Hans-Helmut Kotz: Deutsche Bundesbank Financial Stability Review
2009
Speech by Prof Hans-Helmut Kotz, Member of the Executive Board of the Deutsche
Bundesbank, at the press conference of the presentation of the Deutsche Bundesbank
Financial Stability Review 2009, Frankfurt am Main, 25 November 2009.
* * *
I German financial system stabilised
In early autumn of 2008, the international financial system was on the verge of collapse.
Activity in interbank money markets was severely impaired, with virtually no turnover at all in
the longer maturities. Enormous uncertainty prevailed. Premiums for unsecured loans soared
to 50 times above their pre-crisis levels. All indicators of risk - whether in the equity, bond,
credit or derivatives markets - were standing at all-time highs. There was a danger that the
international financial crisis, interacting with the severest slump in global growth in more than
half a century, would lead to a more or less uncontrollable downward spiral.
A perceptible stabilisation has been under way since the spring of 2009, however, even
though this predominantly reflects the unprecedented measures taken by fiscal, monetary
and financial market policymakers. A worse outcome was averted only thanks to these
nonstandard policy measures, which were applied throughout the world. The international and
German financial systems were only stabilised when the public sector - in Germany as
elsewhere - assumed the role of "risk-taker of last resort". This is the backdrop against which
we present this year's Bundesbank Financial Stability Review.
At the current juncture, domestic credit institutions are benefiting from a more benign global
economic outlook. Prospects have improved markedly, and this applies especially to the
strongly export-oriented German economy. This is having an immediate positive impact on
the conditions in which the financial sector operates.
Nevertheless, the road before us is strewn with obstacles. Major challenges for the German
banking system still lie ahead. The purpose of our Financial Stability Review is therefore to
assess possible risks going forward as well as the German financial system's resilience in
the light of potential, but not unrealistic adverse developments.
Recent upward revisions of growth forecasts should not blind us to the fact that the more
benign global economic climate is mainly the outcome of the large-scale fiscal stimulus
programmes. Concurrently, extraordinary monetary policy measures were deployed to
underwrite the financial system's stability. The process of restructuring the financial sector,
which was made possible by these unprecedented policy initiatives, remains vulnerable,
however, to setbacks in the recovery of the real economy. The upturn is still far from being
self-sustaining. The coming year will show how far fading public-sector stimuli can be
replaced by endogenous private sector activity - in Germany's case, this is typically
generated by the interplay between net exports, capital expenditure and household
consumption. It is still open to doubt, however, whether such a stylised or typical upswing will
actually materialise this time round. Hence, it would be premature to regard the financial
crisis, and the economic crisis directly linked to it, as having already run their course.
Clearly, a protracted period of stagnation in the major economies would pose a substantial
risk to financial stability. The detrimental, self-reinforcing feedback loop between an
unprecedented and globally synchronous reduction in the level of real economic activity and
an essentially dysfunctional financial system, which has been unravelling since the summer
of this year, might then tighten again. It follows from this that exiting the broad-based
stabilisation policies should be predicated on and calibrated to a sustained improvement in
the underlying market conditions as well as in financial sector resilience.
At the same time, it is important to bear in mind the implications which the highly unorthodox
measures taken to support and stimulate the economy inevitably entail. They inherently carry
considerable risks over the medium and long term. A prime example of such risks is
ballooning government debt in many industrial countries. In addition to already
acknowledged, explicit public debt, the bank rescue packages obviously impose an
additional, implicit potential burden on the public sector. Transparent and credible strategies
are therefore crucial for unwinding and managing the fiscal - and, of course, monetary -
policy support measures. Should the policy-making process lose its credibility, this would be
reflected in rising risk premiums and interest rates. Higher interest rates, in turn, would tend
to depress capital expenditure and, therefore, potential growth. In addition, they would further
hamper the already onerous task of consolidating public finances, which is vital to ensure
sustainable debt containment. It is therefore crucial to keep market participants' expectations
of a stability-focused monetary policy as well as a sound fiscal policy firmly anchored.
II Ongoing challenges
The government and other public support measures have bought the financial system time to
cope with losses and to prepare for potential financial strains lurking on the horizon.
Moreover, public-sector intervention has had a decisively positive impact on the outlook for
earnings. Short-term interest rates are at very low levels indeed. The yield curve, ie the
spread between long-term and short-term rates, is exceptionally steep. This naturally allows
substantial income to be generated from maturity transformation (see Chart 1). Income from
commissions and fees has also soared recently, partly on the back of the large-scale
issuance of government bonds which the public sector has been obliged to launch in
response to the financial crisis. Income from commissions and fees is being further boosted
by vigorous corporate issuance activity. This has also begun to boost equity and credit
markets since the spring of 2009, thus improving banks' earnings form brokering and
proprietary trading. Nonetheless, this development is fragile. It is being buoyed by the
nonstandard public sector support packages which - being extra-ordinary - have to be phased
out at some point. Quite clearly, the current conjuncture does not represent a new post-crisis
normality.
Yet this by no means implies that German banks have not recognised the seriousness of the
situation. They have consolidated their balance sheets and also bolstered their capital
buffers (see Chart 2). For instance, the average tier 1 capital ratio rose by 2.4 percentage
points between mid-2007 and mid-2009. Another positive aspect is that, by international
standards, Germany is in a comparatively favourable starting position for weathering the
financial crisis. For one thing, domestic enterprises and households have relatively moderate
levels of debt. Consequently, the percentage of non-performing loans is correspondingly low.
For another, real estate prices in Germany have been flat for a long time, and have thus in
no way decoupled from fundamentals. Obviously, this is limiting credit risk in property
financing.
Nonetheless, even in case a lasting economic recovery is underway, German banks will
have to tackle some sizeable problems. For instance, their balance sheets will have to
accommodate substantial further value adjustments. Based on our empirical assessment, for
the 17 banks mostly involved, with some €90 billion of impairments already recognised, the
peak of write-downs on securitisations is behind them. Given current prospects, additional
write-downs on structured products of some €10 billion to €15 billion are to be expected (see
Charts 3 and 4). If, however, the price recovery in evidence since mid-2009 continues, losses
in the overall portfolio will be lower.
The outlook for the evolution of assets in the loan book is, however, quite different. Here, the
well-established stylised fact is that write-downs lag the real economy's cycle This also holds
in the current situation. Loan losses will be a drag on banks' earnings going forward. Using
the information from a time series as well as a cross-section dimension for the whole
German banking system, we conclude that further write-downs of between €50 billion and
€75 billion are to be expected. It goes without saying that, particularly at this juncture, these
estimates (see Charts 5 and 6) are subject to significant uncertainty. Statistical relations are
likely to be less robust than they have typically been in the past. We should add that our
assumption for economic growth is significantly less benign than the current consensus.
Therefore, if the economic recovery accelerates, as assumed in recent forecasts, banks'
revaluation requirements would be correspondingly lower. Needless to add, the projected
potential write-downs will not automatically translate into additional capital requirements.
Current income as well as loan-loss provisions can obviously also be used to cover potential
losses.
Nevertheless, banks would be well advised to steel themselves against possible negative
developments. They have won time to tackle their accumulated problems and prepare for
future contingencies. They should use the capacity to adjust that has been created, first and
foremost, to bolster their risk provisioning, shore up their capital and enhance their cost
efficiency. Currently, the low level of lending largely reflects German enterprises' weak
demand for credit, hence access to credit is currently not impaired by capital scarcity. But
looking ahead, fatter capital cushions would strengthen banks' capacity to cater to the rising
corporate borrowing demand which typically accompanies an upswing. At the same time, the
pricing of this credit supply should be commensurate with the underlying risks.
III Macroprudential approach - a new focus for supervisors and regulators
After having successfully stabilised the financial system, governments, central banks and
prudential supervisory authorities around the world now face the challenge of drawing the
appropriate conclusions to prevent a crisis of such a magnitude from recurring. By its nature,
financial stability is a public good. It cannot therefore be ensured solely on a private basis.
There is a significant difference between private and social rationality. Actions that are
reasonable from an individual perspective may generate unintended externalities which
produce adverse implications for systemic stability. Consequently, financial stability cannot
be expected to arise spontaneously from the interactions of private players. At the same
time, the absence of financial stability may well entail enormous costs to society - as we
have just painfully experienced. Therefore, together with national and international
institutions, we are working hard to draw the right lessons in order to contain potential
vulnerabilities. As the reasons for the crisis are multifaceted and complex, there are no
simple answers or quick fixes. What is needed, rather, is a set of specific changes and
concrete amendments to the regulatory and supervisory framework. Thoroughness has to
take priority over speed.
One key insight gained from - or perhaps it is more accurate to say reaffirmed by - the crisis
is that the traditional microprudential perspective, focusing largely on individual institutions
only, is no longer appropriate. To address financial stability issues appropriately the
microprudential approach has to be supplemented by macroprudential supervision. Naturally,
microeconomic supervision remains indispensable. It is, however, far from adequate for the
effective prevention of crises which are the upshot of systemic stress. A failure to take a
holistic, system-wide view logically implies a danger of ignoring systemic risks that emanate
from the interaction of the financial market players. Systemic risk is created endogenously
rather than having exogenous origins beyond the remit of financial markets. It can arise, for
example, in the form of herding behaviour. Systemic stress may also result from excessive
homogeneity, which generally renders systems vulnerable. Liquidity risk is a special and
important case in point. Here, feedback effects - between difficult funding conditions and
problematic market liquidity - may bring about a systemic downward spiral. In particular,
repo markets will be affected most severely. The systemic perspective therefore has a
particular relevance for market-oriented financial systems (as opposed to those
characterised by a higher degree of bank intermediation).
The design of macroprudential supervision and regulation hence raises a host of complex
issues. Procyclical elements of regulation - whether they relate to capital requirements or
accounting principles - may, for instance, aggravate the inherent ups and downs of the
financial system. If the impact of these regulations in an upturn is different from their impact
in a downturn, this will have an immediate effect on the real economy. Such generators of
procyclicality may, for example, favour a build-up of credit-financed imbalances in an upturn.
In the same vein, these mechanisms might also potentially amplify feedback effects of
negative market developments during a crisis. To contain these destabilising effects, greater
importance should be attached in future to adequate and, in particular, counter-cyclical risk
buffers.
A second challenge arises from the interconnectedness of the financial system. This is
obviously a necessary feature of any modern financial system. But this interdependence
entails consequences - macroeconomic costs which cannot be accounted for at the
microeconomic level. These systemic externalities increase as institutions become larger and
more interconnected. The macroprudential perspective therefore provides arguments for
treating financial intermediaries differently according to their position in the system as a
whole. This functional view also justifies regulating market participants outside the traditional
banking system identically insofar as they fulfil similar functions or roles. The appropriate
regulation and supervision of big or highly interconnected institutions poses a particular
difficulty as their collapse would jeopardise the financial system as a whole ("too big or too
interconnected to fail" problem). A logical corollary of this is the need for a greater intensity of
supervision. Moreover, additional capital requirements make sound analytical sense. Yet it
should be noted that the practical implementation of these theoretically advisable ideas
involves some difficulties as does, incidentally, formulating anticyclical capital requirements.
However, this must not lead to the issue being ignored, as the potential opportunity costs to
society would be too grave.
It is clear from these brief comments that adding a macroprudential perspective to
microprudential oversight poses major challenges for central banks and supervisory
authorities. The Bundesbank is seeking to face these challenges by devoting particular
attention to macroprudential analysis. Since May 2009, all work on these issues has been
focused within our newly created Financial Stability Department. This department was also
mandated to write this year's Financial Stability Review.
Getting macroprudential supervision right is indeed very much a work in progress. We are in
the middle of a period of intense debate. Nevertheless, concrete progress has already been
achieved in some areas. In this regard, the reform agenda which is being implemented
through the G20 summit process, largely under the guidance of the Financial Stability Board
(FSB), deserves special mention. Given significant mutual interdependence as well as
substantial cross-border effects, there is good reason to establish rules at the international
level. Inconsistencies encourage regulatory arbitrage and thus tend to heighten systemic
vulnerability. Therefore, the Bundesbank is very much involved in the work of the FSB. I
would like to restrict myself to highlighting just two aspects which enjoy a very broad
consensus in the international debate.
First, there is consensus on one of the points mentioned earlier, namely the need to
strengthen financial institutions' resilience; the capital and liquidity buffers for weathering
crises have to be increased. More robust capital and liquidity requirements as well as an
improved measurement of exposures to risks are also necessary so that risks arising from
excessive leverage can be better controlled in the future. Due account should be taken when
devising and implementing rules of the particularities and peculiarities of national financial
systems. This is especially important with regard to the aspired improvement in the quality of
banks' capital base. Here it is essential to focus on the targeted function - the ability to
absorb losses - rather than on legal form. In view of the ongoing difficult economic
environment, it is also evident that appropriate transition periods have to be granted.
Overhasty implementation would pave the way for a likely capital-induced credit supply
failure.
Second, we must ensure that the incentive structures of participants in the financial system
are aligned with the objective of fostering a sustainable development. This will be facilitated
by enhanced transparency, which strengthens market discipline, even though it is obviously
not sufficient on its own. This applies especially to the securitisation process. Significantly
improved standards of quality and integrity are a key precondition for reviving the
securitisation market. Originators should have a direct interest in ensuring that all risks
(including those of correlated defaults) are captured adequately - for instance by retaining a
vertical slice of securitisations. Provided the instruments are designed in a way which makes
microeconomic risk-taking compatible with sound macroeconomic outcomes, they can play
an effective role as a source of funding for the banking sector. They will thereby also
contribute to reliable and properly priced lending to enterprises - which is the most important
aspect from an economic perspective.
In a nutshell, the internationally coordinated reforms should substantially increase the
stability of the financial system. On balance, they will probably imply more moderate earnings
prospects in the financial sector. However, earnings are also likely to be less volatile and
therefore more robust. Given the considerable negative externalities that may arise if
financial institutions run into distress, that seems a price worth paying to safeguard financial
stability. After all, in the long run banks themselves will also benefit from a more stable
financial system.
Chart 1
Chart 2
Chart 3
Chart 4
Chart 5
BIS Review 164/2009
Chart 6
BIS Review 164/2009