Stability of the German financial system improved – focus now on European sovereign debt crisis and medium-term risks from protracted low-interest rate environment

More than three years after its onset, the financial crisis is far from being resolved. The outbreak of the European sovereign debt crisis in May of this year was the most serious challenge to financial stability in 2010. To overcome the current crisis, confidence in the sustainability of public finances in all euroarea countries has to be regained and, as far as possible, lastingly secured. But medium-term risks arising from a potentially protracted phase of low interest rates are likewise increasingly coming under the spotlight.

The Bundesbank’s Financial Stability Review 2010 concludes that, in this environment, the German banking system is now in better shape. “The stability of the German banking system has improved; banks are currently being buoyed by the favourable economic trend in Germany” said Bundesbank Executive Board member Dr Andreas Dombret at today’s presentation of the bank's Financial Stability Review 2010. “Some vulnerabilities and structural weaknesses remain in the German banking system. It is therefore crucial to reduce excess capacity in the German banking market and, where necessary, develop sustainable business models.”

The Bundesbank's Financial Stability Review 2010 notes that the risk situation in the German financial system has eased somewhat. The most vulnerable segments of foreign credit exposures remain commercial real estate funding and structured securities. Loss provisions in the German banking system will fall from around €37 billion in 2009 to an estimated €23 billion in 2010. In 2011, too, the Bundesbank is expecting loss provisions to stay at around €23 billion. At the same time, the German financial sector's resilience has increased. From the first quarter of 2008 to the second quarter of 2010, major German banks with an international focus raised their tier 1 capital ratio by an average of 2.4 percentage points to 10.4%. Professor Franz-Christoph Zeitler, Vice-President of the Deutsche Bundesbank, stated: “There are no indications that the German banking system will be unable to play its part in the economic upturn in Germany through its lending function.”

The Bundesbank believes that enhancements to the regulatory and institutional framework will be one of the main drivers of progress towards a more resilient financial system. The higher minimum capital ratios and tighter definition of capital based more strictly on banks’ loss absorbency capacity, as stipulated in the new Basel III accord, will stiffen their robustness. “For all banks, including those domiciled in Germany, Basel III will entail a significant rise in capital requirements; alongside profit retention and portfolio optimisation, it will also be necessary to raise fresh capital”, said Professor Zeitler. He added that, on the other hand, the implementation of Basel III will ultimately strengthen market confidence in the banking industry.

In its Financial Stability Review 2010, the Bundesbank points out that dealing with systemically important financial institutions presents regulators with special challenges. However, it cautions that the adoption of new, tighter regulations for the traditional banking sector must not be allowed to cause a migration of business to segments of the financial system that are subject to little or no regulation. “We must shed more light on the shadow banking system and include it within the prudential purview in order to identify at an early stage the dangers arising from the fringes of the financial system, which account for a sizeable share of business activities”, says Bundesbank Executive Board member Dr Andreas Dombret. There is an international consensus that, in order to safeguard financial stability, prudential supervision must be geared towards a macroprudential approach that monitors the system as a whole, including interactions and contagion effects. The Bundesbank is actively involved in an ongoing discourse that is currently taking place in a number of international forums concerning the choice and potential deployment of suitable instruments for safeguarding systemic stability.