European Central Bank highlights continued sector-wide risk in latest Financial Stability Review
Geopolitical tensions, lacklustre growth and ever-pressing inflation are leaving European financial markets alarmingly exposed, according to the European Central Bank’s (ECB) bi-annual Financial Stability Review.
The review reveals how “downside surprises” inspired by the current macro-financial environment are weighing heavily on residential and commercial real estate markets in the euro area.
This is primarily in the form of rising debt service costs. For residential real estate, rising mortgage prices have hit affordability and demand hard, while the commercial side has also suffered from a lack of appetite for office and retail spaces as a consequence of the Covid-19 pandemic.
Given the rate at which loan maturity extensions were granted during times of low interest rates, the ECB recognises how “the full impact on economic activity is yet to materialise”, and that the ripples caused by the challenges being felt in real estate now will soon arrive on the doorsteps of financial and non-financial sectors alike, if they haven’t already.
The review says investment funds and other non-bank financial institutions remain “highly sensitive” to this turbulent environment, being especially susceptible to liquidity, credit and leverage risks.
The picture is equally as precarious for banks, too. As the cost of higher interest rates is gradually relayed to depositors, and the composition of their funding transitions from overnight deposits to more expensive term deposits or bonds, the review suggests that banks’ funding costs are headed for an inevitable increase as well.
Furthermore, rising debt service costs paired with a weak macroeconomic environment leads the review to predict the quality of bank assets suffering, while it also anticipates a “substantial drop” in lending volumes.
“The weak economic outlook along with the consequences of high inflation are straining the ability of people, firms and governments to service their debt,” comments Luis de Guindos, vice-president of the ECB.
“It is critical that we remain vigilant as the economy transitions to an environment of higher interest rates coupled with growing uncertainties and geopolitical tensions.”
The review claims that the necessity for vigilance is taking the form of increased capital buffer requirements, as have been imposed by macroprudential authorities in recent months.
The ECB advises banks through the review to maintain these buffers in tandem with existing borrower-based measures, and emphasises that Basel III – which promotes sector-wide risk mitigation – must be “implemented faithfully”.
The review also addresses the state of play for the non-bank financial sector, for which it recommends “a comprehensive and decisive policy response”.