The sharp increase in uncertainty created by abrupt shifts in U.S. policy could imperil financial stability, the European Central Bank (ECB) warns in a new report.
The central bank published the latest edition of its financial stability review, which cautioned that the economic and financial consequences of erratic U.S. policy could negatively impact market stability.
“Rising trade frictions and related downside risks to economic growth are weighing on the outlook for financial stability, said Luis de Guindos, vice-president of the ECB, in a release.
Among other things, the turmoil in global trade policy has driven a “sharp increase in uncertainty, causing large spikes in financial market volatility,” the ECB said, noting that, as of mid-May, markets remain sensitive to tariff-related news.
“Equity markets in particular remain vulnerable to sudden and sharp adjustments as valuations are still high and concerns over risk concentrations persist,” it said.
The ongoing fallout from trade disruptions could also adversely affect both households and businesses, raising credit risk for banks and other financial firms, the central bank noted.
At the same time, “stretched valuations” and low liquidity buffers for non-bank firms are leaving financial markets “vulnerable to further shocks,” it said.
Additionally, government finances remain fragile in certain countries, which are still coping with the rise in debt prompted by the pandemic and the subsequent rise in interest rates. Government plans to increase defence spending in the face of shifting U.S. policy will also weigh on their balance sheets.
“Higher defence spending, together with weaker growth and other structural challenges, such as those posed by climate change, digitalization and aging populations, could compound the already strained fiscal positions” of certain governments, it noted.
Against this backdrop, regulators “should maintain existing capital buffer requirements and borrower-based measures to ensure sound lending standards,” it said.
The ECB also called for “a comprehensive set of policy measures” to boost the resilience of the non-bank sector, given the growth of the shadow banks, and their increased connections to the traditional financial sector.