DNB financial stability report warns of bubbles and market corrections

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The combination of growing confidence in financial markets combined with the search for yield has to a growing risk of asset price bubbles and market correction, Dutch central bank De Nederlandsche Bank (DNB) warned in its latest financial stability report.

According to DNB, financial market sentiments are increasingly positive, with unconventional monetary policy such as quantitative easing and TLTRO’s providing liquidity, while low returns on bonds have created incentives to take greater risks.

The results of the European banking supervision, and the planned European banking union as of 2015 have, according to DNB led to an improved assessment of the European banking sector.

Highlighting the growth of debt to GDP ratios in the Netherlands and using the Hodrick Prescott filter, DNB argues for a reduction of loan to value rations in order to reduce the risks of defaults.

The DNB report also stresses the growing divergence between price earnings ratios of high yield companies compared to their fundamentals, suggesting that asset classes such as high yield, corporate bonds, European government bonds and US equities may be overvalued.

In addition, DNB argues that the low level of liquidity in secondary bond markets as a result of higher capital requirements has affected the ability of banks to respond to market corrections and could have an aggravating effect in the event of another crisis. According to DNB, this is reinforced by the emergence of ETF’s which due to their short term horizon are often particularly susceptible to capital outflows.

DNB concludes that increased risk levels illustrate the importance of structural reforms to complement ECB measures, in addition to micro surveillance and stress tests.

The full report, published in Dutch, can be accessed here.

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