General Administrative Act governing the rate for the domestic countercyclical capital buffer under section 10d of the KWG

This translation is furnished for information purposes only. The original German text is binding in all respects.

The Federal Financial Supervisory Authority is enacting the following

General Administrative Act

1. Effective 1 February 2022, the rate for the domestic countercyclical capital buffer is increased to 0.75 percent of the total risk exposure amount determined in accordance with Article 92(3) of Regulation (EU) No. 575/2013.

2. With effect from 1 February 2023, the rate specified in paragraph 1 must be used to calculate the institution-specific countercyclical capital buffer.

3. The General Administrative Act is addressed to institutions as defined in section 1 (1b) of the Banking Act (Kreditwesengesetz – KWG) and to groups of institutions, financial holding groups and mixed financial holding groups in which at least one member is an institution that must meet the requirements of section 10d (1) sentence 1 of the KWG at the individual institution level, as well as institutions referred to in Article 22 of Regulation (EU) No. 575/2013. It does not apply to the undertakings referred to in sections 2 (7), (7a), (7b), (9a) sentence 1, (9c) and (9e); 51c (4) of the KWG, subject to the conditions set out there.

4. The General Administrative Act is deemed to be announced on the day following its publication and supersedes the General Administrative Act of 31 March 2020 previously in force (ref. no. IFR 2-QA 2102-2020/0002).

Grounds

I.

The Act transposing Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms and aligning supervisory law with Regulation (EU) No. 575/2013 on prudential requirements for credit institutions and investment firms (Act Implementing CRD IV – CRD IV-Umsetzungsgesetz) introduced the requirements set out in section (10d) of the KWG governing the countercyclical buffer with effect from 1 January 2014. Effective 1 January 2016, the Federal Financial Supervisory Authority (BaFin) had thereupon set the rate for the domestic countercyclical capital buffer at 0 percent in the first instance. Based on a recommendation by the Financial Stability Committee (FSC), BaFin increased this rate to 0.25 percent by means of a General Administrative Act of 28 June 2019. In doing so, it not only considered the buffer guide but also, in an overall assessment, other indicators that can be found in detail in the methodological note.¹ In a General Administrative Act of 31 March 2020, BaFin set the rate for the domestic countercyclical capital buffer at 0.0 percent. The objective of this measure was to help avoid procyclical effects in conjunction with the effects of the COVID-19 pandemic. The FSC discussed the reduction of the countercyclical capital buffer and announced that it welcomed this approach.² On 26 February 2021, BaFin announced that it would leave the rate at 0.0 percent until the end of 2021 and had no plans to increase it. The background to this were the credit requirements of the real economy and potential credit defaults in the further course of the COVID-19 pandemic. On 3 December 2021, the FSC advocated the “swift return to prevention mode in macroprudential policy” in a press release.³ The Deutsche Bundesbank also commented that “the overall risk picture appears to indicate that an increase in the countercyclical capital buffer should be effected in a timely manner.”⁴ In a press release on 12 January 2022, the FSC welcomed BaFin’s intention to increase the countercyclical capital buffer.⁵

BaFin continues to believe that the relevant remarks on cyclical systemic risk contained in the FSC’s recommendation of 27 May 2019 are accurate. In the course of its decision-making process, BaFin used current Bundesbank data on the domestic countercyclical capital buffer to update and review its risk assessment.

BaFin published its intended decision on its website on 12 January 2022. BaFin conducted a consultation procedure on the planned General Administrative Act from 12 January 2022 to 26 January 2022. Participants voiced their opinions through their stakeholder associations. BaFin considered the arguments advanced in its decision. The main arguments were:

There is no need for the order in the current economic and political environment, there would be negative impacts because of the ongoing pandemic situation, the subdued state of the economy and political expectations with regard to climate neutrality, digital transformation or housing construction. Attempts by monetary and fiscal policy to support lending and investments would be thwarted. The order would significantly hit the institutions, cut their profitability, and would lead to curbs on lending and/or more expensive credit. It was claimed that what is lacking is a holistic perspective that includes microprudential capital requirements; the blanket increase in the capital requirement is unnecessary because the stability of the institutions is good overall. It could also result in residential property risks being captured twice.

II.

Re number 1:
The criteria for increasing the rate for the domestic countercyclical capital buffer to 0.75 percent of the total risk exposure amount determined in accordance with Article 92(3) of Regulation (EU) No. 575/2013 are satisfied

In accordance with section 10d (3) of the KWG, the rate for the domestic countercyclical capital buffer is 0 to 2.5 percent of the total risk exposure amount determined in accordance with Article 92(3) of Regulation (EU) No. 575/2013. To do this, BaFin assesses the intensity of cyclical systemic risk and judges which rate is appropriate for the domestic countercyclical capital buffer. It sets the rate in line with its assessment or modifies it if necessary. In doing so, BaFin has been considering deviations in the ratio of credit-to-GDP from its long-term trend and any recommendations by the FSC.

The term “cyclical systemic risk” is not expressly defined in law, but it means the risk of disruption in the financial system with the potential to have serious negative consequences for the financial system and the real economy that are attributable to a cyclical component, for example an economic downturn.⁶ The existence of the risk of disruption of the financial system, as described above, results from the following:

The financial system should neither trigger nor amplify and economic downturn. It should therefore be sufficiently resilient, meaning that it must be capable of absorbing losses resulting from unexpected developments in order to prevent negative contagion and feedback effects between the financial market actors, and between the financial system and the real economy.

The aim of the countercyclical capital buffer is to make the banking sector more resilient to cyclical systemic risk. It is certainly the case that the countercyclical capital buffer is supposed to properly reflect the risk to the banking sector of excessive credit growth.⁷ Excessive credit growth is not a mandatory condition, but past experience shows that it is a good indicator of the existence of cyclical systemic risk. Cyclical systemic risks accumulate in particular in phases of excessive credit growth because an economic downturn can lead to large losses in the banking sector in these cases and spark a vicious circle.⁸ As well as the excessive credit growth that underlies the calculation of the buffer guide, other factors are taken into account that flow into the assessment of cyclical systemic risk.

The countercyclical capital buffer is designed to be activated if cyclical systemic risk has been identified. The buffer can be reduced immediately during a system-wide stress phase or tapped in order to cover losses. In this way, the countercyclical capital buffer can help to prevent banks from unduly restricting the supply of credit during times of stress, which might otherwise amplify a downturn or prevent economic recovery.

To set the rate for the domestic countercyclical capital buffer, the methodological note starts by calculating a buffer guide that is based on the deviation in the ratio of domestic lending to GDP from the long-term trend (ratio of credit-to-GDP) and is normally higher than zero if the ratio of credit-to-GDP deviates by more than two percentage points from its long-term trend.

According to the methodological note, the buffer guide is a “rule-based component” that represents an indicator for setting the rate for the domestic countercyclical capital buffer. There are different approaches to calculating the buffer guide. The first of these is to calculate the buffer guide using the standardised method. This corresponds to a proposal by the Basel Committee on Banking Supervision (BCBS) on how to calculate the deviation in the ratio of credit-to-GDP from its long-term trend (credit-to-GDP gap, see also the definition in section 2.1.1.(d) of ESRB/2014/1). The buffer guide can also be calculated using the methodology described in greater detail in the methodological note, which differs from the standardised method due to its narrower definition of credit and a modification of the conversion formula for the buffer guide. The national method produces more beneficial prediction results than the standardised method (see page 18 et seq. of the methodological note).⁹

Based on the most recent figures available for the third quarter of 2021, the credit-to-GDP gap calculated using the national method is thus 5.8 percentage points (after 6.5 percentage points in the second quarter of 2021). The resulting buffer guide is 1.18 percent.

Using the standardised method (based on BCBS’s proposal for calculating the credit-to-GDP gap), there is a credit-to-GDP gap of 10.4 percentage points for the most recent quarter available (second quarter of 2021), following 13.5 percentage points in the first quarter of 2021. This gives a maximum buffer guide of 2.50 percent.¹⁰

However, the buffer guide does not lead to any automatic setting of the rate for the domestic countercyclical capital buffer. The rate for the domestic countercyclical capital buffer is set in an overall assessment that, in addition to the buffer guide, takes into account supporting indicators (”discretionary” component) that capture important aspects of financial stability. This discretionary component allows further quantitative and qualitative indicators to be used to estimate systemic cyclical risk if necessary.

Because of the recession and the correspondingly low GDP growth as a result of the COVID-19 pandemic, both credit-to-GDP gaps widened significantly. However, they are expected to narrow again in the wake of the economic upturn, although as things stand today, they will remain at an elevated level – well in excess of the activation threshold. Such forecasts are naturally subject to a level of uncertainty because this requires an estimate of both GDP and credit growth.¹¹

The macroeconomic outlook has brightened considerably since the beginning of the COVID-19 pandemic. Whereas GDP shrank by 4.9 percent in 2020 – the first year of the pandemic – it already grew by 2.8 percent in 2021.¹² For 2022, the Bundesbank is even projecting economic growth of 4.2 percent.¹³ It is therefore still be expected that the economic recovery will continue, although developments in the wake of the COVID-19 pandemic make it more difficult to make a reliable forecast of economic development

Lending had already risen dynamically in the run-up to the pandemic and was one of the reasons why the domestic countercyclical capital buffer was activated in 2019. This trend also continued during the pandemic.

Dynamic lending growth continues to be observed. However, real growth rates in lending by banks to the non-financial private sector declined in the third quarter of 2021. This is due largely to inflation in the third quarter, which led to a sharp divergence between real and nominal growth rates. The rate of inflation was 4.1 percent in September 2021.¹⁴ In order to assess the rate of credit growth that is relevant from a macroprudential perspective, nominal growth rates for lending are also observed. Nominal growth rates are not affected by temporary fluctuations inflation and provide an indication of the short-term pace of lending at the current margin. These nominal growth rates are considerably higher and also do not indicate any substantial slowing-down of the pace of lending growth.

MFI loans to domestic private households rose by a nominal 5.1 percent and thus grew as fast as last seen in the first quarter of 2000. In comparison, the average growth rate since 1991 has been 3.7 percent. By contrast, real growth in MFI loans to domestic households fell to currently 0.6 percent for the third quarter of 2021. Despite this decrease, the real average growth rate for the past four quarters was also 2.9 percent, and thus considerably higher than the long-term average since 1991 of 2.4 percent.

The economic recovery and the ongoing favourable lending conditions are likely to help the residential real estate market continue to record dynamic growth. The rate of year-on-year nominal growth in housing loans was 7.3 percent in the third quarter of 2021 (real growth 3.0 percent). This credit growth is being accompanied by significantly rising prices. Residential real estate prices rose by 10.9 percent in the second quarter of 2021. This is a new all-time high. The Bundesbank estimates that valuations are too high by a factor of 10 to 30 percent both in urban areas and in Germany overall.¹⁵

Lending to domestic non-financial undertakings weakened slightly. Although these loans to domestic non-financial undertakings rose by 2.3 nominally year-on-year in the third quarter of 2021 (real growth: –2.0 percent), growth was lower than the average for the past four quarters, at 3.0 percent (real growth: 1.5 percent). In the long-term average since 1991, MFI loans to non-financial undertakings grew by 3.6 percent (real growth: 2.3 percent).

Additionally, the vulnerabilities already described in the first activation of the domestic countercyclical capital buffer in 2019 have continued to grow. These are: underestimating credit risk, overvaluing assets, and interest rate risk.

There is a danger that risks are being systematically underestimated. Interest rates have been unusually low and asset prices high for a number of years. Volatility on the financial markets is comparatively low. This reinforces the incentives for market participants to enter into higher risks in their search for returns. Risk premiums for corporate bonds are in some cases lower than before the pandemic.¹⁶ Risk provisioning by banks also fell to all-time lows in the run-up to the pandemic and has hardly grown so far over the course of the pandemic.

Moreover, according to the Bundesbank’s findings, allocation risk in the balance sheets of the banks remains high.¹⁷ This means that the banks have continually increased lending to relatively risky undertakings, although credit risk has fallen in the aggregate since the global financial crisis. Relatively risky undertakings are those undertakings that have a higher leverage ratio or a lower interest cover ratio than other undertakings. Because of this shift in the loan portfolio towards more risky companies, there is a risk that there could be growing losses in banks’ balance sheets in the case of an economic downturn.

Inflated prices bring with them the risk of substantial price adjustments. In the case of residential property, the rise in prices that has been ongoing for many years was also not slowed by the COVID-19 pandemic and exceeds growth in the incomes of private households. Falling prices can in particular lead to disruptions on the real estate markets if there is a sharp economic downturn: falling household incomes can lead to an increase in defaulting loans and, ultimately, to higher loss given defaults in the realisation of real estate collateral. This would result in high losses at banks.

The economic recovery is accompanied by a clear rise in inflation. There is a risk that inflation will take a firm hold. This could be accompanied by substantial interest rate rises and sharp market adjustments.

There are interest rate risks for the banks in particular from maturity transformation. Due to the long-lasting low interest rate phase and the weak earnings performance, there is an incentive for banks to expand their lending activities and to prolong interest lock-in periods. Any abrupt interest rate increase would make funding for the banks more expensive in the short to medium term, and would lead in the short term to substantial write-downs of securities. Moreover, undertakings would face rising refinancing costs, which could ultimately lead to growing credit risks at banks.

An analysis of the indicators and of cyclical systemic risk indicates the following overall: the clearly positive credit-to-GDP gaps under the national and standardised methods point to cyclical systemic risk and hence to an increase in the buffer rate. Although the widening of the credit-to-GDP gaps was reinforced by the recession in 2020 as a result of the COVID-19 pandemic, it is evident that vulnerabilities to cyclical systemic risk have grown again in the banking system. This is also confirmed by the observations in the context of the discretionary component.

The overall assessment of the rule-based and discretionary component shows clearly that cyclical systemic risk continues to grow.

There is thus a requirement to increase the domestic countercyclical capital buffer in order to enhance the resilience of the banking sector to cyclical systemic risk and thus to counter the risk described above of disruption of the financial system.

Macroprudential capital buffers must be increased in a timely and forward-looking manner. That is the only way that they can increase the scope of the supervisory authority for releasing these buffers in a future stress period. This will help the banking system maintain its level of lending in such a period.

Reflecting the remaining uncertainty about the probability of occurrence of the risks described here and the level of the associated economic consequences, BaFin believes that a significant increase in the domestic countercyclical capital buffer as of 1 February 2022 is appropriate. Whereas the buffer guide calculated using the national method suggests a buffer of 1.25 percent, and a buffer of 2.50 percent if it is calculated using the standardised method, after assessing all of the indicators described above and in light of the remaining uncertainty about economic developments in the wake of the COVID-19 pandemic, BaFin considers that a buffer of 0.75 percent is appropriate. In BaFin’s view, the difference between the buffer guide and the actual level of the buffer adequately reflects the uncertainty. Nevertheless, all identified risks must be taken into account.

The implementation period is 12 months, so the banks must have built up the buffer in full by the latest by 1 February 2023.

The measure is proportionate in accordance with section 10d of the KWG. The increase in the rate for the domestic countercyclical capital buffer to 0.75 percent of the total risk exposure amount determined in accordance with Article 92(3) of Regulation (EU) No. 575/2013 effective 1 February 2022 is generally appropriate for limiting cyclical systemic risk and for affecting the credit-to-GDP gap, and hence thus generally serves the objective of the lawmakers codified in section 10d of the KWG. It is also appropriate for achieving this objective in the current economic situation. The increase in the rate serves indirectly to strengthen the credit institutions’ capital base so that they can reduce the additional funds they have built up if required, thus absorbing losses in stressed periods and preventing system-wide risks from emerging.

In light of the positive macroeconomic outlook, now is the right time to set a positive rate for the domestic countercyclical capital buffer. This means that the currently favourable economic environment can be used to more easily build up or conserve capital in the form of buffers in the banking system, so that it can be resilient if risks materialise.¹⁸ Additionally, the indicators described above do not suggest that cyclical systemic risk will decline in the near future.

BaFin does not have more moderate tools at its disposal that achieve the same effect. For example, an increase in microprudential minimum capital requirements, the adjustment of sectoral risk weights or institution-specific Pillar 2 add-ons are not appropriate for adequately capturing cyclical systemic risk (the reasons were already given in the General Administrative Act of 28 June 2019 (ref. no. R 1-AZB 1134-2019/0001) and the earlier recommendation by the Financial Stability Committee of 27 May 2019. With regard to the equity ratio, it should be emphasised that the capital requirement is calculated individually for each institution and should not therefore be confused with a macroprudential measure captured on a one-size-fits-all basis. The Pillar 2 Capital Guidance does not have any direct legal effect. By contrast, the domestic countercyclical capital buffer, as part of the combined buffer requirement (section 10i of the KWG), has direct legal consequences. For example, undershooting the combined capital buffer requirement automatically triggers dividend distribution restrictions.

Capturing the risks of residential mortgage loans twice in Common Equity Tier 1 capital, and at the same time activating a sectoral systemic risk buffer, can be ruled out. When calibrating the sectoral systemic risk buffer, the level of the domestic countercyclical capital buffer now set will be taken into account in order to avoid the same risk being captured twice.

Increasing the rate for the domestic countercyclical capital buffer is also appropriate. Admittedly, the institutions concerned will be indirectly impacted by the measure because the rate for the domestic countercyclical capital buffer must be used to calculate the institution-specific countercyclical capital buffer rate under section 10d (2) of the KWG, and this means that the institutions concerned will have to comply with additional own funds requirements. However, according to BaFin’s findings, the institutions concerned will not be excessively burdened. To do this, BaFin has made calculations that indicate that the additional own funds requirements can be borne overall by the institutions concerned:
In accordance with a capital requirements analysis, the German banks can fund the domestic countercyclical capital buffer of 0.75 percent mainly from existing surplus capital. The total capital requirement for the domestic countercyclical capital buffer is €17.09 billion, which is approximately 10.2 percent of the banks’ surplus capital.¹⁹ A consequence of this is that in the short term, this measure means that there will not be excessive balance sheet shortening in the banking system with the associated market distortions. We therefore do not expect that the higher requirements will limit the lending capacity of the German banking system. Nor are any significant effects on lending conditions expected due to the intense competition in the banking system. Additionally, BaFin does not assume that there will be any significant shift of business activities away from the banking sector.

The resilience of the banking system will increase because the domestic countercyclical capital buffer will conserve existing surplus capital in the short term, and will give the banks an incentive to build up additional capital in the medium term.

In the overall assessment of the buffer requirement, there will also be sufficient surplus capital available after the domestic countercyclical capital buffer is introduced. Due to the fact that the capital requirements will largely be fulfilled using available surplus capital, and the lead time for activating the buffer is 12 months, banks with capital requirements will have sufficient time to decide how they will build up capital.

BaFin is convinced that increasing the domestic countercyclical capital buffer will lead to manageable costs at the banks and to a high level of benefits for society at large. Overall, the banking system is more resilient to cyclical systemic risk, and there are therefore less fears of negative effects on financial stability. The burden on the institutions is also mitigated because severe risks to the financial system as a whole are averted. A stable financial system is important for ensuring the financing of the real economy, not only in periods of stress, but also in times of structural change.²⁰

The domestic countercyclical capital buffer will be reviewed for appropriateness each quarter and adjusted if necessary – if necessary also at short notice. This also applies during the twelve-month phase-in period for the domestic countercyclical capital buffer.

Re number 2:
The application date was determined on the basis of section 10d (4) sentence 1 (2nd alternative) of the KWG. The period of 12 months results from section 10d (4) sentence 2 of the KWG.

Re number 3:
The group of addressees results from section 1 (1b), section 2 (7), (7a), (7b), (9a) sentence 1, (9c) and (9e) in conjunction with section 10d (1) of the KWG.

Re number 4:
The timing of the announcement is based on section 17 (2) of the Act Establishing the Federal Financial Supervisory Authority (Gesetz über die Bundesanstalt für Finanzdienstleistungsaufsicht – Finanzdienstleistungsaufsichtsgesetz – FinDAG) in conjunction with section 41 (4) sentence 4 of the Administrative Procedure Act (Verwaltungsverfahrensgesetz – VwVfG).

Instruction on available remedies

Objections to this General Administrative Act can be submitted to the Federal Financial Supervisory Authority in Bonn or Frankfurt am Main within one month of its announcement.

Mark Branson

This translation is furnished for information purposes only. The original German text is binding in all respects.

Footnotes