iStock

The financial sector should brace for the risk of further market corrections that could constrict liquidity and erode profits and capital, European regulators are warning.

The European Supervisory Authorities (ESAs) — which include banking, insurance, pension and securities regulators — issued their first risk assessment report since the onset of the Covid-19 pandemic on Tuesday, highlighting the effects of the crisis on financial sector profits and investment fund liquidity.

“Valuation, liquidity, credit and solvency risks have increased across the board,” the report said, adding that the investment fund industry saw a “significant deterioration” in liquidity in some asset classes, along with “substantial outflows” from investors.

Looking ahead, the report warned that the prolonged ultra-low interest rate environment will weigh on the future profitability and solvency of financial institutions.

“While low interest rates are important to support economic activity, they negatively impact bank profitability and remain the main risk for the life insurance and pension fund sector,” the report said, adding that low rates also increase valuation risks in securities markets as investors search for higher yields.

The report also indicated that the medium- and long-term economic consequences of the pandemic remain very unsettled, leaving financial markets “fragile.”

“Given the high uncertainty regarding economic and market developments, financial institutions should be prepared for possible further market corrections and deterioration in financial market liquidity,” the report said.

The ESAs called on both financial institutions and regulators to carry out stress testing to assess potential shock scenarios. For the investment fund sector, they recommended particular attention to liquidity management.

The deterioration of bank asset quality is likely to be another key challenge in the years ahead, the ESAs said, as lenders have high exposures to the sectors most affected by the pandemic.

“Banks are likely to face deteriorating asset quality with growing volumes of non-performing loans and rising cost of risk amid the prospective macroeconomic deterioration,” the report said.

Against this backdrop, it’s critical that the financial sector remains well-capitalized, the report said. It suggested that banks make use of their capital and liquidity buffers to absorb losses, enabling continued lending to the economy.

Finally, the report also highlighted the rising operational risks posed by the sector’s increased reliance on technology to cope with the disruptive effects of the pandemic. It called on financial institutions and their service providers to ensure data security, business continuity and that they are prepared to face increasingly sophisticated cyber threats.

“Institutions should also pay particular attention to a growing number and new forms of financial crime in this period of large economic turmoil,” the report said.