In its financial review released on Wednesday 31 May, the European Central Bank presented a somber outlook, cautioning about persistently high vulnerability in financial markets that could lead to disorderly adjustments.
The fragility stems from investment fund vulnerabilities, stretched valuations, high volatility and low liquidity.
According to the report, despite some minor improvements in economic conditions, uncertainties surrounding growth prospects, coupled with ongoing inflation and tightening financing conditions, continue to exert pressure on the financial positions of companies, households and governments.
Focusing on specific vulnerabilities, firms in the euro area face tighter financing conditions and uncertain business prospects, particularly for those burdened with higher debt and weaker earnings following the pandemic.
Households, especially those with lower incomes, are feeling the impact of inflationary pressures, which are eroding their purchasing power and ability to repay loans. This has led to a significant decline in demand for new loans, particularly mortgages, due to rising interest rates.
The real estate markets in the euro area are currently undergoing a correction, with residential markets experiencing a notable slowdown in house price growth, addressing sectoral overvaluation.
While price adjustments have been relatively orderly thus far, there is a risk of disorderly corrections if higher mortgage rates further dampen demand, the ECB warned in the report.
Additionally, there is a potential for unforeseen economic deterioration or increased financial constraints, which increases the risk of disorderly price adjustments in both financial and real estate markets.
Commercial real estate markets continue to face challenges, including tighter financing conditions, an uncertain economic outlook, and weakened demand following the pandemic. This ongoing correction tests the resilience of investment funds with exposure to the commercial real estate sector.
Price stability is crucial for durable financial stability.
The vulnerability of financial markets and investment funds to asset price adjustments persists, with stretched valuations, tighter financing conditions and reduced market liquidity posing an increased risk of disorderly adjustments, particularly if concerns of a renewed recession arise.
Although investment funds have thus far remained largely unaffected by the recent tensions in the US and Swiss banking sectors, there is a possibility of a shift if these funds suddenly face liquidity requirements, leading to forced asset sales.
Euro area banks have demonstrated resilience in the face of challenges experienced by US and Swiss banks, primarily due to their limited exposures. This resilience has been supported by strong capital and liquidity positions, which have been bolstered by the efforts of regulators and supervisors in recent years.
Preserving this resilience is crucial, as concerns persist regarding banks’ capacity to build up capital. Higher interest rates, for instance, can reduce lending volumes and increase banks’ funding costs, potentially impacting their profitability.
Moreover, there are early indications of deteriorating asset quality in loan portfolios exposed to commercial real estate, smaller firms and consumer loans.
As a result, banks may need to allocate additional funds to cover potential losses and effectively manage credit risks.
Given these circumstances, the ECB said that it is imperative to finalise the establishment of a banking union, with particular emphasis on creating a common European deposit insurance scheme.
Furthermore, addressing vulnerabilities in the non-bank financial sector necessitates a comprehensive and decisive policy response to enhance trust in the financial system and fortify its resilience against risks.
“Price stability is crucial for durable financial stability,” stated Luis de Guindos, the ECB’s vice president. “But as we tighten monetary policy to reduce high inflation, this can reveal vulnerabilities in the financial system. It is critical that we monitor such vulnerabilities and fully implement the banking union to keep them in check.”
The full 133-page report is available here.