A historical turnaround in interest rates lies behind us: since July 2022, the European Central Bank (ECB) has raised key interest rates ten times – from 0 to 4.5 percent (see Figure 1). The banking sector and the insurance sector have coped well with the interest rate turnaround so far and proven stable, with the institution-specific add-ons ordered by BaFin also playing a role in this regard. Up until now, BaFin has ordered a SREP1 add-on for interest rate risks for more than 800 banks. Such capital add-ons for interest rate risks account for around 66 percent of the volume of all capital add-ons.
However, many companies have unlocked hidden reserves in order to compensate losses arising in particular from valuations of fixed-interest investments and thereby strengthen their equity.
Last year’s abrupt interest rate turnaround entailed high risks for companies of the financial sector – especially those that were particularly exposed on account of their business and investment policies and had failed to take adequate countermeasures. These risks have been manageable so far. However, if there were to be a further interest rate increase or a stronger inversion of the yield curve, the interest rate risks of the companies supervised by BaFin would worsen again. But the likelihood of additional significant interest rate increases in the course of 2023 has declined – and with it the interest rate risk overall.
Figure 1: Key interest rates of selected central banks
Source: LSEG Datastream, as at October 2023
Banks and Sparkassen
The number of institutions with an increased interest rate risk2 has steadily fallen and remained on a downward trajectory in the third quarter 2023, even though the interest rate risk, particularly among credit cooperatives (Genossenschaftsbanken) and savings banks (Sparkassen), remains high. This is due to the business models of these institutions that are based strongly on maturity transformation. The reasons for the decreased interest rate risk lie, among other things, in changes in the institutions’ balance sheet structures, the losses already realised by a large number of companies and, to a lesser degree, the use of derivatives for the purpose of hedging such interest rate risks.
As a result of the previous interest rate increases and associated valuations losses, the valuation reserves and additional hidden reserves on the balance sheets of the less significant institutions (LSIs) have been used up for the most part (see Figure 2). At the same time, LSIs have in some cases accumulated substantial unrealised losses. Normally, these losses offset each other over time due to the price of bonds converging to par value towards maturity (pull to par effect). For this reason, if fixed-income investments are held until maturity, no need for write-downs arises.
Figure 2: Hidden reserves and unrealised losses in the banking book of German savings banks and credit cooperatives*
Source: Bundesbank calculations, as at September 2023
* Includes only primary institutions with no trading book positions. 1) Ratio of the banking book‘s present value to book value. Values greater than 100% indicate hidden reserves; values lower than 100% indicate unrealised losses. Book value of the banking book approximated by the sum of recognised equity and fund for general banking risks.
The credit institutions’ interest earned has had a positive impact on profitability. The interest rate margin has risen significantly as institutions have not yet passed on the higher interest rates to investors in full. Moreover, interest rates on loans are currently rising more quickly than those on deposits. In recent years, however, institutions have granted a large number of loans with lower interest rates and long interest rate fixation periods, which is limiting their options to increase interest income. At the same time, weaker demand for loans is curbing new lending.
The Tier 1 capital ratio among the significant institutions (SIs) and the LSIs has risen slightly. The institutions’ return on equity increased from 3.7 percent in the fourth quarter of 2022 to 6.94 percent in the third quarter of 2023. The cost-income ratio of all banks in the third quarter of 2023 stood clearly below that of the prior year period (see Table 1).
Table 1: Balance sheet structure and interest rate risks at credit institutions
| Q2 2022 | Q3 2022 | Q4 2022 | Q1 2023 | Q2 2023 | Q3 2023 | |
|---|---|---|---|---|---|---|
* Interest rate risk Source: Joint calculations of BaFin and the Bundesbank based on the supervisory reporting system, as at 30 September 2030 | ||||||
| Cost-income ratio of all banks | 75% | 76% | 70% | 56% | 57% | 57% |
| Return on equity of all banks | 2,00% | 2,10% | 3,70% | 7,80% | 7,20% | 6,94% |
| Institutions with higher IRR* | 590 | 458 | 307 | 326 | 304 | 278 |
| Interest rate coefficient | 10,90% | 9,70% | 9,10% | 8,80% | 8,80% | 8,69% |
| Tier 1 capital ratio LSI | 15,71% | 15,55% | 16,00% | 16,04% | 16,26% | 16,30% |
| Tier 1 capital ratio SI | 15,32% | 14,98% | 15,89% | 16,14% | 16,50% | 16,51% |
Going forward, the interest margin of the credit institutions is likely to narrow significantly at persistently high interest rates due to retail clients and companies increasingly regrouping their portfolios in favour of term deposits carrying higher interest rates and other interest-earning investments. Competition for deposits could additionally intensify. Institutions would then be compelled to further raise their interest rates on deposits (see Figure 3).
Figure 3: Comparison of actual deposit rate and projected deposit rate based on a pass-through model*
Source: Deutsche Bundesbank calculations, Monthly Report, June 2023
*Estimation period: January 2003 to December 2021. Projection period: January 2022 to April 2023.
Vulnerable financing structures
The interest on deposits and their maturity patterns have an influence on the stability of credit institutions’ refinancing structures – especially if these are heavily deposit-based. Higher interest on deposits narrows the interest margin, but, in functioning competitive and market conditions, leads to more stable refinancing structures, and vice versa.
Developments in the US banking sector in the spring of 20233 highlighted this: vulnerable financing structures in conjunction with increased interest rate risks and fragile business models lead to solvency and liquidity problems that can jeopardise an institution’s existence. The very fast and strong outflow of liquidity was spurred by the institutions’ high share of short-term deposits. These outflows were also accelerated by the digital channels used by the customers.
Insurance undertakings
The higher interest rates have improved the economic situation of life insurers and Pensionskassen in the short and long term. They were able to compensate their short-term need for write-downs by means of extraordinary investment income4 and releasing the Zinszusatzreserve (the additional provision to the premium reserve introduced in response to the lower interest rate environment). Over the medium and long term, new investments and reinvestments have become more profitable again. Life insurers were thus able to strengthen their risk-bearing capacity under Solvency II.
However, as in the case of credit institutions, changes in the market value of fixed income investments resulted in a decline in valuation reserves and an accumulation of hidden losses among insurers too. This is particularly the case with life insurers (see Figure 4). Insurers’ room for manoeuvre is thus limited when it comes to investments, but this is not reflected in profit and loss provided the price losses on securities are attributable to interest rates and the companies hold the investments to maturity. Insurers’ liquidity management assumes special importance in these conditions.
Figure 4: Non-netted valuation reserves and losses of life insurers
Source: Supervisory reporting system
The higher rate of inflation could result in an inability or unwillingness on the part of customers to raise the money required to pay their premiums. This would result in more contract cancellations or more suspensions of premium payments. Higher cancellation rates can trigger liquidity outflows among insurers with long-term insurance contracts. In order to offset these outflows, the companies might find themselves compelled to sell securities. They might have to realise hidden losses, which in turn might be negatively reflected in their results. However, the quarterly surveys on liquidity carried out in 2023 among selected insurers showed no signs of liquidity problems. Data available to BaFin also have not revealed any excessive or forced realisations of hidden losses so far.
Among life insurers, the cancellation rate could rise in response to the higher interest rates as other investments become more attractive compared to existing contracts with lower interest returns. A significant decline could indeed be noted in 2023 among life insurers in the area of new business with single premiums, while new business with regular premiums remained relatively stable. The cancellation rate among high-volume insurance contracts increased temporarily in early 2023, but overall only slightly higher cancellation rates could be noted across all life insurers compared with the prior year period.
As regards Pensionskassen, there is no risk of cancellation due to the ban on lump sum compensation payments enshrined in the German Occupational Pensions Act (Betriebsrentengesetz). However, there could be a considerable increase in exemptions from premium payments. Nevertheless, BaFin assesses the probability that Pensionskassen will have to sell investments below book value as minor on the whole. Even so, the current difficult economic conditions are likely to prejudice the general ability of employers to financially shore up institutions for occupational retirement provision if required.
BaFin’s line of approach
- BaFin continues to closely supervise credit institutions with an increased interest rate risk and low capital cover.
- BaFin continues to deal with the consequences of the interest rate development for the institutions it supervises. To this end it conducts stress tests at LSIs and Bausparkassen which include various interest rate scenarios (reductions, increases, turnarounds).
- BaFin also analyses the repercussions of the interest rate turnaround for consumers. If any irregularities are noted in the course of this, BaFin conducts consumer surveys on investment behaviour and loan demand, for example.
- Moreover, BaFin deals with especially vulnerable refinancing structures and the consequences of harsher competition for deposits. All aspects of a potential change in investor behaviour and increased interest rates are examined in the course of this – for example, the consequences for earnings, the reserves for impending losses and any vulnerable balance sheet structures.
- BaFin continues to monitor the liquidity risk for insurers. In 2024 it will include selected companies in the quarterly liquidity monitoring of the European Insurance and Occupational Pensions Authority (EIOPA). Furthermore, BaFin deals in depth with the assessment of liquidity risks among life insurers.
- 1 SREP is the abbreviation for the Supervisory Review and Evaluation Process.
- 2 In accordance with the supervisory standard test, the interest rate risk is deemed to have increased if the present value losses as a consequence of a change in interest rates by 200 basis points exceed 20 percent of a bank’s regulatory capital.
- 3 See comments particularly concerning the failure of the United States’ Silicon Valley Bank in the Stabilitätsbericht 2023 der Deutschen Bundesbank, page 27ff.
- 4 Consisting of (balance sheet) write-ups and/or realisations/releases of valuation reserves in accordance with the German Commercial Code (Handelsgesetzbuch).
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Risks in BaFin's Focus 2024
Foreword by the President
Main Risks in BaFin’s Focus
2. Risks arising from corrections on the real estate markets
3. Risks arising from significant corrections on the international financial markets
4. Risks arising from defaults on loans to German companies
5. Risks arising from cyberattacks with serious consequences
6. Risks arising from inadequate money laundering prevention
7. Risks arising from market concentration due to the outsourcing of IT services
Trends
1. Digitalisation
2. Sustainability
3. Geopolitical turmoil
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Complete edition Risks in BaFin's Focus 2024
