The uneven economic impact of the pandemic means that financial stability risks are concentrated in specific sectors and countries, often with higher pre-existing vulnerabilities, concludes the May 2021 Financial Stability Review (FSR) of the European Central Bank (ECB).

"As the euro area emerges from the third wave of the pandemic, risks to financial stability remain elevated and have become more unevenly distributed," said Luis de Guindos, vice-president of the ECB. "A higher corporate debt burden in countries with larger services sectors could increase pressure on governments and banks in these countries. Extensive policy support, particularly for corporates, could gradually move from being broad-based to more targeted."

Risks emerge as financial support withdraws

Policy measures helped corporate insolvencies to fall to historic lows during the pandemic. However, as this support is gradually removed, considerably higher insolvency rates than before the pandemic cannot be ruled out, especially in certain euro area countries. This in turn could weigh on sovereigns and banks which provided support to corporates during the pandemic.

In parallel, the past six months have seen continued rallies in many financial markets and higher prices in euro area residential real estate markets, increasing worries about overvaluation and the potential for abrupt asset price corrections. Recent increases in US benchmark yields have revived concerns about the potential for shifts in financial conditions. This could affect indebted corporates, households, sovereigns and those investors that have become increasingly exposed to duration, credit and liquidity risk in recent years.

Market sentiment towards banks has substantially improved, as reflected by a marked rise in bank stock prices since the trough last October. However, bank profitability remains weak, while prospects for lending demand are uncertain. Bank asset quality has been preserved so far, but credit risk may materialise with a lag, implying a need for increased loan loss provisions. Effective NPL solutions and full use of available capital buffers are needed to support the recovery.

Non-banks continue to have large exposures to corporates with weak fundamentals and are sensitive to a yield shock given their material bond portfolio duration, exposure to US markets and high degree of liquidity risk.

"The ECB has warned about the financial stability of the euro area as it emerges from the pandemic and has raised concerns around the rally in yields, which could depress bond prices and impact balance sheets for European banks which remain under pressure," commented Jesús Cabra Guisasola, Global Capital Markets Associate at Validus Risk Management. "While the ECB has signalled optimism in its outlook of the European economy, it has highlighted that the pandemic will leave a legacy of higher debt and weaker balance sheets. We believe that this could lead to a weaker euro against the dollar and sterling, as the economic recovery will be uneven in the eurozone with the ECB not sending any clear signs of tapering their bond purchases programme in the short term."

The impact of climate change

The new edition of the FSR also includes analysis about the impact of climate change on financial stability in the euro area. A significant share of bank loan exposures to corporates could be subject to a high level of climate-related physical risk, directly affecting firms’ operations or the physical collateral used to secure loans. 

Both the assessment of risks and the allocation of financing to support the transition to a greener economy can benefit from enhanced disclosures and data, as well as clearer green finance standards. Preliminary results from climate stress testing indicate clear benefits from acting early.