ECB’s Financial Stability Review shows risks rising as economic and financial conditions deteriorate
November 16, 2022
- Households and businesses face multiple challenges, including a weaker economic outlook, rising inflation and tighter financial conditions
- Reduced market liquidity increases the risk of disorderly asset price adjustments, which could test the resilience of investment funds
- Governments must ensure that support for vulnerable sectors is targeted and does not interfere with the normalization of monetary policy
Risks to financial stability in the euro area have increased amid soaring energy prices, high inflation and weak economic growth, according to the November 2022 Financial Stability Review published today by the European Central Bank (ECB). At the same time, financial conditions have tightened as central banks act to contain inflation.
“Individuals and businesses are already feeling the impact of rising inflation and slowing economic activity,” said ECB Vice President Luis de Guindos. “Our assessment is that risks to financial stability have increased, while a technical recession in the eurozone has become more likely.”
These recent developments increase the vulnerability of households, companies and governments which hold more debt. They are also aggravating tensions in financial markets and testing the resilience of investment funds. Additionally, all of these vulnerabilities could deploy simultaneously, potentially reinforcing each other.
Corporate sector challenges have increased amid rising energy and other input costs, with profits expected to decline as financing costs rise. If the outlook deteriorates further, an increase in the frequency of business failures cannot be ruled out, especially among energy-intensive businesses.
Inflation, as well as soaring gas and electricity bills, are also hitting households, diminishing their purchasing power and potentially reducing their ability to repay their loans. Low-income households that typically spend a larger share of their income on energy and food are particularly affected.
As businesses and households find it increasingly difficult to service their debts, banks could face larger credit losses in the medium term. Although the banking sector has recently seen a turnaround in profitability thanks to rising interest rates, there are emerging signs of deteriorating asset quality, which may warrant larger provisions.
Many governments have provided fiscal support to businesses and households to mitigate the impact of rising energy prices. However, high levels of public debt in the wake of the pandemic, coupled with tighter financing conditions, limit the scope for fiscal expansion measures that do not trigger debt sustainability risks. Support should therefore be temporary and targeted to those most affected.
Uncertainty about the outlook for inflation and interest rates has heightened the risk of a disorderly adjustment in asset prices in financial markets, despite recent corrections. Many investment funds remain heavily exposed to further valuation and credit losses. Those with large structural liquidity mismatches and low liquidity buffers are particularly vulnerable to market disruptions and fund outflows. The decrease in liquidity in certain financial markets could also pose problems for adjusting portfolios or raising funds. It also increases the risk of surprisingly large margin calls, which could exacerbate adverse market dynamics if funds are forced to sell assets to meet them.
Overall, the euro area banking system is well placed to face many risks, partly thanks to regulatory and prudential policy reforms over the past decade. Given the deteriorating economic and financial outlook, targeted macroprudential policies such as capital buffers can help further strengthen the resilience of the financial system.
Persistent vulnerabilities and risks in the non-banking financial sector require special attention from relevant supervisors. Urgent progress on regulatory frameworks is needed to strengthen the resilience of the sector, in particular to address liquidity mismatches and leverage.
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