The ECB has published the November 2022 Financial Stability Review (FSR), highlighting an increasing level of risks to financial stability in the euro area.
Most of the key risks mentioned in the ECB’s financial stability review (soaring energy prices, elevated inflation, and low economic growth) are not new risks versus what we have observed earlier in 2022. However, there has been tightening in financial conditions as central banks try to combat inflation and mainstream banks tighten lending criteria to help reduce future exposure to potential deteriorating loans.
The financial stability review highlights that all sectors are facing challenges, from households, to firms and governments – particularly where they hold high levels of borrowing and/or have sensitivity to rising interest rates.
Many households across Europe are experiencing higher energy costs and household expenses and are finding it increasingly challenging to service their borrowing, which increases the possibility that banks will face higher credit losses in the medium term, according to this latest ECB publication. Lower-income households that generally spend a greater percentage of their income on energy and food are being particularly affected.
In the corporate sector, the review notes that risks have also grown, particularly in relation to higher energy costs and costs of goods, with profit margins expected to come under ongoing pressure as passing costs through to customers becomes more of a challenge. An increase in the frequency of corporate defaults is more likely, particularly among more energy-intensive firms.
Whilst the ECB’s financial stability review highlights that residential real estate markets have shown strong prices and lending growth so far, forward-looking indicators suggest a slowdown. The supply of home-loans remains reassuringly stable, but the increase in borrowing costs this year and the expected tightening of lending criteria by banks is likely to reduce demand for new loans going forward, reducing future volumes of property transactions. As purchasing demand for new residential properties slows, the review also suggests that the construction sector could come under pressure.
Similarly, the outlook for commercial real estate (CRE) markets is downbeat. Although CRE prices have remained broadly stable, there has been an increase in the share of investors who view CRE assets as overvalued, with a reported drop in investor demand across all CRE sectors.
Whilst some investors continue to speculate around central bank ‘pivots’, the report highlights that many EU governments have already provided significant fiscal support schemes to both firms and households to soften the impact of rising energy prices, alongside recent Covid-19 support measures. The high levels of government debt following the pandemic will limit the extent of future fiscal support measures if conditions worsen. Future government support is anticipated to be less available and provided on a more selective basis than in recent years.
Given this heightened uncertainty, particularly the outlook for inflation that continues to be heavily driven by high energy costs in Europe, increased market risk and volatility should be expected. The risk of further asset price corrections is still possible, even with some of the recent market corrections now baked in. In addition, the lower investor appetite and tighter liquidity in some financial asset classes could also pose risks for nearer-term maturing debt and increased refinancing risks.
Overall, the ECB financial stability review highlights that the European banking system is better placed to withstand many risks, partly because of the enhanced capital buffers that have been built up over the last decade or so. On the positive side, the report notes that the banking sector has recently experienced a recovery in net-interest margins as interest rates have risen. The main downsides forecast by the financial stability review are subdued fee income as transactional activity remains low and loan quality deterioration, which may require larger provisions, compounded by potentially more volatile market conditions.
As always, planning and paying close attention to risks will help enable financial institutions to mitigate and contain any key challenges they may face in the future.