Higher interest rates challenging highly indebted companies and households

In view of the recent publication of Riksbank’s Financial Stability Report 2023:2, the Central Bank has released an accompanying press statement in which it informs of the key risks identified for financial market stability during its latest assessment. According to the report and the enclosed press release, the following key issues may pose (significant) risks to market stability:
(1) Impact of higher interest rates and geopolitical tensions: The report emphasizes the potential impact of consistently high interest rates and geopolitical tensions on inflation, economic outlook, and financial market turbulence. Specifically, Riksbank notes that although there’s been a decrease in inflation overall, the level remains high. Thus, the Central Bank sees no short way out from high interest rates to cut inflationary pressures which brings about various risks to a large number of market participants (see point (2) and (3) below).
Furthermore, the ongoing geopolitical tensions, particularly events like Russia’s invasion of Ukraine and conflicts in the Middle East, are seen as factors that could influence the economic outlook. These tensions have the potential to create turbulence in financial markets, affecting inflation rates, and economic activities. The outcome remains uncertain, and Riksbank emphasizes that such global tensions could have repercussions for various economies, including Sweden’s.
(2) Vulnerabilities in the property sector: The financial stability assessment reveals ongoing vulnerabilities in the property sector due to increased funding costs and decreased property values. Riksbank warns in this context that these vulnerabilities may lead to financial risks for property companies and particularly banks primarily funding mortgages. In fact, as fixed-interest loans mature and corporate bonds need to be (re)issued to fund property development projects, funding costs may continue to rise for property companies, potentially leading to more firms encountering financial difficulties. It’s crucial, so Riksbank, for these companies to minimize their financial risks. On the other hand, financial institutions are expected to balance these risks by providing needed funding to viable companies while insisting on firms to take adequate measures to mitigate their financial risks.
(3) Household indebtedness and interest rate sensitivity: The latest assessment revealed that more and more households are affected by rising interest rates primarily due to the running out of fixed-interest loans for mortgages and corresponding re-financing needs at high rates. Coupled with increased consumer prices, these increased interest expenditure are likely to cause potential payment issues for consumers, particularly, if the labor market should worsen. Again, this may have significant impacts on loan portfolios of lending institutions.
(4) Banking system resilience: Riksbank acknowledges the resilience of major banks in coping with economic challenges. So far, loan losses are moderate and the capital base of institutions is well beyond what is needed. However, institutions are well advised to adjust their loan loss provisions to take into account increasing risks in consumer and corporate lending. Furthermore, institutions may be impacted by „potential confidence effects“, whereby customers could loose confidence in the economy and the financial market, leading to a loss of confidence in the banking system. This, in turn, could affect banks‘ funding conditions, impacting their ability and willingness to provide credit.
(5) Global (missing) regulatory standards for banks: In view of the recent banking problems in the U.S. and Switzerland which showed the need for evaluating and potentially modifying global regulatory standards for banks, Riksbank sees an increased risk for continuous bank failures, if Basel III is not fully implemented by all institutions around the globe. Also, it is necessary to address the lack of a macroprudential policy framework for non-banking financial institutions, particularly those deemed to be systemically relevant, as a failure of such institutions could have serious impacts on financial stability worldwide.
(6) Corporate bond market issues: As past experience has shown, liquidity in the corporate bonk market is a key constraint, particularly during times of market stress. This risk continues to exist until an adequate corporate bond standard is established facilitating transparency and liquidity in the market. Furthermore, credit rating agencies have been slow in adjusting the ratings of bond issuers in accordance with the financial risks such issuers pose. Such delay causes vulnerability in the financial market and potentially leads to loss of trust and investment.
To improve liquidity in the corporate bond market, fund managers must actively manage liquidity risks in corporate bond funds. They should increase the proportion of liquid assets, especially in stressful market conditions, or impose restrictions on redemptions for investors, if so needed. Educating investors about the limitations of liquidity under various market conditions is also crucial to maintain investor trust and market confidence. Furthermore, Riksbank strongly urges fund managers to introduce liquidity management tools, such as swing pricing, which is now permitted in Swedish fund legislation.
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Overall, while the financial market seems to be robust, firms need to be vigilant to the high risks of inflation, interest rates, and a potential subsequent economic downturn. Moreover, the geopolitical tensions in the middle-east and Russia’s war against Ukraine could pose further risks which need to be carefully monitored.