Risks of global asset market corrections have intensified, ECB warns

The impact of changes in U.S. economic policies remains highly uncertain, the review says, noting that the largest direct impacts could come in terms of changes in trade along with the possible spillover from higher interest rate and inflation expectations in the U.S.

Moreover, the risks to asset prices and financial stability could also feed back to the real economy. “In particular, concerns about debt sustainability might re-emerge despite relatively benign financial market conditions,” the report says. “Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas. This, in turn, could delay much needed fiscal and structural reforms and could in a worst-case scenario reignite pressures on more vulnerable sovereigns.”

Apart from increased market risks, vulnerabilities “remain significant” for European banks, the report says. “Profitability prospects overall remain low across the euro area in a subdued economic growth environment,” it adds. “Banking sector structural challenges stem from high stocks of non-performing loans, high operating costs and excess capacity, with different incidence across countries.”

Another risk to financial stability comes from the non-bank financial sector, the report says. “Investment funds, in particular, have grown rapidly in recent years. The more important role played by investment funds needs to be met with a commensurate increase in monitoring,” it says. “Many of these funds are exposed to liquidity mismatches. This characteristic increases the potential for the investment fund sector to amplify market-wide shocks due to its high interconnectedness with credit institutions.”

Notwithstanding these ongoing risks, financial system “has shown resilience and systemic stress has remained relatively low,” the report says, despite repeated bouts of financial market turbulence over the past six months.