a man on a precipice

As the economic outlook dims, financial markets are facing rising risks, European regulators warn.

In a new joint report, Europe’s major regulatory agencies — the European Securities and Markets Authority, the European Banking Authority, and the European Insurance and Occupational Pensions Authority — warned that deteriorating economic prospects, marked by high inflation and a looming energy crisis, translate into higher vulnerabilities for the financial sector.

“The post-pandemic economic recovery in Europe has dwindled as a result of the Russian invasion of Ukraine,” the regulators said, noting the invasion has “caused a rapid deterioration of the economic outlook.”

Worsening economic conditions, coupled with existing inflationary pressures, have increased the threat of stagflation, the report noted. This, in turn, has raised risks for financial markets as central banks tighten monetary policy.

“The combination of higher financing costs and lower economic output may put pressure on government, corporate and household debt refinancing while also negatively impacting the credit quality of financial institutions’ loan portfolios,” the regulators said.

At the same time, reduced real returns could cause investors to take on more risk, they noted.

The report suggested that both financial firms and regulators should prepare for deteriorating asset quality in the financial sector, and for potential sharp increases in risk premia on financial institutions and other market participants.

The report also warned that cyber risks and climate-related risks remain significant, and that regulators should monitor risks to retail investors — both in cryptoassets, where investors may not fully appreciate the risks, and from the effects of high inflation.

“Retail investors may be unaware of inflation or not pay enough attention to its effects on their assets and purchasing power,” the report said. “Consumers can suffer from behavioural biases, such as money illusion or exponential growth bias, that can lead to insufficient saving and investing. Moreover, when inflation is rising, the effects of insufficient saving on long-term wealth become more pronounced.”