The European Central Bank (ECB) sees elevated financial stability vulnerabilities in a volatile environment, according to its November 2024 Financial Stability Review.
Risks to euro area economic growth have shifted to the downside as inflation has moved “closer to 2%,” while financial markets have “experienced several pronounced but short-lived spikes in volatility in recent months.”
While financial markets have proved resilient so far, there is “no room for complacency.”
As noted in the update from the ECB, underlying vulnerabilities make equity and “corporate credit markets prone to further volatility.”
High valuations and risk concentration, “especially in equity markets, increase the odds of sharp adjustments.”
Should adverse dynamics materialize, non-banks could amplify market stress given their “liquidity fragilities, in some cases coupled with high leverage and concentrated exposures.”
Despite the decline in sovereign debt-to-GDP ratios after the surge during the pandemic, fiscal fundamentals “remain weak in some euro area countries.”
Sovereign debt service costs are expected to continue “rising as maturing debt is rolled over at interest rates that are higher than those on outstanding debt.”
Elevated debt levels and high budget deficits, “coupled with weak long-term growth-potential and policy uncertainty, increase the risk that fiscal slippage will reignite market concerns over sovereign debt sustainability.”
High borrowing costs and weak growth prospects continue to weigh on corporate balance sheets, “with euro area firms reporting a decline in profits due to high interest payments.”
The outlook for real estate markets is mixed, with residential real estate prices stabilising, while commercial real estate markets “are still stressed because of challenges posed by remote working and e-commerce.”
Households, by contrast, are benefiting from “a strong labor market and have bolstered their resilience by increasing savings and reducing debt.”
While the overall increase in credit risks has so far been gradual, small and medium-sized companies and “lower-income households could face strains if growth slows by more than is currently expected, which could, in turn, adversely affect the asset quality of euro area financial intermediaries.”
Losses on commercial real estate exposures are at risk of “rising further and could be significant for individual banks and investment funds.”
In aggregate, banks’ ability to absorb “further asset quality deterioration continues to be supported by high levels of profitability and by strong capital and liquidity buffers.”
In order to preserve financial system resilience in the current uncertain macro-financial environment, it is advisable for macroprudential authorities to “maintain existing capital buffer requirements together with borrower-based measures that ensure sound lending standards.”
In addition, the growing market footprint and interconnectedness of non-bank financial intermediaries calls for “a set of policy measures to increase the sector’s resilience.”
This kind of resilience across the NBFI sector would also reportedly “help to foster more integrated capital markets.”
This should improve overall financial stability and complement the objectives of the capital markets union, which is “aimed at supporting Europe’s productivity and economic growth.”
