The German financial system remains vulnerable to adverse economic developments. In the current environment, future credit risk could be underestimated and the recoverability of loan collateral such as real estate overestimated. “An unexpected economic downturn and abrupt rise in risk premia could hit Germany’s financial system hard,” explained Bundesbank Vice-President Claudia Buch at the press conference on the Bundesbank’s new Financial Stability Review.

Just last year, interest rates had still been expected to rise slowly. These expectations were not met, however. The interest rate level slipped further as economic activity decelerated – Germany’s export-oriented industrial sector, in particular, is in the midst of a downturn – and market participants expect risk-free interest rates to remain low. “But it is precisely in a low interest rate setting that we are seeing a continued build-up of cyclical risks in Germany’s financial system,” emphasised Ms Buch. Addressing the press conference, Joachim Wuermeling, the Bundesbank Executive Board member responsible for banking supervision, added: “The low interest rates are putting institutions’ interest margins under increasing pressure, hurting their profitability and thus also putting financial stability at risk.”

Risk underestimated

According to the publication, however, the weakness in economic activity is not directly apparent in financial markets: bank lending activity remains brisk and valuations in the markets are still high in some places, buoyed by low interest rates and a robust domestic economy. The Bundesbank writes that minor credit risk is also reflected by the small number of insolvencies in the corporate sector and low unemployment. Commensurately low is banks’ risk provisioning, which has been in decline for many years. This could result in the future development of credit risk being underestimated, however.

As the Financial Stability Review puts it, an unexpected economic downturn might lay bare the existing vulnerabilities. On the whole, German enterprises’ creditworthiness is reported to have improved, but the share of borrowers that are riskier in relative terms in German banks’ loan portfolios has gone up. Loss provisions and credit defaults could therefore, in the event of an unexpected economic downturn, rise more rapidly and more sharply than if credit risk were more evenly distributed. “This allocation risk has increased in recent years and is feeding into cyclical vulnerabilities in the German financial system,” explained Ms Buch.

House prices in Germany are still showing brisk growth. Surveys show that households and banks are expecting this trend to continue. “There is thus a danger that market participants will be overly optimistic in assuming that past developments will persist in the future and therefore overestimate the recoverability of collateral,” said Vice-President Buch. The Bundesbank estimates that house prices in German towns and cities are overvalued by between 15% and 30%. It remarked in its publication, however, that there is, as yet, no evidence of a spiral resulting from sharp rises in house prices, an excessive expansion in residential real estate loans and an erosion of lending standards.

Another vulnerability for the German financial system is the ongoing risk of an abrupt rise in interest rates. Banks have expanded their maturity transformation in order to boost their interest income. One out of two new loans for house purchase has an interest rate lock-in period of more than ten years. “Given these factors, banks need to properly price the risks they take and allow for adequate margins,” said Mr Wuermeling.

Countercyclical capital buffer raised to 0.25%

In response to cyclical systemic risk, the German Financial Stability Committee recommended in May 2019 that the Federal Financial Supervisory Authority (BaFin) activate the countercyclical capital buffer and raise it to 0.25% of risk-weighted domestic exposures. BaFin acted on this recommendation with effect from the third quarter of 2019. Banks have been given 12 months to build up the buffer. “The countercyclical capital buffer strengthens the resilience of the financial system and supports lending in periods of stress,” said Ms Buch. The buffer is designed to reduce the likelihood that the supply of credit will be curbed excessively in times of stress and limit any procyclical effects that the banking system may have on the real economy.

Financial system also influenced by climate risk

For the first time, the Bundesbank has dedicated an entire chapter of its Financial Stability Review to climate-related risks. The Bundesbank’s aim here is not to evaluate political decisions but rather to analyse the impact of climate change as well as the political, social and economic responses to it, explained Ms Buch. The results of a special survey by BaFin and the Bundesbank revealed that just under two-thirds of the responding financial institutions have yet to incorporate climate-related risks into their risk analyses. According to the Financial Stability Review, however, 22% of the institutions indicated that they were currently planning to add climate risk to their risk management.