Increasing fragmentation tendencies in the financial system Interview mit dem Handelsblatt

Interview with Jens Weidman conducted by Kathrin Jones und Jan Mallien.
Translation: Deutsche Bundesbank

Ms Buch, now that Omicron is on the scene, the coronavirus crisis is once again intensifying. But banks in Germany were very quick to declare that they’ve pretty much put the pandemic behind them. Are you as relaxed as they are?

No. True, the banks have come through the pandemic very well so far. At the end of the day, though, it has been the fiscal measures that have shielded them indirectly from the pandemic fallout. The banking sector is looking stable, and the capital buffers are sufficient. Although GDP contracted sharply in the past year, banks have hardly had to realise any losses. If the forecasts prove to be correct, the economic recovery will materialise next year – and even if the recovery is delayed, banks would still be able to handle the situation well.

How stable would you say the banks are right now, on a scale from one (very weak) to ten (very strong)?

Roughly eight. But that can only ever be a snapshot, of course.

And where are the residual risks to be found?

In the indirect repercussions of the pandemic and the question of whether the financial system as a whole will experience another bout of stress. That might happen, say, if market interest rates rise abruptly. This could come about if risk premia increase from their current very low levels, and not necessarily as a result of central banks’ monetary policy. A sudden uptick in interest rates would be difficult for everyone: banks and insurers are vulnerable, and funds are, too.

But surely it’s a foregone conclusion now that the US Fed, at least, is going to lift its rates next year, quite simply because the inflationary pressure is much more intense than originally expected.

A scenario in which interest rates lift off gradually isn’t such a problem. In fact, it would even relieve the burden on some financial institutions – I’m talking about life insurers that have guaranteed their policyholders certain nominal returns. Everyone can adjust to a slow increase in interest rates.

What would you advise the European Central Bank, which is turning the rudder rather slowly in tightening its monetary policy?

The Bundesbank and the ECB are, quite literally, physically distanced – the ECB’s headquarters are located on the other side of Frankfurt. Not just that: monetary policy for the Eurosystem is set independently by the ECB Governing Council, and that’s something I would not at all wish to interfere in. In any case, though, a resilient financial system helps the ECB perform its tasks. Financial stability is a precondition for safeguarding price stability.

If the worst comes to the worst, would the banks even have sufficient buffers to absorb the combined impact of coronavirus-induced loan losses and turbulence in the markets?

If a more extreme scenario like that were to materialise, it would be absolutely crucial for the banking sector to use the existing capital buffers as a way of stabilising lending. That is why the countercyclical capital buffer needs to be replenished. This preserves existing capital and means it can be used in response to a crisis. You see, vulnerabilities are mounting and risk awareness is diminishing in the financial system – everywhere you look, the focus is on the search for yield. That gives me cause for concern.

Why is that? Surely returns are desirable ...

Of course banks need to make sure they generate good earnings. But in relative terms, there has been a tendency for some time now to grant more loans to comparatively weaker enterprises. Sound enterprises can raise funding internally or in capital markets. Weaker ones are far more reliant on bank loans. Regrettably, though, banks’ internal models are not very good at showing what effects macroeconomic risks would have. There is a danger that banks might underestimate such risks going forward.

Yes, but you can’t very well tell banks whom they should grant loans to?

No, and that’s not the issue here. Supervisors are there to check whether banks’ risk models work as they should. Unfortunately, models usually look in the rear-view mirror, and a backward-looking perspective might be deceptive. In the pandemic, for instance, banks barely saw their loan losses increase at all. But that’s no guarantee they will get through future recessions unscathed. We look at the financial system in its entirety, to detect whether more substantial risks are building up anywhere. I would also like to note that we need a reliable regime for the recovery and resolution of banks.

We still don’t even know whether it works.

That’s right, the regime still has not been put to the test. Much has already been done, though. We have new legislation and new institutions, and we have the Single Resolution Board (SRB). I’m very optimistic. We have taken a major step forward and now also know how we can make further improvements to the system.

Let’s now turn to the booming real estate market, where prices are rising and rising. Is that a bubble in the making?

There are a couple of ingredients that give us cause for concern. One is the prices, which have increased by roughly 7% of late. Another is the sharp upturn in real estate lending. Also, our surveys indicate that around 90% of households are expecting prices to climb further.

Why haven’t you undertaken stronger regulatory intervention already?

Because lending standards so far have stayed relatively stable. Key indicators like mortgage lending values, i.e. a property’s market value relative to the amount of the loan, household indebtedness or the ratio of debt service to income are not particularly conspicuous. But that is partly due to the current low interest rates.

So what happens if interest rates suddenly increase more sharply, as we discussed just now?

This is a problem we have been flagging for years now. It would take its toll on mortgage borrowers, of course. One thing that also needs to be borne in mind, though, is that roughly one out of every two real estate loans now has a term of more than ten years. So while a rates hike would not have an immediate effect, it would naturally affect the general direction of travel nonetheless.

But then it would impact on banks that agreed to set their lending rates in stone for so long. Even if risks are passed on, they are still ultimately within the financial system, aren't they?

Yes, having a fixed rate for ten years is good for households if interest rates rise, because it means they have locked in the low rates over a long period of time. But it’s then the banks that are exposed to the interest rate risk.

And which banks are particularly affected by this?

Mainly savings and cooperative banks, which traditionally play a particularly important role in loans to households for house purchase. That is something supervisors are keeping a very close eye on. But there are other banks, too, that are very active in this market. We are also seeing insurers expanding into this segment. We are alert to these developments.

Is the strong increase in housing prices in recent years mainly a German phenomenon or is there a similar picture in the euro area?

The low interest rates mean that there is a common factor driving prices. Everywhere we look, we see investors searching for assets that still generate a return, and a flight into real assets.

What can the government do to help?

Risks in the real estate market cannot be addressed in a targeted manner using a broad instrument such as the countercyclical capital buffer on its own.  There is one initiative in the coalition agreement between the three members of Germany’s new “traffic light” government. It outlines plans to create the legal basis for additional regulatory instruments. Specifically, it concerns the possibility of determining two metrics: total household debt to income, and debt service to income.

Why do you think this is important?

Up until now, BaFin, Germany’s regulatory watchdog, has been able to define two minimum standards as and when necessary. It can require a minimum share of equity, plus a minimum amount of a loan that has to be repaid each year. Now it’s a matter of adding more instruments to the toolkit. Not necessarily in order to deploy those new instruments straight away, but to be ready and equipped to address elevated risks.

Talking about risks in the financial system, it is becoming increasingly important to analyse climate-related risks, too. How exactly can these risks be measured?

There is one approach we outline in our Financial Stability Review. We took a look at what carbon prices would be needed to meet the Paris Climate Agreement targets and what changes in valuations that might bring about.

Is that really so easy to do?

If you want to drill down to the level of individual firms, you need to have disclosure requirements and taxonomy obligations – that is, rules that define whether an enterprise’s operations are environmentally friendly or not. We set out to gauge how individual sectors in the real economy would be affected by changes in carbon prices, focusing on banks’ loan portfolios and insurers’ and investment funds’ securities portfolios.

What did you discover?

The changes in value would be fairly small – probably less than 10% of the portfolios. Those are losses that banks and insurers would be able to cope with. Also, the losses would materialise relatively early on, because the markets can see them coming, and then slowly decrease.

Are there other approaches as well?

Another possibility is to take into account physical damage caused by a rise in temperatures, such as heatwaves, droughts or floods. However, that damage materialises more over the long term. Maturities of most bank assets are no more than ten years – in fact, they are far shorter than that on average.

So are climate-related risks to the financial system being overestimated?

What our analysis is rather showing is how important it is to deal early on with the transition to a climate-neutral economy. If that task is done well now, the risks involved in the transition will be manageable. Good climate policy protects the financial sector.

Ms Buch, Joachim Nagel has now been lined up to succeed Jens Weidmann at the head of the Bundesbank. Do you have any special message for him?

I’d like to wish him the best of luck and every success, of course. Joachim Nagel is a highly esteemed colleague with a wealth of experience, and I very much look forward to working with him.

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