Risks have increased for banks Interview published in the Frankfurter Allgemeine Zeitung (FAZ)

Interview with Joachim Wuermeling conducted by Markus Frühauf.
Translation: Deutsche Bundesbank

Mr Wuermeling, are German banks prepared for a recession?

As things stand today, German banks are prepared for a recession. However, the higher inflation and the interest rate reversal pose additional risks. Economic conditions have also deteriorated significantly. Here, too, there is heightened risk. We are therefore keeping a very close eye on developments.

Where are the biggest weaknesses?

One weakness of German banks is their low profitability. Interestingly, this is affecting big banks more than small ones. Profitability is important for stability: the higher the profits, the more losses that can be covered or buffers built up. Having doubled their capital ratios since the financial crisis, German institutions are nevertheless very well positioned. There is a total of €150 billion in surplus capital, which banks have at their disposal to absorb a great deal of strain. We are not currently seeing elevated numbers of non-performing loans or defaults. However, there are negative indicators, such as rating downgrades or higher risk premia on corporate bonds. Banks are therefore preparing for higher levels of risk provisioning.

When will the interest rate reversal lead to higher earnings?

That has already been the case for residential real estate. Interest rates for building finance have tripled since the start of the year, while banks’ funding costs have risen much more slowly. The interest margin has already widened here. However, the increase in yields means that banks are experiencing price losses in their bond and equity holdings. 

Are you concerned about the losses in value on securities investments?

No, 70% of banks will be in positive territory one year on from the interest rate reversal, which is to say that the balance sheet losses will have been worked through and interest income will have risen. Normally, interest margins also widen because deposit rates rise more slowly than lending rates. But even in the run-up to the ECB’s interest rate hikes, the fight for deposits had started. Negative interest rates were scrapped and interest rates on fixed-term deposits were raised. 

The low interest rates will not disappear from banks’ balance sheets that quickly because of long-term loans.

There are banks that have hedged against interest rate risk using derivatives. Other institutions haven’t done this. Overall, around half of German banks are exposed to increased interest rate risk. As supervisors, we have responded by imposing significant capital surcharges, particularly for smaller institutions making relatively little use of derivatives. Many were already aware of their own risks, though, and had voluntarily set up a good capital buffer.

Does high inflation pose specific risks for banks?

Yes, because borrowers are faced with higher costs. This relates to both businesses and households alike. This higher cost burden tends to weaken debt service capacity, increasing counterparty credit risk. That is why enterprises that have taken on a great deal of debt financing are among those which must be monitored critically.

What will be the significance of net commission income, which in recent years has been driven, in particular, by the greater willingness of retail customers to invest in securities?

It is generally very difficult to forecast investment behaviour. Now that interest rates have risen, retail investors are once again able to use fixed-term or instant access savings accounts as alternatives to portfolio investment. However, many savers have had good experiences investing in securities over the past few years, so a flight from portfolio investment is unlikely. Even so, as interest income rises, the share of fee and commission income will generally drop significantly.

US banks have not escaped unscathed in the current difficult stock market environment. Do you fear that price corrections will continue?

We are currently seeing strikingly large fluctuations in the capital markets. Revaluations are affecting various asset classes. We are in a period of high uncertainty that is feeding through to the financial markets, and this is being compounded by the normalisation of monetary policy. However, the German banking sector is well positioned enough to be more likely to absorb any real economic shocks – such as a halt to gas supplies – rather than amplify them. 

What is the situation on the real estate market?

It is currently experiencing a slowdown. Owing to the rise in interest rates, many interested parties are no longer able to afford their desired property. Professional investors, too, are holding off due to the difficulty in making predictions. The same applies to insurers, pension schemes or foundations, which have shifted to the real estate market in recent years owing to the lack of other options. In the meantime, however, they have been able to generate fairly decent income from Federal bonds again. Although demand will fall on the real estate market, it will still exceed supply. We therefore expect price corrections, but not a slump.

What can banks do now and what can supervisors do?

Banks must continue to ensure a high level of capitalisation and thereby watch out for their resilience. They should retain rather than distribute capital, recognise risks early on and quickly process poorer-quality loans on their balance sheets. Supervisors will look at the risk situation very closely and call on banks to prepare for adverse scenarios such as a gas supply halt or a recession.

Should the €2.3 billion still left over in the Restructuring Fund be used to ease the burden on banks or partially cover the losses from bank bailouts?

We believe a case can be made for these funds to be used for banks’ outstanding contributions to the European Single Resolution Fund. The banks themselves raised these funds in order to finance the resolution of distressed banks. The funds do not come from taxpayers.

How satisfied are you with the performance of German banks in the ECB’s climate stress test?

This was a learning exercise for both banks and supervisors. It was striking how many banks in the euro area have not yet devoted sufficient attention to this topic. However, the German banks performed comparatively well and, in some cases, have been leading the way in their methodologies. The results of the stress test show that the transition risks can be managed. Climate risks to banks’ balance sheets are lower than to society. But we need to remain vigilant. Ultimately, quantifying the risks poses considerable difficulties that banks and supervisors will need to keep working on. What is clear is that credit decisions cannot be made without climate considerations in future, as customers’ financed assets also need to have a stable value in the medium term.

If craft industries require a bank loan, will they need to obtain an external rating once the transition periods for implementing Basel III come to an end?

No, this won’t be the case because many Mittelstand firms will still be covered by the exemptions for small and medium-sized enterprises. In Germany, this applies to around 99% of businesses. This is often forgotten in the debate surrounding the EU’s implementation of Basel III. In addition, a large part of these businesses are served by institutions that use the standardised approach for credit risk. The risk weight for enterprises without an external credit assessment does not change for these institutions.

More enterprises than before will require an external rating, though. In France, the central bank is creating such credit ratings, but the Bundesbank is not.

We, too, would need to check the eligibility for central bank operations of enterprises’ loans if banks submit them as collateral. Unlike the Banque de France, we have so far not used these assessments in banking supervision, but exclusively for monetary policy. However, I believe that we can reconsider the matter.

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