Risks Of A Financial Crisis Are Bubbling Up In Europe

Risks Of A Financial Crisis Are Bubbling Up In Europe
Stéphane Renevier, CFA

about 1 year ago5 mins

  • A leading European regulator has identified three severe systemic threats to financial stability: a rising risk of consumer and corporate defaults, the presence of factors that could exacerbate price moves, and increased vulnerability of financial institutions.

  • The European Systemic Risk Board also identified four other elevated (but less severe) threats: vulnerabilities in residential and commercial real estate markets, cyber risks, and sovereign debt dynamics.

  • While Europe is better equipped to deal with those challenges today, it’s still fragile in places And the risk of a financial crisis, while still relatively low, is rising.

A leading European regulator has identified three severe systemic threats to financial stability: a rising risk of consumer and corporate defaults, the presence of factors that could exacerbate price moves, and increased vulnerability of financial institutions.

The European Systemic Risk Board also identified four other elevated (but less severe) threats: vulnerabilities in residential and commercial real estate markets, cyber risks, and sovereign debt dynamics.

While Europe is better equipped to deal with those challenges today, it’s still fragile in places And the risk of a financial crisis, while still relatively low, is rising.

The European Systemic Risk Board (ESRB) – which was created in 2010 to oversee the financial system of the European Union – is sounding an unprecedented warning, cautioning about the rising risks to financial stability in the eurozone. It sees seven systemic threats to the bloc’s financial stability – three of them severe.

What are the threats?

Businesses and households might struggle to pay back debt.

A particularly awful mix of high inflation, tighter financial conditions, and increased geopolitical risk has heightened the probability that Europe will face a recession next year (it’s more than 80%, according to the European Central Bank, or ECB). The issue is: vulnerabilities have been rising for EU corporations and further stress could impair their ability to make payments on their debt. Energy-intensive sectors, companies exposed to real estate, and firms with high debt levels seem particularly vulnerable given the pressures on interest rates, energy prices, and the real estate market

And while households are currently in decent financial shape on aggregate, inflation is squeezing disposable incomes and making it harder for lower-income ones to make necessary debt payments. If house prices fall and the labor market weakens, the financial situation of European households could deteriorate rapidly, potentially enough to become a threat to financial stability. While not directly mentioned in the ESRB report, I’d also highlight the risk to EU countries whose unsustainably high debt levels make them vulnerable to a deterioration in the macro environment.

A sharp fall in asset prices might amplify market volatility and cause liquidity issues.

Challenging macroeconomic conditions could lead to sharp moves in asset prices. This could threaten financial stability in at least three important ways. First, today’s thin liquidity in some markets (mostly bond markets but also others) could exacerbate price moves. Second, levered financial players like asset managers, insurance companies, and hedge funds could be forced to fire-sell their assets to meet big margin calls. Falling prices could lead to a vicious cycle of more margin calls, more selling pressure, and lower prices. Third, since those non-bank financial intermediaries are tightly linked, stress could spread rapidly, magnifying those shocks.

The asset quality and profitability of banks could deteriorate rapidly.

Sure, banks are in a much better position than they’ve been in the past: their capital and liquidity ratios are solid, and higher interest rates safeguard their profitability. But European banks are facing structural issues, are exposed to rising default risks on their loans, and suffer from a rise in short-term interest rates, which makes the funding they get more expensive.

But, in my estimation, the real problem could come from non-bank financial intermediaries, like hedge funds, pension funds, and asset managers. Those less-regulated entities tend to be highly levered, hold riskier and less liquid assets, and rely on riskier short-term funding, making them vulnerable to challenging market conditions. Since they’re now at the core of the financial system (and are now 80% of the size of the total European banking sector), stress for those intermediaries could represent a big threat to financial stability.

While those are the severe threats, the ESRB also identified four other elevated threats:

Residential real estate: years of soaring home prices and mortgage lending growth have made the housing market vulnerable to a fall in real household income.

Commercial real estate: profit margins in commercial real estate are particularly thin in Europe, making the sector vulnerable to rising financing and construction costs.

Cyber risks: big cyber attacks could disrupt the functioning of markets.

Sovereign debt dynamics: rising interest rates and foreign exchange rate risks make it harder for countries to make payments on their already high debt loads.

How worrying is all this?

Let's start with the good news: Europe is better equipped today to deal with these challenges than it was before the global financial crisis. Banks are in better shape, households appear less vulnerable, and risks from securitized products (like mortgage-backed securities and others that helped steer the financial system into the 2008-09 global crisis) seem lower. What’s more, the euro area has new tools at its disposal, aimed at smoothing out the impact of ECB actions – like interest rate changes and bond buying programs – across all 27 countries. All that should provide an additional buffer against shocks and limit the risks to the financial system.

And then, the bad news: you just don’t want to take this unprecedented warning from the ESRB lightly. This group was founded in the wake of the global financial crisis with one job in mind: preventing and mitigating systemic financial risk.

And, if you ask me, the ESRB’s recent warning doesn’t even flag all the risks Europe’s facing right now. The following risks are particularly underappreciated in my view:

Hidden threats: aggregate economic numbers don’t look too scary, but they might be concealing some risks brewing below the surface. For instance, the highest-income earners might have a disproportionate impact on aggregated household debt statistics, and hide some of the risks from lower-income ones.

Safe today doesn’t mean safe tomorrow: sectors that appear to be in strong shape can become vulnerable in the space of a few months. We saw that in 2007, ahead of the global financial crisis.

Risk cocktail: there’s always a chance that various threats materialize simultaneously, interacting with each other and amplifying each other’s impact.

Trouble whack-a-mole: vulnerabilities tend to pop up in unexpected places. For instance, almost no one expected that liability-driven instruments (LDIs), which have been popular in the UK for helping pension funds meet their future payout obligations, would create such a crisis for the country when interest rates surged.

As I argued here, what makes financial stability particularly tricky is that we’re unlikely to be able to predict what will break, when it will break, and how bad the break will be. Sure, we might avoid a repeat of 2008 (we could even avoid a recession altogether). But as geopolitical tensions remain, as central banks keep hiking rates to fight off inflation, and as key sectors like housing slow, a true “tail-risk” event, where markets experience extreme moves, becomes more likely.

In times like these, it’s wise to focus on what you can control, and make sure your portfolio can survive what you can’t control. That might mean avoiding any use of leverage, and thinking hard about whether you can psychologically and financially handle a steep loss. It might also be a good idea to keep some cash on hand in case opportunities arise.

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