The three European Supervisory Authorities (ESA) have called for vigilance from financial institutions, national supervisors and market participants in the face of mounting risks.

In their Spring 2023 Joint Committee Report on risks and vulnerabilities in the EU financial system, the EBA, EIOPA and ESMA noted that EU financial markets remained broadly stable despite the challenging macro environment and recent market pressure in the banking sector.

However, while there has been recent growth following a period of high inflation and tighter financial conditions, the economic outlook was “uncertain” and inflation may remain elevated for longer than expected, the ESAs stated.

They pointed to the collapse of three US banks and the emergency merger of Credit Suisse and the Union Bank of Switzerland (UBS) as evidence of the continued uncertainty, sensitivity of the European financial system to shocks and the potential risks relating to the end of low interest rates.

“Asset prices were highly volatile over the past months with market liquidity fragile,” the report stated.

“Sharp movements in prices triggered sizeable margin calls and put some market participants under liquidity strains, notably non-financial corporations and non-bank financial institutions.

“High levels of uncertainty and imbalances in the supply and demand of liquidity are a drag on the financial system’s resilience against further external shocks.

“In addition to these risks, geopolitical tensions, environmental threats and an increase in the frequency and sophistication of cyberattacks further complicate the risk landscape.”

Against this backdrop, the ESAs urged financial institutions and supervisors to be prepared for a deterioration in asset quality.

They warned that the broader impact of policy rate increases and rises in risks on financial institutions and market participants should be considered in risk management.

Furthermore, liquidity risks arising from investment in leveraged funds and the use of interest rate derivatives should be closely monitored, according to the report, while financial institutions and supervisors were also urged to monitor the impacts of inflation risk.

“The strong regulatory frameworks that underpin the resilience of the financial sector are to be maintained, including by faithfully implementing the finalisation of Basel III in the EU without delay and with as little deviation as possible, and by avoiding further deviations from EIOPA’s advice on the Solvency II review,” the ESAs continued.

“Risk management capabilities and disclosures for environmental, social and governance risks should be enhanced as these risks are increasingly becoming a source of financial risk, and financial institutions should allocate adequate resources and skills to ensure the security of their information and communication technology (ICT) infrastructures and adequate ICT risk management.”

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