The risks to the German financial system have increased sharply this year. High levels of government debt represent the largest challenge for German and European financial stability in the foreseeable future. “It is therefore particularly important to pursue a sustainable fiscal policy and to support that policy with structural reforms”, explained Executive Board member Andreas Dombret at today’s presentation of the Deutsche Bundesbank’s Financial Stability Review 2011. “Germany, too, must continue to consolidate its public finances.” In terms of resolving the sovereign debt crisis, Mr Dombret highlighted the crucial importance of respecting the separation of monetary and fiscal policy.

The Bundesbank’s Financial Stability Review states that, as the environment deteriorates, the German banking system will face new burdens. “The contagion effects emanating from the sovereign debt crisis and the deteriorating economic prospects in Europe are likely also to weigh on German banks’ earnings outlook”, said Sabine Lautenschläger, Vice-President of the Deutsche Bundesbank. “But on the positive side, it must be stressed that the resilience of German banks has grown over the past two years.”

“Overall, the Bundesbank believes that risks arising from exposures to Greece, Ireland and Portugal are manageable”, Mr Dombret added. He pointed out that the volume of exposures to borrowers in the large euro-area countries Italy and Spain is greater. In the Bundesbank’s opinion, persistently low interest rates and high global liquidity continue to pose a risk to the financial system as they could lead to excessive leveraging and intensive maturity transformation. “Moreover, legacy problems at banks resulting from credit claims on commercial real estate and structured securities have not yet been fully dealt with”, Mr Dombret explained. In addition, procyclical behaviour within the financial system itself is aggravating the crisis. There is a lot of co-movement in the financial markets according to the Financial Stability Review, and the increasing use of passive investment strategies is narrowing the range of opinions on the financial markets. Other trading strategies, for instance high-frequency trading, are further amplifying the tendency towards automatic mechanisms.

The overall assessment of the German financial system yields a positive result, according to the Financial Stability Review 2011. The quantity and quality of German banks’ capital has improved. Between the spring of 2008 and the summer of 2011, the tier 1 ratio according to the currently applicable Basel II rules rose from 8.1% to 13.1% for a group of 13 major German banks with an international focus. Leverage – measured as total assets to tier 1 capital – dropped from 43 to 33. Risk-weighted assets have also declined, reducing capital requirements by almost 30%. This group of banks’ earnings have remained stable for some time now. “But the many positive developments in the German banking system should not blind us to the fact that the outlook has deteriorated”, commented Ms Lautenschläger. “New burdens as a result of the direct and indirect consequences of the sovereign debt crisis such as haircuts on euro-area bonds and plummeting prices for many assets are weighing on financial institutions’ earnings.” The Bundesbank therefore welcomes the recapitalisation of large banks that has been initiated at the European level in a bid to counter the loss of confidence in the European banking sector, Mr Dombret said. “Overall, financial institutions must take a more long-term view in their business operations.”

The Financial Stability Review further stressed that, for markets to function, market participants have to be made responsible. “That also means that systemically important financial institutions must be able to exit the market without the financial system collapsing”, Mr Dombret explained.