The European Central Bank (ECB) sees heightened financial stability risks in some sectors and countries due to the uneven impact of the pandemic, according to its latest Financial Stability Review.
The bank said a higher corporate debt burden in countries with larger services sectors could increase pressure on governments and banks.
The ECB's warning comes as volatility has increased on the world’s financial markets after the rallies in the last six months that took world indices to new all-time highs. The top European markets were down over 1.5% on Wednesday afternoon, with the German DAX (-2.2%) leading the corrections.
Increased fears on overvaluation
The rallies seen in many financial markets in the past six months, and higher prices in the euro area residential real estate markets, have increased fears of overvaluation and the potential for abrupt asset price corrections.
"Financial markets have been driven by expectations of an upswing, exemplified by a striking rally in global equity markets. We are optimistic that financial and economic conditions will bounce back," said Luis de Guindos, the ECB's vice-president (pictured left).
"However, the pandemic will leave a legacy of higher debt and weaker balance sheets, which, if unaddressed, could prompt sharp market corrections and financial stress or lead to a prolonged period of weak economic recovery," he added.
The ECB report notes that equity markets remained buoyant, supported by a recovery in expected earnings and robust risk sentiment. The recent rise in composite stock indices has been coupled with a stronger advance by financial stocks.
However, it says the financial markets’ evolution has been "in contrast to weaker economic fundamentals" and "recent bouts of volatility highlight the risk of repricing".
"Despite the recent stock price declines in some sectors, stockmarket valuations remain elevated. In the United States, valuations stand well above pre-pandemic levels, whereas they are at more moderate levels in the euro area".
Bankruptcies could increase
Policy measures helped corporate insolvencies fall to historic lows during the pandemic. However, as this support is gradually removed, considerably higher insolvency rates than before the pandemic cannot be ruled out, especially in certain euro area countries, the ECB says. This could weigh on the countries and banks that provided support to corporates during the pandemic.
At the same time, recent increases in US benchmark yields have revived concerns about the potential for shifts in financial conditions. This could affect indebted corporates, households, states and those investors that have become increasingly exposed to duration, credit and liquidity risk in recent years.
Bank profitability remains weak
The market sentiment towards banks has substantially improved, as shown by the rise in bank stock prices since last October. However, bank profitability remains weak and prospects for lending demand are uncertain.
Bank asset quality has been preserved so far, but credit risk may materialise with a lag, implying a need for increased loan loss provisions, according to the ECB. "Early signs of a rise in loan impairments are becoming increasingly visible," the report also notes.