A new report from the European Central Bank (ECB) highlights potential challenges to financial stability in the euro area due to a rapidly changing geopolitical environment. The May 2025 Financial Stability Review points to shifts in global trade policy that have increased uncertainty and caused significant volatility in financial markets.
The ECB notes that "rising trade frictions and related downside risks to economic growth are weighing on the outlook for financial stability," according to Vice-President Luis de Guindos. The increase in trade policy uncertainty has led to large spikes in market volatility, raising concerns about an economic slowdown.
Financial markets experienced rapid sell-offs in early April, tightening financial conditions. Although risky assets recovered by mid-May, markets remain sensitive to tariff-related news. Equity markets are particularly vulnerable due to high valuations and persistent risk concentrations.
Non-bank liquidity and leverage weaknesses could be exposed amid heightened market volatility, potentially amplifying shocks. While euro area firms and households have improved their balance sheets, ongoing trade tensions and a weaker growth outlook present future challenges.
The euro area's open economy means that trade frictions could impact companies reliant on foreign trade, with possible effects on households if corporate vulnerabilities lead to layoffs. Credit risk exposure may rise for banks and non-banks, though banks' strong profitability and capital buffers should help absorb asset quality deterioration.
Sovereign debt-to-GDP ratios have declined since the pandemic but remain fragile in some countries. Increased defense spending could boost growth if focused on productive investment but also poses risks due to higher issuance needs amid rising funding costs.
In this uncertain macro-financial environment, strengthening the resilience of the financial system is crucial. Macroprudential authorities are advised to maintain capital buffer requirements and borrower-based measures. Additionally, comprehensive policy measures are needed for the non-bank financial intermediation sector to enhance its resilience and support euro area capital market integration.
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