Foreword

Alongside geopolitical and policy uncertainty, global trade tensions are on the rise, increasing the risk of tail events. Financial markets have seen a resurgence of volatility, enduring several notable spikes since the last edition of the Financial Stability Review was published. In the euro area, while inflation pressures are receding, market participants are concerned about the potential for weaker than expected growth.

So far, financial markets have demonstrated resilience, with episodes of volatility proving brief and having only a limited impact on the broader financial system. However, underlying financial market vulnerabilities – notably stretched valuations and risk concentration – remain significant, making further bouts of volatility more likely than usual. At the same time, liquidity fragilities in non-bank financial intermediaries, in some cases coupled with high financial and synthetic leverage, have the potential to intensify and render market stress more enduring.

Meanwhile, sovereign vulnerabilities are deepening. Despite recent reductions in debt-to-GDP ratios, fiscal challenges persist in several euro area countries, exacerbated by structural issues such as weak potential growth and heightened policy uncertainty. While non-financial sectors appear broadly resilient, there are credit risk concerns for some euro area households and firms, particularly in the real estate sector and among lower-income households and small and medium-sized enterprises which would be most affected should growth slow.

The main aim of the ECB’s Financial Stability Review is to promote awareness of systemic risks among policymakers, the financial industry and the public at large, with the ultimate goal of promoting financial stability. This edition marks the 20th anniversary of the Review. Its structure and scope have evolved over the past two decades, adapting to lessons learned from financial crises, the evolution of the financial system and the ECB’s acquisition of a macroprudential policy mandate in 2014. Special Feature A provides a retrospective analysis to commemorate this milestone. Additionally, this edition includes a study of weak productivity among euro area firms, examining the role of finance and its implications for financial stability.

The FSR has been prepared with the involvement of the ESCB Financial Stability Committee, which assists the decision-making bodies of the ECB in the fulfilment of their tasks.

Luis de Guindos
Vice-President of the European Central Bank

Overview

Bouts of market volatility emerge in an environment of high macro-financial and geopolitical uncertainty

Since the previous issue of the Financial Stability Review was published, the balance of macro risks in the euro area has shifted from concerns about inflation remaining high to fears over growth. Consumer price inflation has moved closer to central bank targets in both the euro area and other major advanced economies in recent months (Chart 1, panel a). At the same time, economic data released after June tended to disappoint expectations in the euro area, and private sector forecasters have revised down their 2025 real GDP growth forecasts (Chart 1, panel b). Easing inflationary pressures and weaker growth prospects have allowed interest rate cycles to turn in most major advanced economies. At the time of finalisation of this issue of the Financial Stability Review, financial markets were pricing in additional rate cuts for both the euro area and the United States. While most official and private sector forecasters still see a soft landing as the baseline scenario for the euro area and global economies, risks to growth are tilted to the downside, with the outlook clouded by heightened macro-financial and geopolitical uncertainty. Cyclical headwinds for euro area growth are compounding structural issues of low productivity and weak potential growth across the euro area economy (Chart 1, panel c and Special Feature B).

Chart 1

The balance of risks has shifted from worries that inflation will remain high to growth fears, with structurally low growth potential compounded by cyclical headwinds

a) Inflation and number of central banks hiking/cutting rates in advanced economies	b) 2025 real GDP growth forecasts for the euro area and the United States	c) Average potential output growth in the euro area and the United States from 1991
(Jan. 2004-Nov. 2024; left-hand scale: numbers, right-hand scale: percentages)	(Jan.-Nov. 2024, percentage changes per annum)	(1991-2020, percentages)

Financial markets have experienced several pronounced but short-lived spikes in volatility, while geopolitical risks remain pronounced. Initially, these spikes were linked to unexpected European and national election outcomes, with the effects mostly contained within Europe (Chart 2, panel a). Later in the summer, a combination of stretched positions in a low equity market volatility environment, market expectations of faster US monetary policy easing in a context of disappointing labour market data and an unexpected tightening of monetary policy in Japan (which led to the unwinding of yen-funded carry trades) resulted in a significant volatility spike with global repercussions (Chapter 2). Although the market correction did not last long and prices recovered quickly for most asset classes, these episodes indicate greater sensitivity than usual to macroeconomic data surprises, raising the potential for heightened volatility going forward. Alongside high macro-financial uncertainty, geopolitical risks and economic policy uncertainty have also been on the rise in recent months (Chart 2, panel b), increasing the likelihood of tail events materialising and further amplifying the growing threat of cyber risks. Also, rising global trade tensions and a possible further strengthening of protectionist tendencies across the world raise concerns about the potential adverse impact on global growth, inflation and asset prices.

Chart 2

Heightened macro-financial and geopolitical uncertainty has triggered bouts of market volatility, underscoring the risk of abrupt shifts in market sentiment

a) Implied stock market volatility in the euro area and the United States	b) Trade policy uncertainty, global economic policy uncertainty and geopolitical risk
(1 Jan.-12 Nov. 2024, index)	(Jan. 2014-Oct. 2024, z-scores)

Against this backdrop, there are three key sources of risk and vulnerabilities for financial stability in the euro area over the next two years. First, stretched valuations in equity and corporate bond markets together with high risk concentration make financial markets susceptible to adverse dynamics, which could be amplified by non-bank liquidity and leverage vulnerabilities. Second, heightened policy and geopolitical uncertainty, weak fiscal fundamentals and sluggish trend growth raise concerns about the sustainability of sovereign debt in some euro area countries. Third, credit risk concerns in some cohorts of the corporate and household sectors may lead to asset quality headwinds for banks and non-banks.

Financial markets remain vulnerable to adverse dynamics which could be amplified by non-bank liquidity fragilities

High valuations and risk concentration render financial markets susceptible to sudden, sharp adjustments, notably in equity markets. While stock markets have recently absorbed tail events swiftly, underlying vulnerabilities make them prone to similar episodes in the future. There are signs that investors may be underestimating and under-pricing the likelihood and impact of adverse scenarios, as indicated by record low equity risk premia and relatively compressed corporate bond spreads on both sides of the Atlantic (Chart 3, panel a). Also, concentration of equity market capitalisation and earnings among a handful of single names, notably in the United States, has increased greatly in recent years (Chart 3, panel b). This concentration among a few large firms raises concerns over the possibility of an AI-related asset price bubble. Also, in a context of deeply integrated global equity markets, it points to the risk of adverse global spillovers, should earnings expectations for these firms be disappointed (Chapter 2). As such, there is a greater likelihood that negative surprises – including sharply deteriorating economic growth prospects, sudden changes in monetary policy expectations or further escalation of ongoing geopolitical conflicts – could trigger abrupt shifts in investor sentiment, resulting in spillovers across asset classes.

Concentrated exposures, liquidity mismatches and high leverage in parts of the non-bank financial intermediation (NBFI) sector could amplify adverse market dynamics. Non-banks have remained resilient to recent bouts of market volatility and have continued to support market-based finance in the euro area across all credit risk categories. However, broader market shocks could trigger sudden investment fund outflows or margin calls on derivatives exposures. Given relatively low liquid asset holdings and significant liquidity mismatches in some types of open-ended investment funds (Chart 3, panel c), cash shortages could result in forced asset sales that could amplify downward asset price adjustments (Box 5). While generally limited, pockets of elevated financial and synthetic leverage in some entities, like hedge funds, may add to spillover risks (Chapter 4.2). Concentration in equity portfolios − notably in some investment funds due to their exposure to a few large firms − has also risen markedly in recent years, making investment portfolios more vulnerable to negative firm- or sector-specific surprises. Also, rising exposure to US assets increases the potential for adverse macro-financial spillovers.

Structural vulnerabilities in the NBFI sector require a comprehensive policy response to enhance the sector’s resilience from a macroprudential perspective. A growing market footprint and interconnectedness of non-banks calls for a wide-ranging set of policy measures to increase the sector’s resilience. This includes policies aimed at enhancing the liquidity preparedness of non-bank market participants to meet margin and collateral calls, tackling risks from non-bank leverage, mitigating liquidity mismatch in open-ended funds and fostering the resilience of money market funds to liquidity shocks (Section 5.3). A more integrated EU-wide system of supervision for non-banks would ensure a level playing field and reduce the potential for regulatory arbitrage. A resilient NBFI sector would also help to promote more integrated capital markets, which could enhance financial stability and complement the objectives of the capital markets union that would form part of a renewed strategy aimed at supporting Europe’s productivity and economic growth.

Chart 3

High valuations and increasing risk concentration render equity and credit markets vulnerable to shocks, which could be amplified by non-bank liquidity fragilities

a) Equity and credit risk premia for the euro area and the United States	b) Concentration in US stock markets and euro area non-banks’ US exposures	c) Euro area non-banks’ holdings of cash and HQLA
(Jan. 2009-Nov. 2024, percentages, basis points)	(Q1 2016-Q2 2024, percentages)	(Q1 2021-Q2 2024, percentage of total assets)

Sovereign vulnerabilities are increasing, driven by heightened policy uncertainty and sluggish growth

Heightened geopolitical and policy uncertainty is exacerbating sovereign vulnerabilities. Since the previous issue of the Financial Stability Review was published, election outcomes at the European and national levels, notably in France, have rekindled concerns about sovereign debt sustainability. Greater policy uncertainties and market concerns about their implications for debt sustainability have resulted in some sovereign spreads widening for some euro area sovereigns with high levels of debt (Section 1.2), albeit with limited cross-border spillovers for now. Concurrently, the longer-term trend of rising political fragmentation observed over the past three decades has made it more challenging to form stable government coalitions. This may contribute to delays in reaching agreement on key fiscal and structural reforms while also raising economic policy uncertainty (Chart 4, panel a). Furthermore, rising geopolitical uncertainty may imply an additional burden for sovereigns in dealing with the consequences of geopolitical fallout (e.g. energy subsidies). This would be particularly challenging for countries where public debt levels are high, given their limited fiscal space to support the economy in the event of adverse shocks.

Chart 4

Sovereign vulnerabilities have increased, given heightened geopolitical and policy uncertainty, weak fiscal fundamentals and sluggish potential growth

a) Vote shares of winning parties and economic policy uncertainty in Europe	b) Fiscal compliance scores and budget balances across the euro area	c) Simulated reaction of the sovereign debt ratio to standardised shocks over a ten-year horizon
(1987-2024; percentages, indices)	(scores, percentages of GDP)	(percentage points of GDP)

Fiscal fundamentals remain vulnerable to slippage and weak potential growth in some countries. Despite the declines in sovereign debt-to-GDP ratios after the surge seen during the pandemic, fiscal fundamentals remain weak in some countries, given elevated debt levels, ongoing excessive deficit procedures and poor historical compliance with EU fiscal rules (Chart 4, panel b). Even though the interest rate cycle has turned, sovereign debt service costs are expected to rise further as maturing debt is rolled over at higher interest rates than on outstanding debt. Fiscal slippage or uncertainties around fiscal consolidation paths under the new EU fiscal framework could lead to a repricing of sovereign risk, fuelling bond market volatility and policy uncertainty (Box 1). Structural headwinds to potential growth from factors like weak productivity could also threaten debt sustainability (Chart 4, panel c). Fiscal reform to ensure a long-term growth-friendly composition of public finances and structural reforms are key to raising potential growth in the euro area. Also, greater discipline on current spending would help create the fiscal space needed to meet the structural challenges of climate change, defence spending, ageing and digital transformation, as envisaged by the new EU fiscal framework.

The market response to elections in Europe earlier this year proved temporary and localised, with limited cross-sector spillovers. Greater volatility in sovereign debt markets was paralleled by falling bank share prices in countries where policy uncertainty is high. The falls proved short-lived, however, and spillovers to other sectors and countries remained contained. On a positive note, euro area banks’ sovereign exposures relative to their capital remain, on average, below their multi-year averages despite a recent rise, while sovereign bonds are for the most part also held at amortised cost. This makes increases in sovereign spreads and market volatility less of an immediate worry. Sovereign debt sustainability concerns coupled with heightened policy uncertainty may spill over to the corporate sector via rating downgrades and higher funding costs. They could also result in forced and procyclical asset sales by non-banks if there is an abrupt increase in sovereign bond yields or broad-based rating downgrades, reinforcing adverse feedback loops across sectors.

Credit risk concerns for some corporates and households may affect bank and non-bank asset quality

High funding costs and weak economic growth continue to affect corporate balance sheets, especially of commercial real estate (CRE) firms and SMEs. Interest costs continue to weigh on firm profitability even as new lending rates decline. Insolvencies – a lagged indicator of corporate financial health – have been rising across sectors and countries (Section 1.3), albeit from moderate levels. This reflects both the phasing-out of pandemic-related policy support and continued weak and uncertain business prospects (Chart 5, panel a). The debt servicing capacity of SMEs appears to be particularly vulnerable to a slowdown in economic activity and higher borrowing costs. Conditions in euro area CRE markets show signs of stabilisation, with investor demand recovering somewhat, in line with less restrictive monetary policy (Section 1.5). However, structural factors related to the post-pandemic shift to remote working and e-commerce, as well as environmental considerations, continue to make the outlook for some real estate firms challenging.

Euro area household vulnerabilities have eased, yet interest costs are challenging low-income cohorts. Household finances have benefited from lower leverage, resilient labour markets, strong income growth and higher savings. However, households with lower incomes and floating-rate mortgages are being challenged by high interest rates. Slower growth and weaker labour markets could undermine households’ debt servicing capacity. In turn, residential real estate (RRE) markets could suffer. For now, adjustments have remained orderly, but risks are skewed to the downside, especially in countries with elevated mortgage debt levels and overvalued property markets (Section 1.5). RRE markets could yet face stress if labour market conditions were to worsen markedly, adding to affordability challenges arising from high, albeit declining, mortgage rates.

Chart 5

Credit risk concerns in some segments of the corporate and household sectors may lead to asset quality headwinds for both banks and non-banks going forward

a) Capacity utilisation, order book levels and industrial confidence in the euro area	b) Net NPL flows for SME and CRE lending in the euro area	c) Euro area non-banks’ asset holdings, by issuer country macro-fiscal outlook
(Q1 2021-Q4 2024, percentages, percentage balances)	(Q3 2023-Q2 2024, percentages of total loan stock)	(2021-25, percentages)

Bank asset quality has remained resilient, but credit quality concerns in parts of the non-financial sectors suggest challenges lie ahead. While non-performing loan (NPL) ratios are at historical lows, aggregate losses in cyclically sensitive loan portfolios − notably CRE, SME and consumer lending − have been rising, albeit with significant cross-country variation (Chart 5, panel b). CRE loan books have been the main contributor to weakening asset quality, but their relatively modest size mitigates systemic impacts on the banking sector. At the same time, these exposures are concentrated, and banks with above-average CRE exposures could still face stress if CRE asset quality were to worsen further. The deterioration of SME credit quality has been more contained, but it is also more widespread. Its persistence could have a stronger impact on banks and the real economy than currently expected. The credit risk outlook for corporate and household portfolios remains tilted to the downside, given weak macro-financial conditions, downside risks to economic growth and the lagged impact of high interest rates on borrowers. Banks may yet face higher provisioning costs if risks in non-financial sectors were to materialise, not least because declining collateral values may not be fully reflected in their balance sheets.

Banks’ ability to absorb further asset quality deterioration continues to be supported by high levels of profitability together with strong capital and liquidity buffers. Lower operating expenses and strong net interest margins have enabled euro area banks to maintain high levels of profitability. Their resilience is aided by solid capital ratios and liquidity buffers, despite the gradual phasing-out of funding from targeted longer-term refinancing operations. That said, bank profitability may have peaked, as downward pressure on earnings on floating-rate assets become a headwind for interest income while credit losses start to rise. In this context, it is key for macroprudential capital buffer requirements to be kept at levels that preserve banks’ resilience. Existing borrower-based measures should be maintained to serve as structural backstops and ensure sound lending standards in all phases of the financial cycle.

Asset quality in non-bank portfolios may be impaired by weak corporate fundamentals and property market conditions. Despite some rebalancing of their investment portfolios towards safer assets in recent years, non-banks still face elevated credit risks. High economic uncertainty and weak corporate fundamentals have led to a deteriorating credit outlook, exposing the NBFI sector to revaluation losses from downgrades and increasing default risk. Exposures to countries with low economic growth and fragile public finances seem particularly vulnerable, as weaker sovereigns may lack the fiscal space to help the economy weather adverse shocks (Chart 5, panel c). Valuation risks also extend to non-banks’ real estate portfolios. Sharp falls in CRE prices may not yet be fully reflected in the valuations of real estate investment funds, posing risks of sizeable unrealised losses (Section 4.2). Further price declines in euro area CRE markets could lead to fund outflows, exacerbated by procyclical selling by non-banks. Strong linkages could cause any stress in the NBFI sector to spill over to euro area banks, especially via funding.

Euro area financial stability vulnerabilities remain elevated in a volatile environment

All in all, sources of risk and vulnerability for financial stability have remained elevated since the previous issue of the Financial Stability Review was published. While financial markets and non-banks have proven resilient to recent bouts of volatility, the likelihood of tail events remains high as the balance of risks shifts in the euro area from concerns about inflation remaining high to fears over growth. In a context of elevated macro-financial and geopolitical uncertainty, there could be a sudden sharp reversal in risk sentiment, given high asset valuations and concentrated risk exposures in the financial system. Political and policy uncertainties have turned the spotlight back on sovereign risks, causing sovereign vulnerabilities to rise. Possible escalation in tensions associated with the conflicts in the Middle East and Ukraine, plus heightened trade policy uncertainty, could trigger a weakening of macro-financial conditions, with repercussions for credit risk in the financial and non-financial sectors.

In addition, several cross-cutting structural issues remain critical for financial stability and could interact with and amplify existing cyclical vulnerabilities. These issues are associated with climate-related risks − both transition and physical − on the way to a low-carbon economy; cybersecurity weaknesses, including outages of systemic IT providers, and the rise of AI; and geopolitical fragmentation sending global economic, trade and financial integration into reverse. The potential for these cyclical and structural vulnerabilities to materialise simultaneously and amplify one another raises the risks to financial stability, potentially creating adverse feedback loops across various sectors.

1 Macro-financial and credit environment

1.1 Policy uncertainty and geopolitical tensions weigh on euro area growth outlook

The euro area economy is recovering from the energy crisis and the post-pandemic surge in inflation, albeit at a slower pace than expected six months ago. Progress in bringing down inflation allowed the ECB and other central banks to start lowering their policy rates earlier this year. While the resulting easing of financing conditions should support the economic recovery ahead, the past interest rate hikes are still weighing on the euro area economy. Activity in capital-intensive sectors that tend to be more sensitive to changes in interest rates, such as manufacturing and construction, has underperformed the services sector. That said, recent indicators point to a broader weakening in business activity in the near term (Chart 1.1, panel a). Poor growth in the manufacturing sector partly reflects structural factors related to subdued productivity growth and losses in competitiveness of euro area producers. The latter are due to energy prices in the euro area still being higher than in other regions amid fiercer price competition from third countries. Economic growth in recent quarters has been supported by external demand for euro area goods and services. However, competitiveness issues are likely to continue dragging on euro area export growth. Recent household surveys point to high levels of saving and restrained consumption ahead (Section 1.4), which could pose a downside risk to broader economic growth as well, as private consumption has been making a positive contribution to economic expansion of late (Chart 1.1, panel b). Overall, the pace of economic recovery in the euro area is likely to be slower than expected a few months ago.

Chart 1.1

Economic recovery remains uneven across sectors and domestic demand is picking up only slowly

a) Purchasing Managers’ Indices of economic activity for the euro area	b) Drivers of euro area GDP growth
(June 2022-Oct. 2024, indices)	(Q1 2016-Q4 2019, Q1 2023-Q2 2024; percentages, percentage point contributions)

Risks to the macro-financial outlook are tilted to the downside. The main domestic sources of risk are a stronger than expected impact of past monetary policy tightening, weaker consumer confidence and slower productivity growth. Slow growth could challenge the debt servicing capacity of all sectors in the economy and thus have an adverse impact on financial stability. In this context, Special Feature B looks at the link between low firm productivity and financial stability in more detail. Outside of the euro area, a stronger than expected slowdown in China, coupled with continued downward pressure on global export prices from Chinese producers, could weaken euro area exports further (Chart 1.2, panel a). At the same time, financial markets remain vulnerable to bouts of volatility (Chapter 2) amid persistently high uncertainty about the economic policy and geopolitical outlook.

Chart 1.2

Geopolitical risks and uncertainty about economic policies pose downside risks to the euro area growth outlook

a) Economic activity and producer price inflation in China	b) Share of China in euro area and US trade and trade policy uncertainty	c) Uncertainty in the euro area
(Jan. 2022-Dec. 2025; year-on-year percentage changes)	(Q1 2015-Q3 2024; left-hand scale: percentages, right-hand scale: index)	(Jan. 2015-Oct. 2024, indices)

Uncertainty stemming from geopolitical tensions and economic policies remains elevated. Russia’s war against Ukraine and the conflict in the Middle East continue to be the major sources of geopolitical risk. A further escalation of the tensions could have a considerable adverse impact on euro area growth − through higher energy and import prices and lower confidence among euro area households and firms − and could pose upside risks to the disinflation process. In this context, natural gas prices have declined from their 2022 peaks, but remain higher and more volatile than before Russia’s full-scale invasion of Ukraine, contributing to the competitiveness pressures faced by euro area firms. Relatedly, uncertainty about global trade policy is on the rise as well. While trade links among some of the major economies have weakened in recent years amid heightened geopolitical tensions, this has not been the case for the euro area. For example, China now accounts for a somewhat larger share of euro area trade than before the COVID-19 pandemic (Chart 1.2, panel b). This makes the euro area vulnerable to the risk of further geopolitical, economic and financial fragmentation in the global economy. Finally, domestic uncertainty is also high. In particular, while there now seems to be more clarity regarding future macroeconomic developments, as reflected in declining disagreement among professional forecasters, uncertainty about the future path of domestic economic policy is increasing (Chart 1.2, panel c). This could reflect both upcoming elections and uncertainty about the policies of recently elected governments across the EU.

1.2 Concerns about sovereign debt levels have risen

Projected high levels of sovereign debt in several countries limit the policy space available for governments to respond to adverse shocks. While the aggregate euro area debt-to-GDP ratio has declined considerably from its pandemic peak, debt levels remain high in many countries owing to persistent primary deficits. Given a weaker than expected pace of economic recovery, governments in these countries will have to balance the need to bring debt ratios to prudent levels against the need to support economic growth. In principle, general government primary balances tend to recover during normal times, as a direct result of the cyclical improvement in macroeconomic conditions and its positive impact on government revenues (Chart 1.3, panel a). This in turn allows governments to increase spending in response to adverse shocks without significantly raising debt sustainability concerns. However, primary balances in many countries are currently forecast to remain below the levels observed outside of crisis periods, meaning that future fiscal space to react to such shocks will likely be limited. Large primary deficits also make it harder to provide additional investment to combat structural challenges, including climate change, defence spending and low productivity.^[1] This in turn could give rise to a negative feedback loop between low growth and sovereign debt sustainability. Headwinds to economic growth from factors like weak productivity make elevated debt levels and budget deficits more likely to reignite debt sustainability concerns and to push sovereign credit risk premia higher in the event of adverse macro-financial surprises.

Chart 1.3

Persistent primary deficits raise risks related to high debt levels, especially as interest payments are set to rise further

a) Past and projected general government primary balances across euro area countries	b) Projected interest payments on sovereign debt across euro area countries
(2000-23 and projections for 2025, percentages of GDP)	(2023-34, percentages of GDP)

Interest costs are set to rise further and weigh on government finances for many years to come, raising the need for timely fiscal consolidation. Even though ECB policy rates and borrowing costs for euro area governments are expected to decline further, interest payments on sovereign debt relative to GDP are projected to increase in the medium term and beyond for most euro area countries (Chart 1.3, panel b). This is because, at eight years, the average maturity of sovereign debt is relatively long, as a result of which maturing public debt is still being rolled over at interest rates that are higher than they were a few years ago. Higher interest payments will limit the remaining fiscal space further and make timely fiscal consolidation even more important. Overall, while euro area sovereigns have benefited from the easing of global financing conditions since the end of 2023, their debt service costs are set to rise in the near term, particularly for sovereigns with higher debt-to-GDP levels (Chart 1.4, panel a). In this context, implementing the EU’s revised economic governance framework fully, transparently and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Governments should now make a strong start in this direction in their medium-term plans for fiscal and structural policies. Importantly, given the structural challenges related to low potential growth, consolidation of public finances will need to be designed in a growth-friendly manner.

Elevated policy uncertainty is contributing to rising sovereign vulnerabilities. Policy risks related to European Parliament and national elections, as well as struggles in some countries to achieve planned fiscal targets, caused financial markets to examine high levels of sovereign debt and fiscal policies earlier this year. Measures of stress in sovereign debt markets increased temporarily in countries with high policy uncertainty, and sovereign bond yields rose in countries with high debt levels (Chart 1.4, panel b). In some cases, rising stress in sovereign debt markets went hand in hand with short-lived but noticeable declines in bank share prices, raising fears that the sovereign-bank nexus could re-emerge. The market corrections did not last long and have had limited cross-border spillovers for now. Nonetheless, the persisting policy uncertainty, including around the fiscal consolidation paths under the new EU fiscal framework, and the possibility of further fiscal slippage are weighing on the outlook for sovereign borrowing, as they could lead market participants to reprice sovereign risk further. In addition, as sovereign bonds act as a benchmark for the pricing of other assets, any repricing of sovereign risk could result in a rapid tightening of credit conditions (Box 1). This would have an adverse impact on growth and add to the downside risk surrounding macroeconomic activity.

Chart 1.4

Rising debt service costs and high policy uncertainty in some countries are putting fiscal policies in market focus

a) Sovereign debt, debt service costs and sovereign bond yields	b) Euro area sovereign bond spreads over Germany, by debt level
(Sep. 2024; percentages of GDP, percentage points)	(1 Jan.-12 Nov. 2024; left-hand scale: percentage points, right-hand scale: basis points)

1.3 High borrowing costs and weak growth prospects put pressure on corporate balance sheets

Past interest rate increases are weighing on firms’ debt service costs, despite the gradual easing in financing conditions. Euro area firms surveyed by the ECB in the third quarter of 2024 reported a further deterioration in profits in recent months, consistent with the slower than expected pick-up in domestic demand. They also indicated that high interest payments continued to squeeze their profitability, although the impact had moderated compared to half a year before (Chart 1.5, panel a). Even if falling ECB policy rates keep lowering the cost of new borrowing, external funding is likely to remain expensive compared with the historical average, at least in the near term. However, there is some variation across countries, with bank lending rates on new business loans falling faster in countries that saw larger increases during the monetary tightening cycle, supporting an earlier recovery in lending from the deeper trough experienced in these countries (Chart 1.5, panel b). The effect of high debt service costs on profitability, and thus on retained earnings, should be mitigated to some extent by normalising commodity and other input costs, and by the gradual easing of wage pressures. Nevertheless, with downside risks to economic growth in place, the outlook for firms’ retained earnings is also skewed to the downside.

Chart 1.5

High interest expenses weigh on firm profitability even as new lending rates decline

a) Changes in the economic situation of euro area firms	b) Changes in bank lending rates on new business loans across euro area countries
(Q4 2018-Q3 2024, net percentages of respondents)	(Jan. 2022-Dec. 2023 vs Dec. 2023-Aug. 2024; percentage point changes)

Although corporate debt servicing capacity continues to be resilient in the euro area as a whole, some firms are struggling to meet debt obligations. Overall, firms are coping well with higher funding costs, and low demand for external funding amid higher financing costs has contributed to a considerable decline in their indebtedness. Nevertheless, corporate debt levels are still elevated in some countries. Measures of debt servicing capacity, such as the ratio of firm earnings to interest expenses (interest coverage ratio), continue to worsen on average, albeit from the high levels reached during the COVID-19 pandemic and with some signs of stabilisation for the most indebted large firms (Chart 1.6, panel a). Firm insolvencies – a lagged indicator of corporate financial health – are rising across sectors (Chart 1.6, panel b) and countries too, although from very low levels. Data on bank loan default rates show that SMEs, as well as firms in the commercial real estate sector, have the most fragile balance sheets. While the increase in insolvencies could reflect the fading impact of pandemic-era support measures (Special Feature B), continued economic weakness is also a contributing factor. Looking ahead, lower than expected economic growth – given its impact on corporate earnings – remains the main downside risk to firms’ ability to service their debt.

Chart 1.6

Signs of stretched debt servicing capacity are becoming more visible as corporate bankruptcies rise and deleveraging continues

a) Median ICR of large firms, by debt-to-assets quintile	b) Firm bankruptcies in euro area	c) Firm bank borrowing, by economic sector
(Q1 2021-Q2 2024, ratios)	(Q1 2022-Q2 2024, index: Q4 2019 = 100)	(Jan. 2021-Aug. 2024, annual percentage changes)

New borrowing by firms remains subdued, but with considerable cross-sector heterogeneity owing to varying capital intensity and economic prospects. New borrowing by firms remains muted across all borrowing instruments, driven by weak demand for external financing on the back of sluggish growth and high borrowing costs, as well as by tight lending standards. Loan growth has been the most negative in the capital-intensive manufacturing and construction sectors, which are currently facing the biggest economic challenges, while in the services sector it has moderated but remains positive (Chart 1.6, panel c). As the outlook for near-term growth is subdued across sectors, corporate borrowing is likely to remain weak too. While cash buffers accumulated since the pandemic have helped firms to service their debt and manage short-term liquidity needs without resorting to external financing, they continue to decline. As a result, demand for external funding could rise in the future. If downside risks to economic growth and corporate earnings materialise, and lending standards remain tight for longer, this could hamper firms’ capacity to service their debt.

1.4 Higher savings underpin household resilience

Household vulnerabilities have, overall, decreased from what was already a moderate level. The ECB’s composite indicator of household sector vulnerabilities points to a continued decrease in vulnerabilities over the past six months (Chart 1.7, panel a). This decline has been driven largely by improvements in households’ debt servicing capacity and a reduction in leverage. At the same time, financing conditions have played a greater role in the reduction, likely reflecting the peak in the ECB’s policy rate hiking cycle and the subsequent moderation in the degree of monetary policy restriction. The contribution of economic activity in this context has remained relatively stable, given that the euro area economy has avoided a deep recession.

Robust employment and wage growth have supported the debt servicing capacity of euro area households, although there are signs of softening in the labour market. Unemployment in the euro area as a whole is at a historical low, and it is also at a low level compared with historical levels in a broad majority of individual countries. However, there are early signs of a softening in the labour market with the job vacancy rate, which peaked in 2022, having started to decline significantly (Chart 1.7, panel b). A downturn in vacancies often precedes a rise in unemployment, potentially signalling an impending labour market softening.

Chart 1.7

Households’ economic situation is robust in aggregate

a) Composite indicator of household vulnerabilities	b) Unemployment and vacancy rates	c) Household indebtedness and interest debt service
(Q1 2005-Q2 2024, standard deviations from long-run average)	(Q1 2005-Q3 2024, percentages)	(Q1 2005-Q2 2024, percentages and index)

Households are continuing to repay debt. Since the end of the low interest rate period, households have steadily reduced their debt levels relative to their disposable income. Household debt-to-income ratios have now returned to levels not observed since 2005 (Chart 1.7, panel c). At the same time, debt service costs relative to income continue to rise, but there is some indication that they may be reaching a turning point as the pace of increase has slowed recently. If interest rates fall further, as is currently expected in financial markets, debt service costs may stabilise.

The recent higher propensity to save has also supported euro area households’ balance sheets, although it may have repercussions for the pace of the economic recovery. The saving ratio is currently at an elevated level, and consumer purchase surveys suggest that this trend could continue. Abstracting from the exceptional but temporary jump during the pandemic, the aggregate saving ratio is now at a historical high (Chart 1.8, panel a). The increase in savings over the past six months reflects a recent uptick in liquid financial assets, triggered by high interest rates, a low unemployment rate, subdued consumer confidence and persistent uncertainty. Survey results suggest that household saving levels will remain high over the next 12 months (Chart 1.8, panel b). However, the flipside of thrift is a lower propensity to make major purchases, which are currently at levels associated with a recession. On a more positive note, expectations for major purchases in the next 12 months are more upbeat. If households restrict their consumption, this could compound the current downside risks to growth, with repercussions for firms and their robustness and hence also the labour market. In turn, a weak labour market could challenge households’ resilience, in particular those with low incomes and elevated levels of debt.

Chart 1.8

Higher levels of saving can signal a risk for household consumption and broader economic growth

a) Household saving ratio and allocation	b) Consumer purchase and saving survey
(Q1 2005-Q1 2024, percentages)	(Jan. 2005-Aug. 2024, standardised percentages)

1.5 Downside risks remain in real estate markets despite an improved outlook for the sector

Mortgage lending has stabilised from its previous declines and is showing initial signs of a recovery. The downward trend in mortgage lending that followed the start of the rate-hiking cycle seems to have come to an end as the cost of borrowing has fallen slightly from its recent peak (Chart 1.9, panel a). In addition, euro area banks reported a moderate net easing of credit standards in the first three quarters of 2024, following several quarters of tightening credit standards over the course of the ECB’s monetary policy tightening cycle. The improvement in credit conditions, together with better housing market prospects, contributed to an increase in demand for housing loans in the second and third quarters of 2024 (Chart 1.9, panel b). Going forward, banks expect loan demand to increase again in the fourth quarter of 2024.

Chart 1.9

The downward trend in mortgage credit growth seems to have reversed, supported by a slight decline in borrowing costs and higher demand from households

a) Mortgage lending growth and the cost of borrowing in the euro area	b) Changes in demand for mortgage loans in the euro area
(Jan. 2016-Sep. 2024; annual percentage changes, percentages per annum)	(Q1 2020-Q3 2024, net percentages)

Euro area residential real estate prices (RRE) have bottomed out, while valuation estimates are still signalling stretched valuations in some countries. Euro area RRE prices increased by 1.3% year on year in the second quarter of 2024 after falling for four consecutive quarters. The contraction in house prices was orderly and masked significant differences across euro area countries as some markets had not witnessed a decline in prices since the start of the rate-hiking cycle (Chart 1.10, panel a). Better credit conditions and an increase in demand for mortgage loans are likely to exert upward pressure on house prices going forward. In spite of the recent correction in house prices, several euro area markets are still showing high valuations which could increase still further were price growth to start exceeding income growth again (Chart 1.10, panel b). This could lead to a renewed build-up of vulnerabilities in some markets.

Chart 1.10

Estimates of house price overvaluation across most euro area countries have declined, but valuations remain stretched in some markets

a) Annual growth in RRE prices	b) Overvaluation estimates across euro area countries
(Q1 2000-Q2 2024, percentages)	(percentages)

While any potential easing of monetary policy is positive news for commercial real estate (CRE) markets, downside risks remain. Sentiment indicators suggest that an increasing proportion of investors see the CRE downturn as having reached its trough (Chart 1.11, panel a). Despite this, downside risks remain in the form of continued geopolitical risks and monetary policy easing that may be less than expected as a result. CRE market activity remains at a low last seen during the global financial crisis. Any return to normal activity levels will likely cause prices to fall again as sellers revise their asking prices down.^[3] The easing of monetary policy will directly benefit CRE valuations via reduced discount factors, and CRE investors are starting to report a recovery in investor interest (Chart 1.11, panel b). Tenant demand remains weak, however, with offices in particular seeing significantly higher vacancy rates than before the COVID-19 pandemic (Chart 1.11, panel c). As this is driven mostly by structural factors – such as the shift towards remote working and e-commerce – the trend will likely continue to exert downward pressure on the market over the medium term. As flagged in previous editions of the Financial Stability Review, the outlook for the lower-quality end of the market is particularly negative.

Chart 1.11

While investor sentiment in CRE markets may be improving, there are still downside risks from rising vacancy rates

a) CRE investors increasingly reporting trough in cycle	b) Modest increase in investor demand in recent quarters	c) Perceived vacancy rates rising in office market
(Q1 2019-Q3 2024, percentage of investors surveyed)	(Q1 2015-Q3 2024; perceived change in investor enquiries over last three months, percentages)	(Q1 2015-Q3 2024, perceived change in availability of space for occupation over last three months, percentages)

Overall, euro area RRE prices have bottomed out, but stress in CRE markets is likely to continue in the coming quarters. The recent downward adjustment in RRE prices has been orderly, while better credit conditions and increasing demand for mortgage loans are expected to support price growth in the coming months. Generally, the fall in RRE prices was larger in countries where properties showed signs of greater overvaluation at the start of the rate-hiking cycle. This price correction reduced estimates of overvaluation across most countries, thus lowering the associated vulnerabilities. Nevertheless, some markets still exhibit signs of stretched valuations which could increase still further were RRE prices to start rising again. The commercial segment has seen a steeper downturn, with NPLs rising in banks’ loan books (Chapter 3). Even if the degree of monetary policy restriction moderates further, firms will face significantly higher financing costs than in the years prior to the recent rate-hiking cycle. Coupled with weak profitability growth, this will dent firms’ capacity to service outstanding debt (Box 2). Banks’ aggregate exposures to CRE are substantially smaller than to RRE and are unlikely to be large enough at the euro area level to endanger the solvency of the banking system as a whole. These exposures are not evenly spread across the banking system, however, and stress could arise among the euro area’s most exposed banks (Chapter 3). Additionally, an adverse outcome of such a scenario could be amplified by procyclical selling by non-banks, particularly real estate investment funds (Chapter 4).

2 Financial markets

2.1 Markets respond to a shifting balance of risk

Euro area and global financial markets have experienced several sharp, albeit generally brief, episodes of volatility over the past six months. Risk appetite in financial markets has been affected by rising geopolitical tensions and expectations of more rapid and significant policy rate cuts globally following a reassessment of growth and inflation outlooks (Chapter 1). Deteriorating growth prospects, particularly in the United States in the early part of the summer, fuelled speculation about accelerated monetary policy easing.^[4] Following the first moves, financial markets are still pricing in additional cuts in interest rates in both the euro area and the United States (Overview). Consequently, yield curves on both sides of the Atlantic have largely reverted to their normal positive slope following two years of inversion (Chart 2.1, panel a). This shift indicates that inflation is close to objectives and that interest rates will return towards more neutral levels. ^[5] Additionally, defensive sectors in the euro area – which tend to remain stable and generate consistent returns regardless of overall economic conditions – have mostly outperformed cyclical sectors in equity markets. This suggests that equity investors are also positioning themselves for weaker growth momentum. Correlations between equities and the highest quality sovereign bonds have once again turned negative. This follows several quarters of positive correlation between these asset classes as investors rebalance their portfolios towards safer assets (Chart 2.1, panel b).

Chart 2.1

Financial markets react to growth fears while inflation risks decline, with monetary policy becoming less restrictive

a) 2y10y yield curve spread in Germany and the United States	b) Euro area cross-asset correlations and sectoral equity performance
(3 Jan. 2022-12 Nov. 2024, basis points)	(1 Jan. 2022-12 Nov. 2024, correlation coefficient and percentages)

The early-August spike in volatility was short-lived and followed by a swift recovery. The episode was driven by a combination of factors. First, an extended period of low volatility had led to stretched, large and concentrated positions in AI stocks, classic carry trades and short volatility bets. By July, markets had already experienced some corrections, particularly in tech stocks that had previously surged in valuation (Chart 2.2, panel a). Second, in early August, a disappointing US labour market release led to shifts in expectations regarding US monetary policy easing, prompting investors to reassess their risk exposures. The equity market correction began in the United States on Friday, 2 August, with Japan seeing turbulence the following Monday as markets inferred a hawkish stance after a surprise central bank rate increase on 31 July. The reduced US-Japan interest rate differential triggered an unwinding of yen-funded carry trades that affected the Japanese stock market and emerging market currencies in particular. Global hedge funds and other investors began liquidating concentrated positions.^[6] Additionally, the reversal of short volatility positions, pockets of illiquidity in some derivatives markets and various technical factors further exacerbated market fluctuations.^[7] This culminated in sharp declines in equity prices, currency fluctuations, a broad-based retreat from riskier assets and a surge in volatility (Chart 2.2, panel b and Chart 2.4, panels a and b). The turmoil was intensified by escalating geopolitical tensions, which created a highly uncertain environment. However, financial markets rapidly recovered from the largest unwinding of positions on the back of positive US economic data, communication from the Bank of Japan and still-abundant liquidity.

Heightened political uncertainty also impacted euro area asset prices over the last six months. The outcomes of elections, most notably to the EU Parliament and the snap poll in France, have increased political uncertainty in the EU (Overview, Chart 4, panel a), leading to brief episodes of market volatility. Market corrections were mostly temporary, and most asset classes quickly recovered from their initial losses. While the sovereign bond yield spreads of most euro area members versus German sovereign bonds have continued to fall, the French spreads are now close to or above the levels for several euro area countries with lower credit ratings. More recently, in the week following the US elections, euro area stock markets experienced modest declines. In contrast, US stock markets and certain risky assets such as Bitcoin surged (Chart 2.2, panels a and b), reaching new historical highs.

Chart 2.2

Recent bouts of market volatility reflect shifts in the macroeconomic outlook and AI prospects, amid heightened political uncertainty

a) Global stock market trends	b) Asset returns before/during/after early-August volatility spike
(1 Jan.-12 Nov. 2024, index: 16 May 2024 = 100)	(16 May-12 Nov. 2024, percentages)

Markets remain sensitive to macroeconomic data and corporate earnings prospects. Growing concerns over a potential US recession increased the market’s focus on incoming macro data over the summer. Since that time, greater optimism regarding US macroeconomic developments alongside monetary policy easing has moved international markets substantially and there have also been significant spillovers to euro area equities. Breaking down market developments into structural drivers of euro area equity prices (Chart 2.3, panel a) shows that the August sell-off was primarily driven by the deterioration in the US macroeconomic outlook and global risk sentiment. The subsequent rapid improvement came on the back of moderating growth concerns and expected monetary policy accommodation in the United States and the euro area. The growing sensitivity of global markets to US data is also evident in the increased influence of US employment data releases on euro area market rates since the start of the year. US non-farm payroll surprises have had a much stronger impact on two-year Bund yields than has historically been the case (Chart 2.3, panel b). Corporate earnings prospects have also come under increasing scrutiny. Notably, earnings reporting from large tech companies such as Nvidia (Chart 2.3, panel c) have significantly influenced equity market volatility over the last few quarters.

Chart 2.3

Markets are increasingly sensitive to growth data and AI earnings prospects

a) Drivers of euro area equity prices	b) German 2Y rate sensitivity to US economic data	c) Implied US equity market volatility for major publication dates

Markets may be entering a new era of heightened volatility as investors navigate an increasingly uncertain environment. Since the previous edition of the Financial Stability Review was published, increased uncertainty surrounding economic growth has led to a marked rise in equity market volatility. Additionally, policy uncertainty has become a key driver of price swings across asset classes. Since mid-July the strength of the global rally in equities has waned somewhat, with “Magnificent 7” stocks in the S&P 500 oscillating between strong corrections and bouts of optimism (Chart 2.2, panel a), and S&P 500 small caps outperforming. Typical measures of financial market uncertainty and risk in US equities, such as VIX and the VVIX Index (which measures the expected volatility of the VIX itself and reflects investor uncertainty about future market risk), spiked dramatically during the early-August turmoil (Chart 2.4, panel a) and had already increased in European markets at the time of the snap elections in France (Chart 2.4, panel b). Although these spikes were short-lived, current equity volatility remains higher than it was during the benign market conditions seen in the first half of 2024, even after a sharp decline following the US elections.

Chart 2.4

New volatility regime amid heightened geopolitical and policy uncertainty

a) Implied US stock market volatility	b) Implied euro area market volatility
(1 Jan.-12 Nov. 2024, index)	(1 Jan.-12 Nov. 2024, index)

2.2 Markets remain vulnerable to bouts of volatility amid heightened geopolitical and policy uncertainty

Underlying vulnerabilities in financial markets suggest that recent resilience might not endure under less benign conditions. While markets have recently absorbed tail events swiftly, vulnerabilities stemming from the interplay between the lagged effects of tighter monetary policy, the withdrawal of global central bank liquidity, weaker sovereign backstops (Chapter 1) and fiscal policy triggers indicate that future market resilience cannot be guaranteed. Markets remain vulnerable to sudden shifts in monetary policy expectations, especially if future economic conditions were to diverge across major economies. Additionally, these vulnerabilities could be exacerbated in times of stress by structural issues within the financial system, such as the potential adverse effects on market functioning of the rise in passive investing (Box 3), increased concentration and an increasing reliance on non-banks (Chapter 4 and Box 5).

High valuations and concentration, particularly in equity markets, remain a primary concern, making markets susceptible to sudden corrections. Recent market corrections have not dissipated concerns over the overvaluation of equity markets (Chart 2.5, panel a) or the potential for an AI-related asset price bubble, given that US equity indices rose to new all-time highs already in September and have risen even further since then. While markets have proven relatively resilient thus far, high stock prices may also reflect over-optimistic expectations of firms’ earnings prospects. In addition, there are significant concentration risks in several sectors and markets (Chart 2.5, panel b). Liquidity is concentrated among a narrow group of companies in these sectors and markets, increasing the dispersion of stock. In equity markets, the combination of high valuations and extreme concentration in a handful of individual stocks increases the likelihood of idiosyncratic shocks becoming systemic, as market sensitivity to these companies rivals that of macroeconomic data releases (Chart 2.3, panel c). Valuations and risk premia are therefore vulnerable to a shift in risk appetite. This could be sparked by factors like a weakening of growth prospects, an unexpected uptick in inflation, a further escalation of geopolitical tensions or disappointing corporate earnings. Spikes in market volatility could in turn trigger forced asset sales in euro area investment funds, which could also have a significant impact on euro area bond markets, particularly given the large footprint of these funds in euro area corporate bonds (Box 5). For these non-banks, high and growing concentration in equity investments, particularly in US tech stocks (Chapter 4, Chart 4.2, panel b), increases the potential for revaluation shocks.

Chart 2.5

High valuations and extreme concentration in equity markets, as the AI rally has led to a substantial dispersion of stock returns

a) Price-to-book ratio vs expected earnings growth rate	b) S&P 500 share of top five companies, by market capitalisation and earnings
(Jan. 2023-Nov. 2024; ratio and percentages)	(1994-2024, percentages)

With corporate bond spreads below or around their ten-year medians, market pricing appears benign despite elevated macroeconomic uncertainty (Chart 2.6, panel a). However, corporate bond markets would be vulnerable to a reassessment of risk if macroeconomic conditions were to surprise to the downside. In particular, this is reflected by increased expected default frequencies for high-yield corporates in the euro area manufacturing sector, which is currently facing major economic challenges (Chart 2.6, panel b).

Chart 2.6

Corporate bond spreads appear to be benign but are vulnerable to negative surprises, particularly in the manufacturing sector

a) Euro area corporate bond asset swap spreads and ten-year median	b) Expected default frequency for BB- and B-rated companies
(1 Jan.-12 Nov. 2024, basis points)	(1 Nov. 2021-12 Nov. 2024, percentage points)

Liquidity conditions in euro area corporate bond markets remain supportive, but comparatively high rollover needs could exacerbate liquidity strains for some high-yield issuers. Pricing in corporate bond markets is supported by liquidity conditions that are largely positive, except for the seasonal decline in market liquidity over the summer when market depth is typically low due to the holiday period (Chart 2.7, panel a). Although funding cost pressures are significantly lower than they were last year and might continue to fall in line with further monetary easing, the anticipated debt rollover needs of corporates point to further increases in average bond financing costs. Moreover, despite a decrease in the amount of outstanding high-yield debt in recent years, the maturity structure of the segment reveals a higher than average share of bonds that are maturing over the next two years (Chart 2.7, panel b). This is putting upward pressure on bond funding costs for these high-yield issuers.

Chart 2.7

Corporate bond market liquidity is largely supportive, but rollover costs remain comparatively high

a) Composite indicator of corporate bond market liquidity	b) Measure of rollover cost for corporate bond funding and share of outstanding bonds maturing over the next two years
(Jan. 2020-Oct. 2024, z-scores)	(Jan. 2020-Oct. 2024; left-hand scale: percentages, right-hand scale: percentages)

In summary, while recent market corrections have been short-lived, markets remain susceptible to adverse dynamics if further negative shocks occur under less benign conditions. Thus far, reversals of risk premia have been short-lived, potentially fostering complacency and undue risk taking by investors, with equity indices reaching new all-time highs in September. Ongoing geopolitical tensions, heightened growth risks and upcoming elections in 2025 might serve to increase market volatility. Furthermore, signs of overvaluation and extreme concentration in financial markets are raising concerns over systemic vulnerabilities. In this context, further adverse shocks could trigger sharp adjustments in the valuations of risky assets, potentially undermining broader financial stability.

2.3 High risk of adverse global spillovers to euro area financial markets

The episode of volatility in August has once again underscored the deep interconnectedness of global financial markets. Expectations of policy shifts in one region quickly reverberate around the world across asset classes, impacting global financial conditions. Alongside the unprecedented global IT outage in July, recent market developments have demonstrated how risks to the financial system can materialise rapidly on a global scale.

Shifts in global investment flows could also challenge euro area bond markets. In August the decisions taken by Japanese investors – who have a significant presence in global financial markets, including euro area sovereign debt – were significantly impacted by the shrinking interest rate differentials that followed the tightening of monetary policy by the Bank of Japan. Heightened exchange rate volatility (Chart 2.8, panel a) and a further decline in interest rate differentials, coupled with higher term premia on Japanese sovereign bonds, could stimulate the repatriation of investments.^[8] An abrupt withdrawal of Japanese investors from global bond markets could have a significant effect on prices. This would be particularly evident in more concentrated segments, such as euro area sovereign bonds, that could become stressed (Box 1). Any significant widening of spreads in euro area sovereign bond markets could shift market focus towards fiscal paths. This might be challenged by the fact that the market pricing of sovereign risk in the euro area appears to be more benign than that indicated by credit rating agencies’ assessments (Chart 2.8, panel b).

The euro area’s exposure to the US financial system has grown in recent years and financial linkages between the two regions have deepened. Cross-border listings have increased as a significant number of euro area companies have opted to list on US exchanges to gain access to deeper liquidity and more favourable valuations. In addition, the potential for spillover effects from US equity and debt markets to euro area markets remains high, given persistent US debt sustainability concerns, which might increase financial market volatility due to fiscal slippage.^[9] Any spike in volatility could be accentuated by a deterioration in market liquidity and an increase in volatility in the US bond market (Chart 2.8, panel c).^[10] In stressed market conditions, the growing importance of global hedge funds in European sovereign bond markets could have a potentially amplifying effect via rapid strategy reversals.^[11] This could lead to heightened volatility and pose challenges to the smooth functioning of euro area sovereign bond markets. Moreover, potential shocks in the United States could pose risks to euro area financial stability due to euro area non-banks’ rising exposures to US issuers and big tech (Chapter 4).

Chart 2.8

Interconnected global financial markets render euro area sovereign bond markets vulnerable to external factors

a) Realised FX volatility versus the euro	b) Average rating of euro area sovereign bonds vs market-implied rating	c) Volatility and illiquidity in US Treasury market
(1 Jan. 2019-12 Nov. 2024, percentages)	(2011-24; rating, standardised rating scale)	(Jan. 2019-Nov. 2024, index)

Vulnerabilities in China may also be having an adverse effect on market sentiment, with direct and indirect spillovers to euro area markets. Any potential for negative surprises in the Chinese economy remains a key external risk to the euro area’s medium-term economic outlook (Chapter 1). While direct securities exposure to Chinese companies remains limited overall, several euro area firms in more cyclical sectors have considerable exposure to the ongoing slowdown in China. Also, China-sensitive EU companies have risen in importance in broad euro area equity indices. For this reason, further negative surprises in China may have adverse effects on financial conditions in the euro area as well. In addition, while shocks originating in China have a modest impact on core financial markets, the impact on commodity markets can be larger.^[12]

Geopolitical risks and heightened policy uncertainty continue to exert significant pressure on global financial markets and commodity prices. Geopolitical risks are increasingly influencing investor behaviour and have the potential to significantly disrupt markets.^[13] It remains challenging for markets and financial institutions to price and manage these risks due to their often unquantifiable and binary nature. The more enduring effects of geopolitical risks on financial stability are likely to stem from the real economy. These are already having a noticeably adverse effect on the already-challenging fiscal trajectories in the United States and the euro area. In addition, political fragmentation in the euro area is raising concerns about fiscal policy paths and the implementation of key structural reforms. These uncertainties are elevating market volatility risks, and geopolitical and policy-driven shocks are seen as persistent threats. Any escalation of geopolitical conflicts, particularly in Ukraine and the Middle East, might not only generate financial market volatility but could also have a further impact on energy prices (Chart 2.9, panel a). This could potentially affect inflation dynamics and monetary policy in advanced economies where markets expect policy rates to decline. In this environment, gold has regained momentum as a global hedge against uncertainty (Chart 2.9, panel b). This trend might also reflect a stronger appetite for real assets from some major central banks in emerging economies following the Russian invasion of Ukraine. Since then, the negative correlation between long-term real rates and the gold price has markedly reversed.

Chart 2.9

Global uncertainty and geopolitical tensions are driving trends in commodity markets

a) Volatility skewness implied by crude oil prices	b) Gold prices and ten-year real rates
(1 Jan. 2022-12 Nov. 2024, percentages)	(Q1 2009-Q4 2024; left-hand scale: percentages, right-hand scale: USD per ounce)

3 Euro area banking sector

3.1 Banks’ overall funding costs are set to decline

Marginal funding costs are declining as the ECB eases its monetary policy stance. This easing has been characterised by cuts to policy rates and expectations of further cuts ahead. This has led to a decline in the yield curve (first in the long end and then in the short end) and, in turn, a decrease in banks’ marginal funding costs. Euro area bank bond yields had already fallen from their peak in the second half of 2023, thanks to the compression of risk premia and lower risk-free rates on the back of a lower long end on the yield curve. After that, they fell again last summer due to a further decline in risk-free rates (Chart 3.1, panel a). Overall, bank bond spreads have remained consistently at their lowest levels since the start of the hiking cycle, notwithstanding a brief period of volatility in French security prices following the announcement of snap elections in June (Chart 3.1, panel b). Term deposit rates for new business started to decline around the end of 2023 for both households and firms (Chart 3.1, panel c) as the middle and short end of the yield curve declined. Finally, overnight deposit rates, which typically react more sluggishly to changes in the yield curve, have stopped increasing and have started to decline somewhat for corporate deposits.

Chart 3.1

Marginal funding costs are declining while the cost of banks’ outstanding liabilities is peaking

a) Secondary market bond yields	b) Bond interest rate decomposition	c) Deposit interest rates
(Jan. 2022-Nov. 2024, percentages)	(Jan. 2022-Nov. 2024, percentages)	(Jan. 2022-Sep. 2024, percentages)

The composition of bank funding is stabilising, with a lower share of overnight deposits and Eurosystem funding than during the COVID-19 pandemic period. The substantial shift towards term deposits and market-based instruments triggered by the interest rate hiking cycle has come to an end. The reallocation from overnight to agreed maturity deposits (Chart 3.2, panel a) came to an end in March 2024 and the issuance of bank bonds, still material in the first quarter of 2024, has stalled since then, while the repayment of TLTRO III funds is nearly complete. As a consequence, the liability structure of banks has stabilised, in a partial reversion from the change in composition seen in the decade of negative interest rates from 2012 to 2022 (Chart 3.2, panel b). There has been an increase in deposits with agreed maturity, bonds and interbank deposits as well as a decline in overnight deposits and borrowing from the Eurosystem compared to the pandemic period.

This shift toward more bond issuance and interbank funding has a mixed impact on risk. On the one hand, bonds contribute to the stock of “bail-inable” liabilities, thereby mitigating moral hazard. Also, greater use of bonds broadens the investor base, making funding less sensitive to sectoral shocks. However, the costs associated with bonds are typically more volatile than those for household and corporate deposits, and market access can quickly evaporate in times of stress. Credit risk premia on bank bonds could widen if financial markets reassess sovereign risk in the euro area or adverse geopolitical events materialise (Chapter 2 and Box 1). Moreover, the net issuance of bank bonds has increasingly been absorbed by foreign investors, households, firms and investment funds (Chart 3.3, panel a). While this constitutes a broadening of the investor base, it also poses risks. Foreign investors and investment funds tend to be volatile investors (due to the home bias of the former and the greater sophistication and risk sensitivity of the latter) while households and firms, currently attracted by the high returns available by historical standards, could have less appetite as yields decline.

Chart 3.2

The shift from overnight to term deposit stops while banks’ liability structure stabilises

a) Deposit flows and annual growth	b) Structure of banks’ liabilities
(Jan. 2021-Sep. 2024, € billions, percentage)	(Jan. 1999-Sep. 2024, percentages)

Banks’ outstanding funding costs are peaking and are set to decline. The upward pressure on average funding costs from the rollover of liabilities issued before the hiking cycle has lost a significant amount of steam. With regard to deposits, the gap between new business and outstanding term interest rates is narrowing, indicating that there is low upward pressure on average funding costs from the rollover (Chart 3.1, panel c). For bonds, floating rates are mechanically repricing to declining risk-free rates, while fixed-rate bonds have been progressively refinanced since the start of the hiking cycle (Chart 3.3, panel b). In this context, banks’ overall funding costs are expected to decline in the coming months, although this will be partially attenuated by interest rate hedging.

Chart 3.3

Foreign investors, households, firms and investment funds have absorbed an increased share of recent net bond issuance, while the volume of bonds to be rolled over at higher rates is declining

a) Bank bond holdings, by sector	b) Bank bond rate settlement structure
(Q2 2022-Q2 2024, percentages)	(Jan. 2022-Oct. 2024, 100 = total outstanding Dec. 2021)

3.2 Asset quality is deteriorating slowly and provisioning needs are likely to increase

Aggregate asset quality is continuing to deteriorate slowly from the historically low levels of non-performing loan (NPL) ratios, driven by the most fragile credit segments. NPL ratios for loans to households and firms remain close to their historical lows (2.3% and 3.6% respectively in the second quarter of 2024), despite a slight increase since the fourth quarter of 2022 (Chart 3.4, panel a). The mild increase in headline NPL ratios conceals a stronger deterioration of default rates (Chart 3.4, panel b). This has been partly offset by the continued disposal of legacy NPLs (Chart 3.4, panel c) which are still material in those countries most affected by the European sovereign debt crisis. The deterioration remains modest and is concentrated in the most fragile credit segments: commercial real estate (CRE), small and medium-sized enterprises (SMEs) and consumer credit.

Chart 3.4

NPL ratios have deteriorated as defaulting loans offset the disposal of legacy NPLs

a) NPL ratios	b) Default rates	c) NPLs, by time past due
(Q1 2015-Q2 2024, percentages)	(Q1 2020-Q2 2024, percentages)	(Q2 2020-Q2 2024, € billions)

CRE and consumer credit continue to be the primary drivers of asset quality deterioration, although the volumes are manageable overall and are concentrated in a few banks. CRE NPL ratios are rising, in a CRE context of low prices, rising vacancy rates and low activity (Chapter 1). High and rising NPL ratios are concentrated in the loan-to-value (LTV) buckets above 80%, where the loss given default (LGD) for the lender is largest (Chart 3.5, panel a), while further declines in collateral valuations would push up both the LTV and the LGD. However, the deterioration remains concentrated geographically, as US (and to a lesser extent a few euro area economies) CRE loans appear to be particularly affected (Chart 3.5, panel b). Moreover, these deteriorating exposures are concentrated in a few, mostly German, banks. While aggregate bank exposures to CRE are manageable, at 13% of their total loans to households and firms, and are not expected to cause systemic distress in the banking sector by themselves, this deterioration in the CRE segment could prove challenging for those banks that are particularly exposed to this market. Similarly, the consumer credit segment shows a combination of rising NPL ratios, particularly for non-euro area exposures relating mostly to the United States and Latin America (Chart 3.5, panel c), and contained total exposure for the euro area banking sector (8% of total loans to households and firms in the second quarter of 2024).

Chart 3.5

CRE and consumer credit segments have deteriorated, but exposures are contained in aggregate

a) CRE NPL ratio by LTV and share of volume by LTV	b) CRE NPL ratio, by region of exposure	c) Consumer credit NPL ratio, by region of exposure
(Q2 2020-Q2 2024, percentages)	(Q1 2020-Q2 2024, percentages)	(Q1 2020-Q2 2024, percentages)

Although the deterioration in SME exposures remains contained, it is widespread and could be amplified by a weakening of the euro area economy. Banking sectors have been reporting an increase in their SME NPL ratios in most euro area countries since the fourth quarter of 2023 (Chart 3.6, panel a). Moreover, this deterioration has been driven by non-CRE loans to SMEs, the quality of which has worsened faster than the quality of CRE loans to SMEs in most countries. While the NPL ratios of SMEs are still low by historical standards, the weakening of asset quality in the SME segment, which accounts for 19% of bank loans to households and firms, is directly linked to macroeconomic conditions, particularly employment, in a context of rising insolvencies and falling corporate confidence (Chapter 1). Moreover, SME loans can entail higher LGD when less collateralised than other loans (like RRE and CRE loans). This is reinforced by the fact that in recent years banks have tended to tilt their credit towards less-productive firms, which are more likely to face financial difficulties (Special Feature B).

The size of fragile credit segments and the dynamics of NPL ratios differ across countries. Different banking systems have differing exposure to the most fragile credit segments. Several segments demonstrate large exposures (Chart 3.6, panel b), although these are not necessarily associated with a material deterioration at the present time. The dynamics of NPL ratios also differ, the result being convergence towards the euro area average (Chart 3.6, panel c). NPL ratios are still falling in most countries where they are above the euro area average, on the back of the ongoing disposal of legacy NPLs. However, they are rising slightly in some countries, such as Austria and Germany, where they had initially been low.

Chart 3.6

The deterioration in SME NPL ratios is small but widespread in the euro area, while the exposure to fragile credit segments and the dynamics of NPLs vary across countries

a) Change in SME NPL ratios across countries since Q4 2023	b) Exposure to consumer credit, CRE and SMEs loans across countries	c) Level of and change in NPL ratios across countries
(Q2 2024, percentage points)	(Q2 2024, percentages)	(Q4 2021-Q2 2024; percentages, percentage points)

Provision coverage for corporate loans has declined due to the disposal of well-provisioned legacy NPLs and pandemic-era credit guarantees, but provisioning needs will rise again as new NPLs age and guarantees are phased out. Corporate coverage ratios have declined over the last few years, in particular for the CRE segment (Chart 3.7, panel a). There were two factors behind this decline. First, the disposal of legacy NPLs drove the average coverage ratio down. This can be attributed to a composition effect by which banks typically adjust provisions progressively after a loan defaults, as expected recoveries decrease with NPL age; this means that older NPLs are better provisioned than more recent NPLs (Chart 3.7, panel b). As a result, the continued decline in the share of legacy NPLs (Chart 3.4, panel c) has contributed to a decline in the aggregate coverage ratio. Second, this decline in the coverage ratio was accelerated by the introduction of substantial public credit guarantees during the pandemic. Thanks to this additional protection, guaranteed loans require a lower increase in provisions when they default, driving the coverage ratio down. By the second quarter of 2024, more than 14.3% of the total NPL volume was covered by guarantees, up from 6.7% in the fourth quarter of 2019 (Chart 3.7, panel c), which has helped to lower coverage ratios. Both of these factors will fade going forward, resulting in higher provisioning needs. First, new NPLs will age and, unless banks take action to resolve them (which could incur other costs such as discounted selling prices), will require higher provisions. While the stock of remaining legacy NPLs is low, the impact of further disposals will be limited. Second, pandemic-related credit guarantees will expire in the coming years and loans without guarantees will default. In line with this, the coverage ratio for firms ticked up to 42.7% in the second quarter of 2024 from its all-time low of 42.1% in the first quarter.

Chart 3.7

The decline in coverage ratios, driven by the rising share of new NPLs and guarantees from the pandemic period, is coming to an end as these factors fade

a) NPL coverage ratio, by sector	b) Coverage ratio, by time past due	c) Provisions and guarantees on corporate NPLs
(Q2 2020-Q2 2024, percentages)	(Q2 2020-Q2 2024, percentages)	(Q1 2018-Q2 2024, percentages)

3.3 Bank profitability is set to moderate from multi-year highs

While profitability has remained historically high in 2024 in aggregate terms, most banks have seen it decline slightly as net interest income weakens. Banks’ return on equity (ROE) reached 9.4% in the second quarter of 2024 in annual terms (Chart 3.8, panel a). However, this increase was mostly driven by a decline in administrative expenses and depreciations. The slight increase in net operating income was driven by ancillary factors, in particular higher dividend income. Meanwhile, net interest income has peaked, indicating that the main driver of rising bank profits is losing momentum (Chart 3.8, panel b). Indeed, net interest margins are probably past their peak, while loan volumes remain weak. Consequently, ROE has declined slightly for a majority of banks, with the first quartile and median ROE showing a decrease since the peak in the third quarter of 2023 (Chart 3.8, panel c).

ROE is continuing to improve for the most profitable banks, but it is unlikely that they will continue to outperform the rest of the sector. The dispersion of bank profitability has reached a historical high, driven by the continued good performance of the top 25% of euro area significant institutions. Going forward, this dispersion is likely to decline, as the factors that induced a stronger recovery in profitability are starting to go into reverse. Funding from household deposits and lending at floating rates was a recipe for higher profitability during the hiking cycle, as banks were able to leverage the difference in pass-through between assets and liabilities as rates rose.^[16] Now that rates are declining again, however, the opposite effect is in evidence: while household deposit rates are falling more slowly than other liability costs, floating lending rates are declining in lockstep with the risk-free yield curve.

Chart 3.8

Profitability remains high but has peaked for many banks due to weakening net interest income, in a context of historically high ROE dispersion

a) Quarterly net income and ROE	b) Cumulative change in net operating income	c) ROE
(Q1 2022-Q2 2024; € billions, percentages)	(Q1 2022-Q2 2024; € billions, percentage points)	(Q1 2022-Q2 2024, percentages)

Looking ahead, the decline in net interest income is set to continue amid margin compression and a progressive recovery in lending volumes. Floating lending rates have already started to decline, tracking falling market reference rates. They are expected to decrease still further, while the increase in lending rates on outstanding fixed-rate loans is slowing (Chart 3.9, panel a). As a result, lending margins are declining progressively, which is weighing on profitability. Bank lending flows remain subdued by historical standards but are on a recovering trajectory (Chart 3.9, panel b). Banks expect loan demand to recover further across all loan segments, especially for housing loans, mainly on the back of declining interest rates (Chart 3.9, panel c). They also expect lending standards to ease for housing loans but to tighten slightly for firms, suggesting slower credit recovery for firms than for households.

Chart 3.9

Lending margins to decline and volumes are expected to remain weak in the next quarters

a) Lending rates on loans to households and NFCs	b) Bank lending flows to the non-financial private sector	c) Demand for loans, and lending standards
(Jan. 2019-Sep. 2024, percentages)	(Q1 2021-Q3 2024, € billions)	(Q1 2021-Q4 2024, net percentages)

Profitability is expected to decline slightly for most banks but to remain well above the levels of the last decade. Market analysts expect median bank profitability to fall by 1.4 percentage points by 2026 but to remain comfortably above its pre-hiking cycle level for a sample of listed banks (Chart 3.10, panel a). At the same time, it is likely that aggregate profitability will be supported by a few large banks rebounding. The contribution from net interest income should decline on the back of lower policy rates, as a fall in lending margins more than offsets the positive volume effect (Chart 3.10, panel b). However, the overall decline in net interest income is likely to remain contained, as markets expect interest rates to remain well above the level seen prior to the hiking cycle, which would support lending margins. In addition, banks are expected to continue their efforts to control costs, which has already led to a reduction in their cost/income ratios over the last few years (Chart 3.8, panel a). This has mitigated the negative impact of falling net interest income on ROE. The decline in net interest income will likely mostly affect banks that benefited strongly from the hiking cycle and are currently the most profitable. This would lead to a compression of the high ROE dispersion (see above, Chart 3.8, panel c). Less profitable banks are expected to reinforce their efforts to contain operating expenses and maintain their profitability, also resulting in lower profitability dispersion across banks and alleviating financial stability concerns.

Chart 3.10

Despite a slight decline due to lower net interest income, profitability is expected to remain high thanks to continued efforts to control costs

a) Actual and projected ROE for a sample of listed banks	b) Drivers of expected change in ROE for a sample of listed banks
(2016-26, percentages)	(2023, 2026; percentages, percentage points)

3.4 Capital and liquidity buffers remain robust, but banks’ market valuations are still subdued

Euro area banks’ resilience is underpinned by strong capital ratios built on high levels of retained earnings, with sizeable voluntary buffers that are well above requirements. Euro area banks have maintained broadly stable CET1 ratios of around 15% since early 2023 (Chart 3.11, panel a) and sizeable voluntary capital buffers above CET1 requirements (Chart 3.11, panel b). The strong recovery in net income has allowed them to accumulate retained earnings, offsetting the increase in total assets and risk weight density (Chart 3.11, panel c), while making sizeable distributions to shareholders (both dividends and share buybacks). Looking ahead, such levels of capital provide a buffer which will allow banks to absorb some increase in provisioning needs. Moreover, as most banks communicate their dividend strategy by setting a target payout ratio (the ratio of distributed capital to earnings), the expected slight decline in profitability would result in lower distributions, allowing banks to maintain a robust capital position.

Chart 3.11

Banks maintain robust capital ratios which are well above requirements, thanks to retained earnings

a) CET1 ratios and CET1 requirements	b) Voluntary buffers above CET1 requirements	c) Contribution to change in CET1 ratio
(Q1 2019-Q2 2024, percentages)	(Q2 2024; percentage points, percentage share of banks)	(Q1 2022-Q2 2024, percentage points)

Banks have maintained high liquidity ratios despite repaying TLTRO III funds. The decline in banks’ liquidity coverage ratios has been modest despite the large volume of TLTRO repayments made since the fourth quarter of 2022. This decline can be attributed to an inflow of non-retail deposits that pushed up the numerator of the liquidity coverage ratio and which occurred mostly before the bulk of the repayments had been made (Chart 3.12, panel a). Two elements explain the resilience of liquidity ratios (Chart 3.12, panel b). First, excess liquidity did not fall in lockstep with TLTRO III repayments, as various autonomous factors caused liquidity to be released into the euro area banking system. This was mainly due to the decrease in government and non-euro area resident deposits at the Eurosystem (the money being directed towards agents that deposit it in banks). Second, banks actively increased their holdings of other high-quality liquid assets, in particular sovereign bonds and, to a lesser extent, covered bonds. As these securities have to be marked to market (to be ready for liquidation if required), this shift could result in a lower counterbalancing capacity during episodes of stress. Moreover, the increase in banks’ holdings of sovereign debt securities could reignite concerns over the sovereign-bank nexus. However, there are three factors which limit such concerns at the current juncture: (i) the current levels of sovereign debt holdings are still relatively limited by historical standards; (ii) banks have increased their holdings of non-domestic rather than domestic sovereign bonds; and (iii) adopting a demand-driven operational framework for monetary policy ensures that banks can obtain the central bank reserves they require, as long as they can provide enough adequate collateral.^[17]

Chart 3.12

Banks have maintained robust liquidity buffers despite TLTRO III repayments

a) Liquidity coverage ratios and TLTRO	b) HQLA holdings and liquidity ratios
(Q1 2019-Q2 2024; percentages, € billions)	(Q1 2017-Q2 2024; € trillions, percentages)

Banks’ market valuations remain subdued and volatile, suggesting concerns about the sustainability of bank profits and economic growth in Europe. The stock prices of euro area banks recovered substantially during the monetary tightening cycle, on the back of increasing profitability. Euro area banks outperformed the market and absorbed the market turmoil of March 2023 well, but since March 2024 they have entered a more volatile phase (Chart 3.13, panel a). Share prices have suffered from the more unstable geopolitical environment and recent political uncertainty in several countries. Moreover, euro area banks’ valuations remain subdued, with their price-to-book ratios still under 0.8 (i.e. well below 1) and below those of their US and Scandinavian peers, in a context of country dispersion (Chart 3.13, panel b). These weak price-to-book ratios might reflect investor concerns over both economic growth in Europe and structural challenges.^[18] The weak valuations pose a challenge to increasing capital in the event of a sudden need (such as unforeseen losses), as this would require a substantial dilution of existing shareholders.

Cyber risks remain an important operational risk and is an area in which banks can further improve their resilience. Cyber risks remain an important structural risk for banks and are heightened in a time of high geopolitical uncertainty.^[19] The recent ECB cyber resilience stress test gauged banks’ ability to cope with severe security incidents and showed that although banks have response and recovery frameworks in place, areas for improvement remain.^[20] As such, euro area banks need to continue their digital transformation to further address those risks and the challenges and opportunities associated with the progress of artificial intelligence.^[21]

Chart 3.13

Despite recovering significantly, the valuation of euro area banks remains subdued and has entered a more volatile phase

a) Euro area banks and market stock price index	b) Banks’ price-to-book ratios
(Jan. 2022-Nov. 2024, 100 = 31 Dec. 2021)	(Jan. 2022-Nov. 2024, ratios)

4 Non-bank financial sector

4.1 Non-bank portfolios may face valuation headwinds

Non-banks’ investments in corporate and sovereign debt have continued to support market-based finance in the euro area across all credit risk categories. The euro area non-bank financial intermediation (NBFI) sector remains an important source of funding for corporates and sovereigns. It has played a significant role in absorbing newly issued debt securities, allowing issuers to smoothly refinance maturing debt. While the uptake of sovereign bonds in the first half of 2024 was slightly lower than in 2023, purchases of non-financial corporation (NFC) debt increased to around 55% of long-term corporate bonds issued (Chart 4.1, panel a). This partially reflects the return of investors to comparatively lower-rated issuers, following a period of portfolio de-risking as interest rates rose.

Chart 4.1

Credit risk headwinds may challenge increasingly exposed non-banks

a) Euro area non-banks’ holdings of newly issued debt securities	b) Downgrades of NFC bonds held by euro area non-banks	c) Euro area non-banks’ asset holdings, by issuer country macroeconomic outlook
(Q4 2021-Q2 2024; € billions, percentages of total issuance)	(Q4 2021-Q2 2024, € billions, percentages)	(2025 projections, percentages)

Slowing economic growth in the euro area may weigh on asset quality in non-bank portfolios. A subdued outlook for economic growth in the euro area and external funding costs that are still high compared with historical averages are likely to increase pressure on corporate balance sheets in the near term. Rating downgrades in non-bank NFC portfolios increased sharply in the second quarter of 2024 (Chart 4.1, panel b). Although default rates have picked up across nearly all economic sectors (Chapter 1), the majority of downgrades have so far concerned higher-rated issuers. A significant share of non-banks’ NFC bond and equity holdings is currently allocated to issuers from countries which are projected to experience low economic growth and high fiscal debt in 2025 (Chart 4.1, panel c). Valuations of these investments may be particularly vulnerable, as a potential reassessment of sovereign risks by financial markets (Chapter 2) could spill over to the corporate sector. At the same time, several euro area governments have limited fiscal space to counteract a contraction in economic activity.

Chart 4.2

A higher share of US investments exposes euro area non-banks to global spillovers

a) Euro area non-banks’ exposures to US-issued securities	b) Euro area IF holdings of listed shares, by issuer region	c) Euro area ICPF holdings of listed shares, by issuer region
(Q1 2019-Q2 2024, percentages of total assets)	(Q4 2019-Q2 2024, € trillions)	(Q4 2019-Q2 2024, € trillions)

A rising share of US exposures renders euro area non-banks vulnerable to spillovers from shocks and volatility in global financial markets. Euro area non-banks have continued to increase their holdings of US-issued assets, with the value of total US securities held approaching 15% of total assets as of the second quarter of 2024 (Chart 4.2, panel a). These rising US investments are concentrated in listed shares, for which both purchase amounts and valuation gains have outpaced euro area equity investments. As a result, the amount of US equities held by euro area investment funds has grown to double the size of euro area equities (Chart 4.2, panel b), with insurers and pension funds holding more US listed shares than euro area listed shares for the first time (Chart 4.2, panel c). While higher shares of non-euro area investments can bring diversification benefits to investment portfolios, they also expose non-banks to shocks originating in global and, especially, US markets. In addition, recent episodes of volatility spikes have led to sharp, albeit short-lived, valuation losses (Chapter 2). In particular, the activities of global, leveraged hedge funds may have acted as amplifiers during the early-August market sell-off, and some funds also suffered losses.^[22] Although the episode has not led to wider spillovers in the euro area NBFI sector, it highlights the potential risks emerging from global shocks. For non-banks, such events increase their liquidity risk related to sudden margin calls on derivative exposures or redemptions of investment fund shares. Against this background, global market shocks can translate into forced asset sales with the potential to amplify adverse market developments (Section 4.2).

4.2 A growing investment fund sector remains vulnerable to liquidity, leverage and concentration risks

Inflows into a wide range of euro area investment funds have further increased the sector’s size as well as its relevance. In the context of the post-low interest rate environment and an uncertain macroeconomic outlook, investors have continued to prefer bond investments, which has supported the absorption of debt issued in the euro area (Chart 4.3, panel a, Section 4.1). While flows into equity funds have been more volatile this year, strong valuations, in particular for technology-related firms, have resulted in sizeable inflows (Chart 4.3, panel b). Outflows from comparatively riskier fund types during the global volatility spike in early August were short-lived and small compared with the strong inflows that followed. Since the end of 2023, the euro area investment fund sector has seen an increase in total assets under management of around 8%, to €18.6 trillion. The continuing growth of investment funds highlights not only their increasing importance for financial intermediation but also the need to ensure the sector’s resilience in the interests of wider financial stability.

Chart 4.3

Demand for bonds, technology stocks and non-ESG equities has spurred fund inflows

a) Cumulative flows into euro area-domiciled investment funds, by type	b) Cumulative flows into euro area-domiciled equity and technology funds	c) Cumulative flows into euro area-domiciled equity funds, by investment policy
(Jan.-Nov. 2024, percentages of net asset value)	(Jan.-Nov. 2024, USD billions)	(Jan. 2023-Nov. 2024, USD billions)

Shifts in equity fund investments away from ESG and active investment strategies may give rise to new financial stability risks. Following a phase of decelerating inflows in 2023, equity funds which have focused on SRI and ESG criteria have seen outflows that have intensified in the course of 2024 (Chart 4.3, panel c). This decline in investor demand reflects a combination of different factors, including below-average fund performance and a lack of transparency in the definition of these investment policies. To the extent that this indicates a shift towards more carbon-intensive investments, equity fund valuations may become exposed to comparatively higher transition risk.^[23] Additionally, a significant shift from active to passive equity funds has further increased the share of passively managed portfolios. These benchmark-linked funds can be associated with higher co-movement among stock returns and equity concentration, with potentially adverse impacts on underlying equity markets (Box 3).

Chart 4.4

High concentration in equity holdings increases risk of valuation shocks

a) Share of top 25 issuers held in euro area investment funds’ NFC equity portfolios	b) Composition of top 25 NFC equity issuers held by euro area investment funds
(Q4 2019-Q2 2024, percentages of total NFC equity held)	(Q4 2019-Q2 2024, € trillions)

Equity holdings have continued to become more concentrated, exposing equity funds to volatility and price corrections in a few large US companies. In the course of 2024, investments in the listed shares of NFCs have become substantially more concentrated (Chart 4.4, panel a). As of the second quarter of 2024, the 25 largest issuers in the NFC equity portfolios of euro area investment funds accounted for around 28% of total investments. This increase in concentration can be almost fully attributed to larger holdings in US issuers, primarily within the technology sector (Chart 4.4, panel b). While increased investor demand has also led to additional investment in these firms, the rise in concentration is largely due to significant valuation gains in a few large US companies. In a context of high equity market concentration overall, potential overvaluation concerns and elevated volatility risk (Chapter 2), shocks to individual companies or to the US technology sector could lead to sudden drops in fund returns and subsequent sharp outflows, further amplifying market dynamics.

Chart 4.5

Liquidity mismatches mean investment funds are vulnerable to forced asset sale dynamics

a) Changes in total assets and liquidity mismatch in euro area open-ended funds	b) Cumulative changes in commercial real estate prices and net asset value of euro area real estate funds
(Q4 2015 vs Q2 2024, € trillions, ratio)	(Q1 2022-Q2 2024, percentages)

Forced asset sale dynamics arising from high liquidity mismatches remain a concern in various types of open-ended investment funds. Several types of open-ended investment funds in the euro area feature significant liquidity mismatches, as these allow their investors to redeem at short notice while being invested in illiquid assets. As the investment fund sector has grown over the past ten years, liquidity mismatches have increased in bond and real estate funds in particular (Chart 4.5, panel a). Declining liquidity buffers (Overview, Chart 3, panel c) increase the risk of forced asset sales in funds, which can amplify adverse price dynamics in underlying markets (Box 5). Real estate funds remain particularly exposed, given the illiquid nature of their assets and the persistently uncertain outlook for the commercial real estate market (Chapter 1). Risks from liquidity mismatches in real estate funds may be partially limited by lower redemption frequencies and longer notice periods in several jurisdictions. However, the steep decline in commercial real estate prices may not yet be fully reflected in fund valuations in several euro area countries, notably Germany (Chart 4.5, panel b), implying that the risk of price corrections and subsequent fund outflows remains elevated.

Chart 4.6

Pockets of elevated leverage can amplify market corrections and spillovers

a) Euro area investment funds’ financial leverage from repo borrowing	b) Derivative gross notional outstanding of euro area investment funds, by fund type
(Sep. 2024, repo borrowing divided by net asset value)	(Nov. 2024, percentages of total net assets)

Pockets of vulnerability related to increasing financial and synthetic leverage persist in the investment fund sector, most notably in hedge funds. While financial leverage in most investment fund types has remained limited in aggregate, some funds – especially hedge funds – tend to take on considerable levels of leverage in the form of repo borrowing, for instance (Chart 4.6, panel a). These leveraged positions can amplify return volatility, increase the risk of fund outflows and lead to spillovers to banks and other financial institutions which provide such funding. Also, investment funds make use of synthetic leverage in the form of derivative exposures on different types of underlying asset class. This exposes investment funds to the risk of sizeable margin calls during periods of high market volatility. Although margining serves to reduce counterparty risk in derivative positions, a significant rise in margin calls can also lead to liquidity stress and the need for forced asset sales. Hedge funds may be particularly exposed to such scenarios, given their high outstanding gross notional positions in derivatives contracts (Chart 4.6, panel b). Pockets of leverage, especially in combination with liquidity mismatches, have the potential to cause spillover effects from the investment fund sector to the wider financial system. Strengthening the resilience of the sector, including from a macroprudential perspective, is therefore crucial for euro area financial stability (Chapter 5).

4.3 Strong solvency and improving profitability for insurers

The euro area insurance sector remains resilient as a whole, with underwriting profitability improving for life insurers in particular. Insurers’ Solvency Capital Requirement (SCR) coverage ratios have remained well above the regulatory minimum of 100% (Chart 4.7, panel a).^[25] Underwriting profitability – as measured by the ratio of premiums written to the sum of net claims incurred and expenses – continues to rise for non-life business lines as a whole, although there have also been signs of improvement for life activities since the beginning of 2024 (Chart 4.7, panel b). This follows the decline in underwriting profitability experienced by life insurers in 2023, which was driven by an increase in claims compared with previous years and limited growth in new policies. Looking ahead, however, the materialisation of downside risks to growth could negatively affect underwriting performance.

Chart 4.7

Insurers’ solvency remains strong with underwriting performance improving, but the sector faces longer-term risks related to climate change

a) Solvency coverage ratios of large euro area insurance groups	b) Euro area insurers’ ratio of premiums to claims plus expenses	c) Total and insured losses of natural catastrophes in Europe
(Q1 2022-Q2 2024, percentages)	(Q1 2022-Q2 2024; percentages, four-quarter rolling averages)	(2013-23; € billions, percentages)

In the medium term, higher interest rates than in the recent past may help insurance corporations and pension funds (ICPFs) become more resilient, but CRE exposures continue to pose risks. ICPFs generally benefit from higher interest rates on account of their negative duration gaps.^[26] In addition, higher interest rates than during the period of low interest rates that prevailed until 2022 imply that they can profit from higher returns as they gradually roll over their portfolios. This includes investments in higher quality bonds which, in turn, can reduce credit risk and increase overall portfolio liquidity. However, ICPFs still have significant holdings of illiquid assets, especially in real estate, that were accumulated prior to 2022.^[27] While real estate exposures are primarily indirect via holdings of euro area real estate investment fund (REIF) and real estate company shares, the ongoing downturn in the commercial real estate market could affect these sectors and result in losses for ICPFs.^[28] In particular, potential stress in open-ended REIFs (Section 4.2) could lead to losses for their investors (which include ICPFs). More generally, the share of liquid assets in ICPF portfolios has continued to decline (Overview).^[29] Thus, they remain vulnerable to potential liquidity pressures from large margin calls, which could arise from sharp changes in financial market volatility or interest rates. Previous stress events, such as the March 2020 market turmoil, show that liquidity pressures faced by ICPFs can also propagate stress across the wider financial system. It is therefore important that ICPFs strengthen their liquidity preparedness to meet margin calls.

Insurers also face challenges from climate-related natural catastrophes, which are of growing macroeconomic and financial stability importance. The rise in the frequency and severity of natural catastrophes due to climate change means that the magnitude of economic losses has grown in the past decade (Chart 4.7, panel c). In Europe, severe storms and flooding in the first half of 2024 – especially in France, Germany and the United Kingdom – generated economic losses of USD 6.4 billion and insured losses of USD 2.8 billion.^[30] The severe and tragic flooding events that occurred in central and eastern Europe in September and Spain in November are collectively expected to result in economic losses of over USD 20 billion.^[31] Going forward, the increasing scale of losses could have an impact on insurers via rising claims. At present, however, less than a quarter of climate-related catastrophe losses in the EU are insured (Chart 4.7, panel c). The insurance protection gap – the proportion of economic losses not covered by insurance – could even widen going forward as insurers raise the price of policies in response to rising insured losses. Higher prices for policies may in turn lead to such insurance becoming unaffordable. That could increase burdens on governments, in terms of both macroeconomic risks and the fiscal spending required to cover uninsured losses. A widening insurance protection gap could also be a source of systemic risk, as physical damage can result in falling asset values as well as the repricing of the loans and securities of financial institutions exposed to higher-risk areas. This highlights the importance of taking policy action to reduce the climate insurance protection gap.^[32]

5 Macroprudential policy issues

5.1 Ensuring resilience in times of headwinds and uncertainty remains essential

The macroprudential authorities have continued to implement new (or adjust existing) macroprudential measures to strengthen bank resilience. This includes increasing releasable capital buffer requirements such as the countercyclical capital buffer (CCyB) and the (sectoral) systemic risk buffer (SyRB), with the aim of addressing existing vulnerabilities and further enhancing macroprudential space. These policy actions have resulted in a noticeable increase in macroprudential space (from 0.29% of risk weighted assets in December 2019 to 0.82% in October 2024)^[33] and, as things stand, all euro area countries have implemented or announced some form of releasable capital buffer requirements.^[34] These measures have complemented existing borrower-based measures that have been effective in bolstering borrowers’ resilience and have helped prevent a deterioration in mortgage credit quality.^[35] This comprehensive set of policies has helped make the banking sector more resilient to the series of adverse shocks that have affected the euro area (e.g. the shocks triggered by Russia’s full-scale invasion of Ukraine and the banking turmoil that originated in the United States and Switzerland in the spring of 2023).

Chart 5.1

The financial cycle continues its orderly downturn

Decomposition of the euro area systemic risk indicator

(Q1 2004-Q2 2024, deviations from the median)

Maintaining existing releasable capital buffer requirements and ensuring that adequate borrower-based measures are in place remain key priorities for macroprudential policy in a context of headwinds and uncertainty. The euro area financial cycle has turned in an orderly manner so far, with growth in credit and property prices decelerating or turning negative in some countries (Chart 5.1), while non-performing loans continue to rise slowly, albeit from historical lows (Chapter 3). There are no signs of widespread loss materialisation or credit supply constraints arising from banks’ capital positions, as banks remain profitable and are well capitalised (Chapter 3).^[36] However, headwinds to bank profitability may increase while vulnerabilities remain, particularly in the form of deteriorating corporate fundamentals, debt service challenges faced by pockets of vulnerable households and firms, weak cyclical conditions and overvaluation in some real estate and financial markets (Chapters 1 and 2). Against this background, it is essential to maintain existing buffer requirements in order to preserve resilience in the event of a deterioration in banking sector or macro-financial conditions. At the same time, existing borrower-based measures should be maintained to serve as structural backstops and ensure that lending standards are sound and sustainable throughout all phases of the financial cycle. This is particularly important, given that the downward trends seen in some mortgage lending markets might be coming to an end as demand for housing loans starts to pick up again (Chapter 1).^[37]

Increasing macroprudential space further in the form of releasable capital buffer requirements remains desirable in some countries.^[38] Acknowledging the improvement in macroprudential space mentioned above, a further increase in some countries would enhance macroprudential authorities’ capacity to respond countercyclically to possible future shocks, including those relating to heightened geopolitical and macro-financial uncertainty.^[39] Enhancing macroprudential space could be achieved, for example, by implementing a positive neutral rate for the CCyB or the (sectoral) SyRB.^[40] In an environment of robust bank profitability and comfortable capital headroom, this could be achieved without procyclical effects (i.e. without curtailing lending). Lastly, in a context in which uncertainty remains elevated, ensuring that banks have sufficient capacity to absorb losses comes with the additional significant benefit of allowing monetary policy to pursue its objective more efficiently without risking unintended side effects on financial stability that could impair the transmission of monetary policy.^[41] In general, by pre-emptively increasing the loss absorption capacity of the financial sector (via adequate capital buffers) and promoting the financial soundness of borrowers (via borrower-based measures), macroprudential policy could build up the resilience required to mitigate the potential side effects associated with the changes in monetary policy stance needed to achieve price stability.

The ECB strongly supports regulatory initiatives aimed at creating macroprudential space while maintaining existing requirements and improving the efficiency and effectiveness of the EU macroprudential framework for banks. In this regard, the ECB welcomes recent changes to the Capital Requirements Directive (CRD VI) aimed at simplifying the coordination mechanism used to set various capital requirements. Looking ahead, the ECB will continue to contribute to discussions on the review of the EU’s macroprudential framework. Several elements are under discussion, including (i) facilitating a more flexible use of the CCyB, (ii) enhancing the usability of releasable buffers, and (iii) providing regulatory guidance on the calibration of buffer settings for other systemically important institutions (O-SIIs). Regarding the implementation of capital-based measures, it is important to assess the interactions between the final targets for the minimum requirements for own funds and eligible liabilities and the macroprudential framework.^[42] For systemically important institutions in the banking union, the calibration of capital buffers should be better aligned to avoid unwarranted heterogeneity. This would improve the overall resilience of systemically important banks in the banking union.^[43] It would also contribute to a more level playing field, thus supporting financial integration. The ECB also reiterates its call for a more consistent use of the (sectoral) SyRB to promote the coherent treatment of systemic risk across countries.^[44]

The ECB strongly welcomes the fact that the final elements of Basel III were implemented in EU law in June 2024. The new Capital Requirements Regulation (CRR III)^[45], which includes the bulk of the Basel III elements, will generally be applicable from 1 January 2025 and will be fully phased in by 1 January 2030. The new Capital Requirements Directive (CRD VI)^[46], which implements additional elements, is expected to be transposed in all Member States by 10 January 2026. Moreover, the Basel Committee on Banking Supervision is continuing its work on the disclosure of climate-related risks that complements the standards of the International Sustainability Standards Board. This provides a common disclosure baseline which enables internationally active banks to support market discipline and reduce information asymmetries among market participants in the area of climate risks.

5.2 Progress on the capital markets union will be key to supporting EU-wide productivity and growth

Making progress on the capital markets union (CMU) should form part of a renewed strategy to enhance Europe’s productivity and economic growth, thereby contributing to financial resilience. Recent high-level reports have emphasised the importance of mobilising capital markets in order to deepen the EU’s Single Market and provide adequate financing to innovative and productive firms in Europe.^[47] It will be a big challenge to translate this ambition into concrete policies supporting the development of capital markets. It will imply a greater role for non-bank financial intermediation (NBFI), together with an enhanced macroprudential framework which will safeguard resilience and financial stability in general.

Several factors are contributing to the inefficient allocation of capital in the EU, reducing the productive capacity of the economy and in turn leading to subdued growth and lower financial resilience. The reliance on bank lending (as outlined in Special Feature B), the fragmentation of the EU’s equity markets, the lack of a developed venture capital environment in the EU^[48] and the variation in capital market development across national markets are all leading to higher financing costs and greater inefficiencies in the allocation of capital. In addition, euro area households keep a third of their financial assets in cash and bank deposits on average, while retail participation in capital markets remains limited.^[49] Furthermore, around 40% of assets from the euro area investment fund sector are invested outside the euro area.^[50] These observations point to a lack of opportunities for investors in domestic markets and difficulties for firms in the EU when they seek to obtain adequate funding, especially in innovative, high-potential sectors.

Deepening Europe’s equity markets and encouraging the allocation of savings to the most productive areas of the EU economy are priorities for a sound CMU. Increased retail participation in capital markets could be supported through a new EU savings product associated with coordinated tax incentives across Member States. The aim would be to redirect savings to capital markets while also deepening financial integration and cross-border risk sharing. Reducing the debt-equity bias in taxation frameworks could further contribute to promoting equity financing. Finally, continued efforts to achieve further harmonisation of company law and securities law at the EU level would support the work done by the Eurosystem to integrate the trading and post-trading landscapes and would support a possible consolidation of national infrastructures. This would ultimately make it more attractive and efficient to list and trade in the EU. Public-private partnerships could step up their investment in innovative firms and contribute to the development of capital markets. In this regard, the activities of the European Investment Fund provide blueprints that could be promoted, together with the creation of innovation hubs which would bring together academia, industry and investors to ensure that new ideas, entrepreneurship and funding could come together to boost productivity and innovation in Europe.^[51]

A coherent regulatory architecture for a single market for capital requires further harmonisation in key areas. Shortcomings in matters like insolvency regimes, accounting rules and securities law continue to hamper the cross-border functioning of Europe’s capital markets and deny companies access to the full benefits of the Single Market. In addition, the supervisory ecosystem is key to supporting the development and integration of capital markets and limiting potential financial stability risks. Better integrated supervision of EU capital markets could be an important element of the CMU. It would ensure that the European supervisory authorities, especially the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), have the resources they need to perform their tasks and the kind of governance that supports decision-making that is in the interests of the EU.^[52]

5.3 Enhancing the policy framework for NBFI from a macroprudential perspective

Enhancing the resilience of non-bank financial intermediation (NBFI) is intended to ensure that the provision of finance to the real economy is more stable, minimising the need for extraordinary central bank interventions. Previous stress episodes highlighted vulnerabilities in the NBFI sector, which contributed to and amplified market disruptions. In some cases, extraordinary central bank interventions were required to restore market functioning and safeguard financial stability.^[53] To realise the benefits of the capital markets union (CMU), it is vital that capital markets are a resilient and sustainable source of financing, especially in times of stress. In the long run, the CMU can only be successful if it is accompanied by a more integrated supervision and policies that ensure stability in the NBFI sector. Against this background, the ECB welcomes the European Commission’s consultation on macroprudential policies for NBFI.^[54] In order to tackle systemic vulnerabilities and build a more resilient financial system, several key principles should underpin the design of such an approach to NBFI (see the table below).

It is critical for the EU to proceed with money market fund (MMF) reforms to ensure the stability of short-term money markets and reduce the risk of cross-border regulatory arbitrage. In its latest peer review of MMFs, the Financial Stability Board (FSB) noted that its 2021 proposals to enhance MMF resilience had been implemented unevenly across jurisdictions.^[55] In contrast to the EU, the United States and the United Kingdom have either reformed – or consulted on reforms of – their respective regulatory frameworks for MMFs in a way that is consistent with the FSB’s proposals.^[56] To avoid regulatory arbitrage due to divergences in minimum standards (which could lead to a shift of liquidity risk towards EU MMF markets), the EU should proceed with legal reforms of its MMF regulations as a matter of priority. Risks from liquidity mismatch should be addressed by increasing the liquidity buffer requirements for private debt MMFs and by making liquidity buffers more usable. Further measures could include the removal of threshold effects linked to the breach of liquidity requirements, as outlined by the ESRB recommendations.^[57]

The EU should also move forward with the full and swift implementation of international recommendations aimed at addressing liquidity mismatch in open-ended funds.^[58] While progress has been achieved through the recent review of the Alternative Investment Fund Manager Directive (AIFMD) and the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive,^[59] further work is required to implement the FSB’s recommendations effectively. This will involve classifying funds depending on asset liquidity and adapting rules to mitigate liquidity mismatch in illiquid funds by, for example, introducing EU-wide minimum notice periods for real estate funds.^[60] Ensuring greater use and consistency in the use of anti-dilution liquidity management tools may also require additional work, such as ensuring that less liquid funds use anti-dilution tools or offer redemption terms that are commensurate with their asset liquidity.^[61]

A dedicated tool for limiting structural liquidity mismatch in open-ended funds should form part of the macroprudential toolkit available to authorities. This macroprudential tool could resemble the existing measure in Article 25 of AIFMD for leverage but would be designed to specifically target liquidity mismatch in open-ended funds. The tool could be deployed for both alternative investment funds and UCITS, depending on the nature of the systemic risk posed by cohorts of either fund type. The tool should be discretionary in nature and aim to reduce vulnerabilities from liquidity mismatch ex ante, in order to safeguard financial stability. For instance, it should grant authorities powers to specify longer notice periods for specific fund types that invest in relatively illiquid assets. To help ensure that any new tools are operational and are used consistently across the EU, ESMA should play a greater role in coordinating the policy measures in consultation with the ESRB, consistent with an enhanced coordination mechanism.

Non-bank leverage is another key issue that warrants immediate action to assess and close potential gaps in the existing policy framework in the EU. This includes taking stock of the policy tools that are available to authorities in the EU to contain such risks and then consider potential policy solutions to address them. An important interim step would be to adopt the FSB minimum haircut framework for securities financing transactions.^[62] This would help manage the leverage in the NBFI sector that is generated via securities lending and repo transactions backed by non-government debt collateral. In addition, under the UCITS Directive authorities should be equipped with policy tools for limiting the leverage of complex funds that pursue hedge fund-like strategies. All UCITS funds using value at risk should regularly report on and disclose their leverage in accordance with the commitment approach. Moreover, a discretionary tool should be introduced to impose tighter leverage restrictions on these funds. Further work may be required to align with the proposed measures coming out of the FSB’s work on leverage in the NBFI sector.

The international policy response to risks from non-bank leverage should be comprehensive and based on a broad policy toolkit. Given the cross-border dimension and complexities involved in tackling risk arising from NBFI leverage as well as its interlinkages with liquidity risk, a comprehensive, global approach is needed to close policy gaps. Such an approach should consider how haircuts and margining in derivatives markets help to curb excessive leverage in the NBFI sector, while taking into account the potential unintended effects on the propensity of end users to hedge. Where tools used to constrain leverage at the entity level are already part of regulatory frameworks, as is the case for investment funds in the EU, it is worth considering whether the existing rules need to be enhanced from a financial stability perspective. Another important issue to address is how prime brokers and dealer banks facilitate non-bank leverage in accordance with their risk management practices. This is especially relevant with regard to mitigating the build-up of leverage for entities that are not subject to regulatory leverage constraints, such as hedge funds or family offices. Further work will be needed as part of a comprehensive policy response to develop globally consistent metrics and improve data quality and coverage, as well as information sharing, to assess leverage-related risks.

Enhancing EU-wide coordination and providing ESMA with additional powers would help promote the EU’s level playing field and reduce the potential for regulatory fragmentation. In the context of the macroprudential framework and oversight of non-banks, due consideration should be given to the respective roles of macroprudential authorities at both the national and the European level to ensure consistency in the development and implementation of macroprudential policy tools. In particular, a clearer EU-wide framework for policy coordination and standard-setting would be beneficial. Such an approach should ideally be based on common rules and standards across the EU and accompanied by coordinated supervisory action at the EU level. To guard against cross-border leakages and ensure a level playing field, two elements should be prioritised: a reciprocation mechanism for macroprudential measures aimed at non-banks in the EU and “top-up” powers that could be used by ESMA in collaboration with national authorities after consulting the ESRB.^[63] As outlined in the context of the CMU, the ECB is supportive of further integration in the supervision of EU capital markets.^[64]

To underpin a macroprudential approach to NBFI, it is important that authorities with a macroprudential mandate have access to granular data on non-banks. While the ESCB collects a range of data from non-banks for statistical purposes, current arrangements to access these data across authorities are insufficient to monitor and assess the risk to financial stability. For example, under its monetary and financial stability mandate, the ESCB does not have direct access to entity-by-entity supervisory data already reported (e.g. under AIFMD, the UCITS Directive, the Money Market Funds Regulation, Solvency II or MiFID/MiFIR).^[65] The relevant EU regulations should include provisions ensuring the ESCB has timely and efficient access to granular NBFI data, as well as the sharing of statistical and regulatory data on non-banks between central banks and the relevant EU and national competent authorities. This could help mitigate inefficiencies in data collection and enhance usability, thereby also reducing the reporting burden on non-banks. In addition, given the global nature of capital markets, a mechanism for data sharing would ideally be designed and operated at an international level. The EU should go ahead with lifting legal constraints that hinder data and information sharing, to the extent that such data could enhance the identification of risks to financial stability.

Special Features

A Communication for financial crisis prevention: a tale of two decades

Prepared by John Fell, Sándor Gardó, Benjamin Klaus, Jonas Wendelborn and Stefan Wredenborg^[66]

This edition of the ECB’s Financial Stability Review (FSR) marks the 20th anniversary of its inaugural publication. The FSR was originally launched to help in preventing financial crises, and this special feature draws lessons from two decades of experience in identifying, analysing and communicating about systemic risks via this publication. Although risk analysis and risk communication are distinct processes, the special feature emphasises that they are inextricably intertwined in a seamless cycle where each informs and enhances the other. Effective risk identification is founded on the ability to combine structured, data-driven assessments with qualitative insights and expert judgement. Such an approach requires a comprehensive and adaptive framework that continuously integrates broad reviews of indicators with focused analyses on emerging risks. Early identification of vulnerabilities enables timely intervention, but the complex, non-linear way that the financial system functions means that flexibility remains essential. Clear and transparent communication of systemic risks supports this analytical process by shaping expectations and enhancing market discipline, creating a feedback loop that strengthens both policy response and risk awareness. However, central banks face the challenge of balancing communication frequency and depth in order to avoid false alarms while at the same time maintaining credibility. As the ECB’s FSR has evolved, it has sought to become more accessible and data-driven, while utilising diverse media channels to broaden its audience. Experience confirms that targeted, proactive communication reinforces financial stability by aligning policymakers and markets, underscoring the symbiotic relationship between risk analysis and effective communication in maintaining financial system resilience.

B Low firm productivity: the role of finance and the implications for financial stability

Prepared by Desislava Andreeva, Vasco Botelho, Alessandro Ferrante, Lucyna Górnicka and Francesca Lenoci

Many factors – economic, financial and structural – shape firm productivity. This special feature zooms in on the role played by finance and the allocation of capital across firms. Aggregate productivity, access to credit and financial stability are closely interlinked. Inefficient allocation of capital can reduce the productive capacity of the economy, leading to subdued income growth and lower financial resilience for all sectors. While euro area firms rely mostly on bank lending to satisfy their funding needs, banks do not generally have a strong track record in distinguishing between more and less-productive firms, as their expertise lies in the assessment of credit risk. They tend to lack the skills needed to evaluate early-stage technologies and hesitate to finance risky innovations that involve intangible assets or other assets that are hard to collateralise. Financial markets and equity investors may be better suited to financing novel but risky projects. A more diversified external funding structure, including further progress on the capital markets union, could help boost the productivity of euro area firms, to the benefit of financial stability.