The fight against inflation is not only about the trade-off between recession risk and price stability. Financial stability has become part of the debate. The most recent Financial Stability Review published by the European Central Bank took stock of the vulnerabilities of the European financial system. It highlighted three main risks: volatility in the financial markets, the rise in non-performing loans (NPLs) and the vulnerability of low-income households.
Risk of amplified stress
On markets first, the ECB observed that “the risk of disorderly adjustments has risen with increased market volatility”. Volatility in equity, bond and other markets has risen sharply, along with greater uncertainty about inflation. Despite sharp and widespread asset price corrections, valuations remain vulnerable to the risks of higher inflation and interest rates, the report stated.
The ECB fears that current market stress could be amplified by declining market liquidity and margin calls. The decline in risk appetite is affecting the liquidity of corporate bond markets, especially for the high-yield segment. Unexpected increases in margin requirements could reignite the momentum of the liquidity rush. It was such a scenario that precipitated the last financial run in the UK and cost Liz Truss her job as prime minister.
High volatility, re-pricing risks and liquidity difficulties also make disorderly stress in markets and non-bank sectors more likely. “Structural vulnerabilities of non-banks continue to require a comprehensive and decisive policy response,” said the ECB, which traditionally is in favour of stricter supervision of non-bank funding channels.
Luxembourg banks face fewer NPLs
While banks have been benefiting from the rise in interest rates, they will have to face an increase in non-performing loans. Threats to asset quality may require higher provisions, the ECB stated. The ECB nevertheless noted that the level of non-performing loans was historically low at the beginning of 2022. It reached 2.35% at the end of the second half of the year, with an increase of 80 basis points since the beginning of the year. The cost of risk has also risen from 0.43% to 0.78%.
Households are the main beneficiaries of loans granted by the euro area banking system. In the second quarter of 2022, secured mortgages accounted for more than 75% of household debt on banks’ balance sheets, while unsecured consumer loans accounted for another 10%. 70% of this debt is attributable to high-income households, compared with around 13% to the lower income quintiles. The 13% figure tells ECB experts that the problem will not be systemic.
According to the ECB, Italian, Portuguese, Greek and Cypriot banks are the most threatened by the phenomenon of increasing non-performing loans. French, Irish and Luxembourg financial institutions appear to be the least sensitive to this risk.
However, the ECB acknowledges that the housing market downturn could increase the vulnerability of households, especially low-income households, for whom income pressure and reduced savings could lead to debt servicing problems.
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