Persistently low interest rates and strong growth: risks might be underestimated

Germany’s economy has been expanding for eight consecutive years now. Enterprises and households alike can borrow cheaply, and market volatility is low. However, there is a danger that low interest rates and the favourable economic conditions in Germany might cause market participants to underestimate risks. Risks have built up, in particular, during the prolonged period of low interest rates – the valuations of many investments are very high, and the share of low-interest investments on the balance sheets of banks and insurers has risen steadily. "In this favourable environment, market participants have become more vulnerable to unexpected developments," said Claudia Buch, Vice-President of the Deutsche Bundesbank, at the presentation of the 2017 Financial Stability Review.

Risks can be mutually reinforcing in the financial system

Unforeseen developments such as an abrupt rise in interest rates or a continuation of the protracted period of low interest rates could hit the financial system hard. Negative developments such as these would affect a number of market participants. "Risks stemming from revaluations, changes in interest rates and credit losses could materialise simultaneously and reinforce each other," warned Ms Buch.

Dr Andreas Dombret, the Bundesbank Executive Board member responsible for banking supervision, presented the Financial Stability Review by stressing: "Above all, banks need to ready themselves to weather a hike in interest rates in good time," adding that "if interest rates rise, that will bolster the stability of the German financial system in the medium term; an unexpectedly rapid and strong increase, however, could hit it hard." The resilience of banks in Germany may be good overall, he noted, but cautioned that "we nonetheless continue to have our eye on the weak profitability at many German credit institutions, whose return on equity of 2.1% in 2016 puts them at the bottom end of the spectrum in Europe. This low level of profitability could increase the incentive to take on more risk in order to generate higher returns."

An unexpectedly long period of low interest rates, he explained, will put pressure on small and medium-sized banks as well as life insurers in particular, resulting in greater incentives to take more risks.

Resilience of the financial system might be overstated

Persistently low interest rates and upbeat economic conditions might tempt market participants to overrate their debt sustainability. The residential real estate market in particular is a highly important area for financial stability. Loans for house purchase account for half of German credit institutions’ total lending to the private sector and more than two-thirds of household debt. While the Bundesbank’s model calculations for 2016 indicate that residential real estate may be overvalued by between 15% and 30% in towns and cities, other indicators which have a bearing on risk assessment, such as credit growth and lending standards, are not showing any abnormal behaviour at present. Overall, the risks stemming from housing loans still appear to be limited. "Nonetheless," Ms Buch said, "there is a risk that loans might turn out to be unsustainable if interest rates rise or the lively pace of price growth goes into reverse, eroding the value of collateral." Mr Dombret echoed this remark by pointing to the findings of a stress test conducted as part of the Bundesbank’s low-interest-rate survey this year, explaining: "The risks that can arise in such a situation have a huge bearing on banks, which is why it is essential that they keep a close eye on them."

Structured evaluation of global financial market reforms

Numerous financial market reforms have been initiated since the onset of the global financial crisis. Now it is important to evaluate whether the implemented reforms are having the desired effects, the Financial Stability Review explains. The Financial Stability Board (FSB) devised a framework for the post-implementation evaluation of reforms during Germany’s G20 presidency. "A structured evaluation is the only way to shed light on the costs and benefits of the reforms to society," Ms Buch explained, adding that not all the costs debated in the public arena are in fact macroeconomic in nature. One declared aim of the reforms is to shield taxpayers from the costs associated with crises in future, and to instead ensure that they are shouldered by shareholders and creditors. Ms Buch went on to stress, however, that evaluation should not be used as an excuse to water down reforms or weaken the resilience of the financial system.