ECB warns debt, non-bank growth could constrain monetary policy

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ECB debt, non-bank policy risk

Highlights

ECB's Schnabel warns higher interest rates increase risks of unsustainable government debt, particularly in vulnerable countries like France.
Fast-growing non-bank holdings of public debt, especially by leveraged hedge funds, heighten market volatility and transmission speed of ECB rate moves, risking forced bond sales.
Schnabel urges stricter oversight of non-banks and calls for broader institutional reforms in Europe as public debt interest rates now exceed economic growth.

Warnings on policy transmission and market stability

As reported by Reuters, Schnabel says the ECB is raising interest rates to fight excessive inflation, but higher borrowing costs are also fuelling concerns that some government budgets could become unsustainable, especially in more vulnerable countries such as France.

She says public debt has expanded sharply since the start of the century, while a growing share of that debt is now held by non-banks, including hedge funds that may be highly leveraged. In her speech in Frankfurt, Schnabel warns that this shift means ECB rate moves are transmitted more quickly through markets, potentially increasing volatility and triggering bond sales if falling collateral values and rising margin calls pressure leveraged investors.

Schnabel says central banks may then be forced to stabilise markets to stop a liquidity crisis from becoming a broader credit crisis. Such action, she argues, can interfere with a central bank's mandate and weaken monetary dominance.

Regulatory and fiscal implications for Europe

Schnabel says Europe should resist pressure to deregulate banks and instead strengthen oversight of non-bank financial institutions, including hedge funds, investment funds and insurers.

She adds that tougher rules for non-banks would also strengthen the case for giving them access to central bank facilities, which could support systemic stability. Schnabel is leaving the ECB in January for a senior role at the IMF.

She says the harder challenge may be restoring sound public finances, because the effective interest rate governments pay on their debt is now above economic growth. In her view, that strengthens the case for broader institutional reforms in Europe that could help reverse the decline in potential growth over time.

Our earlier article on Mario Draghi’s warning about the debt-and-inflation trade-off outlined how keeping interest rates above economic growth can worsen public debt dynamics and raise the risk of “fiscal dominance.” He argued that central banks should prioritise bringing inflation under control while keeping rates no higher than necessary, to avoid suppressing productive investment and long-term growth. The piece also noted that clearer policy communication and complementary EU-level measures—such as deeper market integration and targeted investment support—can help limit the growth damage from restrictive monetary policy.

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