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IMF Country Report No. 22/272

GERMANY

FINANCIAL SECTOR ASSESSMENT PROGRAM

August 2022

TECHNICAL NOTE—STRESS TESTING, INTERCONNECTEDNESS, AND RISK ANALYSIS

This Technical Note on Stress Testing, Interconnectedness, and Risk Analysis for the Germany FSAP was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed in April 2022.

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Title Page

GERMANY

FINANCIAL SECTOR ASSESSMENT PROGRAM

August 4, 2022

TECHNICAL NOTE

STRESS TESTING, INTERCONNECTEDNESS AND RISK ANALYSIS

Prepared By

Monetary and Capital Markets Department

Contents

• Glossary

• EXECUTIVE SUMMARY

• BACKGROUND: VULNERABILITY AND RISKS

• A. Introduction

• B. Financial System Landscape

• C. Banking Sector Development Since the COVID-19 Pandemic

• D. Scope and Scenario of the Risk Analysis

• E. Risk and Vulnerabilities

• F. Macro-Financial Scenarios

• SOLVENCY STRESS TEST OF BANKS

• A. Overview

• B. Modeling of Credit Risk and RWAs

• C. Modeling of Interest Rate Risks and Market Risks

• D. Solvency Stress Test Results

• LIQUIDITY STRESS TEST OF BANKS

• A. Overview

• B. Funding Profiles and Liquidity Conditions

• C. Cash Flow Analysis Set-up

• D. Cash Flow Analysis Scenarios

• E. Results

• F. Conclusions

• INTERCONNECTEDNESS AND CONTAGION ANALYSIS

• A. Interconnectedness

• B. Bank Contagion Analysis

• SPECIAL TOPIC: CORPORATE RISK ANALYSIS

• A. Impact of the COVID-19 Pandemic: Sensitivity Analysis

• B. Dynamic Scenario-Based Liquidity and Solvency Stress Test

• SPECIAL TOPIC: REAL ESTATE MARKET

• BOXES

• 1. Cooperative Banks

• 2. Credit Risk Modeling for Loans to Non-Financial Corporates

• 3. Micro-Simulation Model

• 4. Provisioning under IFRS9 Accounting

• 5. Special Covered Bonds (Pfandbriefe)

• 6. Liquidity Strains in European Financial Markets in the Spring of 2020

• 7. LSI Cash-flow Based Liquidity Stress Results and LCR and NSFR Ratios

• FIGURES

• 1. Financial Sector Overall Structure, 2016 to 2021

• 2. Profitability of the SME Sector

• 3. Nonfinancial Corporate (NFC) Debt Over Time and Compared to Peers

• 4. Key Indicators for Listed Non-Financial Groups

• 5. Residential Real Estate Price Dynamics

• 6. Macroeconomic Scenarios

• 7. Adverse Scenario Simulations

• 8. Baseline Solvency Stress Test Simulations for SIs

• 9. SIs’ Solvency Stress Test Under the Adverse Scenario

• 10a. Solvency Stress Test of Less Significant Institutions

• 10b. Solvency Stress Test of Less Significant Institutions II

• 11. Funding Mix Profile of the Banking System

• 12 Net Change in Assets of the Banking sector, 2019-21

• 13. Selected Liquidity Indicators of the Banking Sector, 2020-21

• 14. LSI Sample: Contractual Cash Flows

• 15. Counterbalancing Capacity

• 16. SI Sample: Contractual Cash Flows

• 17. Cash Flow Analysis Results

• 18. US Dollar Liquidity

• 19a. Domestic Exposures of Financial Institutions

• 19b. Cross-Border Exposures of Financial Institutions

• 20. Bank Contagion Analysis

• 21. Aggregated Results of the Sensitivity Analysis of the ICR, Cash Balances, and Equity

• 22. Corporate Sector and Dynamic Scenario-Based Stress Test

• 23. Residential and Commercial Property Price-at-Risk

• TABLES

• 1. Banking System Structure, December 2021

• 2. Banks by Category, December 2021

• 3. IFSR9 Transition Matrix: Concept and Parameters

• 4. LSI (Overall Currency) Sample

• 5. Scenario Assumptions Roll-off Rates and Haircuts

• 6. Interbank Interconnectedness Sample Size

• 7. Matrix of Interbank Linkages by Type of Banks

• 8. Matrix of Contagion Losses by Type of Banks

• 9. Banking Sector Soundness Indicators (September 2021, in percent)

• 10. Financial Soundness Indicators (2008-2021)

• 11. Credit Risk Panel Regression

• 12. Sectoral Credit Risk Regressions

• 13. Aggregated Sectoral Credit Risk Coefficients by Type of Banks

• APPENDIX

• I. Banking Sector Stress Testing Matrix

Glossary

Executive Summary¹

The financial sector weathered COVID relatively well on the back of high pre-crisis capital and liquidity buffers, strong public and private sector balance sheets, and unprecedented public and ECB support. Immediate risks to Germany’s financial stability of Russia’s invasion of Ukraine appear to be manageable due to the banks’ limited direct exposures to Russia. However, risks associated with the economic fallout could impact some individual financial institutions, non-performing loans, and house prices. Real GDP growth was projected to regain momentum from mid-2022 onwards, but the war could hinder the recovery through supply constraints, higher-than-expected above-target inflation (with higher energy prices and supply constraints), a tightening of financial conditions, and shifts in investors’ confidence.

The two structural vulnerabilities identified in the 2016 FSAP, namely low bank profitability and misalignments in the real estate sector prices, have become more prominent and represent potential risk amplifying channels. The FSAP’s residential and commercial property analyses shows higher tail risks since the onset of the pandemic and pockets of vulnerabilities, particularly in larger cities. The FSAP welcomes progress toward closing residential real estate data gaps to support risk monitoring and calibration of macroprudential tools. Also, the FSAP states that limited non-interest revenues, cost factors, and competition will continue to hinder German banks’ performance. Interest rate increases will raise profits, albeit with some delay. At the same time, during the pandemic nonperforming loans remained low, and the significant drop in enterprises’ sales was cushioned by timely official support measures and corporates’ operational adjustments that limited the rise in debt at risk.

The FSAP solvency and liquidity stress tests show that the German significant institutions (SIs) and less significant institutions (LSIs) are resilient under the baseline and adverse scenarios. The main risks to financial stability relate to a global resurgence of COVID-19 cases with extended supply chain disruptions and de-anchoring of inflation expectations in the U.S. and advanced Europe with a scarcity of gas and oil. For SIs, under the V-shaped adverse scenario with conservative assumptions regarding interest rate pass-through, the aggregate capital shortfall remains small (0.3 percent of GDP), with three SIs out of fifteen in the sample falling below the hurdle rate assuming a binding CCyB in 2023-24 but with capitalization of all banks above the minimum CET1 ratio.² With very high overall capitalization, under the V-shaped adverse stress test scenario, LSIs’ aggregate capital remains very high; only 21 very small banks (with up to 3 percent of total LSIs assets) fall below the hurdle rate. Also, the banking system appears generally resilient to liquidity stress. Under the liquidity severe adverse scenario, selected banks’ U.S. dollar exposures could pose a risk and require access to the central bank swap line. The FSAP recommends the need to: (i) continue closely monitor banks’ prudential ratios, in particular large SI commercial banks, and establish microprudential buffers (Pillar 2 guidance) for less capitalized banks as needed; (ii) strengthen LSIs interest rate risk monitoring, including by gathering data on the remaining maturity of retail deposits, wholesale funding, and interest-bearing assets to perform top-down stress tests of interest rate risks. The FSAP also recommends that data sharing between the Bundesbank and the ECB is strengthened.

The interconnectedness and contagion analysis shows that the interbank contagion risks flow from SIs to LSIs and from LSIs as a group to SIs. Germany’s interbank system is strongly interconnected, and a relatively small number of banks account for a large share of interconnections. Germany’s financial system is highly interconnected across borders through financial claims and liabilities. The interbank market appears segmented among SIs, and among LSIs. Risks of domestic interbank contagion flow mostly from SIs to LSIs and from LSIs as a group to SIs, and a few large banks account for most of the contagion risks. The FSAP recommends that risk monitoring and the analysis of domestic and cross-border interconnectedness continue to be strengthened, with a focus on key domestic interbank market institutions and other markets where exposures are located, as needed.

The non-financial corporate sector (NFC) appears broadly resilient to shocks. The pandemic caused a large shock to enterprises’ sales. A sensitivity analysis illustrates the critical importance of the authorities’ and firms’ responses to cushion the impact of the pandemic on NFCs’ balance sheets. In the baseline scenario, enterprises’ capacity to service their debts, measured by the interest coverage ratio (ICR), improves over time and both the share of debt in firms with an ICR<1 and the share of debt in firms with cash<0 falls over time. In the adverse scenario, the significant contraction of economic activity in 2023 causes the share of debt in firms with an ICR<1 to rise again. The share of debt in firms with cash<0 remains more elevated than in the baseline and the probability of default rises in 2023, albeit from a low base and remains relatively low in absolute terms.

Tail risks in real estate have increased since the onset of the pandemic, particularly in the CRE market. High RRE valuations suggest price misalignments in the residential sector, with pockets of vulnerabilities in larger cities. Standard indicators of overvaluation suggest a 21-37 percent deviation from long-run averages as of end-2021, and an econometric model at the country-level that takes account or real interest rates suggests RRE overvaluation of about 10-15 percent as of 2021Q3. The analysis suggests potential pockets of vulnerabilities in bank exposures to real estate.