ECB develops new indicators to monitor euro area bank vulnerabilities

The European Central Bank (ECB) has developed two new indicators to monitor euro area banks’ vulnerabilities between regular stress tests, helping authorities assess whether lenders can withstand future losses and maintain profitability during economic downturns. The indicators, presented in a new ECB working paper, provide quarterly updates on banking sector risks, using information from European Union-wide solvency stress tests conducted every two years by the ECB and the European Banking Authority (EBA). The Stress Vulnerability Index (SVI) estimates how much banks’ capital could be depleted under adverse economic scenarios, particularly when the risk of severe loan losses rises. The Profitability Vulnerability Index (PVI) assesses pressures on banks’ current earnings and their ability to generate capital internally, including through interest income and operating profits. Together, the indicators aim to fill information gaps between stress tests and help supervisors distinguish between potential future capital losses and difficulties generating enough earnings to absorb them. The research found that both indices rose during the global financial crisis and the European sovereign debt crisis, with the profitability indicator showing sharper increases during acute periods of financial stress. However, the indicators can also move in different directions, reflecting the difference between risks that could emerge under a severe scenario and pressures already affecting banks’ earnings. For example, the risk of substantial capital losses may ease while profitability remains weak, or concerns about a future recession may increase even as banks’ current earnings improve. The ECB said these differences can help policymakers decide when to introduce or increase safeguards, maintain existing protections or release them. The paper highlights a recent divergence in which the stress vulnerability indicator remained slightly elevated despite improved profitability reflected in the second index. This supports a cautious approach to maintaining existing capital buffers, rather than reducing them simply because banks are currently earning strong profits while uncertainty and the possibility of severe losses remain. Capital buffers are financial resources banks hold to absorb losses and continue operating during difficult periods. The researchers also tested the indicators against the likelihood of banks receiving state aid after the global financial crisis. Both measures were strongly associated with the probability of receiving public support, with statistically significant positive relationships during periods of high stress for both country-wide and bank-specific recapitalisation schemes. The findings suggest that the indicators can help identify vulnerable banks and countries, supporting decisions by supervisors and authorities responsible for financial stability. The SVI focuses mainly on potential capital losses arising from credit risk and changes in risk-weighted assets under adverse scenarios, following the EBA’s stress-testing approach. The PVI instead captures the effect of current economic conditions on earnings, particularly net interest income, which is the difference between the interest banks earn on lending and the interest they pay on deposits and other funding. The ECB said using both measures provides a broader view of banking sector resilience, helping authorities assess whether banks can withstand future shocks while continuing to generate the capital needed to absorb losses.