Vulnerabilities have been rising for EU corporations and further stress could impair their ability to make payments on their debt. Energy-intensive sectors, companies exposed to real estate, and firms with high debt levels seem particularly vulnerable given the pressures on interest rates, energy prices, and the real estate market.

 If house prices fall and the labor market weakens, the financial situation of European households could deteriorate rapidly, potentially enough to become a threat to financial stability.

The European Systemic Risk Board (ESRB) – which was created in 2010 to oversee the financial system of the European Union – is sounding an unprecedented warning, cautioning about the rising risks to financial stability in the eurozone. They have outlined 4 other elevated threats:

Residential real estate: years of soaring home prices and mortgage lending growth have made the housing market vulnerable to a fall in real household income.

Commercial real estate: profit margins in commercial real estate are particularly thin in Europe, making the sector vulnerable to rising financing and construction costs.

Cyber risks: big cyber attacks could disrupt the functioning of markets.

Sovereign debt dynamics: rising interest rates and foreign exchange rate risks make it harder for countries to make payments on their already high debt loads.

A sharp fall in asset prices might amplify market volatility and cause liquidity issues.

Challenging macroeconomic conditions could lead to sharp moves in asset prices. This could threaten financial stability in at least three important ways. First, today’s thin liquidity in some markets (mostly bond markets but also others) could exacerbate price moves. Second, levered financial players like asset managers, insurance companies, and hedge funds could be forced to fire-sell their assets to meet big margin calls. Falling prices could lead to a vicious cycle of more margin calls, more selling pressure, and lower prices. Third, since those non-bank financial intermediaries are tightly linked, stress could spread rapidly, magnifying those shocks.

The real problem could come from non-bank financial intermediaries, like hedge funds, pension funds, and asset managers. Those less-regulated entities tend to be highly levered, hold riskier and less liquid assets, and rely on riskier short-term funding, making them vulnerable to challenging market conditions. Since they’re now at the core of the financial system (and are now 80% of the size of the total European banking sector), stress for those intermediaries could represent a big threat to financial stability.

However, unlike the period before 2008-2009 financial crisis, the euro area now has new tools at its disposal, aimed at smoothing out the impact of ECB actions – like interest rate changes and bond buying programs – across all 27 countries. All that should provide an additional buffer against shocks and limit the risks to the financial system.

Vulnerabilities tend to pop up in unexpected places. For instance, almost no one expected that liability-driven instruments (LDIs), which have been popular in the UK for helping pension funds meet their future payout obligations, would create such a crisis for the country when interest rates surged.

As geopolitical tensions remain, as central banks keep hiking rates to fight off inflation, and as key sectors like housing slow, a true “tail-risk” event, where markets experience extreme moves, recession becomes more likely.