Financial Crime World

Severe Macroeconomic Downturn Looms as Interest Rates Stay Low

The European economy is bracing itself for a severe macroeconomic downturn over the next three years, with the prolonged COVID-19 pandemic and a “lower for longer” interest rate environment posing significant risks to financial stability. A report by the European Banking Authority (EBA) highlights the vulnerabilities in the banking sector, which could spill over to insurers and Institutional Operators of Retirement Plans (IORPs).

Vulnerabilities in the Banking Sector

The report notes that insurers have a significant exposure to banks through investments in bank bonds, with approximately 13.7% of their total investment concentrated towards banks. IORPs also have material exposures to banks, although they are smaller compared to insurers.

  • The largest subcategory of exposures is insured bonds
  • Senior unsecured bonds make up a significant portion of bank bonds

Risks in the Fund Sector

The report highlights the risks in the fund sector, which remain elevated amid increased risk-taking and high levels of valuations across asset categories. Bond funds, in particular, have seen an increase in credit risk as a result of the macroeconomic crisis.

  • HY bond funds saw their average credit risk profile decrease further in H1 2021
  • Liquidity risk is also a concern for some bond funds, with cash holdings decreasing from 3.1% to 2.3% of assets in H1 2021

Need for Vigilance and Proactivity

The report’s findings underscore the need for financial institutions to be vigilant and proactive in managing their risks, particularly in a low-interest rate environment.

  • The European Securities and Markets Authority (ESMA) has called on investment firms to review their risk management practices
  • Financial institutions must ensure they are adequately prepared for potential future shocks

Uncertain Economic Outlook

As the economic outlook remains uncertain, policymakers and regulators will need to closely monitor the situation and take prompt action if necessary to maintain financial stability.

By staying vigilant and proactive in managing risks, financial institutions can mitigate the impact of a severe macroeconomic downturn and ensure the continued stability of the financial system.