The uncertain economic outlook poses a risk to financial stability that should have regulators and financial firms on guard, according to a new report from Europe’s financial authorities.
In a joint report, the region’s securities, banking and insurance supervisors warned national regulators about the stability risks lurking amid elevated economic uncertainty. They called for financial firms and other market participants to remain vigilant to these risks.
While financial institutions have largely weathered a series of adverse events in recent years — including a pandemic, supply-chain disruptions, Russia’s aggression against Ukraine, the energy crisis, the U.K.’s Gilt crisis, and U.S. bank turmoil — the economy continues to face heightened uncertainty, which presents “material” financial stability risks, the report said.
“Financial institutions and supervisors should remain prepared for a deterioration in asset quality in the financial sector,” warned the report from the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority.
“Against the background of high macroeconomic uncertainty, the risk of a recession, persistent inflation, volatile energy and commodity prices and the prospect of further interest rate increases, supervisors should continue to closely monitor asset quality and loan loss provisioning,” it said.
The regulators noted that rising interest rates have affected all sectors, reducing the value of fixed income assets, and spawning market and liquidity risks for the asset management sector.
The rising rate environment has also reduced insurers’ profitability. While higher rates have boosted banks’ net interest income and margins, the longer-term implications are not as positive, as funding costs and the prospect of loan losses have risen.
“Most affected assets would include real estate lending, unsecured lending to consumers, assets that benefitted from support measures related to the pandemic, and assets of sectors that are particularly vulnerable to rising inflation as well as to volatile energy and commodity prices,” the report said.
Additionally, inflationary trends have an impact on conduct risks, the report suggested, adding that the evolving inflation picture should be factored into suitability reviews.
“Financial institutions and supervisors should make extra efforts to ensure investor awareness on the effects of inflation on real returns of assets and on how these can vary across different types of assets,” it said.
“Recent bank problems in the U.S. and Switzerland highlight the importance of effective risk management and governance arrangements for financial institutions, in particular in relation to liquidity risk and interest rate risk,” the report added.
In this environment, the Joint Committee of the European Supervisory Authorities called on regulators, financial institutions and market participants to “closely monitor the broader impact” of rising rates, prepare to face declining asset quality and to track the effects of inflation risk.