Since the ECB’s latest Financial Stability Review (FSR), which analyzes developments from November 2021 to May 2022, events have overturned: the economic consequences of the COVID-19 pandemic have been joined by the consequences of Russia’s invasion of Ukraine, and inflation has risen more than expected in both the eurozone and the United States. Despite the changed conditions, the current FSR assessment has lost none of its quality, as John Fell, Deputy Director of the ECB’s Directorate General Macroprudential Policy and Financial Stability, emphasized at a joint Policy Web Seminar of the Leibniz Institute for Financial Research SAFE and the Centre for Economic Policy Research on June 14: “The outlook for financial stability has deteriorated since November 2021 for several reasons.”
Moderated by Loriana Pelizzon, Director of SAFE’s Research Department “Financial Markets”, Fell outlined during the event that, for example, corporate sector balance sheets and housing prices already caused concerns in the past. “However, these vulnerabilities have amplified,” said the ECB representative, who has overseen the FSR compilation since 2004. The ECB publishes the report twice a year.
The well-known vulnerabilities proved to be persistent. This could indeed be attributed to the war between Russia and Ukraine, he said. “Both energy prices and other commodities were on the rise before the war as aggregate demand increased. The war only amplified that,” Fell continued. With Russia's invasion into Ukrainian territory, he said, the development of “slowflation” – shrinking economic growth accompanied by rising inflation – intensified, which, in turn, affected financial stability. Global shortages surged commodity prices, which caused liquidity issues in the respective derivatives markets.
As a result, credit risks in the corporate sector are growing. “Companies have faced a new shock from the invasion of Ukraine and are now under pressure in the euro area as input prices soar, and the economic outlook dims,” Fell said. The impacts across sectors and countries are likely to be heterogeneous. In particular, he said, the air transport, textile, as well as the food and beverage industries tend to suffer the most from soaring energy prices. At the same time, he said, house price inflation has never been higher before since the existence of the euro area. “We might be entering a dangerous housing price spiral,” Fell warned.
Using macroprudential regulative space to manage crises
About the trend of rising energy and commodity prices, moderator Loriana Pelizzon raised the question of whether, in the face of sequential crises, it is time to reconsider measures such as the countercyclical capital buffer (CCyB) as a tool for banking supervision to contribute to bank resilience. According to the current FSR, profitability in the banking sector has recovered since the end of 2021, but this could now falter if banks do not grow their capital organically. “Our recommendation is to tailor and adopt macroprudential policies to vulnerabilities at hand,” Fell argued. In doing so, regulatory space could also be used to maintain bank resilience and increase the endowment of the CCyB where possible.
SAFE Professor Pelizzon also wanted to know what could be done beyond macroprudential regulation, especially since other areas, such as the investment sector, were fragile now. For investment funds, in particular, Fell said he sees potential for more stress testing to increase their ability to absorb shocks.