The macroeconomic environment is being shaped by the interest rate reversal and heightened uncertainty. So far, the German financial system has coped well with the rise in interest rates over the last year, but the effects of this rise have not yet fully materialised. Structural change in the economy is also likely to further increase credit risk.

The current good earnings situation is enabling institutions to further strengthen their capital base and thus their resilience to adverse developments, said Claudia Buch, Vice-President of the Deutsche Bundesbank, at the presentation of the 2023 Financial Stability Review. Even in adverse scenarios, financial institutions should have sufficient levels of capital and liquidity to be able to absorb shocks on their own. Resilience, noted Vice-President Buch, would also require investment in IT infrastructure in order to be equipped to deal with cyber risks.

The effects of the rise in interest rates have not yet fully materialised. 

Many institutions are benefiting from the rise in interest rates and are currently seeing higher profits. Banks’ tier 1 capital ratio has risen further recently and currently stands at around 18%. In the medium term, however, interest margins could come under pressure. This is because, to date, higher interest rates have been passed on only partially to depositors. Demand for credit is weak and is limiting the ability of banks to increase their interest income. Banks have tightened their lending standards in response to increased credit risk. In addition, banks have reduced a considerable volume of hidden reserves in order to cushion market price losses on their assets. At the same time, hidden losses have increased among banks and insurers. 

In the real estate market, the interest rate reversal has led to falling prices, which means that collateral needs to be revalued. Credit risk is elevated in the commercial real estate sector in particular, as relatively short interest rate fixation periods are enabling higher interest rates to be passed on to borrowers quickly.

Credit risk arising from the financing of residential real estate is still limited in the medium term, given the stable labour market situation and set interest rate fixation periods, but should also remain an area of focus for institutions and supervisors. 

Structural change is placing additional demands on the financial system.

The German economy is exposed to pressure for structural change, which has further intensified as a result of the uncertain geopolitical situation and the climate crisis. Credit risk is likely to occur in the medium term, especially for highly indebted enterprises that need to adjust considerably to the new framework conditions. “A robust financial sector can make a significant positive contribution to the success of structural change. However, structural change also means more insolvencies and rising credit risks,” said Vice-President Buch.

The decarbonisation of the economy is a key driver of structural change. In an updated scenario analysis, the report examines the impact of an increase in carbon prices on valuations of claims against carbon-intensive industries. The resulting valuation losses for the financial sector are likely to be limited and do not call institutions’ solvency into question. An orderly ecological transformation, a predictable energy transition and transparency about its consequences would also spare the financial sector even larger losses going forward.

Increased risks and uncertainty require sufficient resilience.

The report underscores the importance of a sufficiently resilient financial sector to deal with risks arising from structural change and heightened geopolitical uncertainty. The package of macroprudential measures adopted in January 2022 is therefore still appropriate. This package creates a capital buffer of just under €24 billion. With the exception of a few small institutions, banks were able to meet the requirements without having to generate new capital. Negative effects on lending or interest rates have not been observed. Only if there was a risk of a credit crunch due to high losses would it be appropriate to release the buffers. In such a period of stress, banks could use capital buffers and other capital reserves to absorb losses. A deterioration in the economic outlook is not a sufficient condition for releasing the buffers. 

In terms of regulation, implementing Basel III is the priority, said Vice-President Buch, adding that the regulatory framework should be enhanced in a targeted manner at the same time. The focus here is on risks stemming from the growing importance of non-banks and targeted adjustments to liquidity regulation. It is also important to have strong, proactive supervision that quickly responds to undesirable developments. 

If all stakeholders work together successfully, the financial system can be a strong partner in managing the structural change that lies ahead. Insufficient resilience and a lack of clarity about the political and regulatory framework for the de-carbonisation would exacerbate the high level of uncertainty and existing vulnerabilities.