“The real estate market is vulnerable” Interview published in “Handelsblatt”

Interview with Joachim Wuermeling conducted by Andreas Kröner and Yasmin Osman.
Translation: Deutsche Bundesbank

Mr Wuermeling, institutions will need more capital in order to grant loans to households. How will that affect real estate financing?

At two percentage points, the additional real estate buffer is relatively moderate, and the German banking sector will be able to cover this additional capital requirement overall with existing capital. Rising prices do not necessarily mean laxer credit standards. That said, BaFin’s decision is a clear signal to banks that, with real estate price inflation still unchecked, they should avoid taking greater and avoidable risks. It will not constrain the credit supply or cause a marked rise in interest rates.

Why do you regard the housing loans situation as precarious?

Given sharply rising prices, housing loans have simply become riskier because the trend can quickly go into reverse. Homebuyers’ leverage is increasing: they are funding an ever-larger share of their acquisition costs with loans and putting down less and less capital as a deposit. Market data indicate that, for nearly ten percent of new loans, the loan amount exceeds the purchase price for the house. Housing prices have become decoupled from income growth. Of late, debt service has continued to grow as a share of disposable income, recently reaching 29%.

How important are housing loans to banks?

They are pivotal: the share of housing loans on bank balance sheets has grown enormously. It now makes up 35% of all bank loans. That is also an upshot of rising prices, and the trend is continuing. Loan volume is still surging, at 6%. However, this strong growth can be explained in part by a sharp increase in the price level across the board.

For banks, this initially means more business.

Yet the growth is occurring in a market that is becoming ever more vulnerable owing to rising property prices. Loans with an initial interest rate fixation period of over ten years now make up half of loans to households for house purchase. This means that, in the midst of an interest rate reversal, banks would still have very low-yielding loans on their balance sheets for some years to come but would already have to pay higher refinancing rates.

How is the financial industry reacting to supervisors’ warnings?

Banks have already understood the warning signals. At any rate, lending policies have not become more lax. However, we are seeing rising demand for loans that allow homebuyers to put relatively little or even no significant capital down as a deposit. The reason why purchaser deposits are getting smaller and smaller is that household incomes are not growing as fast as property prices.

Will the new real estate buffer suffice, in your view, or will supervisors impose further restrictions?

The real estate buffer is oriented to the current risk situation and calibrated to address the specific risks associated with housing loans. Should further excessive risks accumulate, we reserve the right to modify the buffers or apply other instruments instead; to avoid high-risk loans, it may make more sense to restrict the debt share of housing loans by capping the loan-to-value (LTV) ratio.

The situation in the real estate market is not the only risk facing banks. How dangerous could the Ukraine war and the sanctions on Russia become for the industry?

The direct impact is negligible. German banks have hardly granted any loans in Ukraine and Russia, and their exposure to both countries is limited in other respects, too. Still, the indirect consequences of, say, supply bottlenecks or sanctions could be considerable for some enterprises to which banks have made loans. The crisis has also made the macroeconomic situation gloomier, which could impact on banks. However, I do not expect a banking crisis in Germany.

Another reason why some banks are quite relaxed is that they assume that, like during the coronavirus crisis, the state will step in to support firms where necessary and thus relieve the banks of risks.

The objective of fiscal measures is to preserve the stability of the economy and society as a whole, not to save each and every distressed entity. We must be on the alert to avoid the state becoming a full-coverage insurer of all risks. That would overstretch the public sector and also create moral hazard. Those taking entrepreneurial risk should also bear the consequences – just as they conversely reap the benefits.

German banks have shown major deficits in their implementation of sanctions in the past. How are punitive measures against Russia working out this time?

The banks are going to every effort to avoid violating sanctions. They have acquired experience in this area now and we are not currently seeing any significant violations. In some quarters, we are even seeing overcompliance with sanctions. Financial institutions need to make sure that they find a “golden mean” and avoid unintentionally discriminating against any party. Contractual commitments must be fulfilled.

What exactly do you mean?

For instance, institutions should not deny citizens with a Russian background access to the banking market across the board for fear of violating sanctions. We expect the banks to comply with the adopted sanctions but not to impose more far-reaching restrictions on any and all actors and entities remotely connected to Russia.

Has the risk of cyber attacks from Russia increased as a result of the war in Ukraine?

Cyber attacks have definitely become more likely. There is a risk that criminals with links to Russia – perhaps even government entities or free riders – will attack German banks, including the Bundesbank. There are no signs of this yet, though. But we must remain vigilant. Since more and more transactions are taking place digitally, the financial system has also become far more vulnerable to cyber attacks in recent years.

Are German banks prepared for the potential strains resulting from the war in Ukraine?

Over the past few years, not only big banks, but also many small and medium-sized institutions have made difficult decisions in order to cut costs and improve profitability. Moreover, German banks are currently holding €156 billion more in capital than mandated by supervisory requirements. They are resilient enough to provide reliable funding to the economy even if the economic environment takes a turn for the worse.

What would a potential interest rate reversal mean for banks?

Higher interest rates will initially place a strain on banks. Institutions need to factor in value adjustments to securities and an increase in interest expenditure. Interest income, on the other hand, will only start to rise after some time has elapsed. This will improve profitability in the medium to long term. Our analyses show that 90% of banks can already expect positive effects in the second year after an interest rate hike. This also stems from the fact that a major cost item – negative interest rates – will then disappear. I think banks would do well to prepare for changing interest rates this year, just as the markets are doing.

Given the war in Ukraine and the impending interest rate reversal, are you expecting cross-border bank mergers in the near future?

Over the last 15 years, the number of institutions in Germany has fallen by an average of 35 to 40 each year – through mergers between small and medium-sized banks. This trend will continue. Cross-border mergers between larger banks are not an end in themselves – and they require thorough preparation. There was insufficient time and opportunity for this during the coronavirus crisis. Now, the uncertainty surrounding the war in Ukraine is an additional factor complicating potential mergers. Cross-border mergers are more likely to take place in a more stable economic setting than at present.

The European banking union, which is still incomplete – a European deposit insurance scheme (EDIS) has yet to materialise – is considered an obstacle to cross-border mergers. The debate about EDIS is now gaining momentum in Brussels. What is your take on that as a supervisor?

A European deposit scheme is a logical step in the completion of the banking union. But we need to avoid false incentives associated with communitising risks incurred under national responsibility. The Bundesbank is therefore in favour of a reinsurance model that covers liquidity risk, in particular.

Meaning that national deposit guarantee schemes would lend each other money in an emergency, but wouldn’t be jointly liable for risk.

A reinsurance system would ensure that investors throughout Europe could rely on the same level of protection for their deposits. However, we would insist on risks being reduced in all participating countries first, regardless of whether they involved non-performing loans or large holdings of domestic government bonds on bank balance sheets.

This year, the ECB will also be looking at banks’ climate risks. How relevant are these risks, in your opinion?

In its most recent Financial Stability Review, the Bundesbank concluded that these risks currently remain limited and are not disproportionately significant compared to credit or market risk.

Are you saying climate change isn’t that important for the financial industry?

I’m not saying that there’s nothing to worry about with regard to climate change itself. Rising temperatures pose a risk to the whole world – just perhaps not specifically to German banks’ balance sheets to begin with. All the same, German banks also need to take a very close look at the risks stemming from climate change.

Banks steer every economy with the credit decisions they make. Should they also help steer the economy in the fight against climate change?

Banks’ activities should continue to be based on the business policy decisions made by the institutions and their shareholders. The economic function of German banks is to finance economic activity within Germany – by which I mean every legal business activity. Decisions as to what type of economic activity is desirable or undesirable from a political, social or environmental point of view should be made by legislators, not banks – and certainly not banking supervisors.

Mr Wuermeling, thank you very much for this interview.

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