MNI POLICY: ECB Says Financial Stability "More Challenging"

By Luke Heighton

     FRANKFURT (MNI) - Euro area financial stability has become "more

challenging" since May, the European Central Bank said in its Financial

Stability Review Thursday, with the liquidity of increasingly risk-oriented

investments funds a rising concern to policymakers.

     Europe's economy is growing, bank resilience has improved, and there has

been only minimal contagion from emerging market volatility, ECB vice president

Luis de Guindos said. Yet downside risks to the global growth outlook are more

pronounced, and downside risks to the eurozone have become more prominent.

     Here are key points from the report.

     -- The four main risks to financial stability over the next two years are:

a disorderly increase in risk premia; debt sustainability concerns (particularly

sovereign debt); low bank profitability, and liquidity strains in the investment

fund sector.

     -- Concerns are rising over increased risk-taking by investment funds,

including liquidity, credit and duration risk. The potential for forced asset

selling into illiquid markets affecting market conditions more widely is

growing. An abrupt and sizeable adjustment of global risk premia could give rise

to first-round losses for bond funds that trigger outflows. Liquidity risks may

be unearthed in situations of forced asset sales to meet investor redemptions.

     -- A disorderly rise in risk premia could be caused by internal and

external market reactions to political or policy uncertainty in the euro area;

further stress in emerging market economies; possible spillovers to advanced

economies, and a sharp turnaround in U.S. macro-financial prospects. This could

be amplified by pockets of high asset price valuations and high correlations

across global financial asset prices.

     -- Italian financial market losses have not meaningfully spilled over to

other euro area countries, and Italy's primary surplus and current account

surplus should not be overlooked, De Guindos said. But Italian sovereign bond

yields and stock prices remain volatile. De Guindos said he expected a solution

to the current disagreements between Brussels and Rome to be found.

     -- Brexit's impact has, with the exception of some exchange rate

volatility, remained limited so far. Yet a cliff-edge Brexit "could have the

potential to pose a more significant downside risk to financial stability" the

report stated. De Guindos seconded the Bank of England's recent pessimistic

analysis, and said a disorderly Brexit would see the UK economy enter into a

"very, very big recession".

     -- A maturing cycle in the United States has led to brittle valuations,

with pockets of stretched valuations in global corporate bond and stock markets

and the risk of a snapback from an unprecedented compression of term premia.

Though the risk is higher in the US - due to the ongoing monetary policy

normalization, expanding leveraged loan markets, compressed spreads and

weakening underwriting standards - if such an increase in term premia were to

materialize, an abrupt increase in long-term interest rates could spill over to

the euro area.

--MNI Frankfurt Bureau; +49-69-720-146; email: luke.heighton@marketnews.com

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com