According to the European Central Bank, risks to the financial system are currently high. It is not only US customs policies and excessive actions on the stock exchange that can be dangerous from the point of view of monetary authorities.
Trade conflicts, the possibility of a bubble in the stock market and obstacles in the dollar: According to the European Central Bank (ECB), risks to financial stability in the euro area remain mixed. Uncertainty in trade policy has “loosened significantly” since the highest level of uncertainty in April.
“But uncertainty persists, with the potential for a new peak,” said ECB Vice President Luis de Guindos, summarizing the findings of the central bank’s semi-annual financial stability report.
There is one danger Stock market correction
In early April, US President Donald Trump sent trading partners and financial markets into turmoil with a massive package of tariffs. The stock market recovered surprisingly quickly from the downturn. However, there is now growing concern that certain trends are overvalued.
Financial markets – especially stock markets – are “vulnerable to strong corrections due to persistently high valuations and increasing stock market concentration,” the ECB wrote. De Guindos recently warned of the dangers of a stock market correction that could stem from highly valued US technology stocks and the excitement around artificial intelligence.
Currency and credit risks for banks
Meanwhile, the ECB called on banks with significant dollar business to create greater liquidity and capital buffers. This is intended to protect against possible shortages and fluctuations in the US currency. The Frankfurt monetary authority has been warning banks since the spring. Trump’s tariffs and pressure on the US Federal Reserve have recently shaken confidence in the world’s reserve currency.
“Capital buffers may be necessary to mitigate higher currency fluctuations and counterparty credit risks,” the report said. “Banks must have liquid dollar assets to offset outflows and act as stabilizing intermediaries.” According to the ECB, dollar business is concentrated in a few heavyweights in the industry.
These include Deutsche Bank, French institution BNP Paribas, Credit Agricole, Groupe BPCE and Societe Generale as well as the Netherlands’ ING and Spain’s Banco Santander. Typically, these banks borrow funds from US money markets to finance hedge funds. They also sell so-called foreign exchange swaps to insurance companies and corporations to hedge their dollar risks.
Financial institutions earn good income
Additionally, it could be problematic for banks if companies heavily impacted by tariffs have difficulty repaying their loans.
The good news: From the perspective of the central bank, which directly monitors the largest banks in the currency area, financial institutions in the euro area are generally in a solid position. These institutions performed well and, thanks to ample reserves in times of crisis, “have proven capable of withstanding recent shocks,” the ECB noted.
