© Frank Rumpenhorst

The calm that has set in is deceptive

"In the year to date, financial stability in Germany has benefited from the easing of tensions on the international financial markets" states the Bundesbank's 2013 Financial Stability Review, presented by Deputy President Sabine Lautenschläger and Executive Board member Andreas Dombret at a press conference in Frankfurt am Main on 14 November 2013. Yet despite the somewhat calmer situation, the European sovereign debt crisis and the current low-interest-rate environment harboured lasting threats to the stability of the German financial system, they emphasised.

Use bought time

"The debt crisis is by no means over," said Sabine Lautenschläger at the press conference, adding that the calm that had set in on the financial markets was deceptive. The Bundesbank's Deputy President, who is responsible for banking supervision, expressed concerns over the fact that levels of public debt had continued to climb in some European countries despite the consolidation measures, noting that the liabilities of private enterprises and households were also high. She emphasised that it was essential to use the time bought by central bank measures to tackle the root causes of the crisis through structural and institutional reforms.

The critical situation of both public and private debtors in some crisis countries remains one of the key risks to the German banking sector. "Although the default and contagion risks have declined, they are still considerable," said Lautenschläger, adding that German banks' exposure to public and private debtors from the four programme countries (Greece, Ireland, Cyprus and Portugal) plus Spain and Italy had dropped from €432 billion to €234 billion since the end of 2009. The key concern expressed by Andreas Dombret, the Executive Board member responsible for financial stability, was that ties between governments and domestic banks had continued to tighten in several European countries. He stressed that "the preferential regulatory treatment of government bonds on banks' balance sheets must therefore be phased out in the medium term".

Undesired side-effects increasing

Dombret identified low interest rates as the second major risk to financial stability in Germany. "One man's joy is another man's sorrow," said Dombret, pointing out that what was "good for house builders and buyers and for shareholders" was bad for savers. But he emphasised that the longer-term dangers affected everyone, adding that "the longer the low interest rates last, the larger the undesired side-effects and the risks to financial stability". He said that German insurers were being hit particularly hard by the low-interest-rate environment, highlighting that "the low interest rates mean that it is ever more difficult for them [German life insurers] to generate the guaranteed returns", a situation which was eating away at insurers' financial buffers. Dombret stressed that insurers needed to build up their capital resources and review their level of distributions to policyholders. He pointed out that some life insurers were now also offering policies without a guaranteed return.

Low interest rates also squeezing banks' profits

Lautenschläger emphasised that the low-interest-rate environment was putting great pressure on banks, as shrinking net interest income was lastingly reducing banks' profitability. A close analysis of the banking sector revealed that banks had "structural profitability problems", she said. In Lautenschläger's view, this is due to the very high provision of bank services in Germany compared with other European countries and to increasing competition for the same groups of customers, such as the Mittelstand or retail customers. Owners and investors would have to prepare for lower returns in the long run, she commented, stressing that if banks were unable to adapt their cost structures and business models in the medium term and therefore failed to generate earnings, market exits should not be a taboo subject.

Adhere to conservative lending standards

The low interest rates are also affecting the German property market. In seven major German cities – Berlin, Cologne, Düsseldorf, Frankfurt am Main, Hamburg, Munich and Stuttgart – residential property prices climbed by almost a quarter overall between 2009 and 2012, compared with a rise of just 8% between 2005 and 2008. The Bundesbank currently assumes that housing is overvalued by up to 20% in the major cities. "Low interest rates have without doubt created incentives for property investments which would not have been undertaken under normal interest rates," said Dombret. Yet he emphasised that this was not a concern for financial stability, as household creditworthiness was good and growth in mortgage lending was moderate. "Germany's banks should ensure that they apply conservative standards when issuing property loans," Dombret stressed.

Comprehensive assessment a major opportunity

Deputy President Sabine Lautenschläger warned that banks and insurers were not the only ones who had to use the current recovery to make reforms – the same applied to supervisors and regulators. She added that many matters concerning the forthcoming European banking union were still unresolved. Lautenschläger said that most progress had been made on the balance sheet assessment to be carried out by the new Single Supervisory Mechanism (SSM). She pointed out that the first step of the comprehensive assessment (or "health check-up"), in which the European Central Bank (ECB) and the European Banking Authority (EBA) will scrutinise the balance sheets of 128 banks, had already been launched. "The comprehensive assessment also represents a major opportunity. A thorough balance sheet cleansing can free banks of legacy problems and enhance the functional viability and stability of the European banking sector," she stressed. However, Lautenschläger emphasised the urgent need for progress on the project to set up a Single Resolution Mechanism (SRM), while also pointing to legal problems: "A true European resolution authority needs a watertight foundation; bank resolution will invariably involve a wave of lawsuits by third parties – in this case, bank investors". Primary law – ie the EU Treaties – needed to be amended in order to create such a watertight foundation, she continued.