16 Dec 2021

Risks to financial stability in the residential real estate market and in the non-banking sector

ECB Financial Stability Review: European financial system weathers the initial shock of the corona pandemic, but now new challenges are building up

The European financial system has performed well through the Covid-19 pandemic and the associated crisis. However, factors including high debt levels and rising energy prices are building up risks in certain sectors that could have medium-term implications for financial market stability. John Fell, Deputy Director General Macroprudential Policy and Financial Stability at the European Central Bank (ECB), outlined which sectors are affected in a SAFE-CEPR Policy Web Seminar on 1 December moderated by Loriana Pelizzion, Department Director “Financial Markets” at SAFE. 

Twice a year, the European Central Bank (ECB) publishes the Financial Stability Review (FSR). It aims to provide the financial industry and the public with an overview of potential risks to financial stability in the euro area. As one of the authors, John Fell presented the FSR findings published mid-November. 

According to the FSR, many economic sectors in the euro area have recovered from the shock of the pandemic. The financial market has also remained stable: " The resilience of the financial system has been tested and its core parts have proven able to absorb the initial impact of Covid-19 shock," Fell said. However, with disruptions in supply chains, rising energy prices and the current high inflation, there are some factors that could slow down the economic recovery. The Omicron variant of Covid -19 is also an unforeseeable challenge that the current FSR could not address, anymore. 

 

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The European banking sector is recovering

"Returns on equity are more or less back to pre-crisis levels," Fell explained. On the other hand, he said, low profitability remains a challenge for European banks. While the banking sector is performing positively, vulnerabilities are becoming apparent in the housing and non-banking sectors. 
Major vulnerabilities have been identified in the residential real estate market. " This is probably where we made the biggest tonal shift in the FSR," Fell said. House prices in the euro area rose 7.3 percent in the second half of 2021, he said. "This is the fastest increase since 2005," the central bank official explained. Both mortgage lending and house prices are increasing, while lending standards may be loosened. Fell warned, " if financial history has taught us anything, it is that signs of easing the credit standards in mortgage markets have often been a harbinger of exuberance."

Financial stability policy needs new direction

The FSR also notes that non-banks, particularly investment funds, are taking on higher risk in their portfolios. If economic conditions worsen, potential interest rate shocks could lead to significant losses.
According to Fell, financial stability policy should be gradually shift from short-term support toward addressing medium-term vulnerabilities. He stressed “This gradual approach is still justified, not least giving a head wing an economic recovery.” In particular, he said, the vulnerabilities in residential real estate markets need to be reduced. In addition, the regulatory framework for the financial sector needs to be improved, including full implementation of the Basel III reforms and a stronger policy framework for the non-banking sector.