Between weak economic growth, threats to global trade and escalating geopolitical uncertainty, the risks to financial system stability are still high, warns the European Central Bank (ECB).
While inflation has receded, financial markets have faced several spikes in volatility over the past few months, it noted in its latest report.
“The outlook for financial stability is clouded by heightened macro-financial and geopolitical uncertainty, together with rising trade policy uncertainty” said Luis de Guindos, vice president at the ECB, in a release accompanying the report.
Financial markets have recovered from their latest bouts of volatility, but the ECB warned that “underlying vulnerabilities” leave both equity and corporate bond markets exposed to further episodes.
“High valuations and risk concentration, especially in equity markets, increase the odds of sharp adjustments,” the ECB said, adding that shadow banks “could amplify market stress given their liquidity fragilities, in some cases coupled with high leverage and concentrated exposures.”
Additionally, sovereign balance sheets remain weak in a number of countries, the report said.
“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,” it said, noting that debt service costs are already set to rise as government debt reprices at higher interest rates.
Similarly, higher borrowing costs and weak growth prospects “continue to weigh on corporate balance sheets,” it said, with companies seeing profits crimped by higher interest costs.
“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… asset quality,” it said.
In particular, commercial real estate remains a weak spot, and potential source of stress for individual banks and investment funds, the ECB noted.
Given the uncertain macro environment, and elevated risks to stability, the ECB called for regulators to maintain existing bank capital buffer requirements, along with measures to ensure sound lending standards.
It also called for continued work to increase the resilience of the shadow banking sector.