Financial Stability Review: market participants should be wary of underestimating risk

The Bundesbank sees nothing to suggest that excessive risks are building up in Germany's financial system, but its 2017 Financial Stability Review nevertheless cautions against expecting too much from future economic developments. "It is imperative that the currently favourable economic situation and low level of volatility in the financial markets do not obscure the fact that there are risks to the stability of the German financial system and that these could grow," states the report, which the Bundesbank’s Vice-President Claudia Buch and her Executive Board colleague Andreas Dombret presented at a press conference in Frankfurt am Main.

Low-interest-rate setting and upbeat economy harbour risk

One of the main risks associated with low interest rates and an upbeat economy is that of overstating the debt sustainability of market participants, Ms Buch explained, singling out two scenarios which she said could hit Germany’s financial system hard.

One risk scenario is a faster-than-expected upturn in interest rates, which might put banks under considerable pressure by driving up their wholesale funding costs significantly, while their interest income would rise at a slower pace initially. The other scenario – one in which interest rates languish at their current low levels for longer than expected – might amplify banks’ search for yield and increase their willingness to take on risk. "A stable financial system needs to be in a position to weather unexpected, but by no means wholly unrealistic, scenarios such as the ones I have just mentioned," Ms Buch observed.

Banks need to further strengthen their resilience

The Bundesbank’s experts believe that the capital adequacy of German credit institutions is much better today than it was before the financial crisis. Tier 1 capital ratios – that is, the ratio of tier 1 capital to risk-weighted assets – have risen from 10% back in 2008 to 15.4% in the second quarter of 2017. Andreas Dombret, whose remit on the Bundesbank’s Executive Board includes banking supervision, welcomed above all the fact that institutions that were not as well capitalised prior to the crisis have raised their tier 1 capital ratio by a particularly large extent.

Commenting on the poor profitability of many German credit institutions relative to their European peers, Mr Dombret called on the banks to further strengthen their resilience and ensure that their funding models are sustainable. They should pay particular attention to maturity transformation and interest rate risk, he said, cautioning that, "To expect the favourable developments of the past to continue indefinitely might otherwise be tantamount to systematically underestimating credit risk."

Risks from housing loans still low

Another major topic covered by the Financial Stability Review is the residential real estate market, given its particular importance for the German economy as a whole. House prices climbed by 6% in 2016 and by a further 5.4% in the first six months of 2017. Bundesbank model calculations suggest that residential real estate is overvalued, especially in urban areas, with overvaluations last year estimated to have ranged between 15% and 30%. That contrasts with 2015, when the share of the price increase which could not be explained by economic fundamentals such as income, interest rates and demographic factors was just 10% to 20%. Yet the risks stemming from housing loans are still relatively low, the Bank’s experts write in the Financial Stability Review.

Bundesbank Vice-President Claudia Buch puts that assessment down to the fact that growth in loans for house purchase is lagging behind the rise in housing prices. At 3.9%, credit growth is down on the long-term average of 4.8%, she observed, adding that there is nothing in the available data to suggest that lending standards have been eased. "Nonetheless, there is a risk that lending activity in the real estate markets will prove unsustainable in future," she warned, saying that this could be the case if interest rates rise or there is a turnaround in price dynamics.

Structured evaluation of reforms

One further topic addressed in the Financial Stability Review is the raft of comprehensive financial regulatory reforms which were initiated in the wake of the crisis with a view to strengthening capital adequacy and ultimately improving resilience across the financial system.

The agreed rules now need to be applied consistently, the report states, if the market mechanism is to function and taxpayers are to be better protected in the future. It is also time to evaluate the impact of those reforms. "A structured evaluation is the only way to gauge the costs and benefits of the reforms to society at large," Claudia Buch reasoned, adding a word of warning that, "The evaluation of the reforms should not be used as a pretext to water them down or weaken the resilience of the financial system."

Video of the press conference

Publications on the Financial Stability Report