Financial system resilient, long-standing issues remain Low profitability of banks, insurers exacerbated by low interest rates German, European authorities should ensure new European financial architecture effective in practice. The financial system of Germany, home to systemically important financial institutions, has been bolstered by EU-wide and global reforms in the financial sector. At the same time, low interest rates and the ongoing transition to new supervisory and resolution mechanisms may pose risks, according to the IMF.
IMF Survey sat down with Michaela Erbenová, Mission Chief for the financial stability assessment, to talk about the outcome of the analysis carried out in systemically important financial markets every five years.
IMF Survey: What was particular about the German financial sector that you had to take into consideration while preparing the report?
Erbenov á : The German financial sector is very complex in many ways. First of all, there are a large number of institutions in the banking sector: we had to deal with more than 1,700 institutions in our analysis. There are also a large number of insurers. These institutions are of varying degrees of complexity, many share common features, and many are potentially important for financial stability.
Germany’s financial sector is also characterized by a high degree of interconnectedness. Our analysis showed that because of this close connection, authorities should continue to closely monitor banks and life insurers and carry out their systemic risk analyses.
Germany is also home to global systemically important institutions, including the insurer Allianz SE, the bank Deutsche Bank AG, as well as the clearing house Eurex Clearing AG, which provides services to almost 190 clearing members from a large number of countries. This creates an additional layer of international interconnectedness that our analysis had to take into account: outside influences can affect developments in Germany, and what happens in the German financial system can have major repercussions around the world. This potentially global impact makes risk management, intense supervision of systemic institutions and the close monitoring of their cross-border exposures particularly important.
IMF Survey : What is your overall assessment of the German financial sector? What has changed since the last review in 2011?
Erbenov á : The assessment built on the previous findings of the 2011 analysis, but in many ways it was a completely different task.
First, following the financial crisis, a transformation of the financial sector is clearly underway, with many institutions reconsidering their business model. In particular, the Landesbanken sector—a group of regionally organized, state-owned banks—has seen important consolidation.
Second, we are facing a very different institutional environment. The reforms in the euro area created the Single Supervisory Mechanism (SSM), which profoundly changed the way banks are regulated and supervised, and the Single Resolution Mechanism (SRM), which established new rules for dealing with crisis preparedness and bank resolution.
A lot of work has been done since the 2011 financial sector assessment. Germany plays a key role in the European reforms and, indeed, in the global standard setting process, having implemented a number of important regulatory initiatives since 2011. Overall, with these reforms, the German financial sector appears resilient to risks identified in our analysis, but also faces a lot of headwinds.
IMF Survey : A part of the headwind is low profitability, which is exacerbated by low interest rates. The banking system is highly dependent on interest income, yet the European Central Bank (ECB) charges -0.4% annually on bank deposits in the hope of boosting inflation and growth?
Erbenov á : Although, in principle, low interest rates help boost credit demand and stimulate economic growth, so they are positive from an overall macroeconomic perspective. However, German banks’ business models are vulnerable to low interest rates. This is because most German banks have businesses based on maturity transformation with a large number of branches and high overhead costs. Net interest income is the most important component of their profits. So far banks have proven unwilling, or even legally unable, to pass on the negative interest rates to depositors, while their assets have recently started to reprice to lower interest rates. This is squeezing their interest margins leading to profitability concerns absent major restructuring. Furthermore, as mentioned by Managing Director Christine Lagarde in her statement on the U.K. referendum on June 24, we will continue to monitor developments closely after the U.K. vote.
IMF Survey: Insurers, providing low-risk fixed income products, are also highly dependent on interest rates?
Erbenov á : Similar to banking, the insurance sector is also characterized by a large number of institutions operating in a very competitive environment, with a traditional life insurance model offering guaranteed rates that are relatively high compared to prevailing interest rates. This makes the insurance sector vulnerable to low interest rates over the medium- to long-term.
This year a new solvency framework for insurers was introduced in Europe, founded on a more risk-based forward-looking approach. It clearly means new pressures for insurers in this low interest rate environment. Nevertheless, they have been able to maintain significant loss absorption capacity, not least thanks to German measures since 2011 that tightened regulatory requirements exactly in view of the structural impact of such low interest rates. Also, supervisors are appropriately enhancing the oversight of insurers to ensure that they can continue meeting their commitments to policy holders in the medium term.
IMF Survey : This is the first time that the IMF has assessed the SSM and the SRM. What is the outcome of the assessment of these new features of the European framework?
Erbenov á : On the supervisory front, we cannot really look at how German banks are supervised without looking at the functioning of SSM, introduced in 2015, and of both the German authorities and the ECB.
We were very positively impressed by what has been achieved in a relatively short period of time since the SSM came into being. The supervision of German banks is now more quantitatively based, and new approaches are being developed for direct assessment of credit risk, for example. But we have also suggested a number of improvements. In particular, for Germany we recommend improvements in corporate governance, internal audit and compliance functions as well as strengthening regulation of related party risk and major acquisitions.
More generally, decision-making under the SSM is very complicated resulting in a cumbersome process and a long reaction time between spotting a problem and a supervisory action. We therefore urge streamlining the decision-making processes in the day-to-day supervision to the extent possible within the existing legal framework.
Recovery and resolution planning for banks in Germany has also undergone major change with the advent of the new European SRM and the Single Resolution Board. Large domestic banks have all been required to have recovery plans, and this requirement is now being rolled out also to smaller banks. Authorities intend to rely on the new tool of bail-in to resolve systemic banks, safeguarding taxpayer resources.
However, authorities have decided not to introduce the extraordinary government financial stabilization tools available in the European legislation. It is a legitimate policy choice that shows commitment to protecting taxpayers, but it is constraining their toolkit in the event of a systemic crisis.
It is now very important that this new framework is urgently operationalized and that the cooperation between the Single Resolution Board, the ECB, and the German authorities is tested in a crisis simulation exercise.