LONDON (Reuters) - Low interest rates that have forced investors to pile into riskier assets in the hunt for yield pose the biggest risk to financial stability at present, top banking regulators in Europe said at this week's Reuters Regulation Summit.
Already historically low interest rates have been pressured further by the European Central Bank's 1 trillion-euro ($1.1 trillion) bond buying spree.
This followed similar quantitative easing (QE) programs in the United States and Britain, prompting investors to scour markets for higher returns anywhere they can find them.
"Investors are looking for yield so they go for products which are more risky or with longer maturities or which are more illiquid," Steven Maijoor, chairman of the European Securities and Markets Authority, said at the Summit.
It is raising risks for asset managers and the rest of the non-banking sector, such as insurers and hedge funds, as they hunt for yield in riskier investments, including lending.
That has raised red flags for banking regulators.
"We need to take care of the spillover risk bouncing back onto banks," said Isabelle Vaillant, director of regulation at the European Banking Authority, the continent's banking watchdog, who said there was a danger of asset bubbles forming.
A sharp rise in bond yields led by German bunds in recent weeks has added to fears bond and equity markets are overvalued.
There are concerns of even bigger market shocks, such as herds of investors dumping bonds at the same time when central banks start to wind down their QE programs.
Market instability could be exacerbated in areas including corporate bonds and high yield or leveraged loans, where banks have reduced their market making, potentially creating some illiquid markets which would be unable to cope with sudden heavy selling.
"For all banks the low interest rate environment is a challenge," said Elke Koenig, head of the Single Resolution Board, the body set up this year to deal with eurozone banks that fail. "It makes me concerned that with a low interest rate environment you might, in the search for yield, get out of your comfort zone.
"As a former supervisor I'm very mindful that's a logical risk in this environment," said Koenig, who previously headed German regulator Bafin.
Her successor at Bafin, Felix Hufeld, said this week German insurers may struggle to meet new EU capital requirements as low interest rates weigh on the sector.
But there is little appetite so far among regulators to take pre-emptive action, said David Wright, secretary-general of the International Organization of Securities Commissions, a global umbrella body for market regulators.
"Interest rates are low because economic activity has been low and interest rates will change as economic activity picks up. What can you do about that?
"Of course there are regulatory spillovers and we have to be attentive to that. Everybody is looking for yield, but risk is inherent in capital markets," he said at the Summit.
Editing by Greg Mahlich