Risks facing the financial system have increased, as inflation weighs on the global economy – Financial Stability Review

• Inflation, geopolitical risks and increased turbulence in markets weigh on the global economy
• Irish economy has proved resilient, but persistent inflation and higher interest rates pose challenges
• Irish banking system has also proved resilient to recent turbulence and has capacity to absorb potential future shocks
• Pockets of the non-bank financial intermediation sector could see existing vulnerabilities amplified
• The Countercyclical Capital Buffer (CCyB) will increase to 1.5 per cent

Risks to financial stability stemming from the rest of the world have increased, while the Irish economy has proved resilient to the inflationary shock so far, the Financial Stability Review published today (7 June 2023) by the Central Bank of Ireland shows.

The report outlines the Central Bank’s assessment of key risks facing the financial system, the resilience of the economy and financial system to adverse shocks, and policy actions to safeguard stability. 

The first Financial Stability Review of 2023 indicates: 

• Risks to the global economy remain elevated, stemming from high inflation and the necessary monetary policy response, a tightening of financial conditions and geopolitical fragmentation.
• Global markets remain vulnerable to shocks, as seen in recent turbulence in the global banking sector, and market volatility could be amplified by the behaviour of non-bank financial intermediaries.
• In Ireland, while many are stretched by the cost of living, households and businesses are proving resilient to the inflationary shock so far. A decade of prudent lending is supporting resilience to rising interest rates.
• Household financial stresses are expected to rise modestly based on the current outlook. However, the Irish economy remains vulnerable to the risk of persistent inflation and an economic slowdown, which could expose vulnerabilities.
• The Irish banking system has capacity to absorb potential future shocks, while profits are expected to remain higher due to the higher interest rate environment. To continue to build resilience, the Countercyclical Capital Buffer (CCyB) rate will increase from 1 to 1.5 per cent, effective from June 2024.
• Liquidity mismatches, leverage and interconnectedness are key potential sources of vulnerability in non-bank financial intermediaries (NBFI) which could be amplified by significant price movements.  Further progress is needed at a global level to strengthen the resilience of the NBFI sector.
• The Irish public finances entered this period from a position of strength but the concentration of corporate tax receipts among a small number of large companies continues to necessitate prudent fiscal planning.  

In his opening remarks, Governor Gabriel Makhlouf said a recurring theme of these Reviews in recent years has been the sheer level of uncertainty owing to the interlocking shocks of the pandemic, Russia’s war against Ukraine and the current inflationary episode alongside the speed with which these events have unfolded and transmitted across the globe.

He said: “The first half of this year has been no different. The global economy has been in an ongoing period of adjustment to these shocks.  Given inflation remains far too high, the ECB began the process of normalising its monetary policy in December 2021, including by raising interest rates last July. A range of signals from across the globe tell us that more work is needed from monetary policy in the short run.  Core inflation in particular has proved more stubborn than many would have predicted.”

Domestically, Governor Makhlouf said the Irish economy continued to surprise with its resilience, and growth forecasts have improved, but that we must remain mindful of the range of adverse outcomes that may materialise. “Rising interest rates have already had immediate effects in the commercial real estate market, and appear to be slowing the housing market in recent months,” he added.

The Governor acknowledged that while many households and businesses are experiencing challenges with the cost of living, at the system-wide level, lower levels of indebtedness, household income growth and robust employment remain a key source of strength. He said: “They are supporting mortgage repayment capacity, and are of course a key determinant of the revenues of local businesses. Our assessment is that, if the economy continues to evolve in line with our expectations, we are likely to see only modest increases in financial stress among domestic borrowers, despite clear challenges for some groups of borrowers.”

The Governor said the failures of banks on both sides of the Atlantic have provided another example of the speed with which risks can materialise. He outlined how Irish banks are in a very different situation and that banking reforms introduced since 2008 have built resilience. In his assessment of Irish banks, the Governor said that while some borrowers will face difficulties, higher levels of bank profitability are likely to continue. “Of course there are tail risks that we must continue to factor in and be ready to address. However, the banking system has ample headroom above regulatory requirements in both capital and liquidity, with very high levels of cash reserves.  All of these support the resilience of the sector.”

To continue building this resilience, the Governor announced the countercyclical capital buffer would increase from 1 to 1.5 per cent (effective from June 2024), which “ leaves us at the rate set out in our macroprudential strategy last June, above or below which we will move when we deem that cyclical risks are either particularly elevated, or particularly subdued.” The Central Bank also published a paper to inform stakeholders on the factors that will guide its judgement in ongoing quarterly reviews.

On mortgage measures, the Governor said the Central Bank is only beginning to see how the changes made to the framework late last year are operating in the context of broader mortgage and housing market developments. He said the Central Bank would continue to carry out detailed research and analysis on the measures.

Given the vulnerabilities in the non-bank financial sector in Ireland, and building on the announcement of macroprudential measures for Irish property funds last year, Governor Makhlouf said the Central Bank is continuing to work with international partners to develop and operationalise a macroprudential framework for the sector. To advance global discussion and progress in this area, Governor Makhlouf said the Central Bank will publish a discussion paper in the coming weeks on an approach to macroprudential policy for funds and will seek stakeholder feedback in the months ahead.