ECB warns of financial turbulence as populism adds to risks

[FRANKFURT] The European Central Bank warned that risks of financial-market turmoil have increased amid slower growth in emerging economies, weak bank profitability and the rise of populist movements across the 19-nation euro region.

"A sharper-than-expected fall in Chinese growth could well lead to a synchronized downturn across other emerging-market economies, particularly commodity-exporting economies," the ECB wrote in its twice-yearly Financial Stability Review published on Tuesday.

"Under such a scenario, the financial systems of advanced economies may be challenged by a reduction in consumer and business confidence, and renewed financial-market volatility potentially intensified by sudden stops in or reversals of cross-border capital flows."

Following an oil slump, the Frankfurt-based central bank has deployed an array of unconventional stimulus to support a cyclical recovery in the euro area and jolt prices out of the deflation-risk zone. The measures - which include negative rates, asset purchases and cheap credit to banks - have been criticized for eroding banks' profits and fuelling the risk of asset bubbles.

ECB Vice President Vitor Constancio acknowledged that the institution's negative-rate policy has limits.

There are levels that "would then lead to a preference for cash, and the policy would then not be efficient any more and create other problems" but "we are still very far away from that," he said in an interview with Bloomberg Television. While officials can't ignore the impact of sub-zero rates on bank profitability, "the overall effect of our policy has been positive," he said.

In its report, the ECB highlighted the low profitability of financial institutions and emerging-market weakness as "medium- level systemic risks." Higher political uncertainty amid the success of populist parties that want to stop or even reverse structural reforms in the euro area has also been added as a "potential" risk.

"Rising political risks at both the national and supranational levels, as well as the increasing support for political forces which are seen to be less reform-oriented, may potentially lead to the delay of much needed fiscal and structural reforms," the report said. "This, in turn, may cause renewed pressure on more vulnerable sovereigns and potentially contribute to contagion and re-fragmentation in the euro area."

Presidential elections in the US and the planned referendum in the UK on its membership in the European Union could hurt business and consumer confidence, and thus economic growth, the ECB said.

Mr Constancio said "banks are aware of the risks" related to Brexit.

"Judging by the amounts of exposure we identified out there, banks will be resilient to such an hypothesis that nevertheless, if it happens, will have for a while a negative impact," he said.

The region's lenders, faced with a twin challenge of a sluggish recovery and negative rates eating into profit margins, in some countries are still saddled with a crisis-era legacy of soured debts. They should be ready to expand and merge across borders, according to the ECB.

While monetary stimulus is making financial conditions more favourable and is supporting loan demand, "these measures alone are not sufficient to ensure a profitable and healthy banking sector over the medium term," the report says.

"Some banks may need to further adapt their business models to ensure long-term sustainability - via consolidation, cost-cutting or other efficiency measures."

Overall, the ECB maintains that "euro-area systemic stress has remained contained despite a challenging external and financial environment," with little risk of its easy monetary policy fuelling bubbles for now.

"Risks of dangerous asset price booms and busts materializing in the euro area are limited, not least as asset price developments have not been accompanied by elevated credit growth," it said.

BLOOMBERG