The European Central Bank indicates that it is worried about risk-taking investors, global imbalances, and energy prices, among other things, according to the latest issue of its Financial Stability Review.

“Within the euro area financial system, the main source of vulnerability in the period ahead continues to centre around concerns that a global search for yield may have led investors in the euro area to underestimate or take on an excessive level of risk,” it warns. “Very low long-term risk-free rates of return and ample liquidity in global financial markets were key factors in driving investors to seek higher expected returns in riskier markets, possibly raising asset prices in the euro area beyond intrinsic values, especially in corporate bond and credit risk transfer markets.”

As for sources of risk and vulnerability outside the euro area, financial imbalances continued to expand, the ECB notes. “While primarily observed at the global level, these were also seen in the euro area. Global financial imbalances continue to pose medium-term risks to the stability of financial markets,” it says.

“By raising energy costs, the further surge in oil prices over the six months to early May 2006 could dent future corporate sector profits if it proves to be as persistent as futures prices currently suggest,” it adds.

Also, at the euro area level, “concerns remain regarding the implications that rising household sector indebtedness and house prices observed in some euro area countries will have for credit risk and wealth. In addition, there are some concerns that the period of balance sheet consolidation in the euro area corporate sector may have come to an end, and that the risk of an adverse turn in the corporate credit cycle may have increased,” it notes.

“Looking ahead, the durability of euro area banking sector profitability could, despite its current strength, be tested in the period ahead. Declining loan impairment charges could adversely affect the ability of banks to cope with an unforeseen deterioration in credit quality. Moreover, given their risk exposures, concerns about financial asset price misalignments have left some euro area financial markets and institutions vulnerable to changes in global liquidity conditions and unexpected credit developments,” it adds.

The ECB points out that the shock absorption capacities of euro area financial institutions have been improving, but warns that the fact that risks and vulnerabilities have remained, with some increasing, “means that there is no room for complacency: the financial stability outlook still rests upon a delicate balance. While a positive outcome remains the most likely prospect in the period ahead, the possibility that the risk management systems and loss-absorption capacities of financial institutions may be severely tested, while still small, cannot be excluded.”

The bank’s stability review has been published semi-annually since December 2004. It assesses the stability of the euro area financial system with regard to both the role it plays in facilitating economic processes and its ability to absorb adverse shocks and prevent them from having an inordinately disruptive impact.