Higher rates ‘testing resilience’ of households, firms: ECB

Higher interest rates to combat inflation are “testing the resilience” of eurozone households and companies as credit conditions tighten, the European Central Bank (ECB) said in a report published Wednesday.

“As we tighten monetary policy to reduce high inflation, this can reveal vulnerabilities in the financial system,” ECB vice-president Luis de Guindos said in a statement accompanying the Financial Stability Review.

The ECB has hiked its key interest rates by an unprecedented 3.75 percentage points since last July in an attempt to bring down rapidly rising consumer prices in the 20-nation currency club.

Although economic conditions have “improved slightly” and energy prices have fallen, higher borrowing costs and stricter credit conditions “are testing the resilience of euro area firms, households and sovereigns”, the twice-yearly report said.

Demand for new loans, especially mortgages, declined sharply in the first quarter of 2023, it found.

The current “correction” in real estate markets “could turn disorderly if higher mortgage rates increasingly reduced demand”, the report warned.

Financial markets and investment funds were also “vulnerable to disorderly adjustments”, it said, “particularly in the event of renewed recession fears”.

Eurozone banks meanwhile had coped well with the turmoil caused by the failure of several US lenders and the forced takeover of Credit Suisse by UBS in March, the ECB said, largely thanks to their “strong capital and liquidity positions”.

“These events have served as a powerful reminder of the importance of ensuring that banking system fundamentals are sound,” de Guindos said.

The report however warned that banks “may need to set aside more funds to cover losses” amid signs of deteriorating loan portfolio quality, while reduced loan volumes because of higher interest rates could hit banks’ profitability.

“The outlook for euro area financial stability remains fragile,” the report said.

Eurozone inflation stood at seven per cent in April, still well above the ECB’s two-per cent target. Another rate hike is expected in June.

Financial markets and investment funds remain vulnerable to asset price adjustments. Stretched valuations, tighter financing conditions and lower market liquidity might increase the risk of any adjustment becoming disorderly, particularly in the event of renewed recession fears. So far, investment funds have been largely unaffected by recent tensions in the US and Swiss banking sectors. This could change, however, if funds suddenly required liquidity, forcing them to sell assets quickly.

Euro area banks have also proved resilient to stresses in US and Swiss banks on account of their limited exposures. This resilience was supported by strong capital and liquidity positions resulting from regulators’ and supervisors’ efforts over recent years. It will be essential to preserve this resilience amid some concerns about banks’ ability to build up capital. For example, higher interest rates reduce lending volumes and increase banks’ funding costs, which may impair their profitability. Furthermore, there are already signs of deteriorating asset quality in loan portfolios exposed to commercial real estate, smaller firms and consumer loans. Banks may therefore need to set aside more funds to cover losses and manage their credit risks.

In this context, it is essential to complete the banking union and, in particular, to establish a common European deposit insurance scheme. Additionally, vulnerabilities in the non-bank financial sector require a comprehensive and decisive policy response in order to further increase trust in the financial system and its ability to withstand risks.