of transmission of higher interest rates into net interest margins. how banks ’ cash flow responds to the changes in the macroeconomic environment depends on their business model and market power. over the medium to long - term, higher interest rates allow banks to generate higher cash flow and exploit benefits of maturity transformation. however, over shorter time horizons, banks ’ ability to generate cash flow can be suppressed – thus limiting banks ’ ability to respond to adverse developments in the market environment. in the german banking sector, higher interest rates are increasingly being passed through to banks ’ funding costs. smaller savings and cooperative banks in germany, traditionally have higher interest rate margins than the larger banks – around 1. 5 % of the balance sheet total as compared to 0. 5 % [ figure 5 ]. for the larger banks, the net interest margin has been relatively flat over the past decade. for smaller banks, it has declined quite significantly from almost 2. 4 % in 2014. the net interest margins of these banks also recovered a bit recently, reflecting their higher pricing power in local markets. as regards the funding structure of german banks, figure 4 has shown the shift from demand towards time deposits, which are more costly for banks but, potentially, also a more stable form of funding. figure 5 : net interest income of selected categories of banks in germany the digitalisation of financial services is likely to affect banks ’ funding structures and the franchise value of deposits. retail deposits have typically been considered to be a stable form of bank funding with a relatively low sensitivity to interest rate changes. [ 36 ] in this sense, retail deposits allow banks to hedge some interest rate risk on the asset side of their balance sheet : when interest rates rise, the value of assets falls, and the value of the deposit franchise rises. however, the deposit franchise is valuable only if depositors remain in the bank. online banking and the digitalisation of financial services can lead to quite disruptive adjustments of deposits, in particular for uninsured depositors, as evidenced by recent bank run episodes. banks ’ ability to pass higher funding costs through to lending rates is currently limited by two factors. in germany, high shares of long - term loans with fixed interest rates limit interest rate pass through. moreover, credit demand is relatively weak at the current juncture, thus restricting banks ’ pricing power. in the first quarter of 2023, banks reported tightened credit conditions in the bank lending survey, driven in large part by increasing credit risks. evidence on lending conditions is mixed.

’ credit lines relative to central bank balances has been rather stable. moreover, the funding structure of german banks has started to shift from sight to time deposits. both would point to a declining liquidity dependence. figure 6 : central bank reserves and credit lines of banks in germany figure 7 : credit lines relative to a bank ’ s total assets going forward, monitoring the liquidity situation of financial institutions is central to our macroprudential surveillance. from the u. s. experience, we know that market reactions to a withdrawal of liquidity may be quite abrupt. a severe stress episode in september 2019 forced the fed ( federal reserve system ) to pause its first period of quantitative tightening. [ 19 ] the stress quickly faded when quantitative tightening stopped, and volatility declined as asset purchases resumed. hence, although there are, at the moment, no clear indications that sustained liquidity dependence would be a major concern in germany, we certainly have to err on the side of caution and monitor liquidity, credit lines, and changes in deposits carefully. 2. 3 do banks underestimate future macroeconomic risks? financial crises often coincide with macroeconomic turning points. from a financial stability perspective, understanding how the macroeconomic environment affects the health of banks, how banks assess their exposure to macroeconomic risks, and taking preventive action if macroeconomic risks are underestimated is thus crucial. at the same time, modelling exposure to future macroeconomic risks is challenging. adjustment patterns of the past may not be very informative with regard to future risks. yet, our formal models and informal heuristics largely rely on observations from the past. this potential underestimation of risk is particularly relevant today. given the benign macroeconomic and financial conditions during the past decade, models may not sufficiently account for adverse scenarios. the patterns in the data that we have seen in the past may paint an overly optimistic picture of the future. while the pandemic caused a severe economic recession, this was barely associated with losses in the financial system. so far, credit losses have remained fairly contained. loan loss allowances and non - performing loans remain at historically low levels of 0. 5 % and 0. 8 % of gross lending, respectively. there has been a small increase, but only since the last quarter of 2022. the capitalisation of banks has even increased during the pandemic, with capital in excess of the regulatory minimum increasing by €36 billion to €165 billion between the first