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ECB Worried About Fed-Driven Crash

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It’s usually a Jeremy Grantham or John Hussman from whom one expects a gloom and doom report on the economy and investing, whereas a central bank like the Fed seeks to calm investors with soothing references to “financial market stability,” ascribing negative developments to “transitory factors.”

But the Fed’s transatlantic cousin, the European Central Bank, has just issued its biannual Financial Stability Review, and despite the soothing name, the report has plenty of fodder for the investment industry’s professional worrywarts.

Weighing in at 173 pages, the tome starts off promisingly enough with the placid assurance that Eurozone financial conditions have been calm over the past half year.

That may be the calm before the storm, however, as the document goes on to describe a series of systemwide vulnerabilities contained within — or perhaps triggered by — an essentially dichotomous risk environment, which the ECB puts thusly:

“In sharp contrast to the rise in financial risk-taking, economic risk-taking in the euro area is clearly lagging. This is vividly illustrated by the contrast between appreciating financial asset prices and a low level of real investment, which still remains below that of 2008, after a much more marked fall than those seen after previous recessions.”

In other words, asset prices are rising sharply, even though the economic fundamentals lag, leading to a “medium-level systemic risk” that would ensue from an “abrupt reversal” in global asset prices.

The ECB sees two main potential triggers for the reversal, and interestingly a Greek debt default isn’t one of them. (Indeed, the impact of prolonged negotiations over Greece was largely contained, triggering “only minor volatility in sovereign yields.”)

Rather, European central bankers worry most of all about their American colleagues:

“In particular, a faster than expected withdrawal of U.S. monetary policy accommodation harbors some potential to translate into higher risk premia, even in the euro area,” says the report.

Trigger No. 2 relates to “geopolitical tensions and emerging market risks, notably related to the BRIC countries (Brazil, Russia, India and China) that had operated as a key driver of global economic growth in the last few years.”

To get a picture of what these risks look like, here’s the scenario the ECB has used in its stress-testing of European financial institutions:

“A negative confidence and stock price-driven shock emanating from the United States is assumed. Simultaneously, adverse effects are assumed to materialise in major emerging markets, namely a financial market shock accompanied by a slowdown of potential GDP growth. These shocks, in turn, would lead to a recession in the United States and a sharp slowdown in key emerging market economies, and would – via trade and confidence spillovers – have negative implications for the global economic outlook. This effect also includes the impact of derived increases in oil and other commodity prices. In addition, the reversal of the search for yield is assumed to lead to a marked worldwide increase in corporate bond spreads from their current low levels.” A second medium-level systemic risk the report addresses is “weak profitability prospects for banks and insurers in a low nominal growth environment, amid slow progress in resolving problem assets.”

This brings us back to that dichotomy between a hot market and cold economy. The economic recovery is described as “still fragile” even seven years after the height of the global financial crisis, and has magnified another dichotomy in Europe’s banking sector.

Namely, banks in stronger European countries, while not as strong as their U.S. counterparts, have turned the corner since the crisis and continue to improve, while “in more vulnerable countries, the stock of [nonperforming loans] remained high during the crisis, and a clear cyclical turning point has not yet been reached.”

What’s more, the low-interest rate environment that has prevailed since the financial crisis has made it tough for insurance companies to remain profitable. Most affected are “life insurers that have locked in high return guarantees and have large asset/liability duration gaps.”

The ECB report identifies a third lower-level “potential systemic risk” regarding the sustainability of sovereign and corporate debt amid persistent low growth.

Here “unexpected developments in Greece” could be the trigger for systemic crisis, as could continued low growth or a sudden growth slowdown. “Benign financial market conditions” could also precipitate crisis if they “obscure the urgency of fiscal and structural reforms.”

The ECB identifies a rapidly growing shadow banking sector as the fourth and final potential systemic risk. Though this risk is seen has having less impact than a reversal in asset prices, the ECB views shadow banking contagion vulnerability to have increased the most since its previous November report.

While banks have muddled along since the financial crisis, the investment fund sector has shot up more than 70% from 2009 to 2014. The ECB worries about “amplification effects” of this growing sector’s response to triggers such as an asset price reversal.

Specifically, the ECB worries about large-scale outflows from investment funds aggravated by asset managers seeking first-mover advantages or forced to redeem shares. Warns the ECB:

“So-called liquidity spirals could be triggered if funds were to be confronted with high redemptions or increased margin requirements, as these could result in forced selling on markets with low liquidity. With these liquidity conditions, initial asset price adjustments would be amplified, triggering further redemptions and margin calls, thereby fuelling such negative liquidity spirals.”

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