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Risks and stability analysis

Risk and stability analysis

01.01.2016

The Bundesbank analyses the entire German financial sector (credit institutions, insurers, the shadow banking sector and other financial intermediaries, financial markets and financial infrastructures).­ It focuses in particular in interconnectedness within Germany and between German and non-resident agents and markets. The objective is to identify systemically important changes and emerging risks as early as possible.

This risk and stability analysis adopts a risk-based approach, which often relies on looking at "downside scenarios". Unlike projections, which show the most likely development, downside scenarios describe less likely events that might cause major harm to the whole economy. Owing to the magnitude of the potential harm, these scenarios need to be studied despite appearing to have a low likelihood of materialising. Stress tests have an important role to play in this regard. Such tests show the impact that negative events or developments, eg an overall recession, would have on the financial system.

Systemic risk

Under the macroprudential perspective, systematic risks move centre-stage. Systemic risk is said to exist wherever developments in the financial system have a severe impact on the overall economy – as was the case during the international financial crisis of 2008-09. Systemic risk to the financial system is created by contagion and feedback effects which can set in motion a self-reinforcing mechanism, resulting in risks at individual institutions spreading throughout the financial system. Such contagion can be triggered by an exogenous shock, such as a deterioration in the macroeconomic framework not caused by the financial system – a case in point being a change in the macroeconomic propensity to invest. However, endogenous shocks stemming from within the financial system, such as the bursting of an asset price bubble, can cause systemic risk to emerge.

Feedback loops between the financial system and the real economy

Macroprudential analysis develops macrofinancial models which examine feedback loops between the financial system and the real economy. One area of investigation, for example, aims to establish the adequacy of private sector access to funding for investments and the sustainability of debt structures. For instance, high corporate or household leverage can increase the likelihood of bank loans defaulting, which can weaken the financial system's resilience. A weakened financial system is capable of significantly stunting a country’s economic growth. Conversely, a recession frequently causes increased defaults on bank loans and financial asset losses.

The economic and financial circumstances within the financial system and in the real economy may be mutually reinforcing both during a boom and during a downturn. Loose lending may, for instance, result in an increase in leveraged purchases of assets, such as property. The increased demand can cause the prices of these assets to rise, which can, in turn, have implications for their valuation as collateral. This higher valuation of collateral, for its part, makes it easier to access credit. In a downturn, when asset prices fall, this mechanism functions in the exact opposite direction.

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