ESAs call for vigilance in the face of mounting financial risks

The three European Supervisory Authorities (EBA, EIOPA and ESMA - ESAs) issued their Spring 2023 Joint Committee Report on risks and vulnerabilities in the EU financial system. While noting that EU financial markets remained broadly stable despite the challenging macro environment and recent market pressure in the banking sector, the three Authorities are calling on national supervisors, financial institutions and market participants to remain vigilant in the face of mounting risks.

The second half of 2022 witnessed a worsening of the macro environment due to high inflation and tighter financial conditions, and the economic outlook remains uncertain. Although recent growth forecasts no longer point to a deep recession and inflation is showing signs of moderation, price growth may remain elevated for longer than previously expected. Recent market pressure on banks following the collapse of a few midsize banks in the United States and the emergency merger of the distressed Credit Suisse with the Union Bank of Switzerland (UBS) highlighted continued high market uncertainty, the sensitivity of the European financial system to exogenous shocks and potential risks related to the end of over a decade of very low interest rates.

Asset prices were highly volatile over the past months with market liquidity fragile. Sharp movements in prices triggered sizeable margin calls and put some market participants under liquidity strains, notably non-financial corporations and non-bank financial institutions. High levels of uncertainty and imbalances in the supply and demand of liquidity are a drag on the financial system’s resilience against further external shocks. In addition to these risks, geopolitical tensions, environmental threats and an increase in the frequency and sophistication of cyberattacks further complicate the risk landscape.

Against the backdrop of these risks and vulnerabilities, the Joint Committee of the ESAs advises national supervisors, financial institutions and market participants to take the following policy actions:

• financial institutions and supervisors should remain prepared for a deterioration in asset quality and supervisors should keep a close eye on loan loss provisioning;
• the broader impact of policy rate increases and sudden rises in risk premia on financial institutions and market participants should be considered and accounted for in (liquidity) risk management;
• liquidity risks arising from investments in leveraged funds and the use of interest rate derivatives should be monitored closely;
• financial institutions and supervisors should closely monitor the impacts of inflation risk. Inflation can have an impact on asset valuation and asset quality as borrower debt servicing is affected. Inflationary trends should be taken into account in product testing, product monitoring and product review phases and investors should be made aware of the effects of inflation on real returns;
• banks should pursue prudent capital distribution policies to ensure their long-term financial resilience given the uncertain medium-term outlook for profitability;
• the strong regulatory frameworks that underpin the resilience of the financial sector are to be maintained, including by faithfully implementing the finalization of Basel III in the EU without delay and with as little deviation as possible, and by avoiding further deviations from EIOPA’s advice on the Solvency II review;
• risk management capabilities and disclosures for environmental, social and governance (ESG) risks should be enhanced as these risks are increasingly becoming a source of financial risk; and
• financial institutions should allocate adequate resources and skills to ensure the security of their information and communication technology (ICT) infrastructures and adequate ICT risk management.