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Our financial stability assessment has also changed considerably compared to one year ago. In our Financial Stability Review of November 2021, we underlined the impact of improved economic conditions in reducing risks to financial stability. Since then, the outlook for financial stability has been downgraded twice: in our Financial Stability Review of May 2022, and the one to be published this week, which sets out how deteriorating economic and financial conditions have further increased risks to the stability of the euro area financial system.
The Russian invasion of Ukraine triggered a substantial correction in the market prices of financial assets. So far, this repricing has generally been orderly, but market volatility increased, leading to knock-on effects for margins and liquidity. Asset valuations remain sensitive to the uncertain path of inflation, to monetary policy normalisation and to economic activity.
Repricing risks and liquidity difficulties render financial markets and non-bank financial institutions vulnerable to disorderly risk adjustments. Investment funds’ liquid asset holdings remain low and could thus amplify a market correction in a forced selling scenario. Since last year, rising rates reduced by around 4% the value of insurance companies and pension funds’ bond portfolios. This points to risks from further valuation losses, especially for leveraged and liquidity-constrained institutions.
Higher interest rates are supporting euro area banks’ profitability, with interest margins improving. Bank profitability has in fact steadily strengthened throughout 2022 mainly due to lower operating expenses and higher operating income. The outlook is, however, clouded by a weaker macroeconomic backdrop which is not yet reflected in loan loss provisions and overall lending volumes. Inflation is also pushing up operating expenses for banks, whose profitability was strongly supported by cost-cutting efforts over the past years. Banks could face higher credit risk from their increased exposures in recent years to vulnerable sectors, notably residential real estate markets. The flipside of higher interest rates is that funding costs will ultimately rise too. Furthermore, longer-term fragilities persist associated with low cost-efficiency, limited revenue diversification and remaining overcapacity in parts of the euro area banking sector.
Fiscal support helped cushion the impact of the pandemic over the past years and higher energy prices this year. But higher deficits coupled with rising funding costs may limit the fiscal space available to shelter the economy from future shocks. It may also put debt dynamics on a less favourable trajectory, especially in countries with higher levels of debt. To preserve debt sustainability, it is therefore essential that support measures are temporary and targeted towards the most vulnerable entities.
The corporate sector, which benefited from the fiscal support and a strong recovery in the second half of last year, has seen profitability above pre-pandemic levels in the first half of 2022. But soaring prices for energy and commodities are likely to hurt activity, especially in energy-intensive sectors. Corporate insolvencies have remained well below pre-pandemic levels. But some sectors have already seen an increase in expected default rates and might be at greater risk of insolvencies in the event of adverse economic surprises or a further tightening of financial conditions.
In 2021, households benefited from the economic recovery, low unemployment and favourable financing conditions. But they are now feeling the effects of higher inflation and recession fears, as reflected in declining consumer confidence and projections of households’ future financial situation. Low-income households have been disproportionately affected by consumer price and interest rate increases in 2022, as they spend around 70% of their income on basic living expenses such as food, energy and housing. Further increases in the cost of living would severely limit their ability to withstand further shocks.
Let me conclude.
We are living in a period of high uncertainty due to a deteriorating economic outlook, inflationary pressures, tighter financing conditions and geopolitical tensions. A resilient financial sector is essential in these times. Thanks to regulatory advances and active use of prudential policies since the global financial crisis, the banking sector is in a good position to withstand economic shocks. To enhance resilience over the medium term, the focus should remain on improving the effectiveness of the macroprudential toolkit and faithfully implementing Basel III.
In the non-bank financial sector, it is imperative to reduce vulnerabilities arising from liquidity mismatch by better aligning redemption terms with asset liquidity. International efforts should prioritise developing a globally consistent approach for addressing risk from leverage – including synthetic leverage. High financial market volatility and associated liquidity challenges have once more highlighted the need to improve margining practices and the ability of non-banks to meet margin calls in derivatives transactions.
The currently high inflation is expected to stay above our target for an extended period. Our monetary policy must therefore remain focused on reducing support for demand and guarding against the risk of second-round effects. Amid the present uncertainty, future decisions on policy rates will continue to be data-dependent and taken on a meeting-by-meeting approach. The policy decisions we will take at our next meeting will be based on various elements, including our December macroeconomic projections. At this meeting, we also expect to lay out the key principles for reducing the bond holdings in our monetary policy portfolios. We will proceed with prudence, continuing to normalise our monetary policy in line with our medium-term price stability objective.