andreas dombret : deutsche bundesbank – financial stability review 2010 speech by dr andreas dombret, member of the executive board of the deutsche bundesbank, frankfurt am main, 25 november 2010. * i. * * the situation the stability situation in the german financial system continued to be dominated by risks stemming from the international environment. the focus here is on two key topics which will continue to occupy us for the foreseeable future : first, the european sovereign debt crisis that has persisted since the early summer of this year and, second, the potential inherent risks of an extended period of low interest rates. against this backdrop, it is all the more important to note that the stability of the german banking system has shown a marked improvement since the publication of the last financial stability review. its resilience has increased thanks to more stable earnings and better capitalisation ; the situation with regard to risk has eased slightly, especially in domestic lending. nevertheless, the german banking system still has vulnerabilities and structural shortcomings. above all, the revised regulatory provisions for more capital and for a more appropriate liquidity reserve will bring about a longer - term gain in stability. one key challenge that still has to be resolved, however, is how to deal with systemically important financial institutions. ii. risks of high sovereign debt and persistent low interest rates the european debt crisis has been the crucial event of the past few months. its onset in the early summer of this year placed european financial stability in acute danger. the response of governments and central banks was rapid and on a massive scale, thus preventing an escalation of the crisis. our “ heat map ” shows the increasing risk in the european government bonds segment ( figure 1 ) : since the previous year, the “ traffic lights ” have jumped from green to red. yet, it is possible to identify positive developments, too. tensions in the interbank market have eased, for example, not least because the banks are now hoarding significantly less liquidity. the problem of high sovereign debt is still active, however, and will keep us busy for some time to come. it will also be important to tackle the longer - term challenges and ensure the long - term sustainability of public finances. there are three key approaches to this. first, the fiscal rules have to be hardened. second, macroeconomic developments in the member states have to be monitored more closely in future. both of these points of approach are designed to prevent government debt crises.

however, such crises cannot be ruled out entirely in the future either. therefore, third, it will be necessary to establish a crisis management and resolution mechanism as a prudent and necessary supplement to the existing regulatory framework. given strict compliance with the “ no bail - out ” principle, assistance to individual member states linked to strict conditionality and a very limited timeframe should be possible if stability of monetary union as a whole is at risk. in a well - regulated crisis mechanism of this kind, private debtors should not be allowed to escape their responsibility. it should be stated explicitly, however, that such a mechanism should be established only after the end of the crisis and not interfere with existing agreements and obligations. in addition to the risks of the debt crisis, it is crucial not to lose sight of the risks inherent in an extended period of low interest rates. this includes, in particular, the possibility of new bubbles being formed in some markets for assets as part of a resurgent “ search for yield ”. this is not a problem at present, but could become an issue in the medium term. persistently low interest rates incite, furthermore, the entering of liquidity risks and thus put banks at the whim of market sentiment. expanding banks ’ short - term refinancing was more or less unavoidable in periods of strong mistrust ; the correction of this expansion has not taken place so far. this means that the banks may be on a collision course with the large financing needs of general government, since large issuances of government bonds are to be expected over the next few months. finally, an abundant supply of liquidity may incite banks to defer a necessary clearing - up of their balance sheets. major legacy problems in the loan portfolios may lead to banks holding back longer in granting new loans. iii. aspects of the risk situation in the german banking system beyond the risks emanating from the global setting, the risk and stability situation in the german financial system looks more positive than it did a year ago. banks ’ profitability has recovered since its slump in 2008 and their capital adequacy has improved. between the first quarter of 2008 and the second quarter of 2010, large complex financial institutions increased their tier 1 capital ratio, on average, by 2. 4 percentage points to 10. 4 %. finally, the german banking system has remained fully functional at all times and the credit crunch that was feared for a time did not materialise.