Are EU Financial Markets About to Pop?

7 min read

The European Systemic Risk Board (ESRB), created in 2010 to oversee the financial system of the European Union, is sounding an unprecedented warning about the rising risks to financial stability in the eurozone. It sees seven systemic threats to the bloc’s financial stability, three of them severe.

Main Threats

Debt payments on mortgages and business loans

A combination of high inflation, tighter financial conditions, and increased geopolitical risk has made a recession in Europe next year highly likely, according to the European Central Bank. 

This could pose problems for EU corporations that are already under stress and may have difficulty making debt payments. Energy-intensive sectors, companies exposed to real estate, and firms with high debt levels are particularly vulnerable to the pressures on interest rates, energy prices, and the real estate market.

Though households are generally in good financial condition at the moment, inflation is cutting into disposable incomes and making it more difficult for low-income households to pay off necessary debts. If housing prices drop and the job market weakens, European households could see a rapid deterioration in their financial situation, potentially to the point where it becomes a threat to financial stability. 

Though it’s not mentioned directly in the ESRB report, I would also highlight the risk to EU countries whose unsustainably high debt levels make them vulnerable to a worsening macroeconomic environment.

Steep Decline in Asset Prices & Subsequent Liquidity Issues

If macroeconomic conditions continue to challenge investors, we could see some drastic moves in asset prices that threaten financial stability. 

For example, today’s lack of liquidity in certain markets could cause prices to fluctuate wildly, while levered financial players like asset managers, insurance companies, and hedge funds could be forced to sell their assets at a loss to meet margin calls. This could create a downward spiral of ever-lower prices.

Third, non-bank financial intermediaries are tightly linked, so stress could spread rapidly and magnify those shocks.

Banks Albeit Strong(er) Now, May See a Steep Decline as Well 

Banks have improved since the last financial crisis- their capital and liquidity ratios are strong, and higher interest rates provide them with more profits. However, European banks are still struggling structurally, they have more loans at risk of default and rising short-term interest rates make it more expensive for them to get funding.

But in our opinion, the real problem could come from non-bank financial intermediaries, such as hedge funds, pension funds and asset managers. These less-regulated entities are often highly leveraged, hold riskier and less liquid assets and rely on riskier short-term funding, making them vulnerable to challenging market conditions. 

As they are now at the core of the financial system (and are now 80% of the size of the total European banking sector), stress for these intermediaries could represent a big threat to financial stability.

Four Other Possible Threats

The housing market is vulnerable to a fall in real household income because of years of soaring home prices and mortgage lending growth.

Commercial real estate in Europe is particularly vulnerable to rising financing and construction costs due to thin profit margins.

Cyber risks are a big threat to the stability of markets.

The high-interest rates and foreign exchange risks make it difficult for countries to make payments on their already high debt loads.

Is the European Financial Crisis Really That Likely?

The good news is that Europe is better equipped today to deal with these challenges than it was before the global financial crisis. Banks are in better shape, households appear less vulnerable, and risks from securitized products seem lower. What’s more, the euro area has new tools at its disposal, aimed at smoothing out the impact of ECB actions across all 27 countries.

An additional buffer against shocks and risks to the financial system should be provided by all of this.

The bad news is that you don’t want to take this unprecedented warning from the ESRB lightly. This group was founded in the wake of the global financial crisis with one job in mind: preventing and mitigating systemic financial risk.

In our opinion, the ESRB’s recent warning doesn’t even come close to flagging all the risks Europe is currently facing. Some of the risks that are particularly underappreciated include:

Hidden threats: aggregate economic numbers may not look too scary, but they could be hiding some risks that are brewing below the surface. 

For instance, the highest-income earners might have a disproportionate impact on aggregated household debt statistics, which could hide some of the risks from lower-income earners.

Safe today doesn’t mean safe tomorrow. Just because a sector appears to be in strong shape now doesn’t mean it can’t become vulnerable in just a few months. We saw that happen in 2007, right before the global financial crisis.

There’s always a chance that multiple risks will crop up at the same time and interact with each other to magnify the overall impact.

Trouble can pop up in unexpected places. For example, few people anticipated that when interest rates rose, liability-driven instruments (LDIs) – which are popular in the UK for helping pension funds meet future payout obligations – would create such a crisis.

The ironic thing is that a financial crisis is rarely timed and forecasted correctly. That’s why it is often so painful and almost seems like it’s inevitability is an inherent utility that it brings – showing the markets about their inefficiencies and helping to fix the unfixable by allowing the economy to trim extra weight. 

This being said, we believe that now is not the time to overextend on leveraged positions and bet on major economies to recover over the next year (perhaps two) miraculously, instead, stay in cash as much as you can afford, set aside capital to purchase good looking assets should they drop further, alternatively, have a decent margin account to make calculated bets on the further drop in major indices like DAX30, SP500, perhaps longs on EUR/USD. 

We will be trading news on Portfolio ECS and using our collection of EAs to reap the benefits from the increased volatility. If you are well-diversified enough, we invite you to either invest in our managed account or get some of the software for yourself. Reach out if you have any questions about staying exposed without being too exposed 😎via [email protected]

Safe Trading
Team of Elite CurrenSea 🇺🇦❤️

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