Challenges for financial stability at the Eurozone

The European Central Bank has released its “Financial Stability Review” (FSR) from May 2021 highlighting that “vulnerabilities remain elevated as the coronavirus pandemic continues to dominate the euro area outlook”. Among the main vulnerabilities the ECB point out to the uneven economic recovery by countries and sectors and the “higher corporate debt burden” in some countries, that eventually could increase pressure on governments and banks as public support measures are gradually removed.

The European Central Bank (ECB) “Financial Stability Review” report provides an overview of potential risks to financial stability in the euro area. In its last edition from May 2021 highlights that vulnerabilities remain elevated as the coronavirus pandemic continues to dominate the economic outlook. In this context the FSR points out to the following main vulnerabilities:

• The increasingly uneven economic recovery “has led to a clustering of risks in some sectors and countries”. By sectors the euro area services sector such as trade, transport and accommodation, arts and entertainment continues to be the more adversely affected by the mobility restrictions during the pandemic, by contrast, the industrial sector has been recovering faster.
• Disorderly corrections in financial markets. While the decoupling between financial markets and economic fundamentals has going on, the ECB alerts that “the recent rise of long term interest rates has increased focus on asset repricing risks, which may affect non-bank financial institutions”.
• Euro area banks are in better shape and bank valuations have improved, but profitability challenges remain and corporate insolvencies could increase as public support measures are gradually removed. In this regard the report offers the following data:
  - Debt-to-equity ratios have increased considerably among the most leveraged firms on average at 270% in 2020 (from 220% in 2019).
  - Euro area banks profitability (ROE ratio) expected is of 3% and 5% for 2021 and 2022 respectively, given higher provisioning needs and lower expected operating income.
• Corporate insolvencies may resume concerns on sovereigns and banks nexus. This may add concerns to sovereign debt sustainability due to the increase in sovereign debt-to-GDP ratio (The aggregate euro area ratio rose to 100% in 2020, up from 86% in 2019) and the continued need to support the recovery. Another potential spillovers from corporate insolvencies could be increasing unemployment and correction in residential property markets.
• Climate related risks and opportunities: The review also comments that Euro area financial institutions face material exposures to climate-related risks, recognizing the key role of green finance “to help foster an orderly transition to a low-carbon economy”.