The budding economic crises in a number of emerging countries, like Turkey and Argentina, illustrate that a sudden tightening of financial conditions constitutes one of the major risks to financial stability.
Financial conditions in the developed countries have remained accommodative to date, but a turnaround is possible in these countries, too. The trigger for such a turnaround may be a quicker than anticipated tightening of monetary policy in the United States, but it may also be further escalating trade tensions, or a hard Brexit. These developments are discussed in our Autumn 2018 Financial Stability Report (FSR), published today.
Accommodative financial conditions are fuelling vulnerabilities
Ten years after the crisis, financial conditions in most developed countries are accommodative. Prolonged accommodative financial conditions fuel financial stability risks, however, as they lessen the incentive to pay off debts and stimulate risk-seeking behaviour on the financial markets. If financial conditions were to tighten suddenly, debtors will be severely hit by rising financing costs and financial markets may experience sharp corrections, which may in turn translate into heavy losses in the investment portfolios of financial institutions.
Risks are already surfacing in a number of emerging countries
Particularly in emerging countries with large financial and macroeconomic imbalances, financial conditions have been tightening over the past few months. This has painfully revealed the vulnerabilities that have been building up over time, such as high corporate debts denominated in foreign currencies. All emerging countries may be faced with ongoing capital outflows if investor confidence deteriorates and investors at the same time do not differentiate between vulnerable and less vulnerable countries. In due course, a budding economic crisis in emerging countries may also hit the Dutch financial sector through direct exposures and negative confidence effects.
Rising real estate prices demand attention
Real estate markets in the Netherlands are running at full steam, especially in prime locations. House price rises are driven by the insufficient supply of homes, low interest rates and vigorous economic growth. Easing of the borrowing capacity relative to the borrower’s income is undesirable as this would only serve to fuel overheating in the market. In order to ease the pressure on house prices, the housing supply must be increased, particularly in the middle segment of the rental market. The price increases on the commercial real estate market are being driven mainly by the search for yield among investors. As a result, this market is more sensitive to a turnaround in sentiment. As vulnerabilities often build up in times of economic boom, financial institutions must pay extra attention to monitoring and managing the risks associated with commercial real estate in the period ahead.
Further efforts by insurers remain necessary
This issue of DNB's FSR also discusses the vulnerabilities in the Dutch insurance sector. Although insurers are making progress in developing a future-proof insurance sector, further efforts of insurers, supervisors, and policymakers remain necessary, including successful implementation of the recovery and resolution framework.
Disruptive energy transition stress test
DNB developed a targeted stress test in order to quantify the possible effects of a disruptive energy transition on the Dutch financial sector. The stress test revealed that a disruptive energy transition may induce severe losses for Dutch financial institutions. Governments can prevent unnecessary costs by implementing timely and effective climate policies, while financial institutions should include energy transition risks in their risk management process.