Higher interest rates to combat inflation are "testing the resilience" of eurozone households and companies as credit conditions tighten, the European Central Bank said in a report published Wednesday.
"As we tighten monetary policy to reduce high inflation, this can reveal vulnerabilities in the financial system," ECB vice-president Luis de Guindos said in a statement accompanying the Financial Stability Review.
The ECB has hiked its key interest rates by an unprecedented 3.75 percentage points since last July in an attempt to bring down rapidly rising consumer prices in the 20-nation currency club.
Although economic conditions have "improved slightly" and energy prices have fallen, higher borrowing costs and stricter credit conditions "are testing the resilience of euro area firms, households and sovereigns", the twice-yearly report said.
Demand for new loans, especially mortgages, declined sharply in the first quarter of 2023, it found.
The current "correction" in real estate markets "could turn disorderly if higher mortgage rates increasingly reduced demand", the report warned.
Financial markets and investment funds were also "vulnerable to disorderly adjustments", it said, "particularly in the event of renewed recession fears".
Eurozone banks meanwhile had coped well with the turmoil caused by the failure of several US lenders and the forced takeover of Credit Suisse by UBS in March, the ECB said, largely thanks to their "strong capital and liquidity positions".
"These events have served as a powerful reminder of the importance of ensuring that banking system fundamentals are sound," de Guindos said.
The report however warned that banks "may need to set aside more funds to cover losses" amid signs of deteriorating loan portfolio quality, while reduced loan volumes because of higher interest rates could hit banks' profitability.
"The outlook for euro area financial stability remains fragile," the report said.
Eurozone inflation stood at seven percent in April, still well above the ECB's two-percent target. Another rate hike is expected in June.