Statement at the presentation of the Deutsche
Bundesbank's 2019 Financial Stability Review
Speech delivered at the press conference to unveil the Financial Stability
Review
21.11.2019 | Frankfurt am Main | Claudia Buch
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1 Underestimation of credit risk
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2 Overvaluation of assets and loan collateral
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3 Interest rate risk
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4 Countercyclical capital buffer
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5 Need for action to ensure a stable financial system
This time last year, the economic outlook was slightly more positive than it is at present.
Although economic warning signs were already apparent, interest rates were still expected
to rise gradually. Unfortunately, this has not come to pass; downside risks to the economy
have since emerged worldwide. Germany's export-oriented industry has borne the brunt of
this. Robust domestic demand - bolstered by favourable financing conditions and an
upbeat labour market situation - has prevented an even greater economic downturn thus
far.
Unlike in the previous year, market participants are now expecting risk-free interest rates to
remain low in the years to come. A scenario in which interest rates are low for an extended
period has therefore become more likely.
From the perspective of financial stability, this means that cyclical risks are continuing to
accumulate within the German financial system. These risks are not directly visible as low
interest rates are keeping valuations high in some cases, the markets are liquid, and asset
prices and loans are still experiencing dynamic growth. At the same time, the vulnerabilities
of the German financial system to unexpected macroeconomic developments are growing
further.
We have described these vulnerabilities in past years:
After ten years of positive economic development, future credit risks are potentially
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being underestimated.
Meanwhile, the recoverability of loan collateral such as real estate is potentially being
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overestimated.
The situation is further compounded by interest rate risk: both an abrupt rise in interest
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rates and persistently low interest rates would put pressure on the financial system.
Two developments, in particular, could expose these vulnerabilities.
An unexpected economic downturn could hit Germany's financial system hard. One
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potential trigger could be bad news concerning the global economy. Furthermore,
external weaknesses may have a greater impact on domestic demand. Credit defaults
would then increase and assets would lose value.
An abrupt rise in interest rates triggered, say, by the materialisation of downside risks
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and a sudden increase in risk premia in the markets, could also jeopardise financial
stability.
A stable financial system should be able to cushion such shocks as much as possible rather
than amplifying them. This year, the German Financial Stability Committee (FSC) thus
recommended raising the countercyclical capital buffer to 0.25% on account of increased
cyclical systemic risks.
Allow me to explain in more detail how we assess these risks and what action needs to be
taken.
1 Underestimation of credit risk
Overall, the credit scores of German enterprises have been exceedingly good and
insolvencies correspondingly low over the past few years. Hence, it follows that the
number of non-performing loans has declined.
However, there are mounting signs that future credit risks are being underestimated:
Banks' risk provisioning remains exceptionally low, reflecting the low number of
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insolvencies.
Economic downturns coupled with steeply increasing credit risks are likely to be
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underrepresented in many banks' risk assessments. This is indicated, for instance, by the
low risk weights of banks which use internal ratings-based models.
In addition to this, at around 5% over the past year, lending to the private sector
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reached a 15-year high. Large, systemically important financial institutions have recently
expanded their lending in this area to a greater degree than small and medium-sized
institutions.
Allocation risks may thus emerge for the entire loan portfolio that appear paradoxical at
first glance: even if the creditworthiness of all enterprises has improved following a long
upswing, making each individual loan appear sound, the structure of the loan portfolio
may shift to enterprises that are riskier in relative terms.
Allocation risks, then, are not themselves a new risk, but rather a further indication that
credit risks are being underestimated.
Creditworthiness varies between enterprises. Most enterprises have a fair credit score,
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although there are some which are rated particularly highly, and others which are
weaker.
This distribution is broadly reflected in banks' portfolios, too, although some enterprises
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also obtain funding via the capital market, whilst others draw on equity capital.
Now, what happens during a cyclical upswing? In such an event, all enterprises see an
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improvement in their creditworthiness. Strong enterprises increasingly turn to retained
earnings or the capital market as sources of funding. Even relatively riskier enterprises are
able to take out more loans from banks on the strength of an overall improvement in
creditworthiness.
These are merely initial theoretical considerations which serve to illustrate the mechanism.
But what concrete developments are we seeing in banks' portfolios?
Here, enterprises' creditworthiness has in fact seen an improvement. Compared with the
beginning of the new millennium, enterprises' interest coverage ratio - in other words,
earnings relative to interest expenditure - has undergone continuous enhancement.
Unsurprisingly, other indicators of creditworthiness present a very similar picture.
At the same time, comparatively risky enterprises have received more loans on account of
their improved creditworthiness. The composition of loan portfolios has shifted. This is a
statistical finding, first and foremost. It tells us nothing about the drivers behind this trend,
such as higher risk-taking propensity among banks or a change in the demand for loans.
Viewed in the context of banks' creditworthiness assessments or from a supervisory
perspective, this shift is not necessarily a problem.
However, banks are now increasingly financing the very enterprises that would be the first
to encounter problems in the event of an unexpected economic deterioration.
What could happen in the event of an unexpected economic downturn?
Enterprises' creditworthiness would deteriorate and more loan defaults would occur.
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Loan losses and write-downs would increase more sharply than they would if credit risk
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were distributed more evenly.
Banks' portfolios would then include a greater number of borrowers with lower credit
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ratings.
Such allocation risks are evidence of the fact that credit risk may potentially be
underestimated following a long period of favourable economic developments. They have
increased in recent years and are feeding into cyclical vulnerabilities throughout the whole
banking system.
2 Overvaluation of assets and loan collateral
As market participants see it, interest rates are likely to remain low for longer than
previously anticipated. Low interest rates bolster valuations in the global bond and equity
markets. This is one reason why the weaker economic activity has barely made itself felt in
the financial markets as yet.
At the same time, the banking system as a whole has become more vulnerable to an
abrupt increase in risk premia. Should global political risks emerge or economic activity
deteriorate unexpectedly, valuations would likely decline, meaning that losses would then
have to be absorbed.
And in a low-interest-rate setting, asset prices react more strongly to minor changes in risk
premia. Unexpected changes in market interest rates could thus be accompanied by a
higher degree of volatility. This could potentially result in increased capital requirements for
market risk.
Valuations in the real estate market are particularly significant for the German financial
system. This is because more than half of all loans to households are loans for house
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purchase. [1] At 80%, real estate makes up the lion's share of fixed assets in Germany.
Our assessment of the real estate market situation is similar to that of last year: cyclical
risks, to which the real estate market is making a significant contribution, are continuing to
mount. However, we see no need to activate borrower-based instruments intended to
stabilise lending standards - in other words, a loan-to-value ratio and an amortisation
requirement.
How have we reached this assessment?
House prices are an important indicator and have continued to grow sharply, rising by
around 8% over the past year. Property prices in German cities are likely to stand around
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15% to 30% above the value that would correspond to the fundamentals. [2]
At present, however, we do not see any clear indications of mounting speculation being
driven by credit. Whether there is a self-reinforcing "narrative" - to use the words of Nobel
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Prize winner Robert Shiller - cannot be clearly assessed. [3] There are indications of this,
however.
First of all, the competition in granting residential real estate loans is highly intense. With
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growth of 5%, loans for residential property recently grew at a slightly above-average
rate. Segments of the market have shifted to the savings banks and credit cooperatives.
Prudential surveys amongst institutions show that there are certain signs of lending
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standards being relaxed - but only slightly and not across all institutions.
Households and banks expect residential property prices to rise further. It is difficult to
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say whether they are being overly optimistic here. At the very least, households are
expecting less pronounced price rises in rural areas than in big cities and they expect
smaller increases in prices per year over a period of five years than over one year.
All in all, it would therefore be premature to issue the all-clear for the real estate market.
There is a need for action in two areas.
In a warning to Germany, the European Systemic Risk Board (ESRB) has just recently
highlighted the need to close existing gaps in the data. We still know too little about one
particular central indicator for estimating risk: the quality of lending standards.
Surveys of institutions, like those we have conducted once again over the past year,
provide us with vital information. Ultimately, however, they are costly for all involved and
do not offer a robust statistical footing for forward-looking policy. Over the past year, we
have therefore continued to work on creating the preconditions for a legal basis regarding
the collection of the necessary data. High-quality data are also urgently required in many
other areas of public policy that concern the real estate market. However, it is policymakers
who must ultimately reach a decision on the data collection recommended by the German
FSC in 2015.
Furthermore, two additional income-based instruments should be created. Both
instruments are oriented around indicators that banks use to assess creditworthiness in
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order to prevent borrowers from taking on excessive debt. [4] Both instruments likewise
feature in the recommendations proposed by the ESRB and the German FSC for the
German residential real estate market.
3 Interest rate risk
The German financial system remains vulnerable to an abrupt rise in interest rates. Many
institutions have increased the interest rate fixation periods of their assets, not least to
stabilise their interest income. For instance, the share of new loans for house purchase with
an interest rate lock-in period of more than ten years has risen from 26% in 2010 to its
current level of 50%.
Although this initially protects the borrower from rising interest rates, the risks do not
disappear but are instead borne by the banks. A rise in interest rates would therefore
impact many institutions at the same time. Funding costs would rise immediately, but
interest income would only rise gradually. Savings banks and credit cooperatives would be
affected to a considerably greater extent than larger banks.
4 Countercyclical capital buffer
These cyclical risks can emerge together and reinforce each other. An unexpected
economic downturn could be amplified if banks restrict their lending. In order to prevent
dangers to financial stability, banks must maintain capital buffers designed to absorb
losses.
Macroprudential capital requirements serve precisely this buffer function. Under certain
circumstances, banks can undershoot macroprudential buffers without measures such as
the withdrawal of their banking licence being immediately imposed. Instead, bonus
payments and profit distribution would be restricted. Macroprudential policy therefore
complements supervisory measures that aim to ensure robust capitalisation and good risk
management amongst banks.
The countercyclical capital buffer increases the resilience of the banking system and
stabilises lending during periods of stress. Should cyclical systemic risks materialise, the
buffer can be lowered straight away
In May 2019, the German FSC recommended that the Federal Financial Supervisory
Authority (BaFin) activate the countercyclical capital buffer. Germany is thereby following in
the footsteps of other European countries that have activated or increased the
countercyclical capital buffer. BaFin followed this recommendation and raised the buffer to
0.25% of risk-weighted domestic exposures in the third quarter of 2019. Banks have 12
months to build up the buffer, and, for the most part, they may use their surplus capital to
meet the requirement.
The recommendation makes allowances for uncertainty about economic developments.
Future adjustments to the countercyclical capital buffer will depend on whether and to
what extent cyclical risks continue to build up in the financial system. The financial cycle,
and not the economic cycle, is the relevant factor here.
5 Need for action to ensure a stable financial system
Digitalisation, climate change, demographic change, and globalisation are megatrends that
are impacting all areas of the economy and society. The financial sector mirrors these
developments and, at the same time, is a key catalyst for the necessary structural change.
For the first time, this year's Financial Stability Review features a chapter on the impact of
climate-related risks on the financial system. In this context, our goal is not to evaluate
climate-policy decisions. Instead, we aim to analyse the impact of climate change as well as
the political, social and economic responses. To this end, more than 45 central banks and
supervisors worldwide have joined forces in the Network for Greening the Financial System
(NGFS), pooling their methodological capabilities and building up a robust information
base. At the international level, the Financial Stability Board's (FSB) Task Force on
ClimateRelated Financial Disclosures undertook important preliminary work for CO risks to be
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better disclosed in enterprises' balance sheets. [5]
In order to tackle climate change effectively, it is necessary to implement a policy regime
that adjusts the relative prices between carbon-intensive and low-carbon economic
activities. This, in turn, necessitates significant structural change. A functioning financial
system is key to ensuring that structural change can succeed without hampering innovation
or jeopardising stability.
However, structural change has also not stopped short of the financial sector itself. Banks -
just like firms in other economic sectors - must therefore be allowed to withdraw from the
market or to shrink if their business strategies are no longer sustainable. An effective
resolution and restructuring regime can help market mechanisms to function properly. With
the banking package recently passed by the EU, key regulations on creditors participating
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in losses - known as a bail-in - have been brought into line with international standards.
[6] Also at the international level, the FSB is currently evaluating the impact of too-big-to-
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fail reforms. [7] A corresponding consultative report will be published in June 2020.
Footnotes:
1. This figure refers to lending to domestic households and enterprises.
2. The Bundesbank estimates that house prices in German towns and cities were
overvalued by between 15% and 30% in 2018. See Deutsche Bundesbank (2019),
Monthly Report, February 2019. The fundamentals include per capita real estate
holdings, per capita income, population density, and the age structure of the population.
3. See Robert J. Shiller (2019), Narrative Economics: How Stories Go Viral and Drive Major
Economic Events. Princeton University Press. Oxford and Princeton.
4. Relevant indicators include, amongst others, aggregate debt as a percentage of
household income as well as the percentage of household income needed to make
interest and redemption payments.
5. See Task Force on Climate-Related Financial Disclosures (2017), Final Report, Financial
Stability Board.
6. In this context, the minimum requirement for own funds and eligible liabilities (MREL)
was revised.
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7.
https://www.fsb.org/2019/05/fsb-launches-evaluation-of-too-big-to-fail-reforms-andinvites-feedback-from-stakeholders/