BERLIN (MNI) – The Bundesbank on Thursday pointed to medium-term
risks from a possible protracted phase of low interest rates in the
Eurozone.

“A protracted phase of low interest rates may create undesirable
incentives,” the German central bank warned it its latest financial
stability review.

“These include the danger of a re-emergence of the search for yield
coupled with high risk-tolerance, which was a widespread phenomenon
ahead of the recent financial crisis and one that had damaging
consequences,” the report stated.

Moreover, persistently low interest rates are promoting the trend
towards short-term refinancing and increased maturity transformation,
the Bundesbank cautioned.

“The abundant supply of liquidity could encourage a prolongation of
impaired loans,” it remarked. “In the longer term, this could create
potential weaknesses in the financial sector.”

Bundesbank board member Andreas Dombret remarked that a continued
low interest rate phase could lead to the formation of bubbles on some
asset markets.

“This is not an acute problem, but could become relevant over the
medium term,” he said in remarks prepared for a press conference to
present the report.

More than three years after its onset, the financial crisis is “far
from being resolved,” the report noted. “To overcome the current crisis,
confidence in the sustainability of public finances in all Eurozone
countries has to be regained and, as far as possible, lastingly
secured.”

Still, “the stability of the German banking system has improved,”
Dombret said. “Banks are currently being buoyed by the favorable
economic trend in Germany.”

“There are no indications that the German banking system will be
unable to play its part in the economic upturn in Germany through its
lending function,” Bundesbank Vice President Franz-Christoph Zeitler
said in a press statement.

“Temporary fears of a credit crunch have not materialised,” the
stability report points out.

Loss provisions in the German banking system will fall from around
E37 billion in 2009 to an estimated E23 billion in 2010, the Bundesbank
predicted. For 2011, it expects loss provisions to stay at around E23
billion.

The most vulnerable segments of foreign credit exposures remain
commercial real estate funding and structured securities, the report
points out.

In a risk scenario based on a 4% GDP drop, aggregate write-downs
would total E35 billion, some E9 billion more than the average of the
last five years, the Bundesbank estimated.

Dombret noted that some vulnerabilities and structural weaknesses
remain in the German banking system. “It is therefore crucial to reduce
excess capacity in the German banking market and, where necessary,
develop sustainable business models,” he advised.

The low short-term interest rates are encouraging banks to take on
liquidity risk and, thereby, increase their dependence on volatile
market developments, the Bundesbank remarked.

The percentage of German institutions’ outstanding bank debt
securities with a residual time to maturity of less than a year, which
for many years was stable at 22%, has risen to around 30% at the last
count, the report noted.

“The necessary reversal of this expansion in the short-term
maturity segment is overdue,” the central bank said, urging banks to
limit potential risks arising from asset liability maturity mismatches.

While this short-term bias continues in wholesale funding, the
German banking system has made progress towards achieving a more stable
mix of funding sources, the Bundesbank acknowledged.

Still, banking groups whose business model typically involves
maturity transformation based on large deposits by non-banks continue to
face high, albeit slightly reduced, interest rate risk, it said.

“From a systemic perspective, it is cause for some concern that
banks active in the markets are again displaying similar response
patterns in proprietary trading and therefore a comparable risk profile
as the sovereign debt crisis widens,” the central bank argued.

Given that new public debt crises cannot be ruled out completely in
the future, an orderly crisis mechanism in the European Union is needed,
Dombret said.

Any future bailouts in the context of public debt crises in the
Eurozone must come at a cost to creditors, he said, reaffirming the
Bundesbank’s stance.

However, such a mechanism should be implemented only at the end of
the crisis and should not apply to existing contracts, Dombret said,
echoing Bundesbank president Axel Weber’s comments on Wednesday.

–Berlin bureau: +49-30-22 62 05 80; email: twidder@marketnews.com

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