Financial markets are less stressed than they have been in the years since the global financial crisis, but the European Central Bank (ECB) says that it still sees significant risks to financial sector stability.
In its latest Financial Stability Review, the ECB says that stress indicators and euro area fundamentals suggest that financial market tensions are easing, particularly in terms of banks’ funding. The ECB says that indicators measuring systemic stress have almost fallen back to their pre-crisis levels. And, it notes that fundamentals have continued to improve, albeit at an uneven pace.
However, it also notes that financial stability conditions remain fragile, and that the adjustment process is incomplete. “Several countries need to continue to strengthen government balance sheets as well as carry forward structural reforms,” it says.
The ECB also says that there needs to be further work done to create a genuine banking union. “While an on-going strengthening of capital and liquidity buffers enhances banking sector resilience, further efforts are needed to correct losses in countries’ competitiveness and improve profitability in the banking sector,” it adds.
Indeed, the bank identifies four key risks to euro area financial stability. First, it says that economic and financial shocks that affect asset valuations and bank profitability could erode confidence in the financial sector. “Continued action is needed to mitigate lingering scepticism regarding euro area bank balance sheets,” it says.
Renewed tensions in sovereign debt markets as a result of delayed national reforms, unforeseen bank recapitalisation needs, or a rise in global bond yields, is also a notable risk.
Global financial market turbulence, with asset mispricing and low market liquidity, is seen as a risk too. “Banks, insurers and pension funds need sufficient buffers for an eventual normalisation of compressed risk premia,” it says, adding that central bank guidance is needed to facilitate a smooth exit from their exceptional monetary policies.
Finally, funding challenges that force banks to deleverage excessively is also cited as a central risk. “While there has been some improvement in bank funding conditions, remaining fragmentation requires further steps towards a genuine euro area banking union,” it notes.