German Bundesbank: Pandemic May Have Increased Danger of Underestimating Financial Stability Risks

25 November, 2021

By David Barwick – FRANKFURT (Econostream) – Although the financial system functioned well during the pandemic, existing vulnerabilities mounted and the risk of underestimating threats may have further increased, the German Bundesbank said on Thursday in its financial stability report for 2021.

‘…during the pandemic, the financial cycle and existing vulnerabilities in the German financial system continued to build up’, the German central bank wrote, noting higher corporate, household and sovereign debt levels.

‘High valuations in some market segments hold potential for setbacks and the upswing in the residential property market continues unabated’, the Bundesbank said.

Moreover, the pandemic appears to have solidified a disconnection between micro- and macroeconomic risks that has been forming over the last two decades, ‘and may have more firmly anchored the expectation that even in future recessions there will be only minor losses in the financial system’, the report said.

‘The experience from the Corona pandemic may thus have tended to further increase the danger of underestimating risks that has existed for some time’, it warned.

The Bundesbank noted in this connection that while the macroeconomic consequence of the pandemic had been a major recession, at the micro level the impact was much smaller, with insolvencies actually declining for both companies and households.

‘For the stability and performance of the financial sector, it would be a cause for concern if market participants were to assume, based on the experience of the past two recessions, that the relationship between macroeconomic and microeconomic risks will remain loose in the future’, the Bundesbank said.

It is often impossible to evaluate the appropriateness of risk assessments beforehand, the central bank observed, but risks in some market segments are now seen as low, with investors not taking higher corporate debt to imply an increase in the risk of defaults.

‘Even companies with poorer credit ratings can finance themselves comparatively cheaply on the capital market’, the report said. ‘In addition, financing conditions for companies in almost all sectors are more favourable than the long-term average and than before the outbreak of the pandemic. This also applies to those sectors that were particularly affected by the pandemic or which are facing accelerated structural change.’

With an eye toward the economic impact of supply constraints and shortages, the Bundesbank urged that ‘[r]eal economic downside risks must therefore not be lost sight of.’ Should the economic recovery falter, this would have ‘an impact on the loan and securities portfolios of German financial intermediaries, but the effects are likely to be limited.’

‘In such a scenario, there should currently be no severe negative repercussions from the financial system on the real economy’, it added.

The Bundesbank warned of growing vulnerabilities in German banks’ balance sheets, pointing to the increase in recent years of the share of loans to less robust firms. Moreover, vulnerabilities related to the housing market are rising further, it said.

‘Financial stability would be jeopardised if a destabilising dynamic were to set in on the real estate market, in which rising loan volumes and prices were accompanied by a lower debt sustainability of borrowers’, according to the report.

While there is no sign yet of a significant loosening of credit standards for new residential real estate loans, ‘in view of rising prices, lending standards could be relaxed in order to make it possible to conclude loan agreements in the first place’, it reasoned. ‘Rising prices could make the associated risks appear low, as expected future price increases would reduce the loss potential from today's perspective.’

Looking back, the Bundesbank deemed that the financial sector operated properly during the pandemic, with ‘no liquidity crunch or even a crisis of confidence’.

‘The extensive fiscal policy measures have contributed significantly to protecting the real economy and - indirectly - the financial system from the consequences of the pandemic. Impending insolvencies could thus be largely avoided’, the Bundesbank said. ‘The banks' capital buffers did not have to be used, as a feared sharp increase in losses did not occur.’