| Business cycle | A business cycle describes recurring short-term to medium-term fluctuations in macroeconomic activity. A cycle includes an upswing and a subsequent downturn (recession). Adjusted for the general longer-term growth path, the upswing phase is characterised by positive and the downturn phase by negative real economic growth. |
| Calibration | Calibrating a model means setting estimation parameters with the aim of obtaining realistic and reliable probabilities or results for forecasts. Methodologically, calibration can be based on historical (extreme) losses, stress test results, model approaches or expert evaluations, for example. |
| Contagion effect | The term contagion effect in the sense of financial stability is used where shocks or losses are transmitted from one intermediary to another, potentially even making them worse. This can happen through direct channels (for instance, mutual contractual relationships in the form of loans). Alternatively, contagion may occur through indirect channels (for instance, similar business models, correlated portfolios or market price developments). In this process, market players who were completely unaffected by the initial shock at first may experience negative developments. Direct contagion occurs via direct (reciprocal contractual) business relationships between financial intermediaries. Examples of triggers are a borrower defaulting or a business becoming insolvent. Contagion is not direct if it happens because intermediaries are interlinked. Indirect contagion describes adverse effects on a market participant without that market participant being involved through a direct transaction or interaction. Indirect contagion is usually triggered by adverse price or information effects and is not spread via direct interlinkages. Contagion via third parties (markets, intermediaries, sovereigns) and through a chain of intermediaries also represent indirect contagion. Indirect contagion through price effects occurs, for example, when a loss forces an intermediary to sell assets (see also fire sales) and this causes prices for these assets to drop. These lower prices then force other intermediaries holding similar assets to also write down the value of those assets or adjust their market value. Indirect contagion effects can also come about if an intermediary becomes distressed and market participants expect other intermediaries with a similar credit portfolio or business model to encounter similar problems (information channel). This could result in deposits being withdrawn, fund shares being redeemed or insurance policies being lapsed. As a consequence, these intermediaries, too, could run into difficulties. |
| Credit cycle | The credit cycle describes fluctuations in the issuance of loans by banks and non-banks over a period of more than one business cycle. The credit cycle comprises periods of expansion in which lenders issue more loans and ease lending conditions. It also includes periods of contraction in which lending declines and lending conditions are tightened. The credit cycle is the part of the financial cycle that relates only to lending. These cycles are often closely linked to the macroeconomic situation and can strengthen or weaken business cycles. |
| Default risk | Default risk (also known as counterparty risk or counterparty credit risk) is the risk that a borrower will be unable to make due principal or interest payments on time, in full or at all – in other words, that the borrower will “default”. The worse the borrower’s economic situation, the higher their default risk. |
| Deleveraging | Deleveraging describes the reduction of the debt used to finance on-balance-sheet and off-balance-sheet assets. In other words, leverage (the ratio of debt to equity) becomes smaller. The term deleveraging is also used when the volume of on-balance-sheet and off-balance-sheet assets is reduced to lower debt capital. Deleveraging may involve derisking but does not have to. Deleveraging is also derisking if debt capital is reduced by cutting back on riskier assets. |
| Derisking | Derisking describes the reduction of risk by lowering on-balance-sheet and/or off-balance-sheet assets in order to bring down the level of risk. Derisking may involve deleveraging but does not have to. Derisiking is also deleveraging if debt is reduced as well as risk. |
| Excess capital | Common equity tier 1 (CET1) capital over and above supervisory requirements and recommendations (guidance). Requirements and recommendations include capital requirements and recommendations (1) for the risk-based component (RWAs), (2) for the leverage ratio and (3) for the resolution framework (MREL,TLAC). |
| Financial cycle | The financial cycle describes medium-term co-movements in financial and real economic variables. Key variables include the aggregate loan supply and real estate prices. The financial cycle is distinct from the business cycle, which measures shorter fluctuations in economic activity. The credit cycle is the part of the financial cycle that relates only to lending. A sharp upswing in the financial cycle can increase financial system vulnerability and lead to a build-up of systemic risk. Developments in the financial cycle cannot be monitored directly, which is why various indicators are used as an aid. Regulators use the ratio of aggregate loans to gross domestic product as an indicator, amongst others. If this ratio rises sharply and exceeds the long-term trend of the past years, this indicates that the financial cycle is in an expansionary phase and vulnerabilities for the financial system could arise as a result. |
| Financial intermediary | Financial intermediaries are institutions or businesses that act as intermediaries between lenders and borrowers. They do so by collecting money from savers or investors and passing it on to borrowers or businesses. By doing this, financial intermediaries such as banks, funds or insurers help to provide the financial system with liquidity, diversify risk and improve the efficiency of capital allocation. |
| Financial stability | The stability of the financial system, financial stability for short, refers to a state in which financial intermediaries (such as banks, fonds or insurers), markets and market infrastructures perform their economic functions even during periods of stress. These economic functions include, first and foremost, lending and investing savings, distributing risk appropriately, and settling payment, securities and derivatives transactions. The financial system should be able to do this in normal times, but also in stress situations, for example when a speculative bubble bursts, and during times of structural upheaval – such as the phase-out of fossil fuels. Macroprudential policy is intended to ensure the stability of the financial system. In Germany, the German Financial Stability Committee (G-FSC) coordinates and strengthens cooperation among the authorities involved. |
| Financial system | The financial system comprises financial markets, financial intermediaries (including banks, insurers and funds), payments and market infrastructures (for instance, central counterparties). In a broader sense, the term also includes financial supervision and legal frameworks, including accounting standards. The financial system is where savings and investment are coordinated, risks are redistributed, and payment, securities and derivatives transactions are settled. These are the key economic functions of the financial system. Public institutions such as central banks, supervisory authorities and ministries are responsible for safeguarding financial system stability (financial stability) through macroprudential policy. |
| Fire sale | Fire sales are sales of assets under time pressure to satisfy an abrupt rise in liquidity needs. They can trigger price-liquidity spirals: falling prices can lead to lower market liquidity, further sales and falling prices. This momentum can be self-reinforcing and spill over to other markets, potentially leading to a general loss of confidence and market disruptions. Such fire sales may be triggered by a significant and abrupt withdrawal of liabilities, forcing an intermediary to sell liquid assets in order to service cash outflows. Alternatively, an intermediary may be obliged to make fire sales if there is a risk that its capital ratio would otherwise fall below a threshold required by supervisors or the market. In this case, fire sales could help reduce risk-weighted assets and consequently help improve the capital ratio. Other possible triggers are margin calls. |
First-round effect | First-round effects from a financial stability perspective describe the immediate impact of a shock or negative scenario on directly affected financial intermediaries, markets and market infrastructures or the real economy. They arise, in particular, if credit, market, interest rate or liquidity risk materialises. Negative first-round effects typically manifest themselves in market value or balance sheet losses at intermediaries and may jeopardise their solvency or liquidity. Stress tests are an important analytical tool for estimating first-round effects. |
| Interest rate risk | Present value interest rate risk arises when the market value of all future cash flows changes directly as a result of movements in the interest rate level. Earnings-related interest rate risk is the risk of current interest income (net interest income) being adversely affected by changes in interest rates. |
| Liquidity risk | Liquidity risk refers to the risk that due payment obligations cannot be met in full, on time, or only at disproportionate cost. Put simply, an entity is liquid if its cash holdings plus inflows exceed its outflows during the same period. |
| Market risk | Market risk is the risk of an investor losing money on an investment if the relevant market value changes to the investor's detriment. A change in market prices could be caused, for example, by movements in market interest rates, stock market prices or exchange rates. These changes cannot be predicted reliably. Market prices are subject to constant fluctuations; for market participants, they can result in both profits (opportunity) and losses (risk). |
| Procyclicality | Procyclicality is behaviour that amplifies cyclical developments in the financial system and/or the real economy. It may refer to the behaviour of financial intermediaries, markets and market infrastructures or measures taken by supervisory authorities, central banks or the government. Procyclical behaviour can amplify both economic upturns (for instance the build-up of vulnerabilities) and downturns (impact of shocks, say). Financial market regulation seeks to minimise procyclical effects. |
| Resilience (of the financial system or financial intermediary) | Resilience is the ability of the financial system or a financial intermediary to absorb a shock or to prevent a shock from being amplified (by contagion or feedback effects, for instance). In other words, it is the ability to cushion a shock. |
| Second-round effect | From a financial stability perspective, first-round effects may impact other financial intermediaries, markets and market infrastructures or the real economy – that were originally not, or not so strongly, affected by stress effects – in a further round. This is then termed a second-round effect. Shocks may be amplified in this manner. Second-round effects materialise via contractual relationships such as loans, for instance (contagion effects). They may also be caused by activity in the same market or adjustment reactions such as deleveraging. |
| Shock | Unexpected, abrupt change that affects one or more endogenous variables relevant to financial stability. (Endogenous variables are those determined within the system.) |
| Systematic(ally) | Based on a system |
| Systemic | Affecting the entire system |
| Systemic risk | In connection with financial stability, systemic risk is the name given to the danger of difficulties experienced by one or more market participants, or their responses to a shock or changed conditions, potentially jeopardising the stability of the entire financial system. |
| System-wide | Across the whole system |
| Uncertainty | Unknown conditions for which no probabilities of occurrence are available (unknown unknowns). |
| Volatility | Volatility describes the magnitude of the fluctuations of a random variable (for instance, yields, prices and many more) around its expected value. It is measured by calculating the standard deviation (a statistical measure of the average deviation from the mean of the random variable). |
| Vulnerabilities (of the financial system or financial intermediary) | When used in connection with financial stability, the term vulnerability describes the exposure of the financial system to shocks. In other words, it describes how strongly the system would be affected in the event of a shock. The greater the vulnerability, the higher the potential losses are if a shock occurs. The degree of vulnerability, together with the severity of the shock and the level of resilience, determines whether systemic risk could arise. |
