ECB’s inflation fight exposes fragilities in financial system

The European Central Bank’s fight against stubbornly high inflation has revealed fragilities in the financial system that are becoming increasingly difficult to ignore.

Higher interest rates are testing the resilience of households, companies, governments and property markets, the institution said Wednesday (May 31) annual Financial Stability Review.

That’s leaving markets vulnerable to disorderly adjustments, it cautioned. And while banks have been remarkably resilient to recent turbulence in the US and Switzerland, higher funding costs and lower asset quality could still dent their profitability.

The warnings serve as a comprehensive impact report on what’s already the most aggressive monetary-tightening campaign in the ECB’s 25-year history. But despite the swirling dangers to financial stability and economic growth in the 20-nation euro zone, officials battling to return inflation to 2% say the spate of rate hikes since last July isn’t over.

“Price stability remains as crucial as ever for durably preserving financial stability,” ECB vice president Luis de Guindos wrote in the preface of the report, before elaborating on the side effects policymakers must now accept.

“Tighter financing conditions to forcefully address high inflation have contributed to a reappraisal of the economic outlook and to a reversal of overly compressed asset-price risk premia,” he said. “As financial conditions normalis, this may expose fragilities and fault lines in the financial system.”

Property is one area the ECB singled out. House prices have cooled considerably over a relatively short period of time and could plummet further if higher mortgage costs continue to reduce demand.

At the same time, commercial real estate markets remain in a downturn thanks to tougher financing conditions, an uncertain economic outlook and weaker post-pandemic demand. That correction could test the resilience of investment funds, the ECB said.

It also identified some bright spots, while warning they shouldn’t be taken for granted after the financial turmoil that began in the US.

“In all of these challenges, the resilience of euro-area banks has been noteworthy, but should not give way to complacency,” Guindos said.

Lenders have been supported by strong capital and liquidity positions that must now be preserved, according to the ECB. Authorities should keep macroprudential capital buffers in place while some countries may also consider “targeted increases,” it said.

Given the elevated risks to economic growth and recent market tensions, banks should refrain from lifting their payout ratios and focus on preserving their existing resilience instead, the ECB said.

Several large European banks won approval from the ECB’s supervisory arm earlier this year to distribute billions of euros in excess capital to investors via share buybacks.

“Strengthening the banking union - and notably making progress on a common European deposit insurance scheme - will reinforce the ability of the euro area financial system to withstand risks going forward,” Guindos said.