Tree blowing dollars

In its latest review of financial stability, the European Central Bank (ECB) says financial markets remain vulnerable amid the widespread effects of tighter financial conditions.

“While economic conditions have improved slightly, uncertain growth prospects, paired with persistent inflation and tightening financing conditions, continue to weigh on the balance sheets of firms, households and governments,” it said.

It noted that further economic or financial shocks could lead to “disorderly price adjustments” in financial and real-estate markets.

In particular, financial markets and investment funds are exposed to declining asset prices, it pointed out.

“Stretched valuations, tighter financing conditions and lower market liquidity might increase the risk of any adjustment becoming disorderly, particularly in the event of renewed recession fears,” it said.

While investment funds have proven resilient to intensified stress in the banking system so far, the ECB said this could change if liquidity tightens, sparking pressure to sell off assets.

Certain investment funds are also exposed to turmoil in real-estate markets, it noted, with residential markets retrenching and commercial real estate facing weaker demand alongside tighter financing conditions and economic uncertainty.

“The ongoing correction could test the resilience of investment funds with interests in the commercial real estate sector,” it said.

Additionally, banks may have to increase loan-loss provisions amid deteriorating asset quality and rising credit risks, it noted.

Against this backdrop, the report also called for policy action to bolster deposit insurance and to address vulnerabilities in the non-bank financial sector “in order to further increase trust in the financial system and its ability to withstand risks.”