Risks to the stability of the financial system have continued to rise as both economic and financial conditions deteriorate, according to a new report from the European Central Bank (ECB).

The impact of an energy crisis in Europe on top of weaker economic growth and tighter financial conditions has driven financial stability risks higher, the ECB said.

“People and firms are already feeling the impact of rising inflation and the slowdown in economic activity,” ECB vice-president Luis de Guindos said in a release accompanying the report.

“Our assessment is that risks to financial stability have increased, while a technical recession in the euro area has become more likely,” he added.

The tougher economic and financial conditions particularly increase the vulnerability of highly-indebted households, firms and governments, the report noted.

“Corporate sector challenges have grown amid higher energy and other input costs, with profits expected to decline as funding costs increase. If the outlook deteriorates further, an increase in the frequency of corporate defaults cannot be excluded, particularly among energy-intensive firms,” it said.

Similarly, households are facing continued high inflation, which weighs on their purchasing power and potentially on their ability to service debt.

“As firms and households find it increasingly challenging to service their debts, banks could face higher credit losses in the medium term,” the report said.

While higher interest rates are boosting banks’ core revenues and incomes, “there are incipient signs of asset quality deterioration, which may require larger provisions,” the ECB noted.

These mounting financial market stresses may also test the resilience of investment funds, it said, as many funds “remain heavily exposed to further valuation and credit losses.”

Investment funds that face large structural liquidity mismatches and low cash buffers “are particularly vulnerable to market dislocations and the outflow of funding,” the report said.

“Moreover, all of these vulnerabilities could unfold simultaneously, potentially reinforcing one another,” the report warned.

For instance, reduced liquidity in some financial markets could create challenges to investment funds seeking to reshape their portfolios, or raise funds. “It also raises the risk of unexpectedly large margin calls, which could aggravate adverse market dynamics if funds are forced to sell assets to meet them,” it said.