ECB disguises dangerous influence of low interest rates
What are the biggest threats to the stability of the financial system? The ECB and the Bundesbank published their assessments almost at the same time. The tone in terms of ultra-low interest rates differs significantly, the risk analysis is similar.
By Michael Rasch, Frankfurt
29.11.2017, 15:12 Uhr
The ECB currently does not see any danger in low interest rates. (Armando Babani / EPA)
Extremely low interest rates over many years are likely to be among the most important risks to financial stability. However, the European Central Bank (ECB) press release on the regular financial stability report does not even touch on the topic of low interest rates. Only on demand does Vítor Constâncio acknowledge that a rapid interest rate change is one of the risks in the euro zone. However, the vice-president of the ECB immediately points out that extremely low interest rates are not only a consequence of central bank policy but that real interest rates are also very low. In addition, the primary mandate of the ECB is price stability rather than financial stability. To reassure Constâncio, there was no general overvaluation of assets in Europe and bank lending continued to be muted.
Warning of long low-interest phase
On the other hand, the tone is noticeably different at the Deutsche Bundesbank, which also published its Financial Stability Report 2017 on Wednesday. Persistently low interest rates and high economic growth could undermine risks, according to the monetary authority. In Germany, the risks of low interest rates are particularly pronounced, as the business models of many banks are strongly geared to interest income. Owing to the extremely low interest rates, income in the classic deposit and lending business fell significantly. In addition, the penalties introduced by the ECB additionally depress the profitability of banks. With a return on equity of just 2.1% in 2016, Germany’s banks ranked at the lower end of the scale in a European comparison, according to the Bundesbank.
If the period of low interest rates took an unexpectedly long time, the Bundesbank would, in particular, put even smaller and medium-sized banks and life insurers under even greater pressure. In any case, they now have higher incentives to take on greater risks, for example by investing in riskier securities. In addition, it is likely to be dangerous when interest rates rise rapidly and sharply, as both the ECB and the Bundesbank state. German institutions have extended their maturity transformation in recent years in order to stabilize yields in times of very low interest rates. This was done by increasing the maturities and fixed interest periods of their loans.
ECB currently sees four main risks
The ECB currently sees primarily four risks. First, there may be a rapid reassessment of assets in the financial markets, such as the emergence of geopolitical risks or changing growth and / or inflation expectations. Currently, risk premiums and market volatility are extremely low. Greater risk-taking is therefore a concern, according to the ECB. However, the institute sees a very high valuation of asset classes such as stocks, above all in the US, less in the euro zone.
Second, banks continue to face challenges in terms of profits. Although these had improved because of higher revenues outside the lending business, there were still big differences in the valuation of the banks, the share price development and the earnings outlook. Non-performing loans also remained a problem in some regions. Several structural challenges would affect the earnings outlook for banks, such as overcapacity, lack of diversification in profits and inefficient cost structures. However, there is no word on the part of the ECB that the extremely low interest rates and last but not least the penalty rates for banks are also weighing heavily on the profitability of the institutions.
Third, high public and private debt raises concerns about debt sustainability in some countries. An interest rate shock in the form of rapidly and sharply rising interest rates could exacerbate the refinancing costs of heavily indebted countries. In the medium term, however, stronger growth and rising inflation would help to manage the debt, Constâncio said. Fourth, the ECB identifies investment fund risks. These would have increased their risks in recent years by investing more heavily in moderately valued debt securities. Constâncio did not mention that an important reason for this was the hunt for higher yields in the low interest rate environment.
Danger of a tearful end
Overall, the ECB sees an average systemic risk in three out of four key areas, which has not changed in comparison to the last Financial Stability Report. The Bundesbank also worries that the risk-bearing capacity of the financial system as a whole could be overestimated. The residential real estate market in particular is an important field for the stability of the system, since its financing accounts for half of all bank lending to the private sector and accounts for more than two-thirds of private household debt. According to the Bundesbank’s model calculation, residential real estate was overvalued between 15 and 30% in 2016. Although the Bundesbank still considers the risks arising from residential real estate financing as limited, because loan growth and lending standards have developed inconspicuously, the boom could well be followed by a tearful end.