Claudia Buch: The Deutsche Bundesbank's Financial Stability Review
2015
Speech by Prof Claudia Buch, Deputy President of the Deutsche Bundesbank, at the press
conference to unveil the Deutsche Bundesbank's Financial Stability Review, Frankfurt am
Main, 25 November 2015.
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Ladies and gentlemen
I would like to warmly welcome you to the unveiling of the tenth Financial Stability Review of
the Deutsche Bundesbank. It is almost ten years ago to the day that current governor of the
Reserve Bank of India and then professor at the University of Chicago, Raghuram Rajan,
asked the following question: has financial development made the world riskier? A cornerstone
theory addressed in his speech delivered at the Federal Reserve Bank of Kansas City's annual
Economic Policy Symposium in Jackson Hole was that low monetary policy interest rates
incentivise excessive risk-taking.
The situation today is quite similar to 2005. Interest rates are low, which is squeezing banks'
and insurers' earnings, and investors are on the hunt for higher returns. But fundamental
framework conditions have shifted as well. Notably, better possibilities exist today for
regulators to tackle systemic risk.
1. What factors influence financial stability?
For in recent years, microprudential supervision and regulation have been increasingly
complemented by a macroprudential perspective so as to encompass the stability of the
financial system as a whole. The extent to which individual institutions are high-risk and their
compliance with regulatory capital buffer requirements form the foundation of microprudential
supervision, which is designed to safeguard the stability of individual institutions. But
safeguarding "financial stability" goes beyond this. It involves ensuring that the financial system
is able to perform its key macroeconomic functions at all times - particularly in periods of crisis
and upheaval.
The European financial system has overcome two such periods of stress in the past year: First,
the heightened uncertainty over the summer surrounding Greece's future in the euro area and,
second, concerns surrounding the deceleration of growth in China and in other emerging
market economies. Despite a number of significant and sometimes abrupt price movements,
it can be said that the financial markets have, to date, proved themselves resilient to such
events, not least thanks to strengthened regulation.
At the same time, monitoring systemic risk is an ongoing task. We do this by focusing on two
questions.
First, can the failure of a market participant (or a group of market participants)
compromise the functional viability of the entire financial system? Are individual
market participants very large - that is to say, too big to fail - or too closely
interlinked with other market actors, meaning they are too connected to fail.
Second, can many smaller market participants collectively engender systemic risk
given that they are exposed to similar risks - are they too many to fail? For
instance, a sharp hike in interest rates could weigh on multiple credit institutions at
the same time.
The objective of macroprudential oversight and regulation is to identify and contain such risks
and misguided incentives. This can only be achieved by ensuring sufficient resilience in the
financial system as a whole.
2. Key statements of the Financial Stability Review 2015
Against this backdrop, allow me to summarise the current situation in the German financial
sector by outlining the key statements made in our report.
1. Low interest rates pose risks to financial stability as they squeeze banks' and insurers'
earnings. Institutions could then assume greater risks without having sufficient capital
buffers to be able to cushion the impact of these risks.
2. Dangers are also associated with an abrupt sharp hike in interest rates. Banks that,
for instance, had granted long-term, low-yielding loans would then have higher
funding costs.
3. The business volume in Germany's shadow banking sector has grown. We see no
evidence of heightened risks at this time, however.
4. Macroprudential instruments are gradually being put in place. These instruments are
intended to curb scale effects and procyclical effects. Instruments that can be
employed to mitigate risks arising from mortgage lending are under development.
5. The European capital markets union will be an important complement to the banking
union. Better developed and integrated equity markets, in particular, could play a role
in improving the way in which risks are shared.
3. Low interest rates and financial stability
The current low interest rates are a global phenomenon. They reflect the low real economic
growth and expansionary monetary policy stance observed around the world. Consequently,
attention is currently focused on monetary policy decisions and their impact on interest rates.
However, an expansionary monetary policy can also cause significant risks to financial stability
to build up. Empirical studies have shown that monetary policy has an impact on the price of
shares, bonds and real estate. The longer interest rates stay low, the more incentive market
participants have to take greater risks. However, it can end up being a problem if misguided
incentives cause risk premiums to drop to an excessively low level.
We have to meet these challenges in order to avoid a medium-term trade-off between
monetary policy and financial stability. Such a conflict would give rise to the danger that, given
the build-up of risks to financial stability, monetary policymakers would put off the appropriate
normalisation measures for far too long - the precise effect of which would be to cause further
risks to accumulate.
4. Risks in the German financial system
To answer the question of where systemic risks can arise in the German financial system, it is
useful to take a look at interconnections within the system. Within the German financial system,
the most pronounced interlinkages are between banks. My fellow Executive Board member
Andreas Dombret will therefore give you a more detailed account of the situation in the German
banking sector shortly.
However, it is not only banks but also insurers that play a crucial role in households'
investment. Banks and insurers perform different functions in the financial system. Insurers
obtain the majority of their funding through long-term premium payments. Banks derive their
funding from short-term deposits and the interbank market, in particular.
At present, low interest rates are squeezing banks' and insurers' earnings. Persistently low
interest rates would jeopardise the resilience of many insurers. The Life Insurance Reform Act,
which came into force in August 2014, helped bolster their resilience. Low interest rates lead
to high valuation reserves, but these are only paid out to a limited extent to policyholders whose
policies are now lapsing, meaning that the reserves are retained for the remaining
policyholders.
Added to this, dividend payments by insurers to owners are restricted. This, too, strengthens
their equity and resilience. Profit transfers on the basis of intragroup profit transfer agreements
are not affected by this restriction, however. Some life insurers did not actually conclude a
profit transfer agreement with their parent company until 2014 with an eye to being able to
distribute profits in spite of this restriction. In individual cases, this undermines the original
objective of the moratorium on dividend payments.
The chart shows how many insurers would hold insufficient own funds based on various
assumptions regarding future interest rate movements. In the baseline scenario, it is assumed
that excess returns on insurers' bonds revert to their historical mean and that yields on Federal
bonds, or Bunds, increase in line with market participants' current expectations. Only one
insurer would be at risk in such a scenario. However, many life insurers would have insufficient
own funds if Bund yields persisted at their current levels or if their excess returns were to
additionally fall back to their all-time low.
What the scenario analysis also tells us is that there is time for the enterprises to make the
adjustments needed to cushion the negative interest effects and to implement
countermeasures. Additionally, the introduction of the new Solvency II regime next year will
improve the disclosure of risks. While there is a 16-year transition period prior to full
implementation of Solvency II, firms should not waste any time in setting aside adequate own
funds against their risks. However, Solvency II tends to make insurers' capital requirements
more procyclical. The risks this can cause will need to be monitored closely, since a solvency
balance sheet focusing largely on market values as per Solvency II can produce a more volatile
picture of insurers' resilience. This can have repercussions for insurers' investment policy. If,
say, insurers attempt to increase their solvency ratio during crises, such endeavours can lead
to fire sales, which might further accelerate the fall in asset prices.
Even what currently appears to be a rather unlikely scenario - that of interest rates climbing
sharply within a short space of time - can pose a real threat to the stability of life insurers. This
is because the regulations in Germany leave them with no option but to offer fixed surrender
values for products paying guaranteed returns. Since life insurers invest the bulk of their
customers' premiums in fixed-income securities, the market value of their investment is
sensitive to interest rates, while surrender values are not. Thus, if interest rates were to
suddenly climb sharply higher, that might be a rational reason for customers to lapse their
policies. In a worst-case scenario, that might spark an upsurge in policy lapses. Surrender
values that move in line with the market value of insurers' assets might be one way of
eliminating this risk caused by regulation. For new policies, that would be possible without
interfering in property rights.
5. Significance of the shadow banking sector
Improvements in the regulation of banks and insurers might act as incentives for agents to
switch to unregulated territory. That is why action has been taken in recent years to improve
surveillance over what are known as shadow banks. But that term is a little misleading because
there's nothing "shadowy" about shadow banking entities. Just like banks in the traditional
sense, they are part of the financial system and provide important services - funding
investment and helping investors to diversify risk more effectively. But just like the traditional
banking system, shadow banks can also be a source of risk. Areas of the shadow banking
sector which had contributed to the financial crisis are currently dwindling in importance -
securitisation, to name but one. That holds true not only for Germany but worldwide, too.
But at the same time, there are other areas of the shadow banking sector which are coming to
the fore. Mutual funds are just one example. This shows that shadow banks are not operating
in a "regulatory vacuum" because mutual funds are subject to the Capital Investment Code
(Kapitalanlagegesetzbuch). Valuation effects are one of the key factors driving up the volume
of assets managed by these funds. Inflows of capital prompted by changes in the regulatory
setting in other areas and portfolio reallocations tend to be less significant.
Just like any other intermediaries, shadow banking entities can be systemically important on
account of their size, interconnectedness or a co-movement of risks. The key metrics do not
currently indicate an increase in risk. First, maturity and liquidity transformation in the mutual
fund sector are stable for the most part. Second, leverage through the use of debt tends to be
on the low side. Fund investments by insurers and pension funds are geared more to the long
term, bringing a degree of stability to the mutual fund sector. Third, concentration levels within
the sector are mounting, however. This means that the size of some individual mutual funds
could make them systemically important. It is not least for that reason that we will continue to
keep a close eye on the shadow banking sector and potential risks in the future.
6. Macroprudential instruments
Financial sector regulation has been improved since the financial crisis. One of the main thrusts
of these new regulatory packages was to introduce instruments that curb the risk caused by
the size and concentration of institutions - that is to say, instruments which tackle the
too-bigto-fail problem head on.
The Recovery and Resolution Act for banks came into force in Germany at the
beginning of this year.
Starting in January 2016, systemically important banks will need to build up
additional capital buffers.
As from 2019, global systemically important banks will have to maintain sufficient
total loss-absorbing capacity, or TLAC, in the form of debt and equity capital, which
can be tapped in a resolution or recovery event.
All these measures are designed to reduce the likelihood of larger institutions running into
difficulties and to facilitate the recovery or resolution of a failing institution without the need for
taxpayer support.
But smaller institutions, too, can be a source of risk if they are too interconnected and exposed
to similar risks. The countercyclical capital buffer (CCB) will be added to the macroprudential
toolkit in January 2016 in an effort to combat procyclical risk. Banks will be forced to step up
their provisioning in times of excessive credit growth, thus bringing capital adequacy levels
across the entire banking system into line with economic activity. In the current situation,
however, there is no need to ask institutions to set aside more capital because there are no
signs of excessively rapid lending growth.
Financial crises are often triggered by excesses in real estate markets. Up to now, Germany
has not had any macroprudential instruments which directly address the lending relationship
between the creditor and the borrower. This deficit prompted the German Financial Stability
Committee, in June 2015, to recommend the Federal Government to create legal foundations
for a set of new macroprudential instruments regulating housing loans. These instruments
include a cap on the credit volume relative to the property value (loan-to-value, or LTV, ratio)
and a cap on the borrower's debt servicing capacity relative to their income
(debt-service-toincome, or DSTI, ratio). Our work on these instruments does not necessarily mean that they
will be activated in the near future. We do, however, need to be capable of nipping any
unwelcome developments in the bud.
7. The European capital markets union
Before I bring my remarks to a close, I would like to take a look beyond the realm of banking
regulation. The banking union was without doubt a huge step forward in curbing risk and
making it more manageable. But in a monetary union, financial stability hinges on other factors
as well - the functioning of the European capital markets and the way in which they facilitate
the distribution of risk.
At the current juncture, cross-border capital flows in Europe are largely made up of debt capital
- bank loans, mostly. This is a source of risk. Debt capital flows are more prone to a sudden
reversal than other capital movements. What is more, debt capital does not cushion enterprises
against risk - except when they become insolvent. Equity capital, by contrast, absorbs losses
and can make businesses more resilient, ultimately strengthening financial stability.
The planned capital markets union can help to dismantle barriers that are currently distorting
businesses' funding structures and the capital flows in the European Union. It can improve the
conditions for a more efficient distribution of capital and risk alike. Stronger growth and deeper
integration across the markets for equity capital could be the key to sharing risk more efficiently
and, in turn, bolstering the resilience of the financial system. That "double dividend" - more
growth, and a more stable financial system - is something the capital markets union promises
to deliver.