"Low interest rates pose risks to financial stability as they squeeze banks' and insurers' earnings," warned Bundesbank Deputy President Claudia Buch and Executive Board member Andreas Dombret at the press conference to unveil the Bundesbank's 2015 Financial Stability Review in Frankfurt am Main. According to the Bank's new publication, the longer interest rates stay low, the more incentive market participants have to incur increased risk. It goes on to say that problems arise when market players lack sufficient capital buffers to cushion these risks. Professor Buch said: "We have to meet these challenges in order to avoid a medium-term trade-off between monetary policy and financial stability." Otherwise, she explained, the attendant build-up of risks to financial stability might prompt monetary policymakers to put off the warranted normalisation measures for too long - the precise effect of which would be to cause further risks to accumulate.

Banks are more resilient

The impact of the low-interest-rate environment on the German banking system's earnings and stability has been limited so far, the Financial Stability Review states. "Institutions have strengthened their resilience in the past few years," said Mr Dombret, the Bundesbank Executive Board member responsible for banking supervision. He added that banks have continued to increase their capital and reduced their leverage ratio. The tier 1 capital ratio of the German banking system as a whole rose by 0.6 percentage point between June 2014 and June 2015, and currently stands at 15.6%, he noted. At the beginning of 2008, the year the global financial crisis took hold, the tier 1 capital ratio in Germany averaged around 9.1%. Mr Dombret went on to say that the banks' leverage ratio has likewise declined further. To fulfil the minimum leverage ratio requirement under the Basel III regime, eight of the major German banks would now have to raise a combined total of less than €1 billion of additional tier 1 capital, he pointed out. The corresponding figure at the end of 2013 was around €18.5 billion.

Mr Dombret emphasised that, in order to safeguard resilience on a sustained basis, however, banks would also need to be sustainably profitable. International comparison shows that German banks are suffering from persistent low earnings, he explained. Although the low-interest-rate environment is not yet making itself felt in this regard, he warned: "Looking to the medium to long-term future, small and medium-sized institutions, in particular, look set to feel the pinch." Mr Dombret stressed the continued importance in the current market setting of encouraging German institutions to cut their costs further and reduce their dependency on interest-rate business over the medium term.

Burdens for insurers

Speaking of the risks that low interest rates pose for insurers, Deputy President Buch warned that, in her view, given the persistent low-interest-rate environment, there is a danger that insurers' earnings will no longer be sufficient to meet their obligations. She pointed out that, although the Life Insurance Reform Act (Lebensversicherungsreformgesetz), which came into force in 2014, will curb the outflow of funds from insurance companies, thereby strengthening insurers' capital base, Bundesbank analyses indicate that this relief cannot offset the impact of the further drop in interest rates. However, insurers still have time to make the necessary adjustments to further boost their resilience, she said.

Growing importance of the shadow banking sector

The shadow banking sector, which includes the likes of hedge funds and money market funds, specialist exchange traders and asset managers, has gained in importance within the German financial sector. The Bundesbank’s Financial Stability Review states that areas of the shadow banking sector which had contributed to the financial crisis are currently dwindling in importance. These include securitisations, for instance. Other segments such as mutual funds have been experiencing particularly strong growth, Professor Buch reported, although she emphasised that mutual fund business is not an unregulated part of the financial system.

"Key metrics currently do not indicate an increase in risk in the shadow banking industry," she said, pointing out, however, that the size of some individual mutual funds could make them systemically important. "Not least for that reason we will continue to keep a close eye on the shadow banking sector and potential risks in the future," the Deputy President said.

Eurobonds through the back door

Mr Dombret said that he considered year one of European banking supervision a success. He went on to say that many of the items on the reform agenda of the Basel Committee, a body that draws up proposals for banking regulation, have been ticked off. Mr Dombret took a critical view of the plans for a European deposit guarantee scheme as unveiled by the European Commission on 24 November, commenting that, in his view, the groundwork for such a scheme has not yet been laid. To a large extent, it is still domestic fiscal and economic policymaking which determines the state of play in the banking system, he noted. As a case in point he mentioned corporate and personal insolvencies; these, he pointed out, are still regulated very differently across Europe. "Bearing this in mind, if a common deposit guarantee scheme were in place, the repercussions of flawed national policy decisions could be passed through to savers throughout the euro area," commented Mr Dombret. He warned that, in his view, a common deposit guarantee scheme would ultimately introduce Eurobonds through the back door and mutualise the risks of sovereign debt as long as banks continue to carry a large stock of sovereign bonds issued by their home country on their balance sheets.

Continued close monitoring of the housing market

The current risks to financial stability emanating from the housing market are rated by the Bundesbank as low. Professor Buch said that there are no indications of excessive property price developments in Germany, in spite of dynamic price developments in a number of regions. She explained that growth in mortgage lending is still moderate in the longer-term maturity segment, but added that, while the risk of a price correction accompanied by mass mortgage defaults is fairly small at present, developments still need to be monitored intensively. In this context, Professor Buch said that the German Financial Stability Committee recommended in June 2015 that the Federal Government create the legal basis to equip policymakers with macroprudential instruments capable of regulating housing loans. These recommendations include a cap on credit volume relative to property value and a cap on property buyers' debt servicing capacity relative to their income. "We could then nip any unwelcome developments in the bud," she concluded.