Claudia Buch: The Deutsche Bundesbank's 2018 Financial Stability
Review
Speech by Prof Claudia Buch, Deputy President of the Deutsche Bundesbank, at the
presentation of the 2018 Financial Stability Review of the Deutsche Bundesbank, Frankfurt am
Main, 14 November 2018.
* * *
This summer was unusually long and warm. But this summer has now come to an end, as
"seasons come and seasons go".
But times are still good on the economic front. The economy is expanding at a robust pace,
interest rates are still low, asset prices are high, and volatility in financial markets is relatively low.
So, for the most part, the expectations regarding economic developments have been confirmed.
Furthermore, there is currently a general consensus that growth will continue and that interest
rates will slowly start to pick up again. It might seem, then, that there is nothing much new under
the sun.
But the setting of strong growth and low interest rates has contributed to the build-up of
vulnerabilities - and this trend has continued to the present day. We have already described
these vulnerabilities in earlier Financial Stability Reviews.
Underestimation of credit risk,
Overvaluation of assets and loan collateral, and
Exposure to interest rate risk.
And the clouds are already gathering on the horizon. Unlike last year, the risks to future economic
activity are today skewed to the downside.
Geopolitical risks have intensified.
Trade tensions remain unresolved and could particularly harm the internationally open
German economy.
It is still unclear how the United Kingdom will withdraw from the EU.
So the downside risks to the economy have increased substantially. If these risks materialise,
the ensuing market corrections would expose the vulnerabilities.
At the global level, too, financial sectors have become more vulnerable. Globally, private and
public sector debt today is far higher than it was ten years ago. This limits the capacity of
governments in some countries, in fiscal terms, to cushion a potential downturn in the economy.
This is the time to build up sufficient resilience for tougher times ahead. It is rather like the human
body - we need to boost our immune systems long before the flu season breaks out. Once a flu
epidemic is in full flow, it's often too late to get vaccinated. But we don't always follow sound
advice like that.
What does this mean for the financial markets? It is precisely when the economy is in good
shape that we can be tempted to underestimate the likelihood of catching the flu and neglect the
need to make build up our defences.
1 Macroeconomic environment
The German economy is experiencing the longest period of expansion since the country's
reunification. This good setting is benefiting households. The positive economic situation and
sound financing conditions have contributed to the decline in the German unemployment rate.
The number of consumer insolvencies has also fallen.
As a consequence, household debt as a percentage of gross domestic product, at roughly 50%,
is at its lowest level in two decades.
Enterprises have boosted their capital from roughly 20% to 30% over the past two decades, and
leverage in the corporate sector has receded slightly.
Similarly, high valuations in the financial markets reflect the strong economy and low interest
rates. However, they also point to vulnerabilities in the financial system.
Measured relative to leverage in the corporate sector, risk premia are low - investors are
thus charging a very low "price" for taking on risk. This is evident not just in Germany, but
also from an international perspective.
Real estate prices in Germany have been rising steadily since the onset of the financial
crisis, not just in urban centres. According to Bundesbank estimates, real estate prices
exceed levels that would be justified by fundamentals such as regional or demographic
patterns by about 15-30%.
Let me therefore give you a more detailed description of the vulnerabilities lurking in Germany's
financial system.
2 Underestimating credit risk
Future credit risk might be underestimated. The good situation for enterprises at present is being
reflected in low provisioning at banks.
This has contributed to the rise in banks' capital ratios. However, the risk-weighted capital ratio
rose by more than the unweighted ratio. Larger, systemically important financial institutions tend
to have lower unweighted capital ratios than smaller banks.
An economic downturn would put pressure on banks' capital buffers due to the ensuing credit
losses and increasing risk weights. This could reverse the trend observed over the past ten
years. This period has seen the average risk weights for corporate loans and in retail banking -
that is to say, business with households and small and medium-sized enterprises - decline.
Furthermore, banks have restructured their investment portfolios towards exposures with lower
risk weights.
However, a glance at banks' credit portfolios also shows that there has been a shift in the
borrower structure. Generally speaking, there has been a relatively strong increase in loans to
financially vulnerable enterprises. Thus, the share of loans to enterprises with low capital ratios
and high interest burdens has increased over time. In addition, a lower value-at-risk for market
risk in the last two years has helped boost capital ratios. Thus, a sharp rise in financial market
volatility could put pressure on banks.
3 Overvaluing assets and loan collateral
High valuations point to another weak spot in the financial system - the possibility that loan
collateral values may be overestimated. Let me illustrate my point by taking the German real
estate market as an example. The real estate market is crucially important for the German
economy as a whole: loans for house purchase account for more than half of lending to
households and enterprises. Our assessment of developments in the residential real estate
market from a financial stability perspective is based on three indicators:
Housing prices are continuing to increase dynamically.
But lending is growing at a below-average pace by historical standards.
And overall, credit standards have not changed remarkably - household debt, for instance,
has remained almost static.
Overall, we currently see no need to activate any macroprudential instruments in order to contain
risks to financial stability emanating from the residential real estate market. We are, however,
continuing to closely monitor this market. Because the strong appreciation in prices harbours the
risk that the quality of loan collateral is possibly being overestimated.
In the event of a correction, the value of collateral might decline unexpectedly sharply, pushing up
losses from residential real estate loans as a result. One stress test exercise reveals that an
economic slump and shrinking real estate prices would in some cases take a heavy toll on the
real estate lending portfolios of German banks.
4 Interest rate risk as a result of maturity transformation
Finally, the German banking system has become more vulnerable to an abrupt increase in risk
premia and thus in interest rates. The share of newly granted loans with an fixed-term interest
rates of over ten years has risen from 26% at the beginning of 2010 to 45% at last count. If
interest rates were to quickly spike higher, this would instantly drive up the costs of funding these
loans. But interest income would only increase with a time lag.
This would affect savings banks and cooperative banks more than the larger credit institutions.
And precisely because many institutions would be affected simultaneously, it would not be
possible to cushion the impact by stepping up new lending business. In an economic downturn,
especially, credit demand would decline.
A "snapback" in interest rates would not be the only risk to financial stability. Persistently low
interest rates close to the zero lower bound would also continue to put pressure on the financial
system. In this scenario, risk-taking incentives would remain.
This means that both risk scenarios - a "snapback" in rates, and persistently low rates - would
affect the German banking sector as a whole. And other parts of the financial system would
barely be able to offset the impact. That is because insurers and pension institutions might also
come under pressure in both scenarios.
5 Potential pro-cyclical impact of the financial system
What does this imply for financial stability? The vulnerabilities I have just mentioned all have one
thing in common: we have evidence to suggest that market participants are tending to
underestimate the risks they incur and that they are tending to not charge enough for them.
Underestimating risk is not synonymous with a credit bubble. Although the materialisation of
individual risks would be manageable, credit, valuation and interest rate risk may well intensify
within the financial system. Market participants might potentially underestimate downside risks to
the economy. An unexpectedly strong economic downturn and falling asset prices would then
simultaneously expose different vulnerabilities. The financial system could intensify unexpected
negative developments in the economy. In particular, its highly interconnected network allows the
financial sector to perform its key functions, which are to finance the economy, ensure that
payment systems operate smoothly, and hedge risk. However, interconnectedness also entails a
risk of contagion.
Let me illustrate this point by using an economic downturn as an example. If the trade conflicts
escalate, for instance, this could hit the German economy hard - external demand might soften,
or value-added chains might become more fragile. Insolvencies might increase in the corporate
sector.
An economic downturn would put pressure on banks' equity capital, which would be squeezed by
losses, write-downs and mounting risk weights.
How might banks looking to fulfil the capital ratios set by supervisors or expected by markets
respond to this scenario?
Banks might respond by increasing their capital internally. That is, they would retain profits and
pay out less to shareholders. But this particular avenue would be blocked off, especially if the
economic slump eroded banks' profits or even causes losses.
Another response might be to tap the markets for additional capital. But here again, if many
banks try to take that particular road in times of crisis, they will end up blocking it for everyone.
Confidence in entire segments of the market may well erode as a result.
That leaves us with the third possible response, which is to deleverage the balance sheet.
Overall, this would reduce the supply of credit to households and enterprises. This could well
amplify an economic slump by spilling out across the financial system.
Whether and with what magnitude an economic downturn is amplified by the financial system
depends on the buffers within the financial system. It is thus a welcome development that
German banks have increased their capital since the financial crisis. This is due to numerous
microprudential regulatory measures that have already been implemented or will be implemented
in the near future as well as to capital buffers for systemically important banks.
However, the vulnerabilities are not confined to individual institutions; they affect the entire
system. This risk is particularly acute when market participants are overly optimistic in good
times. In other words, each bank on its own would act in a risk-conscious manner and attempt to
strengthen its capital buffers. But there is no way it can have a full picture of the potential impact
on the financial system as a whole. This is how systemic risk potentially comes about.
6 Need for macroprudential action
Macroprudential policy aims to identify such risks to financial stability at an early stage and to
take timely measures to ensure that the financial system functions smoothly. Germany's
financial system has become more vulnerable over the past years - the impact of credit risk,
asset repricing, and interest rates on the financial system might be underestimated. At the same
time, the downside risks have increased. This means that action needs to be taken.
First, each individual market participant needs to build up sufficient resilience to unexpected
events. Even when the economy is less favourable, financial institutions should have
sufficient capital to cover the risks they take. Risk management and financing decisions
should take scenarios that could lead to large losses into account. This applies especially to
political risks such as the possibility of a "hard Brexit".
Second, cyclical risks call for timely preventive action. Buffers against economic risks need
to be built up in good times. This can reduce the likelihood that contagion effects within the
financial system might amplify an economic downturn. The macroprudential toolkit includes
warnings and recommendations as well as macroprudential capital buffers.
Third, effective financial stability surveillance calls for improved data on the residential real
estate market, as recommended by the German Financial Stability Committee. Detailed
information is needed about developments in property prices, the debt levels of investors,
and especially those of households, as well as lending conditions. When it comes to
systematically capturing some of these indicators, Germany remains near the bottom of the
league in Europe.
To summarise, the favourable economic situation at present offers a good opportunity to bolster
balance sheets and build up resilience for a rainy day.