According to the Bundesbank’s assessment, the extended spell of strong growth and low interest rates has seen vulnerabilities build up. As the Financial Stability Review 2018 points out, an unexpected, sharp economic downturn could expose these vulnerabilities, and contagion effects in the financial system could amplify the downturn. It is the Bundesbank’s view that the probability of such a scenario has increased. “Now is the time to build up sufficient capital and strengthen the financial system’s defences,” Vice-President Claudia Buch told the Financial Stability Review press conference.

Building up defences when times are good

According to the Bundesbank, as in previous years, the vulnerabilities arise in particular from market participants potentially underestimating credit risk or overestimating assets and the value of loan collateral. Furthermore, the Financial Stability Review also points to the existence of interest rate risk. “It is precisely when the economy is in good shape that we can be tempted to underestimate the likelihood of catching the flu and neglect the need to build up our defences,” said Ms Buch, who is the member of the Bundesbank's Executive Board responsible for overseeing statistics and financial stability.

© Frank Rumpenhorst

© Frank Rumpenhorst

© Frank Rumpenhorst

© Frank Rumpenhorst

© Frank Rumpenhorst

© Frank Rumpenhorst

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From the Bundesbank's perspective, downside risks to the economy have risen. Geopolitical risks have increased and trade conflicts could particularly harm the internationally open German economy. Furthermore, it is still unclear how the United Kingdom will withdraw from the EU. If these downside risks materialise, Ms Buch warned, the associated negative repercussions could be amplified by the existing vulnerabilities in the financial system. 

According to Bundesbank experts, an unexpectedly severe economic slump is likely to entail a considerable correction of asset prices, thus exposing several of the vulnerabilities cited above, all at the same time. Rising losses from credit defaults and heightened risk provisioning would be accompanied by falling values of assets and loan collateral. Losses would eat into banks’ available capital buffers, Ms Buch remarked. Banks would also have to hold more capital in order to meet regulatory or market requirements. In the short term, the only way banks could do this would be to limit their lending, thus potentially further aggravating the downturn.

Decisive importance of resilience

Whether, and to what extent, adverse macroeconomic developments are amplified by the financial system depends decisively on its resilience, according to the Financial Stability Review. Addressing the press conference on the Financial Stability Review, Joachim Wuermeling, the member of the Bundesbank’s Executive Board in charge of banking and financial supervision, said: “It is therefore a positive sign that, since the financial crisis, banks have built up a significantly larger capital base – thanks also to stronger regulation and the introduction of capital buffers for systemically important banks.” Although Germany’s banks are resilient, noted Mr Wuermeling, this does not rule out risks to financial stability. Existing buffers might not be sufficient if, on the heels of a downturn, risks from credit defaults, asset repricing and interest rate changes, for example, were to materialise simultaneously. “We therefore call on banks not to ease up in their efforts to further strengthen their capital reserves,” Mr Wuermeling said. 

Assets and loan collateral overvalued

In the assessment of Bundesbank experts, valuations on the asset markets remain high. A sharp economic downturn could contribute to a decline in prices for real estate, equities or bonds. According to current Bundesbank estimates, house prices in German cities are overvalued by between 15% and 30%. Nevertheless, Ms Buch does not at present see any acute need for macroprudential action specifically targeting the real estate market, as credit growth is still rising at a below-average pace in a longer-term comparison and there are no strong signs of credit standards being eased. Risks could arise, in particular, from an overestimation of real estate loan collateral values, said Ms Buch. She also pointed out that there was still insufficient data availability on the housing market in Germany, with a lack of reliable and disaggregated information for assessing the risk situation. 

Interest rate risk 

In the event of an unexpected economic downturn, interest rate developments could aggravate vulnerabilities. According to the Bundesbank, over the past several years, banks have increasingly been granting loans with longer maturities and fixed-term interest rates. For instance, 45% of new loans to households for house purchase now have interest rate lock-in periods of more than ten years, Ms Buch pointed out. According to Bundesbank experts, an abrupt rise in interest rates could see many institutions being put under pressure simultaneously. This would primarily affect small and medium-sized banks, some of which have sharply expanded their maturity transformation in recent years. However, if interest rates were to remain low for an extended period to come, risk-taking incentives would remain in place. Other parts of the financial system – insurers or funds – would be affected in a similar manner and be unable to offset the impact, Ms Buch remarked.

Need for macroprudential action 

According to Ms Buch, the interaction between credit risk, real estate risk and interest rate risk has created a need for macroprudential action. Ms Buch underscored that, “At the current juncture, a good economic situation provides the opportunity to build sufficient buffers against unexpected developments,” as this could limit contagion effects within the financial system and prevent them from spilling over into the real economy. The aim of macroprudential policy is, she said, to take timely countermeasures against risks to financial stability in order to keep the financial system functioning smoothly. Available macroprudential policy instruments include warnings and recommendations as well as capital buffers, she explained. Ms Buch went on to say that discussions were currently being held on whether a countercyclical buffer should be introduced, as in other countries. In periods in which cyclical risks build up, as is the case at present, banks would then build up additional capital. In the event of a crisis, banks could use these buffers to absorb losses. With regard to the housing market, Ms Buch reiterated that the availability of data still needed to be improved.

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