Tag: Deutsche Bundesbank

From price to financial stability: Closing data gaps with regard to real estate markets

Prof Claudia Buch Vice-President of the Deutsche Bundesbank spoke about issues in Germany relating to property prices and financial stability. Sounds familiar, especially about the lack of good data!

One of the lessons of the global financial crisis has been that instabilities in markets for real estate can threaten financial stability. In contrast to price stability, there is no generally agreed metric for “financial stability”. Increases in real estate prices may indicate that risks to financial stability are building up. But other indicators, reflecting credit standards and the build-up of housing debt, need to be considered as well. These include the leverage of households, debt sustainability, amortisation requirements, and loan-to-value ratios.

Traditional statistics often do not reflect these indicators of financial instabilities. The G20 Data Gaps Initiative addresses this.

  • In its first phase, a Handbook on Residential Property Price Indices was published in 2013. With regard to residential property prices, the bulk of the conceptual work has been done, and the focus has shifted to compilation and dissemination. Quality adjustment remains a controversial topic and is still a major source of deviations across residential property price indices.
  • The initiative is currently in its second phase. Its main objective has shifted to implementing the regular collection and dissemination of reliable and timely statistics for policy use.

In Germany, prices of real estate property are available from several official and private providers. These indicators differ in terms of representativeness, periodicity, timeliness, breakdowns, and length of the time series. These data show that the prices of both residential and commercial property have risen considerably since 2010. Owner-occupied housing is currently about 25 per cent more expensive than in 2010, and prices for multi-family dwellings have increased by about 40 per cent. On average, commercial property prices have also increased by 25 per cent since 2010, driven mostly by prices for office space.

As regards commercial property prices, however, many conceptual issues still need to be clarified. For example, while office buildings, retail space, and industrial structures are classified as “commercial real estate”, the classification of multi-family dwellings is not clear and depends on whether one follows the perspective of users or investors. Data availability remains challenging, too. The number of transactions is lower than for residential real estate, and heterogeneity is more pronounced. In the absence of official data, analysts rely on private data provided by market observers.

The figure below depicts deviations in the measurement across indicators for price changes in German property markets. With regard to residential property prices in Germany, analysts may consider four main indicators published by different data providers. In this case, they are confronted with measurement deviations of about 1 percentage point for the annual price change of the total market on average (left-hand column). For office and retail space, the mean absolute deviation is considerably larger at 2½ percentage points. This is one of the underlying challenges of assessing such data.

Given that real estate prices have increased strongly, are risks to financial stability building up? Two issues need to be considered.

First, changes in prices need to be compared to changes in fundamentals such as income expectations, demographics, and the macroeconomic environment. These factors may indeed explain a significant share of the price increases in Germany. But there is still an unexplained component, and that component seems to have increased over time.

Second, risks to financial stability emerge if a strong rise in real estate prices coincides with a strong expansion in credit volumes and an easing of credit standards. The house price momentum has caused credit growth, too, to accelerate since the beginning of the upswing on the German property market. Housing credit to households increased by 3.7 per cent in 2016. This is lower than the long-run average: since the early 1980s, the growth rate of housing credit has been about 5 per cent annually.

It is important to note that Germany currently has no consistent reporting on credit standards, eg the loan-to-value ratio or the debt service-to-income ratio.

The relevance of and urgent need for progress in the measurement of real estate prices is widely acknowledged. I am looking forward to the contributions that will be presented at this conference and encourage the statistical community to push ahead with this strand of research and practical implementation

Banks spellbound by innovation?

A useful speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank in which he explores the impact of digital on banking. He looks at potential scenarios based on the use of mobile devices, and explores the cultural and structural issues emerging, and the impact of fintech.  He concludes:

Can banks sit out the current situation using a strategy that was successful in the past? I am convinced that the answer is: no.

What type of innovation is being called for here? In my view, digitalisation will reward not those who “reinvent the wheel” but those who are generally more competent at what they do.

Can banks be innovative? Yes; at the very least, there are enough starting points and actionable areas. For it will not be possible to “sit out” digitalisation. To put it very clearly, in the words of Graham Horton: “Innovation is not compulsory, but neither is survival.”

We will be talking about nothing less than innovation in the financial industry – a subject which, by its very definition, cannot be boring. Innovation basically boils down to the introduction of something new. But is that all there is to it? Edward de Bono, thinking about progress in the world of transport, once described a key element of innovation with the following words. “Removing the faults in a stage-coach may produce a perfect stage-coach, but it is unlikely to produce the first motor car.”

Whenever we talk about innovation, it’s not, then, a question of perfecting habitual modes of thought and action but about harnessing inspiration and thinking laterally.

I would like to kick off today’s event by posing three questions that have greatly occupied me recently in my capacity as a banking supervisor.

  1. Why have innovations in the financial industry become a hot topic now, of all times?
  2. What do we mean, exactly, when we talk about innovation in banking business?
  3. Can banks even be innovative?

2 Innovation: why now, of all times?

Let’s start with the first question: innovations in the financial industry – why now, of all times? I would like to begin by saying that this question is not an inappropriate one. After all, you could say that, given the lessons learned from the financial crisis, it should not be in our interest to urge banks to churn out one innovation after another. Someone who is often quoted in this regard is Paul Volcker, who once said that the industry’s “single most important” contribution in the last 25 years has been automatic telling machines.

Let me be quite clear on this point. Innovations which are no more than smoke and mirrors are not what I came to speak about today. I am here to talk about innovations which offer new solutions, because they are exactly what the banking sector needs for a host of questions it is facing.

At first glance, Germany’s banking sector would appear to be faring quite well: the country’s banks and savings banks have managed to keep their earnings steady recently, and they have rigorously built up their capital buffers. Yet the outlook for profitability is gloomy, and there are a multitude of reasons for this. There are two particular factors I would like to single out because they shine a harsh light on what needs to be done.

The first concerns interest business: it is no secret that the low-interest-rate environment is squeezing margins and deteriorating the outlook for earnings. But saying that, rising interest rates are not a panacea either. Contrary to what is often assumed, they do not bring relief initially, but exacerbate interest rate risk, and that is particularly the case in Germany. Institutions will need to provide for this.

The second reason why profitability is weak is, of course – and I won’t shy away from it – regulation. Regulatory standards were made far tighter in response to the financial crisis, setting the bar higher for banks. That was the right move, and it was an important move – I think you will agree that a stable financial system is in everyone’s interest. But it is also right to say that tighter regulation is taking its toll on many banks. These shifts in the framework conditions are making themselves felt on banks, of course.

Time and again, institutions have raised these two points in an effort to pin the blame for their woes on monetary policy and regulation. But this “we’d be better off without you” mindset is of no help to anyone. Albert Einstein once even said that “insanity is doing the same thing over and over again and expecting different results”. Because there’s no getting around the fact that the rules of the game of banking have changed. There is little to be gained from coming over all helpless – it is up to everyone to adapt to the new environment. Actionable areas include different pricing models, cost reductions or also consolidation.

But innovation is an actionable area, too. And given the huge splash made by digitalisation in recent years, it is a field that has garnered a great deal of attention. If nothing else, the wave of digitalisation has unleashed a strong sense of optimism about the future – fintechs bursting with fresh ideas and business models, customers keen to adopt digital banking, and, not least, the necessary technical capabilities such as broadband internet, especially, have certainly seen to that. The centuries-old banking business has seen the emergence of a kind of virgin territory – a place where, all of a sudden, lateral thinking counts again and where perfecting mathematical models isn’t necessarily one of the best strategies for earning money any more. Innovation, then, is booming in banking business at the moment, and there are two reasons for that: first, the gloomy prospects for many traditional business fields; and second, the challenges and opportunities presented by digitalisation.

3 What does innovation (not) mean?

What exactly does innovation mean in the age of the digital bank? The digitalisation of the financial sector would not have become such a hyped-up topic, were it not for the existence of three visionary, but at the same time, ominous scenarios: I am talking about disruption, revolution and the infinite freedom of digital banking.

Let me talk you through these scenarios one by one.

The first scenario was, and still is, disruption. Disruption means the fear that fintechs, and especially tech giants as well, might offer far more innovative financial services far more cheaply, which would very quickly transform them into overpowering rivals for traditional institutions.

That is not entirely a far-fetched scenario – just take exchange trading, for example, much of which left the trading floor quite some time ago. What you will instead find in Frankfurt and at other exchanges are vast spaces filled with high-performance computers. This example shows us that when it comes to high frequency trading, machines are making ever greater inroads into the services sector. Decisions which were once the preserve of floor traders are now being made by algorithms. The chief difference is that algorithms make up their minds in milliseconds – that is, around the clock – and they can communicate worldwide. Their main cost factor is the electric bill.

But so far, disruption has only affected individual components of the banking business. As yet, not a single technological innovation has managed to fully replicate the economic functions of a bank or savings bank. And even if there have already been instances, such as online payments, where the well-established institutions fell far behind the pace of developments within a relatively short space of time, it is often the case that innovations are beset by what is known as the “curse of the first mover”. That is, the first player to come up with a bright idea frequently founders because that idea is not market-ready. Silicon Valley’s tech giants, on the other hand, often buy up ideas, but they make them a success. So time to market is not everything.

I don’t see widespread disruption happening today or in the foreseeable future. Right now, day-to-day relations between fintechs and banks in Germany can best be described by the relationship status “It’s complicated.” We are currently seeing almost every model conceivable in the business world, from a traditional fintech takeover and white label banking to the idea of the bank as a digital ecosystem. While fintechs started off being quite feisty towards the established institutions, we are now seeing a diverse coexistence based on competition, cooperation and expanding the service offering.

The second scenario is the one I dubbed “revolution”. That is another scenario which has not materialised so far. Digitalisation, it seemed, held out the prospect of creating alternatives to today’s financial system which would be less error-prone and more closely aligned with what customers really want. That is why fintechs presented themselves as a counterpoint to traditional institutions, dressed in hoodies rather than a suit and tie, and claiming to be “small, no-frills outfits” rather than “too big to fail”. But do a sense of a new dawn breaking and a customer-centric culture alone really make such a huge difference? Does the image which fintechs have of themselves really justify supervising them less strictly?

Perceived differences never did have a bearing for supervisory authorities, and the same is true to this very day. It is concrete evidence of safety and reliability that counts. News of glitches and failures, combined with isolated cases of fraud at fintechs around the world, just go to show that accidents and misconduct cannot be eliminated through technology and a fresh appearance alone.

From a prudential vantage point, then, there is little to be gained from constructing an artificial distinction between innovative start-ups and established institutions as long as they both run the same business model. That is also why regulators and supervisors only have eyes for a business’s actual business model. If you’re engaged in banking business, say – that is, you take in deposits and grant loans – you’re going to be treated as a bank by supervisors. You’ll need a licence and be expected to satisfy supervisory standards. Whether a bank only appears on a smartphone screen or it is a well-established institution with a number of branches is neither here nor there. The same reasoning applies to the business activity of financial services institutions and payment institutions. So if a fintech in Germany remains exempt from supervision, that is simply because its business model contains nothing which, from today’s perspective, presents a risk that needs to be supervised by us. The notion of “same business, same risk, same rules” therefore remains the guiding principle for supervisors.

Let me now briefly touch upon the third digitalisation scenario I mentioned earlier: the desire for infinite freedom in financial services, too. A trendsetter some years ago in this regard was bitcoin – a virtual currency, made up entirely of bits and bytes and not managed or controlled by an external authority. Could the underlying idea, to use a computer program to make human interaction manipulation-proof and trustworthy, work across the entire financial community?

I would initially like to state that I regard technical innovations – the best-known of which are blockchain and the distributed ledger – as being highly sophisticated. If combined correctly, they make it impossible for anyone to forge a transaction, a contract or a document, and transactions can be settled in a matter of seconds. In that regard, blockchain can be very attractive as a business factor. It can replace, in part, onerous administrative procedures and external control mechanisms.

But, once the initial excitement has dissipated, one thing becomes clear: there is nothing developing here which will exist outside the current financial system as an unregulated area. Of course, people can, and will, use “blockchains”. But, by the same token, people in the financial system of the future will also rely on the security afforded by our legal system. Financial questions are often existential, and by no means will it be possible to resolve every conflict by a ruling issued by a computer program. There is thus no doubt that technology will have to submit to the law. For banks, this means that they are permitted to use blockchain technology as long as this technology is in line with the legal framework and the bank’s management is willing to take responsibility for the risks of such applications.

Ladies and gentlemen, my remarks should have made one thing clear regarding the question of “What is innovation in the digital banking industry?”: the extreme scenarios of digitalisation have largely converged towards the middle. These days, most companies are not concerned about reinventing the wheel but instead doing many things more practically, quickly and, in particular, more cost-effectively. The question is no longer “bank or fintech?” but programming interfaces and calculating costs.  It is no longer a race to become the “most digital” bank or savings bank but to create an innovative – and therefore convincing – overall package.

4 Can banks be innovative?

Let me now come to the third question I asked in my introductory remarks: “Can banks be innovative?” In recent times, credit institutions have not exactly distinguished themselves as hotbeds of innovation – at least relative to fintechs. Though banks have, in the meantime, initiated their own innovations – up to now, fintechs have proven to be the drivers of digitalisation.

That said: it is not individual ideas we are talking about, but a bank’s overall package. And it is less about inspiration and more, above all, about perspiration. Innovation is thus manageable. It is not my job, as a banking supervisor, to dictate to institutions how they should evolve. We are, and shall remain, neutral to innovation: our job is merely to ensure that banks and savings banks are able to shoulder the risks of their specific business themselves. But our supervisors are, of course, monitoring developments. In the process, we have identified three aspects which are important for making innovation a success.

First: innovation presupposes openness to new ideas and developments. A not-inconsiderable share of change to date has taken place in peoples’ heads. Many senior bank executives first had to learn to take digitalisation and the new competitive situation seriously and to put themselves time and again in the place of their customers. I’m not saying that bank executives have to start learning to understand programming languages or memorise network plans. However, they should generally be able to understand the language of digitalisation.

Second: innovation presupposes the ability to do justice to complexity. Banks’ cyber defences are a good example. Credit institutions are certainly a particularly popular target for attack because the rewards are huge. Given the mounting threats, institutions are in a state of high alert.

But being on high alert is just not enough. For cyber defence is by no means a trivial matter. In the Middle Ages, it was relatively easy to defend castles: by building moats and fortresses. And it was mostly clear from what direction the enemy – often the same enemy – would advance. The reality of IT is a different matter altogether: enemies are unknown and almost never come out into the open. In some cases, professional hackers hide for months on end within a company’s fortress walls. And even if the company has detected a system breach, this does not mean for a minute that the assailant has been driven out of the system – this requires, in some cases, top-of-the-line criminology techniques. IT security must therefore be more akin to an immune system than to a fortress. And you can very well imagine that a good antivirus scanner and a firewall are far from enough to protect this immune system sufficiently.

For a bank’s immune system to be healthy, it has to have suitable corporate structures. Put simply: governance has to be good. Our supervisors therefore order some institutions to tear down the responsibility “firewall”, where no one is willing to assume responsibility for the many interlinked aspects of cyber risk. In addition, the “human” factor has to be taken into account as a weak link in IT and cyber risk.

Therefore, this IT security aspect has to be directly factored into any new projects on to which an institution embarks. By the way, the same goes for financial services start-ups. Despite their reputation for having more state-of-the-art IT knowledge, in the absence of comprehensive security management, they can easily fall prey to dangers from the internet.

I still owe you a third point: innovation often has to be a matter for each individual institution. In the patchwork quilt of banks here in Germany, there is no “one-size-fits-all” solution: each and every institution, be it large or small, rural or urban, special-purpose financing vehicle or universal bank, has to find and go its own way.

 

Germany’s Overvalued Real Estate Market Poses Risks for Banks and RMBS

From Moody’s

Last Monday, the Deutsche Bundesbank, Germany’s central bank, reported that residential real estate prices in German cities are overvalued by 15%-30% relative to fundamental measures of value, with the large cities at the upper end of the range (see Exhibit 1). Such overvaluation is credit negative for banks with concentrated retail mortgage books in urban areas, banks with large retail mortgage franchises and residential mortgage-backed securities (RMBS). Overvaluation creates the risk of losses if foreclosed properties backing mortgage loans are sold after a fall in house prices. The credit effect for covered bonds is limited owing to the statutory protection provided by Germany’s covered bond law (Pfandbrief Act).

For banks, the risk lies in their exposure to retail mortgages if a price correction occurs once interest rates rise materially, along with an acceleration in new housing loans originated in the past two years and margins that have shrunk. Although the combination of these factors in and of themselves do not immediately lead to higher defaults owing to the long-term fixed-rate nature of German residential mortgages, a lower recovery value following a price correction in a foreclosure would require the banks to increase cash provisions on defaulted exposures.

Bundesbank data also show that over the past two years, German banks have increased their new lending volumes by 20% versus the average origination volume during 2009-14 (see Exhibit 2). Hence, if residential property prices were to fall following an increase in interest rates or because of supply-demand imbalances, banks would face meaningful loan-loss provisions in case of default. If residential property prices were to retreat to 2010 levels, we would expect the share of loans with loan-to-value ratios (LTV) of more than 100% to increase to more than 40% of all outstanding mortgages.

RMBS would be negatively affected if house prices were to correct because loss severities (the proportion of the loan not covered by the proceeds from selling the property) would rise. German RMBS typically contain loans originated at high LTVs of 90%,6 on average, with some at above 100%. Deleveraging and house price increases in recent years have resulted in current market price LTVs averaging 55%.7 However, this ratio is primarily driven by one transaction (Pure German Lion RMBS 2008). For instance, EMAC-DE transactions and Kingswood Mortgages have LTVs of 80% on average.

The mortgage covered bonds of Sparkasse KoelnBonn and Hamburger Sparkasse (all rated Aaa) are most exposed to a potential correction of urban residential real estate prices. Both programs have a large share of residential and multifamily mortgage loans in the cover pools, and these issuers focus mortgage loan underwriting on urban areas. Nevertheless, German Pfandbrief are well protected against a potential fall in house prices. The 60% loan-to-lending-value threshold prescribed in the Pfandbrief Act ensures that only loan parts equal to the first 60% of a property’s lending value (defined in the act as the long-term sustainable property value excluding any speculative price components) are eligible for cover pools. The Pfandbrief Act also stipulates that property valuations are not adjusted upward after loan origination in case of property price increases, providing a buffer against price declines if borrowers default on their mortgage loans.

What is the future of global cooperation?

In a speech by Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank there are some insightful remarks about the future of global cooperation and the trade-offs which must be made beyond ideological stances. Is a middle way feasible?

When talking about global market liberalisation and economic cooperation, we hear extreme, ideologically motivated solutions all too often: for instance, populist nationalism promises that everything will get better if we build new walls between our societies. At the other extreme are those who favour hyper-globalisation, that is, no borders to economic activity at all and full harmonisation.

History has proven that both solutions are mere ideologies. The theories of both sides have proven to be unrealistic and in considerable part, plain wrong.

So what form of international economic coordination is actually viable?

To answer that – without giving a long lecture – we can borrow a simple yet powerful analysis: the globalisation trilemma. Dani Rodrik, a well-known economist from Harvard University, argues that we face the following trilemma: we cannot have all three things at once: (a) full, global market liberalisation, (b) national sovereignty, and (c) democracy. We must choose two of these three, and give one up.

If we choose full economic globalisation, without any obstacles to free trade, then we must give up either our national sovereignty or our democratic ability to oppose global rules. For example, if we give up democracy, an autocratic ruler could decree that everyone has to accept the global rules. If we give up national sovereignty, we could have a global democracy. I think it is fair to say that we would rather not give up democracy or national sovereignty.

What remains is to limit market liberalisation, where our societies deem this necessary. This is not a convenient truth, because it means we have to look for answers in less clear waters: we need to find those areas where global cooperation and harmonisation is sensible, and how far it can go. This strategy must then go hand in hand with more national autonomy for finding domestic solutions to national challenges.

Given these constraints, a realistic middle ground would be focused global cooperation: continuing to cooperate and to harmonise regulations, where possible – but also focusing and improving our efforts. Focused global cooperation would also offer greater scope for solutions that respect the legitimate interests of countries wanting to run their economies independently

The possible impact of the Brexit on the financial landscape

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke about the potential impact of the Brexit on the financial sector.

Let’s start with the potential impact of the Brexit on the financial landscape. First and foremost, this means talking about market access. We should not forget that this is a two-way street, and so I will talk about market access in both directions. But the centre of attention is certainly on market access for UK based financial institutions to the EU, as this potentially has the largest impact for banks and other financial institutions. It affects all institutions, both from the UK and the rest of the world, which currently use London as a hub for their continental European business.

The debate on market access was transformed in mid-January. Prime Minister May made it clear that the UK is looking for a clean break from the EU’s single market. For the financial industry, this means that the current model of using London as a gateway to Europe is likely to end. Banks from third countries need a licensed entity inside the European Economic Area to gain access to the whole area, known as “passporting”. Shortly before the Prime Minister’s speech, CityUK already dropped demands for maintaining access through passports.

Instead, many are now hoping for an equivalence decision to fill the gap left by passporting rights. If the European Commission deems the regulatory and supervisory regime in the UK to be equivalent to that in the EU, market access would be partly retained. However, I am rather sceptical about whether equivalence decisions – may they be likely or not – offer a sound footing for long-term location decisions of banks. Equivalence is truly different from single market access.

There are three major drawbacks to equivalence decisions. First, they only cover the wholesale business of banks. Second, given the fact that banks need time to build up a new entity elsewhere, an equivalence decision would have to be taken quite soon to actually have a bearing on the location decisions of banks. Third, equivalence decisions are reversible, so banks would be forced to adjust to a new environment in the event that supervisory frameworks are no longer deemed equivalent. These drawbacks lead me to the overall conclusion that equivalence decisions are not a reliable substitute for passporting.

So it seems that the prospects for EU market access through the UK look rather dim. To ease the pressure on financial institutions, a transition period could help. It would reduce risks and increase planning security for banks, which would be economically beneficial. Furthermore, it could support a smooth relocation process by taking pressure off both supervisors and banks, for example by making “first mover advantages” less important. This being said, transition periods would be a politically sensitive topic in the negotiations, and it is unclear how likely such an agreement might be.

As mentioned earlier, we should not forget about the access of European banks to the UK, which is also an important issue. For German banks, for example, the UK is the second-most important foreign market, right after the US. It will be up to the UK Prudential Regulation Authority to decide under what circumstances European banks can retain access to the UK. Whether the UK would be prepared to unilaterally grant access for EU financial institutions in order to retain the attractiveness of London as a financial centre, remains an open question. And let me add that it is of course not regulation alone that plays a role when European banks decide on opening a branch or a subsidiary in the UK. It is also a question of what kind of entity their counterparties and clients want to do business with.

Let me summarise the prospects for market access, at least from my point of view. Continued passporting rights are rather unlikely, and an equivalence decision would be a somewhat imperfect substitute. A transition period could ease some of the pressure, but it clearly is a sensitive issue.

Could a free trade agreement be the solution? According to their Brexit white paper, the UK government will strive for an ambitious free trade agreement with the EU as a long-term solution. But regardless of the fact that negotiating comprehensive free trade agreements is an arduous and time-consuming task, financial services are an especially tricky area. So far, the EU has never fully integrated finance in its free trade agreements with third countries.

Where does this lead us? So far, while acknowledging and accepting the divorce, policymakers are trying to find ways to hold the UK and EU economic areas and jurisdictions together. And they will continue trying so. The reason is that most of us are convinced that harmonised rules eliminate unnecessary frictions and act as a powerful catalyst for business across national borders – for the real economy as well as the financial sector. However, looking at the facts that I’ve just laid out we also have to acknowledge that it is at least questionable whether this undertaking will be easily achieved. Financial institutions should take into consideration that, in the end, there might well be two separate jurisdictions in which they operate, and that these jurisdictions might diverge over time – or instantly, once the divorce has gone through.

Applying Basel III to small banks

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke on the finalisation of Basel III  – “One size fits all? Applying Basel III to small banks and savings banks in Germany“.

A demanding 2017 lies ahead of banks and savings banks: While the sector is witnessing a structural scale-back of sorts, low interest rates and competition from digital service providers are weighing on profit opportunities. At the same time, the risks that need to be managed have not got any smaller – no, the challenges posed by the low-interest-rate environment are, together with mounting interest rate risks, making them even more demanding.

Many institutions are therefore seeking new strategies and rethinking their business models. To make matters more difficult, a raft of further regulatory reforms is just around the corner.

2 Basel III and the completion of regulatory reform

I’m talking, first and foremost, about the finalisation of Basel III in the Basel Committee on Banking Supervision and its transposition into EU law by way of CRR II and CRD V.

The finalisation of Basel III is the topic of much discussion at the moment, which centres specifically around approaches for calculating risk-weighted assets (RWA). Although many parts of this last package of reforms are already done and dusted – primarily the fundamental revamping of trading-book approaches – some final parts are still being debated in the Basel Committee. This is the case with respect to reforms concerning the treatment of credit risk and operational risk, for instance.

Many banking industry representatives are afraid that this last package of reforms will create a new set of burdens. I see it the other way around: these reforms are necessary, as they complement and round out the Basel reform process. What we saw during the financial crisis was that the approaches to calculating RWA produced capital requirements that were too low in some cases, and a response is urgently needed.

That is why the Basel III package will not be complete until these further reforms have been implemented, and that is why we are referring to the process as the finalisation of Basel III. What I want, here and now, is to clearly disabuse people of the notion that a completely new standard is being introduced.

Of course, what is being asked of institutions is significant and by no means negligible. However, all outstanding reforms are based on the existing regulatory framework and take it a step further. I therefore believe that they should be easier to implement than many fear.

That said, I do understand why banks and savings banks would be jittery at the prospect of a further increase in capital requirements. That is why, in the Basel III finalisation process, the Bundesbank has come out strongly against a further increase in capital requirements. Our motto must therefore be that no agreement in Basel is better than a bad agreement. At the same time, though, an international standard has a very high value that must not be underestimated. This is all the more true in a time in which more and more countries are turning inwards. The Bundesbank will also continue to work towards a compromise on Basel III – one that benefits Germany.

3 Reforms and smaller institutions: a one-size-fits-all solution or graduated rules?

Let me turn now to a second, different topic. In talks with smaller banks and savings banks about the post-crisis reforms, I hear one concern being echoed time and again: that smaller institutions perceive the operational burdens of regulation as being particularly overwhelming. As they put it, a burden that is much more onerous on small banks and savings banks than on their much larger competitors. This is an issue I take very seriously, for the banks and savings banks are right.

Therefore, for the next few minutes I will discuss the question as to whether banking regulation should be offered only as a one-size-fits-all solution for all banks and savings banks – or whether multiple different regulatory regimes should be created to fit different sizes of institutions.

Ladies and gentlemen, it is my firm view that there is absolutely no way a one-size-fits-all approach can do justice to today’s banking landscape – with its very large and complex institutions, its numerous smaller and regional institutions, and the wide expanse of medium-sized institutions! It will positively damage the structure of our banking system – a structure that gave us stability during the financial crisis.

You may well all be familiar with the allegation that the purpose of the new regulatory regime is to encourage more and more consolidation in the industry – including Germany’s banking industry. Of course, mergers among banks and savings banks must not be a taboo topic – but, by the same token, they must not be a regulatory objective, either. I admit to being a fan and proponent of diversity in terms of bank size and business model, as this makes our banking system more stable. Supervisors are not supposed to be making structural policy; rather, they ought to be actively working towards proportionality in regulation.

This is precisely why banking regulation and banking supervision are already designed with a large degree of proportionality. However, the ambitious reforms following the financial crisis have made the rulebook more complex, particularly because the rules were oriented to the epicentre of the financial crisis: large and medium-sized institutions with risky business models.

This new regime has made compliance a much more difficult and time-consuming affair. This overhead is high for each and every institution – regardless of its size. However, small banks and savings banks, owing to their smaller staff sizes, are far less able to spread the costs of compliance across their employees and have to either hire additional staff or enlist external aid. This leads to comparatively higher burdens.

For that reason – and because smaller institutions pose less of a threat to financial stability than medium-sized to large institutions – I think that offering relief to small banks and savings banks is the right thing to do.

One thing that is of paramount importance to me, however, is this: any relief measures being discussed here have to solve the actual problem – which is not, first and foremost, the minimum capital requirements, but primarily the operational burdens imposed by the need to comply with complex rules.

What this means specifically is that any relief for smaller banks and savings banks must be about removing operational burdens – and of this I am firmly convinced. On the other hand, there cannot and must not be any easing of capital and liquidity requirements.

Moreover, no relief should be permitted to jeopardise financial stability. Medium-sized, highly systemically interconnected institutions – those referred to as “too interconnected to fail” – and those institutions with risky business models should not be provided any relief. The recent financial crisis, during which many insolvent institutions had to be bailed out, is still fresh in all of our minds. We also need to be careful not to create any loopholes that end up being used by so many small institutions that a situation of general distress results.

I am therefore firmly convinced that institutions need to be regulated with a sense of proportionality without diluting the new regulatory regime. I am committed to ensuring that the debate on greater proportionality is not used as a pretext for reducing capital and liquidity requirements but that it instead results in an actual reduction in operational burdens on smaller banks and savings banks.

4 Greater proportionality – but how?

How can the goal of regulatory proportionality be achieved in a reasonable manner without any side effects?

There are two conceivable approaches. The first is a details-driven approach that involves introducing special exceptions or adjustments to individual rules.

The second is the creation of separate regulatory frameworks for smaller institutions, on the one hand, and large multinational institutions, on the other.

The details-driven approach has already been pursued as part of the EU reforms I explained earlier, with the Commission emphasising a reduction in the burden on smaller institutions in all reform areas. In its draft consultative document, it has proposed a variety of relief measures and de minimis thresholds, such as in disclosure and reporting requirements. Institutions below these thresholds will be subject to considerably simplified rules, with some requirements even being abolished altogether, which is something I can only welcome.

We just need to be careful not to set the de minimis thresholds too high, as otherwise there would be considerable risks that were inadequately regulated.

With that in mind, I would like to return to the conviction I expressed earlier on: relief measures that reduce capital and liquidity requirements need extremely careful consideration. Examples include some of the exemptions to the leverage ratio (LR) and the net stable funding ratio (NSFR). Another is the considerable enlargement of the SME factor. Whereas real economic growth is unlikely to receive any boost, the minimum requirements for institutions’ risk provisioning could be weakened.

Let me come to the second approach: the two-tiered system. The fact that work is being done on a details-driven approach doesn’t mean at all that this fundamental approach cannot be pursued as well.

Specifically, we are talking about a fundamental approach that envisages a dedicated rulebook for smaller institutions – an approach that would systematically address the excess burden placed on smaller institutions’ operational capacities.

In this scenario, only banking multinationals would be subject to the fully loaded Basel III requirements in the EU. This would be appropriate from a risk perspective: we would be regulating global banking institutions under a harmonised set of global rules, while smaller institutions and those operating within a certain region would be governed by graduated rules that do justice to their different business models and risk profiles by setting less complex requirements.

The Basel Committee would also benefit from such a dedicated rulebook for banks operating internationally. If the 28 member states knew that the fully loaded Basel standards were only applicable to large, internationally active banks, we wouldn’t have to worry any more about detailed national exemptions, but could instead devote our entire energy to the key task: standards for large, internationally active banks.

I feel very much that Brussels and Basel should examine this approach with an open mind. Such a systematic approach to relieving the burden on smaller institutions, to the extent that it is deliverable, is generally superior to a patchwork of exemptions. In this connection, I am very eager to open up a dialogue with the banking community. To this end, a joint working group was recently established, comprising delegates from the Federal Ministry of Finance, the Bundesbank, BaFin and the central associations of the German banking industry, in order to develop proposals along these lines.

5 Conclusion

Ladies and gentlemen, the implementation of Basel III will impose further demands on banks and savings banks – but I think that less time and effort will be required than many currently fear.

With regard to the implementation of reforms, two things are of paramount importance to me. Under no circumstances must we water down what has been achieved since the financial crisis; rather, we must maintain a robust regime of rules.

That said, a one-size-fits-all approach will not do justice to the banking landscape. One of the objectives guiding the actions taken to finalise the agenda of reforms in Europe should therefore be to lessen the operational burdens on small, low-risk institutions – ie to make the final regulatory regime more granular.

The objective must not be to erode minimum capital requirements and thereby open a new gateway for stability problems. Instead, it is about reducing operational burdens on small institutions without hollowing out capital and liquidity requirements.

This, ladies and gentlemen, is how we can secure a diverse, successful and, above all, stable financial sector – to serve the German economy.

Digital Finance and Fintch – Benefits and Risks

Dr Jens Weidmann President of the Deutsche Bundesbank spoke on “Digital finance – Reaping the benefits without neglecting the risks“, drawing  important links to financial literacy, financial stability and fintech.

More than 20 years have passed since Bill Gates famously said that “Banking is necessary, banks are not”.

While banks still exist – and I am sure they will continue to do so -, recent developments have shown that non-banks are just as capable of providing bank services. And that is not least due to the huge strides made in the field of information and communications technology (ICT), which has opened up a whole new world of possibilities for designing and distributing financial services.

And this has even transformed traditional banking business. Online banking, for example, has become the main point of access for many bank customers.

Digital finance, and the fintech industry in particular, have experienced very rapid growth in recent years on the back of both supply-side and demand-side forces.

On the supply side, technological progress plays an important role, but so, too, do efforts to drive down the costs of financial services. These forces are being propelled by the increasing availability of ICT infrastructure, the provision of unique access points to financial services, and the growing number of digital natives.

And on the demand side, “always on” customers are increasingly expecting to be able to bank with a minimum of fuss, whenever and wherever they like.

Digital finance opens up a host of opportunities, but we should not neglect the risks it entails. But how can we capitalise on these opportunities without losing sight of the potential risks? That is a key question of this conference – one that will be addressed by a panel discussion and also by Bank of England governor Mark Carney in his keynote speech this afternoon.

From an economic point of view, digital finance can deliver a wealth of benefits. First of all, digital financial services can bring about significant efficiency gains. Digitalisation can also stoke competition within the financial system and raise the contestability of financial markets. Some commentators even argue that digitalisation has the potential to revolutionise financial services and infrastructure.

The key buzzword here is “disruptive”. And many believe the most disruptive potential is to be found in blockchain or distributed ledger technology, which promises to allow payment transactions and securities settlement to bypass banks and central counterparties altogether.

Originally developed for the bitcoin virtual currency, this distributed ledger technology, it would appear, has turned out to be a multi-purpose tool. And even central banks – which aren’t typically known for being early adopters of new technologies – are currently doing experimental research on the potential use of blockchain.

The Bundesbank, for example, has recently launched a joint project with Deutsche Börse to develop a blockchain-based prototype of a securities settlement system.

But even apart from radically transforming the payments and securities settlement infrastructure, digitalisation enables newcomers to mount a challenge against incumbent market players.

Data-driven technologies can boost the transparency of the financial system and thus reduce information asymmetries. Big data analysis, for example, can improve the estimation of default risks even in the absence of a longstanding bank-customer relationship.

An increasing number of suppliers of financial services is particularly good news for households and enterprises lacking access to traditional sources of finance. In the end, this might drive up the number of projects that receive financing.

Online crowdfunding or peer-to-peer lending platforms might enable investment projects which would otherwise be too risky or too small for traditional banks, to go ahead.

In general, digital finance facilitates access to financial services. And this benefit is not confined to tech-savvy consumers in advanced economies. Indeed, digital technologies can be key drivers of financial inclusion in less developed countries, too.

In Kenya, for example, the share of people with a financial account rose from 42 % in 2011 to 75 % in 2014. Over the same period, the respective global figure rose from 51 % to 61 %.

In tandem with the mounting ubiquity of cell phones, mobile money accounts have gained popularity, particularly in Sub-Saharan Africa. In some countries, there are even more adults with a mobile money account than a conventional bank account.

Financial inclusion is thought to be conducive to promoting economic growth and lowering inequality. Financially included people are in a better position to start and develop businesses, to invest in their children’s education, to manage risks, and to absorb financial shocks.

On the other hand, there is a trade-off between financial inclusion and financial stability. Expanding access to financial services – especially to credit – at too fast a pace and with too little control exposes economies to stability risks, and households to the risk of over-indebtedness. The Indian microfinance crisis in 2010 showed us what can happen if too many households have access to credit despite being subprime borrowers.

And that is why financial literacy is so crucial. People with access to finance need a basic understanding of financial concepts like compound interest and risk diversification.

Surveys, however, provide some worrying results. According to an International Survey of Adult Financial Literacy Competencies, which was commissioned by the G20 and published by the OECD, overall levels of financial literacy, as indicated by knowledge, attitudes and behaviour, are relatively low.

And another study, the S&P Global Financial Literacy Survey, which was supported by the World Bank, reveals that two out of three adults are not financially literate, albeit with major variations across countries. While more than half of adults are financially literate in most of the advanced economies, that goes for fewer than one-fifth of people in some developing or transformation countries.

There are, of course, other aspects of digital finance which have a bearing on financial stability.

Herding behaviour, for example, could be amplified by automated advisory services in portfolio management. Robo advisors might exacerbate financial volatility and pro-cyclicality if the assets under management reach a significant level, which is not yet the case.

Traditional banks in many countries are currently suffering from dwindling profitability due, most notably, to the low-interest-rate environment. Disintermediation, however, could intensify the problems of narrow profit margins. This might be the flipside of the mounting competition unleashed by the more widespread use of digitised financing.

And decentralisation might make it more difficult to tell who is exposed to whom, and to detect where financial risks ultimately lie.

Another point worth noting is that fintech business models have not yet run through an entire credit cycle. Experience with digital finance in economic downturns is very limited.

That being said, it is quite obvious that regulating fintechs and the entire digital financial industry smartly without hindering financial innovation is warranted. That’s why the objectives of the German G20 presidency include taking stock of the different regulatory approaches. Our aim is to develop a set of common criteria for the regulatory treatment of fintechs.

Fintechs should not base their business models on regulatory loopholes. Using lax regulation to attract business is a mistake that was already made before the latest financial crisis. Whatever we do, we need to avoid a regulatory race to the bottom. Rather, we should go for a level playing field.

To quote the words of the former ECB President Jean-Claude Trichet who said in 2010: “(…) “the crisis has exposed the risk of regulatory arbitrage, shedding a more negative light on the competition among different systems and rules.””

Getting a clearer picture of fintechs’ business activities is essential if we are to better understand whether and in what way they might pose a threat to financial stability. It is therefore an important endeavour of the Financial Stability Board to further investigate and promote data availability. Without reliable data, any assessment of risks is unfeasible.

Another threat – and certainly not just to financial stability – comes from cyber risks.

The more market infrastructures rely on digital technologies, the more vulnerable our interconnected global financial system becomes to criminal attacks, be it from computer hackers, cyber saboteurs or even terrorists.

Cyber criminals have repeatedly targeted financial institutions around the world, including central banks. There are plenty of financial institutions I could name whose defences have been successfully breached. The damage unleashed by successful attacks goes beyond the financial loss incurred. Cyber-attacks can potentially undermine peoples’ trust in the financial system.

So to avoid jeopardising the positive impact of digital finance, it will be crucial to address these risks and for banks to manage their IT and cyber risks with as much diligence as they do their traditional banking risks.

Cybersecurity risks will be a major item in a talk this afternoon with Thomas de Maizière, German Federal Minister of the Interior. And a research dialogue tomorrow will also address the topic of cyber security.

Challenges for (European) banks

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke on “Banks Navigating Uncharted Waters.” Non performing loans double what they were in 2009, Brexit, Basel, digital disruption and low interest rates are all creating uncertainty.

dbund-pic

Let me start with the pending divorce of the UK and the EU. I have mentioned it because of its political impact. But as you know, it has strong implications for the financial sector as well and will continue to do so. Many eyes are on the question of whether, and in what form, the UK will retain access to the single market. In the financial realm, the related question is whether financial firms in the UK will continue to benefit from what we call “passporting”. Currently, many international banks use London as a hub to conduct business within the European Economic Area. But depending on the deal that will be struck between the UK and the EU, passporting in its current form might end – and with it the possibility to enter the European market through the UK. Another open question is whether the City of London will still be in a position to clear euro-denominated swaps and other euro-denominated transactions once the UK has formally exited the EU.

These are just two of the most prominent examples of the regulatory uncertainty that is troubling the financial sector in the wake of the UK referendum. Further questions such as the free movement of labour, goods and services affect the UK economy as a whole and with it all the clients of banks.

Given that formal negotiations have not even started yet between the EU and the UK, there are still plenty of plausible scenarios for their future relations, and thus for the environment banks will have to operate in. This uncertainty surrounding Brexit will stay with the financial sector for some time to come, and there is no easy way around it.

Let’s move on to the second issue, which concerns regulation more generally. Earlier this week, I was in Santiago de Chile to meet with my colleagues from the Basel Committee, where we discussed details for completing Basel III. The rules based on this regulatory regime are currently being finalised and phased in. Important aspects of the current negotiations are the revisions made to the level and the calculation of capital requirements.

The need to adapt to, and comply with these new requirements is imposing costs on banks and causing headaches among bank managers. This holds for European financial institutions in particular. In comparison to Brazil, for example, the use of internal models for calculating risk-weighted assets and thus capital requirements is widespread in Europe. Consequently, any changes to this approach – as currently discussed – have much stronger implications for European banks than for their counterparts elsewhere.

It is therefore crucial that the final result of our current negotiations will be regionally balanced and does not undermine the risk-oriented approach of the Basel framework. The Committee was not able to reach such an agreement yet. We will continue our negotiations with the goal of ending regulatory uncertainty as soon as possible. And we will work towards finding a compromise before the Committee’s oversight body – the Group of Governors and Heads of Supervision – will meet in January.

In parallel with reforming Basel III, in Europe we have established the banking union with a whole new supervisory architecture at its core – the Single Supervisory Mechanism. This supervisory mechanism is still relatively new territory for banks, as it has just recently celebrated its second anniversary.

As you can see, the regulatory and supervisory world is changing significantly and rapidly for banks. Keeping up with these developments is a challenging task.

On top of that, we are currently seeing significant structural changes in the market environment for banks. Two developments are decisive here.

On the one hand, digitalisation is rapidly transforming the banking business. While technology has always played a prominent role in banking, the speed and force of the current wave of digitalisation is unprecedented for European banks. Small FinTech start-ups as well as major tech giants are forcing their way into the market, for example by providing instant payment services with a speed and convenience unmatched by the traditional services that banks have on offer. In parallel, technologies with the potential to disrupt individual business models are being honed and refined, and made ready for the market.

In contrast to some banks in Europe, most Brazilian banks are already well-advanced in digitalising their business. Ironically, this is due to the fact that they mostly set up their IT later than their European counterparts. This observation is very much at the heart of the challenge posed by digitalisation: in the field of IT and digital services, it is not sufficient to put up a high upfront investment in order to ensure quality that will last for years. Instead, you need to do both: move early on and then continuously keep up with the pace of digital innovation. Only then can you ensure both –  IT and cyber security as well as the quality necessary to satisfy an increasingly elusive customer base.

The impact of digitalisation on the financial world – and the world as a whole – cannot be overestimated. But there is a second structural challenge that is even more pressing for many financial institutions. I am, of course, talking about the prolonged period of very low interest rates.

The low-interest-rate environment is a prime candidate for the lure of the easy answer. And the seemingly easy answer is that low interest rates are the result of misguided monetary policy. But this answer reflects a common misperception as to the root causes of the low rates.

The downward trend in long-term nominal and real interest rates across the world has been visible since the 1990s. This trend accelerated after 2007 with the financial crisis. The macroeconomic literature currently discusses a number of structural causes as potential explanations. Without going into details on the research, there are indications that show that a slowdown in global growth together with shifts in savings and investment behaviour, partly driven by demographic change in industrial countries, have led to a fall in the price of capital. With the financial crisis and the recession that followed, the fall in the desired levels of investment together with expansionary monetary policy have pushed down rates even further.

In summary, not only are the very low interest rates influenced by central banks: they also reflect an economic malaise in the global and in the euro-area economies.

Irrespective of their origin, the very low interest rates pose a serious challenge for profitability in the financial sector. This is particularly the case for banks whose business model depends heavily on net interest income. First of all, the margins derived from maturity transformation are declining because of the very flat yield curve. And second, deposit-based refinancing which we have always regarded as highly desirable as a stable source of funding, even in crisis periods, becomes less attractive. This is because it is difficult to pass on negative rates to small private depositors in a very competitive market and when depositors always have the alternative of hording cash.

Despite the low rates, net interest income hasn’t been affected much so far. But the pressure on margins is going to mount over the medium term as outstanding loans are repaid and replaced by lower-yielding ones.

A major risk associated with a low-interest-rate environment materialises when that spell comes to an end. In this scenario, pre-tax net income would probably suffer a short-term slump, especially if interest rates were to climb abruptly following a long period of low rates. In the short term, this would lead to present-value losses. More importantly, as banks are by their very nature engaged in the business of maturity transformation, a rise in interest rates will force them to roll over their liabilities at higher interest rates. But the yields on their assets will still reflect the low-rate environment.

Moreover, the longer banks have to cope with low interest rates, the more they are likely to take risky assets onto their books. We can observe that banks are extending the average maturity on the asset side, which is exposing them to more credit default and market risk.

At the same time, European banks are still holding significant amounts of non-performing loans in their books. For the euro area as a whole, the stock of NPLs amounts to roughly 9% of euro-area GDP, more than double the level in 2009, and is only declining slowly. If we instead measure the amount of NPLs relative to total loans, we get the so-called NPL ratio. This ratio stands at 5.5% on average for European banks. However, we can see a strong dispersion of NPL ratios across countries. The highest NPL ratios are present in those member states that were hit hardest by the economic crisis that followed the financial crisis after 2007.

The high stock of NPLs ties up operational capacity of the affected banks, it involves legal as well as administrative costs, and it weighs on the capacity of those banks to extend new loans to realise profits and to support economic recovery.

Deutsche Bundesbank and Deutsche Börse blockchain prototype

Deutsche Bundesbank and Deutsche Börse jointly presented a functional prototype for the blockchain technology-based settlement of securities.

Small-Chain-Picture

The innovative prototype is designed to provide the technical functionality for the settlement of securities in delivery-versus-payment mode for centrally-issued digital coins, as well as the pure transfer of either digital coins or digital securities alone. In addition, it is capable of settling basic corporate actions such as coupon payments on securities and the redemption of maturing securities.

The Deutsche Bundesbank and Deutsche Börse plan to develop the prototype further over the next few months, and this product will then be used to analyse the technical performance and the scalability of this kind of blockchain-based application.

With the blockchain prototype, the Deutsche Bundesbank and Deutsche Börse want to work together to find out whether this technology can be used for financial transactions, and if so, how this can be achieved. The Deutsche Bundesbank hopes that this prototype will contribute to a better practical understanding of blockchain technology in order to assess its potential,explained Carl-Ludwig Thiele, Member of the Deutsche Bundesbank’s Executive Board.

Along with the Deutsche Bundesbank we are innovatively and creatively addressing potentially radical technological opportunities for the financial sector. We will continue to do our utmost to leverage blockchain’s efficiency potential and to better understand and minimise the associated risks of this technology, added Carsten Kengeter, CEO of Deutsche Börse AG.

The blockchain-based prototype is the first result of a collaborative research project between Deutsche Börse and the Deutsche Bundesbank. The prototype is purely a conceptual study. It is far from being market-ready. The two institutions will continue to work on improving the prototype and drawing up a test concept.

The prototype has the following features:

  • Blockchain-based payments and securities transfers as well as the settlement of securities transactions against both instant and delayed payment
  • Maintenance of confidentiality/access rights in blockchain-based concepts on the basis of a flexible and adaptable rights framework
  • General observance of existing regulatory requirements
  • Identification of potential to simplify reconciliation processes and regulatory reporting, and
  • Implementation of a concept based on a blockchain from the Hyperledger project.

German Bank Profitability “Too Feeble”

Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank discussed the state of play in Germany’s banking sector as they unveiled the Deutsche Bundesbank’s Financial Stability Review.

He said that first, the supervisory environment for banks has become even more European since the last Financial Stability Review. Second, German banks have boosted their stability still further – equity capital ratios are up again, leverage is down again. Third, persistently weak earnings are taking their toll on German banks. The low-interest-rate environment will particularly make itself felt at small and medium-sized institutions over a medium to long-term horizon. Institutions will need to tackle these challenges head on if they are to safeguard their stability and profitability.

dbund-pic The latest financial stability review identified some key risks:

  1. In the current macroeconomic setting, there is a danger of risks being underestimated. Low interest rates, low risk premiums and high valuation levels are affecting all sectors of the economy – firms, households and general government. The incentive is there to amass more debt. This increases vulnerability to future changes in prices or interest rates.
  2. The current macroeconomic setting can favour a credit-financed real-estate boom. Prices are rising in the German real-estate sector, and lending is on the rise. However, there are no acute signs of an easing of credit standards. Preventive measures can mitigate future risks, though.
  3. Risks are accumulating in financial institutions’ balance sheets. The amount of low-interest long-term loans is rising, while the share of low-yielding assets has increased. This is leading to increased liquidity and interest rate risks. Persistently low interest rates would hit precisely those financial institutions whose business models depend heavily on interest rates.

German banking sector still stable …

I’ll start with the good news: German institutions have substantially increased their capital levels – and thus their resilience as well – since 2010.

The tier 1 capital ratio of the German banking system as a whole rose by just a slim 0.16 percentage point between June 2015 and June 2016, leaving it broadly unchanged at its year-end 2015 level of 15.7%. But this underlines the long-term trend improvement in capital adequacy, which is the key determinant of any banking sector’s resilience. In early 2008 – the year of the global financial crisis – the tier 1 capital ratio averaged no more than roughly 9.1%.

A major effect that impacted positively on the tier 1 capital ratio in Germany came from the decline in risk-weighted assets since 2008. That is to say, banks have stepped up their investment in assets with lower capital requirements.

The results of this year’s EBA stress test confirm that the German institutions which took part in that exercise are more robust to macroeconomic shocks today than they were just a few years ago. To sum up – there can be no doubts as to the solvency and liquidity of the German banking sector.

… but profitability is too feeble by international standards

Yet having a stable capital base alone isn’t enough to ensure sustained resilience. Banks need to generate sufficient profits as well.

Let’s start by looking at Germany’s major banking multinationals. Compared with their total assets, these institutions have slightly improved their operating income, which is up from 1.31% in 2009 to 1.51% in 2015.

However, the major banks saw their return on total assets dip again for the first time last year. While it is true that the provisions made by one major institution had a negative impact on the return on total assets in Germany, if we exclude that particular institution, the remaining group of banks saw an increase in return on total assets, at 0.35%. All in all, that figure is still low by international standards, however. German banks as a whole are likewise lagging behind the international field – their aggregate return on equity, for example, languishes at just under 6%.

What’s causing these problems? The diagnosis is relatively simple. Profitability is exceedingly weak among German credit institutions, and the persistent low-interest-rate environment is only making matters worse. Credit institutions whose business models are heavily geared to net interest income, in particular, might encounter serious medium to long-term problems if the phase of rock-bottom interest rates persists. The longer rates remain low, the more the pressure on net interest income in Germany will intensify.

But for now, we can cautiously sound the all-clear, particularly for small and medium-sized German institutions, because although the low rates are leaving a dent in their profits, most banks and savings banks are still bearing up. Net income from traditional interest business for German banks as a whole was down by €0.9 billion at €78.1 billion, but that decline was offset by an increase in net fee and commission income, which was up by €1.2 billion at €30.5 billion. Credit cooperatives and savings banks – institutions that are heavily reliant on interest business, relatively speaking – also managed more or less to maintain the previous year’s net figure.

But the low-interest-rate environment is also posing a threat to the financial system. As higher-yielding legacy loans mature, they are being replaced by ones generating lower returns, some of which have longer tenors.

Moreover, the narrow spreads between short-term and long-term interest rates are squeezing the margins that banks can generate from maturity transformation. Together, these effects are crimping net interest income. Furthermore, banks are recording stronger flows of short-term deposits, which increases their exposure to interest rate risk. Ever since 2011, we have been seeing an almost steady rise in the Basel interest rate coefficient, which is a measure of interest rate risk. What this means for German credit institutions is that they should actively manage and hedge their higher interest rate risk – having an adequate capital base helps as well.

A major risk associated with a low-interest-rate environment materialises when that spell comes to an end. In this scenario, pre-tax net income would probably suffer a short-term slump, especially if interest rates were to climb abruptly following a long period of low rates. This would not only generate present-value losses in the short run, but might also cause interest expenses to outpace interest income in the medium term. Moreover, German institutions are now carrying more risky assets in their books than they were just five years ago. Not just that: they are also extending the average residual maturity in their proprietary business, which is exposing them to more credit default and market risk.

But from a long-term vantage point, an interest rate hike would help the banking sector recover and regain stability. And that’s precisely why it’s so important for the banking system to be adequately capitalised, since that would help it cushion shocks over a short to medium-term horizon.

Supervisors are closely monitoring German institutions in this setting. Following on from our exercises in 2013 and 2015, we at the Bundesbank are planning to conduct another survey on the low-interest-rate environment next year among the institutions we supervise directly – this time with added interest rate, credit and market risk stress tests. We hope this survey will give us an insight, early on, into any critical and risky developments in the banking sector and assist supervisors in their dialogue with institutions.

Past survey results tell us that credit institutions are responding to the new setting and pushing up their earnings from commission business – which includes, amongst others, account management and payment fees – and also increasingly passing on negative interest rates to major customers. We have also been seeing a steady flow of consolidation and mergers in the savings bank and cooperative sectors.

For all the progress we have made, there’s still one topic that continues to worry me. Roughly eight years on from the onset of the financial crisis, a number of European banks are still saddled by disturbing amounts of non-performing loans (NPLs). Therefore, scaling back these legacy exposures is one of the foremost aims of banking supervisors in the euro area, and rightly so.

There are two main reasons why we’re interested in NPLs. One, they make banking systems more vulnerable because they drive up both capital requirements and funding costs. Two, they make it harder for the banks in question to supply credit; this, in turn, puts the brakes on growth in the euro area. As a consequence, NPLs don’t just weigh on credit institutions’ earnings; they also intensify solvency risk and obstruct economic activity in Europe.

In this context, I would like to highlight the public consultation on the draft guidance to banks on NPLs which was initiated by the ECB and ran until yesterday. Equipped with this guidance, banking supervisors will be in a position to uniformly assess banks’ internal handling of NPLs as part of their regular supervisory dialogue.

But as far as financial stability in Germany is concerned, I see no immediate cause for alarm. NPLs are far less of a problem in the German banking system than they are in some of the other euro-area countries. At roughly 2%, the NPL rate in Germany last year was well down on the euro-area average. That figure also includes non-performing shipping exposures, and they certainly do worry me because there are still no signs that the economic situation in the shipping industry is about to recover. It goes without saying, then, that we shall continue to keep a close eye on banks with substantial exposures to shipping loans.

As for the institutions saddled by NPLs, we expect them to take measures that are conducive to promptly reducing legacy exposures and bolstering their resilience. These measures include not just thoroughly cleansing their balance sheets of both existing and anticipated losses but above all conducting appropriate credit risk management and holding an adequate level of capital.