In a weak economic environment, with tighter financial conditions and elevated geopolitical risk, the outlook for financial stability remains fragile, says the European Central Bank (ECB).
In a new report, the ECB said the financial system is vulnerable, as the effects of higher interest rates continue to work their way through the global economy, weighing on growth, and straining household and corporate finances.
“While tighter financial and credit conditions are increasingly translating into higher debt service costs, the full impact on economic activity is yet to materialize,” the ECB said.
As loans mature and need to be refinanced at higher rates, both financial and non-financial corporate sectors could face challenges, it warned — noting that these stresses are already evident in real estate markets, which are undergoing a downturn.
“The weak economic outlook along with the consequences of high inflation are straining the ability of people, firms and governments to service their debt,” said ECB vice president, Luis de Guindos, in a release.
“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,” he added.
At the same time, banks are facing rising funding costs, which pressures margins and profits. Bank asset quality is expected to continue deteriorating, given the financial and economic environment, while loan growth is seen slowing too, further weighing on bank profits.
Additionally, investment funds and other non-banks “remain vulnerable to liquidity, credit and leverage risks,” the ECB said.
The banking system is well positioned to withstand these risks, thanks to their robust capital positions, it said. However, it also highlighted the need to continue adopting the post-crisis reforms to banks’ capital, leverage and liquidity requirements, known as Basel III.
For non-banks, policymakers still need to address certain structural vulnerabilities, such as leverage and liquidity risks, the ECB said.