Long-standing risks to the financial system have persisted, including the low interest rate environment, the search for yield, and weak profitability at Europe’s financial institutions, according to a report released Tuesday by the European Supervisory Authorities (ESAs)
More recently, a decline in market liquidity has possible negative implications for asset managers, the report says.
In addition, the still-fragile economic recovery “continues to adversely affect profitability and asset quality” in the financial sector, the report warns. There are also political and economic risks due to residual uncertainty around Greece’s financial situation, it says; and, heightened concerns about the economic prospects of emerging market economies, particularly China.
Given these risks, the ESA regulators call for “rigorous action” to enhance asset quality and shore up their business models. Financial firms need to step up efforts to clean up their balance sheets, to address legacy assets and non-performing loans, “this includes assessing the sustainability of business models as a key supervisory concern,” the report says.
The report also calls for greater disclosure, given the valuation risks in illiquid markets, and it emphasizes the need for harmonized regulation.
Looking ahead, the report also highlights possible future threats, including the risk that concerns about sovereign debt sustainability resurface. “This could trigger a change in market sentiment if a further tightening in credit spreads would not be in line with future economic developments,” the report says.
“Another potential trigger for a change of sentiment in European markets could be increasing international risks,” the report adds, pointing to the threat of heightened market volatility, structural concerns about China’s economy, fluctuations in commodity prices, or divergence of monetary policy, as possible concerns.