On September 11, the Joint Committee of the European Supervisory Authorities (ESAs) published a report on risks and vulnerabilities in the EU financial system, which sets out recommendations for policy action.

The report highlights the following risks as potential sources of instability:

• Abrupt yield increases could generate substantive asset price volatility and lead to losses across asset classes;
• Repricing of risk premia and potentially increasing interest rates could affect financial institutions and may bring with them a risk of contagion between different sectors; and
• Uncertainties around the terms of the UK’s withdrawal from the European Union and the need to prepare for a no-deal scenario, as well as trade policy uncertainties and wider geo-political risks.

In light of the ongoing risks and uncertainties, the ESAs recommend the following policy actions by financial institutions and by EU and national competent authorities:

• Stress tests. Against the backdrop of rising interest rates and the potential for sudden risk premia reversals, it remains crucial to conduct and develop further stress test exercises across all sectors.
• Risk appetite. Supervisory authorities need to pay continued attention to the risk appetite of all market participants. Banks should accelerate addressing their stocks of non-performing loans and adapt business models to sustainably improve profitability, and financial institutions need to carefully manage their interest rate risk.
• Contagion risks. Macro and micro prudential authorities should contribute to addressing possible contagion risks, including continuing their efforts in monitoring lending standards and asset quality.
• Brexit. It is essential that EU financial institutions and their counterparties, as well as investors and retail consumers, plan appropriate mitigating actions to prepare for the UK’s withdrawal from the European Union.

The report is available here.