The growing hunt for yield in a low-return environment may be stoking a build-up of new financial system risks, the European Central bank (ECB) warns.
In a new report, the ECB says that stress on the European banking system has eased in recent months as efforts to adopt a new supervisory framework have gained ground, and banks have continued to strengthen their balance sheets. It says that, overall, Euro area financial system stress has been moderate over the last six months.
However, it also warns that new risks are emerging, “particularly a growing search for yield across regions and market segments, driven by increased investor confidence and some rebalancing of portfolios away from emerging markets, among other factors.”
While this so-called search for yield has helped the banks repair their finances, and bolstered sovereigns too, the ECB cautions that “as the breadth of the search for yield widens at the global level, risks of a possible reassessment of risk premia with implications for global financial markets are increasing. ” Indeed, concerns about the possible accumulation of imbalances are rising, it says, and with it, the risk of a “sharp and disorderly unwinding of recent investment flows.”
“As the potential for disorderly adjustment in financial markets remains, financial institutions need to have sufficient buffers and/or hedges to withstand it,” the ECB says.
In addition to this concern about possible imbalances, the ECB says that the other key risks for euro area financial stability over the next 18 months include weak bank profits and balance sheets; and, the possible re-emergence of sovereign debt concerns.
To that end, it suggests that there remains a need for action to mitigate lingering skepticism of banks’ balance sheets. And, in terms of sovereign debt worries, it says “complacency or reform fatigue” must be avoided.