The Deutsche Bundesbank publishes its 2019 Financial Stability Review

The German financial system remains vulnerable to adverse economic developments. 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,” Bundesbank Vice-President Claudia Buch explained, adding that a stable financial system should be able to cushion such shocks rather than amplifying them.

Just last year, interest rates had still been expected to rise slowly. These expectations were not met. Export-oriented industry in Germany is in the midst of a downturn, whereas the forces of growth have the upper hand in the domestic economy. The interest rate level slipped further as economic activity decelerated, and low risk-free interest rates continue to be expected. “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. “The low interest rates are putting institutions’ interest margins under increasing pressure, hurting their profitability and thus also putting financial stability at risk,” added Joachim Wuermeling, the Bundesbank Executive Board member responsible for banking supervision.

Risk underestimated

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. Minor credit risk is 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.

An unexpected economic downturn might lay bare the existing vulnerabilities. On the whole, German enterprises’ creditworthiness has 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 evenly distributed. This allocation risk has increased in recent years and is feeding into cyclical vulnerabilities in the German financial system.

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.

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 stabilise their interest income. Thus, one out of two new loans for house purchase now 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

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, and, for the most part, they may use their surplus capital to meet the requirement. “The countercyclical capital buffer strengthens the resilience of the financial system and stabilises 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.

Need for action to ensure a stable financial system

A functioning financial system is key to ensuring that structural change can succeed without hampering innovation or jeopardising stability. One of the major challenges is climate change. With that in mind, this year’s publication has dedicated a chapter to the impact of climate-related risks on financial stability. From the vantage point of macroprudential supervision, it is crucial that the financial system is sufficiently resilient to uncertainties and risks surrounding climate change, and that systemic risk does not accumulate. The results of a special survey by BaFin and the Bundesbank indicate that most financial institutions have yet to incorporate climate-related risks into their risk analyses. “Only a small proportion of the responding institutions indicated that they were currently planning to add climate risk to their risk management. There is some catching-up to be done here,” said Mr Wuermeling.

Structural change has also not stopped short of the financial sector. An effective resolution and restructuring regime for banks helps market mechanisms to function properly. For this reason, the Financial Stability Board is currently seeking feedback from stakeholders as part of its evaluation of the effects of the too-big-to-fail reforms agreed by the G20.