German pension funds and insurance companies could face further liquidity risks related to derivative transactions, the Financial Stability Committee (FSC) said in its 10th report examining the country’s financial stability.
The FSC, a body supervising systemic risks for the financial system, added in the report handed over to parliament that further increases in interest rates, or exchange rate fluctuations, could lead to extensive, additional margin calls from hedging transactions.
Therefore, the Committee welcomed the introduction of a revised liquidity monitoring mechanism by the financial supervisory authority BaFin that will assess liquidity risks of insurers and pension funds in real-time, it said.
In the first half of 2022, marking calls led to outflows of liquidity from German pension funds and insurance companies but, in contrast to other European countries where pension funds use much more extensively derivative transactions, in Germany “self-reinforcing processes” did not occur, it said.
Life insurance companies, which have benefited from rising interest rates, saw their solvency ratios increasing on average from 400% to almost 600% in 2022, the strongest jump since the introduction of Solvency II in 2016.
Withdrawals from German funds were limited in the period under review – from April 2022 to March 2023 – despite significant losses in market values. Investment funds have been able to absorb the decline in the market value of bonds holdings, it said.
The structure of the securities portfolios held has however been adjusted, with investment funds increasingly holding bonds with remaining maturities of up to two years.
The FSC said that, in addition to the impact of further rising interest rates, a slump in the real economy represented a risk for the German fund industry.
Substantial rating downgrades of securities held by German investment funds could lead to high outflows, which could put a greater strain on the industry, the body added in the report.
The FSC drafted the report considering risks posed to financial stability as a result of macro-economic environment shifts, energy and real estate markets, and the banking crisis in the US and in Switzerland, with the near collapse of Credit Suisse.
The reaction of policymakers in the US and Switzerland contained contagion effects of the crisis on the German financial system. The FSC, however, will work on reviewing regulatory standards against the background of the events in the banking sector, especially in the US, in the coming quarters.
Rising interest rates have led to write-downs in securities portfolios held in Germany, with increasing financing costs and high inflation that had a negative impact on the country’s residential real estate market, and the credit business, the report said.
The real estate office market experienced a downturn with prices, and the volume of transactions that fell significantly from the second quarter of last year.
The vulnerabilities of German banks from real estate loans remain high, the report disclosed, adding that in recent years small- and medium-sized banks in particular have strongly expanded their lending business to finance residential real estate.
The financial stability body also examined issues arising from climate change, concentration risks resulting from the outsourcing of IT services, and the European Central Bank’s current plans concerning the introduction of a digital euro, it added.
It is calling on Institutions for Occupational Retirement Provision (IORPs) to reinforce mechanisms to deal with the risks resulting from climate change, after a stress test taking into account those risks showed that assets invested by occupational pension funds can lose up to 14% of market value if, for example, the price of CO2 emissions suddenly increases to meet the Paris Agreement target.
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