CRE valuations have fallen by about 10 per cent from their peak in June 2022 and equity valuations of European real estate groups continue to fall.6 In this context, the ESRB issued a Recommendation earlier this year to help address vulnerabilities in CRE markets.7 The sector is particularly vulnerable to lower growth, heightened inflation and higher interest rates. Rising vacancy rates result in lower income streams and lower property values. Lower collateral values and tighter financing conditions reduce CRE investors’ scope for refinancing existing debt and for taking out new loans. This, in turn, may force some investors to sell properties to meet maturing debt obligations and liquidity needs, even under stressed market conditions, thereby adding further downward pressure on prices. The cyclical vulnerabilities are compounded by adverse factors that relate to structural change. They include the impact of climate-related economic policies, the shift towards e-commerce and a greater demand for flexible office space to accommodate mobile and hybrid working models. And large falls in CRE prices could lead to spillovers on the financial system. Let me now turn to risks related to financial market corrections. This is important as all financial institutions, including banks and non-banks, interact in financial markets. Such asset price corrections and heightened volatility could be exacerbated by vulnerabilities in the non-bank financial sector. In fact, there have also been several episodes of market volatility in recent months that resulted in liquidity challenges for non-bank financial intermediaries.
On the positive side, the EU economy proved to be more resilient than expected in the face of the large negative terms-of-trade shock from Russia’s war in Ukraine and growth forecasts for 2023 were revised upwards. However, developments last autumn in the UK gilt market and, more recently, in the US and Swiss banking sectors remind us of the need to remain vigilant in regard to vulnerabilities in a challenging and rapidly changing macro-financial environment. In this context, let me explain the ESRB’s view on the key risks affecting the European Union’s financial sector. The aforementioned ESRB Warning set out four key risks to EU financial stability:3 • The challenging macroeconomic outlook coupled with elevated geopolitical tensions underscores the importance of a prudent management of credit, market and funding risks in the banking business. • An environment of still subdued growth prospects and elevated inflation may put firms' and households’ balance sheets under stress. • Vulnerabilities in the non-bank financial sector could trigger asset price corrections and amplify volatility. • System-wide cyber incidents remain a severe threat. The Warning has promoted a closer monitoring of risks by national and EU authorities that are members of the ESRB. Let me now offer an update of our current assessment. The EU banking sector remains strong in terms of its aggregate capital and liquidity position.