General Administrative Act ordering a capital buffer for systemic risks under section 10e 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 April 2022, the Federal Financial Supervisory Authority (hereinafter referred to as: “BaFin”) is ordering a capital buffer for systemic risks in the amount of two percent of Common Equity Tier 1 capital under section 10e (1) of the German Banking Act (Kreditwesengesetz – KWG).

2. In accordance with section 10e (1) sentence 2 of the KWG, this capital buffer is being ordered for all exposures – or parts of exposures –- to natural and legal persons for which mortgages on residential property located in Germany are taken into account as deductions when determining capital requirements.

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 10e (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 (4) sentence 1, (5) sentence 1, (7), (7a), (7b), (9a) sentence 1, (9e) and 51c (4) of the KWG, in each case subject to the conditions set out there.

4. Effective 1 February 2023, the rate specified in paragraph 1 must be used to calculate the capital buffer for systemic risks.

5. This General Administrative Act is being made public in accordance with section 41 (3) and (4) of the German Administrative Procedure Act (Verwaltungsverfahrensgesetz – VwVfG) in conjunction with section 17 (2) of the German Act Establishing the Federal Financial Supervisory Authority (Finanzdienstleistungsaufsichtsgesetz – FinDAG) and is deemed to be announced on the day following its publication.

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 (German Act Implementing CRD IV – CRD IV-Umsetzungsgesetz) introduced the requirements set out in section 10e of the KWG governing the capital buffer for systemic risks with effect from 1 January 2014. Following this, the Federal Financial Supervisory Authority (“BaFin”) had issued orders on setting and rescinding a countercyclical capital buffer also introduced by the Act Implementing CRD IV. BaFin has not previously ordered a capital buffer for systemic risks.

With the Act Transposing Directives (EU) 2019/878 and (EU) 2019/879 on the reduction of risks and the strengthening of proportionality in the banking sector (Risk Reduction Act) (Risikoreduzierungsgesetz – RiG) of 9 December 2020, the lawmakers implemented requirements of the “banking package”. On the basis of the new requirement in section 10e (1) sentence 2 of the KWG, among other things BaFin may also order sectoral systemic risk buffers, i.e. restrict the scope of the capital buffer to certain subgroups of exposures. When forming possible subgroups, point (b) of Article 133(5) of Directive (EU) 2019/878 and the “EBA Guideline on the appropriate subsets of sectoral exposures to which competent or designated authorities may apply a systemic risk buffer in accordance with Article 133(5)(f) of Directive 2013/36/EU”¹ must be taken into account; BaFin has issued a statement under Article 16(3) of Regulation (EU) No. 1093/2010 of 24 November 2010, according to which it will comply with the above Guideline.

In its press release of 12 January 2022, the Financial Stability Committee (FSC) welcomed BaFin’s intended “package of measures”, which also provides for the establishment of a capital buffer for systemic risks. The AFS considered this necessary in view of the risk situation in the German financial system: “It is also intended to address the specific risks from residential real estate loans. Due to the protracted upswing in the residential real estate market, structural risks have also formed alongside cyclical risks. […] If credit and price dynamics in the residential real estate market continue in this form, this harbours the risk of greater vulnerability for new borrowers to interest rate rises and market corrections. BaFin is therefore intending to impose a sectoral systemic risk buffer as a complementary instrument. The sectoral systemic risk buffer will additionally counteract the specific risks in the real estate market that cannot be fully addressed by the countercyclical capital buffer. The rate of the sectoral systemic risk buffer on loans secured by residential real estate is intended to be set at 2.0%.” In its communication of 3 December 2021, the AFS had already made the following assessment: “Residential real estate prices are rising sharply and the rates of growth have reached historic highs. Overvaluations and debt levels are on an upwards trajectory. At the same time, residential mortgage lending has recorded a strong rise. If lending and price dynamics on the residential real estate market as well as household debt trends continue, there is a risk of that debt sustainability may deteriorate, especially among borrowers who take out new loans.”

In the light of the most recent data from the Bundesbank, BaFin has also taken on board the comments on the non-cyclical components of systemic risk and updated and reviewed its risk assessment.

BaFin published the planned 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:.

A. General: There is no need for the order in the current economic and political environment, and there were negative impacts because of the ongoing pandemic situation, the subdued state of the economy and political expectations with regard to transformation in the area of renewable energy and digital transformation. Attempts by monetary and fiscal policy to support lending and investments would be thwarted. Growth in prices and lending were an outcome of the expansionary monetary and fiscal policy and were not based on excessive risk-taking by the banking sector. The order would significantly hit the institutions, would lead to additional capital requirements, would cut profitability, and would lead to curbs on lending and/or more expensive credit.

B. Measurement of collateral: The institutions had sufficient risk buffers and the existing collateral for mortgage lending was sufficient in all circumstances. Once a loan was granted, there was no regular adjustment of the collateral values in the portfolios to bring them in line with market performance. The collateral values in the portfolio were therefore mainly significantly lower than the current market values. The measure was therefore not the appropriate solution; if at all, it would have to be limited to new business and may not be allowed to be applied to low-risk business with a low loan-to-value ratio.

C. Lending standards and over-indebtedness: There was no evidence of any erosion of lending standards; institutions were sticking to their conservative, risk-based lending practices. Variable rate loans were not common on the German market. Information from the Bundesbank’s Financial Stability Review should be interpreted in such a way that lending standards have now been tightened again after being relaxed during the pandemic. Risks to financial stability from lending to households were thus manageable, and household overindebtedness is also currently declining. Moreover, the data situation about lending standards is still incomplete where financing for residential properties of private households is concerned.

D. Risks are captured twice: There is a risk that institutions will be hit by overlapping capital requirements (the same risks are captured twice): for example, the sectoral systemic risk buffer for residential real estate is likely to overlap with the countercyclical capital buffer and with the Pillar 2 requirements if, among other things, the risk from negative developments in real estate financing is factored into the stress test to determine the Pillar 2 Capital Guidance (P2G).

E. Unequal treatment: Institutions that use the Credit Risk Standardised Approach would be treated better than institutions that use the IRB Approach. According to Article 125 of the CRR, the former would only have to back the secured portion of the loan exposure with the additional requirements, whereas institutions using the IRB Approach would have to back the entire exposure with the capital add-on.

F. Bausparkassen: The arguments of cautious lending and a limitation to new business were especially valid for these institutions. Their business model is already specifically limited by statutory requirements.

Once it had completed the consultation procedure, BaFin clarified the content of the order and made available further questions concerning detail and interpretation for publication in an FAQ list on its website.

II.

Re numbers 1 and 2:
“The criteria for ordering the rate for a sectoral capital buffer for systemic risks of two percent of total risk exposure amount determined in accordance with Article 92(3) of Regulation (EU) No. 575/2013 are satisfied.

The order is based on section 10e (1) to (3) and (7) of the KWG. This states that a capital buffer for systemic risks may be ordered in order to reduce or ward off systemic or macroprudential risks that may lead to disruption with serious negative consequences for the national financial system and the real economy in Germany.
Section 10e (1) sentence 2 last half-sentence of the KWG enables the formation of the subgroup referred to in number 2 of the order. This is in line with section 36a (1) of the German Solvency Regulation (Solvenzverordnung – SolvV), which represents application guidance for section 10e (1) sentence 2 of the KWG, as well as with the requirements of the “EBA Guideline on the appropriate subsets of exposures in the application of SyRB”², which refers to point (f) of Article 133 (5) of Directive 2013/36/EU. The subgroup is formed from exposures to natural and legal persons (no. 2a) and d) as well as c)) located in Germany (section 36a (1) no. 2 of the SolvV), in an EEA signatory state (no. 3) or in a third country (no. 5) and is further limited by the criterion of including mortgages on residential property located in Germany (when determining the capital requirements). The sectoral systemic risk buffer defined in this way therefore refers to the standard financing arrangements for residential property in Germany, with the result that distortions of competition in the residential property market because of the measure are largely avoided. BaFin also has a wide margin of judgement and discretion with regard to calibrating use of the instrument. The goal is to reduce or avoid long-term, non-cyclical systemic or macroprudential risks, ignoring insignificant risks.³

To the extent that banking industry associations have argued that institutions using the IRB Approach to assess credit risk would be put in a worse position than institutions that use the Credit Risk Standardised Approach, BaFin does not consider this to involve any legally significant unequal treatment. The Credit Risk Standardised Approach allows real property loans to be split although a single contract is entered into (“unechtes Realkreditsplitting”, Article 125 of the CRR), under which the property used to secure the loan is only set off, and the risk reduced, for fully secured exposures. On the other hand, portions of the exposure that exceed the eligible property value under Article 125 of CRR are assigned the risk weight of the actual borrowers, in other words they are considered to be unsecured. The IRB Approach does not allow real property exposures to be split although a single contract is entered into. The residential property collateral therefore reduces the risk for the entire exposure amount. This means that IRBA institutions can use property used to secure loans much more extensively than CRSA institutions. Because of this advantage, the sectoral systemic risk buffer implicitly has further scope for IRBA institutions.
BaFin is addressing residential property risks through a package of measures. For example, the cyclical aspects of residential property risks, together with other cyclical risks, are covered by the parallel definition of a countercyclical capital buffer. In this respect, the sectoral systemic risk buffer will only be used to address complementary risk components in the residential property market: specifically, structural components and intended targeted control effects. The buffer amount was determined using calculations by the Deutsche Bundesbank on the basis of its residential property stress test. Assuming a base stress scenario and a 0.75% countercyclical capital buffer, these indicate a conditional sectoral systemic risk buffer of around 2%. BaFin endorses these findings by the Bundesbank; it therefore considers the value of 2% for addressing non-cyclical systemic risks to be necessary, but also sufficient at the present time.

In the current economic situation, BaFin considers there to be systemic macroprudential risks within the meaning of section 10e of the KWG. Systemic risk refers to the risk that the proper functioning and stability of the entire financial system is jeopardised. In contrast to microprudential risks, macroprudential risks affect not only an institution and its creditors, but the entire financial system. The existence of the risk of disruption of the financial system, as described above, results from the following:

The financial system 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. In the current economic situation, however, BaFin considers the occurrence of a disruption with serious negative consequences for the national financial system and the real economy in Germany to be a possibility:

The German residential property market has since 2010 been characterised by rates of price increases whose momentum has increased markedly over time. With an increase of most recently 12.4%⁴, the extent has now become extremely high; price growth has increasingly been decoupled from fundamental economic parameters (including incomes). As a consequence, the Deutsche Bundesbank is observing nationwide overvaluations of 20–35%.⁵ In this situation, there is a fundamental risk that, in anticipation of further rising prices, there will be a further expansion in the debt-financed acquisition of residential property and banks will overestimate both the debt-servicing capacity of their borrowers and the recoverability of real estate collateral because of over-optimistic expectations.⁶ The Deutsche Bundesbank has already identified signs of weakening in income-related parameters in its current Financial Stability Report⁷; lending also shows clearly expansionary trends.⁸ Substantial macroprudential risks therefore continue to exist in the residential property market.⁹

The significant overvaluations in the residential property market are being increasingly accompanied by the risk of an inevitable correction sooner or later. There is also a risk that exaggerations could be reduced in an (abrupt) economic downward trend. In such a situation – which, according to all experience, is accompanied by rising unemployment – the debt-servicing capacity of borrowers can be significantly reduced. This means that the default risk of the banks would risk, especially in relation to loans to particularly heavily indebted households. In the case of a significant price correction in the residential property market, companies in the housing industry can also get into economic difficulties and increase the default risk of the banks. At the same time, the institutions are thus confronted with the situation that they have to realise loan collateral. This amplifies the trend toward sinking residential property prices. As a consequence, this results in the need for asset write-downs and possible inventory risks at the banks. If, as often happens in a crisis, such risks occur simultaneously, the financial system as a whole may no longer be able to fully perform its tasks. This can lead in particular to restrictions in the supply of credit to the real economy and further exacerbate an existing crisis.¹⁰ Experience indicates that economic crises that emerge from the real estate sector are more acute and last longer than other types of crises. BaFin assesses the risk of such a disruption to the financial system and the real economy in Germany as significant. The risks observed must be addressed by measures affecting the credit supply of the residential property market as a whole, which is why it is necessary to include exposures to natural and legal persons

To the extent that banking industry associations have argued that overvaluations do not result in any risks because of the conservative valuation practice and the abundant measurement of collateral, it should be noted that the primary arguments for introducing the capital buffer lie in particular in rising property prices and credit volumes as well as in the further growth in private household debt. Although overall household overindebtedness may be declining, the severe price increases in the residential property sector, with accompanying increases in residential mortgage loans, have led to sharp increases in the indebtedness of property buyers. The degree of overvaluations may differ from region to region, but they do exist almost nationwide; in other respects, any regional differentiation of the measure is prohibited merely because of expected moves to evade it. A limitation to new business would also not be sufficient, since calculations from the residential property stress test have shown that even in the relatively moderate base scenario, significant losses can also occur in existing business despite conservative valuation methods.
In BaFin’s view, no separate treatment of special business sectors such as Bausparkassen is required. It is argued that the mortgage lending values are determined conservatively in accordance with the requirements of the Mortgage Lending Value Regulation (Beleihungswertverordnung) and are not adjusted to reflect market developments. However, this is not a mandatory differentiation criterion. Since 2015, Bausparkassen have been allowed to grant mortgages up to the mortgage lending value when financing owner-occupied residential property. The way how the mortgage lending value is determined generally features additional precautionary components. Ultimately, however, there is a wide range of structuring opportunities here. In accordance with section 7 (7) of the German Bausparkassen Act (Bausparkassengesetz – BauSparkG), the only mandatory statutory upper limit for determining the mortgage lending value is the market value.

There is no other way to address the risks described above within the meaning of section 10e (1) no. 2 of the KWG because measures under Regulation (EU) No 575/2013 (CRR) or the capital buffers under sections 10d, 10f and 10g of the KWG would not be available or effective:
This means that a similar adjustment of risk weights or an adjustment with the same effect under Articles 124 and 164 of the CRR would not be practicable. Use of this instrument requires not only the forward-looking analysis of future risks in the residential property market, but also implementation of a backward-looking hard test. This requires the loss experience from the previous year to be compared with fixed supervisory limits. Although the loss rates increased significantly in 2020, they are still well below the defined limits that would indicate a need to increase the risk weights. In the case of a combined assessment of past and forward-looking aspects, there is no indication of any need to adjust risk weights and minimum loss given default (LGD) ratios.
Adjusting risk weights in accordance with Article 458 of the CRR cannot be considered because the (sectoral) systemic risk buffer instrument takes priority over this requirement. BaFin considers the application of the systemic risk buffer instrument to be effective and does not consider stricter national measures within the meaning of Article 458(2) of the CRR to be more effective; moreover, the latter would not negatively impact institutions to a lesser extent than the systemic risk buffer instrument.
The risks described above are also not, and cannot be, covered by the countercyclical capital buffer (section10d of the KWG). This instrument serves to address cyclical risks in the framework of the current package of measures. In addition to other cyclical risk types, the countercyclical capital buffer also explicitly addresses cyclical risk elements in the residential property market. However, due to its broad application to all domestic exposures and its exclusive focus on cyclical risks, the instrument is not suitable for comprehensively addressing residential property risks in a targeted fashion. Structural risks in the residential property market must therefore be covered using another instrument. The desired control effects on the residential property market also require a different instrument.
Likewise, the capital buffers for globally systemically important institutions (section 10f of the KWG) and the capital buffers for other systemically important institutions (section 10g of the KWG) cannot cover the risks that have emerged as both instruments have no specific relationship to residential property risks.

Capturing the risks of residential mortgage loans twice in Common Equity Tier 1 capital, and at the same time activating any sectoral systemic risk buffer, can be ruled out: when calibrating the sectoral systemic risk buffer, the level of the domestic countercyclical capital buffer will be explicitly taken into account in order to avoid the same risk being captured twice. To the extent that it is argued that the same risks are captured twice because the risk from negative developments in property financing is included in the stress test to determine the Pillar 2 Capital Guidance, the response is that this Pillar 2 Capital Guidance (P2G), as a supervisory expectation, does not form part of the P2R SREP capital requirement and does not have any legally binding effect.

BaFin has no evidence that there is any disproportionate impairment of the financial system or of parts of the financial system of another state or of the European Economic Area as a whole.
Equally, BaFin addresses the risk of undesirable evasive reactions. However, cross-border financing of residential property located in Germany by foreign banks has so far only been of only minor quantitative significance. In order to prevent future evasive reactions to circumvent the order, BaFin has asked the European Systemic Risk Board to issue a recommendation under Article 16 of Regulation (EU) No. 1092/2010 on the reciprocal application of the capital buffer for systemic risks by European states to relevant states of the European Economic Area (especially the neighbouring countries).
The establishment of a sectoral systemic risk buffer is also proportionate. It is suitable for achieving the targeted objective of reducing or preventing disruption with serious negative consequences for the national financial system and the real economy in Germany. The instrument is addressed to all addressees referred to in number 3 of this General Administrative Act who are able to offer financing for residential property located in Germany. Specifically, it only increases the capitalisation of those banks that are active in the business of providing residential property financing and that would be particularly affected by the systemic risks in the German residential property market outlined above. Changes in relative prices make residential property financing less attractive than other loans, as additional capital must be held; this means that the measure counteracts any overheating in the residential property market. By setting the sectoral systemic risk buffer, the banks’ resilience to risks specifically in the residential property financing portfolio will be preventively strengthened. The sectoral systemic risk buffer is therefore suitable for achieving the objective described above.

BaFin does not have more moderate tools at its disposal that achieve the same effect; in particular, the tools described above (adjustment of risk weights, additional capital buffers) inherently do not constitute suitable tools in the current economic situation.

Setting the capital buffer is also reasonable.

BaFin reviewed the objections raised relating to the general economic and political environment, but they did not lead to any other outcome. The wide variety of challenges facing the business environment have already been factored in to the calculations and continue to be considered to be reasonably tolerable. BaFin does not expect any significant impact on the credit supply or its pricing in the future in this respect.

The severity of the intervention is comparatively low. Calculations carried out on the basis of the Deutsche Bundesbank’s residential property stress test and downstream capital charge calculations indicate that affected institutions are generally able to easily cover the capital requirement from the sectoral systemic risk buffer out of their surplus capital. A capital requirement that has to be covered externally only arises at a smaller number of institutions; the resulting disadvantages are attributable to the legally intended steering effect. As a rule, institutions can continue to extend residential property loans, albeit if they are willing to accept an additional capital charge. Whether and to what extent the banks respond to this change to the financial incentive situation is up to them.
The intervention is further mitigated by the fact that the institutions can use a preparation time of ten months to fully meet the capital buffer requirement (number 4).

Re Number 3:
The group of addressees results from sections 1 (1b), 2 (4) sentence 1, (5) sentence 1, (7), (7a), (7b), (9a) sentence 1, (9e) and section 51c (4) of the KWG, in conjunction with section 10e (1) of the KWG.

Re Number 4:
The institutions concerned have until 1 February 2023 at their disposal for administrative implementation and for a gradual increase of the capital buffer. The authority for this results from section 36 (2) no. 1 of the KWG. The rate of two percent specified in paragraph 1 therefore does not have to be met in full until 1 February 2023.

Re Number 5:
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).

Mark Branson

Footnotes