The German financial supervisory authority, BaFin, has warned that Pensionskassen face the prospect of sinking hidden reserves to pay pension promises with rising interest rates.

It is particularly important for Pensionskassen and life insurers to consider that hidden reserves diminish gradually with falling prices of existing fixed income assets, and burdens increase, the regulator said in a report on risks for financial institutions and the pensions system in 2023 – Risiken im Fokus der BaFin 2023.

Pensionskassen and life insurers invest heavily in long-term, fixed-income assets to meet the promises pledged to members. Life insurers benefit from rising interest rates on new investments with a positive impact on their solvency ratios, it added.

BaFin has also underlined in its report the risks posed by Non-Bank Financial Institutions (NBFIs) that have increased significantly.

The risks, according to the regulator, relate to certain alternative investment funds and vehicles that are less or not at all regulated, therefore lacking in transparency.

In recent years, the number of alternative investment funds and non-transparent vehicles has grown significantly in Europe, with investors hunting for higher returns in a low-interest environment, the regulator said.

But promised returns through risky investment vehicles can often only be achieved through “extremely high leverage,” leading to big losses when prices fall and panic to sell assets, shaking financial markets and triggering sharp corrections.

BaFin’s report highlighted the LDI crisis in the UK last year, when pension funds were forced to cut their leverage in the short term, as an example of how risks can quickly materialise.

The risk of contagion increases as a result of the link between NBFIs and regulated banks, for example in the lending business, it added.

Therefore, BaFin has identified financial institutions with particularly high exposures to NBFIs to assess risk management measures, and analysed the growth of alternative investment funds (mainly Spezialfonds), in particular with regard to leveraging risks.

The supervisory authority will also continue to monitor developments in energy markets, taking a closer look at their impact on trading, the clearing of derivative contracts through central counterparties and members.

BaFin has listed six main risks for 2023, including those coming from abrupt interest rate increases, real estate market corrections, international financial market corrections, the default of loans of companies, cyber attacks, and insufficient money laundering prevention.

The regulator is also looking at long-term trends such as sustainability, digitisation of the financial sector and “geopolitical upheaval”, according to the report.

Mark Branson, BaFin’s president, said: “So far, the players in the financial sector and the German financial system have proven to be stable and resilient, also because the safety buffer has been strengthened over the past few years thanks to regulatory requirements.”

He added: “This state of stability should be maintained. BaFin continuously analyses the risks for market participants and ensures that these risks are contained. Therefore, BaFin takes the following approach: the greater the risk, the more time and staff it uses to counteract it.”

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