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. 3 / 5 bis central bankers'speeches 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