Financial system faces rising risks, warn European supervisors

Some of Europe's most important financial supervisors have warned that risks to the EU's financial system have become more entrenched, despite signs that the eurozone is experiencing its best growth spurt for years.

A combination of cheap oil, the weak euro and more aggressive monetary easing by the European Central Bank has spurred hopes of higher growth in the single currency area in 2015. However, monetary policy makers' shift towards policies such as quantitative easing and negative interest rates has also led investors to take on more risk as ultra-low interest rates ate into their profits, according to the report by the Joint Committee of the European Supervisory Authorities.

The committee - which includes the European Banking Authority, as well as regulators of securities and markets and pensions and insurance - said this search for yield had heightened the threat of instability once the ECB eventually started to raise rates.

The ECB's forecasts imply the central bank may have to start to hike interest rates in 2017, though markets expect rates to remain at their current record-low levels for longer than that.

The committee's report covers the period between September 2014 and March 2015 when the yield on hundreds of billions of euros' worth of government bonds turned negative. When yields turn negative, investors in effect pay for the privilege of holding a government's debt, should they hold the bond to maturity.

Since March, yields on some of the safest government bonds have risen. Yields on German Bunds have leapt in recent weeks, sparking concerns of a volatile sell-off.

The report said: "Persistently low interest rates have sustained the demand for riskier investments and provided investors with incentives for enhancing their portfolio returns. This is frequently achieved by renewed build-up of leverage and an extension of portfolio maturities." The build-up of leverage, which usually involves taking on higher levels of debt, was concentrated on financial institutions other than banks.

The increased sensitivity of investors to yields in turn created a higher chance of price fluctuations, with market players shifting into different asset classes, producing bubbles in the process. "Given the low relative performance of growth rates, savers turn to bubbles to reach their return targets. Over time, productive investments are crowded out, as real resources are misdirected."

While recent data have pointed to a stronger economic recovery in the currency area, the regulators' report underlined how threats to the economic outlook remain strong. The conflict in eastern Ukraine and uncertainty surrounding Greece's continued membership of the euro are cited as two possible triggers of market panic.

It said: "Geopolitical and macroeconomic developments in Ukraine and Russia elevate the risk of instability in the region, and current economic and financial uncertainties regarding the negotiations over the long-term trajectory of the Greek fiscal position could lead to further instability and may affect sovereign bond markets."

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