 The financial stability outlook in the euro area remains fragile. Higher interest rates and weaker economy prospects are putting pressure on borrowers, especially in real estate markets. Are there reasons to worry? We've just released our latest financial stability review, which twice a year takes stock of the potential risks to financial stability in the euro area. Today we'll talk about whether the financial system is stable and take a closer look at the emerging risks, especially in property markets. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Stefania Secola. I'm joined by John Fell, who works in our financial stability department and is a regular guest here on the ECB podcast. Nice to have you here again, John. Thank you, Stefania. John, let's start from taking a look at what has changed in the six months since you last talked on our podcast. Back then, financial markets were shaken after bank failures in the US and Switzerland. Today, key interest rates are record levels. This is helping to bring down inflation, which is very welcome development. There are two sides to this coin, though, and some worry about sluggish economic prospects. How are financial markets responding to this environment? Well, first off, financial markets quickly shook off the shock that was triggered by the US and Swiss bank failures that you mentioned. While there were expectations that those stresses might have led to an earlier end to the monetary policy tightening cycle, in order to safeguard financial stability, the avoidance of contagion and spillover saw those expectations quickly dissipating. And despite some turbulence in AT1 markets, Euro-area banks largely weathered the storm. So resilience was tested, and once again, after the stresses caused by the pandemic and the war on Ukraine, I think we can say that it was proven. And since then, broadly speaking, market sentiment has gone through two phases. First, there was a period of excessive optimism about prospects for a soft landing of the global economy, and so that's the soft landing narrative is one whereby disinflation would proceed sufficiently rapidly that it would allow central banks to make an early so-called pivot so that start to reduce interest rates and avoid recession. And this widespread optimism seemingly acted as a kind of a counterbalance to the tightening of monetary policy. Now, we consider this market narrative to be overly optimistic, and we thought that it was setting markets up for disappointment. And then when US inflation started picking up again and with Euro-area inflation coming down a bit more slowly than we might have hoped, the narrative started to change and market conviction about a soft landing faded somewhat. And with that capitulation, the more adverse, higher for longer scenario gained traction, and it resulted in a rout in the bond market and the US stock market briefly re-entered to correction territory. And since then, the consensus has changed again, and it seems safe to say that uncertainty is high and it has been rising. And of course, uncertainties have also been compounded by the flare-up of geopolitical tensions in the Middle East. Okay, yeah, yeah. And indeed, let's look at the geopolitical situation. There are several conflicts going on, and it's a human tragedy. My heart goes out to all the victims. From a financial stability perspective, what do the war in Ukraine and the conflict in the Middle East mean? Well, I think we've all seen how these geopolitical conflicts have entailed dreadful humanitarian suffering, including the deaths of innocent people, the displacement of people from their homes, and of course refugee crisis as well. Both events impacted energy markets adversely as well, although this was much more so the case following the invasion of Ukraine because of the sanctions on Russia, supply disruptions, and shifts in energy trade patterns as many European countries work to reduce their reliance on Russian gas. Now, whenever geopolitical tensions escalate in the Middle East, it's a relatively safe bet that oil prices will rise. Yeah. And that's because it's a major oil-producing region, and oil markets tend to be highly sensitive to events that could cause supply disruptions. Even perceptions can be enough, and so oil prices did actually rise briefly during the first couple of weeks after October 7th when Israel was attacked, but with concerns easing about the likelihood that an oil-producing country would become involved, they've since fallen back. Now, you asked what does it all mean for financial stability? Yeah. Well, so geopolitical risk can affect financial stability in several ways through economic channels, through financial ones, and then simply by creating uncertainty. So if energy markets are affected, the economy will be confronted with the so-called supply side shocks. So that's where production capacity is affected negatively, causing prices to rise. And we saw that with the surge of inflation after the invasion of Ukraine. Now, that required a response from monetary policy to bring inflation down. Now, with market views somewhat torn between a soft-landing outcome and interest rates staying higher for longer, any geopolitical tensions which could push inflation higher would make the higher-for-longer scenario more likely. And at the same time, then, the uncertainty part, investors often react to uncertainty by moving their assets to safer havens. That can lead to capital flight from riskier investments, for instance. In the episode, we show a lot of evidence that market pricing is underestimating the risks that lie ahead. So if shifts like that were to occur in response to a geopolitical event, it could destabilize financial asset prices. I see. Yeah. Let's talk about banks now. And because here in Europe, they've been quite strong lately. Higher interest rates have pushed their profits to a multi-year high. However, as you point out in the Financial Stability Review, their valuations have not responded to the improvement in bank fundamentals and profitability. Why? What's the actual health condition of your era banks? So, I mean, if we look back to late 2008, so 2019, sorry, just before the pandemic, low bank profitability in the Euro area was high on our list of sources of financial stability concern. But this year, profitability has been going from strength to strength. The reasons are, I think, relatively well known. Average funding costs have risen much more slowly than the returns that banks have been able to earn on their assets. So that has boosted net interest income margins. And then with margins increasing, more in countries where loans are contracted mostly on floating terms. And where so-called deposit betas have been low. Can you repeat that? Deposit? Deposit betas. So as an aside, I sometimes think it might be easier to understand them if these betas were called retas. So the realized interest transmission effect or how much of the official rate change is passed through to deposit rates. But as you said, we do have something of a conundrum. When we look at bank share price developments compared to bank profitability developments, profitability has on average doubled from the pre-pandemic levels that was giving rise to those financial stability concerns. But price book ratios, so that's one of the most common metrics of valuation for banks, have hardly changed. And price earnings ratios even fell. So what's going on? Well, for one, the cost of equity has risen by about as much as the return on equity has. Now, that's partly due, of course, to the fact that interest rates are higher, risk-free rates are higher. And that raises required returns across the board regardless of what kind of business you're talking about. But the conundrum is why has improved profitability? So that's a source of organic growth in bank capital. Banks can grow their capital if they are profitable. And that should make them less risky. But it hasn't actually lowered their so-called equity risk premium. Now, we offer some answers to this conundrum in box five of the episode. The main one being that neither bank analysts nor investors expect that this year's bumper profits are going to last. And they're projecting lower profits next year. So revenues are set to decline because loan demand is expected to remain weak and the cost of credit risk. So that's the cost of loan impairment. So it borrowers default on their loans and those costs are rising. And then added to that now, this really depends on how the economy performs in the future, but we're expecting funding costs to rise over time as competition among banks for deposits becomes more intense causing that retail to rise. Now, all of this is to say that investors are not convinced that euro area banks offer so-called value opportunities. The valuation ratios are low that might seemingly make them attractive for investors, but it can't really be excluded that low bank profitability is going to make a comeback as a financial stability concern going forward. Now, the reason for that is the legacy of low for long. We had this period of very low interest rates for a long time. And as a result of it, many banks have been left holding low yielding assets with long maturities. So think about mortgages that are 20 or more years in maturity and have very low interest rates. Now, we also show on box 5 that so-called windfall taxes can raise the return that investors require for holding bank equity. So in addition to reducing the resilience of the banks at a time when they are likely to be facing increasing challenges, taxes like that make it actually more expensive for banks to raise equity in the market and that's not positive for financial stability. I see. Interesting. It clarifies now. And another point in the report is the description of real estate markets as a source of concern for financial stability at this moment. Higher interest rates are squeezing borrowers. If somebody wants to buy a house today they may think twice or think of people who took variable rate mortgages or again households which have to renegotiate their terms now. So for individuals, this is very tough. But what does it mean for banks and ultimately for financial stability? So the impact of rising interest rates on borrowers indeed does as you said definitely depend very much on whether the financing is contracted at variable rates or if the term of the loan is short and whether it must be refinanced with a new loan. Borrowers with contracts like these they feel the pinch of higher mortgage payments sooner than those who have taken out loans at fixed rates for longer terms. So in the Euro area mortgage lending terms when we look across countries are rather heterogeneous. Around two-fifths of mortgages have rates that are fixed for more than ten years and more than half have fixation periods of five years or longer. So for those that have some years to go before the fixation period comes to an end they actually won't have noticed any change in their payments yet. But those on variable rates are at the end of their fixation period the ones that you were speaking of they will be in a worse position now for financial stability but the important feature of lending practices in Europe is that non-recourse mortgages so let me those are mortgages where the lender's only recourse in case of a default is to repossess the mortgage property and then has no further claim against the borrower those kinds of mortgages are not very common I mean we saw problems with those kinds of mortgages in the US in 2008 this means that households who have seen the values of their house all they can't simply hand the keys back to the bank without expecting consequences and if they're facing challenges in making higher mortgage payments they're more likely to run down their savings or to cut back on consumption say luxuries before defaulting on their mortgages now budget arithmetic for a household will change of course when faced with unemployment now that is when we would expect to see defaults rising and where we might see some financial stability problems now we don't see any concrete signs of the labour market turning yet but we have seen we have been seeing unemployment slowly rising in some countries and of course a sharper rise would obviously be a downside risk so what about commercial properties John? now indeed we have a bit more concern here about the commercial real estate market and here one could say that this time really is different and it really is different because the normal cyclical downturn is being amplified by structural challenges affecting in particular the retail and the office segments of the commercial property market so a report published by the EU commission earlier this year shows that the proportion of e-shoppers in Europe grew from 55% in 2012 to 75% in 2022 and that of course was no doubt spurred by the pandemic people doing more of their retail shopping online and that has taken away that has taken business away from the high street shops and has an impact on their values also working from home on the positive side it minimized disruption in many service sectors during the pandemic but now we have a legacy of the remote working has been retained higher vacant that means higher vacant rates in office buildings which reduces the value of those buildings and then with higher interest rates we are seeing leveraged property company owners facing challenges in refinancing their existing debt now ultimately this can lead to an increase of loan defaults and foreclosures and we have been seeing a bit of this already and it puts downward pressure on the prices then that sellers can get for those properties now question is does this pose a systemic risk and we try in a special feature in the FSOR to answer that question and the answer is well that a commercial property crisis would not be enough on its own to cause widespread capital depletion capital depletion in the banking system the reason for that is that bank exposures while they are material are simply not large enough to cause widespread problems but a decline in real estate markets of course can spill over to other sectors so for example construction companies, real estate agencies and other businesses can suffer and that could lead to job losses and reduced economic activity and then additionally a decline in commercial property values don't forget there are investors in those properties there's an impact on the rental incomes for investors and that affects their financial health and their ability to invest in other areas so it is not the commercial property market is not an island so to speak yes they are not isolated indeed and on balance I mean what you just described is the situation that looks rather gloomy do you see any reasons for optimism so the financial cycle has unmistakably turned and the severity of the contraction we think is going to depend on whether we get a soft landing or a harder one now a particular challenge that we are confronted with that this juncture is that we have several vulnerabilities unraveling simultaneously so housing and commercial real estate and others now that may seem gloomy but I always say a financial stability assessment is not complete without an evaluation of resilience and here we can derive I think a measure of reassurance it was not always the case that the Yin balanced the Yang certainly not before the global financial crisis but our view is that the deliberate efforts taken since then to fortify capital and liquidity buffers within the banking system have positioned it well to face these higher risks so the EBA carried out a stress test of European banks this summer and despite a scenario that had severe negative shocks including a global recession higher unemployment and increased interest rates and credit spread so everything going wrong simultaneously European banks remained resilient in that stress test and the reason for this the reason for this positive outcome was that the average fully loaded common equity tier one capital ratio so that's the important ratio for regulators at the start of the exercise that was 15% and it allowed banks to withstand capital depletion and still meet regulatory requirements at the end of the exercise now that's not to say that there's any room for complacency that's why we're advocating in this issue of the FSOR for targeted macro potential policy intervention where needed so in real estate markets for example with the aim of safeguarding the enduring strength of this resilience through the challenging times that we think lie ahead so gloomy picture the safeguards in place are stronger than before but it's not time for complacency this is in a nutshell the message thanks John so it's good to end on a more positive note before we wrap up we always have a question for our guests and that's for a hot tip John, today's topic so real estate markets and financial stability John, what's your hot tip today? So actually as we started with geopolitical risk issues and it has been a recurring theme of these podcasts on financial stability since we started them I thought I would actually make a recommendation for what I view as a valuable and independent source for gaining a deeper understanding of politics and that is the YouTube channel of Johnny Harris an Emmy Award winning journalist and filmmaker Harris has an exceptional talent I think for breaking down complex global geopolitical issues into digestible and engaging content he has a unique storytelling style which he combines with really stunning visuals often based on maps involving in-depth research and his explanations of current our historical events are really I think easy to understand and concise and I think it's no wonder that his videos routinely reach millions within days of being uploaded Wow, so Johnny Harris style Johnny Harris Very good, thank you John sounds very interesting and this brings us to the end of this episode I want to thank John Fell Deputy Director General Financial Policy and Financial Stability at ECB, thank you John Thank you, Stefania Dear listeners, check out the show notes for more on this topic You've been listening to the ECB podcast with Stefania Serkola If you like what you've heard please subscribe and leave us a review In the spirit of Europe today I'd like to end in French and say, à bientôt Until next time, thanks for listening