The dangers to financial stability aren’t gone: They’re just lurking

• Europe might not be facing an imminent crash, but there are three types of risks that could threaten the financial system: interest rates making borrowers’ debts harder to repay, an economic slowdown leading to rising defaults, and troubles in the real estate market creating pressures for financial institutions.

• While the financial system appears better equipped to deal with those risks, banks are still facing their fair share of challenges, and there may be many hidden risks posed by shadow banks.

• So make sure your portfolio is built to withstand unforeseen shocks and have a game plan in case things turn sour.

The dust from last spring’s mini-banking crisis seems all but settled, but you probably don’t want to let your guard down just yet. The European Central Bank (ECB) has just released the results of its latest of financial stability review, and it says the threats to the system haven’t gone away – they’re just lurking. And that means we’re in a delicate spot, where unexpected political or economic events, or troubles from unregulated shadow banks, could trigger a cascade of issues. Here’s what to watch for…

So what’s the problem?

Europe might not be facing an imminent crash, but the ECB's financial stability experts found that three types of risks could imperil the financial system.

Default risk: borrowers could struggle to make payments on their debt if interest rates remain higher for longer.

In the wake of history’s most aggressive interest rate hikes, funding costs have skyrocketed for everyone – not just everyday households, but also big corporations, financial institutions, and even governments. That surge means higher costs for those whose loans aren’t locked in for the long haul, those who need to refinance, and those who have to take on new debt. Ideally, this would just slow down borrowing and cool off the economy, but in a bad scenario – the kind that’s historically happened more often than not – it could leave a lot of people and companies unable to pay their debts. Governments aren’t immune either and the risks are climbing, especially in areas already burdened by high debt, like Greece, Italy, and Portugal.

So far, the blow has been surprisingly soft. That’s because households saved up during the pandemic, and companies and governments locked in long-term loans at low rates. But those things will only last so long and the full impact of these steep rate increases is on the horizon. That’s likely to seriously threaten the weakest firms and poorer consumers. And, sure, interest rates have probably hit their peak and many expect them to fall as early as next year. But ongoing EU reforms, a spike in energy costs due to geopolitical tensions, or a resurgence of inflation could keep interest rates higher for longer.

Economic risk: households and companies could struggle to service their debt if the economy weakens.

The economy in Europe’s been sluggish, especially when compared to the US, and it faces a grim outlook with high interest rates dampening the prospects for a rebound next year. The situation is further complicated by a potential spike in energy prices and a slowdown in China’s economy. In other words, it’s not facing an immediate crash but there are major downside risks. A deepening economic slowdown could reduce consumer spending and hit company profits, especially if paired with rising unemployment or stubbornly hot inflation. That, too, is likely to lead to many borrowers defaulting on their debt. In fact, with default rates already exceeding pre-pandemic levels, this may already have started to happen.

Real-estate repricing risk: eroding demand could lead to a critical decline in commercial real estate values.

Commercial real estate (CRE) is going through a tough time. After the pandemic, there was less demand for office buildings and shopping malls, and the cost to finance them has gone way up, leading to stress in the sector. It’s hard to tell just how far property prices have fallen at this point because there isn’t a clear, all-encompassing metric. And while this situation alone might not be severe enough to push the euro area’s banking sector below minimum capital requirements, both regular and shadow banks (those operating like banks but with less oversight) could face problems. After all, they’ve both lent a lot of money to the sector. Plus, housing market struggles are making things harder for households in the euro area, adding more stress to the situation.

So those are the risks that could put the economy and markets under pressure. But there are other risks that could make things worse and spread trouble across the wider financial system:

Bank risks: higher interest rates and cost of living increases can dramatically hinder borrowers’ abilities to pay back their loans.

The good news here is that the European banking sector is in a much better position now than it was before the global financial crisis. It has strong financial foundations and has shown it can handle market turmoil, like this year’s mini-banking crisis in the US and Switzerland. Even with some recent decreases in key financial measures, the sector’s overall stability is still solid, as also shown by the latest European Banking Authority stress tests in 2023.

The bad news is that European banks are still facing plenty of challenges. Higher interest rates and rising living costs are making it harder for borrowers to pay back their loans, which ultimately could hurt the banks’ asset quality. There’s also a decrease in loan demand and rising costs for banks to borrow money, which could impact their profits. The real estate market, both commercial and residential, is also unstable, adding to the banks’ troubles given its high exposure to the sector. Although loan defaults are still low, there are signs they are picking up, suggesting banks might be under pressure sooner rather than later.

Shadow banks risks: stresses in these interconnected non-bank institutions could quickly spread, intensifying market shocks.

Shadow banks, which include entities like investment funds and insurance companies, function similarly to traditional banks but with less regulation and oversight. They face significant risks because of their high borrowing (leverage) and potential cash shortages (liquidity mismatches). These issues could escalate in a tough economy, leading to drastic price changes in assets and threatening financial stability. Thin market liquidity or activity, particularly in bond markets, could exacerbate price fluctuations. Additionally, leveraged financial entities might find they need to sell assets quickly to meet margin calls, a situation that could create a downward spiral of falling prices and further selling.

What does this all mean?

Right now, financial markets are upbeat: volatility is extremely low, stocks are doing great, and the extra payback investors want for riskier investments is fairly minimal. However, this positive vibe is delicate and things could go quickly from bad to worse if things don’t go to plan. The base case is still that everything will be fine, but you shouldn’t ignore those lurking risks to financial stability. Especially since financial crises are unpredictable, difficult to time, and almost always end up being more severe than expected.

In such uncertain times, it’s prudent to focus on what you can control – like ensuring that your portfolio is built to withstand unforeseen shocks. That might involve avoiding leverage and having a game plan, both mentally and financially, for what you’d do if things turn sour. And it might also involve keeping some cash available for emerging opportunities. In essence, it’s about being cautious and prepared for the unexpected in a landscape where vulnerabilities can emerge from unforeseen quarters.