To evaluate forecasts it is necessary to understand what these forecasts are based on. Solely model-based forecasts mean, for instance, that there is only one interest rate, linear relationships, that the household sector is represented by one household and that imperfections in the financial markets are not picked up. The fact that there is only one interest rate means, for instance, that the effects of unusually low long-term real interest rates are not included. The fact that the relationships are linear means, for instance, that the model will never be able to forecast abrupt falls in demand following a shock. So how should a central bank judge whether there is a risk that lending and asset prices are increasing too quickly if the inflation forecasts provide no signals of this? What one wishes to avoid are abrupt corrections in asset prices leading to a large fall in demand and low inflation in the future. Although it is possible to extend the forecast horizon, as the DSGE models are based on rationality, they provide no opportunity to quantify such a risk scenario or to answer the question of whether an interest rate increase now would be able to reduce imbalances. The central bank must nevertheless make decisions and in some way take into account the risks it envisages.
The non-performing loan ratio has continued its downward trend and stands at 11.2  3/4  BIS - Central bankers' speeches  percent as at June 2022, with total non-performing loans amounting to € billion, which is the lowest level observed since 2014 when the definition was harmonised across the European Union. So far the first round effects from the geopolitical crisis have been manageable and of limited direct extend. Nevertheless, the second round effects are yet to be materialised. Adverse macroeconomic developments may weaken banks' profitability and deteriorate asset quality, causing delinquencies and an upward pressure on impairments and provisions. It is therefore important for banks to adapt their business models to the new realities as shaped by the consecutive crises. Challenges emerge through various channels. Intense competition, from entities not falling in the traditional banking spectrum, threat of additional provisions due to increased credit risk, the need to invest in digitalisation to streamline operations, and the costs of managing climate change and the transition towards a sustainable greener economy are among the challenges that the Cyprus banking sector faces. It is important to say that these challenges are not country specific to the banking system of Cyprus. They are challenges that are commonly faced by European banks. Especially the issues of digital transformation together with the management of climate risks and the transition to a green economy are key issues that should be on top of the agendas' of European economies and banks. They surely are on the top of the supervisory agenda.