Deutsche Bundesbank published the results of its annual financial stability review. The report, which considers developments up to September 30, 2020, focuses on the risks stemming from the coronavirus pandemic and the associated economic shock. The report highlights that reforms implemented after the global financial crisis are paying off: banks are now better capitalized, have additional capital buffers, and can use them more flexibly. In the future, limiting existing vulnerabilities will be one of the main priorities. The analysis reveals that, in the further course of the pandemic, insolvencies in the corporate sector are likely to increase and that policymakers should prepare early to deal with any unfavorable developments.
The coronavirus pandemic and the measures taken to contain it led, in the first half of 2020, to the severest economic downturn for decades, with nearly all sectors of the real economy being affected. Even though the shock did not originate in the financial system—unlike the global financial crisis in 2007-08—its indirect impact there was nonetheless significant. As a result of the pandemic, existing vulnerabilities in the financial system are amplified. Debt in the private and public sectors has risen while low interest rates are encouraging a search for yield and an underestimation of credit risk. Asset prices could drop sharply. In adverse scenarios, there are risks to financial stability that call for adequate preparation. The report points out the possibility of insolvencies and the associated credit defaults rising unexpectedly sharply. This would weigh on capital ratios of banks, encouraging banks to restrict their lending to meet the capital ratios required by the market and by supervisors. Existing capital buffers could go unused and some banks could run into financial distress. In this case, banks should use their existing capital buffers to continue lending, as the buffers were built up in good times as a preventive measure so that they can be used in times of crisis. This scope was created by the supervisory reforms implemented following the global financial crisis.
Given these risks, market participants, policymakers, and supervisors should prepare early on for very unfavorable developments and identify related bottlenecks so that the financial system can fulfil its functions, even in such circumstances. Sufficient capacities and experience in handling insolvencies—both at banks and public authorities—is likely to be of relevance for the future development of the economy. Insolvency proceedings ultimately have the aim of coordinating the different interests of creditors and debtors of distressed enterprises. Precisely because insolvencies were at an all-time low in Germany over the past decade, capacities in the private and public sectors might not be sufficient to deal with the sharply rising numbers of insolvencies. Accordingly, preparations for such an eventuality are needed. Policymakers face the challenge of striking the right balance: on the one hand, their aim is to support the economy with fiscal policy measures and to limit the damage caused by the pandemic; on the other hand, any structural change that needs to happen should not be delayed unnecessarily. Furthermore, possible cliff effects should be taken into consideration. There is a threat of these materializing, for instance, if insufficient provision is made for the fact that time-limited measures will be discontinued, with ensuing large-scale adjustments in the real economy or financial system.
Keywords: Europe, Germany, Banking, Financial Stability Review, COVID-19, Regulatory Capital, Credit Risk, Stress Scenarios, Insolvency Risk, Real Estate, Bundesbank
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