Safeguarding financial stability in an era of transformation Research Areas and Programme
Introduction
In response to the global financial crisis, policymakers enacted financial sector reforms and expanded their set of instruments, strengthening existing regulations and introducing new capital, leverage and liquidity requirements. The goal of these regulatory measures is to ensure the soundness of banks and ultimately the stability of the financial system. Macroprudential policy has been introduced as a new policy area, with new institutions at the national and European level. Bundesbank research contributes to the development of tools and methods for designing and evaluating microprudential and macroprudential regulations. Meanwhile, the financial industry is undergoing rapid structural change through the emergence of new business models and digital technologies. Moreover, climate change and policies addressing it are also giving rise to new challenges for the financial system. Not least because of its financial stability mandate and its role as a banking supervisor, the Bundesbank needs to understand the implications of these trends.
Topics of the Research Area
In the euro area, and particularly in Germany, the banking sector provides the bulk of external financing for households and firms. Understanding banks’ credit supply and risk-taking decisions is therefore of vital importance for banking supervision and ultimately for financial stability. Policymakers therefore need to understand which strategies banks choose and what this implies for bank performance in order to develop and adapt the supervisory framework, and to close potential regulatory gaps. An important element in accomplishing this task is the increased availability of granular data as provided, for example, by the recently developed AnaCredit database. Using such data sets, Bundesbank research identifies and analyses key factors that influence banks’ credit supply decisions. Further research in this area studies the role of cross-border mergers and acquisitions and the consequences of bank opacity and complexity. Bundesbank research also investigates whether banks change their portfolio allocation when facing reforms that increase the relative cost of their debt by taxing bank leverage.
As they transform long-term loans into short-term deposits and illiquid assets into liquid liabilities, banks are affected by the monetary policy stance. Bundesbank researchers analyse the implications of persistently low or negative policy rates on the interest rates banks offer, their lending and risk-taking decisions, and their profitability. One potential consequence of sustained low interest rates is a decline in firm exits, which might lead to an increase in lending to “zombie firms”, with potential implications for aggregate productivity. This research also sheds light on the relationship between monetary policy at the macroeconomic level to banks and firms at the microeconomic level.
Global banks continue to play a particularly important role in the international transmission of shocks and the spillover of regulatory policies to financial systems. The Bundesbank plays an active role in the International Banking Research Network (IBRN), in which central bank economists from around the world study issues pertaining to global banks. Since Germany is an open economy and a member of a currency union, almost all regulatory changes have potential international implications. Assessing these spillovers is an important task for Bundesbank research.
The footprint of non-bank financial institutions in the financial system has grown in recent years. Non-bank financial intermediaries have become an important funding source for households and firms. Bundesbank research aims to investigate drivers of this growth to better understand the role of non-bank financial institutions in funding the real economy. The increasing degree of digitalisation in financial services such as deposit-taking, lending, and payment systems has a profound impact on financial intermediation. The market entry of new, technologically advanced intermediaries such as fintech and bigtech players poses a particular challenge to the banking sector. Bundesbank research analyses these trends, for example by studying the business models of new intermediaries, which often focus only on parts of the value chain of banks. Another important development over recent years has been the increasing use of blockchain technologies, which many digital currencies rely on. Bundesbank researchers contribute to the understanding of this development by studying the fundamental demand for crypto currencies, the driving forces of the market price of crypto assets and the role of cyber risks for financial stability.
Capital market financing has gained heightened importance for the German and euro area economies in recent years. Consequently, financial markets can be both a source of shocks, as became clear during the global financial crisis, but also mitigate or amplify macroeconomic shocks. Bundesbank researchers analyse how financial markets process information about major shocks such as the COVID-19 pandemic, and how the financial sector responds to cyclical changes in risk.
Monetary policy is transmitted to the real economy via its direct effects on interest rates, but also indirectly through other asset prices. Understanding price formation in financial markets, and especially price responses to central bank policy, is thus crucial for Bundesbank research. Issues currently being addressed in this area comprise the impact of unconventional policy measures, scarcity effects in collateralised funding markets, the determinants of investment fund flows, the consequences of synthetic leverage in this sector, the effects of low and negative short-term interest rates on the term structure, and the interaction between risk taking, the term structure and regulatory policy.
The careful design, calibration, and evaluation of microprudential and macroprudential regulatory measures are of the utmost importance in ensuring their success. Bundesbank research contributes to assessing the effectiveness and potential side effects of regulation. Questions currently being investigated include, for instance, how financial regulation affects bank market structure, merger and acquisition activity, competition and bank business models and how the regulation of bank holdings of sovereign debt affects default incentives of governments.
Regulators continuously monitor whether financial sector regulations are effective in achieving their intended stabilisation role or whether they have unintended consequences. Bundesbank research contributes to these efforts by conducting evaluation studies of various regulatory measures. Prominent examples are the Bundesbank’s contributions to the evaluation of financial regulatory reforms under the umbrella of the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). In addition to assessing the effectiveness of regulations, Bundesbank research analyses the effect of financial stability communication on households and financial markets.
With effective regulation in place, banks should be able to withstand both idiosyncratic shocks and system-wide stress. Nevertheless, banks will always be subject to some degree of fragility, as the maturity transformation between long-term loans and short-term deposits exposes them to run risk. Bundesbank researchers analyse how to design bank resolution mechanisms that help to avoid bailouts by governments or disorderly liquidations via bank runs. Amongst other things, they analyse the conditions under which bail-out expectations lead to moral hazard by banks that are “too big to fail”, putting other banks at a disadvantage and jeopardising financial stability.
In addition to the various trends and structural forces affecting the financial sector, cyclical build-ups of systemic vulnerabilities may pose threats to financial stability. To develop indicators that can guide macroprudential policy decisions, research at the Bundesbank contributes to the measurement and identification of financial cycles and systemic risk. Since financial market regulations ultimately affect lending to households and firms, Bundesbank research analyses the impact of various regulatory measures not only on the financial sector, but also on the real economy. An important aspect of this research is the development of several short-term forecasting models that take macroeconomic and financial linkages at a disaggregated level into account.
House prices are important for financial stability; when they drop sharply, many borrowers face negative equity, resulting in foreclosures and bank losses. Banks may react with cuts in lending and fire sales, leading to a downward spiral in asset prices and yet more lending cuts. Indeed, financial crises are often accompanied by boom-and-bust cycles in housing markets. An understanding of house price dynamics is thus one of the key elements in successfully monitoring financial stability. Bundesbank researchers contribute to this understanding by investigating the driving forces behind house price developments and the effects of borrowerbased and financial institution-based regulations.
Climate change and the policies required to mitigate it affect all parts of the financial system. Bundesbank research studies the impact of climate change on financial intermediaries and markets from various angles. For example, the continued growth of markets for sustainable investments like green bonds or sustainable mutual funds requires a deeper knowledge of the structure of demand and supply on these markets. Other recent Bundesbank work studies how transition risks arising from climate-related policy measures like carbon prices affect firm values, asset prices and portfolio allocations. Bundesbank research also analyses the importance of natural disasters for individual banks.
Economists at the Bundesbank are also developing a coupled economy and financial system-wide methodology for climate risk stress testing. The aim is to identify vulnerabilities and to assess the resilience of the financial system to physical as well as transition risks. This includes work on a set of models such as environmental DSGE models, disaggregated short-term macro-financial models, sectoral input-output-models and financial market models to analyse sensitivities and second-round effects for all financial intermediaries. The goal is to analyse transition risks stemming from environmental policy, technology or preference changes, worldwide CO2 prices and equivalent policies, and to analyse physical risks through channels likely to play a role in Germany. A particular emphasis is placed on second-round effects within and across different financial sectors, feedback with the real economy, and firm-level analysis.
The Bundesbank also tackles the challenge of closing climate-related data gaps, for example by integrating firm-level emissions data or granular weather and climate data into its analyses. Recent statistical Bundesbank work focuses on improving the measurement of the carbon footprint of products, firms and industries. Moreover, by incorporating requirements for the disclosure and measurement of climate-related risks in Eurosystem monetary policy operations and financial regulation, the Bundesbank also acts as a catalyst for various policy initiatives aiming at the production of such high-quality data, e.g. the EU Corporate Sustainability Reporting Directive, the FSB Task Force on Climate-Related Financial Disclosure, or the EU Taxonomy for Sustainable Activities.