Financial Stability Review, May 2024

Against this backdrop, three key themes are shaping the outlook for euro area financial stability. First, benign risk pricing in financial markets and structural liquidity vulnerabilities in non-banks harbour the potential for sudden shifts in market sentiment in response to adverse shocks, triggered, for example, by negative macro-financial surprises or heightened geopolitical tensions. Second, rising debt service costs are challenging euro area households, firms and sovereigns with weak balance sheets, and the downturn in property markets is, in some cases, compounding household and corporate vulnerabilities. Third, euro area banks have remained resilient, supported by strong profitability. Bank earnings appear set to moderate somewhat from recent highs in the next two years. At the same time, bank market values, while having risen somewhat, remain stubbornly below book values − indicating deeper seeded investor concerns about the durability of bank profitability.

Chart 2

Geopolitical tensions may spark volatility and trigger adjustments in financial markets, which could be amplified by non-banks with low liquidity and high leverage

a) Global equity markets and high-yield corporate bond spreads	b) Historical volatility distributions, by geopolitical risk regime	c) Liquidity mismatch and leverage among euro area investment funds
(1 Jan. 2021-7 May 2024; index, basis points)	(3 Jan. 2000-7 May 2024, indices)	(Q4 2023, ratios, bubble size: total assets, € trillions)

The non-bank financial intermediation sector could still amplify any market correction, given liquidity vulnerabilities, leveraged exposures and rising concentration risks. Non-banks have benefited from improving market conditions in recent months, supporting their portfolio valuations, while higher interest rates have also boosted investment income from debt securities. However, asset quality in non-bank portfolios may still be impaired by worsening corporate sector fundamentals and real estate market conditions together with rising geopolitical risk (Special Feature A). In this context, any shocks to market valuations could trigger a rise in investment fund outflows or margin calls on derivative exposures. Given low liquid asset holdings and significant liquidity mismatches in some types of open-ended investment funds, this could result in forced asset sales that may negatively affect wider financial stability (Chart 2, panel c). Although generally limited, pockets of elevated financial and synthetic leverage in some entities may add to spillover risks. In addition, concentration in equity portfolios − notably in investment funds due to exposures to US-based technology firms − has increased markedly in recent years (Chapter 4), making investment portfolios more vulnerable to idiosyncratic shocks or adverse developments in the US economy. For the insurance sector, uncertainties around a weak macro-financial outlook highlight possible profitability headwinds. These include both underwriting profitability challenges for life insurers and consistently low returns on debt securities portfolios.

Euro area household and corporate balance sheets have been bolstered by a resilient labour market and strong post-pandemic profits. Corporate profitability has continued to hold up relatively well, supporting firms’ debt servicing capacity (Section 1.3). Declining energy and other input costs have boosted corporate earnings despite weak consumer demand, although the impact of anaemic growth and higher labour costs on profit margins might not have fully materialised yet. While corporate insolvencies have continued rising to above pre-pandemic levels in a number of euro area countries, defaults and non-performing loan rates have remained relatively low. At the same time, euro area household vulnerabilities have been mitigated by the resilience of labour markets, coupled with government support measures and excess savings accumulated during the pandemic. While household and corporate debt-to-GDP levels have dropped below pre-pandemic readings, the pass-through of higher interest rates to debt service costs is incomplete. Continued loan repricing at higher market rates than on outstanding loans (Chart 3, panel c), together with weaker than expected growth and deteriorating labour market conditions, could erode household and corporate debt servicing capacity. At the same time, evaporating liquidity buffers (Chart 4, panel a) may render households and firms vulnerable to unexpected adverse shocks.

Pockets of vulnerability remain, as high interest rates weigh on the debt servicing capacity of vulnerable households and firms. High debt service costs could prove especially challenging for firms with lower credit ratings, as reflected by the rise in expected default frequencies in the high-yield segment. Expected default rates are also highly uneven across economic sectors, with firms operating in wholesale trade or in real estate seeing some of the largest increases in expected default rates (Chart 4, panel b). Defaults could rise if yields remain high, energy prices soar again or global supply chain disruptions intensify. Euro area households, especially those with lower incomes and in countries with mainly floating-rate mortgage lending, are being relatively more challenged by higher interest rates (Chart 4, panel c). However, middle-income households may be affected too, especially if labour market conditions were to weaken considerably. In such a scenario the implications for banks mortgage portfolios could become notable.

Geopolitical tensions have risen, posing risks to the global growth outlook and the euro area disinflation process. Russia’s war against Ukraine and the conflict in the Middle East are key sources of tail risk. The recent attacks on cargo ships on the Red Sea trade route triggered an abrupt rise in shipping costs between Asia and Europe in December 2023 (Chart 1.2, panel b) and global supply chain pressures have been on the rise since last autumn. The immediate risks to inflation and growth in the euro area from the Red Sea attacks seem limited owing to their minimal impact on oil production costs, current spare capacity in global shipping and subdued global demand. However, the impact on euro area growth and inflation could be substantial if the disruptions were to escalate to the broader region and last longer. The recent intensification of the Iran-Israel conflict has increased the probability of such a tail-risk scenario materialising. The expected reduction in oil production by its main exporters, as well as supply disruptions to oil and gas facilities in Russia and Ukraine, pose further upside risks to oil and gas prices. The rise in geopolitical tensions between major economies in recent years is also leading to weakening global trade links. For example, the share of imports to the United States from China declined from 25% in 2017 to 15% in 2023, and the number of protectionist measures targeting cross-border trade is increasing globally (Chart 1.2, panel c). Continued geopolitical tensions pose the risk of economic and financial fragmentation in the world economy, with potential adverse effects on financial stability in the euro area and globally. These potential effects could include slower productivity growth and higher production costs resulting from less efficient resource allocation, greater macro-financial volatility due to reduced international risk-sharing opportunities, and lower profitability and a higher cost of funding for financial institutions on the back of reduced cross-border capital flows. In this context, the record number of elections due to take place across the world in 2024 are likely to keep the uncertainty around global economic policies elevated.

National budget deficits are expected to stay larger than they were before the pandemic as many of the support measures taken have remained in place. While most of the energy and inflation support measures introduced after the Russian invasion of Ukraine are being phased out, many of the measures taken during the pandemic have not been fully rolled back. Moreover, structural primary balances (i.e. budget balances adjusted for the impact of changes in economic growth due to business cycle fluctuations and excluding interest payments on outstanding debt) are expected to remain well below pre-pandemic levels over 2024-25. This is the case for almost all euro area countries, irrespective of their starting level of sovereign debt (Chart 1.3, panel b). Potential fiscal slippages are an additional concern, as weakening economic activity has already contributed to some countries missing deficit targets in 2023, and the upcoming cycle of elections is increasing the risk of fiscal targets being missed as well. The lack of envisaged fiscal consolidation, combined with high debt levels, makes national budgets vulnerable to intensifying geopolitical tensions should these require increases in spending on defence, for example. It would also be more difficult to accommodate additional investment in areas such as climate change and digital technology, which would have a negative effect on euro area growth potential.

High levels of debt make euro area sovereigns vulnerable to adverse shocks, especially given the structural weakness in productivity and potential growth. While the government debt-to-GDP ratio in the euro area has fallen gradually from its pandemic-era peaks, the drop has been primarily driven by the post-pandemic recovery in nominal GDP, which has more than offset the impact of higher debt service costs on debt levels (Chart 1.4, panel a). With weaker nominal growth prospects ahead and little change expected in the structural primary balances, the debt-to-GDP ratio is falling at a slower pace. As a result, public debt levels in most euro area countries are expected to remain above pre-pandemic levels in the short to medium term (Chart 1.4, panel b). More importantly, structural headwinds to potential growth, from weak productivity for instance, are raising concerns about longer-term debt sustainability, making sovereign finances more vulnerable to adverse shocks and elevating risks to the financial stability outlook.

Vulnerabilities are elevated, particularly in those sectors and countries most exposed to the impact of higher interest rates. While the overall debt servicing capacity of euro area firms has been resilient, tight financing conditions have had a bigger impact on some countries and sectors than on others. Among large firms, the ability to meet interest payments from earnings has declined substantially since the end of 2019 in those sectors, such as real estate and discretionary consumer goods, affected by weaker demand on the back of higher interest rates on consumer and mortgage loans (Chart 1.5, panel c). Firms in the real estate sector have seen particularly large declines in their profitability since mid-2022, making them highly vulnerable to continuing tight financing conditions and to downside risks to the growth outlook (Section 1.5). Default rates on bank loans to commercial real estate firms are rising (albeit from low levels), reflecting eroding financial health. The same also applies to loans to small and medium-sized enterprises, since they have smaller liquidity buffers and lower profit margins than bigger firms (Chapter 3). Finally, corporate interest burdens have also increased more strongly in euro area countries where floating-rate lending is prevalent than in countries with a larger share of fixed-rate loans (Box 1). At the same time, if downside risks do not materialise, NFCs with floating-rate loans will also benefit more quickly from the expected declines in market rates than borrowers with fixed-rate loans.

Lending standards are expected to remain tight for some time, which could create additional headwinds for firms with high near-term refinancing needs. New borrowing by firms has remained subdued across all borrowing instruments in recent months (Chart 1.6, panel a), particularly for small and newly established firms. To a certain extent, this weakness reflects low demand for external financing because of high borrowing costs and an uncertain business outlook, as well as tight credit standards imposed by lenders. While the cost of new credit has been falling recently as lenders start to price-in the expected decline in central bank interest rates, it remains historically high, with the average interest rate on new bank loans to corporates at above 5% since September 2023. With the outlook for near-term growth subdued and lending standards expected to remain tight going forward, the near-term outlook for corporate borrowing is weak. This could pose a risk to firms’ debt rollover capacity, especially if growth continues to surprise to the downside and if the downward pressure on corporate profitability reduces firms’ capacity to substitute external with internal funding.

The ongoing corporate deleveraging should support firms’ access to external financing once the economy picks up and financing conditions ease. Weak new borrowing since late 2022 and the negative effect of past high inflation on corporate debt ratios have contributed to considerable deleveraging among firms, with the aggregate NFC gross-debt-to-GDP ratio in the euro area declining from 106.4% in the second quarter of 2022 to 98.4% in the fourth quarter of 2023. Although the countries with the highest levels of NFC debt have seen the largest declines in indebtedness (Chart 1.6, panel b), corporate debt levels are still elevated in some jurisdictions. At the same time, the decline in overall indebtedness, as long as it remains orderly, will likely put firms in a better position to access external funding in the medium term, once interest rates start declining and economic activity gains strength.

The cost of new borrowing and outstanding debt service have plateaued, while real income growth is supporting households’ debt servicing capabilities. Interest rates on new and renegotiated mortgages as well as on new consumer loans peaked in the fourth quarter of 2023, likely in anticipation of policy rate cuts later in 2024 (Chart 1.8, panel a). Countries with predominantly variable-rate mortgages have seen their debt service costs increase considerably. At the same time, households’ debt servicing capabilities in countries with mainly fixed-rate mortgages will depend on future interest rates when mortgage fixation periods end. The less rapid rise in interest rates together with the recent pick-up in wages across the euro area led to the aggregate debt service-to-income ratio plateauing as of the fourth quarter of 2023. Additionally, households have likely used excess savings accrued during the COVID-19 pandemic to reduce debt burdens in recent years (Overview, Chart 4, panel a), limiting the overall deterioration in their ability to service their debts compared with the previous hiking cycle between 2006 and 2008.

There are some signs of stabilisation in residential real estate (RRE) prices, but downside risks remain. Euro area RRE prices declined 1.1% year on year in the fourth quarter of 2023. This fall in aggregate euro area RRE prices masks significant differences across countries, with around two-thirds of euro area countries still exhibiting positive price dynamics in the same period. In addition, high-frequency data on RRE prices available for a selected number of countries indicate that the drop in RRE prices in some countries might have slowed or even come to a halt in the second half of last year (Chart 1.10, panel a). The orderly contraction in RRE prices has led to a reduction in overvaluation measures, which is reflected in slightly lower tail risk for euro area RRE prices compared with the third quarter of 2022 (Chart 1.10, panel b). Nonetheless, downside risks remain elevated in some euro area countries, as housing affordability is at low levels owing to high interest rates and high prices, with some markets still showing signs of overvaluation. The tightening in financial conditions has been followed by a stark deceleration in RRE investment, which will likely have a negative impact on supply going forward (Chart 1.10, panel c). The reduction in housing supply and expectations of rising construction prices, albeit much slower than in the recent past, might to some extent mitigate the risk of prices falling substantially going forward.

The downturn in RRE markets has remained orderly thus far, while some signs of materialising risk can be observed in CRE markets. The downward adjustment in RRE prices remains orderly, with signs of stabilisation in some countries. Generally, the contraction in RRE prices has been larger in countries where properties showed signs of greater overvaluation at the start of the rate hike cycle. Risks remain tilted to the downside, however, especially in those countries where debt levels are elevated and properties might still be overvalued. The commercial segment has seen a steeper downturn, and rising financing costs pose challenges to the debt servicing capacity of real estate firms, especially where rental income is also under pressure. This development is reflected in positive and rising non-performing loan inflows in banks’ CRE portfolios, although these remain contained for now. Banks’ aggregate exposures are substantially smaller to CRE than to RRE and are unlikely to be large enough at the euro area level to threaten the solvency of the banking system as a whole. However, these exposures are not evenly spread across the banking system, and stress could arise among the euro area’s most exposed banks (Chapter 3). Additionally, an adverse outcome of such a scenario could be amplified by procyclical selling among non-banks, particularly real estate investment funds (Chapter 4).

Total bond funding costs are still expected to increase further. At the end of 2021, marginal bond funding costs were substantially lower than total bond funding costs in both the euro area and the United States (Chart 2.4, panel a), indicating that pandemic-related policy easing had not yet been fully transmitted. The rapid increase in bond yields over 2022 has reversed these dynamics but, until recently, the overall increase in total bond funding costs had been relatively limited. While current bond yields reflect the policy rate cuts anticipated by investors, the limited scale of the expected easing cycle leaves scope for further total funding cost increases (proxied by the distance to the 45-degree line in the chart). This might put pressure on more indebted corporates, especially if the subdued economic growth currently observed in the euro area continues. In the sovereign bond space, while total funding costs are also expected to increase further, the scale of expected increase varies substantially across individual countries (Chart 2.4, panel b). In contrast to the situation for corporates, it appears that more of the past tightening has already been transmitted to more indebted sovereign issuers than to less indebted ones (the higher the marginal cost of bond funding, the closer it is to the total cost of bond funding). This is because of the significant amount of lower-rated sovereign debt which has already been rolled over at higher rates. In addition, the recent substantial compression of spreads has further mitigated the expected additional increase in average sovereign funding costs.

The rally in equity markets has pushed both valuations and concentration levels higher. Robust earnings, investor optimism and the related compression of risk premia have resulted in a strong equity performance in recent months, taking major indices to all-time highs. In the United States, some equity valuation metrics have reached decade-high values (Chart 2.6, panel a), fuelling concerns of overvaluation or, even, an AI-related asset price bubble. Although cyclically adjusted metrics are still below dotcom bubble levels, they are also substantially above the historical median, suggesting that there is scope for a market correction and lower long-term returns going forward (Chart 2.6, panel b). In addition, there have been increasing concerns over heightened market concentration, as the largest companies in the United States now account for a historically high share of broad index capitalisation (Chart 2.6, panel c). This could lead to the prevalence of idiosyncratic risks related to the key themes driving earnings expectations higher – as was the case for internet development in the 1990s and is the case for AI currently. Elevated uncertainty surrounding the ultimate impact of AI on the real economy could therefore contribute to high volatility in the overall equity market, irrespective of whether the “AI rally” is displaying asset price bubble dynamics or not. In the euro area, while market concentration has also risen, equity valuation indicators have not increased to the levels seen in the United States. As the respective equity markets are deeply integrated, financial stability risks for the euro area might relate mostly to spillovers from the United States or to potential negative earnings surprises, particularly if subdued economic growth continues.

While the corporate sector is perceived as resilient on aggregate, pockets of vulnerabilities have become more apparent. Buoyant investor sentiment has also been observed in the corporate bond market. Progress seen in the convergence of inflation towards central bank targets has strengthened baseline expectations among investors that the global economy will experience a soft landing. In such a scenario, default rates – even those for more indebted borrowers – are expected to remain contained, which has supported the continued compression of high-yield bond spreads in both the euro area (Chart 2.7, panel a) and the United States (Chart 2.7, panel b). While this would be a desirable outcome from a financial stability perspective, there are still some concerns over the heterogeneous situation of individual sectors. In the euro area, this has been reflected in the substantial increase in spread dispersion to levels last seen during the global financial crisis (Chart 2.7, panel c). The sectoral split indicates that distressed borrowers are concentrated in the real estate sector, which has recently become more vulnerable because of the downturn in the commercial segment (Chapter 1). While the small share of such troubled borrowers points to limited potential spillovers to the broader corporate bond market, it might reflect the deteriorating asset quality of some bank loan portfolios (Chapter 3). By contrast, in the United States spreads have compressed substantially even for the lowest-rated borrowers, which might reflect a better economic outlook.

Investor concerns about euro area sovereign debt sustainability have decreased greatly, despite medium-term vulnerabilities. Declining uncertainty in the interest rate market has continued to be one of the key drivers of sovereign spread compression in the recent period (Chart 2.8, panel a). In addition, substantial debt issuance by more vulnerable countries has been well absorbed by market participants, in part due to the growing demand for duration exposure. Investors have become more confident that risks in the sovereign bond market will remain contained. Consequently, the market pricing of sovereign credit risk still appears benign in comparison with the views of credit rating agencies (Chart 2.8, panel b). Because of the rise in interest expenses and still-elevated debt levels, some euro area countries may experience significant spread widening if they are unable to consolidate their fiscal positions. This may prove challenging, given the subdued economic growth outlook (Chapter 1).

Although sentiment is buoyant, market participants are trying to weigh up geopolitical risks. Since the beginning of the unjustified Russian invasion of Ukraine, investors have increased their attention to geopolitical risks, as reflected by the frequency at which the topic is mentioned in corporate calls with market participants and analysts (Chart 2.10, panel a). The risk of the conflict escalating has also been reflected in the outperformance of defence sector companies, especially in the euro area, where military spending has already risen significantly and is expected to rise still further. In addition, gold prices have recently reached all-time highs, likely driven by the demand for geopolitical risk hedges. While the immediate market reaction to Hamas’ attack on Israel has been quite muted, increased tail risks have also been priced in by the energy market, which is often an important channel of geopolitical risk contagion (Special Feature A). Risks to crude oil prices are typically skewed to the downside, but when geopolitical risks grow this pattern inverts, as reflected by the option-implied volatility skewness (Chart 2.10, panel b). That said, the potential escalation of international conflicts, especially when they involve or are close to important commodity exporters, might increase the risk of negative supply shocks substantially. Such a scenario could undermine disinflation efforts and put significant pressure on asset valuations.

Weak loan demand and tight credit standards suggest that loan growth will remain subdued. Rates charged by banks on new loans to households and non-financial firms have already lost momentum over recent months and appear to have reached their peak (Chart 3.3, panel a). Year-to-date bank lending flows to the non-financial private sector were at record lows at the end of March, driven by large reductions in mortgage lending and loans to non-financial corporations (NFCs) (Chart 3.3, panel b). Banks have tightened their credit standards further since the previous issue of the Financial Stability Review was published and expect those standards to tighten again over the second quarter of 2024, which should further dampen loan growth over the medium term. At the same time, the demand for loans from households and NFCs has weakened further but is expected to recover slightly during the second quarter of 2024 (Chart 3.3, panel c).

Floating-rate assets could weigh on banks’ interest income, as market reference rates are expected to fall. Three-quarters of the increase in banks’ interest income from loans can be linked to loans remunerated at variable rates. This is because these loans repriced alongside rising market reference rates while rate dynamics for fixed-rate loans have remained comparably muted (Chart 3.4, panel a). However, floating-rate loans become a headwind for bank profitability under assumptions of an imminent turn in market reference rates, as implied by current market expectations. Similarly, banks’ liquid assets, such as central bank reserves, reverse repos and short-term debt securities, have been a major source of increased profits, but their yields would shrink quickly once market interest rates fell. Banking systems with large shares of floating-rate loans and liquid assets are the most exposed to declining market reference rates, including several countries where almost the entire loan book to NFCs has been granted at variable rates (Chart 3.4, panel b).

The outlook for deposit rates remains uncertain, as new business deposit rates lose momentum while rates on the outstanding stock continue to rise. With policy rates expected to fall and the pass-through of changes in policy rates at similar levels to previous hiking cycles, term deposit rates are likely to decline going forward. The cost of new term deposits from NFCs has already reached a plateau, and rates offered on new term deposits from households already started falling in November 2023. This contrasts with the evolution of overnight deposit rates, for which the pass-through of policy rate increases remains compressed and which continue to rise slowly (Chart 3.6, panel a). Moreover, the share of overnight deposits remains high by historical standards and depositors continue to move funds into better remunerated term deposits. The implications for aggregate deposit rates are uncertain but if historic regularities from previous hiking cycles were to be repeated, deposit costs on the stock of outstanding deposits could, on average, increase further and lag the turn in the short-term interest rate cycle (Chart 3.6, panel b). This implies that deposit costs could become a headwind for bank profitability going forward, especially for those banks most dependent on deposit funding, such as those with small reserve ratios which have already seen larger changes in deposit rates over recent months.

Market-based funding costs have decreased since the previous issue of the Financial Stability Review was published, with credit spreads tightening considerably for the riskiest instruments. The cost of issuing new debt has risen significantly since the start of the monetary policy hiking cycle. Bond yields have, however, declined since the previous issue of the Financial Stability Review was published, benefiting from expectations of monetary policy rate cuts, which affect the yield curve, and strong bank fundamentals which supported a reduction in credit spreads (Chart 3.7, panel a). Despite some volatility in the market for covered bonds secured on commercial property loans in early 2024, there have been no spillovers to broader bank funding markets. Tighter credit spreads created a window of opportunity for some issuers to front-load issuance in early 2024. As a result, year-to-date cumulative issuance volumes are close to record levels (Chart 3.7, panel b). Market analysts expect the strong issuance activity to continue in 2024 – especially across covered and senior segments, which offer tighter pricing relative to other debt instruments – due to continued TLTRO repayments. In addition, with sizeable redemptions looming, issuance of AT1 instruments is also expected to increase considerably over previous years. By contrast, the issuance of senior non-preferred bonds is expected to slow, as banks have already built out MREL buffers to required levels.

Bank funding costs are expected to increase further, despite favourable developments in market funding conditions. With interest rates expected to decline, market-based short-term liabilities, such as those with financial institutions, should reprice downwards swiftly, reversing rate effects. By contrast, longer-term market-based liabilities, such as bonds, should continue to reprice at higher rates, given that outstanding bond rates are still below current market yields. In conjunction with the low and lagged pass-through of policy rates to deposit rates, overall funding costs might increase further, despite the easing of funding pressures.

Looking ahead, analysts expect bank profitability to decline slightly over the next two years, albeit to still comfortable levels above historic averages. Analysts expect the ROE of listed banks to fall from the present level of 11% to 10.7% and 10.4% in 2024 and 2025 respectively (Chart 3.13, panel a). This decline in bank profitability is expected to be driven by a mild reduction in net interest margins together with a slight rise in the cost of risk (Chart 3.13, panels b and c).

Euro area bank valuations lag those of some global peers, reflecting investor concerns about the durability of bank profits. The aggregate price-to-book ratio of euro area banks has improved in recent months and currently stands at 0.77 (Chart 3.14, panel a). Notwithstanding the recent improvement, the ratio remains notably below 1 and below that of some international peers, reflecting investor concerns about the ability of euro area banks to sustain current profitability levels durably given headwinds from weaker asset quality, lower revenues and cost of funding. In addition, one-off factors such as the introduction of bank levies and lingering structural problems across the industry may play a role. However, a track record of strong profitability and a low cost/income ratio are important determinants of increased price-to-book ratios at the individual bank level, suggesting that sustained bank profitability and efficiency provide a path to improved bank valuations (Chart 3.14, panel b).

Liquidity buffers have declined further, despite higher returns on more liquid asset classes, limiting the capacity of the NBFI sector to absorb shocks. The cash and liquid asset holdings of euro area non-banks remain low in aggregate, exposing the NBFI sector to liquidity risks (Chart 4.1, panel b). This represents a structural vulnerability in open-ended investment funds as it increases the risk of forced asset sales in the event of an unexpected rise in shareholder redemptions (Section 4.2). Sudden liquidity needs may also arise from margin calls on derivative exposures (Box 5), especially for interest rate derivatives amid elevated interest rate volatility (Chapter 2). Ensuring adequate preparedness against spikes in demand for liquidity therefore remains a key element in preserving financial stability in the NBFI sector (Chapter 5).

NBFI portfolio valuations have been supported by improved market sentiment, while equity exposures have become more concentrated. Improved financial market sentiment in late 2023 and early 2024, especially in US equity markets (Chapter 2), has helped to push up asset valuations in the NBFI sector. Over the course of 2023, euro area non-banks’ holdings of listed shares issued by non-financial corporations became more concentrated, reflecting both a reduction in overall equity portfolio size and an increasing market footprint of a few large issuers. The share of the 25 largest issuers held among non-financial equities has risen to 24% for investment funds and 25% for insurance corporations and pension funds (ICPFs) (Chart 4.2, panel a). By contrast, portfolio concentration is relatively stable or declining for non-financial debt holdings. Equity portfolios may therefore be increasingly vulnerable to idiosyncratic risk, especially in investment funds, where holdings are additionally concentrated in US-based technology firms (Section 4.2). As such, sudden drops in the share price of one or a few individual companies could trigger significant portfolio losses and result in fund outflows, with the potential for spillovers to the wider financial system.

Downside risks to asset valuations remain, especially for NBFI portfolios with high credit risk, a focus on real estate or exposures sensitive to geopolitical risk. While the overall outlook has improved over the past six months, the macroeconomic environment remains characterised by elevated uncertainty (Chapter 1). Pockets of vulnerability therefore remain in different parts of the euro area NBFI sector, which may still face valuation losses. While a risk of rising corporate defaults may impair asset quality for a wide range of NBFI entities, a further downturn in real estate markets may particularly affect valuations of real estate investment funds or ICPFs with sizeable real estate holdings (Sections 4.2 and 4.3). Investment portfolios held by the euro area NBFI sector are also sensitive to increases in geopolitical risk, and tensions related to ongoing conflicts and upcoming elections may also indirectly spill over to the sector (Special Feature A). The risk of potential valuation losses in this context could thereby be amplified by elevated credit risk in a significant share of asset holdings with medium or high levels of sensitivity to geopolitical risk (Chart 4.2, panel b).

Authorities need to carefully balance key trade-offs when designing policy measures – their effectiveness, feasibility and potential costs. A wide range of policy measures are used by authorities across the globe to address leverage-related risks (Box 6). The choice of measure requires careful consideration of the given circumstances, as these affect how suitable a tool is for targeting specific risks. At the same time, authorities may face significant constraints, including the scope of their financial stability mandates and the complexity involved in calibrating the measures. Moreover, it is important to ensure that the resulting actions do not impose disproportionate costs, such as those associated with negatively affecting liquidity and pricing in underlying markets or hedging incentives. To cite one example, while entity-based measures (e.g. leverage limits) can be effective in targeting leverage directly, their use may not always be feasible as entities may lie outside the regulatory perimeter (e.g. family offices), for instance, or engage in highly complex investments (e.g. multi-strategy hedge funds). In such cases activity-based measures (e.g. haircut/margin requirements or clearing mandates) may be an important complement. However, haircuts and margins may be less effective in targeting the build-up of concentrated positions and, if set too strictly, could impose excessive costs on hedging for end users.