 People in Europe are facing multiple challenges. Inflation is high and interest rates are rising at the fastest pace in the Eurozone's history. At our borders, war also continues to rage on. We've just released our latest Financial Stability Review, which twice a year takes a look at risks to the financial system, the ability of our financial system to weather this storm is worsening. That's what we'll be focusing on in the next two episodes. Today, we'll talk about the risks we see for financial markets, for governments and in the real estate market. And in the next episode, we'll zoom in on a completely new topic, cyber risks and what they can mean for financial stability. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. I'm joined by John Fell and Tamara Shakir, who both work in our Financial Stability Department here at the ECB. Hello to both of you. It's always a pleasure to have you on the podcast to talk about this topic. John, I want to talk first about one area that has been in the news a lot recently, and that's financial markets. There have been big market movements, I think we can say, in some sectors and regions. Now, financial markets have become more volatile, with prices going up and down more than before. And this is partly because of all the uncertainty we're facing. For example, investors simply don't know how inflation will develop and they're trying to second guess, if you will, what central banks' next move will be. John, can you break down for us a bit what's been happening in financial markets? This has really been an awful year for financial markets. Prices of almost any asset class one could think of are showing double-digit declines this year. There are actually very few exceptions across the globe, but if you look across different economic sectors, one that really stands out is the energy sector. And the outperformance of big oil producers' stock prices in particular offer some clues about the drivers, not only of the source of the declines, but also of the highly correlated nature of these declines. Now, we have a box, box two in the episode, which highlights a particularly unusual feature of financial market developments this year. And that was the simultaneous decline of stock and bond prices. We have not seen anything like this in more than 20 years. In fact, since 1998, there have been three euro area stock market declines of 20% or more. But risk-free bond returns have never been negative and stocks have fallen, except for this year. And that's an issue right for investors because usually they try to diversify their portfolios and have a bit of both, a bit of stocks and bonds. Absolutely. It means that there will be very few investors who will have managed to avoid large losses this year. Why has it happened? Well, I think it can be broken down into three distinct sets of factors. So the first is valuations. The second is fundamentals. And the third is amplifiers. So if I start with evaluations, you may remember in last year's episode, we warned the very high valuations for many asset classes. Now, our assessment at the time was that this created vulnerabilities to adverse developments or shocks. The type of shock we worried most about was a so-called supply-side shock. The hallmark symptoms of supply-side shocks are rising prices together with lowered output. And so bridging to the second factor, the fundamentals, the Russian invasion of Ukraine triggered a supply-side shock. That raised energy prices and that in turn raised cost of production in the economy. Now, while it benefited the oil producers, other sectors have suffered. And this has been bad for both bonds and stocks because it created uncertainty about inflation. Also, the path of interest rates related to inflation expectations and economic growth. And that explains this positive correlation that we've seen. And then finally, we have the amplifiers. So once a correction gets underway, market sentiment often turns sour and financial market activity often is scaled back. Now, we've seen this manifesting this year in sizable cutbacks of issuance activity by euro area corporations. And that's both for bonds and for equities. So they're holding off issue in bonds. Exactly, yes. So lowered risk appetite is holding investors back because they're just simply nervous about buying, taking on exposure to new issues while issuers seem to be waiting for camera market conditions and better prices to return. So while the basic motivation of market participants is caution, this actually has a paradoxical effect of reducing market liquidity. And then we have fewer buyers. It becomes harder for sellers to dispose of assets without moving the prices against themselves. And so markets become more volatile as we've seen. So where we would have concerns are situations of acute volatility spikes. Now, because these can cause vicious cycles for all three of those factors that I mentioned. So concerns about overvaluation, deteriorating fundamentals, and also receding market volatility can end up reinforcing one another. So far, this has been largely avoidable. We have seen some episodes in the energy markets. Okay, John. So there are a lot of different factors at play in markets at the moment. Definitely something that we need to keep an eye on. Now, we've been talking about energy prices and indeed one area that we've seen soaring price rises, as you said, John, is energy. And energy prices are fueling a large part of the high inflation that we're seeing at the moment. But something that is helping companies and people through this tough time is government support. Now, Tamara, I want to talk a bit more about that with you, about what it means for countries debt levels and what the repercussions are as well for financial stability. So just to put some numbers on that, in the financial stability review, we say that countries have spent around 1.4% of GDP on support measures since the start of Russia's unjustifiable war in Ukraine. And this has been in part to cushion the rise in energy prices. Tamara, what exactly are the risks there that are linked to this government support? The first thing I'd say is actually the government support has a lot of good reasons behind it, both because think morally we want to see measures taken to avoid the most vulnerable people being overwhelmed by something that's also completely out of their control. Also economically, it's really useful that there's something that helps smooth this big shot going through the economy so that it means that non-energy consumption has also given a chance to adjust to what's going on in the energy market. So it could be overwhelming otherwise. The situation though that we have to be really mindful of is this is all being undertaken on the back of a few years in the pandemic where there were also really big government support measures going on. And the implication of that has been that we've been running slightly larger deficits for a few years. The aggregate debt to GDP ratio in the euro areas now gotten over 95% and there needs to be a plan to bring that back. I think a lot of countries kind of expected that after the pandemic they would be able to reconcile that the higher debt that they had with well bringing it down basically, right? Exactly and John was talking about the investor reaction in financial markets and some of that is people looking at what's going to be the median term implications of all of this. And indeed funding costs have also started to rise, including for governments. And another dimension of that increase in funding costs is also coming from monetary policy. So high inflation above 10% in the euro areas still has really got to be the focus of monetary policy authorities right now. Fiscal policy needs to respond a bit to that as well. So fiscal policy measures were too broad, too supportive. It'd be a bit like trying to run up an escalator that's going in the other direction. They would be going against each other and you wouldn't get anywhere. So that's partly why we say much more targeted temporary fiscal policy measures would help reduce those risks right now. OK, so as we know with financial stability when one part of the financial system wobbles, shall we say, then it can have knock on effects on other parts. You've said what the risks are, but if we look at it from a financial stability perspective, what effect could this higher government debt have on other parts of the economy and the financial system? The risks of it are particularly for countries that maybe have higher debt is if they were seen to be losing a bit control of their fiscal position. The response could actually end up in a vicious cycle where markets respond badly, the funding costs rise even further. And that's where you can get a sovereign crisis from. But the other implication is also that in general, if we need more targeted support this time round is we may have to accept the implications for the economy of less support. I think we've talked on this podcast before actually a few issues ago about how we've been relieved by how corporate defaults have been, for example. And a big part that the pandemic was indeed corporate fiscal support measures. I mean, at some points, I think there were predictions of very large waves of defaults that could arise and they didn't, which has allowed businesses to carry on. It's meant that we haven't then also seen unemployment rising really sharp. In fact, unemployment still historically very low in the euro area, but with slightly more targeted support, it could be that we have to expect that if there is a period of weaker growth, possibly even a recession to come, we have to let some of the effects of that go through. And that could have knock on effects if there was to be a pickup and default in the economy. Let's talk about another topic that we have actually touched on in the past tomorrow. And that's real estate. Now, obviously as rates go up, interest rates go up, taking a mortgage out or renegotiating an old one becomes more expensive. Now, the financial stability review does find that people are still taking out mortgages. There's still demand for mortgages out there. And in fact, the number did increase in the last few months, but it does look as if this trend is set to slow. We're also seeing a sharp drop in those intending to buy or build homes. And banks have become more cautious when giving out loans as well. Tamara, how is this changing situation impacting the real estate market and specifically property prices? What do you see there? The context here is, as you said, we talked about this before. And in the last few years in the euro area, we've had a real estate market that's actually been running pretty hot. So historically very high house prices, although mortgage growth has actually been pretty moderate in comparison to those fast house price growth. And that's what we've seen in the data up to Q2. We're in a bit of a gap at the moment. So we're waiting to see the latest data for the aggregate euro area picture. But we have started to see in the monthly data and at national level that the market's slowing. And that's kind of consistent with these very challenging economic times that we're all talking about. So market slowing means that house prices are going down and that demand for houses is going down. Well, at least the pace of house price growth will be expected to slow whether or not we actually get a contraction and house prices is to be seen. But we've been talking for some time a bit like John was saying about asset prices overall being stretched. House prices in a lot of euro area countries look somewhat overvalued especially compared to incomes. And the implication is we also suspect then that in recent years there'll be some borrowers who have stretched themselves a bit in order to be able to get a house. And that's all well and good when interest rates are very low. But as the interest rate rises start to trickle through various mortgages depending on what kind of mortgage you've got for some people that could be a squeeze. And we've got a couple of other confounding facts of course which is with higher inflation of purchasing power what people have in their pocket to spend is feeling reduced overall. Then there could be difficult choices for some people to make about affording their house going forward or the implications in the wider economy of that. I've seen in the news that there's a lot of talk about fixed interest rates and variable interest rates. You know different countries have different systems in place. Is that a piece of good news for us that in the countries where there are more fixed interest rate mortgages that maybe the impact won't be as bad? Yes, I think overall we would agree with that. So for mortgage owners themselves that gives you breathing room it means that you don't see the effect of interest rates coming through all in one go depending on what mortgage you personally have but on average in the euro area we've seen more and more people with fixed terms. The other big factor is also then unemployment. That's a huge thing that unemployment is historically low and it's a big shield. That's the thing we've got to watch out for. I think if we were to see unemployment pick up that would probably be a flag for us about the direction that this could take. For the system as a whole the other thing is also that whilst the fixed rate mortgages are good for the borrowers it can mean more pressure on banks but overall in our assessment what's also fortunate is our banking system looks to be in relatively robust shape certainly compared to historical periods so it's sort of the dog that isn't barking right now. That's a good way to put it. Okay, thank you Tamara. Now John the last topic I want to talk about on this episode is non-banks because there's a very specific mention in the review about the issues that are facing these institutions. Now I think maybe it's worth me explaining what an earth and non-bank is because it's a pretty vague concept but non-banks are basically financial institutions that offer some of the services that a bank does, right? So like investing but they don't actually have a banking license so things like investment funds, hedge funds they're the kind of things you think of when you say non-banks. And since the global financial crisis the number of non-banks has actually grown quite a bit and they have actually been playing a key role in providing credit to the economy. Now John, why was there such a specific mention of non-banks in the financial stability review? What exactly are you seeing there? So this has been something that we have been monitoring actually for quite some time. Before the pandemic the paradigm that dominated our thinking on financial stability risks was one of a low for long interest rate environment hunt for yield and liquidity abundance in financial markets. Now one symptom of this was substantial growth of the non-bank financial sector as you mentioned. These non-banks have become a very important source of finance for the real economy and greater diversity within the financial system was offering firms more options for raising finance on better terms so there were plenty of positives. But we did have a number of concerns and they had mostly to do with what we call the pro cyclicality of non-bank finance. Now that's basically... Can you break that down? It's just simply the tendency to amplify trends both either up turns or downturns that the sector moves together with the cycle but it can make it even more amplified. Now low interest rates had set a dynamic of hunt for yield in motion whereby funds, investment funds for instance took on greater risk to generate higher returns. It was very difficult to find decent returns for commitments that they might have made to investors. So this was done in a number of ways including through taking on greater credit duration and liquidity risk and sometimes also through leverage. Leverage is when you... When you borrow to buy an asset. Yeah, exactly. Actually leverage is what you do when you buy a house but you can do that in financial markets as well. And that's the liquidity of the assets that were held by non-banks especially investment funds as the liquidity declined. That made them more prone to fire sales of assets in situations where they needed to raise cash quickly. So these would be assets that would be difficult to sell because they're not very liquid. So for instance if they faced redemption requests from their end investors they might have difficulty. What we're seeing now looks more like an orderly retreat of non-bank finance. When markets are correcting it can lead to nervousness among end investors. So those are the people who invest in the investment funds and they might be asking for their money back because they don't want to suffer even further losses. Now when that starts happening investment funds have to find the cash and this is often done by selling assets. So this retreat of non-bank finance of course it also diminishes the capacity of the investment fund sector then to fund businesses and sovereigns because investors are taking their money out. Now whether it reduces the overall availability of finance in the economy and now that would be a source of concern if that were to happen. That depends on whether banks would have the willingness or the capacity to step in and fill the gap as non-bank finance retreats. But should adjustment become disorderly say because of further asset price declines we have concerns that funds may not have sufficient cash our liquid assets on hand to be able to cope would say an extreme but plausible scenario of redemption requests by end investors. Now it is on those grounds that we've been making a case for more macro potential oriented regulation that would require funds to hold a certain minimum proportion of their other assets in cash and liquid securities so that that kind of stress could be avoided. Thank you John and thank you Tamara for this conversation. Now before we wrap up as you know very well we always ask our guests for a hot tip linked to the topic we've been discussing today. Now your previous hot tips included Roman Emperors and Eddie Murphy films so I'm quite curious to see where we're heading today. Tamara I'll start with you what's your hot tip for our listeners on the topic of well broadly financial stability. Well my hot tips actually related to monetary policy but it's so relevant to the what we're seeing today. I recommend it although I'm only halfway through so Ben Bernanke who was the former chair of the federal reserve particularly during the great financial crisis and recently was awarded the Nobel Prize. He released a book earlier this year on monetary policy I think monetary policy in the 21st century it's called or the other way around and I think it's a really really clear actually I'm learning a lot exposition of how particularly the US but central banking has changed and very thoughtful so and there's been a period of actually quite sizable development in how central banks operate and he writes really well I find really clear. John how about you? I mean a key question facing many market participants today is whether we are nearing the end of the market correction or not and so I have a book recommendation but the name of the book is Valuing Wall Street Protecting Wealth in Turbulent Times. It was published by Andrew Smithers and Stephen Wright in 2000. So even before the global financial crisis? Even before the global financial crisis and even before the dot-com bubble burst they couldn't have had better timing with the publication of the book but it's as relevant today as it was then in making the case that equity markets are strong mean reversion properties in the long run and what is meant by that is what goes up or goes up too far eventually comes down. Well that brings us to the end of this episode. Thank you so much to my guests John Fal and Tamara Shakia from our financial stability department for explaining what's going on in financial stability at this very difficult time. Be sure to check out the show notes for links to the financial stability review and for further reading on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. Until next time, thanks for listening.