The Bundesbank sees potential risks to the stability of the German financial system in the persistently low interest rates and muted global economic growth. This was stated in the Financial Stability Review 2016, which Vice-President of the Deutsche Bundesbank Claudia Buch and Bundesbank Executive Board member Andreas Dombret unveiled at a press conference held in Frankfurt am Main.

© Stefan Krutsch

© Stefan Krutsch

© Stefan Krutsch

© Stefan Krutsch

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Resilient financial sector

"In the current macroeconomic setting, there is the danger that market participants might underestimate risks and fail to adequately take into account the possibility of asset prices falling and interest rates rising," said Buch. "It is therefore crucial that market participants ensure that contractual terms are appropriate and that they build up risk buffers that are large enough to also absorb losses from unexpected developments," she stressed.

In the assessment of the Bundesbank's experts, this raises the risks potentially associated with an increase in the interest rate level for banks and life insurers, in particular. According to Buch, adequate capitalisation is therefore a prerequisite for the financial markets to be able to discharge their function for the real economy and to promote real economic growth. "Financial stability considerations warrant the build-up of risk buffers so that losses from unforeseen events can also be cushioned," said Buch. The larger these buffers are, the lesser the contagion effects and self-reinforcing mechanisms that are set in motion whenever unexpected events occur, stated Buch, who believes that this does not represent a burden to financial institutions and the economy. "Better capitalised banks are more competitive and tend to grant more loans," she added.

Potential collective misjudgement

Buch warned that the current macroeconomic environment could fuel a credit-financed real-estate boom, noting that "prices are increasing in the German real-estate sector, and lending is on the rise." This could pose risks to financial stability whenever a sharp rise in house prices coincides with a strong expansion in credit volumes and an easing of credit standards, which could happen particularly if many market participants were to come to an overly positive assessment of future debt sustainability. "However, there are no acute signs of an easing of credit standards," said Buch. "Overall, the indicators show that developments in the German residential property market do not currently pose any immediate threats to financial stability," the Vice-President pointed out.

Increased risks in the German banking sector

In addition, the Financial Stability Review 2016 extensively addresses risks in the banking sector. According to the Review, the business models of German banks and savings banks, which rely heavily on lending and deposit business, are also coming under pressure. "Banks are issuing loans with longer maturities in Germany as a way of keeping their interest income stable," Andreas Dombret, the Bundesbank Executive Board member responsible for banking and financial supervision, said at the press conference. One consequence of interest rates being locked in for relatively long periods was that it made the banking sector less flexible in responding to interest rate changes. "The longer interest rate fixation means that banks and savings banks incur higher interest rate risk. This risk needs to be actively hedged," Dombret remarked, noting that this was why banks needed to be adequately capitalised.

Overall, he believes that German banks and savings banks are robust: "There can be no doubts as to the solvency and liquidity of German banks and savings banks. A positive development is that institutions have raised their capital levels in recent years and fared well in this year's EBA stress test," Dombret continued.

Amber gamble regarding profitability

At the same time, he warned that a lot of German banks are not profitable enough. The low-interest-rate environment would particularly make itself felt at small and medium-sized institutions over a medium to long-term horizon. "With regard to profitability, banks are being amber gamblers."

Alongside the protracted low-interest-rate phase and the regulatory reforms in the banking sector, the digitalisation of the financial sector also presented a challenge for German banks and savings banks, he explained. Against this backdrop, the Financial Stability Review also examines the spread of technology-enabled financial innovations, known as fintechs. These new technologies can help make the financial system more stable, for instance by improving lending and the diversification of risk. However, they can also encourage herding behaviour. That is why these markets are being watched very closely.

The Financial Stability Review also discusses the greater importance of central counterparties (CCPs). Back in 2009, the G20 decided that standardised over-the-counter derivatives should henceforth be cleared only via CCPs. The Bundesbank holds the view that CCPs can help reduce channels of contagion between banks. But, according to the Financial Stability Review, they must be properly regulated at the same time.