FRANKFURT (Reuters) - The European Central Bank will increase scrutiny over how banks manage credit risk and diversify funding, it said on Monday while outlining its 2023 priorities as the euro zone heads into a likely recession and faces soaring borrowing costs.
The 19-country currency bloc is facing the double whammy of sky-high inflation and a sharp economic downturn, largely a fallout of Russia's war in Ukraine, which has forced the ECB to tighten financing conditions even as it exacerbates economic pain.
The ECB, which supervises more than 100 big banks in Europe, said it will now take a closer look at lenders exposed to the most vulnerable sectors, including energy and energy trading, and will also keep a close eye on residential mortgages and commercial real estate.
"Higher interest rates and a sluggish or possibly recessionary growth outlook may challenge the debt-servicing capacity of borrowers going forward," the ECB said in a statement.
A recent supervisory review also confirmed shortcomings in banks' risk controls, particularly in monitoring loans, classifying distressed borrowers and provisioning, the ECB said.
"This renders banks vulnerable to a sharp correction in some property markets, especially the residential real estate segment, given the price dynamics observed in recent years," the ECB said.
The ECB will conduct more targeted reviews at lenders in order to encourage "fair and timely" recognition of expected credit losses via higher provisions.
"Moreover, surging interest rates and higher construction costs are likely to negatively affect the commercial real estate market, especially the office sector, which is already reeling from the shift in work practices and search for quality arising from the pandemic," the supervisor said.
Another key risk to watch is how banks handle rising borrowing costs.
Lenders have borrowed more than 2 trillion euros ($2.11 trillion) worth of ultra cheap, multi-year funding from the ECB but that facility is now being wound down and lenders, who have handed back 800 billion euros of central bank cash, have to return to market funding.
This return may be more complicated as costs rise and investors' risk appetite declines, likely cutting into the profitability of the banks and challenging their ability to maintain liquidity and funding ratios, the ECB said.
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