ECB raises alarm over rising dangers to monetary system

A poisonous mixture of recession, hovering inflation, rising funding prices and decrease liquidity is threatening to set off monetary market turmoil within the euro space, the European Central Financial institution has warned.

Luis de Guindos, ECB vice-president, known as for banks to take extra provisions for dangerous loans, urged world regulators to make funding funds maintain extra liquid belongings and mentioned the central financial institution ought to be prudent in beginning to shrink its €5tn bond stockpile subsequent 12 months.

The ECB’s twice-yearly monetary stability evaluate mentioned excessive inflation, a rising chance of a recession and rising financing prices “pose rising challenges” for indebted households, companies and governments and will produce extra bankruptcies and monetary market volatility. 

“All of those vulnerabilities may unfold concurrently, probably reinforcing each other,” the report added.

The ECB has itself contributed to the strains by elevating rates of interest sharply this 12 months and it plans to debate easy methods to begin shrinking its virtually €5tn portfolio of bonds at its subsequent coverage assembly in December — a transfer that’s prone to improve stress on market liquidity. 

This ought to be accomplished “with lots of prudence”, de Guindos mentioned, including that in his private opinion, it might imply beginning with “partial and passive” quantitative tightening, which suggests solely changing a few of the bonds that mature, somewhat than actively promoting securities.

This 12 months’s turmoil in UK gilt markets and an earlier money crunch that hit European power merchants have underlined how the area’s monetary system is more and more weak to sharp strikes in market costs that might spill over right into a broader disaster, the ECB mentioned.

The ECB known as on world regulators — co-ordinated by the Monetary Stability Board — to speed up work to handle the non-bank monetary sector’s vulnerability to liquidity squeezes, much like one which hit cash market funds after the pandemic struck in March 2020.

De Guindos mentioned the ECB’s precedence was for funding funds uncovered to the chance of fast and large-scale withdrawals in instances of market stress to be compelled to carry a sure proportion of liquid belongings.

Money holdings by eurozone funding funds have risen because the begin of this 12 months, however the ECB mentioned their holdings of liquid belongings “stay comparatively low”. It warned: “The danger stays excessive that funding funds may, in an hostile situation, amplify a market correction through procyclical promoting behaviour.”

Whereas many lenders are benefiting from improved revenue margins because of rising rates of interest, the ECB warned “a weaker economic system and elevated credit score threat could weigh on financial institution profitability prospects within the medium time period”.

Some firms in sectors reminiscent of development and utilities had been fighting excessive power costs, elevated debt ranges and a restricted capability to go on greater prices to prospects, de Guindos mentioned.

He added that greater rates of interest would weigh on households’ capability to service their money owed, notably in international locations the place variable-rate mortgages are widespread. To arrange for greater defaults, he mentioned the ECB was “calling for a rise in provisioning” by banks.

The central financial institution additionally urged governments to make sure their assist measures in response to the power disaster had been focused and short-term, having already dedicated to spend an additional 1.4 per cent of euro space gross home product. “It can’t be the identical ‘no matter it takes’ fiscal coverage method that we’ve seen throughout the pandemic,” mentioned de Guindos.

“Extended excessive deficits in numerous international locations, coupled with rising funding prices, could not solely restrict the fiscal area accessible to shelter the economic system from future shocks, however can also put debt dynamics on a much less beneficial trajectory, particularly in international locations with greater ranges of debt,” the ECB warned.

Requested concerning the collapse of FTX, one of many greatest crypto buying and selling platforms, de Guindos mentioned the ECB had “to date not seen any spillover impact” to the broader monetary system, whereas including that “we’ve to maintain monitoring it”.