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KBD reports on Central Bank warning of Rising Financial System Risks Amid Inflation and Geopolitical Tensions

The Central Bank of Ireland’s Financial Stability Review for the first half of 2023 highlighted the growing risks to the global financial system due to rising inflation, geopolitical tensions, and market volatility. Kelly Bradshaw Dalton reports that the Central Bank warned that inflation, a tightening of financial conditions and geopolitical fragmentation are escalating threats to the global economy.

Global markets remain exposed to shocks, as illustrated by recent unrest in the global banking sector. There is concern that these effects could be further magnified by non-bank financial intermediaries. Despite these risks, the Irish economy and its banking system have demonstrated resilience. However, persistent inflation and higher interest rates pose significant challenges.

The Review mentioned that households and businesses in Ireland are weathering the inflationary shock fairly well so far, owing to a decade of prudent lending that supports resilience to rising interest rates. However, household financial stress is anticipated to increase modestly, with the economy at risk of persistent inflation and a potential slowdown.

The Irish banking system is considered to be well-equipped to handle possible future shocks. The report stated that bank profits are expected to stay high due to the elevated interest rate environment. To further fortify resilience, the Countercyclical Capital Buffer (CCyB) rate will be raised from 1 to 1.5 per cent, effective from June 2024.

The report also highlighted potential sources of vulnerability in non-bank financial intermediaries (NBFI), including liquidity mismatches, leverage and interconnectedness. Significant price movements could exacerbate these vulnerabilities, and therefore, global efforts are required to bolster the resilience of the NBFI sector.

Regarding public finances, Ireland started the current period from a strong position. However, the concentration of corporate tax receipts among a small number of large companies underscores the need for cautious fiscal planning.

Governor Gabriel Makhlouf emphasised the uncertainty faced by the global economy due to the interrelated shocks of the pandemic, Russia’s war against Ukraine, and the current inflationary surge. Makhlouf pointed out that the process of normalising monetary policy, started by the ECB in December 2021, needs to continue given persistent high inflation levels.

He also lauded the resilience of the Irish economy, indicating improved growth forecasts but cautioned about possible adverse outcomes. Makhlouf noted the immediate effects of rising interest rates in the commercial real estate market and a slowdown in the housing market in recent months.

Makhlouf further mentioned that Irish banks, due to banking reforms introduced since 2008, are better prepared for such scenarios. He noted that while some borrowers might face difficulties, higher bank profitability is likely to persist, and the banking system has ample capital and liquidity buffers to ensure resilience.

The Central Bank of Ireland announced an increase in the countercyclical capital buffer from 1 to 1.5 per cent, effective from June 2024, as a measure to enhance this resilience. The Bank also published a paper detailing the factors that will guide its judgement in ongoing quarterly reviews.

Governor Makhlouf revealed that the Central Bank is still observing the impact of the changes made to the mortgage framework last year in the context of broader mortgage and housing market developments. Given the vulnerabilities in the non-bank financial sector in Ireland, the Central Bank plans to work with international partners to develop a macroprudential framework for the sector, including publishing a discussion paper for stakeholder feedback.