The European Central Bank (ECB) sees growing risks for the financial stability of the euro area. “People and businesses are already feeling the effects of rising inflation and the slowdown in economic activity,” said ECB Vice President Luis de Guindos at the presentation of the central bank’s Financial Stability Report in Frankfurt.
“In our view, the risks to financial stability have increased and a technical recession in the euro area has become more likely,” said the ECB Vice President. If the economy shrinks two quarters in a row compared to the previous quarter, economists speak of a “technical recession”.
High inflation as the main risk to financial stability
“The main risk to financial stability and growth right now is that inflation remains at very high levels,” de Guindos said in a video link. “Our main contribution to financial stability now is to establish price stability.” The ECB sees this guaranteed in the medium term at two percent inflation in the euro area. Inflation has been a long way from this for months: consumer prices in the euro area in October were 10.7 percent above the level of the same month last year. In Europe’s largest economy, Germany, the inflation rate rose to 10.4 percent in October.
“Monetary policy must be aimed at price stability,” emphasized de Guindos – even if the rapid turnaround in interest rates poses a challenge for the financial sector. After a long period of hesitation, the ECB has been trying to get the extremely high inflation under control by raising interest rates sharply since July. The key interest rate in the euro area, which was frozen at a record low of zero percent for years, is now 2.0 percent.
The ongoing war in Ukraine remains a significant risk to inflation and growth, the ECB noted. Asked about Tuesday’s rocket attack in Poland, which killed two people, de Guindos said: “It is clear that these types of incidents increase geopolitical risks.”
Possible credit defaults at banks
As the deteriorating environment makes it more difficult for companies and households to repay their debts, banks could face higher loan defaults in the medium term, the ECB warns. If the prospects continue to deteriorate, an increase in corporate insolvencies cannot be ruled out, particularly among energy-intensive companies.
“Although the profitability of the banking sector has recently recovered as interest rates have risen, there are early signs of deterioration in asset quality, which could call for larger provisions,” writes the ECB. De Guindos reiterated: “We should not be blinded by the near-term improvement in European banks’ profitability.” Overall, however, the central bank, which directly supervises the largest banks in the euro area, considers the banking system in the currency area of the 19 countries to be “well positioned to withstand many risks”.
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