Low interest rates and low volatility raise market participants’ risk appetite. This harbours the risk of exaggerations. Although German banks’ deleveraging has been successful, their earnings are weak. The banking union is creating better conditions for the recovery and resolution of failed banks. The real estate market remains under observation, but mortgage loans are currently recording relatively moderate growth.

The international market environment has continued to be characterised by low interest rates and low volatility in 2014. "The longer the period of low interest rates lasts, the greater the risk of exaggerations in certain market segments," Professor Claudia M Buch, Deputy President of the Deutsche Bundesbank, said at today’s presentation of the 2014 Financial Stability Review. "Signs of an excessive search for yield are particularly evident in the corporate bond and syndicated loan markets," Buch stated.

As a general rule, German banks have been able to strengthen their capital positions over the past year by raising new equity and through profit retention. Both the European Central Bank’s comprehensive assessment and macro stress tests conducted by the Bundesbank show that German credit institutions could withstand large-scale burdens. "An isolated interest rate shock could be absorbed by German banks," said Dr Andreas Dombret, the Bundesbank’s Executive Board member responsible for banking supervision. But: Dombret went on to say that "A sharp and abrupt increase in short-term interest rates would leave a considerable dent in banks’ profit and loss accounts". Furthermore, the joint occurrence of several shocks could pose problems for the German financial sector. Dombret therefore sees a need for banks to improve their profitability. "In the long-term, German banks must earn more in order to be able to hold their own in the competitive environment." Banks should examine their business models and explore cost reduction potential and profit synergies.

The Bundesbank is still paying close attention to developments in the real estate market. Excessive – primarily credit-financed – price increases in the real estate markets have often triggered financial crises in the past. But: "So far, rising housing prices in Germany do not harbour excessive risks to financial stability," said Deputy President Claudia Buch. There are very few signs of procyclical behaviour by banks when granting housing loans. A destabilising nexus between lending activity and price developments has not been discernible to date. However, survey data indicate that the German ban­king system is structurally exposed to falling real estate prices and rising default rates. "We are keeping a very close eye on the real estate market. As soon as we detect risks to the financial system, we will act," said Buch.

The banking union is an important step towards improving how risks are dealt with. The Single Supervisory Mechanism (SSM) is able to apply stringent and uniform supervisory standards and practices, as well as draw cross-border comparisons. When the Single Resolution Mechanism (SRM) is launched, the banking union will improve the conditions for the recovery and resolution of failed banks. Buch explained that "The guiding principle of the new rules is the bail-in tool". In future, shareholders and creditors will, as a general rule, be bailed into the costs of bank restructuring. The private sector would thus also assume responsibility for any future risks it incurs that materialise. "The new rules must now be applied rigorously," stated Buch. "In particular, it should only be possible to deviate from the bail-in principle in very exceptional cases".

However, even the banking union cannot completely sever the close risk nexus between the banking system and sovereigns. This is because regulation still gives preferential treatment to sovereign exposures. "The sovereign debt crisis has shown that the mutual dependence that exists between banks and sovereigns destabilises the financial system," said Buch. Thus, the preferential treatment given to sovereign exposures in financial market regulation needs to be abolished in the medium to long term. "In order to permanently reduce the risk of contagion between banks and sovereigns, our rules and regulations need to stop giving preferential treatment to government securities," explained Buch. Therefore, in its 2014 Financial Stability Review, the Bundesbank calls for sovereign exposures to be adequately backed by capital, large exposure limits to also apply to sovereign exposures, and the liquidity regulations to classify government bonds as they actually are.