which is a primary concern of the LTI limit, is not applicable in these cases,” the Central Bank explained.

Meanwhile, the level of debt owed by SMEs to Irish banks has fallen by more than a third over the last five years and SMEs are increasingly using retained earnings to fund spending and investment rather than borrowing.

“As a small and highly globalised economy, with a particular reliance on activity from foreign multinational companies, Ireland is both more sensitive to developments in the global cycle and more prone to structural macroeconomic shocks,” commented acting Central Bank Governor Sharon Donnery.

Ms Donnery said it is critical that the Central Bank continues to identify, plan and prepare to mitigate the impact of those shocks, should they materialise.

“Building a resilient system is central to this. Resilience is not something that can be built after an event, but is something that should be in place well before any issues arise,” she added.

The Central Bank also said today that it has kept its Countercyclical Capital Buffer (CCyB) rate at 1%. The CCyB aims to strengthen the resilience of the banking sector to a future downturn.

It said it stands ready to adjust the rate in either direction “as the risk environment evolves in a manner consistent with the objective of mitigating procyclicality and supporting a sustainable supply of credit to the economy”.

The Central Bank said its macroprudential policies, which currently include its mortgage measures, the CCYB and capital buffers for systemically-important institutions contribute to safeguarding financial stability here.

The Minister for Finance today has confirmed that the power to set a Systemic Risk Buffer is to be granted to the Central Bank, which will complete the macroprudential framework for bank capital, it said.

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