Common deposit insurance essential for financial stability, says ECB

The eurozone needs to complete the banking union in order to preserve financial stability, the European Central Bank said today (May 31).

The central bank’s financial stability review stresses that, although the region’s banks have remained resilient following the collapse of Silicon Valley Bank (SVB) in the US and Credit Suisse in Switzerland, stability “remains fragile”.

Against this backdrop, the review says: “It is essential to complete the banking union and, in particular, to establish a common European deposit insurance scheme.”

The institution stresses there is no room for complacency because higher inflation and interest rates are putting pressure on households and firms. Additionally, it points out risk can arise in several areas, including the real estate market, the traditional banking sector, as well as among non-banking financial entities.

“Price stability is crucial for durable financial stability,” said ECB vice-president Luis de Guindos. “But as we tighten monetary policy to reduce high inflation, this can reveal vulnerabilities in the financial system. It is critical that we monitor such vulnerabilities and fully implement the banking union to keep them in check.”

The ECB has increased interest rates from -0.5% in July 2022 to 3.25% now. This has contributed to lower inflation, which fell from a 10.6% peak in October to 7% in April. Nonetheless, it remains way over the 2% target. The ECB’s staff March macroeconomic projections foresee inflation should come back to the 2% target in the second half of 2025.

“We are in the correct trajectory. But we need to look very carefully at the evolution of core inflation,” de Guindos told reporters after the report’s release. “We are going to see volatility in headline inflation due to base effects, and because governments will phase in and out support measures that were introduced at the beginning of the energy crisis.”

Growing threats to banks

The ECB’s report acknowledges banks in the eurozone have remained stable during the turmoil experienced in the US and Switzerland earlier this year.

This resilience was supported by “strong capital and liquidity positions resulting from regulators’ and supervisors’ efforts over recent years”, says the financial stability review. “It will be essential to preserve this resilience amid some concerns about banks’ ability to build up capital.”

The report highlights how higher interest rates are already reducing lending volumes, increasing banks’ funding costs, which imperils lenders’ profitability.

Additionally, the institution says there are 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,” it adds.

The ECB recommends macro-prudential capital buffers should remain at least unchanged. In fact, the central bank thinks there is room for “targeted increases in capital buffer requirements”. This could be possible in countries with a positive neutral rate for the countercyclical capital buffer. “The build-up of the buffer towards the neutral rate is welcome, provided that procyclical effects are avoided,” adds the ECB.

The report points out that in a context of weaker growth prospects and elevated uncertainty, banks should avoid increasing payout ratios and should focus instead in preserving their resilience.

Non-banking risks

Once more the ECB’s financial stability review stresses potential risks stemming from non-bank financial institutions. For years the central bank has warned these market participants are vulnerable to shocks.

Tighter financing conditions and high market valuations could tip the current balance, triggering sudden capital outflows.

“So far, investment funds have been largely unaffected by recent tensions in the US and Swiss banking sectors,” says the report. “This could change, however, if funds suddenly required liquidity, forcing them to sell assets quickly.”

These 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”, stresses the ECB.

Real estate factor

The ECB also examines the real estate market. It says property prices are flattening or even starting to fall.

In residential markets, price increases have decreased over the last few months, reducing overvaluation in the sector. Nonetheless, although these adjustments have been gradual they risk becoming abrupt, especially in countries with floating mortgage rates. This could sharply reduce credit demand in a key financial sector.

Furthermore, “commercial real estate markets remain in a downturn, facing tighter financing conditions and an uncertain economic outlook, as well as weaker demand following the pandemic”, says the report. “The ongoing correction could test the resilience of investment funds with interests in the commercial real estate sector.”