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The still-rampant Covid-19 outbreak is intensifying corporate vulnerabilities and could threaten the resilience of banks, warns the European Central Bank (ECB).

In its latest review of financial stability, the ECB said it sees increasing challenges for both banks and companies due to the effects of the ongoing pandemic.

“The sharp rise in corporate and sovereign indebtedness increases the risks to financial stability from an emerging sovereign-corporate bank nexus in the medium-term, as banks and sovereigns alike are exposed to pandemic-induced risk faced by euro area firms,” the central bank said.

Given these risks, the ECB warned against dialling down fiscal supports to both businesses and households that are grappling with the economic effects of the pandemic.

“Premature withdrawal of fiscal support – including government loan guarantees and statutory loan moratoria – could set back the economic recovery, transforming the corporate liquidity challenges observed at the outset of the pandemic turn into solvency issues,” it warned.

While banks began the pandemic with stronger balance sheets than they did the global financial crisis in 2008, the ECB said that removing government supports could lead to an additional wave of losses.

The central bank added that institutions will see ongoing pressures on profitability, “including from a weaker outlook for lending and continued structural challenges.”

“Bank profitability is expected to remain weak. Provisions have increased but look optimistic in some cases, while guarantees and moratoria may have lengthened the time it takes for weak economic performance to translate into loan losses,” said Luis de Guindos, vice president of the ECB.

“Government support schemes are essential currently but should remain targeted towards pandemic-related economic support and avoid giving rise to debt sustainability concerns in the medium term,” he added.

Alongside the challenges facing banks, the ECB said increased risk-taking by non-banks, including investment funds, “also increases their vulnerability to outflows and losses should corporate credit risks rise materially.”

Persistent gaps in the oversight of the non-bank sector aggravates these risks, it noted.

At this point, banks’ capital buffers remain “comfortable”, the ECB said, adding that such buffers should be adequate to “absorb losses and support lending for an extended period.”

Regulators need to ensure their policies to support banks’ use of their capital buffers, and to prevent deleveraging, are working as intended, the central bank noted.

“Looking beyond the pandemic, it is important for banks, together with the rest of the financial system, to manage the financial stability risks posed by climate change and support the transition to a greener economy,” the ECB concluded.