Risks to financial stability are rising thanks to the economic fallout from Russia’s invasion of Ukraine, the European Central bank (ECB) warned on Wednesday.
In a new report, the ECB said that, as a result of the war in Ukraine and its effect on both commodity prices specifically and inflation generally, financial stability conditions have deteriorated.
“The terrible war in Ukraine has brought immense human suffering,” said ECB vice-president, Luis de Guindos, in a release. “It has also increased financial stability risks through its impact on virtually all aspects of economic activity and financing conditions.”
So far, the market reaction to the conflict has been “largely orderly,” the report said.
“However, prices for commodities and energy have remained elevated and volatile, which has caused some stress in derivatives markets,” it said, adding that “some assets remain at risk of further corrections should the growth outlook weaken further and/or inflation turn out to be significantly higher than expected.”
Looking ahead, the ECB warned that stability risks may increase due to the uncertain outcome of the Russia-Ukraine war and evolving monetary policy expectations in the advanced economies.
Additionally, threats such as a resurgence of Covid-19, increased economic turmoil in major emerging markets or a sharper slowdown in China could also exacerbate growth and inflation risks, it said.
Higher input prices and weaker growth could lead to increased corporate defaults, “especially for firms and sectors that have not yet fully recovered from the pandemic,” the report said. “Moreover, highly indebted firms and those with lower credit ratings may struggle with tighter financing conditions.”
In the banking sector, the prospect of declining asset quality means that banks’ profitability potential has “weakened again, following a strong recovery in 2021,” the ECB noted.
That said, it reported that a recent vulnerability analysis found that the banking sector “should remain resilient even under severely adverse economic scenarios.”
The report also called for tougher regulation — including more effective capital buffers for banks, and policy action in the non-bank sector to address leverage, margining and liquidity issues — to bolster the resilience of the financial system.
In particular, it noted that parts of the investment fund sector face risks due to excessive leverage in derivatives, and crypto investments.