The European Central Bank has warned of an increased vulnerability of financial stability in the euro area to unexpected shocks as inflation continues to fight and real estate is among the risky sectors.

In a financial stability review published on Wednesday, the ECB noted that financial markets remain vulnerable to less favourable results on economic growth and inflation, with tighter credit conditions testing the resilience of businesses and households in the euro area.

Higher interest rates test the resilience of households, companies, governments and property markets, the Frankfurt-based institution said in its biennial financial stability review. This leaves investors potentially exposed to unusual adjustments, the ECB warns.

While banks have so far been extremely resilient to recent turmoil in the U.S. and Swiss banking sectors, higher funding costs and lower asset quality may still reduce their profitability, the central bank said in its report.

ECB: Interest rate hike must continue

"Financial markets remain vulnerable to less favourable outcomes in terms of economic growth and inflation. Unfavourable market dynamics may be exacerbated by forced sales of securities," the ECB noted.

Although banks across the single currency bloc have been poorly exposed to recent banking stress, the ECB noted that headwinds in funding and asset quality could weigh on future profitability.

The ECB therefore concludes that it is essential to complete the Banking Union and strengthen non-banking financial sector policies in order to further enhance the resilience of the financial sector.

The property market is one of the areas that the ECB highlighted. House prices have fallen significantly in a relatively short period of time and could fall further if higher mortgage costs continue to reduce demand. At the same time, commercial real estate markets remain in decline thanks to tighter financing conditions, an uncertain economic outlook and weaker demand after the coronavirus pandemic. This adjustment may test the sustainability of investment funds, the ECB report said.

"A correction in property markets could become chaotic in the event of negative macro-financial surprises," the report said.

The warnings serve as a comprehensive report on the impact of the most aggressive monetary tightening campaign in the ECB's 25-year history. But despite swirling dangers to financial stability and economic growth in the 20 eurozone countries, central bankers struggling to bring inflation back to their 2 percent target say the wave of rate hikes since last July is not over.

"Price stability remains as important as it has always been for the continued preservation of financial stability," ECB Vice President Luis de Guindos wrote in the report's foreword, before explaining the side effects.

"Tighter financing conditions to decisively address high inflation have contributed to a reassessment of the economic outlook and to reversing excessively compressed asset price risk premia. As financial conditions return to normal, this could reveal vulnerabilities and fault lines in the financial system," he noted.

"Strengthening the Banking Union – and in particular advancing the common European Deposit Insurance Scheme – will strengthen the ability of the euro area financial system to withstand future risks," De Guindos said.


Financial stability