Potential for abrupt reversal in risk remains significant, ECB says

Euro area systemic stress has remained relatively low over the past six months, despite bouts of market turbulence, the European Central Bank said.

Nonetheless, "more volatility in the near future is likely and the potential for an abrupt reversal remains significant amid heightened political uncertainty around the globe and underlying emerging market vulnerabilities," the ECB said in its twice-yearly Financial Stability Report.

The impact of higher political uncertainty following the UK referendum and the US elections, together with that from worries about the long-term profitability of euro area banks, had been offset to a degree by continued accomodative monetary policies and lessened worries about a possible sharp slowdown in China, the monetary authority explained.

Hence, risk premiums world-wide continued to be compressed.

In its report, the ECB pointed out four main risks for the Eurozone economy: 1. A repricing of global risks which could lead to financial contagion, 2. An adverse freedback loop between weak bank profits and low nominal economic growth; 3. That reforms might stall in the face of political uncertainty; and 4. Prospective stress in the investment fund sector.

Banks´ main challenge continued to be the large stock of non-performing loans

As regards euro area banks' profitability, the ECB said volatility in stockmarkets had increased their so-called cost of equity, which might hamper their ability to lend to the real economy.

A still subdued nominal growth environment meant banks´ ability to generate capital themselves in an 'organic' manner was constrained too.

Yet the main challenge for banks continued to be the large stock of non-performing loans in several countries, incomplete business models and overcapacity in some national banking sectors.

"Going forward, the higher cost of external financing coupled with the prospect of limited internal capital-generating capacity increase the likelihood that an adverse feedback loop could emerge between weak bank profitability and the sluggish economic recovery."

The FSB also warned that policy decisions at the national and EU level might lead to weaker fiscal and structural reform efforts, in turn hurting both public finances and economic growth, thus complicating the situation of lenders.

Closer monitoring of investment funds required

Frankfurt also pointed out the that risks were building up in the euro area investment fund sector, highlighting the run on some open-end UK property funds following Brexit.

While admitting the sector´s positive contribution to the economy and capital markets more generally, the FSB cautioned that "the rapid growth in this sector over recent years needs to be met with a commensurate increase in monitoring. Many of these funds are also exposed to liquidity mismatches.

"This characteristic increases the potential for the investment fund sector to amplify market-wide shocks."