Financial Crime World

Economic Crisis Looms: Severe Macroeconomic Downturn Expected Over Next Three Years

A prolonged COVID-19 pandemic and a “lower for longer” interest rate environment are expected to lead to a severe macroeconomic downturn over the next three years, according to experts.

Banking Sector Vulnerability

The banking sector is particularly vulnerable, with insurers and Institutional Operators of Reinsurance and Pension Funds (IORPs) at risk due to their interconnectedness. As of 2020:

  • 13.7% of insurers’ total investments were concentrated towards banks.
  • IORPs had an average exposure of around 12% towards banks.

However, these exposures are mostly considered low-risk, with insurers typically investing in bank bonds.

Potential Risks to the Financial System

The European Banking Authority (EBA) highlights the potential risks to the financial system, stating that vulnerabilities in the banking sector could spill over to other areas. The EBA warns that a severe macroeconomic downturn would have significant consequences for the insurance and IORP sectors.

Fund Sector Risks

The fund sector is also at risk, with:

  • Elevated levels of valuation across asset categories.
  • Increased risk-taking.
  • Bond funds are exposed to credit risk due to the impact of the macroeconomic crisis on corporate solvency and ratings. High-Yield (HY) bond funds, which represent 5% of all bond funds, have seen their average credit risk profile increase further in recent months.

Liquidity risk is also a concern for some bond funds, with:

  • Cash holdings decreasing from 3.1% to 2.3% of assets over the past year.
  • Managers’ liquidity management strategies during stress episodes.

Insurance and IORP Sectors

European Insurance and Occupational Pensions Authority (EIOPA) statistics show that insurers reduced their exposure to banks by approximately two percentage points in 2020, while IORPs have smaller exposures compared to the insurance sector. However, both sectors remain materially exposed to the banking sector through investments in bank bonds and derivatives.

Conclusions and Recommendations

The report concludes that a severe macroeconomic downturn over the next three years is likely, with significant implications for the financial system. Regulators must take immediate action to address these vulnerabilities and mitigate the risks to the economy.

Recommendations:

  1. Regulators must take immediate action to address vulnerabilities in the banking sector.
  2. Insurers and IORPs must closely monitor their exposures to banks and manage risks accordingly.
  3. The fund sector should prioritize liquidity management strategies during stress episodes.

Key Statistics

  • 13.7% of insurers’ total investments concentrated towards banks (as of 2020)
  • IORPs have an average exposure of around 12% towards banks
  • EUR 150 billion: Solvency II value of EEA insurers’ bilateral OTC non-cleared in CCPs with positive mark-to-market values
  • 5% of all bond funds are High-Yield (HY) bond funds, whose average credit risk profile has increased further in recent months

The full report can be accessed on the EBA’s website.