 Russia's devastating war in Ukraine is raging on, and it continues to cause enormous human suffering. As we record this episode, how the conflict will be resolved is still completely unknown, and of course we all hope that peace will prevail. Now the war is also affecting the economy, and it's against that backdrop that we've just released our latest six-monthly look at financial stability in the euro area. Also known as the Financial Stability Review. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. Today we're talking about how financial stability is faring as we emerge from the pandemic into this highly uncertain world. We'll look at how the financial system is doing, and then zoom in on two areas where we see risks emerging. Housing markets and crypto assets. I'm here today with my colleagues Tamara and John, who both work in our Financial Stability Department at the ECB. Regulars to our podcast might know them from previous episodes on the topic. Tamara, John, a warm welcome to you both on the podcast. Really nice to have you back here. Thank you very much. Now, it's a very complex situation that we find ourselves in, right, John? I mean, our economies had started to reopen as we emerged from the pandemic and then war broke out on the edge of Europe. And we're now three months into Russia's invasion of Ukraine. And as we sit here speaking, there's no end in sight. Now, John, I'd like to start the conversation by asking you, I call it a slightly more personal question. How has it been for you to look at this very difficult situation with your financial stability hat on? Well, Katie, there have been, I would say, really both personal and professional aspects to this whole situation of the invasion of Ukraine. On the personal side, waking up on the morning of the 24th of February to the news that Russia had invaded Ukraine was actually quite a shock for me. And as you might imagine, the financial stability consequences were not my first thought. Reading news reports of explosions in Kiev, Kharkiv, Odessa and the Donbass and the Russian tanks rolling across the border into their homeland. My thoughts were with the people of Ukraine and the fear that they must have been feeling at that very moment. Since then, I think the whole world has been inspired by the incredible bravery of the Ukrainian people in defending their country. The human suffering, as you mentioned, of course, has been unspeakable. And I've seen estimates from the Kiev School of Economics suggesting that the cost of the conflict for Ukraine could rise to $600 billion. So that's about four times the nation's annual GDP. My goodness. We haven't seen such a devastation of a European country since the Second World War. And we can only hope that the conflict would be swiftly brought to a piece of inclusion. And so that's the personal side of it. I can certainly attest to that level of emotion. I mean, I've definitely seen that in myself and also amongst colleagues when working on this really, really tough topic. On the professional side, the work that we do in the financial stability area, I mean, it really aims at assessing the likelihood of financial crisis. So maybe, you know, crisis like the one that we saw after the collapse of the human brothers in 2008. We also advise on policy options. Now, that work tends to draw, I would say, on past experience with similar situations. I think Mark Twain put it nicely when he said that history never repeats itself. But it does often rhyme. And looking to past events usually helps us to make a start with our analysis. Now, in preparing this issue of the FSOR, we had literally no experience to draw from. I mean, it's completely unprecedented, isn't it? One precedented, yeah. So where do you start on analyzing the consequences of a war in Europe? Now, there's plenty of examples in the FSOR. But if I take a very specific example, you will have seen that we focus a lot on the FSOR this time on commodity markets and also on commodity derivatives markets. Now, commodities are things like raw goods, right? Like wheat, grain, oil. Yeah, exactly. So before the war, our knowledge and experience with these markets was very limited. But with energy prices soaring because of fears of shortages, we had to learn quickly if we were to make useful assessments for the policymakers. I think one big advantage we have is the diversity of knowledge and expertise of our financial stability experts. As you might imagine, for a central bank we have many macroeconomists. But we also have people with business, legal, computer programming, and even physics backgrounds. And we also have a wide network of contacts working in the financial industry and basically in all of the major global centers, financial centers. So that means that if we don't know something, we can quickly find someone in our market intelligence network who does. And then I would say last but certainly not least, and I've seen this time and again at times of crisis, people take their duty as European public servants very seriously. They really pull together and make extraordinary efforts to produce well-informed analysis. Absolutely. Now, let's look at how financial stability is actually faring in this really tough environment. John, I'd like to start with a kind of big picture of what's going on. Can you give us a snapshot of how things are looking from the financial stability perspective? So that's a big question. Yes, I'm afraid it is. I start with a bird's eye view. I think arguably we're in the middle of a paradigm shift where supply-side shocks to the economy are becoming more and more important. Now, what I mean here is that economic structures are changing. We see it with the transition that climate change is forcing from fossil fuels to renewable sources of energy. The COVID-19 outbreak also demonstrated how reliant we are on global supply chains and just how sensitive those supply chains are to shocks. I mean, I'm sure you will remember the pictures of the tanker that blocked the Suez Canal for six days in March last year. I was just about to mention that example actually. And how we all suddenly understood how that disrupted global trade. Now with the Russian invasion of Ukraine, geopolitical risks have come to the fore. And in our view, it has blighted a financial stability outlook that was already impaired actually by higher than expected inflation and a loss of economic growth momentum. So the main message that we have this time is that financial stability conditions have deteriorated since last November. Maybe if I could just mention a few of the reasons for that. Please do. So at first, before the invasion, as I mentioned, we had concerns about the building up of vulnerabilities. And those vulnerabilities we saw building up in financial and in housing markets also on private sector balance sheets. And then as the war had led to amplified inflation expectations, lower growth expectations. And that was in fact a kind of supply side shock and constellation of triggers that we really feared the most from the macro economic point of view. Many of those vulnerabilities are now amplified relative to where we were last November. So you've got a lot of things that were kind of already there because of the pandemic or largely because of the pandemic. And then the war came precisely. Yes. So made the situation even worse. And then a second point that we have been saying for a long time in the financial stability review is that we thought that financial asset prices. And I'm talking specifically about equities. Stocks and shares. Stocks and shares, exactly. They were difficult to reconcile with the fundamentals. So they were basically overvalued compared to the actual situation on the ground, shall we say? Absolutely. And I think we were pretty clear about that. And now with interest rates rising, both long term on both sides of the Atlantic and then in the U.S. also short term, those fragilities are being exposed. I mean, I think it's fair to say that a correction is now ongoing in the U.S. stock market and it is spread also to the stock markets of the Euro area. Ben, a third point. After the stresses that the COVID-19 pandemic had imposed on basically all non-financial sectors, rising interest rates and import costs. So again, what I was speaking about earlier, energy, also non-energy costs. We think that that is likely to test the resilience of balance sheets. Now non-financial, we mean things like companies and firms. And firms. And also households. Also households. So if we were to just take a look, for instance, at household balance sheets, we have a chart on page 32 of the FSOR. And it shows the fraction of household income that European households spend on food and energy. And you can see there on that chart that 60% of households were spending more than 20% of their income on food and energy. But before the war, we have a two-year average period for the construction of that chart. But you could say that that was the situation essentially before the war. And the war has caused, as we know, a surge in the prices of both food and energy prices. And that's going to make it more difficult for households to make mortgage payments and also as interest rates rise. And then forth, maybe different to what many analysts thought at the start of the outbreak. Maybe we could, ourselves included here, the banking sector has remained remarkably resilient and profitability has recovered strongly. But we have, in a way, what I would call a deja vu on the banking sector outlook now, because while we do think that the sector is likely to prove resilient to the fallout from the war, arguably we're also back to where we were in late 2019 before the pandemic, where we had concerns about low profitability in the banking sector and that that could pose risks for financial stability going forward. Actually, the last example that you've given John with the banks brings me on to my next question because you said there's a kind of positive sign there that banks have been more resilient than perhaps expected. There's obviously a lot of darkness in what's going on at the moment for people, for companies, as you've described. But have you seen any more positive signals, anything that, dare I say, it might offer some hope? Well, yes. Actually, we're very careful this time in the episode to balance our assessment of the sources of risks and vulnerabilities against our assessment of the resilience of the financial sector, mitigating factors and so on. So I already mentioned the resilience of the banking sector. The sector has basically recovered from the adverse economic consequences of the pandemic. And in the end, when we look back, it was largely, it turned out to be largely a hit to profitability of the sector and capital positions were even strengthened last year. Now we have the war and we find that direct exposures of your area banks to Russia and Ukraine prove to be small and where they were small proved to be mostly manageable. Now, if we're a bit more forward-looking, we have a box in the episode, Box 6. You can find the results in that box of a vulnerability analysis that we carried out in partnership with our banking supervision colleagues to assess how the sector would fare if energy and food commodity prices were to rise by even more than what we have seen so far. And that analysis confirms the resilience of the sector. Okay, that's good news. That's good news because it means that banks can then keep lending to the economy during these difficult times. Absolutely. And then if we look outside the banks, to the non-banks, they too largely weathered the shock of the war without any major incidents. Non-banks are things like insurers, investment funds. Exactly. And if we look at the investment funds for instance, we did see the usual pattern that we almost always see during episodes of market stress, safe haven flows to the U.S. bond market. But we didn't really see suspensions on outflows. So that's when investors in funds are looking to get their money back because they're in a panic and then funds can suspend payments. That didn't really happen except for funds that were focused on Russia, of course. So that's quite different to what we saw at the start of the pandemic, isn't it? Totally different. So I would say it's not all doom and gloom in this issue of the FSO or Katie. And if the war were to end quickly, our assessment would undoubtedly improve. Okay, that's good news. I'm pleased to hear that it's not all doom and gloom, John. Now Tamara, I'll turn to you now. Let's go into a little bit more detail on one of the points that John has been mentioning, and that's higher inflation. What have you seen in the financial stability review on higher inflation? Well, the first thing is inflation is a big theme of this financial stability review, which might not at first sight seem obvious because we're not the natural people to focus on price stability. The same thing is also inflation can be a bit of a false friend for financial stability, at least at first sight, because as the general price level increases, the value of outstanding debt will fall in real terms. So in principle, if inflation also rises faster than interest rates on that debt, the debt payments also get smaller in real terms too. So it helps borrowers, in theory, inflate away your debt. But there are two snags to this, and I think that's where we get into in the FSR. The first is the debt risk for the whole financial system depends on the capacity of the most heavily indebted borrowers to keep paying their debts as prices rise. And the second is how financial markets and lenders react to higher inflation environment and the knock-on effects that that will have for financing conditions going forward for everyone. So maybe if I come back to that first point on debt servicing capacity, here the issue is the type of inflation that we've seen, and John was talking how that was really coming through in terms of higher prices. That's where we start for a lot of it. I think there's more complexity to the inflation story than simply that at this point, but certainly price rises for goods have been dominant, specifically energy and commodities. So if you're a heavily indebted business, for example, maybe I'll start there. I can imagine there are quite a few after the pandemic. Exactly, and that's a theme we've picked up on for several FSRs. The impact on your business finances depends on how much you rely on those types of commodities in order to produce your services and also whether or not you can pass the price rises on to your customers. I can imagine that's quite difficult at the moment because companies aren't, they're trying to recover after the pandemic so they don't want to then increase their prices to kind of dissuade the customers from coming. Well, it can vary, right? So it depends on what type of business you are and your power in the market. I see. One of the things that we've looked at in this financial stability review is in the box, box three, we look a bit at firms and the types of margins different firms seem to be able to get away with, and there we do find a trend where actually more heavily indebted firms seem to have lower margins to begin with, which might suggest that they tend to have more margin squeeze and also smaller firms tend to have more trouble with margins than larger firms. So they're already heavily indebted and then even worse, they're earning less money on what they do. Exactly, they're more likely to face the squeeze. The second thing you actually you just mentioned that there about him how the pandemic coming after the pandemic and the other thing we try and identify is who are the firms that are getting this double whammy effect of they haven't quite recovered from the pandemic or they're more affected by the pandemic and they also probably more hit by some of the price shocks and supply shocks we're seeing now where we do find a few sectors accommodation, food services, airlines that may be in that more vulnerable category. So that's where one aspect of inflation comes through how easy will they find it to keep surfacing their debt. I mentioned a second point as well so that's about paying your existing debt. The second is what happens to financing conditions and financial markets as inflation rises if you get a sustained period of higher than expected inflation. So the first thing is if inflation rises faster than nominal interest rates actually borrowing costs fall in real terms and I think that's about what we where we are at the moment but if higher inflation persists that's really unsettling for markets and it can lead to really abrupt increases in rates because investors want to start hedging inflation much more in their portfolios and they also want compensation for higher inflation because borrowers might be inflating away their debt and people lending them to them want to recoup that back in the medium term. And this is this whole idea that people go to the markets to get credit essentially because you don't just go to a bank and you can also sell your stocks and shares and get money that way. Exactly, well you can go to the markets and you can go to the bank and anyone lending you money if inflation was to be more elevated for longer would want to start wanting compensation. Absolutely, yeah. For that and we've already seen a lot more volatility in recent months and John was talking about how investors have been adjusting in markets and also adjusting to shift some monetary policy in parallel because monetary policy is now trying to address the situation. For financial stability we don't just focus on what's happening in general to financing costs but also how it varies for different borrowers and I think that's one thing that we've honed in a bit on this financial stability report that the technical term will use as credit risk premium. So not just the lowest risk borrowers but also if you're a high risk borrower you pay a premium on that. And what we do find is that for more risky borrowers they can face a double hit of higher risk free rates and then also higher credit risk premium. The latter is more uncertain but these do tend to rise. We have evidence that these central wideness rates rise. I think at the moment we haven't really seen large moves in those spreads yet not things that we've seen even in 2012 or in 2008 that's good news but they have picked up a bit. The spreads are the difference between the extra price you pay if you're a higher risk borrower than a lower risk borrower. So that's something we want to flag is that something we keep an eye on is how will those financing conditions change in the future. I think my overall message is to try and say that maintaining price stability really will support financial stability in the end as well so there are lots of bits of the ECB's role going harmony. Got it. Let's take a closer look now at something that I personally find a very interesting part of financial stability because it affects many of us and that's house prices. Now John for years there's been talk of a bubble in terms of house prices. What's going on at the moment? I mean indeed stories about housing market bubbles were rampant in the press earlier this year I would say if you were to search the term house price bubble on Google trends you'll see that maximum interest in the topic was reached at the end of March globally and a month later in Germany and other European countries. Now in the FSO we're not actually saying there is a bubble but we do have concerns about the interaction between on the one hand rising house prices, rapid mortgage credit growth and now the war on juice strains that I mentioned earlier the difficulties that households are facing as the basic necessities of food and energy consumption is absorbing a larger fraction of their incomes. We had already warned in the FSO that signs of overvaluation in the Euro area housing markets were becoming a source of concern for financial stability and I think we had that in both issues last year and then the latest Euro area aggregate data so that's data that covers the Euro area for as long as the Euro area has existed is now showing actually the highest rate of house price inflation in at least the last 20 years. This does look to be partly driven by rising costs of building houses so again back to the supply side team. Yeah because the materials are harder to get obviously that then has a knock on effect to that. Exactly so the commodity price surge is also spilling over into activities like housing building, construction, mortgages. But at the same time we can't exclude that we may be entering a dangerous house price credit spiral so that's one where house prices are rising and then people are borrowing more to pay for the price of a larger house and on and on that causes house prices to rise and then we get into this spiral where we have seen history has shown us that those spirals can be very very dangerous when they reverse. Now this looks like it could be the case or we could be on the border of it in some countries of the Euro area already and in fact the European systemic risk board had been issuing warnings to countries about their housing market vulnerabilities over the last year many have taken counter measures primarily by activating macro potential policies then in addition though to the mitigating factors that I already mentioned and we do see another one we've seen an important shift to fixed rate mortgage lending in the Euro area over the last decade or so. So the consequence of this is that interest rate risk so that's the change in the financing burden that a household may face if interest rates were to change that risk has actually moved away from households and it's now with the banks to the extent that they have been lending fixed. Because the interest rates on these loans is fixed for a long period of time what happens exactly what happens to the interest rate doesn't have a difference. It will have no impact. It will have an impact on people who are taking out new mortgage. Absolutely. But not how people already have one. But that doesn't mean that the risk has gone away it's just moved somewhere else and the ability of the system to absorb the risk it really depends on how well the banks are managing it and we have spent we've devoted some space to that issue in the financial stability review. Okay so definitely an area to keep an eye on thank you John. Now there's one more topic that I'd like to talk about in a little bit more detail today which is also one that people have been keeping a very close eye on recently and that's crypto assets. Now we've touched on this in previous financial stability podcasts and we'll obviously link to those in the show notes. But Tamara in this issue of the financial stability review you've taken a closer look specifically at the risks that crypto assets could pose to financial stability. Now before we get into the risks themselves could you give us a bit of background? What is the state of what we call the crypto asset universe at the moment? So indeed we've given more attention to this than the Cephasars and colleagues have written in very nice special feature on it and what they set out is it's really been growing a lot in a few ways. So overall size has increased about tenfold in two years. Tenfold? Yeah that's what they get to and then we still think it's less than although we still think it's less than 1% of the financial system in social size and it's growing really beyond Bitcoin which is probably the one that everyone knows and there's about 20 plus unbacked crypto tokens that have a capitalisation of a small equity size. There's also now lots more exchanges and lots more activity going on. I think most of us are pretty aware of that actually every time we open social media I think we're being confronted by this offers. Yeah absolutely. So it has been expanding and it's also been expanding in a number of other dimensions in terms of products that sit alongside the crypto assets themselves so contracts that can be taken derivative style contracts that can be taken around them but also connections to other parts of the digital economy so what they call decentralized finance or DeFi. So it's a general growth in what they've, authors have labelled the ecosystem of crypto assets. So a derivative contract is something, a contract that derives its value from this asset. Yes it might not be having the crypto itself but it's a contract in and around the value of a particular crypto either in the future or relative to another asset or something like that and various of them that are being offered. So I think that's how it's grown. What hasn't changed is it's still a very volatile asset class so people are very interested in it but we also keep seeing these repeated surges and falls. Not least, most recently I think I saw something that the price fell by more than 98% overnight which is just an example of its instability. The terror example. Yeah exactly. And the stablecoin, the stablecoin is a slightly different group of crypto assets though the backed assets but it's all I think part of a story of how much interest has grown in these markets. And backed is where it has an intrinsic value. I mean in the sense that it's linked to something else. Yes the stablecoin actually we talked about stablecoin in the last FSR in November but these ones have a set of assets that might be behind them. I mean I think people might have different views on how robust that is but crypto are the unbacked. Okay so the crypto asset market has grown but it's still a very small part of the global financial system. Now of course that doesn't mean that the risks are any less important. What have you found in terms of the risks that these crypto assets pose then for financial stability? So for us in financial stability the thing that we've been paying most attention to is how this crypto asset universe is getting more and more in touch with the traditional financial system and also how it's growing. So I mentioned the development of these contracts that can be taken in and around crypto and what we look at in this FSR is how on the back of that it allows people to get what they call levered interest into crypto assets. That means that you only need to put a small amount of money down at the beginning in order to get an exposure but that exposure could lead to bigger losses for you. I see, yep. And once we see those developments happening it means that you start to see a sort of more sophisticated type of financial market around it. Other things that we picked up on are people being able to use crypto as collateral in lending for cash, so normal lending activities and the growing interest and I think that's probably the heart of our concern is the growing interest of establishment financial sector entities so different types of investment funds, other funds and even banks getting more and more interested not necessarily engaging in scale but showing more and more interest in how they interact with crypto assets. And so that's where we could see potential risks and the reason the risks arise is because relative to other assets crypto is still much less regulated the entity is a regulator that will get involved in them but the asset class itself sees is much harder to govern and regulate and I think people are working hard now on getting standard died data and disclosure around it and then going from there to see what regulation is required. So it's becoming a lot more connected with the financial system and the fact that it is unregulated means it brings a danger with it then. Yes, so the difference in regulation when you've got a part of the system that's regulated to a very different degree than the core financial system that's often a sign of where arbitrage and other forms of trouble can lurk. Okay, so another one to be keeping a very close eye on thanks a lot to both of you Tamara and John but before we wrap up we do always have a question that we ask all our guests on the podcast and that's for a hot tip linked to the topic that we're discussing today so financial stability. John have you thought of something to perhaps inspire our listeners? So I think this time I'll give you a book recommendation and it's really based on times of adversity in my life and I think that this perhaps has been one of those times I've often found myself returning to read extracts of meditations by Marcus Aurelius not only was he a Roman emperor but he was also a stoic philosopher and his 1800-year-old writings I think still have relevance today. One thing that he teaches us is that adversity should be welcomed with gratitude as an opportunity to prove one's courage, fortitude and resilience. Well it's a book I know and love myself so I'm very much behind that book recommendation I think it's really relevant in today's time. Thank you John. Now Tamara I remember last time I think you had a couple of film recommendations what have you got for us today? Well to say I think reflecting on events for me we've talked a lot about financial stability there's also been broader economic discussions about how events might affect globalization our presidents talked about the peace dividend and these concepts and I've been trying to get behind some of the history of it so my recommendation is a podcast, a rival podcast Allowed this one time? It's a pretty popular one called The Rest is History and they have a series of really insightful podcasts that go way back I think into both events happening in Russia and Ukraine and also more broadly that help provides really some context to what we're seeing I think at the moment I found them very informative anyway. The Rest is History. Okay I'll definitely be checking that one out tonight. Thank you so much both of you for being here. Thank you very much. Well that brings us to the end of this episode thanks again to Tamara Shakia and John Fell from our financial stability department for joining the conversation and giving us their insights. And you can of course check out the show notes 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.