08 Dec 2023

Fragile financial stability in the euro area

European financial markets have shown resilience this year, but there are significant downside risks, experts from the European Central Bank explain in a SAFE-CEPR Policy Web Seminar

In addition to tight financial and credit conditions for banks and financial intermediaries, the geopolitical situation is a key reason why the European Central Bank’s (ECB) latest Financial Stability Review (FSR) speaks of existing risks. In a joint Policy Web Seminar of the Leibniz Institute for Financial Research SAFE and the European Financial Architecture Network of the Centre for Economic Policy Research, moderated by SAFE Director Florian Heider, ECB economists Desislava Andreeva and Jan-Hannes Lang presented the main findings of the FSR.

While six months ago, rapidly rising interest rates were still the dominant issue regarding European financial stability, Andreeva emphasized in the online event on 29 November: “We are now in a fragile macro-financial and geopolitical environment.” According to the central banker, three factors are coming together. "Markets are vulnerable to adverse dynamics," Andreeva said as the first point. Increasing credit and liquidity risks can also be observed among financial intermediaries outside the banking sector. Secondly, rising debt service costs in non-financial sectors pose a challenge, with indebted households, firms, and governments being the most affected. “The resilience of the euro area government bond market could be tested by higher interest rates,” Andreeva added. Finally, the profitability of European banks is likely to face a serious test.

“Significant downside risks have not yet been priced in”

Although bank profitability remains at multi-year highs, financial markets have been remarkably resilient this year. “But significant downside risks have not yet been priced in,” Andreeva said. For example, if credit risks were to materialize, it would have a negative impact on pension funds. In addition, a further deterioration in the public finances of the already burdened euro countries could lead to a sharp rise in sovereign debt.

The cost of bank loans to companies is comparatively high, which is currently leading to a decline in bank lending. “Given the high mortgage rates, we are seeing a significant correction in residential real estate prices,” Andreeva said.

Her colleague Jan-Hannes Lang followed up, noting that both residential and commercial real estate markets are in a downturn with falling prices across Europe, although there is great heterogeneity across countries. Loans for commercial real estate are more exposed to higher interest rates than residential real estate. “Higher interest rates are likely to further depress commercial and residential real estate prices and increase debt servicing for variable-rate borrowers,” Lang predicted. There are also major structural challenges, such as teleworking, e-commerce, and new environmental, social, and governance (ESG) requirements. Lower-quality buildings in particular have a lot of catching up to do in terms of ESG criteria.

Real estates as key determinant of financial stability

“Banks’ exposure to real estate is significant,” says Lang. Commercial real estate exposure is only about ten percent of total loans. But some eurozone banks are more exposed than others, which could lead to tensions. “Developments in the real estate sector will be a key determinant of financial stability in the euro area,” Lang concluded.

In the ensuing round of questions to the ECB representatives, the question arose whether the ECB, as a banking supervisor, should not ask banks to retain at least part of their interest income to strengthen the capital ratios of credit institutions in view of the increased risks presented in the FSR. Desislava Andreeva replied that now was not the time to do so. Maintaining these buffers was necessary in order to be prepared if the various risks outlined above materialized. Asked whether the ECB still saw risks for European banks from US bank failures in the spring, she pointed out that the high regulatory standards in Europe served as a “source of reassurance” and that the European banking system was resilient.