22 Dec 2023

Financial Stability Review: Unrealized losses in German banking books pose a risk to resilience

Experts from the German central bank shed light on the challenges of rising interest rates for the German financial system in a SAFE Policy Web Seminar

The European Central Bank has initiated an interest rate turnaround in 2023, with short-term interest rates now at a 25-year high. The Deutsche Bundesbank’s latest Financial Stability Review shows that German banks have coped well with the rise in interest rates. However, one of the risks to their resilience in times of economic stress may be the increased unrealized losses in their banking books.

In a SAFE Policy Web Seminar on 6 December, Kirstin Hubrich, Frank Heid, and Tobias Herbst (all from the Bundesbank’s Directorate General Financial Stability) explained that the effects of the interest rate turnaround have not yet fully materialized and that the countercyclical capital buffer and the buffer for residential real estate loans are therefore still justified. SAFE Director Florian Heider moderated the event.

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German banks were able to increase their profitability despite the rise in interest rates, according to Bundesbank expert Frank Heid: “This was initially rather surprising because we know from past interest rate increases that profits actually fall,” Heid said. When interest rates on deposits rise, refinancing usually increases more than interest income from lending, he explained.

However, the proportion of savings banks and credit cooperatives with unrealized losses in their banking books has increased significantly. Due to varying accounting rules, the banks have not fully shown the losses in value but have built up unrealized losses because prices of the securities have fallen below the purchase price, Heid continued. Overall, bank capitalization is stable, but the impact of rising interest rates has yet to be fully transmitted to the financial or corporate sectors. As a result, banks’ interest expenses will rise in the future, and credit risk in the corporate sector, for example, is expected to increase.

“We are not only facing economic weakness but also structural challenges,” said Kirstin Hubrich, Deputy Head of the Directorate General Financial Stability at Bundesbank, summarizing current developments in the macro-financial environment. The economic and financial system is in a phase of rising interest rates and transition, characterized by significantly higher prices and interest rates.

Commercial real estate as a risk factor

In the medium term, more insolvencies and rising credit risks are expected in the corporate sector, said Tobias Herbst, referring to risk factors from the real economy. There has already been a slight increase in insolvencies, particularly in the real estate sector: “This sector is important because about one-third of all corporate loans in the German banking sector are granted to the real estate and housing sector.” In the commercial real estate markets in particular, many loans will need to be refinanced over the next three years, as they often have shorter fixed interest rates. At the same time, real estate prices are falling, creating a double burden on the sector, according to Herbst. This could lead to many loan defaults, which will weigh on the banking sector.