Higher interest rates and inflation, weak growth and geopolitical uncertainty are set to test the resilience of households, firms and governments in the coming months, according to the latest ECB's latest Financial Stability Outlook, with the full impact of tighter financial conditions on the euro area economy yet to be felt.

Euro area banks have seen improved profitability from rising interest rates, with some monetary policymakers favouring a reduction in the amount of money the ECB pays to remunerate excess cash reserves, the report notes. Banks also face headwinds from higher funding costs, worsening asset quality and lower lending volumes as credit demand shrinks, while financial markets remain exposed to risks from adverse macro-financial and geopolitical developments.

“The weak economic outlook along with the consequences of high inflation are straining the ability of people, firms and governments to service their debt,” ECB Vice-President Luis de Guindos said. “It is critical that we remain vigilant as the economy transitions to an environment of higher interest rates coupled with growing uncertainties and geopolitical tensions.”