The three European Supervisory Authorities (ESAs) – European Insurance and Occupational Pensions Authority (EIOPA), European Securities and Markets Authority (ESMA) and European Banking Authority (EBA) – have warned institutional investors of a deteriorating economic outlook as high inflation and rising energy prices increase vulnerabilities across the financial sectors.

The trio advise national supervisors, financial institutions and market participants to prepare for challenges ahead in the latest issue of its Autumn 2022 joint risk report.

After a long period characterised by very low inflation and interest rates, policy rates are being raised in response to high inflation. The resulting higher financing costs and lower economic growth may put pressure on governments, the report stated, and on corporate and household debt refinancing.

It will likely also have negative impact on the credit quality of financial institution loan portfolios, the report added. Financial institutions are moreover faced with increased operational challenges associated with heightened cyber risks and the implementation of sanctions against Russia. The financial system has to date been resilient despite the increasing political and economic uncertainty.

In light of such risks and uncertainties, the joint committee is advising financial institutions and supervisors to continue to be prepared for a deterioration in asset quality in the financial sector.

Considering persistent risks that have been amplified by the Russian invasion and a deteriorating macroeconomic outlook, combined with a build-up of medium-term risks with high uncertainty, supervisors should continue to closely monitor asset quality, including in real estate lending, in assets that have benefitted from previous support measures related to the pandemic, and in assets that are particularly vulnerable to rising inflation and to high energy- and commodity prices, the joint committee recommended in the report.

The three ESAs also warned of the impact on financial institutions and market participants more broadly of further increases in policy rates and noted the potential for sudden increases in risk premia should be closely monitored.

“Inflationary pressures coupled with uncertainty on risk premia adjustment raise concerns over potential further market adjustments. Rising interest rates and yields are expected to improve the earnings outlook for banks given their interest rate sensitivity,” the report said.

“They could also reduce the valuation of fixed income assets, and result in higher funding costs and operating costs, which might affect highly indebted borrowers’ abilities to service their loans,” it added.

Credit risks related to the corporate and banking sector also remain a primary concern for insurers and for the credit quality of bond funds. High market volatility stemming from the above economic and geopolitical situation could also raise short-term concerns and disruptions for market infrastructures.

The report also warned that financial institutions and supervisors should be aware and closely monitor the impact of inflation risks, highliting the economic consequences of the Russian aggression mainly channel through energy and commodity markets, trade restrictions due to sanctions and the possible fragmentation of the global economy.

”Financial fragmentation, including fragmentation of funding costs, could threaten financial stability and put pressure on price stability. Inflation is not only relevant from a risk perspective, but is expected to reflect also on the actual benefits and pensions, inflationary trends should be taken into account in the product testing, product monitoring and product review phases,” the ESAs stated.

Financial institutions and regulators should make extra efforts to ensure investor awareness on the effects of inflation on real returns of assets, and how these can vary across different types of assets, they warned.

Read the digital edition of IPE’s latest magazine