Financial stability and credit markets in Europe:
Opportunities and risks in the current setting
Professor Claudia M. Buch
(Deutsche Bundesbank)
Dinner talk at the second Süddeutsche Zeitung conference on the topic of "private debt and
direct lending"
Frankfurt am Main
18 September 2018
It is nearly ten years ago to the day that the global financial crisis reached its initial peak. The
global economic crisis that followed was the most severe since the Great Depression. In the
wake of the crisis, reforms to the financial markets were introduced with the aim of making
financial markets more resilient, and many of these reforms have already been
implemented. After all, the stability of the financial system is a key prerequisite for an
efficient and dynamic economy. Just as preventive medical care and a good immune system
help to limit the effects of disease, a prudent approach coupled with good defences helps
the financial system to mitigate the effects of economic shocks. The question today is how
far the international financial system is better placed to deal with unexpected developments
than it was just a decade ago.
The global economy is currently fraught with uncertainty on a number of fronts. Geopolitical
tensions have escalated, and trade disputes have erupted, some of which threaten to tip
into a trade war. In Europe it is unclear under what circumstances the United Kingdom will
leave the European Union. Germany's economy may be booming right now, but every period
of growth, no matter how long it lasts, ultimately gives way to an economic downturn. How
well prepared is the German financial system to face a potential economic slump? What
happens if risks materialise?
1 With the global economy in good shape and interest rates low, risks can
be underestimated.
The world economy is currently doing well. According to calculations by the International
Monetary Fund (IMF), global growth will amount to 3.9% both this year and next year (IMF
2018). For the coming year, the IMF is forecasting only a slight fall in growth from 2.4% to
2.2% for industrial countries and from 2.2% to 1.9% for the euro area.
At the same time, the IMF has emphasised that this growth is not without risk and that some
risks are already materialising. For example, the debt level in some emerging market
economies has gone up sharply in recent years, and these liabilities are often denominated
in foreign currency. This has created vulnerabilities which have surfaced in recent weeks and
months. For example, the Turkish lira has lost nearly 40% of its value in the year to date, and
the Argentine peso as much as 50%, or thereabouts.1 Thus far, market participants have
regarded these issues as relatively isolated incidents. Currently, the effects on global
financial markets are small. But possible contagion effects and interactions with global risks
are difficult to forecast.
Public and private debt, which are close to their all-time highs in global terms, are one of the
global financial system's vulnerabilities. Industrial countries which bore the brunt of the
crisis have seen public debt levels balloon, largely on the back of measures to shore up the
financial sector. This has shifted risk from the private sector to the government sector. In
many emerging market economies, by contrast, it is above all (non-financial) private sector
debt that has increased. In fact, it has more than doubled in recent years. Compounding this
situation further, some of these sectors are highly exposed to currency risk.
Banking sector debt has generally diminished in recent years. Measured in terms of
riskweighted assets, the capitalisation of the banking sector at the end of 2017 stood at roughly
17% in the euro area, compared with 14.2% in the United States. However, measured in
terms of total (unweighted) assets, these ratios were significantly lower, at 5.8% in Europe
and 9.3% in the United States (CGFS 2018). It should be noted that, due to the differing
accounting standards, these figures are not directly comparable.
In Germany, banks' tier 1 capital ratio - i.e. tier 1 capital in relation to risk-weighted assets -
has climbed from from 9% at the start of 2008 to 16.4% at the start of 2018 (Chart). The
unweighted capital ratio, i.e. tier 1 capital in relation to total assets, rose in the same period
from 3.1% to 6.2%.
Furthermore, capital adequacy levels sometimes vary significantly from one bank to the
next. The tier 1 capital ratio of the large, systemically important financial institutions in the
first quarter of this year stood at 16.9%, while the unweighted capital ratio came to 4.9%.
For small and medium-sized banks, the equivalent figures were 15.6% and 8.1%.
The wide variation in capital ratios shows that the amount of capital banks have to cushion
against unexpected events depends not least on how well future risks are captured by the
risk weights. At the moment, the economic environment in Germany is highly favourable.
The German economy has now been expanding for nine consecutive years, which is the
longest period of growth since German reunification. According to the Bundesbank's
projections, the economic boom is set to continue, with gross domestic product forecast to
rise by 2% this year and 1.9% next year (Deutsche Bundesbank 2018). Enterprises and
households alike can borrow cheaply, and they have accumulated comfortable capital
buffers. The number of insolvencies and credit defaults is low, and valuations in financial
markets are high. This upbeat macroeconomic situation is conducive to a gradual rise in
interest rates. Assuming the economy does indeed follow its expected path, the risks to
financial stability will probably be limited.
But what if the economy takes an unexpected turn for the worse? What if there is an
unforeseen downturn in real economic momentum and interest rates remain low - and
close to zero - for even longer, or if political risks materialise and risk premiums spike in
financial markets?
A resilient financial system needs to be in a position to weather such scenarios, which
though unexpected, cannot be fully ruled out. This is especially true in boom periods,
because the longer these continue, the more market participants tend to take them for
granted and not prepare for gloomier times. Unexpectedly weak growth and an increase in
volatility could then have even greater repercussions.
Scenarios like this are not out of the question, even for Germany. The German economy is
closely interlinked with the global economy, so it would be hit hard by possible abrupt
corrections in international markets. Possible negative effects can be amplified if many
market participants are exposed to similar risks.
2 The German financial system is vulnerable to negative macroeconomic
developments.
Over the last decade, German banks have improved their resilience and built up capital.
However, this capital is also counterbalanced by greater macroeconomic risk. The effects of
risks on individual banks is something that supervisors keep a watchful eye on. However, an
assessment of the overall risk situation needs to look at more than just individual
participants or sectors in isolation. A macroprudential, or systemic, perspective is therefore
needed to complement the microprudential approach. This way, it is possible to take into
account contagion mechanisms in the financial system that can give rise to systemic risks.
After all, problematic developments in individual parts of the financial system can ripple out
across institutions and ultimately take their toll on the real economy. These amplification
effects can particularly come to bear if many banks are exposed to the same risk and if
macroeconomic risks correlate strongly with each other.
Monitoring systemic risk in Germany is the task of the German Financial Stability Committee
(AFS). The Committee consists of representatives from the Federal Financial Supervisory
Authority (BaFin), the Deutsche Bundesbank, and the German Federal Ministry of Finance,
which acts as chair. In its latest report to the German Bundestag, the Committee examined
the state of Germany's financial system (German Financial Stability Committee 2018).
At present, there is a danger that future economic risks might be underestimated. For
example, there could be an unexpected downturn in the economy, which would result in
insolvency rates and thus credit risks rapidly rising. Reserves and capital might be insufficient
to cover the losses from such an unexpected event, particularly if risk assessments scarcely
take into account periods of crisis fraught with economic downturns and correspondingly
higher credit default rates, or even ignore them altogether.
In the current long period of economic expansion, there is the possibility that credit risks are
being underestimated in the real estate market. This market, which is significant for
Germany in macroeconomic terms, could harbour risks to financial stability. This would be
the case, for example, if a sharp increase in real estate prices led to an excessive rise in
lending and a loosening of credit standards. Prices are continuing to rise dynamically.
Bundesbank estimates indicate that house prices in German towns and cities were
overvalued by between 15% and 30% in 2017. Growth in residential loans currently stands at
4.3% (second quarter 2018) and thus below its long-term average of 4.8%.2 At the same
time, there is no clear evidence to suggest that banks have loosened their credit standards
for residential loans. However, given the strong upward pressure on prices in recent years, it
cannot be ruled out that the value of loan collateral is being overestimated. The value of
loan collateral will probably turn out to be lower, particularly in the event of an economic
downturn. This increases the risk of unexpected losses arising as a result of defaults on
loans.
One key macroeconomic risk that the German financial system is exposed to is interest rate
risk. In recent years, banks have sharply increased the share of new loans with long interest
rate lock-in periods. The share of newly issued loans with an interest rate lock-in period of
over ten years stood at 45% in the second quarter of 2018; at the start of 2010, this share
was markedly lower, at 26%. By contrast, bank funding tends to be of a short-term nature,
and often at variable interest rates. This means that banks have become more vulnerable to
a potential rise in interest rates. An abrupt increase in interest rates would drive up banks'
financing costs, but their interest income would rise less quickly to begin with.
If risks materialise that are larger than expected, this could set negative momentum in
motion in the financial system. In the short term, a critical situation is a particularly
inopportune time for banks to raise capital in the markets, at the very time this capital would
be needed to absorb losses. Individual banks would then have to shrink their balance sheets
in order to fulfil the increased capital requirements. They would have to sell assets, scale
back existing lines of credit to the real economy, or cut back on the issuance of new loans. If
fire sales send securities or real estate prices plummeting, this can also take its toll on
institutions for which loan losses were barely an issue to begin with.
3 Now is the time to strengthen the financial system's resilience in
readiness for tougher times ahead.
"The time to repair the roof is when the sun is shining".3 The International Monetary Fund
has repeatedly drawn attention to this principle in recent times. Public sector budgets need
to be put on a sustainable footing, debt levels need to be reduced, and budgetary leeway for
more difficult times needs to be created.
That said, protection against unexpected macroeconomic developments also needs to be
put in place in the financial system, too. Everyone should make provisions for unexpected
developments to ensure that they can still service their debt if the economic conditions
worsen. Unexpected developments can happen in the home market, but they can also occur
in emerging market economies or other industrial countries and then spill over to Germany.
Many mature economies are currently experiencing buoyant economic conditions, output
gaps have been closed in many cases, and cyclical risks in the financial system are mounting.
Financial institutions with higher levels of capital are more robust and thus also make the
financial system as a whole more resilient. If all market participants have strong defences,
the risk of contagion falls. Unexpected events will then have less severe consequences.
However, resilience needs to be built up in good time - once a recession has begun it may
already be too late. It's rather like building up protection against the flu. Once a wave of
influenza has broken out, it is too late to get vaccinated. The only problem is that when the
weather is fair and you feel well, it is all too easy to forget that times may also take a turn for
the worse.
It is therefore important to take preventive action. If the financial system is not resilient
enough, this can amplify an economic downturn. Banks would then excessively curtail their
lending precisely when the economy is already running into difficulties. This is precisely what
happened around the globe in the last crisis. Defences therefore have to be built up when
times are good.
Currently, the sun is shining on the markets, we are experiencing the longest period of
growth since the 1970s, and credit losses are low. Now is the time to build up sufficient
capital, which will strengthen the resilience of individual institutions and the financial system
as a whole in the event of an economic downturn.
4 List of references
Committee on the Global Financial System - CGFS (2018). Structural changes in banking after
the crisis, CGFS Papers No 60, January 2018.
Deutsche Bundesbank (2018). June 2018 Monthly Report.
German Financial Stability Committee (2018). Fünfter Bericht an den Deutschen Bundestag
zur Finanzstabilität in Deutschland, June 2018.
International Monetary Fund - IMF (2018) World Economic Outlook Update, July 2018.