## _cr16195 ## Source details **Canonical URL:** [_cr16195](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16195.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16195.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16195.pdf.json) --- ### Overview and Key Finding - Global concern about decline in market liquidity, especially for fixed income assets; reference to IMF’s October 2015 Global Financial Stability Report (GFSR) Chapter Two. - German financial system dominated by banks; aggregate bank funding relies more on deposits than many other advanced economies, but certain institutions rely on market funding. - Current level of liquidity of the banking system is abundant, underpinned by active central bank support, but resilience of liquidity in some bank funding markets appears less than in the past. - April 2015 Bund tantrum cited as evidence that market liquidity can be fragile even in otherwise liquid markets. ### Recent Developments Affecting German Banking - Crisis legacy exposed weaknesses in bank funding practices; several large institutions required rescue and consolidation continued. - Central bank actions (quantitative easing, negative policy rates) produced prolonged low interest rates and a flat yield curve, exacerbating low bank profitability. - Post-crisis global regulatory change aimed at improving liquidity and stability of bank balance sheets is being implemented. - These developments pose challenges for bank funding conditions and practices. ### ECB Policy Actions and Market Impact - In mid-2014, the ECB lowered the interest rate on its deposit facility below zero amid growing concerns about deflationary pressures. - Later in 2014 the ECB began to purchase covered bonds and asset-backed securities. - In early 2015, the ECB initiated a program to purchase public sector bonds with the intention to inject a total of EUR 60 billion per month of liquidity into the system until inflationary expectations are more in line with policy objectives. - "The yield on every German benchmark bond with maturities up to six years is already negative, and the 10-year bond yield fell to 0.075 percent in April 2015; the current 10-year yield is about 0.5 percent." ### Short-Term Interest Rates and Benchmarks - Several short-term interest rates have fallen below zero, including benchmarks used for pricing mortgage loans. - EURIBOR tenors: - became negative for tenors below six months, - nearing zero for six-month funds, - fell below 0.15 percent for one-year maturities. - Money market rates shown include EONIA, EURIBOR 3m, EURIBOR 6m, EURIBOR 12m and German T-Bills (monthly averages referenced). ### Regulatory Changes Affecting Bank Funding - Liquidity Coverage Ratio (LCR) requires banks hold sufficient highly liquid assets to cover net liquidity outflows over a 30-day stressed period; phased in from 60 percent coverage in 2015 to full coverage in 2018. - Anticipation of the Leverage Ratio (LR) and the Net Stable Funding Ratio (NSFR) affects banks’ willingness to hold certain assets. - LCR likely raises buy-and-hold demand for highly liquid assets as an alternative to providing short-term funding for other banks. ### Structural Shifts and Funding Market Changes - Short-term unsecured funding from both U.S. and euro money market funds has fallen steadily and is now a fraction of former levels. - Repurchase markets have contracted significantly, with higher haircuts and costs. - Longer-term debt markets have become more domestically focused, with smaller potential issuance sizes, shorter maturities, and constrained depth due to limited secondary market trading. - Bank balance sheets are about 10 percent smaller than at their peak. - Financing has shifted toward more reliance on non-bank deposits. ### German Banking System Structure and Funding Profiles - Number of institutions declined by more than 60 percent since 1990. - First pillar (private commercial banks): Deutsche Bank, Commerzbank, HypoVereinsbank; Deutsche Bank owned 93.7 percent of outstanding shares of Deutsche Postbank as of end-2014; announced intent in April 2015 to reduce Postbank holdings to less than 50 percent. - About 160 private commercial and other smaller commercial banks, plus over 100 foreign banks with local branches. - Second pillar (public sector banks): regional savings banks (Sparkassen), Dekabank, six regional Landesbanken. - Savings banks: average loan-to-deposit ratio about 90 percent. - Landesbanken obtain only about a third of funding from customer deposits; Landesbanken accounted for nearly 40 percent of total outstanding covered bonds at end-2014. - Third pillar (cooperative banks): more than 1,000 entities at end-September 2015; overall loan-to-deposit ratio just over 90 percent. - Two regional central institutions: Deutsche Zentral-Genossenschaftsbank (DZ Bank) and Westdeutsche Genossenschafts-Zentralbank (WGZ Bank); DZ Bank and WGZ Bank announced intention to merge, target completion by end 2016. - Mortgage finance institutions: 16 mortgage banks (Hypothekenbanken) and 21 building and loan associations (Bausparkassen). - Special purpose banks: 19 institutions, largest is Kreditanstalt für Wiederaufbau (KfW). - Funding patterns: - Large commercial banks: customer deposits account for less than half of total financing; about 10 percent of funding obtained on longer-term capital markets via covered bonds and other debt securities; largest borrowers in repurchase market. - Regional and smaller private banks: bulk funding from customer deposits. - Savings and cooperative banks: funded mainly by customer deposits, often with deposit surpluses. - Landesbanken and mortgage banks: rely more on interbank borrowing and capital markets; active on repurchase market. ### Short-Term Money Markets and Vulnerabilities - Short-term money market defined as maturities less than one year: negotiable certificates of deposit, bankers acceptances, commercial paper, repurchase agreements, Treasury bills, and other short-term instruments. - Interbank funding dropped from about 30 percent to about one fifth of overall financing of German banks during the euro crisis. - Shift to less stable overnight maturities increased reliance on ECB liquidity provision. - Main challenges: - Low/negative interest rates reduce attractiveness to investors and lower flow of funds to the sector. - Negative rates incentivize holding cash (implicit zero rate) or other assets rather than bank deposits, reducing flows to short-term markets and complicating liquidity needs. - Low/negative rates may encourage disintermediation by large corporates setting up investment entities outside the banking system. - Money market fund statistics: - Assets managed by money market funds worldwide at end-June 2015 amounted to EUR 4.1 trillion. - U.S. funds accounted for about 60 percent of the market. - Exposure of U.S. money market funds to German banks at end-September 2015 was about EUR 40 billion, about a third of earlier levels. - Prime U.S. money market funds allocate about 3.5 percent of their portfolio to German banks, compared to about 10 percent at end-2006. - Reduced reliance on money market fund financing removes a source of volatility but requires banks to find alternative funding sources. ### Short-Term Secured (Repo) Markets - European repo market size: - Peaked at EUR 6.8 trillion in June 2007. - Fell to EUR 4.3 trillion in December 2008. - Recovered to previous peak in June 2010. - Stood at EUR 5.5 trillion at end-December 2014. - Outstanding liabilities of all German banks from repurchase agreements at end-2014 were only about half their level of June 2010; fall particularly marked for Landesbanken and mortgage finance institutions. - Haircuts and costs of repo operations have increased. - Pricing defined by cost of borrowing against general collateral; near-zero interest rates complicate pricing and can lead to negative rates on special collateral. - Standard repurchase contracts (Global Master Repurchase Agreement, GMRA) assume positive interest rates; the 2011 GMRA optional supplementary condition would set the repo rate to zero in event of a failure to deliver and give the buyer right to terminate a failed transaction at any time. - Regulatory changes requiring larger liquidity buffers and more capital for short-term repo activity reduce short-term funding availability for trading portfolios. - Weaker short-term funding reduces secondary market liquidity for longer-term instruments, leading to more volatility, higher costs, and less capacity for primary issuance. - Standard repo contracts lack mechanisms for negative interest charges; ad hoc solutions used so far but contract modification necessary if negative rates persist. ### Bank Securities Markets and Covered Bonds - Bundesbank data: outstanding bank bearer debt (senior debt, subordinated debt and covered bonds) declined by more than one fourth from mid-2010 to end-2014; decline largely from Landesbanken (fell by 40 percent) and mortgage banks (fell by over 60 percent). - Unsecured debt outstanding of German banks: - Remained fairly stable during initial phases of global crisis. - Began to decline in mid-2010 and fell by about 15 percent through end-2014. - More recently stabilized as banks adapt strategies to raise additional senior financing for bail-inable capital needs. - Covered bonds: - Total outstanding balance nearly EUR 1 trillion in 2006; EUR 402 billion at end-2014. - Share financing property loans rose from about a quarter to nearly half between 2006 and 2014. - Nearly 80 issuers have covered bonds outstanding. - Covered bonds typically issued with average maturity of five to eight years; underlying loans generally much longer (20–30 years with interest reset periods of 10 years or less), creating inherent refinancing risk. - Covered bonds declined to about 5 percent of total banking system liabilities, compared with 15 percent prior to crisis; funding risk concentrated within mortgage banks where covered bonds account for almost half of funding. - Combined issuance of jumbo and benchmark covered bonds has fallen by more than 60 percent from pre-crisis levels. - More than one fifth of investor base for German covered bonds comprised of foreign institutions. - Regulatory treatment: - Basel III in the EU allows most liquid covered bonds to be classified as Level 1 HQLA up to a ceiling of 70 percent of their value with a haircut of 7 percent. ### Liquidity Effects from ECB Quantitative Easing - ECB guidelines allow purchases of up to 33 percent of sovereign bond issues and as much as 70 percent of eligible covered bonds (limits applied after consolidating holdings in all national central bank portfolios). - Market sources estimate ECB purchases of sovereign bonds on the secondary market have regularly been near the limit for some countries. - The ECB has often taken up to 50 percent (and occasionally more) of eligible covered bond issues in the primary market and added further in secondary markets to reach holdings near the limit for some bonds. - Large ECB holdings reduced potential trading volumes for affected bonds and made price discovery more difficult, even as systemic liquidity increased dramatically. - German government bonds remain highly liquid but depth deteriorated somewhat in late 2015 with gradual increases in bid-ask spreads and temporary widening during market stress. - Willingness and ability of financial intermediaries to provide balance sheet for market making and to hold proprietary trading positions is reduced, partly due to regulatory change and erosion of the repo market. ### Interconnectedness and Mutualized Guarantee Schemes - Landesbanken derive about 20 percent of their funding from regional savings banks, exposing savings banks to Landesbanken credit risk. - Central cooperative banks (DZ Bank and WGZ Bank) depend for about 60 percent of their funding on their shareholder cooperative banks. - Mutualized guarantee schemes provide interconnections: - Savings banks guarantee funds organized regionally or functionally; a multi-tiered liability scheme regulates financial support including additional contributions by savings banks. - Cooperative sector has an institutional protection scheme operated by the National Association of German Cooperative Banks; members can be required to provide additional support to the scheme recognized as deposit guarantee scheme if financial means are inadequate. - Mutualized guarantee of commercial banks: - Direct guarantee of deposits not covered by statutory deposit protection scheme. - Amount limited to 20 percent of equity capital of participating institution (down from 30 percent before 2015); guarantee will be further reduced to 15 percent of equity capital in 2020 and 8.75 percent of equity capital in 2025. - Cross-pillar linkages concentrated through Landesbanken and central credit cooperative institutions. ### Potential Financial Stability Issues - Low interest rate environment and flat yield curve have exacerbated low bank profitability and stressed markets as ECB policy rates and German sovereign benchmark bond yields became negative. - ECB quantitative easing will place additional pressure on benchmark and liquid longer-term yields. - New regulatory reforms (LCR, leverage, NSFR) pose issues for liquid short-term and long-term instruments; weakened market structures make system less resilient when quantitative easing is scaled back. - High level of deposit funding in German banking system eases adjustment to these changes. ### Policy Implications and Recommendations - Short-term market functioning and interventions - ECB liquidity injections currently ensure high liquidity, but actions may be needed to support short-term market functioning going forward. - Improve flexibility of interbank markets; facilitate transfer of excess liquidity within and across banking pillars. - Consider eliminating barriers to competition and consolidation among banks, particularly within savings banks and credit cooperatives (e.g., relax regional principle; encourage finance professionals in management boards). - Monitor repurchase market closely; be prepared to provide support if private sector flows are inadequate, secondary markets dry up and volatility becomes excessive. - Eurosystem securities lending program provides an institutional liquidity backstop that could be adapted if needed. - Monitor impacts of international regulatory measures on repo market liquidity and reassess if reductions produce undue negative externalities. - Follow up on survey on interest rate sensitivity by requiring institutions to indicate how they will manage risks to profitability and funding from further reduction in interest rates and/or flattening of the yield curve; sensitize banks to risks of eventual transition to higher interest rates. - Adapt funding strategies for institutions most at risk from a sharp rise in interest rates to reduce mismatch between fixed rate assets and floating rate liabilities. - Improving resilience of long-term markets - Promote robust secondary trading to underpin investor confidence, efficient pricing and adequate absorptive capacity. - Improve efficiency and liquidity of broader long-term debt markets to benefit covered bonds (important because of inclusion of covered bonds as HQLA for LCR calculation). - Review factors adversely affecting participation of financial intermediaries in secondary markets; identify regulatory issues that may inhibit participation. - Monitor impact of NSFR and, if necessary, consider macro-prudential or other measures to reduce refinancing risk inherent in financing long-term loan assets with medium-term covered bonds. - Timing and opportunity - Most issues are medium-term rather than immediate concerns. - Current high liquidity provides opportunity to address structural inefficiencies at lower cost. ### Main Recommendations (from Table 1) — Priority: Medium - Improve flexibility of interbank markets by facilitating transfer of excess liquidity within and across the banking pillars; consider measures to further consolidation and develop cross-pillar financing mechanisms. - Monitor repurchase markets closely and be prepared to provide support if secondary markets dry up and volatility becomes excessive. - Follow up on survey of interest rate sensitivity of bank balance sheets by asking for action plans to manage risks from further reduction in interest rates and/or flattening of the yield curve; sensitize banks to risks of eventual transition to higher rates. - Review factors adversely affecting participation of financial intermediaries and reducing resilience of liquidity in long-term markets to accommodate additional demand for long-term bond issuance resulting from regulatory reform. *Source: _cr16195 — International Monetary Fund (excerpted content)* ### EXECUTIVE SUMMARY ___________________________________________________________________________ 4 ### EXECUTIVE SUMMARY ### Overview - Global concern about decline in market liquidity, especially for fixed income assets, and its resilience. Reference: IMF’s October 2015 Global Financial Stability Report (GFSR) Chapter Two. - Relevance to Germany: - Financial system dominated by banks; generally sound and robust to shocks. - Aggregate bank funding relies more on deposits than many other advanced economies, but certain institutions rely on market funding. - Smooth functioning of short- and long-term funding markets is important. - Key finding: Current level of liquidity of the banking system is abundant, underpinned by active central bank support, but resilience of liquidity in some bank funding markets appears less than in the past. - April 2015 Bund tantrum indicates market liquidity can be fragile even in otherwise liquid markets. ### Recent developments affecting German banking - Significant changes since crises: crises exposed weaknesses in bank funding practices; several large institutions required rescue; need for new business models became clear. - Consolidation of banking system continued since the crisis began. - Central bank actions (quantitative easing, negative policy rates) have produced prolonged low interest rates and a flat yield curve, exacerbating low bank profitability. - Post-crisis global regulatory change aimed at improving liquidity and stability of bank balance sheets is being implemented. - These developments pose challenges for bank funding conditions and practices. ### Changes in funding markets and consequences - Legacy of the crisis: shift in availability, form and cost of funding for German banks. - Short-term markets contracted significantly, including repurchase transactions; will face further challenges from negative interest rates. - Longer-term markets: more domestically focused; potential issuance sizes smaller; maturities shorter; depth constrained by absence of robust secondary market trading. - Markets will face further challenges adapting to quantitative easing and implementation of liquidity, leverage and stable funding regulations. ### Policy implications highlighted - ECB liquidity injections currently ensure high liquidity, but actions may be needed to support short-term market functioning going forward. - Improve flexibility of interbank markets; facilitate transfer of excess liquidity within and across banking pillars. - Consider eliminating barriers to competition and consolidation among banks, particularly within savings banks and credit cooperatives. - Monitor repurchase market closely; be prepared to provide support if private sector flows are inadequate, secondary markets dry up and volatility becomes excessive. - Eurosystem securities lending program provides an institutional liquidity backstop that could be adapted if needed. - Too early to recalibrate international regulatory measures that may adversely affect repo market liquidity, but impacts must be monitored carefully. - Follow up on survey on interest rate sensitivity by requiring institutions to indicate how they will manage risks to profitability and funding from further reduction in interest rates and/or flattening of the yield curve; sensitize banks to risks of eventual transition to higher interest rates. - Adapt funding strategies for institutions most at risk from a sharp rise in interest rates to reduce mismatch between fixed rate assets and floating rate liabilities. - Improve resilience of liquidity in long-term markets: - Promote robust secondary trading to underpin investor confidence, efficient pricing and adequate absorptive capacity. - Improve efficiency and liquidity of broader long-term debt markets to benefit covered bonds, important because of inclusion of covered bonds as HQLA for LCR calculation. - Mitigate transitional costs of monetary easing and regulatory reforms on market functionality to facilitate successful implementation. ### Timing and opportunity - Most issues are medium-term rather than immediate concerns. - Current high liquidity provides opportunity to address structural inefficiencies at lower cost than otherwise. --- ### Main Recommendations (from Table 1) - Improve the flexibility of interbank markets by facilitating the transfer of excess liquidity within and across the banking pillars. Measures to further the on-going consolidation of savings banks and cooperative banks and to encourage development of additional cross pillar financing mechanisms should be considered. - Priority: Medium - Monitor repurchase markets closely and be prepared to provide support if secondary markets dry up and volatility becomes excessive. - Priority: Medium - Follow up on survey of interest rate sensitivity of bank balance sheets by asking for action plans of measures to manage risks to profitability and funding of a further reduction in interest rates and/or flattening of the yield curve. Sensitize banks to risks of eventual transition to higher rates. - Priority: Medium - Review factors adversely affecting the participation of financial intermediaries and reducing the resilience of liquidity in the long-term markets, so as to be able to accommodate the additional demand for long-term bond issuance resulting from regulatory reform. - Priority: Medium *Source: _cr16195 - EXECUTIVE SUMMARY* ### 7. In mid-2014, the ECB lowered the interest rate on its deposit facility below zero amid ### _cr16195 - 7. In mid-2014, the ECB lowered the interest rate on its deposit facility below zero amid ### ECB policy actions and market impact - In mid-2014, the ECB lowered the interest rate on its deposit facility below zero amid growing concerns about deflationary pressures. - Later in 2014 the ECB began to purchase covered bonds and asset-backed securities. - In early 2015, the ECB initiated a program to purchase public sector bonds with the intention to inject a total of EUR 60 billion per month of liquidity into the system until inflationary expectations are more in line with policy objectives. - Reflecting these developments, the yield on sovereign bonds has fallen to negative rates in several countries. - "The impact in Germany has been particularly marked. The yield on every German benchmark bond with maturities up to six years is already negative, and the 10-year bond yield fell to 0.075 percent in April 2015; the current 10-year yield is about 0.5 percent." ### Short-term interest rates and benchmarks - Several short-term interest rates have fallen below zero, including for benchmarks used for pricing important products such as mortgage loans. - EURIBOR rates: - became negative for tenors below six months, - nearing zero for six-month funds, - fell below 0.15 percent for one-year maturities. - Money market rates shown (monthly averages, in percent) include EONIA, EURIBOR 3m, EURIBOR 6m, EURIBOR 12m and German T-Bills (Figure 3 referenced). ### Regulatory changes affecting bank funding - The Liquidity Coverage Ratio (LCR), adopted as part of the European Union’s implementation of Basel III, requires that banks hold a sufficient amount of highly liquid assets to cover net liquidity outflows over a 30-day period under a stressed scenario. - Application is being phased in from 60 percent coverage in 2015 to full coverage in 2018. - Anticipation of the Leverage Ratio (LR) and the Net Stable Funding Ratio (NSFR) is also affecting banks’ willingness to hold certain kinds of assets. - The LCR is intended to reduce liquidity shortages and will likely raise the buy-and-hold demand for highly liquid assets as an alternative to providing short-term funding for other banks. ### Structural shifts and funding market changes - Legacy effects of the crises: - Short-term unsecured funding from both U.S. and euro money market funds has fallen steadily and is now a fraction of former levels. - Repurchase markets have contracted significantly, with higher haircuts and costs. - Longer-term debt markets, even for collateralized instruments such as covered bonds, have become more domestically focused, with smaller potential issuance sizes, shorter maturities, and constrained depth due to limited secondary market trading. - Bank balance sheets are about 10 percent smaller than at their peak. - Financing has shifted toward more reliance on non-bank deposits. - Some changes reflect regulatory reforms aimed at promoting a more stable financial system. ### German banking system structure and funding profiles - Consolidation: - Number of institutions declined by more than 60 percent since 1990. - Crisis-era consolidation involved a number of larger institutions and affected banks in public and private sectors. - Pillars and major banks: - First pillar: private commercial banks dominated by Deutsche Bank (including Deutsche Postbank), Commerzbank, and HypoVereinsbank (UniCredit subsidiary). - Deutsche Bank owned 93.7 percent of outstanding shares of Deutsche Postbank as of end-2014. Deutsche Bank announced in April 2015 intent to reduce its Postbank holdings to less than 50 percent of outstanding shares. - About 160 private commercial and other smaller commercial banks exist, plus over 100 foreign banks with local branches. - Second pillar: public sector banks, mainly regional savings banks (Sparkassen), Dekabank, and six regional Landesbanken. - Savings banks: average loan-to-deposit ratio is about 90 percent, operate within local regions, supported by responsible public bodies. - Landesbanken obtain only about a third of funding from customer deposits and relied on interbank borrowing and capital markets; Landesbanken accounted for nearly 40 percent of total outstanding covered bonds at the end of 2014. - Third pillar: cooperative banks (Volksbanken and Raiffeisenbanken) — more than 1,000 entities at end-September 2015. - Overall loan-to-deposit ratio of cooperative banks is just over 90 percent. - Two regional central institutions: Deutsche Zentral-Genossenschaftsbank (DZ Bank) and Westdeutsche Genossenschafts-Zentralbank (WGZ Bank). - DZ Bank and WGZ Bank have recently announced intention to merge, with a target for completion by end 2016. - Mortgage finance institutions: 16 mortgage banks (Hypothekenbanken) and 21 building and loan associations (Bausparkassen). - Special purpose banks: 19 institutions (development banks and others), largest is Kreditanstalt für Wiederaufbau (KfW). - Funding patterns: - Large commercial banks: customer deposits account for less than half of total financing; about 10 percent of funding obtained on longer-term capital markets via covered bonds and other debt securities; borrow on interbank market and from money market funds; largest borrowers in repurchase market. - Regional and smaller private banks: bulk funding from customer deposits. - Savings banks and cooperative banks: funded mainly by customer deposits, often with deposit surpluses over loan books. - Landesbanken and mortgage banks: rely more on interbank borrowing and capital markets; active on repurchase market. ### Potential financial stability issues in bank funding - Low interest rate environment and flat yield curve have exacerbated low bank profitability and put markets under increased stress as ECB policy rates and German sovereign benchmark bond yields became negative. - ECB quantitative easing will place additional pressure on benchmark and liquid longer-term yields. - New regulatory reforms (LCR, leverage, NSFR) will pose issues for liquid short-term and long-term instruments; market structures weakened by crisis make the system less resilient when quantitative easing is scaled back. - The high level of deposit funding in the German banking system eases adjustment to these changes. ### Short-term money markets and vulnerabilities - Short-term money market defined: assets and liabilities with maturities less than one year, including negotiable certificates of deposit, bankers acceptances, commercial paper, repurchase agreements, Treasury bills, and other short-term instruments. - Interbank market: - Interbank funding dropped from about 30 percent to about one fifth of overall financing of German banks during the euro crisis. - Shift to less stable overnight maturities increased reliance on ECB liquidity provision. - Main challenges: - Low/negative interest rates reduce attractiveness to investors and lower flow of funds to the sector. - Precondition for return to higher rates unlikely to exist for quite some time. - Short-term rates effects: - Cuts in ECB policy rate in mid- and late-2014 reflected in lower money market interest rates. - Extended low rates erode lending margins and embed on asset sides of balance sheets, complicating future adjustments. - Short-term unsecured markets: - Negative rates incentivize holding cash (implicit zero rate) or other assets rather than bank deposits, reducing flows to short-term markets and complicating liquidity needs. - Low/negative rates may encourage disintermediation by large corporates setting up investment entities outside the banking system. - Investments in Europe by money market funds have fallen: - Assets managed by money market funds world-wide at end-June 2015 amounted to EUR 4.1 trillion. - U.S. funds continued to account for about 60 percent of the market. - Exposure of U.S. money market funds to German banks at end-September 2015 was about EUR 40 billion, about a third of earlier levels. - Prime U.S. money market funds are allocating only about 3.5 percent of their portfolio to German banks, compared to about 10 percent at end-2006. - Continued low interest rates and U.S. regulatory changes (variable net asset value reporting, liquidity fees, redemption limits) may lead to further reductions in European exposure. - Reduced reliance on money market fund financing removes a source of volatility but requires banks to find alternative funding sources. *International Monetary Fund — Germany: selected excerpts on ECB policy, bank funding, and financial stability issues* ### 27. Assets managed by European money market funds increased during the global ### _cr16195 - 27. Assets managed by European money market funds increased during the global ### European money market funds - Total assets managed by European money market funds fell by about 25 percent from end-2009 to end-2014. - Such funds are domiciled mainly in France, Ireland and Luxemburg. - Nearly half of the assets of European money market funds are denominated in currencies other than the euro. - The outstanding balance of German money market funds at end-2014 was nearly 90 percent below the level prior to the crisis. ### Short-term funding and ECB operations - Access by banks to short-term funding has not been impaired despite weaker sources of short-term financing and stress from low and negative interest rates. - ECB operations, including quantitative easing, replaced short-term market liquidity previously provided from other sources. - Excess liquidity in the banking system increased from a low of just over EUR 100 billion in November 2014 to more than EUR 500 billion in September 2015. ### Short-term secured (repurchase) markets - European repo market size: - Peaked at EUR 6.8 trillion in June 2007. - Fell to EUR 4.3 trillion in December 2008 (nearly one third decline). - Recovered to previous peak in June 2010. - Stood at EUR 5.5 trillion at end-December 2014. - German bank repo funding: - Outstanding liabilities of all German banks from repurchase agreements at end-2014 were only about half their level of June 2010. - The fall was particularly marked for the Landesbanken and mortgage finance institutions. - Haircuts and costs of repurchase operations have increased. - Pricing in repo markets is defined by the cost of borrowing against general collateral; near-zero interest rates complicate pricing and can lead to negative rates on special collateral. - Reduced attractiveness of money market funds directly impacts repo market liquidity because money market funds have traditionally been a common source of repo funding. - Repo market likely to remain weak while negative rates persist; regulatory changes requiring larger liquidity buffers and more capital for short-term repo activity reduce short-term funding availability for trading portfolios. - Weaker short-term funding reduces secondary market liquidity for longer-term capital market instruments, leading to more volatility, higher costs, and less capacity for primary issuance. - Standard repurchase contracts assume positive interest rates and lack mechanisms for negative interest charges, potentially creating perverse incentives and operational frictions; ad hoc solutions have been used so far, but contract modification will be necessary if negative rates persist. - The standard repurchase contract referenced is the Global Master Repurchase Agreement (GMRA); an optional supplementary condition in the 2011 version would set the repo rate to zero in the event of a failure to deliver and give the buyer the right to terminate a failed transaction at any time. ### Bank securities markets (longer-term bank debt) - Bundesbank data: outstanding bank bearer debt (including senior debt, subordinated debt and covered bonds) declined by more than one fourth from mid-2010 to end-2014. - Most of the decline attributable to Landesbanken (outstanding amounts fell by 40 percent) and mortgage banks (outstanding amounts fell by over 60 percent). - Unsecured debt outstanding of German banks: - Remained fairly stable during initial phases of the global crisis. - Began to decline in mid-2010 with onset of euro financial crisis. - Fell by about 15 percent through end-2014. - More recently stabilized as banks adapt funding strategies to raise additional senior financing to meet bail-inable capital needs. - Regulatory impacts: - Unsecured private placements used by Landesbanken and central institutions are not considered liquid for LCR purposes and are likely to decline. - Short-term borrowing for financing trading positions or longer maturity assets will be penalized in NSFR calculations, potentially forcing banks to obtain longer-term financing or reduce underwriting and trading businesses. - Simultaneous need for many banks to increase bail-inable capital to comply with the EU Bank Recovery and Resolution Directive could challenge banks seeking additional longer-term unsecured financing. ### Covered bonds - Covered bonds are the second largest bond market in Germany after government bonds; used mainly to finance loans to the public sector or for property, with niche in shipping and aircraft finance. - Total outstanding balance of covered bonds: - Nearly EUR 1 trillion in 2006. - EUR 402 billion at the end of 2014. - Drivers of decline in covered bonds: - Fall in bonds financing loans to the public sector. - Reduced public sector borrowing, increased direct access to capital markets by local authorities, lower Landesbanken issuance following elimination of government guarantees. - Less arbitrage after exclusion of higher-spread sovereign bonds once the euro crisis began. - ECB liquidity operations provided cheaper funding alternatives for some potential issuers. - Composition change: - Share of covered bonds financing property loans rose from about a quarter to nearly half of the total outstanding balance between 2006 and 2014. - Market structure and risks: - Nearly 80 issuers have covered bonds outstanding. - Covered bonds are important for private mortgage banks, public mortgage banks, and Landesbanken. - Covered bonds are typically issued with average maturity of five to eight years; underlying loans generally much longer (20–30 years with interest reset periods of 10 years or less), creating inherent refinancing risk. - Secondary market liquidity for covered bonds has been thin since the global financial crisis. - Covered bonds declined to about 5 percent of total banking system liabilities, compared with 15 percent prior to the crisis, but funding risk is concentrated within mortgage banks where covered bonds account for almost half of funding. - Combined issuance of jumbo and benchmark covered bonds has fallen by more than 60 percent from pre-crisis levels. - Covered bond investors are often domestic or regional and may have limited alternatives; historical disappearance of buyers during the global financial crisis demonstrates refinancing risk can materialize. - Regulatory treatment: - Basel III implementation in the EU allows the most liquid covered bonds to be classified as Level 1 HQLA up to a ceiling of 70 percent of their value with a haircut of 7 percent. - This treatment should in principle support bank demand for covered bonds, but crisis experience shows liquidity can be less than expected. - Treatment under the NSFR could affect willingness of bank investors to hold covered bonds. ### Liquidity effects from ECB quantitative easing - ECB guidelines allow purchases of up to 33 percent of sovereign bond issues and as much as 70 percent of eligible covered bonds (limits applied after consolidating holdings in all national central bank portfolios). - Market sources estimate ECB purchases of sovereign bonds on the secondary market have regularly been near the limit for some countries. - The ECB has often taken up to 50 percent (and occasionally more) of eligible covered bond issues in the primary market and added further in secondary markets to reach holdings near the limit for some bonds. - These large ECB holdings have reduced potential trading volumes for affected bonds and made price discovery more difficult, even as systemic liquidity has increased dramatically from ECB operations. - The liquidity of high quality unsecured and secured bond markets appears lower post-crises; German government bonds remain highly liquid but depth deteriorated somewhat in late 2015 with gradual increases in bid-ask spreads and temporary widening during market stress. - Willingness and ability of financial intermediaries to provide balance sheet for market making and to hold proprietary trading positions is reduced, partly due to regulatory change and erosion of the repo market. ### Interconnectedness within the German banking system - Landesbanken funding and exposures: - Landesbanken derive about 20 percent of their funding from the regional savings banks, exposing savings banks to Landesbanken credit risk on the asset side. - Savings banks are generally major shareholders of Landesbanken and have considerable subordinated capital at risk. - Cooperative banks and central institutions: - Central cooperative banks (DZ Bank and WGZ Bank) depend for about 60 percent of their funding on their shareholder cooperative banks. - The large commercial banks obtain significant interbank funding from smaller banks, exposing the smaller banks to credit risk. - Mutualized guarantee schemes heighten interconnectedness within pillars: - Guarantee systems (regional or functional) aim to provide mutual support to protect member institutions from insolvency and liquidation, protecting client deposits but exposing a broad range of institutions to failure of one member. - Savings banks guarantee funds are organized regionally or functionally and in a crisis a multi-tiered liability scheme regulates financial support, including additional contributions by savings banks; depositors ultimately protected by the national deposit insurance scheme. - Cooperative sector has an institutional protection scheme funded by banks and operated by the National Association of German Cooperative Banks, with enforcement powers to safeguard member solvability; members can be required to provide additional support to the scheme recognized as deposit guarantee scheme if financial means are inadequate for deposit protection. *Source: Excerpt from IMF country report content unit _cr16195.* ### 44. The mutualized guarantee of the commercial banks operates somewhat differently in ### The mutualized guarantee of the commercial banks operates somewhat differently in ### Mutualized guarantee of commercial banks - The mutualized guarantee is a direct guarantee of deposits not covered by the statutory deposit protection scheme. - The amount of the guarantee is limited to 20 percent of the equity capital of a participating institution (down from 30 percent before 2015); the guarantee will be further reduced to 15 percent of equity capital in 2020 and 8.75 percent of equity capital in 2025. ### Fragmentation and cross-pillar linkages - The system is fragmented by the banking pillars, resulting in relatively few linkages across the banking pillars to other parts of the financial system. - Commercial banks rely to an important extent on capital markets instruments, many of which are placed with investors in other banks, including the savings banks and cooperative banks. - Much cross-pillar investment is channeled through the Landesbanken and central credit cooperative institutions, concentrating linkages; these central institutions are important nodes of interconnectedness. - Savings banks and cooperative banks face increased competitive pressures from commercial banks in the retail and SME sectors. - Several foreign commercial banks with retail-focused business models are also competing in those sectors. ### Interconnections via financial instruments and markets - A broad range of banks, insurance companies and pension funds are investors in money market funds, which have traditionally been major lenders in the repurchase market. - Repurchase contracts are an important source of finance for financial intermediaries in long-term capital market instruments such as covered bonds. - A drop in money market fund holdings by banks or insurance companies can impair liquidity in the longer-term bond market and lead to difficulties for mortgage finance institutions and others that rely on that market for funding. - Other interconnections stem from derivative transactions (other than those channeled through CCPs), which generally involve one or more of the large commercial banks; smaller institutions do not make markets in these instruments. ### Covered bond market and international interconnectedness - Covered bonds are major investments in the portfolios of many German banks, insurers and financial intermediaries. - Covered bonds finance significant amounts of cross border exposure to certain non-German markets. - More than one fifth of the investor base for German covered bonds is comprised of foreign institutions. ### Key findings and policy recommendations - Prompt action by the authorities and the injection of substantial government resources stabilized the German banking system in the initial stages of the global financial crisis; ECB monetary operations and interest rate policy continued to provide necessary support as the euro financial crisis evolved. - Many funding markets remain fragile and there are potential side effects of supporting measures that need to be taken into account in policy formulation going forward. Measures to improve interbank market functioning - Consider measures to facilitate transfer of excess liquidity within and across banking pillars to ensure excess savings can be intermediated efficiently once ECB operations end. - Elimination of barriers to competition and consolidation among banks, particularly within the savings banks and credit cooperatives (e.g., by relaxing the regional principle to allow economically justified changes or by encouraging more participation by finance professionals in management boards), could help promote efficient intermediation. - Encourage direct financing linkages between banks across pillars (e.g., by developing co-lending arrangements involving Landesbanken and some of the larger savings banks) to broaden channels for cross-pillar financing. Repurchase market monitoring and support - Authorities should monitor the repurchase market closely and be prepared to consider providing support if private sector flows are inadequate, secondary markets dry up and volatility becomes excessive. - A liquid repurchase market is critical as a source of short-term funding and underpins lower volatility and more efficient pricing in longer-term bond markets. - If support is necessary, it could take the form of provision (presumably through the ECB) of a temporary alternative source of liquidity and/or securities to dampen price swings. - A liquidity backstop is in place through the ECB; the Bundesbank makes securities acquired under the ECB’s Public Sector Purchase Program (PSPP) available for securities lending. These programs provide an institutional framework that could be adapted in collaboration with the ECB to a broader range of collateral and pricing if needed. - Monitor impacts of recent international regulatory measures on repurchase market liquidity and bank funding; reassess if reductions in liquidity have unduly negative externalities. Improving long-term bank debt and covered bond market efficiency - Explore measures to improve the efficiency of the senior unsecured long-term bank debt market, including steps to promote robust secondary trading to underpin investor confidence and ensure efficient pricing and adequate absorptive capacity. - Support for a liquid repurchase market should be part of the strategy to improve long-term debt markets. - Identify and review possible regulatory issues that may inhibit participation of financial intermediaries in the secondary market. - Covered bonds will benefit from improvements in long-term debt market efficiency, including active secondary markets and liquidity. - Authorities may wish to monitor the impact of the introduction of the NSFR and, if necessary, consider macro-prudential or other measures to reduce refinancing risk inherent in financing long-term loan assets with medium-term covered bonds. Managing regulatory transitions and interest rate risk - The implementation of the LCR in the EU and prospective adoption of the leverage ratio and NSFR are likely to require adjustment of financial portfolios and further effects on bank funding practices. - Adjustments should be managed to limit impact on market conditions during the transition phase through close ongoing monitoring of bank funding conditions and adoption of appropriate policy responses to ensure market liquidity and smooth system functioning. - Authorities should follow up on the recent survey on interest rate sensitivity of bank balance sheets; financial institutions should indicate how they will manage risks to profitability and funding from further reduction in interest rates and/or flattening of the yield curve. - Institutions most at risk from a sharp rise in interest rates should adapt funding strategies to reduce mismatch between fixed rate assets and floating rate liabilities. Conclusion - Most issues highlighted are medium-term concerns rather than immediate threats. - The current highly liquid state of many markets provides an opportunity to address underlying structural inefficiencies with lower cost than might otherwise be the case. *GERMANY INTERNATIONAL MONETARY FUND 25* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16195.pdf_