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Financial markets have performed well due to expectations that central banks will be cutting interest rates later this year. But given the growing uncertainty around rate cuts, the risk of a market correction has risen too, European regulators warn.

A trio of regulatory agencies — the European Securities and Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pension Authority (EIOPA) — issued their latest assessment of the risks facing the financial system on Tuesday.

The assessment suggests threats to the financial system are “elevated in a context of slowing growth, an uncertain interest rate environment and ongoing geopolitical tensions.”

There’s a heightened risk of a correction in the context of markets’ strong performance in recent months, the regulators said.

“Credit risk is also expected to continue to increase as refinancing needs grow, particularly for high-yield debt and real estate,” the report said, adding that asset quality in the banking sector “is expected to deteriorate as economic growth slows further.​”

“The real estate slowdown could also drive impairments at banks,” it added.

While both capital and liquidity metrics for the banking sector are solid, thanks to robust profits in 2023, “the outlook is more challenging, as banks face the repricing of liabilities and assets with prospects of lower interest income, slower loan growth, high costs and the challenging macro environment,” the report noted.

For investment funds, both fund performance and net flows have been “volatile” in the evolving interest rate environment, it said.

“While funds have managed the transition to higher interest rates, concerns remain regarding the valuation of real-estate fund assets, and liquidity risks in these funds could have wider spillover effects,” the regulators warned.​

Escalating geopolitical instability and cybersecurity remain key risks as well.

“The number of attacks and cyber threats is increasing, and while the impact of these attacks so far has been limited, cyber-related insurance claims keep increasing, and the (re)insurance industry is further strengthening pricing techniques and risk-transfer mechanisms,” the report said.

“In the banking sector, the findings from the cyber resilience testing currently underway will be important,” the regulators added.