The European Central Bank (ECB) has issued a dire warning that a compounding combination of recession, soaring inflation, rising funding costs and lower liquidity is threatening the euro area financial market.
ECB warning over growing risk to EU financial system
Luis de Guindos, ECB vice-president, called for banks to take more provisions for bad loans, urged global regulators to make investment funds hold more liquid assets and said the central bank should be prudent in starting to shrink its €5 trillion bond stockpile next year – according to the FT.
The ECB’s twice-yearly financial stability review said high inflation, a growing likelihood of a recession and rising financing costs “pose increasing challenges” for indebted households, businesses and governments and could produce more bankruptcies and financial market volatility.
“All of these vulnerabilities could unfold simultaneously, potentially reinforcing one another,” the report added.
The ECB has itself contributed to the strains by raising interest rates sharply this year and it plans to discuss how to start shrinking its almost €5tn portfolio of bonds at its next policy meeting in December — a move that is likely to increase pressure on market liquidity.
This should be done “with a lot of prudence”, de Guindos said, adding that in his personal opinion, it would mean starting with “partial and passive” quantitative tightening, which means only replacing some of the bonds that mature, rather than actively selling securities.
This year’s turmoil in UK gilt markets and an earlier cash crunch that hit European energy traders have underlined how the region’s financial system is increasingly vulnerable to sharp moves in market prices that could spill over into a broader crisis, the ECB said.
The ECB called on global regulators — co-ordinated by the Financial Stability Board — to accelerate work to address the non-bank financial sector’s vulnerability to liquidity squeezes, similar to one that hit money market funds after the coronavirus pandemic struck in March 2020.
De Guindos said the ECB’s priority was for investment funds exposed to the risk of rapid and large-scale withdrawals in times of market stress to be forced to hold a certain proportion of liquid assets.
Cash holdings by eurozone investment funds have risen since the start of this year, but the ECB said their holdings of liquid assets “remain relatively low”. It warned: “The risk remains high that investment funds could, in an adverse scenario, amplify a market correction via procyclical selling behaviour.”
While many lenders are benefiting from improved profit margins thanks to rising interest rates, the ECB warned “a weaker economy and increased credit risk may weigh on bank profitability prospects in the medium term”.
To prepare for higher defaults, he said the ECB was “calling for an increase in provisioning” by banks.
The central bank also urged governments to ensure their support measures in response to the energy crisis were targeted and temporary, having already committed to spend an extra 1.4 per cent of euro area gross domestic product.
“It cannot be the same ‘whatever it takes’ fiscal policy approach that we have seen during the pandemic,” said de Guindos. “Prolonged high deficits in a number of countries, coupled with rising funding costs, may not only limit the fiscal space available to shelter the economy from future shocks, but may also put debt dynamics on a less favourable trajectory, especially in countries with higher levels of debt,” the ECB warned.
Asked about the collapse of FTX, one of the biggest crypto trading platforms, de Guindos said the ECB had “so far not seen any spillover effect” to the wider financial system, while adding that “we have to keep monitoring it”.
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