The Deutsche Bundesbank's 2016 Financial Stability Review

Persistently low interest rates and muted growth in the real economy are encouraging the build-up of risks to financial stability. "In the current macroeconomic setting, there is the danger that market participants might underestimate risks and fail to adequately take into account the possibility of asset prices falling and interest rates rising," said Claudia Buch, Vice-President of the Deutsche Bundesbank, in remarks made at the unveiling of the 2016 Financial Stability Review. "It is therefore crucial that market participants ensure that contractual terms are appropriate and that they build up risk buffers that are large enough to also absorb losses from unexpected developments," Buch stressed.

According to the Financial Stability Review, banks and life insurers in particular would suffer if interest rates were to rise. Adequate capitalisation is therefore a prerequisite for the financial markets to be able to discharge their function for the real economy and to promote real economic growth.

Furthermore, the low interest rates also increase the incentives to invest in residential property. According to the Financial Stability Review, this can pose risks to financial stability whenever a sharp rise in house prices coincides with a significant expansion in credit volumes and an easing of credit standards. This can happen particularly if many market participants come to an overly positive assessment of future debt sustainability. "Although house prices in Germany have been moving sharply higher since 2010, there is currently nothing to suggest excessive lending or a weakening of lending standards," Ms Buch said.

Lower lending rates are also putting pressure on the business models of German banks and savings banks, which rely heavily on lending and deposit business. "Banks are issuing loans with longer maturities in Germany as a way of keeping their interest income stable," Andreas Dombret, the Bundesbank Executive Board member responsible for banking and financial supervision, said at the unveiling of the Financial Stability Review. One consequence of interest rates being locked in for longer was that it made the banking sector less flexible to respond to interest rate changes. "The longer interest rate fixation means that banks and savings banks incur higher interest rate risk. This risk needs to be actively hedged," Dombret remarked, noting that this was why banks needed to be adequately capitalised. Overall, he believes that German banks and savings banks are robust: "There can be no doubts as to the solvency and liquidity of German banks and savings banks. A positive development is that institutions have raised their capital levels in recent years and fared well in this year’s EBA stress test," Dombret continued. At the same time, he reiterated his warning that a lot of German banks are not profitable enough. Alongside the protracted low-interest-rate phase and the regulatory reforms in the banking sector, the digitalisation of the financial sector also presented a challenge for German banks and savings banks, he explained.

Against this backdrop, the Financial Stability Review also examines the spread of technology-enabled financial innovations, known as fintechs. These new technologies can help make the financial system more stable, for instance by improving lending and the diversification of risk. However, they can also encourage herding behaviour. That is why the Bundesbank is watching these markets very closely.

The Financial Stability Review also discusses the greater importance of central counterparties (CCPs). In 2009, the G20 decided that standardised over-the-counter derivatives should henceforth be cleared only via CCPs. CCPs can help reduce channels of contagion between banks, but being a potential source of systemic risk, they also require an adequate level of regulation.