The ECB is alarmed by the growing risks for the financial system

A toxic combination of recession, soaring inflation, rising funding costs and declining liquidity threatens to trigger turmoil in eurozone financial markets, the European Central Bank has warned.

ECB Vice-President Luis de Guindos called on banks to take more provisions for bad loans, urged global regulators to ensure investment funds hold more liquid assets and said the central bank should be cautious in starting to reduce its stock of bonds by 5 billion euros next year. .

The ECB’s bi-annual Financial Stability Review said high inflation, a growing likelihood of a recession and rising funding costs “pose growing challenges” for indebted households, businesses and governments and could lead to more bankruptcies and volatility in financial markets.

“All of these vulnerabilities could deploy simultaneously, potentially reinforcing each other,” the report adds.

The ECB has itself contributed to the tensions by raising interest rates sharply this year and it plans to discuss how to start cutting its bond portfolio by almost 5 billion euros at its next policy meeting. in December – a move likely to increase pressure on market liquidity. .

This should be done “with a lot of caution,” de Guindos said, adding that in his personal view it would mean starting with “partial and passive” quantitative tightening, which means replacing only some of the maturing bonds. , rather than actively selling securities.

This year’s turmoil in UK gilt markets and an earlier liquidity crisis that hit European energy traders have underscored how the region’s financial system is increasingly vulnerable to sharp swings in market prices that could turn into a wider crisis, the ECB said.

The ECB has called on global regulators – coordinated by the Financial Stability Board – to speed up work to address the vulnerability of the non-banking financial sector to liquidity restrictions, similar to that which hit money market funds after the coronavirus pandemic. March 2020.

De Guindos said the ECB’s priority was that investment funds exposed to the risk of rapid and large withdrawals in times of market stress be forced to hold a certain proportion of liquid assets.

Cash holdings of eurozone investment funds have increased since the start of this year, but the ECB said their holdings of liquid assets “remain relatively low”. He warned: “The risk remains high that investment funds could, in an adverse scenario, amplify a market correction via pro-cyclical selling behavior.”

While many lenders are benefiting from improved profit margins thanks to higher interest rates, the ECB has warned that “a weaker economy and increased credit risk could weigh on banks’ profitability outlook. medium term”.

Some companies in sectors such as construction and utilities were struggling with high energy prices, high debt levels and limited ability to pass on higher costs to customers, de Guindos said.

He added that higher interest rates would weigh on the ability of households to service their debts, especially in countries where variable rate mortgages are prevalent. To prepare for an increase in defaults, he said the ECB was “calling for increased provisioning” by banks.

The central bank also urged governments to ensure that their support measures in response to the energy crisis are targeted and temporary, having already pledged to spend an additional 1.4% of the euro zone’s gross domestic product. “It can’t be the same ‘whatever it takes’ approach to fiscal policy that we’ve seen during the pandemic,” de Guindos said.

“High and prolonged deficits in a number of countries, coupled with rising financing costs, may not only limit the fiscal space available to protect the economy from future shocks, but may also place debt dynamics on a less favorable trajectory, especially in countries with higher levels of debt,” the ECB warned.

Asked about the collapse of FTX, one of the biggest crypto trading platforms, de Guindos said the ECB had “so far not seen a ripple effect” on the financial system within the meaning wide, while adding that “we have to keep monitoring it”.

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