Risks that abruptly increasing yields generate substantive asset price volatility and lead to losses across asset classes remain imminent and high. Financial markets experienced a return of market volatility in the first half of 2018 with corresponding episodes of sharp equity price declines and a sizable widening of sovereign and corporate bond spreads.
Risks related to the repricing of risk premia and possibly increasing interest rates directly affect financial institutions and retail consumers and might also cause contagion. The return of volatility puts additional pressure on bank profitability, not least shown by decreasing net trading income in early 2018. Increasing interest rates may also pose additional challenges to the still high – albeit decreasing – stock of non-performing loans in the EU, which still needs to be addressed.
The potential for sudden risk premia reversals also remains a major concern for insurance companies and pension funds, as this could negatively affect the value of their assets. On the other hand, the value of liabilities might decrease, in case such a reversal is combined with an increase in interest rates. Retail investors may also be affected by valuation risks through their portfolio holdings.
Finally, contagion between sectors after abruptly increasing yields might, e.g., occur through interconnectedness of the European banking sector with the market-based finance sector, as well as with the insurance sector, or from the still highly leveraged non-financial private sector.
Uncertainties around the terms of the UK’s withdrawal from the EU still have the potential to expose the EU27 and the UK to economic and financial instability and to weaken market confidence, particularly if negotiations end in a disorderly fashion. The need to prepare for a withdrawal of the UK from the EU without a withdrawal agreement, including the risk of reduced access to market infrastructures and contract continuity, have become very critical issues.
In light of the above mentioned risks and uncertainties, supervisory vigilance and cooperation across all sectors remains key. The Joint Committee advises the following policy actions by the European Supervisory Authorities (ESAs), national competent authorities, financial institutions and market participants moving forward:
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Against the backdrop of rising interest rates and the potential for sudden risk premia reversals, it remains crucial to conduct and develop further stress test exercises across all sectors.
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Supervisory authorities need to pay continued attention to the risk appetite of financial institutions. In particular, banks should accelerate addressing their stocks of NPLs and adapt business models to sustainably improve profitability.
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Macro- and micro prudential authorities should contribute to further address possible contagion risks, and they should continue their efforts in the monitoring of lending standards. Authorities concerned should moreover continue their efforts in monitoring and improving asset quality.
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It is crucial that EU financial institutions and their counterparties, as well as investors and retail consumers plan appropriate mitigating actions in a timely manner, to prepare for the UK’s withdrawal from the EU.
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