Risk-taking in financial markets is gaining momentum, according to the latest bi-annual Financial Stability Review of the European Central Bank (ECB).
Vulnerabilities are building up in global financial markets and a surge in volatility in US stock markets in early February highlighted the current fragile market sentiment, the EBC found.
The ECB advised: 鈥淣arrow risk premia and signs of increased risk-taking in most global financial markets require close attention.鈥�
Systemic risk for the euro area has, however, remained low over the past six months, helped by better growth prospects, both outside and in the euro area, said the ECB in its summary of the review.
However, the ECB singled out four possible risks to financial stability in the euro area over the next two years. The first risk relates to spillovers from a disruptive repricing of risk premia in global financial markets.
The second risk relates to a potential hampering of the ability of banks to intermediate amid weak financial performance compounded by structural challenges.
The third risk relates to public and private debt sustainability concerns amid historically high debt levels.
The fourth risk relates to liquidity risks that could emerge in the non-bank financial sector, with contagion to the broader system.
All four risks are intertwined and any one of them could trigger the others, said the ECB.
In addition to the investment overview, the review also contains three special features. The first of these is a new composite financial stability risk index aimed at predicting large adverse shocks to the real economy in the near term.
The second introduces a composite cyclical systemic risk indicator designed to signal risks of a financial crisis over the medium term.
The third analyses the distribution of interest rate risk in the euro area economy using balance sheet data and information on derivative positions from significant credit institutions.
The ECB said that at this stage, while no broad- based asset price misalignments can be observed across euro area financial and tangible assets, some pockets of stretched valuations are appearing. This is particularly so for lower-rated bonds and certain real estate markets.
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The profitability of euro area banks improved on the back of a better cyclical situation, it added. However, the level of profitability is, however, still weak, reflecting persisting structural challenges.
The review also highlighted risks building up in the investment fund sector. Aiming to boost returns, funds have extended the maturity and increased the credit risk of their portfolios, noted the ECB.
At the same time, in contrast with their banking counterparts, they have drawn down their
liquidity buffers.
The ECB said that taken together, these developments make investment funds more prone to amplifying any repricing in global financial markets.
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