Financial Stability Review, May 2025

When the US Administration announced a new set of tariffs in April this year, it caused a spike in financial market volatility while testing stretched market valuations. Although expectations for tariff rates have eased somewhat since then, the repercussions of the shock continue to reverberate and the risks of an economic slowdown have increased markedly. Financial markets across the globe sold off at an unsettling speed in early April and financial conditions tightened considerably. While risky assets have been recovering their losses since temporary tariff pauses were announced, markets remain highly sensitive to news about global trade arrangements.

The abrupt change in US tariff policy forms part of a larger shift in the geopolitical environment, with economic and financial impacts that could yet test euro area financial stability. Uncertainty lingers within many important policy domains beyond trade – from regulation to national security. In this environment, the likelihood of increasingly frequent and impactful adverse tail events has increased. Furthermore, while global imbalances remain a long-standing issue in the policy debate, it is not clear that tariffs are the best-placed policy instrument to address them.

Financial market functioning held up well during the recent sell-off. Despite the drawdowns, equity valuations remain high while credit spreads still appear out of sync with underlying credit risk. Open-ended funds investing in corporate bonds have seen some outflows and do not appear well prepared to withstand significant liquidity stress. In the event of renewed turmoil, these funds may be forced to sell assets. This could turn price swings into more disorderly adjustments.

The euro area is an open economy, with firms strongly integrated into global supply chains. Trade frictions will have a direct impact on the revenues and costs of those companies that rely on foreign trade. Furthermore, adverse confidence effects are likely to lead market players to act with greater caution, which could also engulf sectors that are less exposed to the direct effects of tariffs. This may challenge the management of credit risk by euro area financial intermediaries. Should economic growth fall short of expectations, moreover, this could put pressure on government finances, which are already facing strains from higher defence spending needs.

This edition of the ECB’s Financial Stability Review includes three analytical special features. The first analyses recent developments in crypto markets and their growing interconnectedness with the traditional financial sector. The second investigates risks to financial stability from trade tensions, while the third looks into how population ageing could affect financial stability in the financial and non-financial sectors.

The FSR is intended to promote awareness of systemic risks among policymakers, the financial industry and the public at large, ultimately promoting financial stability. It has been prepared with the involvement of the ESCB Financial Stability Committee, which assists the decision-making bodies of the ECB in the fulfilment of their tasks.

Luis de Guindos,
Vice-President of the European Central Bank

Soaring policy uncertainty leads to major shifts in market sentiment

Geopolitical and policy uncertainty have spiked from already high levels since the previous edition of the Financial Stability Review was published. Just as uncertainties stemming from political risks within euro area countries were subsiding, external sources of uncertainty, notably those associated with the unpredictability of a broad range of US policies, have soared (Chart 1, panel a). A lack of clarity surrounds several important economic policy domains, including trade, regulatory and fiscal policies, as well as the level of commitment of the new US Administration to international cooperation (Chart 1, panel b). While it is hard to predict the medium to long-term implications of these individual layers of uncertainty, they entail a broad risk of geoeconomic fragmentation across the globe, in turn raising the likelihood of increasingly frequent and impactful adverse tail events. Although the announcements of trade agreements between the United States and some of its trading partners point towards an easing of trade tensions, concerns remain that these tensions could escalate into a trade war with the potential for significant adverse impacts on global growth, inflation and asset prices. As the euro area is a very open economy which is well integrated into global supply chains, vulnerabilities to these sources of risk are pronounced.

Intensifying trade tensions have triggered a spike in market volatility, fears of slowing economic growth and a sharp repricing in financial markets. The higher than expected US import tariffs announced on 2 April 2025 injected significant volatility into financial markets (Chart 1, panel c). The prospect of slowing economic activity, notably for the United States (Chart 2, panel a), led to a major sell-off in riskier assets, with magnitudes not seen since the early stages of the COVID-19 pandemic. Markets rebounded strongly after a 90-day tariff pause was announced for most countries and had mostly recovered their initial losses by mid-May (Chart 2, panel b). During the turmoil, market functioning – which can be thought of as the ability to trade financial assets quickly without moving prices inordinately – in euro area financial markets held up well. This was despite some atypical shifts away from some traditional safe havens like US Treasuries and the US dollar. In part, this may have been due to technical factors such as investors needing to raise liquidity to meet fund redemptions or margin calls as market volatility rose (Chapter 4), with an unwinding of asset swap or basis trade positions contributing to the sell-off in US Treasuries. But these moves might also have reflected perceptions of a more fundamental regime change, with investors seeming to reassess the riskiness of US assets, possibly leading to broader shifts in global capital flows. This would have potentially far-reaching consequences for the global financial system. Meanwhile, euro area non-banks stayed resilient, with signs of a rotation in fund flow dynamics from the United States to the euro area (Chart 2, panel c).

Against this backdrop, three key sources of risk and vulnerability for euro area financial stability stand out. First, price adjustments in stretched and concentrated asset markets risk becoming disorderly, particularly if liquidity and leverage fragilities in parts of the non-bank financial intermediation sector amplify asset price swings. Second, rising trade tensions could affect euro area corporates and households both directly, via exposures to tariff-sensitive activities, and indirectly, via confidence effects, translating into credit risks for banks and non-banks. Third, a combination of weaker growth, defence spending needs and other structural challenges could compound the already strained fiscal positions of some euro area sovereigns. The potential for these vulnerabilities to materialise simultaneously given common triggers, possibly amplifying each other further, increases the risk to financial stability.

Stretched valuations and declining non-bank liquidity make markets prone to further outsized reactions

Financial markets, particularly equity markets, remain vulnerable to sudden and sharp adjustments due to persistently high valuations and risk concentration. Previous editions of the Financial Stability Review have warned about the vulnerabilities posed by high valuations that are not backed by fundamentals. This source of risk has now partly materialised, with the larger than expected US import tariffs announced on 2 April 2025 acting as the trigger. Despite notable declines following this announcement, US equity valuations have remained high since the market recovery. Meanwhile, strong market concentration, along with exposures to a handful of large firms (mostly US-based technology companies), continues to expose global markets to risks arising from shocks to these entities. Credit spreads have risen too but they still appear to be out of sync with the currently very high level of geopolitical and policy uncertainty (Chart 3, panel a). As such, investors may be underestimating and underpricing the likelihood and impact of adverse scenarios, not least because soaring uncertainty renders the materialisation of tail events more likely. Negative surprises – including sharply deteriorating economic growth prospects, sudden changes in monetary policy expectations or an escalation of trade tensions – could lead to further abrupt shifts in investor sentiment, causing spillovers across different asset classes while fuelling investors’ interest in alternative asset classes such as gold (Box 2).

Real estate markets have shown signs of recovery but face headwinds from elevated uncertainty. The downturn in euro area commercial real estate (CRE) markets appears to be bottoming out as recent price corrections have reduced broader overvaluation, while easing monetary policy has strengthened confidence in CRE markets to some extent (Section 1.5). That said, downside risks prevail, as the sector continues to be challenged by structural factors such as lower demand for office space and for non-prime and non-energy efficient properties – which is also evident in higher vacancy rates. Similarly, residential real estate (RRE) prices have shown signs of improvement in countries that experienced rapidly falling prices from their 2022 peaks, supported by improving demand for mortgage loans on the back of lower interest rates. However, tail risks remain due to persisting RRE overvaluation in some countries and possible adverse effects should unemployment rates rise. In fact, real estate markets are highly sensitive to fluctuations in long-term interest rates and business cycle developments, which implies notable downside risks against the current backdrop of high macroeconomic uncertainty and geopolitical risks.

The liquidity and leverage weaknesses of euro area non-banks could amplify market drawdowns. Overall, non-banks have so far weathered adverse market disturbances relatively well. The non-bank financial intermediation (NBFI) sector has also continued to absorb a high proportion of sovereign debt, underscoring the important role it plays in euro area sovereign bond markets in a context of higher debt issuance. That said, in an environment of heightened geopolitical and trade policy uncertainty, non-banks may face higher valuation losses and more frequent margin calls as trade tensions increase market volatility and weigh on asset quality in corporate portfolios. Significant exposures to US dollar assets may also increase the risk of additional spillovers from potential US market shocks and exchange rate fluctuations, especially where equity portfolios are concentrated in a few large US issuers. Declining liquid asset holdings (Box 5) and significant liquidity mismatches in some types of open-ended investment fund (e.g. corporate bond funds), coupled with procyclical fund flow dynamics, could amplify adverse market shocks (Chart 3, panel b). At the same time, pockets of elevated financial and synthetic leverage in some entities (e.g. hedge funds) may exacerbate the risk of financial contagion and expose liquidity vulnerabilities through margin calls (Chart 3, panel c).

Persistent liquidity and leverage vulnerabilities in the NBFI sector require a comprehensive policy response. A bigger market footprint and the increased interconnectedness of non-banks raises the risk of NBFI vulnerabilities amplifying adverse market developments across the financial system. This calls for a comprehensive set of policy measures aimed at increasing the sector’s resilience to market-wide shocks. An adequate policy response should focus on addressing key structural vulnerabilities in the NBFI sector, including monitoring and tackling risks arising from non-bank leverage, enhancing the liquidity preparedness of non-bank market participants to meet margin and collateral calls, and mitigating liquidity mismatch in the investment fund sector. The further deepening and integration of capital markets forms part of a renewed strategy aimed at supporting Europe’s productivity and economic growth in a competitive global environment. Strengthening NBFI policies from a macroprudential perspective would help ensure that non-banks remain resilient under stress, underpinning the long-term success of the capital markets union agenda. Enhanced EU-wide supervisory coordination will be needed to foster a level playing field and reduce the potential for regulatory arbitrage.

Escalating trade tensions could affect euro area firms and households, implying credit risks for banks and non-banks

Euro area firms and households have seen balance sheet fundamentals improve in recent years, but trade tensions, high funding costs and a weaker growth outlook point towards future headwinds. On aggregate, euro area corporate and household balance sheets have improved markedly in recent years, with indebtedness falling below the levels observed prior to the global financial crisis. That said, higher interest costs continue to weigh on firm profitability even as new lending rates decline, while insolvencies have been rising across sectors and countries in light of continued weak and uncertain business prospects. On top of increased foreign competition, mounting global trade tensions could add to credit risk in the corporate sector (Chart 4, panel a), which would have a negative impact on the profitability of firms operating in highly export-oriented and tariff-sensitive sectors such as steel and carmaking. Households are currently continuing to benefit from stable labour markets, rising real wages and higher savings. However, this situation could reverse should trade-related corporate vulnerabilities unravel and lay-offs in the corporate sector rise, translating into possible adverse employment and consumption effects. Any notable tightening of financial and credit conditions induced by trade uncertainty could amplify these adverse effects, particularly if also accompanied by weakening consumer confidence and increased precautionary household savings.

Euro area banks’ asset quality remains robust, but non-performing loans and provisioning needs may rise in the wake of rising trade tensions. On aggregate, euro area banks’ non-performing loan (NPL) ratios remain near historic lows, despite a slight uptick in 2024 driven mainly by net NPL inflows in the corporate loan book (notably CRE and SME loans). That said, the credit risk outlook for corporate and household portfolios remains tilted to the downside, given weak macro-financial conditions, the lagged impact of high interest rates on borrowers and escalating trade tensions. As such, banks may yet face higher provisioning costs if risks in non-financial sectors materialise. In particular, any broader and longer-lasting macro-financial effects of trade policy uncertainty could lead to a deterioration of bank asset quality, with stronger effects on banks with higher exposures to sectors relying on extra-EU trade (Chart 4, panel b and Special Feature B).

The ability of banks to absorb further asset quality deterioration is supported by the strength of profitability and ample capital and liquidity buffers. Robust net interest income and strong non-interest income growth enabled euro area banks to maintain high levels of return on equity (above 9%) in 2024. Banks’ resilience is also supported by capital and liquidity ratios that are well above regulatory requirements (Section 3.5). There are, however, persistent downside risks to bank profitability arising from lower net interest income, especially for banks with a higher share of floating-rate loans, and a higher cost of risk. A highly uncertain external environment reinforces the need for macroprudential capital buffer requirements to be kept at levels that preserve banking sector resilience. Existing borrower-based measures should be maintained to ensure sound lending standards in all phases of the financial cycle. The prevailing regulatory and supervisory framework, including in the macroprudential remit, has been effective in maintaining financial stability while also supporting economic growth. Nevertheless, there is scope for making the framework more efficient and effective by reducing unwarranted complexities without compromising bank resilience or undermining compliance with the Basel framework, and by completing the banking union.

Asset quality in non-bank portfolios may be impaired by deteriorating corporate fundamentals and property market conditions. Downgrades in the corporate debt portfolios of euro area non-banks have remained relatively stable in recent years. However, weak economic conditions, coupled with rising protectionism and trade policy uncertainty, have led to a deteriorating credit risk outlook, exposing the NBFI sector to revaluation losses from unexpected downgrades and increasing default risk. In particular, trade tensions may weigh on corporate asset quality, with exposures to sectors that are both import and export-reliant primarily concentrated in equity funds (Chart 4, panel c). Risks also extend to non-banks’ real estate portfolios. Any further decline in CRE prices – triggered by downside risk to the wider macroeconomic environment, for example – could lead to an increase in fund outflows. Strong linkages could cause any stress in the NBFI sector to spill over to euro area banks, especially via the funding channel.

Defence spending needs and material downside risks to growth reinforce sovereign vulnerabilities

Planned increases in defence spending may unlock positive growth effects if focused on productive investment and sourced from within the EU. Risks to euro area sovereigns have shifted from political uncertainties tied to national elections to broader geopolitical concerns in recent months. The European Commission’s recently announced “ReArm Europe Plan/Readiness 2030” aims to bolster national security across Europe. The plan includes unleashing public funding for defence at the national level by activating the national escape clause of the Stability and Growth Pact, enabling Member States to act swiftly. Higher defence spending has the potential to stimulate economic growth, provided spending is targeted towards productive investments in European defence industrial capabilities and R&D. Moreover, sourcing defence equipment from within the EU would imply a higher fiscal multiplier, with the stimulus possibly helping to absorb some of the slack currently affecting sectors like the automotive industry.

However, planned fiscal expansion could also challenge the balance sheets of euro area sovereigns. Higher defence spending, along with the substantial infrastructure investments announced in the euro area, is likely to lead to an increase in the supply of sovereign bonds. Against the backdrop of the Eurosystem’s reduced footprint in bond markets, the capacity of the investor base to absorb any additional issuance will be key to the orderly functioning of sovereign bond markets. Market expectations of higher government financing needs as well as possible positive growth effects have contributed to a rise in ten-year euro area sovereign bond yields. The rise was, however, partly reversed as a result of flight-to-safety flows into euro area sovereign bond markets following US tariff announcements. Higher defence spending and an increase in the cost of servicing debt could further strain fiscal positions, especially in countries which have high short-term refinancing needs and are already burdened by large debt levels (Chart 5, panel a). That said, most of the more highly indebted countries have so far not pledged to greatly increase their defence spending. Moreover, risks to growth resulting from trade tensions and higher defence spending may limit the fiscal space needed to shelter the economy from future adverse shocks, as well as to address structural challenges associated with digitalisation, low productivity, population ageing (Special Feature C) and climate change.

Unless potential growth can be raised, concerns about sovereign debt sustainability could re-emerge in some countries. Despite a post-pandemic decline, the government debt-to-GDP ratio is still above the long-term average for the euro area aggregate, unlike the corporate and household sectors (Chart 5, panel b). At the same time, the aggregate euro area public debt ratio remains well below that of international peers. Debt-financed increases in defence spending and further rising interest expenditures may complicate the path towards fiscal consolidation in some countries under the new EU fiscal framework and could cause debt levels to start rising again. This, together with structural headwinds to potential growth from factors like weak productivity, could rekindle concerns about the sustainability of sovereign debt. Any repricing of sovereign risk could spill over to the corporate and financial sectors via rating downgrades and higher funding costs.

While the euro area financial system is resilient overall, shifting geopolitical conditions could test financial stability

All in all, the financial stability landscape has seen a major uncertainty shock since the previous edition of the Financial Stability Review was published. Despite multiple sources of resilience in both euro area financial and non-financial sectors, there is no room for complacency. Uncertainties arising from trade tensions, deregulation and reduced international cooperation are fuelling concerns about global economic and regulatory fragmentation. Rising trade tensions pose particular risks for the euro area, given its open economy and deep integration within global supply chains. In this highly uncertain and volatile environment, the likelihood of tail events remains high. Risk sentiment could deteriorate again as some risky asset valuations remain high. Increased defence spending, while having the potential to boost growth if well targeted and sourced from within the EU, may exacerbate fiscal vulnerabilities in some countries. While euro area corporates and households are resilient on aggregate, trade policy uncertainty could have an adverse impact on trade-reliant firms, with associated broader economic repercussions translating into rising credit risk for banks and non-banks.

In addition, several cross-cutting structural issues remain critical for financial stability and could amplify existing cyclical vulnerabilities. These include cybersecurity weaknesses in a challenging geopolitical landscape (Box 1), the growing importance of artificial intelligence (which provides both opportunities and risks of destabilisation along the innovation path), risks stemming from global regulatory fragmentation, challenges associated with ageing populations and climate-related risks on the way to a low-carbon economy. The potential for these cyclical and structural vulnerabilities to materialise simultaneously and amplify one another heightens the risks to financial stability. This could lead to adverse feedback loops across various sectors.

1.1 Trade tensions, policy uncertainty and geopolitical risks weigh on growth outlook

Euro area growth has continued to recover at a moderate pace. Euro area GDP grew by 0.9% in 2024. Growth was driven by private and government consumption and net exports, albeit with large differences across countries (Chart 1.1, panel a). Buoyed by stable real wage growth and high savings, households are in a good position to increase consumption still further (Section 1.4). Moreover, the easing of financing conditions following the ECB’s policy rate cuts since June 2024 should support the recovery going forward. In line with this, survey indicators point towards a notable easing of the downturn in the relatively interest-rate-sensitive industrial sectors (Chart 1.1, panel b), while services sectors have generally been performing better than industrials.

Growth expectations for 2025 have been revised downwards as weak external demand and domestic structural challenges persist. Low productivity growth and a loss of competitiveness, especially in industrial sectors such as the automotive industry, continue to weigh on economic growth. The higher energy costs seen since Russia’s full-scale invasion of Ukraine have represented a particular competitive disadvantage for euro area firms. In addition, domestic demand in China has remained muted as a result of the housing sector crisis, leading to lower demand for European goods and overproduction in the manufacturing sector. Manufactured goods not absorbed in China are being exported instead, increasing competition for European firms. An appreciating euro may further compound these challenges, especially for export-oriented firms. As such, growth expectations for 2025 have been revised downwards since the previous edition of the Financial Stability Review was published (Chart 1.1, panel c).

Trade tensions are a source of significant downside risks for euro area growth and may lead to global fragmentation. The euro area economy is open to trade and is highly integrated into global supply chains (Chart 1.2, panel a). As such, the implementation of protectionist measures such as tariffs and other trade barriers by major trading partners is expected to have a negative impact on euro area growth and, potentially, financial stability (Special Feature B). While the current account with the United States is relatively balanced overall, the euro area has a sizeable surplus in goods trade, rendering export-oriented euro area firms particularly vulnerable to US tariffs (Chart 1.2, panel b and Section 1.3). Firms could also be indirectly affected by tariffs on countries producing for the US market if trade were rerouted to the domestic or other third markets, resulting in intense competition. A renewed escalation of trade tensions with a cycle of retaliation would risk igniting a trade war, with significant downside risks to euro area and global growth and increasing geoeconomic fragmentation.

The outlook for euro area growth is also clouded by high economic policy uncertainty and geopolitical risks, but increased defence spending may catalyse economic activity. Uncertainty about economic policies beyond trade has been rising against the backdrop of a shifting geopolitical landscape. Since the 2024 US presidential election, uncertainty has surged further as the new US Administration has changed direction in several policy areas. Such sustained uncertainty is blurring the planning horizon for firms and households and could delay investment and consumption decisions. In addition, the war in Ukraine and the conflict in the Middle East remain unresolved, despite recent peace efforts. A further escalation in either or both of these could weigh on euro area growth, dampening firm and household confidence. It could also affect energy markets that are already posing challenges due to volatility and possible increases in natural gas prices. Firms could also face operational disruptions caused by incidents affecting critical infrastructures or by cyberattacks (Box 1). In this environment, the EU has forged ahead with a number of initiatives targeting greater self-reliance in the defence of Europe. These include a push towards greater defence spending and the strengthening of defence capabilities and cooperation. Additional government outlays in this context could cushion the potential economic slack deriving from trade frictions. This could also act as a catalyst for longer-term growth, but only if well calibrated and accompanied by structural reforms aimed at tackling low productivity and fostering the innovation needed to promote the competitiveness of euro area economies (Section 1.2).

1.2 High spending needs and low growth complicate fiscal consolidation

Euro area sovereign budgets are facing cyclical and structural challenges in an uncertain international environment. Many euro area countries, including some large economies, are expected to run sizeable budget deficits in 2025, complicating the path towards fiscal consolidation under the new EU fiscal framework (Chart 1.3, panel a). In addition, global trade tensions, coupled with high uncertainty about the outlook for other economic and regulatory policies as well as ongoing geopolitical conflicts, present pronounced downside risks to economic growth. As such, weaker growth would weigh on fiscal positions and further limit fiscal space to react to adverse shocks in many euro area countries. These conditions present obstacles to the high levels of investment and spending needed to tackle the structural challenges associated with climate change, digitalisation, ageing populations, low productivity and defence.

Necessary increases in defence spending could have a significant impact on budgets, requiring more fiscal space. As European security parameters shift, some governments are aiming to boost self-reliance in defence. Given the wide range of current defence expenditures and the new spending target currently under discussion in European and international fora, some countries may need to make substantial increases. The short-term capacity to meet these needs varies greatly because refinancing needs and debt levels are uneven across countries (Chart 1.3, panel b). Accordingly, most of the more highly indebted countries have so far not pledged to greatly increase their defence spending. To create the required fiscal space, the European Commission’s “ReArm Europe Plan/Readiness 2030”^[3] suggests activating the national escape clause of the Stability and Growth Pact and disbursing loans from new joint borrowing using the Security Action for Europe (SAFE) instrument. In addition, the plan suggests repurposing parts of the existing EU budget and mobilising private capital by accelerating the formation of a savings and investment union. The European Investment Bank could also play a role.

Debt levels and interest costs are set to rise and will weigh on government finances beyond the short to medium term. After falling from the highs reached during the COVID-19 pandemic, sovereign debt levels may rise again as increases in defence spending and potential further stimulus packages will be financed largely by additional debt (Chart 1.4, panel a). Despite lower ECB policy rates, current borrowing costs exceed the interest rates sovereigns pay on existing debt (Chart 1.4, panel b). Given the relatively long average maturity of new sovereign debt, the refinancing of maturing debt issued at very low rates before 2022 at current market conditions, together with the issuance required to finance additional spending, is likely to increase interest payments relative to GDP for years to come.^[4] As the Eurosystem is continuously reducing its presence in the bond market, the private sector needs to increasingly absorb new sovereign debt. Euro area banks, non-banks and foreign investors have increased their holdings of euro area sovereign bonds since the end of quantitative easing. While some investors may require higher yields, overall they seem well positioned to provide further liquidity if this is needed (Sections 2.3 and 3.4)^[5].

A well-planned fiscal expansion, combined with structural reforms, could foster long-term growth and ensure debt sustainability. Debt-driven fiscal expansion must remain sustainable and comply with the new EU fiscal framework to retain the confidence of creditors. Over the medium to long term, higher defence spending should be funded out of government coffers, raised either by collecting new revenues or by reprioritising budgets to enable appropriate fiscal consolidation. Additional defence spending should therefore promote euro area growth while enhancing defence capabilities in a timely manner. For instance, the fiscal multiplier could be increased by sourcing from within the EU or investing in domestic military research and development which could result in technological spillovers to civilian industries.^[6] Structural reforms are essential to tackle low productivity, and stimulus packages should focus on investments that enhance euro area growth potential. However, more fragmented parliaments may create political deadlock, causing crucial reforms to be delayed.^[7] Consequently, funding costs for sovereigns could increase rapidly if market participants or rating agencies were to reassess sovereign risk. Given the benchmark role of sovereign bonds, any such repricing could easily spill over to funding conditions for banks and non-financial corporations (Chart 1.4, panel c). This would negatively affect investment and business activity, slow growth and add to debt sustainability concerns.

1.3 Firms face higher debt service costs alongside trade tensions

Improved financing conditions are shoring up firms’ resilience, but interest expenses and macroeconomic uncertainty are weighing on balance sheets. Even though interest rates on new business loans are falling, firms’ debt servicing capacity remains weak because of compressed interest coverage ratios and revenue generation. In addition, weak economic activity and profitability are posing a challenge to corporate resilience in the euro area (Chart 1.5, panel a). Recent survey data signal that firms are becoming wary about the long-term effects of an environment riddled with geopolitical and macroeconomic uncertainty. More specifically, euro area banks have again reported a tightening of credit standards for loans to firms on the back of an increased perception of risk and lower risk tolerance. In addition, the reported share of rejected loan applications has increased for SMEs, driven by developments in Germany, with banks pointing to higher credit risk for smaller firms.^[8] This is echoed by firms reporting muted demand for bank loans amid lower lending rates and slightly tighter other loan conditions.^[9] For the time being, the prevailing wait-and-see dynamics suggest that corporate investment might trend sideways.

Macroeconomic and financial headwinds are clouding the outlook for firm solvency in the short term. The debt service ratio of euro area firms worsened further in 2024, driven by sluggish growth, the resultant stagnant net income and further increases in firms’ interest expenses. Corporate insolvencies were on the rise up to the end of 2024, with significant differences across sectors (Chart 1.5, panel b). For example, insolvencies have decreased strongly in the transport sector of late while continuing to increase in industry (excluding construction). In particular, the automotive sector is struggling due to stagnating new car registrations, higher energy costs and the considerable spending needed to reduce the carbon footprint,^[10] while also becoming a focal point of current trade tensions. Challenges that already existed before the trade tensions culminated in an increasing number of downgrades in 2023 and 2024, which clearly exceeded the number of upgrades (Chart 1.5, panel c). As net downgrades can be seen as an early indicator of future defaults, bankruptcies may be expected to increase further. At the same time, indicators of economic activity paint a mixed, but slightly more optimistic picture overall (Section 1.1). Most notably, the composite, manufacturing and services PMIs on expectations for future business activity in the next 12 months are signalling an expansion.

Trade frictions could significantly affect the resilience of euro area firms in key export-oriented industries. As of 2024, firms in the machinery and transport, manufactured goods and chemicals industries alone accounted for 84% of all exports and 72% of all imports (Chart 1.6, panel a). Abstracting from intra-EU trade, which accounts for the vast majority of goods traded, the United States is the most important export market for euro area firms in these three industries. China, on the other hand, is the most important trading partner in terms of goods imported. Consequently, escalating trade frictions with the United States could have twin repercussions for the profitability and resilience of euro area firms. The first stems from higher tariffs imposed on goods exported by euro area firms themselves. The second relates to stronger competition not only from China but also from other countries facing tariffs imposed by the United States. Goods from these countries might be rerouted to domestic and other markets, reducing profit margins and limiting the growth of capital and investment for euro area firms. Both effects depend, however, on trade elasticities with less severe implications for euro area companies producing more differentiated and less substitutable goods.

Intensifying trade frictions could worsen the outlook of firms, especially in the manufacturing sector. Euro area firms in the manufacturing, other industry and information sectors are most exposed to global trade conflicts, as they exhibit both large foreign market and large foreign input reliance (Chart 1.6, panel b and Special Feature B). Most notably, not only is manufacturing one of the biggest sectors in terms of gross value added, it has also experienced weak growth momentum. Given the already high levels of labour hoarding in industry, this could be a catalyst for rising lay-offs (Section 1.4). As European security parameters shift, however, governments are aiming to boost self-reliance in defence by creating fiscal space for future investments, preferably into European aerospace and defence manufacturing firms. Together with further fiscal stimulus packages, this could potentially offset losses from rising trade frictions, which is echoed by positive market sentiment following announcements of fiscal expansion in the euro area (Chapter 2.3). Unlocking additional investment capacity and stimulating growth dynamics through initiatives that aim to deepen the EU’s Single Market^[11] would help shore up euro area firms’ financial resilience and global competitiveness.^[12]

1.4 Elevated savings support household resilience

Household vulnerabilities have eased slightly and are expected to remain low in the near future. The ECB’s composite indicator of household sector vulnerabilities suggests a continued decline in vulnerabilities over the past six months (Chart 1.7, panel a). Improvements in financing conditions, debt servicing capacity and, to a lesser extent, leverage contributed to this fall. Looking ahead, a further reduction in leverage and an increase in economic activity are expected to reduce the level of vulnerabilities even further from their current historical low. Conversely, the expected moderation in income growth may have a negative impact on overall vulnerabilities.

Robust growth in real disposable income has coincided with a saving ratio that remains elevated compared with pre-pandemic levels. As inflation approaches the ECB’s target of 2%, nominal disposable income growth is declining from its peak in March 2023 (Chart 1.7, panel b). The catch-up dynamics of nominal income to recoup lost purchasing power during the period of high inflation, caused by the infrequent adjustments in negotiated wages, are losing steam. Real disposable income is maintaining a healthy growth rate of around 2%. Despite a modest rise in consumption, the aggregate saving rate is reaching historical highs, aside from the exceptional surge during the pandemic. Households’ propensity to save more is likely influenced by precautionary motives amid an uncertain economic outlook and heightened macroeconomic risks (Section 1.1). In such an environment, deep uncertainty and a possible tightening of financial conditions may induce households to cut back consumption, exacerbating the decline in the demand directed to firms associated with the trade tensions.

Household sentiment has plateaued following an earlier rebound, with expectations remaining clouded. Recent household sentiment, which aggregates a broad set of individual surveys, indicates stabilisation, albeit significantly below the long-term average (Chart 1.8, panel a). After the initial shock stemming from Russia’s full-scale invasion of Ukraine, there was a partial recovery in overall sentiment. However, a recent survey indicated a decline in the broader sentiment over the past six months and a more pronounced decline in households’ expectations for their economic situation over the coming year, likely accelerated by the rising trade uncertainty.

Upon first examination, the labour market appears robust, yet potential risks are beginning to emerge. Unemployment is historically low, and gains in other indicators, such as the labour participation rate, also point towards a relatively strong labour market (Chart 1.8, panel b). However, these indicators typically lag the business cycle, which can conceal underlying vulnerabilities. The European Commission’s labour hoarding indicator reflects the proportion of firms with a deteriorating outlook that do not anticipate reducing their workforce.^[13] The longer labour hoarding persists above the non-recession average, the higher the risk to employment. At the aggregate level, and especially for the industrial sector, labour hoarding exceeds non-recession averages. Furthermore, labour hoarding in the industrial sector has been trending upwards since the start of 2022, albeit with a mild reversal in the recent past. Given that the industrial sector is particularly vulnerable to trade tensions and other structural challenges, it could become a catalyst for future increases in unemployment.

1.5 Recovering real estate markets may face headwinds from elevated uncertainty

Falling borrowing costs have supported demand for mortgages, but construction activity has remained subdued. Following the decline in borrowing costs and the easing of lending standards in recent quarters, the demand for mortgage loans from households has increased of late (Chart 1.9, panel a). The main driver of this has been the fall in interest rates and to a lesser extent a slightly improved outlook for the residential real estate (RRE) market. RRE investment growth has continued to decline, however, even if the pace of that decline has moderated recently. In addition, forward-looking indicators of construction activity and construction prices signal subdued activity and expectations of higher prices, although these expectations are substantially less marked than at the peak of the cycle (Chart 1.9, panel b). This imbalance between supply and demand in the RRE market could potentially exert upward pressure on prices in the medium term.

The likelihood of a severe contraction in RRE prices is lower than at the peak of the cycle, but tail risks are still present. In the fourth quarter of 2024, RRE prices in the euro area increased by 4.2% year on year, following a decline of 1.1% in the equivalent quarter of the previous year. The situation differed markedly among countries. While some countries experienced robust price growth, a few still witnessed a contraction in prices, even though this was generally less pronounced than in the previous year (Chart 1.10, panel a). The recent correction in house prices has reduced estimates of overvaluation in most countries. Combined with improved financial conditions, this has led to a decrease in tail risks compared with the situation at the peak of the cycle in 2022 (Chart 1.10, panel b). That said, conditions vary greatly across the euro area, and some countries still face significant tail risks due to persistent overvaluation, low affordability and economic headwinds. A sharp increase in unemployment and associated income uncertainty in the event of a significant deterioration in the economic outlook could therefore lead to renewed downward pressure on house prices (Section 1.4).

Confidence in commercial real estate (CRE) markets has continued to strengthen in light of easing monetary policy, although downside risks remain. Sentiment indicators point towards a sharp drop in the share of investors reporting adverse credit conditions and a downturn in CRE markets. The number of investors who view CRE as expensive has also fallen. This suggests that the market downturn may be bottoming out and that the recent price correction may have reduced broader overvaluation in the market (Chart 1.11, panel a). While the easing of monetary policy will directly benefit CRE valuations via reduced discount factors, the recent downturn has also been driven by structural factors which affect demand for CRE. These include the shift towards remote working and falling demand for lower-quality offices.^[14] Indeed, those office markets which have seen the sharpest decline in capital values since the COVID-19 pandemic have typically also seen the biggest increase in vacancy rates (Chart 1.11, panel b). These structural challenges are likely to persist, even in an environment of further monetary easing. Given their exposure to both international capital flows and local economic conditions, CRE markets are also highly vulnerable to the ongoing macroeconomic and geopolitical uncertainty. As previous editions of the Financial Stability Review have noted, the outlook for the lower-quality end of the market is particularly poor.

Despite signs of a gradual recovery in real estate markets, financial stability risks could still materialise and should be closely monitored. Real estate markets are highly sensitive to fluctuations in long-term interest rates and real economy developments. This implies that tail risks are still present, in light of current economic policy uncertainty and geopolitical risks. Given the size of banks’ residential mortgage portfolios (22.2% of total assets as of the third quarter of 2024), a significant rise in unemployment could pose financial stability risks where it results in a substantial increase in credit risk in this portfolio. While CRE markets may be even more vulnerable to a deterioration in the economic environment – given ongoing structural challenges and a particularly high sensitivity to real economy demand – these exposures are more contained and are unlikely to endanger the solvency of the euro area banking system as a whole (5% of total assets as of the third quarter of 2024). However, these exposures are not evenly spread across the banking system, and stress could arise among the euro area’s most exposed banks. An adverse real estate market outcome could also be amplified where outflows from real estate funds result in (forced) procyclical selling (Chapter 4.2).

2.1 Financial markets have been volatile

The announcement of significantly higher than expected US import tariffs on 2 April led to a sharp increase in market volatility and a sell-off in risky assets. Increasing trade tensions following the US tariff announcement on 2 April 2025 and subsequent retaliation by China led to a broad-based sell-off in risky assets (Chart 2.1, panel a). This came to a halt when the US Administration announced a 90-day tariff pause for most countries which was followed by a strong rebound in risky assets. The S&P 500 climbed 9.5% on 9 April, its highest gain since 2008, and euro area equities have also seen unusually strong gains since 9 April. Driven by further positive news on easing trade tensions, in particular between the United States and China, US and euro area equities had mostly recovered the losses incurred after 2 April by the cut-off date of this edition of the Financial Stability Review (Overview). In line with the way tariffs have dominated the financial headlines since the start of the year (Chart 2.1, panel b), these price swings illustrate the strong sensitivity of markets to both positive and negative tariff-related news.

The decline in value of US safe-haven assets during the April market sell-off may reflect higher liquidity needs or a broader reassessment of US assets. The April market sell-off was characterised by a breakdown in standard cross-asset correlations. While there were inflows into euro area sovereign bonds and German sovereign debt yields declined in a flight to safety, US Treasury yields increased, indicating a sell-off. This is unusual in times of market stress (Chart 2.1, panel c). In addition, the US dollar depreciated, including against the euro, despite an increasing interest rate differential. At the same time, currencies like the Japanese yen and the Swiss franc appreciated, supported by flight-to-safety flows. Gold prices temporarily dipped but have generally continued their long-term trend in registering new record highs (Box 2). There may be technical reasons for these unusual moves away from some traditional safe-haven assets. Investors needed to raise liquidity to meet fund redemptions or margin calls as market volatility rose (Chapter 4), and an unwinding of asset swap or basis trade positions has contributed to the decline in US Treasuries.^[15] Furthermore, the breakdown of standard correlations, the basis of risk management frameworks, drove the sell-offs, as a lack of diversification benefits led to higher portfolio losses. At the same time, these moves might also have reflected a more fundamental reassessment of US assets. The unpredictability of a broad range of US policies seems to have led investors to require higher risk premia on US assets. At the same time, it could also have shaken confidence in the US dollar as the global reserve currency and US sovereign bonds as safe-haven assets.

Implied equity volatility spiked in April but then fell again to levels that appear disconnected from the prevailing still-high uncertainty. Implied volatility in risky assets spiked after 2 April but then fell back to levels close to those seen when the previous edition of the Financial Stability Review was published (Chart 2.2, panel a). A similar pattern was observed across other risky asset classes, including corporate bonds, where implied volatility currently stands below its historical average. This swift retracement in market-implied volatility is notable, particularly in the context of persistently high levels of perceived economic policy uncertainty. By contrast, measures of realised volatility remain elevated. Moreover, futures for implied equity volatility suggest that price fluctuations are expected to remain moderate. This may reflect market perceptions that downside risks, such as those stemming from global trade tensions, have diminished. However, such dynamics could also signal a degree of investor complacency, heightening the risk of abrupt volatility spikes should any adverse news emerge. In the euro area, market pricing, and hence volatility, remains highly sensitive to further tariff-related shocks across all euro area equity sectors, with markets considering the automotive, consumer products, IT, industrials, materials and financial sector to be the most exposed (Box A, Special Feature B).

Despite the increase in volatility, financial markets have continued to function in a rather orderly manner, with only a limited decline in euro area bond market liquidity. Volatility in euro area corporate bond markets has more or less increased in line with equity volatility (Chart 2.2, panel b). Liquidity conditions in euro area corporate bond markets have declined somewhat, the fall being driven mainly by a decrease in tightness (which measures the cost and price impact of executing a trade), but have stayed at levels which are about average (Chart 2.3, panel a). Liquidity conditions in euro area sovereign bond markets remained resilient during the sell-off in risky assets in April. They then deteriorated, before subsequently recovering to above-average levels (Chart 2.3, panel b). As volatility may surge again, coupled with the risk that market dynamics may turn disorderly in the event of further market stress, market liquidity indicators warrant further monitoring.

2.2 The medium-term implications of tariffs might still challenge risky asset valuations

Equity valuations moved towards their long-term average but remain elevated and could be further challenged by a deteriorating economic outlook. Equity valuations have declined in recent months (Chart 2.4, panel a), particularly in the United States. As long as market functioning remains generally orderly, this decline reduces overvaluation concerns and is beneficial from a financial stability viewpoint. Valuations remain elevated, however, and might be further challenged. This could occur as the medium-term implications of higher tariffs for the global economic outlook, despite the recent easing of trade tensions, become clearer and market participants adjust their positions accordingly. Markets are pricing in some slowing of growth, but a global recession is not the baseline expectation.^[16] Decreasing earnings expectations would likely cause prices to fall further. Earnings momentum has been mostly negative for both the United States and Europe in recent weeks (Chart 2.4, panel b). Another trigger for further price corrections might be if tariffs have a greater impact on inflation than expected, resulting in a repricing of future interest rate paths.

Persistently elevated concentration in US equity markets poses additional downside risks, as illustrated by shifts in AI sector valuations at the start of the year. Market concentration remains elevated, especially in US equity markets, despite declining somewhat (Chart 2.5, panel a). This remains a critical vulnerability, as idiosyncratic risks related to key sectors and technologies could easily result in market-wide adverse dynamics. The sharp decline in AI-related stock valuations after the release of the DeepSeek-R1 model in January underscores this vulnerability (Chart 2.5, panel b).^[17] The stock prices of the seven dominant US technology companies, known collectively as the “Magnificent 7”, fell by 16.5% between the release of the model and 2 April, which also affected euro area technology sector valuations and the wider market. Trade tensions then led to further price fluctuations. Additional tariffs imposed on key resources or companies in the AI sector might cause this vulnerability to translate into larger price losses.

Corporate bond spreads seem low in light of the unprecedented levels of economic policy uncertainty. Corporate bond spreads widened during the tariff-related market downturn, but mostly recovered since then (Chart 2.6, panel a).^[18] They appear disconnected from policy uncertainty levels, which reflects a change from the generally positive correlation between the two over the last few years (Chart 2.6, panel b). Increased uncertainty may lead firms to take a more cautious stance on corporate investments, which could be positive for debt holders. At the same time, general market sentiment could turn negative again with spillovers to corporate bond markets and slowing economic growth might lead to credit losses.

Pressure on corporate bond spreads might increase, as a substantial amount of maturing debt securities will need to be refinanced at a higher cost. Corporate bond issuers took advantage of falling rollover costs, which are the costs associated with issuing new debt to replace maturing debt, in the course of 2024 (Chart 2.7, panel a). Since the start of 2025, issuance has been significantly weaker than it was in the same period of the previous year. This might be due to uncertainty weighing on corporate business and investment activity, together with volatile market conditions. Although rollover costs had been falling, they have turned again and increased for lower-rated credit, in line with the widening of corporate spreads. With an exceptionally high share of outstanding debt rated at or below BBB set to mature in the next few years (Chart 2.7, panel b), corporates might need to refinance under less favourable conditions, which could reduce their debt servicing capacities, especially if they are not offset by higher growth. This could trigger a repricing of corporate debt and result in losses, especially for investment funds, which could further amplify adverse market movements (Chapter 4.2).

2.3 Higher inflows and the prospect of fiscal expansion could support euro area financial markets

The more positive stance taken by markets on the euro area might continue as global investment portfolios might move away from their previously strong US overweight. Markets started the year by shifting to a more positive stance on the euro area, driven by diverging trends in economic outlook, as indicated by the purchasing managers’ indices (PMIs) for both regions (Chart 2.8, panel a). Until March, growth sentiment for the euro area had been gradually improving, albeit from much lower levels than those in the United States, where sentiment declined. In addition, while sentiment for the euro area deteriorated in response to the 2 April tariff announcement, the impact of the announcement has so far been smaller on the euro area than on the United States. This is reflected in the outperformance of euro area equities since the start of the year and slightly smaller aggregate losses in April. In addition, there are initial indications of a rotation out of US markets and into euro area markets (Overview and Section 4.2).

Before the tariff shock, markets were optimistic that the planned fiscal expansion in the euro area would improve its economic outlook. Announcements of a major expansion in defence and infrastructure spending, along with the proposed reform of the German “debt brake”, led to an increase in Bund yields (Chart 2.8, panel b). Corroborated by a model-based decomposition and by market intelligence, this was primarily due to the positive impact on growth the fiscal expansion is expected to have for the German economy and the euro area economy as a whole. In line with the limited increase in inflation swap rates – which fully reversed their initial rise over subsequent weeks – the decomposition also suggests that markets appear less concerned about potential inflationary pressures stemming from the announced fiscal expansion.^[23] The initial increase in sovereign bond yields has fully reversed, driven by the tariff-related market turmoil and further policy rate cuts. However, market intelligence and surveys indicate that a large share of market participants remain hopeful that the longer-term growth impact of the fiscal expansion will be substantial, despite near-term tariff-related headwinds.^[24] A reassessment of this sentiment would likely trigger revaluations.

The planned fiscal expansion could harm sovereign debt sustainability and challenge markets’ optimistic views on sovereign credit risk. Euro area spreads remained stable despite the initial increase in sovereign bond yields after the planned fiscal expansion was announced. Risks to spreads are, however, skewed to the upside. A simple model suggests that raising defence spending to 2.5% of GDP or higher could lead to uneven increases in bond yields across the euro area (Chart 2.9, panel a), some of which might already be priced in. This is due to differing current levels of defence spending (Chapter 1.2) and to varying sensitivities to changes in deficits across countries. At the same time, most of the more highly indebted countries have not so far pledged major increases to their defence spending and markets have shown limited sensitivity to fiscal deficits in recent years.^[25] This trend could reverse if fiscal consolidation efforts stutter and growth expectations are disappointed. In addition, the fiscal expansion taking place alongside the ongoing normalisation of the ECB’s balance sheet will result in a larger amount of net bond supply, which might also affect euro area sovereign bond spreads. Higher issuance by less-indebted countries could lead to higher yields overall and challenge more-indebted countries, especially if spreads widen. That said, sovereign bonds might be particularly attractive in times of increased uncertainty and there have been capital inflows into the euro area which could support absorption capacity. Shifts in global portfolio flows could pose an additional challenge for euro area bond markets, as Japanese bond yields have significantly increased since the previous edition of the Financial Stability Review was published. This could potentially trigger repatriation flows by Japanese investors, who are important players in euro area bond markets.^[26] Despite these risks, market sentiment in sovereign bond markets has generally been broadly optimistic. This is reflected in market-implied ratings which continue to be significantly better than actual sovereign ratings, especially for more-indebted countries (Chart 2.9, panel b).

3.1 Bank profitability remains solid but faces headwinds

The valuations of euro area banks improved up until late March but have been volatile since then amid increased uncertainty about the outlook for banks’ earnings. Euro area banks’ share prices outperformed the broad market indices in the first three months of 2025, and their median price-to-book ratio rose above 1 in late March. This was supported by robust earnings and an improvement in investor sentiment towards the euro area (Chapter 2), including towards banks (Chart 3.1, panel a, left graph). However, bank share prices have been more volatile since 2 April, experiencing a sharp fall after the initial US tariff announcement followed by a recovery upon the news on a 90-day tariff pause for most countries and, subsequently, on easing trade tensions, in particular between the United States and China. Looking at year-to-date changes in price-to-book ratios, banks with higher expected profitability have been outperforming their peers since the beginning of 2025 (Chart 3.1, panel a, right graph). Over a longer time horizon, higher deposit franchise values are also associated with higher market valuations (Box 3). Notwithstanding the increased volatility, the valuation gap between US and euro area banks has narrowed significantly since the beginning of 2025, due to a general shift in sentiment towards euro area banks and better profitability from euro area banks as of 2024 (Chart 3.1, panel b). It is also due to a decline in US banks’ market valuations that had started even before the US tariff announcement.

Bank profitability stabilised in 2024, albeit at still-high levels, as net interest income growth had stalled due to falling interest rates. Banks’ trailing return on equity (ROE) continued to hover at around 9.5% during 2024, a level it first reached in the third quarter of 2023. Growth in net interest income made a positive contribution to the change in ROE on an annual basis, but it stalled in the second half of 2024 due to a combination of slightly tighter margins and subdued volume growth. As a result, growth in operating income has increasingly been driven by non-interest income in recent quarters. The impact of higher revenues was offset by moderate increases in operating expenses and equity as well as a stronger negative impact from other items (Chart 3.2, panel a). The dispersion in bank profitability has remained wide, with a quarter of banks showing an ROE of above 14% and another quarter of banks recording less than 6% (Chart 3.2, panel b, left graph). The main differentiating factor is that the top quartile of banks entered the hiking cycle with operating income that was already higher and these banks increased their revenues (notably net interest income) at a much faster pace between 2021 and 2024 than the lowest quartile of banks. This is partly due to differing sensitivities to the rate cycle, as many banks in the lowest ROE quartile are based in countries where fixed-rate loans are prevalent and this group of banks also includes some specialised, not-for-profit institutions. To a lesser extent, differing trends in cost efficiency and the cost of risk also contributed to the divergence (Chart 3.2, panel b, right graph).

Revenue growth is expected to slow in 2025, as net interest income is set to decline. Banks’ loan-deposit spreads on new business have continued to decline (Chart 3.3, panel a), as a significant share of their loan books is tracking falling short-term rates. This is expected to gradually feed through to net interest margins on outstanding amounts and thus put pressure on revenue growth, in particular for banks with a larger share of floating-rate loans. At the same time, growth in fee and commission income picked up in 2024, partly driven by asset/wealth management activities (Chart 3.3, panel b). This item tends to be more volatile than items related to commercial banking activities (e.g. payment services, loans and guarantees) and could be vulnerable to adverse market shocks affecting investment fund flows (Section 4.2).

Cost control will remain important for offsetting slower revenue growth, but rising cybersecurity challenges require investment. However, banks’ operating expenses grew at a faster pace over the course of 2024, when adjusted for contributions to deposit guarantee schemes and resolution funds, driven mainly by payroll costs (Chart 3.3, panel c). Furthermore, banks face upward pressure on costs due to the increasing need to invest in IT and cybersecurity, given that cyber threats continue to pose substantial risks to financial institutions amid heightened geopolitical uncertainty (Box 1). Almost half of significant cybersecurity incidents reported by financial institutions in the EU from January 2023 to June 2024 concerned banks,^[27] and the number of significant cyber incidents affecting banks supervised by the ECB rose to a new high in 2024. Survey data reveal that cybersecurity remains the primary concern among the chief risk officers of global banks, with 75% of them agreeing it is the main risk over the next 12 months, slightly up from 73% a year earlier.^[28]

Banks’ profitability is expected to fall slightly in 2025, driven by a decline in net interest income and, to a lesser extent, by an increase in the cost of risk. For a sample of listed banks, private sector analysts project that aggregate ROE will decline slightly in 2025 before stabilising in 2026 (Chart 3.4, panel a). For the median listed bank, a moderate decline in net interest income is forecast for 2025, but banks with a higher share of floating-rate loans are expected to see their net interest income fall more significantly (Chart 3.4, panel b). The negative effect of lower rates on margins could be offset, at least in part, by structural hedging, a gradual pick-up in bank lending flows in home markets and, in some cases, continued growth in higher-margin lending activities outside the euro area. Differences in rate sensitivity across banks are also apparent in the wide range of estimated declines in net interest income under the scenario of a downward shift in the yield curve.^[29] As at the end of 2024, the median bank would see its net interest income fall by 11% relative to the baseline under such a scenario, but there is a wide dispersion across banks, with an interquartile range of between -6% and -16%. Finally, in spite of a still weak macroeconomic outlook for 2025, analysts expect only a slight increase in banks’ cost of risk in 2025 and a stabilisation in 2026 (Chart 3.4, panel c). That said, banks’ provisioning needs may increase further amid increased downside risks to banks’ credit risk outlook (Section 3.2)

3.2 Asset quality deterioration has remained contained, but credit risk and provisioning needs are likely to increase

As a whole, euro area banks’ asset quality remains robust, albeit with some divergence at the country level. The aggregate non-performing loan (NPL) ratio of euro area banks remains close to its historical low, despite a marginal increase in 2024, while the Stage 2 ratio is broadly unchanged from a year earlier (Chart 3.5, panel a). Net NPL flows were positive over 2024 as a whole, driven mostly by NPLs in the corporate loan book, although they turned negative in the last quarter of 2024 for the first time since the end of 2022 (Chart 3.5, panel b). However, a benign asset quality picture overall masks diverging trends at the country level, as banks located in some euro area countries where NPL ratios used to be low saw an increase in their NPL stocks in 2024 (Chart 3.5, panel c). By contrast, countries which had experienced a significant increase in NPL ratios during the sovereign debt crisis saw further declines in NPL stocks in 2024, driven by the continued disposal of long-dated NPLs.

Pockets of slow deterioration in asset quality remain, however, with a further (albeit decelerating) deterioration evident in commercial real estate (CRE) lending. The aggregate CRE NPL ratio increased marginally in 2024, with the pace of deterioration slowing compared with a year earlier, partly reflecting diverging trends by borrower location (Chart 3.6, panel a). In particular, the CRE NPL ratio for US exposures continued to rise significantly, up by nearly 4 percentage points since the end of 2023. CRE NPLs on US exposures accounted for 18% of the total at the end of 2024, but these continue to be largely concentrated in a few, mostly German, banks. Exposures to euro area CRE borrowers are performing significantly better, with only contained deterioration or even improvements recorded over the course of 2024 (Section 1.5).

The quality of SME and consumer loans has also deteriorated slightly. The aggregate SME NPL ratio continued to rise gradually for much of 2024, before declining slightly in the last quarter. By contrast, early arrears picked up again in the second half of 2024, although their share in total SME loans remained relatively contained (Chart 3.6, panel b). In the household segment, the quality of consumer loans also showed small signs of deterioration as early arrears picked up in the fourth quarter of 2024, although the NPL ratio remained broadly stable (Chart 3.6, panel c). Due to their higher cyclical sensitivity, banks face the prospect of a further decline in the credit quality of their SME and consumer loans portfolios amid a weakening economic outlook.

Rising global trade tensions could also add to credit risk in the non-financial sector. Firm profitability may be negatively affected by the implementation of tariffs in some manufacturing segments which are highly exposed to extra-EU trade, such as carmaking and machinery (Chart 3.7, panel a). The broader and longer-lasting macroeconomic effects of trade policy uncertainty could also lead to a deterioration of bank asset quality, albeit with stronger impacts for banks with higher exposures to sectors relying on extra-EU trade (Special Feature B). In an adverse scenario, where escalating trade tensions could also lead to lay-offs in affected sectors, the negative impact on asset quality could extend to parts of banks’ household loan portfolios.

Provisioning costs remain subdued but may rise again as new NPLs age and guarantees are phased out. As stated in the November 2024 edition of the Financial Stability Review, banks’ NPL coverage ratios for corporate loans have declined over the last few years, driven by the disposal of legacy NPLs with higher coverage, the inflow of new NPLs with lower coverage and the use of substantial public credit guarantees during the pandemic. However, this reduction in coverage ratios may start to reverse in 2025 as two factors that contributed to this decline fade away. First, new NPLs will likely require higher provisions as they age, with the average provision coverage on NPLs rising from 44% when they are less than a year old to 68% for loans that are more than two years old (as of end-2024). This will mostly affect countries which have seen NPL inflows in recent years and where this dynamic has been more prevalent (Chart 3.7, panel b). Second, the share of government-guaranteed loans stock will continue to decrease in 2025, with 42% estimated to have already left the portfolio since the end of 2022. Beyond these structural factors, banks may see some increase in provisioning costs due to the worsening growth outlook for 2025 (Section 1.1), which could lead to higher expected loss estimates under the IFRS 9 framework.

3.3 Banks’ funding costs have fallen but are encountering frictions on their downward path

Bank bond yields have declined over the past year, but spreads have been volatile recently. Bank bond yields have fallen considerably, reaching their lowest levels since the onset of the last round of monetary policy tightening. Much of this decline had already occurred before policy rates started to fall, as markets priced in policy cuts earlier (Chart 3.8, panel a). Bank bond yields have, however, been volatile recently, affected by fluctuations in both the underlying risk-free rate and bond spreads since the announcement of trade tariffs by the US Administration on 2 April. Credit spreads for more junior instruments have risen notably and contributed to an increase in the average secondary market yield. By contrast, spreads on covered bonds have narrowed, with market participants favouring these assets in a flight to safety (Chart 3.8, panel b). In response, some banks delayed primary market bond issuances of more junior instruments, timing them with the return of more favourable market conditions after temporary tariff pauses had been announced (Chart 3.8, panel c).

Deposit rates have also declined, but differences in funding conditions across banks persist. Since the ECB’s first policy rate cut in June 2024, euro area banks have substantially reduced interest rates on term deposits. Meanwhile, interest rates on shorter-maturity accounts, such as overnight deposits and deposits redeemable at notice, have changed little from their peak. This is, however, consistent with the more muted pass-through of rate increases during the hiking cycle (Chart 3.9, panel a). Across banks, differences in deposit rates persist and may be partly explained by differences in net stable funding ratios (NSFRs) (Chart 3.9, panel b). As retail deposits represent stable funding, a lower share of deposit financing decreases banks’ NSFRs but might also allow them to pay higher deposit rates, depending on their business model. However, there could also be a more structural relationship between funding liquidity and deposit rates: those banks with ample funding liquidity might not feel the same pressure to bid up for deposits as those with lower NSFRs.

Deposit growth has contributed to ample funding liquidity, but the composition of deposits is shifting towards demand accounts. Deposit growth has been positive since the beginning of the easing cycle, supported most by inflows into overnight deposits. This marks a reversal in the dynamics observed over the tightening cycle until April 2024, when deposit growth was driven by term deposits and shifts tended to be away from overnight deposits towards better-remunerated accounts (Chart 3.9, panel c). The renewed growth in overnight deposits, alongside subdued growth in term deposits, reflects lower demand for savings accounts due to the narrowing gap between term and overnight deposit rates (Chart 3.9, panel a). Moreover, it signals a change in preferences for more liquid assets, as the dynamics reversed even when term deposit rates were still at high levels and this benefits banks by shifting the funding composition towards the cheapest source of funding. Over recent years, depositor preferences have also evolved through the digitalisation of financial services and the increasing presence of online banks (Box 4).

Despite the recent market turmoil, there have not been any signs of funding stress. While the contractual maturity of banks’ deposit funding shortened with the changing composition, deposit data at weekly frequency have not shown any evidence of increased funding stress recently. In the same vein, wholesale funding from money markets has been stable as well. Although some euro area banks have strong international linkages through their activities as intermediators of US dollar liquidity via repo and FX swap markets^[31], market functioning has been orderly. Neither have there been any signs of impaired access to foreign currency funding via repo and FX swap markets, despite the volatility seen in other market segments.

3.4 Banks maintain robust liquidity and capital buffers

Liquidity buffers remain comfortable, while the composition of euro area banks’ liquid assets has been moving away from cash and towards debt securities. The total stock of banks’ high-quality liquid assets (HQLA) has been fairly stable, with the aggregate liquidity coverage ratio (LCR) standing at 159%, substantially above the minimum requirements and pre-pandemic levels. However, the composition of HQLA has changed with the reduction of the ECB’s balance sheet. Excess reserves have declined, as banks have used funds to meet TLTRO redemptions, and have been replaced by sovereign bond holdings. The share of sovereign bonds in HQLA has nearly doubled since the third quarter of 2022 as a result (Chart 3.10, panel a). Despite this shift, the HQLA composition is still skewed towards cash compared with pre-pandemic levels, although this is likely to change with the ongoing normalisation of the ECB’s balance sheet and increased public financing needs (Chapter 1).

Banks’ sovereign bond portfolios have become larger, but more diversified. While home bias persists, banks have diversified sovereign bond holdings by purchasing non-domestic bonds. This limits concerns about the sovereign-bank nexus. Nonetheless, larger sovereign bond portfolios leave banks more exposed to adverse market movements. Any resulting valuation losses can affect banks’ LCRs, since eligible securities are generally marked-to-market for the purpose of LCR calculations. In a similar vein, adverse market movements can, for securities which are not accounted for at amortised cost, result in lower solvency (Chart 3.10, panel b).^[33] In the context of liquidity and capital ratios well above regulatory requirements, this risk currently appears small and may be further mitigated by hedges on bond portfolios. But with the increasing net supply of euro area sovereign bonds (Chapter 1), banks’ liquid asset holdings may continue to evolve, and market risks could become more prominent over time.

Strong profitability has helped banks maintain high capital ratios and increase shareholder remuneration. The average CET1 ratio has been stable over the past year, at 15.4%, and remains well above regulatory requirements. High internal capital generation in the form of retained earnings has continued to have a strong positive effect on banks’ capital ratios. Meanwhile, a marked increase in credit risk requirements has had a negative impact, owing to an increase in risk-weighted assets from corporate and unsecured retail exposures, rather than a deterioration in credit quality (Chart 3.11, panel a). Unless a default occurs, credit risk weights are rather insensitive to changes in asset quality, so credit risk exposures are instead mainly driven by volume effects and thus will increase further once lending growth revives. By contrast, a deterioration in asset quality would more likely be reflected in a higher cost of risk and lower retained earnings moving forward. At the same time, euro area banks distributed about half of their 2024 earnings to shareholders, and shareholder remuneration reached the highest levels observed since the Single Supervisory Mechanism was set up in 2015.^[34] It may, however, decline moving forward, should earnings start to fall (Chart 3.11, panel b).

The euro area banking sector remains resilient, underpinned by robust earnings and contained asset quality deterioration, together with high capital and liquidity buffers. Despite the challenging macroeconomic environment, euro area banks continue to report profits that are strong enough to both support healthy capital ratios and remunerate shareholders. Deterioration in asset quality has been confined to specific portfolios so far and funding costs are decreasing. Looking ahead, banks could see their net interest income decline somewhat as interest rates fall, while the broader and longer-lasting macroeconomic implications of trade policy uncertainty could lead to deteriorating bank asset quality and rising provisions. At the same time, capital and liquidity buffers remain ample and should protect banks from potential headwinds in light of global uncertainty.

3.5 Preserving bank resilience is essential in an uncertain environment

Elevated financial stability vulnerabilities and heightened geopolitical uncertainty mean that preserving the resilience of the banking sector system remains a key priority for macroprudential policy. Countries participating in European banking supervision have made significant progress in building up releasable capital buffer requirements, with all countries now having implemented some form of releasable capital buffer, thereby contributing to the resilience of the banking sector. Since the November 2024 edition of the Financial Stability Review was published, another jurisdiction has implemented a framework for the early activation of the countercyclical capital buffer (CCyB), bringing the total number of countries with such a framework in place to ten.^[35] In addition to ensuring countries have the wherewithal to address vulnerabilities stemming from the domestic environment, the availability of releasable capital buffers is particularly important in those that are more vulnerable to external shocks, especially given current trade tensions and high levels of global uncertainty.^[36],[37] Further targeted increases in buffer rates remain desirable in countries where their overall levels are still relatively low, as long as favourable banking sector conditions mitigate the risk of procyclicality and limit the potential costs of measures.^[38] In this regard, some countries that have announced a positive neutral approach have yet to reach their target rate (Chart 3.12). Existing borrower-based measures should also be maintained to ensure that lending standards are sound and sustainable throughout all phases of the financial cycle. Lastly, notwithstanding the comfortable liquidity buffers built up by banks so far, liquidity developments should be closely monitored given potential challenges ahead (Section 3.4).

The ECB supports the revision of the EU macroprudential framework with a view to enhancing its effectiveness, streamlining processes and establishing consistency across jurisdictions. Ensuring the usability and releasability of macroprudential buffers is crucial given the complex interactions between prudential and resolution frameworks. Improved usability of buffers would allow national authorities to act countercyclically in an effective manner and strengthen the banking system’s ability to withstand losses on a going concern basis. In this context, the ECB encourages greater exchange of information between microprudential, macroprudential and resolution authorities, the harmonisation of methods for measuring buffer usability and releasability across jurisdictions, and the promotion of a more common framework for the implementation of the CCyB (including its use early in the cycle), with a view to fostering effective and consistent use of the instrument across countries, while remaining mindful of the country-specific risk environment. Furthermore, the ECB advocates greater harmonisation in the setting of buffers for systemically important institutions, updating its floor methodology in 2024 to improve the assessment of capital buffer decisions. The floor methodology aims to ensure consistent treatment of other systemically important institutions (O-SIIs) under European banking supervision.^[39] The ECB also continues to advocate the creation of a common EU methodology for setting O-SII buffers, taking into account national specificities, institutional and structural developments, and insights gained since the introduction of the O-SII buffer.

The ECB also supports the ongoing implementation of the outstanding elements of the Basel III reforms and of enhancements to the EU bank crisis management and deposit insurance framework. The Group of Governors and Heads of Supervision, including the ECB, reaffirmed their commitment in February 2025 to the full, timely and consistent implementation of Basel III, as any delay could undermine the global level playing field. The ECB also remains committed to coordination with international fora more generally, including the Basel Committee on Banking Supervision, helping to avoid regulatory fragmentation. However, following the postponement of the date of application of the Fundamental Review of the Trading Book to 1 January 2026, the European Commission is considering options to further adjust the EU’s implementation of the market risk rules to maintain a level playing field with other jurisdictions, such as the United States and the United Kingdom, in which implementation is either delayed or unclear.^[40] In this context, the ECB stands ready to contribute to any ongoing consultations. Alongside this, the Commission has made a legislative proposal to enhance the bank crisis management and deposit insurance framework, with a view to better managing bank crises and including smaller and medium-sized banks, and the European Parliament and EU Council have adopted their negotiating positions. The ECB calls for continued progress in the trilogue between the Parliament, the Council and the Commission to reach a consensus, which is vital for advancing the banking union.

Looking ahead, the ECB remains committed to reducing unwarranted complexities in the regulatory and supervisory framework, while preserving its resilience and compliance with the Basel capital framework. The COVID-19 pandemic and the banking turmoil in March 2023 were stark reminders that a resilient banking sector is the cornerstone of a healthy economy, contributing to financial stability and fostering economic growth. Today, the European banking sector is resilient thanks to banks’ solid capital and liquidity positions (Section 3.4), together with the current regulatory and supervisory framework, which has thus far served its purpose well. Nevertheless, reducing unwarranted complexities would make it more efficient and effective. Besides the macroprudential aspects already mentioned above, there is room for further improvement in the areas of supervision, reporting and regulation, in which the ECB is already conducting significant work.^[41] With regard to regulation, the ECB stands ready to provide expert input into the evaluation of the effects of the current regulatory framework and potential enhancements to its effectiveness, while preserving financial stability. Importantly, any potential adjustments should not come at the expense of resilience or undermine compliance with the Basel framework, and need to be based on a sound impact assessment and cost-benefit analysis.

4.1 Trade disputes may test non-bank asset valuations

Non-banks remain key investors in euro area sovereign debt markets, but valuation dynamics have shifted portfolios towards riskier asset types. Along with overall sector growth, the euro area non-bank financial intermediation (NBFI) sector continued to expand its nominal holdings of euro area sovereign bonds in 2024. Higher volumes in sovereign debt issuances and increased purchases by households and non-euro area investors have, however, led to a slight reduction in the overall share of outstanding sovereign debt absorbed by non-banks (Chart 4.1, panel a). Moreover, high stock market valuations and increasing investments in corporate bonds have tilted aggregate NBFI securities portfolios towards comparatively riskier asset types (Chart 4.1, panel b). Together with declining sovereign bond valuations, this may also reduce the relative amount of highly liquid assets available to non-banks when confronted with liquidity shocks (Box 5).

Non-banks may face higher risks of valuation losses and margin calls as global trade tensions increase market volatility and weigh on corporate issuers. Euro area non-banks’ investments include sizeable exposures to trade-intensive economic sectors. Around half of all European stocks held by the NBFI sector come from issuers that rely to a significant extent on both imports from and exports to the United States (Chart 4.2, panel a). Rising protectionism and trade policy uncertainty are likely to weigh on the outlook of these issuers in the medium term, resulting in lower valuations. Although revised fiscal plans have the potential to boost euro area economic growth and improve market sentiment, debt and equity portfolios may continue to see more frequent episodes of price volatility going forward. Non-banks’ assets are also characterised by a large share of international investments, exposing them to potential spillover shocks and higher market volatility globally, including in US markets (Chapter 2). This can also result in more frequent margin calls for non-banks hedging currency risks in their sizeable US dollar portfolios (Chart 4.2, panel b). Following the US tariff announcements at the beginning of April 2025, variation margin calls for NBFI entities exceeded €60 billion. On average, this equals 3.6% of cash buffers for the NBFI sector and a notably higher 5.4% for pension funds (Chart 4.2, panel c). Although it seems these margin calls were manageable, they demonstrate the importance of adequate levels of liquid asset holdings across the different NBFI sectors to ensure resilience to further global market shocks.

4.2 Liquidity mismatches and increasing leverage in parts of the investment fund sector

Flows into euro area corporate funds have reversed amid rising trade tensions, while demand for real estate and sustainable funds remains muted. A wide range of euro area investment funds continued to see sizeable inflows after the last edition of the Financial Stability Review was published, contributing to further sector growth in the second half of 2024 and early 2025. Flows into bond funds continued to outpace flows into equity funds in relative terms, while environmental, social and governance (ESG) investors also shifted from equities to bonds. However, the US tariff announcements at the beginning of April triggered a sharp reversal in corporate bond fund flows as investors reduced their exposure to riskier assets, most notably high-yield corporate bonds (Chart 4.3, panel a). Despite the recently improved outlook for real estate markets, demand for real estate investment funds (REIFs) is still muted. REIFs remain under pressure in multiple countries as procyclical outflows continue to materialise (Chart 4.3, panel b).

Liquidity mismatches in open-ended investment funds might amplify adverse market dynamics as global trade disputes increase the risk of sudden fund outflows. Several open-ended investment fund types continue to show significant structural liquidity mismatches. As a result, liquid asset holdings are frequently insufficient to cover a severe yet plausible redemption shock. Liquidity mismatches persist in parts of the equity fund sector and are especially pronounced for corporate bond funds (Chart 4.4, panel a). Following the US tariff announcements in early April, sizeable outflows from funds investing in comparatively riskier asset types, such as high-yield corporate debt or emerging markets assets, have illustrated the potential for amplification dynamics as investors react procyclically to changes in fund returns (Chart 4.4, panel b). Given the significant liquidity mismatches, these funds may have to sell their less liquid assets at unfavourable terms to meet redemptions. This could lead to a further drop in fund performance, put market prices under additional downward pressure and encourage more investors to redeem their shares. High levels of trade policy uncertainty accompanied by bouts of market volatility could increase the risk of sudden share redemptions. In particular, large volatility in equity markets could expose equity funds to redemption shocks should trade tensions intensify. Significant holdings in US assets may also be at risk of further spillovers from US market shocks and rising volatility in currency markets (Chapter 2; Chart 4.2, panel b). In the current environment of prolonged periods of high uncertainty, funds’ resilience could gradually weaken over time as more frequent outflows limit their ability to restore liquidity to adequate levels.

Euro area hedge funds increased their leverage in 2024, with sizeable derivative exposures in both alternative and UCITS funds. Although hedge funds remain a comparatively small subsector of euro area investment funds^[42], it is a segment with a high concentration of potential leverage-related risks. Hedge funds increased their financial leverage further in 2024 and early 2025 (Chart 4.5, panel a) from levels which were already structurally higher than in other investment fund types. They make significant use of synthetic leverage in the form of derivative exposures, which may give rise to margin calls during spikes of market volatility and re-enforce liquidity vulnerabilities in the sector. Euro area hedge funds regulated under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive have become more prevalent and tend to take on significant amounts of derivative exposures (Chart 4.5, panel b). Internal value-at-risk models used to determine leverage limits under the UCITS Directive may underestimate the risks related to leverage. Furthermore, in contrast to funds regulated under the Alternative Investment Fund Managers Directive (AIFMD), the authorities currently lack the power to impose stricter leverage limits where excessive levels are deemed to pose a potential risk for financial stability (Section 4.4).

4.3 Insurance and pension fund sectors remain resilient, but uncertainty poses risks

The euro area insurance and pension fund sectors remain resilient on aggregate, but geopolitical and macroeconomic uncertainty poses risks. The Solvency Capital Requirement (SCR) coverage ratios of euro area insurance groups have remained well above the regulatory minimum of 100% (Chart 4.6, panel a).^[44] Despite this, uncertainty stemming from trade conflicts, geopolitical risks and potential financial market volatility could affect euro area insurance corporations and pension funds (ICPFs) through the portfolio valuation, liquidity and underwriting channels. This includes risks stemming from elevated financial market and exchange rate uncertainty, particularly for US exposures. Euro area ICPFs have large holdings of US dollar-denominated assets, although the share varies across countries (Section 4.1). The associated exchange rate risks are typically hedged by derivatives, but shocks in US financial markets could still have a negative impact on the valuations of these portfolios.

More generally, ICPFs remain vulnerable to potential liquidity pressures that could arise from margin calls on their derivative exposures. ICPFs make extensive use of interest rate derivatives for hedging purposes, with total gross notional exposures to derivatives being heterogeneous across countries and largest among reinsurers and pension funds (Chart 4.6, panel b).^[45] ICPFs – especially pension funds – experienced a rise in margin calls on these derivative exposures following the announcement of US tariffs at the beginning of April, which they appear to have been able to meet (Section 4.1). However, further sharp or sudden changes in either financial market volatility or long-term interest rates could result in renewed, and possibly large, margin calls. This would leave ICPFs vulnerable to potentially rising liquidity pressures that could, in turn, require them to sell assets. A decline in high-quality liquid assets in insurers’ portfolios (Box 5) suggests that the sector is not as well prepared to deal with liquidity shocks from margin calls as it was in the past.^[46] Previous stress events, such as the March 2020 market turmoil, show that liquidity pressures faced by ICPFs can also propagate stress across the wider financial system. It is therefore important that ICPFs strengthen their liquidity preparedness to ensure they can meet margin calls.

Additionally, the profitability outlook for the insurance sector remains uncertain, despite signs of improvement for life insurers. Underwriting profitability – as measured by the ratio of premiums written to the sum of net claims incurred and expenses – remains strong for non-life insurers, while life insurers have seen improvements over the course of 2024 (Chart 4.7, panel a). However, the outlook for underwriting profitability remains uncertain for both sectors. The materialisation of downside risks to economic growth could negatively affect underwriting performance. Trade tensions could also have an impact on insurers that offer policies on trade-related risks (e.g. trade credit, transit and exchange rate insurance) or via investments in trade-intensive corporates (Section 4.1). Similarly, higher inflation uncertainty could have an impact on premium repricing and on the costs associated with insurance claims and expenses.

Non-life insurers also face growing challenges from the physical risks associated with climate-related natural catastrophes. The increasing frequency and severity of natural catastrophes due to climate change are causing growing economic losses through the destruction of physical property and infrastructure and a reduction in economic activity. In Europe, preliminary evidence suggests that natural disasters resulted in €30 billion of economic losses in 2024, of which only €13 billion was insured.^[47] A historical comparison, however, shows that a large proportion of economic losses in the euro area has typically always been uninsured, and the long-run average share of insured losses is continuing to fall across the euro area as a whole.^[48] The proportion of economic losses not covered by insurance (the insurance protection gap) could widen even further going forward as non-life property insurers, who appear most exposed to rising insured losses, raise policy prices in response. Higher premiums could also result in such coverage becoming unaffordable, thereby eroding the underwriting business of these insurers.

A widening insurance protection gap is also a source of systemic risk. Physical damage has a negative impact on asset values, leading to the repricing of the loans and securities of financial institutions in higher-risk areas. It also increases the potential burden on the public sector, both in terms of the macroeconomic risks and in terms of the greater fiscal spending required to cover uninsured losses. This is particularly relevant given that the more highly indebted euro area countries are also those facing the largest economic costs from climate-related natural catastrophes, most of which are uninsured (Chart 4.7, panel b). This highlights the importance of taking policy action aimed at reducing the climate insurance protection gap.

4.4 Enhancing the NBFI policy framework from a macroprudential perspective and supporting resilient capital markets

Non-banks play a crucial role in capital market development, yet they operate without a comprehensive macroprudential framework. The euro area non-bank financial intermediation (NBFI) sector has grown significantly since the global financial crisis to become a vital source of funding for the real economy. This growth has helped to diversify sources of financing and support capital market development. Nevertheless, parts of the NBFI sector display notable vulnerabilities. Liquidity mismatch and leverage are pronounced in parts of the investment fund sector and have been rising over the past few years (Section 4.2). Moreover, the decline in high-quality liquid assets in insurers’ portfolios suggests that the sector is not as well prepared to deal with liquidity shocks as it was in the past (Box 5). This is especially important during stressed market conditions, when non-banks may have to sell illiquid assets, thereby amplifying liquidity stress. Previous examples of this include the March 2020 market turmoil and the 2022 UK gilt market stress. Excessive leverage in hedge funds and other leveraged investment funds can amplify stress via the position liquidation and counterparty credit risk channels. It is therefore important that the NBFI policy framework is strengthened from a macroprudential perspective, as the current framework focuses primarily on investor protection and market integrity rather than on reducing systemic risk.

An effective macroprudential policy framework for non-banks requires EU-wide coordination to be enhanced. Given the significant cross-border activities in the asset management sector, a nationally based framework might not be sufficient to ensure that EU-wide risks to financial stability are dealt with consistently. To guarantee a level playing field within the EU and reduce the potential for regulatory fragmentation or arbitrage, it is essential that cooperation between European and national authorities is strengthened.^[49] The framework should ideally rest on a common set of rules and standards across the EU, accompanied by coordinated supervisory action at the EU level. Against this backdrop, two elements should be prioritised: (i) a mechanism for the reciprocation of macroprudential policy measures, and (ii) granting the European Securities and Markets Authority (ESMA) “top-up” powers to be used in collaboration with national authorities and after consulting the European Systemic Risk Board (ESRB). ESMA would be tasked with coordinating the reciprocation requests – in consultation with the ESRB – to ensure that macroprudential measures also apply to the exposures of non-domestic entities operating in, or exposed to, the market of another EU Member State. In addition, ESMA – in collaboration with national macroprudential authorities and competent authorities and after consulting the ESRB – should be given the power to request the implementation of new macroprudential measures or to top up existing national measures. The combination of reciprocation and top-up powers would help address EU-wide risks and overcome inaction bias against activating policy tools in the NBFI sector.

The macroprudential policy toolkit should be expanded by adding a dedicated tool for addressing structural liquidity mismatch in open-ended funds. Article 25 AIFMD, which allows authorities to limit excessive leverage in alternative investment funds, is currently the only macroprudential tool for investment funds.^[50] To enhance this macroprudential toolkit, the Eurosystem suggests introducing a similarly dedicated macroprudential tool to address liquidity mismatch in open-ended funds.^[51] The tool should be used to enhance resilience in advance, thereby safeguarding financial stability. For example, authorities could use the tool to impose longer notice periods or other measures to mitigate liquidity mismatch in open-ended funds. To ensure consistent implementation of such macroprudential tools, ESMA, in consultation with the ESRB, should play a greater role in policy coordination across the EU, as discussed above.

It is essential to close the regulatory gaps under the UCITS Directive that relate to leverage in complex funds. While most UCITS funds are subject to direct leverage limits, the current framework allows funds with hedge fund-like strategies to use value-at-risk (VaR) models to determine their leverage indirectly. This could potentially lead to higher leverage levels than are typically permitted under the more widely used commitment approach.^[52] A comparison between UCITS using hedge fund-like strategies and hedge funds under the AIFMD shows that such UCITS generally display higher levels of gross leverage (Section 4.2). They also tend to be more complex and more interconnected and face higher liquidity risk.^[53] While authorities have tools which can be used to contain excessive leverage in alternative funds, they do not have such tools for UCITS funds. Closing this gap is therefore crucial to address potential systemic risks arising from leverage in UCITS. The Eurosystem suggests introducing discretionary powers that would allow authorities to impose stricter leverage limits on these funds if they posed a risk to financial stability (in the same way that Article 25 AIFMD does). It also recommends that all UCITS funds should be required to report their leverage using the commitment approach.^[54]

Addressing leverage-related risks requires a global perspective and a multi-faceted approach, targeting specific entities or activities. Given the cross-border dimension and the complexities involved in tackling risk arising from NBFI leverage, as well as its interlinkages with liquidity risk, a comprehensive, global approach is needed to close policy gaps.^[55] This includes activity-based measures (such as haircuts and margins), entity-based measures (such as leverage limits), guidance on leverage providers and enhanced transparency to promote market discipline. Even if measures have differing primary objectives (e.g. reducing procyclical deleveraging or cutting counterparty losses), they can directly or indirectly limit leverage build-up. For instance, while entity-based measures like leverage limits directly target leverage, they might not apply to entities such as hedge funds or family offices. In the latter case, activity-based measures like margin requirements could partly compensate for a lack of entity-based measures. However, haircuts and margins may be less effective in targeting the build-up of concentrated positions and, if set too strictly, could impose excessive hedging costs on end users. The authorities thus need to carefully balance key trade-offs (effectiveness, feasibility and potential costs) when designing policy measures.

Authorities with a macroprudential mandate must have access to granular data on non-banks if they are to monitor risks effectively. While the European System of Central Banks (ESCB) collects a range of data from non-banks to carry out its tasks, the ESCB does not yet have access to NBFI entity level data collected for supervisory purposes (e.g. reported under the AIFMD, the UCITS Directive, Solvency II or MiFID/MiFIR). The relevant EU regulations should include provisions which ensure that the ESCB has timely and efficient access to such granular NBFI data to support its financial stability tasks. This could help mitigate inefficiencies in data collection and enhance usability, while also reducing the reporting burden on non-banks. Given the cross-border activities in capital markets, further work will be needed at the global level to improve international consistency in the definition and calculation of relevant risk metrics, improve data quality and coverage, and enhance information sharing across borders.

Mobilising capital markets is key to deepening the EU’s Single Market and providing sufficient and diverse sources of financing for innovative firms. Current challenges include a reliance on bank lending, fragmented equity markets, underdeveloped venture capital markets and disparities in capital market development, leading to inefficient capital allocation and higher financing costs. To address these issues, the EU must deepen its equity markets and channel savings into productive sectors.^[56] The European Commission’s savings and investment union strategy includes a number of actions that can support this objective.^[57]

• Introducing an EU standard for savings and investment products with coordinated tax incentives could boost retail participation in capital markets and enhance financial integration. Together with steps to encourage pension savings (e.g. via automatic enrolment into a retirement savings scheme), this is an important way of meeting the challenges of an ageing population (Special Feature C).
• Reducing the debt-equity bias in taxation and taking action to support investment in equity could further promote equity financing and diversify the sources of financing in the economy. In particular, it could attract institutional investors and improve the venture capital landscape (Box 6).
• Harmonising company and securities law would support market integration and make listing and trading in the EU more attractive.
• A coherent regulatory framework for a single capital market necessitates harmonisation in areas like insolvency regimes and accounting rules, which currently hinder cross-border market functioning.

Advancing the capital markets union requires better integrated supervision and policies that ensure stability in the NBFI sector. Integrated supervision of EU capital markets is vital for the development of a capital markets union. This will ensure that the European supervisory authorities, particularly ESMA and EIOPA, have the resources they need to perform their tasks and will guarantee the kind of governance that supports decision-making that works in the interests of the EU.^[58]

A Just another crypto boom? Mind the blind spots

Prepared by Senne Aerts, Alexandra Born, Zakaria Gati, Urszula Kochanska, Claudia Lambert, Elisa Reinhold and Anton van der Kraaij

The market capitalisation of crypto-assets has surged recently, fuelled by positive and broadening investor interest, including from traditional finance. Several key financial stability risks associated with crypto-assets have been identified in past editions of this publication, and by the Financial Stability Board. They include, among others: interconnectedness with traditional finance; market volatility and lack of transparency; liquidity and maturity mismatches; and leverage and concentration. This special feature focuses on the first two. For these sources, risks for financial stability in the euro area appear limited, but there are signs that interconnectedness between the crypto-asset ecosystem and the traditional financial sector is strengthening. As it does, new channels of potential contagion are opening up, warranting closer monitoring. At the same time, euro area households’ direct exposures are slowly rising from low levels. Data gaps, especially for the crypto exposures of non-banks and leverage, pose challenges both for monitoring and for assessing the scale of these sources of systemic risk. It is therefore essential that these data gaps be closed and that responsible authorities remain vigilant. Although the EU has established a stringent regulatory framework, global regulation is either fragmented or absent, raising the risk of regulatory arbitrage and contagion from abroad.

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B Risks to euro area financial stability from trade tensions

Prepared by Pauline Avril, Paul Bochmann, Stephan Fahr, Aoife Horan, Cosimo Pancaro and Riccardo Pizzeghello

Trade tensions can be a threat to financial stability, with both the implementation of trade restrictions and trade policy uncertainty resulting in adverse consequences. In this special feature, we show that trade policy uncertainty can adversely affect the real economy as well as banks’ funding, asset quality, profitability and lending. Policy authorities need to identify risks stemming from trade tensions, monitor their transmission and evaluate their potential impact on financial stability. Sound capital and liquidity buffers are financial institutions’ first line of defence to absorb shocks stemming from trade disruptions. However, banks should also conduct regular assessments to identify and evaluate these specific risks. In addition, they should diversify portfolios to minimise their exposure to such risks. A box within the special feature analyses the risks of euro area equities repricing across sectors in response to developments in the United States, with a particular focus on news relating to trade policy.

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C Navigating financial stability in an ageing world

Prepared by Sándor Gardó, Benjamin Klaus, David Kurig and Manuela Storz^[62]

The number of older people in the EU has increased markedly in recent decades and is projected to go on rising. This trend may pose challenges to financial stability given the adjustments needed in both the real economy and the financial sector to adapt to the demands of an ageing society. Building on the extensive body of literature examining the impact of population ageing on the real economy, this special feature investigates the channels through which population ageing could elevate financial stability concerns in the financial and non-financial sectors, bearing in mind possible interdependencies across sectors. Comprehensive policy actions appear warranted to meet the challenges posed by an ageing population to financial stability. These can range from boosting productivity growth and labour force participation rates to ensuring the sustainability of pension systems by increasing market-based retirement savings, also in the context of the developing capital markets union.

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