Although there is no consensus on a single definition, financial stability can be defined as a condition in which the financial system – which comprises financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalance without giving way to cumulative processes, which impair the allocation of savings to investment opportunities and the processing of payments in the economy.

Therefore, a strong and integrated financial system is essential to support the growth and resilience of the euro area real economy. It is therefore paramount to constantly assess and address the financial stability impacts of the economic environment.

The banking sector turmoil that happened in Spring 2023 in the United States and Switzerland is a powerful reminder of the speed with which underlying financial system vulnerabilities can be exposed. The European banking sector has shown remarkable resilience, but this resilience should not turn into complacency. Indeed, bank liquidity challenges could intensify, rolling over maturing bonds is pushing up banks’ market funding costs, while competition for deposits is likely to rise and translate into faster deposit repricing. Muted economic growth and signs of weakening credit quality pose downside risks to bank earnings.

Lasting zero – and even negative – interest rates implemented since the EU sovereign debt crisis (2011-2012) and until late 2021 have allowed businesses, states and leveraged investors to take on unreasonable debts, making them vulnerable to deteriorating economic and market conditions. In that regard, the rise in interest rates to tackle high inflation is calling into question the sustainability of sovereign and private debts, as well as resilience of the financial system to resist the challenges that come its way. Furthermore, elevated inflation means that central banks may have to keep policy rates higher in a way that stretches the capacity of borrowers to repay debt.

Additionally, the non-bank financial sector – investment funds, insurance companies, hedge funds… – has become increasingly important in recent years: credit granted by non-banks to euro area Non-Financial Corporates (NFCs) has gone from 15% to 26% of all credit granted by financial institutions between 2008 and late 2022. The growing role of non-banks is an opportunity to diversify the source of financing and can thereby help ensure a smooth provision of funding for the real economy, but it also brings about new risks and vulnerabilities (e.g., liquidity mismatches, synthetic leverage than can amplify shocks and create spillover risks for banks, stress episode as non-banks have insufficient preparedness to meet large demand for liquidity). Finally high levels of interconnectedness among Non-Bank Financial Institutions (NBFIs) and with traditional banks can also become an important amplification channel of financial stress.

Thus, strong policy responses and international cooperation are required to tackle the financial stability challenges posed by the recent crises, and to strengthen the system to better respond to upcoming ones.

This section considers the financial stability implications of the economic environment (characterized by inflation and low growth) on the banking and non-banking financial institutions, taking into account the financial vulnerabilities, including those related to financial market functioning, debt sustainability, and bank profitability.