"There are incentives for investors to engage in riskier behaviour in the current low-interest-rate environment." This is one of the key findings of the Deutsche Bundesbank's 2014 Financial Stability Review, which Deputy President Claudia Buch and Executive Board member Andreas Dombret presented at a press conference in Frankfurt am Main on 25 November 2014. "We should not allow ourselves to be lulled into a false sense of security," cautioned the Deputy President, who is responsible for financial stability. "The longer the period of low interest rates lasts, the greater the risk of exaggerations in certain market segments."

The Bundesbank sees signs of an excessive search for yield primarily in the corporate bond markets. Buch pointed out that risk premiums were currently very narrow and were approaching the lows seen in the pre-crisis era. The Bundesbank used these risk premiums to compute implied default rates, which are lower than the historical norm. "This suggests that risk is being underestimated – all the more so when one considers the frail state of the economy," Buch cautioned.

"Improve resilience further"

The Bundesbank found that the picture in the banking sector was mixed. It was to be welcomed that banks had improved their capital base during the past year, while the European Central Bank's comprehensive assessment had shown that German credit institutions could withstand large-scale burdens, explained Andreas Dombret, the Executive Board member responsible for banking supervision. He went on to say that a sharp and abrupt increase in short-term interest rates would, however, take a heavy toll on banks. Furthermore, he added, the joint occurrence of several shocks could pose problems for the German financial sector. Banks therefore needed to improve their resilience further and explore, for instance, whether there was scope for further strengthening their capital resources.

Dombret 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," the Executive Board member said. Since German banks' business models were strongly reliant on interest income, relatively speaking, this presented something of a challenge in the present environment. The International Monetary Fund (IMF), writing in its recent Global Financial Stability Report, likewise called on the German banking sector to diversify its earnings base more strongly and to be less reliant on interest income. Dombret urged banks to review their business models to identify the scope for cutting costs and tapping synergies.

The Bundesbank will continue to monitor developments in the real estate markets. All in all, price dynamics in Germany over the past 20 years have been much more moderate than in the euro area. But property prices in big cities have climbed sharply – by just over a third since 2008 in the big cities most affected by this trend: Berlin, Cologne, Düsseldorf, Frankfurt am Main, Munich and Stuttgart. That being said, there is still no cause for concern in the real estate segment. "So far, rising housing prices do not harbour excessive risks to financial stability," said Buch.

However, data from a Bundesbank survey indicate that the German banking system is structurally vulnerable to falling property prices and rising default rates.

"If a decline in urban real estate prices were to coincide with climbing default rates, this would have a considerable impact on banks' profits," Buch cautioned. The Bundesbank was therefore keeping a very close eye on the market. "As soon as we see a risk to financial stability, we will act," the Deputy President stated.

Abolish privileges

Buch explained that the banking union marked an important step forward in identifying risks at credit institutions. The Single Supervisory Mechanism (SSM), which was launched in November, is able to apply stringent uniform supervisory standards and practices, as well as draw cross-border comparisons. She went on to say that the Single Resolution Mechanism (SRM) would improve the conditions for the recovery or resolution of struggling banks. "In future, the private sector will share the cost of restructuring banks," Buch pointed out. She conceded that even the banking union would be unable to loosen the sovereign-bank nexus. Sovereign exposures continued to enjoy preferential regulatory treatment, and it was these privileges which needed to be abolished, the Deputy President concluded.