Since the assessment of potential risks to financial stability in the euro area in May 2022, the expectations for monetary policy and financial stability have changed once again. Experts from the European Central Bank (ECB) show in their Financial Stability Review from November that within Europe, financial stability, especially for low-income households, deteriorated further due to tighter financial conditions and recession risks driven by the energy crisis and the Russian-Ukraine war.
Moderated by SAFE Director Jan Pieter Krahnen, Manuela Storz, Daniel Dieckelmann, both ECB Financial Stability Experts, and Tamarah Shakir, Deputy Head of the Systemic Risks and Financial Institutions Division at the ECB, discussed key aspects of the report in a SAFE-CEPR Policy Web Seminar on 21 November 2022.
“We see a recession risk of 80 percent for 2023”, emphasized Manuela Storz. Since markets face greater uncertainty, money and bond market volatility have increased tremendously, especially in interest rate markets as inflation expectations rose, she explained further. According to her, traditional portfolio allocation is under pressure which means that there are simultaneous equity and bond corrections. Non-banks, such as investment funds, pension funds, and insurance firms, de-risk their portfolios because of their outflows and low cash buffers. Higher buffers, however, would help to reduce market volatility and ultimately reduce risks. Adding to Storz’s assessment, Tamarah Shakir explained that if inflation does not get back to target, it will become a major problem for everyone. Inflation is the key figure to focus on in the near-term analysis, Daniel Dieckelmann stated.
Dieckelmann focused on a special feature of the November report concerning household inequality and financial stability risks: “Especially low-income households are extremely on the verge”, he said. Dieckelmann explained that these households usually spend a large portion of their income on basic consumption goods, such as food, energy, utilities, and rent. Further, low-income households would be particularly prone to overindebtedness, making them vulnerable to sudden, sizable changes. In many countries, limited liquid assets coincide with high debt service ratios for lower-income households.
Continuous credit risks call for policy support
“The demands for policy support rise but at the same time, there are still large deficits within the economy and returning fiscal constraints because of the COVID-19 pandemic,” argued Shakir. Overall, she outlined that there is an excessive spread widening in 10-year government bond yields. Concerning non-financial corporations, Shakir explained that they face renewed headwinds as corporate earnings growth expectations have continued to decline and default risks rise for most economic sectors, especially energy-intensive ones. Arguably, Shakir outlined that low-income households would be confronted with tighter incomes as the housing market turns and lower buffers might trigger debt-servicing problems.
She added that banks, on the other hand, enjoy the tailwinds of higher rates, but the costs of risk are still very low. Storz ultimately emphasized the importance of the financial stability outlook. Financial intermediaries would be able to prepare and take countermeasures – and especially banks should plan for certain situations. As Shakir explained, “we have seen ruptures after a long time of low interest rates and in the bumpy period to normalize monetary policy, accidents can happen, but price stability is a necessary condition to financial stability.”