ECB admits that eurozone remains vulnerable to financial shocks

The global economic slowdown has intensified since May due to a resurgence in protectionism and stress in emerging markets, while Brexit and wider political turbulence have all combined to make the eurozone’s financial system more vulnerable to shocks, the European Central Bank (ECB) said in its latest Financial Stability Report.

In its report, the ECB explained how vulnerabilities in financial markets continue to build amid pockets of high valuations and compressed global risk premia.

On top of that, the eurozone is contending with political uncertainty, primarily in the form of Brexit, but also Italy, with the country’s government looking to approve a 2019 budget that will dramatically increase spending and force the EU Commission to threaten sanctions to stop the country ‘sleepwalking into instability’.

‘The ECB has plenty to be concerned about from a financial stability perspective,’ Aberdeen Standard Investments economist Paul Diggle said. ‘Market risk premiums are highly compressed and valuations are elevated, creating a potential vulnerability just as quantitative easing is coming to an end.’

‘Sovereign debt sustainability has been called into question by Italy’s planned fiscal splurge and European banks’ ability to lend to the real economy is being hampered by ultra-low interest rates,’ he added.

Emerging market risks

The prospect of renewed stress in emerging market economies tested the resilience of the global financial system over the summer, with Argentina and Turkey both seeing significant increases in bond spreads, falling stock prices and large currency depreciations, the ECB said.

Higher US interest rates or rising trade tensions driven by president Donald Trump could spark further stress in emerging market economies, the ECB warned.

‘The ECB hasn’t yet grasped the extent of the eurozone economic slowdown, amid an increasingly challenging global economic outlook,’ Diggle said.

‘A slowing macroeconomy could bring many of the ECB’s concerns to the fore over the next few years,’ he added.

EU banks remain stable, but profitability remains restrained

Eurozone banks profitability has stayed relatively stable during the first half of the year, but the average return on equity sits at roughly 7%, which is still falling short of banks’ cost of capital, the ECB said.

Structural vulnerabilities including overcapacity in certain domestic banking markets and high operating costs continue to dampen bank profitability.

At the same time, reductions in non-performing loans (NPLs) continued apace. As a result, banks’ NPL ratios have nearly halved since 2014.

The recent European Banking Authority stress test confirmed that the capitalisation of eurozone banks is sufficient to weather a severe adverse scenario.