The fight against inflation is not just abouttrade-off between recession risk and price stability. Financial stability is now invited into the debate. The Financial Stability Review of the European Central Bank (ECB) takes stock of the vulnerabilities of the European financial system. And it highlights three main risks: the volatility of financial markets, the increase in non-performing loans (NPLs) and the vulnerability of low-income households.
Risk of stress amplification on the markets
On the markets in the first place, the Frankfurt institute sees an “increased risk of disorderly adjustments in volatile financial markets”. “Volatility in equity, bond and other markets has increased significantly, along with increased uncertainty about inflation. Despite strong and broad asset price corrections, valuations remain vulnerable to rising inflation and interest rate risks.
The ECB fears that the current tension on the markets could be amplified by the decline in market liquidity and margin calls. “Declining risk appetite is hurting liquidity in corporate bond markets, especially for the high yield segment. Unforeseen increases in margin requirements could reignite the momentum of the rush for cash.” It was such a scenario that precipitated the latest financial race in the UK and cost Liz Truss the post of Prime Minister.
High volatility, revaluation risks and liquidity constraints also make disorderly tensions in markets and non-bank sectors more likely. “The structural vulnerabilities of non-bank institutions continue to require a comprehensive and decisive policy response”, insists an ECB traditionally in favor of stricter supervision of non-bank financing circuits.
Luxembourg banks little threatened by NPLs
In the banking sector, if banks benefit from rising rates, they will have to deal with an increase in non-performing loans (NPLs). “Threats to asset quality may require higher provisioning,” notes the ECB. However, it notes that the level of NPLs was historically low at the beginning of 2022. It reached 2.35% at the end of the second half, an increase of 80 basis points since the beginning of the year. The cost of risk also increased, the projection for which went from 0.43% to 0.78%.
Households are the main beneficiaries of loans granted by the euro area banking system. In the second quarter of 2022, secured mortgages accounted for more than 75% of household debt on bank balance sheets, while unsecured consumer loans accounted for about another 10%. 70% of this debt is attributable to high-income households, compared with about 13% for the lowest income quintiles. This figure of 13% makes ECB experts say that the problem will not be systemic.
According to the ECB, Italian, Portuguese, Greek and Cypriot banks are the most threatened by the phenomenon of the increase in non-performing loans. French, Irish and Luxembourg financial institutions appear to be the least sensitive to this risk.
The ECB acknowledges, however, that the downturn observed in the real estate market “could aggravate the vulnerability of households”, especially low-income households “for whom income compression and reserve reductions can lead to debt service problems” .