A year ago, the German financial system was facing major challenges following the strongest rise in interest rates in the past 25 years. During the protracted period of low interest rates spanning from the end of the global financial crisis to mid-2022, considerable vulnerabilities had built up in the German financial system. These had left the financial system – i.e. financial intermediaries and markets together with their infrastructure – susceptible to various shocks. The positive economic developments and steady decline in credit defaults had made it increasingly difficult to assess medium-term credit risk and had increased the likelihood of risks being underestimated. Risk provisioning was low in view of the low default rates, while credit growth was extremely dynamic. There were overvaluations in asset markets, such as residential real estate, as a result of which credit collateral would also be overvalued. In addition, banks were exposed to major interest rate risk and life insurers to earnings and solvency risk due to high guaranteed returns.
High inflation and the period of rising interest rates commencing in 2022 had left a significant mark by the time 2023 came to a close. The macroeconomic environment had fundamentally changed and vulnerabilities had, to a certain extent, been exposed. High inflation, the tense economic situation and increased interest rates weighed on household incomes and firms’ profits. Real estate markets were experiencing a downturn. Credit risk had therefore risen. Even back in 2022, valuation losses on interest-bearing assets had already culminated in realised and unrealised losses on banks and insurers’ balance sheets. In this environment, the risk of disorderly developments was elevated.
At the end of 2023, the transmission of high key interest rates to the real economy was not yet complete and it was difficult to gauge how this transmission to the financial system would continue to play out. Specifically, it was unclear how banks’ significantly mounting interest expense would affect their future net interest income, notwithstanding the fact that banks were able to profit from low deposit rates in 2023. For life insurers, it was uncertain whether liquidity risk would materialise in the form of policy lapses in large numbers. At the same time, there was uncertainty regarding the duration and scope of the correction in the real estate markets. Given the combination of elevated interest rates and weak real economic activity, uncertainty also arose regarding the evolution of credit risk on financial intermediaries’ balance sheets.
The macro-financial environment has gradually improved since last year, but remains challenging (see Chapter 4 "Stability situation in the German financial system"). Overall, there are signs of a return to price stability in the euro area and Germany, and so the ECB began to lower its key interest rates in June 2024. Even so, Germany’s economy remains mired in a period of weakness, though distortions characterising a crisis are not expected. Risks in commercial real estate are still elevated. The corporate sector is also encumbered by weak economic activity and structural change. Overall, disorderly developments have become less likely compared with last year, but geopolitical tensions entail significant downside risks (see the supplementary information entitled "Geopolitical risks: impact on financial stability").
German banks weathered the phase of rising interest rates well overall and have proved stable (see section 4.2 "Banking system: vulnerabilities and resilience"). As interest rates on overnight deposits have risen by surprisingly little, banks’ profitability is at a comfortable level. The major vulnerabilities stemming from the period of low interest rates have so far been declining in an orderly manner, but only gradually. This is true of residential real estate loans, in particular. Risks remain high for commercial real estate loans. Banks’ capitalisation is sound. As losses in the value of interest-bearing positions during the hike in interest rates often did not need to be reported, capital ratios were relatively high. Substantial unrealised losses have decreased considerably in the meantime. Average risk weights remain low and possibly underestimate existing credit risk. If risk weights were to rise sharply due to increasing credit risk, this would lead to a decline in risk-weighted capital ratios.
Although German non-bank financial intermediaries (NBFIs) likewise weathered the phase of rising interest rates well, they continue to face liquidity risk (see section 4.3 "Non-bank financial intermediaries: vulnerabilities and resilience"). Liquidity risks in open-end real estate funds could amplify developments in the commercial real estate market. Redemption notice periods and minimum holding periods are keeping the liquidity risks of open-end real estate funds for the retail market in check. Investment risks from commercial real estate are manageable for the life insurance sector, in part due to its sound capital base. The liquidity risks of life insurers, by contrast, remain elevated, even if the risk of an upsurge in policy lapses is limited. Unrealised losses lessen the incentives for life insurers to trade actively during periods of stress and to purchase securities when prices have fallen sharply. As a result, they may absorb shocks in the financial system to a lesser extent than they did previously.
Given the overall risk situation, it is still vital that the German financial system remain sufficiently resilient (see section 4.4 "Overall assessment and implications for macroprudential policy"). The package of macroprudential measures announced by BaFin in January 2022, containing the countercyclical capital buffer (CCyB) and the sectoral systemic risk buffer (sSyRB), remains adequate. Downside risks are still high and economic developments pose a challenge to the corporate sector. The risk of adverse shocks remains high amid current geopolitical tensions. The downturn in the commercial real estate markets continued during 2024, albeit with weakened momentum. The developments currently unfolding in the residential real estate market point to slowly diminishing risks for residential real estate loans granted up to 2022. Overall, an orderly reduction of vulnerabilities in the residential real estate market has become more likely. Macroprudential supervisors will closely monitor further developments, not least taking into account data collected since 2023 on the lending standards for newly issued real estate loans.
Macroprudential policy continues to evolve. In order to ensure that banks remain resilient in the long term, macroprudential supervisors must retain their scope for action, particularly in periods of stress. Against this background, a number of European countries have adjusted their macroprudential strategies for the banking sector. They tend to activate the CCyB at an earlier stage, and some have introduced a CCyB target rate that applies even when cyclical risks are not elevated (see the supplementary information entitled "The economic benefits of releasable capital buffers and the positive neutral rate"). The regulation of NBFIs, should strengthen its macroprudential perspective particularly with respect to liquidity risk. One major reason why this is important is because problems in the insurance and fund sectors may spread quickly to the banking sector due to their interconnectedness. In order to better assess risks arising from cross-border interconnectedness with NBFIs, foundations should be laid for European data sharing among macroprudential authorities. At the international level, such as in the Financial Stability Board (FSB), ways should also be found to better assess the global financial stability risks of NBFIs.
The financial system must cope with both real economic structural change and structural change in the financial system itself, such as digitalisation. Climate policy and climate change are driving structural change in the real economy and the financial system. A special chapter examines the risks arising from an unexpected and immediate carbon price increase for the German financial system (see Chapter 5 "Special chapter: Risks arising from an unexpected and immediate carbon price increase"). While the effects are likely to be manageable in isolation, a predictable climate action trajectory generally reduces climate risks. A consistent disclosure requirement for carbon emissions helps to mitigate the impact of climate risks and should continue to be pursued. Another driver of structural change in the real economy and financial system is digitalisation. This year’s Financial Stability Review looks at the impact of the introduction of a digital euro on the banking system (see the supplementary information entitled "Digital euro: impact on bank liquidity and funding costs").
In addition, the Financial Stability Review highlights structural change in the financial system arising from the increased importance of NBFIs and banks’ interconnectedness with NBFIs (see section 4.3 "Non-bank financial intermediaries: vulnerabilities and resilience" and the supplementary information entitled "Contagion channels between banks and investment funds"). A special chapter compares the market and holder structure of the German and Italian government bond markets and of the repo market in which these government bonds are used as collateral (see Chapter 6 "Special chapter: The German and Italian government bond markets from a financial stability perspective"). The Bundesbank’s joint project with the Banca d’Italia reveals various differences: whilst Italian government bonds are mainly traded via a regulated electronic trading platform and centrally cleared, German government bonds are mostly traded bilaterally over the counter. In addition, German government bonds are held primarily by foreign investors as well as euro area-based investment funds. By contrast, Italian government bonds are held mainly by domestic banks and insurers. NBFIs play an important role in both markets. Their behaviour is crucial for price discovery and shock propagation mechanisms in the financial system, which in turn can affect liquidity.
