Trade tensions haven’t fully abated, but as they’ve eased, concerns about overvalued equity markets have taken over as the chief threat to financial stability, the European Central Bank (ECB) says.
In its latest review of financial stability risks, the ECB said the ongoing economic and financial fallout from tariffs, and continued policy uncertainty, is still weighing on the outlook — but, as that policy uncertainty has eased since April, global stock markets have reached new record highs.
Against that backdrop, financial markets, particularly equity markets, “remain vulnerable to sharp adjustments due to persistently high valuations and increasing equity market concentration,” the report said.
“Market sentiment could shift abruptly on account of deteriorating growth prospects, for example, or disappointing news on artificial intelligence (AI) adoption,” it said.
At the same time, “Liquidity mismatches in open-ended investment funds, pockets of high leverage among hedge funds and opacity in private markets could amplify market stress,” the regulator warned.
Concerns about strained public finances, and high levels of sovereign debt, could also lead to stress in global bond markets, which also impact financial stability, the ECB noted.
“Two elements may strain sovereign balance sheets in the medium term and pose risks from higher issuance needs and funding costs: first, the fiscal expansion associated partly with necessary defence spending, and; second, persistent structural challenges, including digitalization, low productivity, population ageing and climate change,” it said.
So far, banks have proven resilient, “amid strong profitability and ample capital and liquidity buffers,” the report said.
Additionally, both household and corporate balance sheets have improved, it noted.
“However, as the impact of tariffs unfolds, the corporate sector remains vulnerable,” the report said — and, if this leads to rising unemployment, household finances would suffer too — potentially driving banks’ credit risks higher as a result.
In this environment, strengthening the resilience of the financial system is key, the regulator said.
“In this context, macroprudential authorities should maintain existing capital buffer requirements and borrower-based measures to preserve sound lending standards,” it said.
Policymakers should seek measures to bolster the resilience of the non-bank sector, the ECB added.
“Such resilience would also help advance the integration of euro area capital markets.”